ITEM 1.
BUSINESS
General
CNA Surety Corporation (“CNA Surety” or the “Company”) is an insurance holding company in the United States formed through the September 30, 1997 combination of the surety business of CNA Financial Corporation (“CNAF”) with Capsure Holdings Corp.’s (“Capsure”) insurance subsidiaries. CNA Surety is currently one of the largest surety providers in the United States with an approximate market share of 7.8% (based upon 2009 Surety and Fidelity Association of America (“SFAA”) written premium data). CNA Surety’s wide selection of surety products ranges from very small commercial bonds to large contract bonds.
Formation of CNA Surety and Merger
In December 1996, CNAF and Capsure agreed to merge (the “Merger”) the surety business of CNAF with Capsure’s insurance subsidiaries, Western Surety Company (“Western Surety”), Surety Bonding Company of America (“Surety Bonding”) and Universal Surety of America (“Universal Surety”), into CNA Surety. Through its insurance subsidiaries, CNAF owns approximately 61% of the outstanding common stock of CNA Surety. Loews Corporation owns approximately 90% of the outstanding common stock of CNAF. CNAF, through its operating subsidiaries, writes multiple lines of property and casualty insurance, including surety business that is reinsured by Western Surety. 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”).
CNAF Proposal
In October 2010, the Company received an unsolicited proposal from CNAF to acquire all of the outstanding shares of common stock that are not currently owned by subsidiaries of CNAF at a purchase price of $22.00 per share in cash (the “CNAF Proposal”). The Company’s Board of Directors appointed a special committee (the “Special Committee”), comprised solely of the Company’s three independent directors, to review and evaluate the CNAF proposal. The Special Committee retained both legal and financial advisors to assist in their consideration of the CNAF Proposal.
On February 4, 2011, the Special Committee announced that it does not support the terms of the proposal and advised CNAF that it is open to alternate proposals.
Description of Business
The Company’s corporate objective is to be the leading provider of surety and surety-related products in North America and to be the surety of choice for its customers and independent agents and brokers. CNA Surety’s insurance subsidiaries write surety and fidelity bonds in all 50 states through a combined network of approximately 37,000 independent agencies. CNA Surety’s insurance subsidiaries are Western Surety, Surety Bonding and Universal Surety. The insurance subsidiaries write, on a direct basis or as business assumed from CCC and CIC, small fidelity and non-contract surety bonds, referred to as commercial bonds; small, medium and large contract bonds; and errors and omissions (“E&O”) liability insurance. Western Surety is a licensed insurer in all 50 states, the District of Columbia and Puerto Rico. Surety Bonding is licensed in 28 states and the District of Columbia. Universal Surety is licensed in 44 states and the District of Columbia.
Financial Strength Ratings
A.M. Best Company, Inc.
In February 2010, A.M. Best Company, Inc. (“A.M. Best”) affirmed the A (Excellent) rating and stable rating outlook for Western Surety, Surety Bonding and Universal Surety. An A (Excellent) rating is assigned to those companies which A.M. Best believes have an excellent ability to meet their ongoing obligations to policyholders. A-rated insurers have been shown to be among the strongest in ability to meet policyholder and other contractual obligations. A.M. Best’s letter ratings range from A++ (Superior) to F (In Liquidation) with A++ being highest. The rating outlook indicates the potential direction of a company’s rating for an intermediate period, generally defined as the next 12 to 36 months.
Through intercompany reinsurance and related agreements, CNA Surety’s customers have access to CCC’s broader underwriting capacity. CCC’s A rating and stable rating outlook was also affirmed in February 2010.
Standard and Poor’s
CCC, Western Surety, Surety Bonding and Universal Surety are currently rated A- (Stable) by Standard and Poor’s (“S&P”). S&P’s letter ratings range from AAA (Extremely Strong) to CC (Extremely Weak) with AAA being highest. Ratings from AA to CCC may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories. An insurer rated A has strong financial security characteristics, but is somewhat more likely to be affected by adverse business conditions than are insurers with higher ratings.
Product Information
The United States surety market is represented by bonds required by federal statutes, state laws and local ordinances. These bonding requirements range from federal construction projects, where the contractor is required to post performance and payment bonds which guarantee performance of contracts to the government as well as payment of bills to subcontractors and suppliers, to license and permit bonds which guarantee compliance with legal requirements for business operations.
Products and Policies
Unlike a standard, two-party insurance policy, surety bonds are three-party agreements in which the issuer of the bond (the surety) joins with a second party (the principal) in guaranteeing to a third party (the owner/obligee) the fulfillment of some obligation on the part of the principal. The surety is the party who guarantees fulfillment of the principal’s obligation to the obligee. In addition, sureties are generally entitled to recover from the principal any losses and expenses paid to third parties. The surety’s responsibility is to evaluate the risk and determine if the principal meets the underwriting requirements for the bond. Accordingly, surety bond premiums primarily reflect the type and class of risk and related costs associated with both processing the bond transaction and investigating the applicant including, if necessary, an analysis of the applicant’s credit-worthiness and ability to perform.
There are two broad types of surety products - contract surety and commercial surety bonds. Contract surety bonds secure a contractor’s performance and/or payment obligation generally with respect to a construction project. Contract surety bonds are generally required by federal, state and local governments for public works projects. Commercial surety bonds include all surety bonds other than contract and cover obligations typically required by law or regulation.
Contract bond guarantee obligations include the following:
Bid bonds: used by contractors submitting proposals on potential contracts. These bonds guarantee that a contractor will enter into a contract at the amount bid and post the appropriate performance bonds.
Performance bonds: guarantee to the owner the performance of the contractor’s obligations according to the terms and conditions of the contract.
Payment bonds: guarantee payment of the contractor’s obligations under the contract for labor, subcontractors and materials supplied to the project. Payment bonds are utilized in public projects where liens are not permitted.
Other examples of contract bonds are completion, maintenance and supply bonds.
Commercial surety business is comprised of bonds covering obligations typically required by law or regulation, such as the following:
License and Permit bonds: required by statutes or ordinances for a number of purposes including guaranteeing the payment of certain taxes and fees and providing consumer protection as a condition to granting licenses related to selling real estate or motor vehicles and contracting services.
Judicial and Fiduciary bonds: required by statutes, courts or legal documents for the protection of those on whose behalf a fiduciary acts. Examples of such fiduciaries include executors and administrators of estates and guardians of minors and incompetents.
Public Official bonds: required by statutes and ordinances to guarantee the lawful and faithful performance of the duties of office by public officials.
CNA Surety also assumes contract and commercial surety bonds for international risks. Such bonds are written to satisfy the international bond requirements of domestic customers and for select foreign clients.
In addition, the Company markets surety-related products such as fidelity bonds and E&O insurance. Fidelity bonds cover losses arising from employee dishonesty. Examples of purchasers of fidelity bonds are law firms, insurance agencies and janitorial service companies. CNA Surety writes E&O policies for two classes of insureds: notaries public and tax preparers. The notary public E&O policy is marketed as a companion product to the notary public bond and the tax preparer E&O policy is marketed to small tax return preparation firms.
Although all of its products are sold through the same independent insurance agent and broker distribution network, the Company’s underwriting is organized by the two broad types of surety products - contract surety and commercial surety, which also includes fidelity bonds and other insurance products for these purposes. These two operating segments have been aggregated into one reportable business segment for financial reporting purposes because of their similar economic and operating characteristics.
The following tables set forth, for each principal class of bonds, gross written premiums, net written premiums and number of domestic bonds and policies in force and the respective percentages of the total for the past three years (amounts in thousands):
The following table sets forth the average bond penalty/policy limit for each principal class of bonds for the past three years (amounts in thousands):
In 2010 no individual agency generated more than 1.2% of aggregate gross written premiums. Approximately $93.3 million, or 21.2%, of gross written premiums were generated from national insurance brokers in 2010 with the single largest national broker production comprising $22.9 million, or 5.2%, of gross written premiums.
Marketing
The Company principally markets its products in all 50 states, as well as the District of Columbia and Puerto Rico. Its products are marketed primarily through independent producers, including multi-line agents and brokers such as surety specialists, many of whom are members of the National Association of Surety Bond Producers. CNA Surety enjoys broad national distribution of its products, which are marketed through approximately 37,000 of the approximately 44,000 independent property and casualty insurance agencies in the United States. In addition, the Company employs 40 full-time salaried marketing representatives and 5 telemarketing representatives to continually service its vast producer network. Relationships with these independent producers are maintained through the Company’s 38 local branch offices.
The following table sets forth the distribution of the business of CNA Surety, by state based upon gross written premiums in each of the last three years:
(a)
Includes the District of Columbia and Puerto Rico. No other state represented more than 2.3% for the year ended December 31, 2010.
Contract Surety
The Company broadly targets contractors with less than $200 million in contracted work in progress, and more selectively targets contractors with larger work programs. During 2010, the Company extended its strategy to also target contractors with the largest work programs. Often referred to as “jumbo” contractors, these accounts are typically served by a group of sureties with each surety taking a share of the bonds written for the account. The Company’s contract market is comprised of small contractors (less than $10 million in work in progress), medium contractors ($10-$100 million) and large contractors (greater than $100 million). With respect to contract surety, exposures are measured in terms of bonded backlog which is an indication of the Company’s exposure in event of default before indemnification recoveries. The Company actively monitors the exposure on each account through a variety of underwriting methods. Some of these accounts are maintained on a “co-surety” or joint insurer basis with other sureties in order to manage aggregate exposure.
Commercial Surety
A large portion of the commercial surety market is comprised of small obligations that are routine in nature and require minimal underwriting. Customers are focused principally on prompt and efficient service. These small transactional bonds and related fidelity bonds and E&O products represent approximately 79% of the Company’s non-contract gross written premiums and 29% of the Company’s total gross written premiums.
The Company continues to focus its marketing efforts on this small commercial bond market through its Sioux Falls, South Dakota service center. In this market segment, CNA Surety emphasizes one-day response service, easy-to-use forms and an extensive array of commercial bond products. Independent agents use bONdLINE, which is an Internet-based tool, to request and deliver bonds. In addition, the Company may provide independent agents with pre-executed bond forms, powers of attorney and facsimile authorizations that allow them to issue many standard bonds in their offices. CNA Surety’s insurance subsidiaries may also direct their marketing to particular industries or classes of bonds on a broad basis. For instance, the Company maintains programs directed at notary bonds.
CNA Surety also maintains specific underwriting staff in Chicago, Illinois dedicated to middle market and “Fortune 1000” accounts. The Company’s corporate commercial account business represents approximately 21%
of the Company’s commercial gross written premiums and approximately 8% of the Company’s total gross written premiums.
Underwriting
CNA Surety is focused on consistent underwriting profitability. The extent and sophistication of underwriting activity varies by type of risk. Contractor accounts and large commercial surety customers undergo credit, financial and managerial review and analysis on a regular basis. Certain classifications of bonds, such as fiduciary and court appeal bonds, also require more extensive underwriting.
CNA Surety also targets various products in the surety and fidelity bond market which are characterized by relatively low-risk exposure and small bond amounts. The underwriting criteria, including the extent of bonding authority granted to independent agents, varies depending on the class of business and the type of bond. For example, relatively little underwriting information is typically required of certain low-exposure risks such as notary bonds.
Competition
The surety and fidelity market is highly competitive. According to 2009 data from the SFAA, the U.S. market aggregates approximately $6.3 billion in direct written premiums, comprised of approximately $5.2 billion in surety premiums and approximately $1.1 billion in fidelity premiums. The 20 largest surety companies account for approximately 82% of the domestic surety market and 94% of the domestic fidelity market. The large diversified insurance companies hold the largest market shares. In 2009, CNA Surety was the fourth largest surety provider with a 7.8% market share.
Primary competitors of CNA Surety are approximately 20 national, multi-line companies participating in the surety market throughout the country. Management believes that its principal strengths are diverse product offerings, service and accessibility and long-term relationships with agents and accounts. Competition increased as a result of ten years of profitable underwriting experience through 1999. This competition has typically manifested itself through reduced premium rates and relaxation of underwriting standards. Beginning in 2000 and through the end of 2005, the surety industry’s underwriting performance was negatively impacted by the significant increases in corporate defaults. Firming of rates, more stringent underwriting and an improved economy resulted in the surety and fidelity industry returning to profitability in 2006. The surety market has been profitable for most carriers since 2006 and competition remains strong. However, the surety market remains steady, with little, if any, deterioration in underwriting and pricing.
Reinsurance
The Company’s insurance subsidiaries, in the ordinary course of business, purchase reinsurance from other insurance companies and affiliates. Reinsurance arrangements are used to limit maximum loss, provide greater diversification of risk, minimize exposure on larger risks and allow us to meet certain regulatory restrictions that would otherwise limit the size of bonds the Company can write. Reinsurance contracts do not relieve the Company of its primary obligations to claimants. Therefore, a contingent liability exists with respect to reinsurance ceded to the extent that any reinsurer is unable to meet the obligations assumed under reinsurance contracts. The Company evaluates the financial condition of its reinsurers, monitors concentrations of credit risk and establishes allowances for uncollectible amounts when indicated. At December 31, 2010, the Company holds approximately $4.2 million of letters of credit as collateral for reinsurance receivables.
The Company’s reinsurance program is predominantly comprised of excess of loss reinsurance contracts that limit the Company’s retention on a per principal basis. The Company’s reinsurance coverage is provided by third party reinsurers and related parties. Refer to Item 7., Management’s Discussion and Analysis of Financial Condition and Results of Operations and Item 8., Note 6 of the Notes to the Consolidated Financial Statements, Reinsurance, for further discussion.
The Company had no reinsurance receivable from affiliates as of December 31, 2010 or 2009. CNA Surety’s largest reinsurance recoverable from a third party, a company rated A+ by A.M. Best, was approximately $7.8 million and $9.0 million at December 31, 2010 and 2009, respectively.
Due to the nature of the reinsurance products available to the Company and other sureties, reinsurers may cover principals for whom the Company writes surety bonds in one year, but then exclude or provide only limited reinsurance for these same principals in subsequent years. As a result, the Company may continue to have exposure to these principals with limited or no reinsurance for bonds written during years that the Company had reinsurance covering these principals.
Reserves for Unpaid Losses and Loss Adjustment Expenses
Periodic actuarial analysis of the Company’s loss reserves is performed. This analysis is based on a variety of techniques that involve detailed statistical analysis of past reporting, settlement activity, and indemnification activity, as well as claim frequency and severity data when sufficient information exists to lend statistical credibility to the analysis. The analysis may be based upon internal loss experience or industry experience. Techniques may vary depending on the type of claim being estimated. While techniques may vary, each employs significant judgments and assumptions. Annually, the reasonableness of actuarial assumptions used and the sufficiency of year-end reserves for each of the Company’s insurance subsidiaries are actuarially certified.
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) indemnity 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 income in the period in which such changes are determined to be needed. The determination of the Company’s reserves for unpaid losses and loss adjustment expenses is inherently a subjective exercise which requires management to analyze, weigh and balance numerous macroeconomic, customer specific and claims specific factors and trends, most of which, in and of themselves, are inherently uncertain and difficult to predict. A discussion of this process is included in Item 7., Management’s Discussion and Analysis of Financial Condition and Results of Operations.
A table is included in Item 8., Note 7 of the Notes to the Consolidated Financial Statements, Reserves for Losses and Loss Adjustment Expenses, that presents the activity in the reserves for unpaid losses and loss adjustment expenses for the Company and is incorporated herein by reference. This table highlights the impact of revisions to the estimated liability established in prior years.
The following table sets forth a reconciliation of the consolidated loss reserves reported in accordance with generally accepted accounting principles (“GAAP”), and the reserves reported to state insurance regulatory authorities in accordance with statutory accounting practices (“SAP”) as of December 31, 2010 (dollars in thousands):
The following loss reserve development table illustrates the change over time of reserves established for the Company’s estimated losses and loss adjustment expenses at the end of various calendar years. The first section shows the reserves as originally reported at the end of the stated year. The second section shows the cumulative amounts paid as of the end of successive years with respect to that reserve liability. The third section shows
re-estimates of the original recorded reserve as of the end of each successive year which is the result of management’s expanded awareness of additional facts and circumstances that pertain to the unsettled claims. The last section compares the latest re-estimated reserve to the reserve originally established and indicates whether the original reserve was adequate or inadequate to cover the estimated costs of unsettled claims on net basis, excluding the effect of foreign exchange revaluation on loss reserves assumed in non-U.S. currencies, primarily the Canadian dollar. 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 following table provides a reconciliation of the Company’s re-estimated reserves on a net basis provided above to the re-estimated reserves on a gross basis (dollars in thousands):
Claims
Proactive claims management is an important factor for the profitable underwriting of surety and fidelity products. The Company maintains an experienced and dedicated staff of in-house claim specialists. Claim handling for the Company’s contract and large commercial account business is performed in Chicago. Claims for the Company’s small commercial bonds and the related fidelity bonds and E&O insurance are handled in Sioux Falls. The disposition of claims and other claim-related activity is performed in accordance with established policies, procedures and expense controls designed to minimize loss costs and maximize indemnification recoveries. Indemnity and subrogation rights exist on a significant portion of the business written, enabling the Company to pursue loss recovery from the principal.
Environmental Claims
The Company does not typically bond contractors that specialize in hazardous environmental remediation work. The Company does, however, provide bonding programs for several accounts that have incidental environmental exposure. In the commercial surety market, the Company provides bonds to large corporations that are in the business of mining various minerals and are obligated to post reclamation bonds that guarantee that property which was disturbed during mining is returned to an acceptable condition when the mining is completed. The Company also provides court and other surety bonds for large corporations wherein the underlying action involves environmental-related issues. While no environmental responsibility is overtly provided by commercial or contract bonds, some risk of environmental exposure may exist if the surety were to assume certain rights in the completion of a defaulted project or through salvage recovery. At December 31, 2010, the Company estimates it has no incurred losses on open claims of this nature.
Regulation
The Company’s insurance subsidiaries are subject to varying degrees of regulation and supervision in the jurisdictions in which they transact business under statutes that delegate regulatory, supervisory and administrative powers to state insurance regulators. In general, an insurer’s state of domicile has principal responsibility for such regulation which is designed generally to protect policyholders rather than investors and relates to matters such as the standards of solvency which must be maintained; the licensing of insurers and their agents; the examination of the affairs of insurance companies, including periodic financial and market conduct examinations; the filing of annual and other reports, prepared on a statutory basis, on the financial condition of insurers or for other purposes; establishment and maintenance of reserves for unearned premiums and losses; and requirements regarding numerous other matters. Licensed or admitted insurers generally must file with the insurance regulators of such states, or have filed on its behalf, the premium rates and bond and policy forms used within each state. In some states, approval of such rates and forms must be received from the insurance regulators in advance of their use.
Western Surety, Surety Bonding and Universal Surety are domiciled in South Dakota. Western Surety is licensed in all 50 states, the District of Columbia and Puerto Rico. Surety Bonding is licensed in 28 states and the District of Columbia. Universal Surety is licensed in 44 states and the District of Columbia.
Insurance regulations generally also require registration and periodic disclosure of certain information concerning ownership, financial condition, capital structure, general business operations and any material
transactions or agreements by or among affiliates. Such regulation also typically restricts the ability of any one person to acquire 10% or more, either directly or indirectly, of a company’s stock without prior approval of the applicable insurance regulatory authority. In addition, dividends and other distributions to stockholders generally may be paid only out of unreserved and unrestricted statutory earned surplus. Such distributions may be subject to prior regulatory approval, including a review of the implications on Risk-Based Capital requirements. A discussion of Risk-Based Capital requirements for property and casualty insurance companies is included in both Item 7., Management’s Discussion and Analysis of Financial Condition and Results of Operations and Item 8., Note 13 of the Notes to the Consolidated Financial Statements, Statutory Financial Data. Without prior regulatory approval, Western Surety may pay stockholder dividends of $140.2 million to CNA Surety in 2011. For the year ended December 31, 2010, CNA Surety received no dividends from its insurance subsidiaries.
CNA Surety’s insurance subsidiaries are subject to periodic financial and market conduct examinations. These examinations are generally performed by the domiciliary state insurance regulatory authorities; however, they may be performed by any jurisdiction in which the insurer transacts business. During 2008, the South Dakota Division of Insurance began its financial examination of Western Surety, Surety Bonding and Universal Surety as of and for the period January 1, 2004 through December 31, 2008. The final financial examination report was filed with the South Dakota Division of Insurance on December 11, 2009. On January 13, 2010, the Company was notified that the final examination report was adopted by the Director of the South Dakota Division of Insurance as filed. No adverse findings were included in the final examination report.
Certain states in which CNA Surety’s insurance subsidiaries conduct their business require insurers to join a guaranty association. Guaranty associations provide protection to policyholders of insurers licensed in such states against the insolvency of those insurers. In order to provide the associations with funds to pay certain claims under policies issued by insolvent insurers, the guaranty associations charge members assessments based on the amount of direct premiums written in that state. Such assessments were not material to CNA Surety’s results of operations in 2010.
Western Surety and Surety Bonding each qualifies as an acceptable surety for federal and other public works project bonds pursuant to U.S. Department of Treasury regulations. U.S. Treasury underwriting limitations are based on an insurer’s statutory surplus. The underwriting limitations of Western Surety and Surety Bonding were $54.7 million and $0.7 million, respectively, for the twelve-month period ended June 30, 2010. Effective July 1, 2010 through June 30, 2011, the underwriting limitations of Western Surety and Surety Bonding are $67.1 million and $0.8 million, respectively. Through a surety quota share treaty (the “Quota Share Treaty”) between CCC and Western Surety, discussed in both Item 7., Management’s Discussion and Analysis of Financial Condition and Results of Operations and Item 8., Note 6 of the Notes to the Consolidated Financial Statements, Reinsurance, CNA Surety has access to CCC and its affiliates’ U.S. Department of Treasury underwriting limitations. Effective July 1, 2010 through June 30, 2011, the underwriting limitations of CCC and its affiliates utilized under the Quota Share Treaty total $892.1 million. CNA Surety management believes that the foregoing U.S. Treasury underwriting limitations are sufficient for the conduct of its business.
Investments
CNA Surety insurance subsidiaries’ investment practices must comply with insurance laws and regulations. Generally, insurance laws and regulations prescribe the nature and quality of, and set limits on, the various types of investments that may be made by CNA Surety’s insurance subsidiaries.
The Company’s investment portfolio generally is managed to maximize after-tax investment return, while minimizing credit risk with investments concentrated in high-quality income securities. CNA Surety’s portfolio is managed to provide diversification by limiting exposures to any one industry, issue or issuer, and to provide liquidity by investing in the public securities markets. The portfolio is structured to support CNA Surety’s insurance underwriting operations and to consider the expected duration of liabilities and short-term cash needs.
An investment committee of CNA Surety’s Board of Directors (“Investment Committee”) establishes investment policy and oversees the management of each portfolio. A professional independent investment advisor has been engaged to assist in the management of each insurance subsidiary investment portfolio pursuant to established Investment Committee guidelines. The insurance subsidiaries pay an advisory fee based on the fair value of the assets under management.
Employees
As of December 31, 2010, the Company employed 719 persons. CNA Surety has not experienced any work stoppages. Management of CNA Surety believes its relations with its employees are good.
Availability of SEC Reports
A copy of this Annual Report on Form 10-K, as well as CNA Surety’s subsequent Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to such reports are available, free of charge, on the Internet at CNA Surety’s website (www.cnasurety.com) when filed with or submitted to the Securities and Exchange Commission (the “SEC”). CNA Surety also provides links to the SEC’s website (www.sec.gov) that contains reports, proxy and information statements and other information regarding issuers, including CNA Surety, that file electronically with the SEC. Any materials the Company files with the SEC may be read and obtained at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. Information regarding the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. This reference to CNA Surety’s website or the SEC’s address does not constitute incorporation by reference of the information contained on the website and should not be considered part of this document.
ITEM 1A.
ITEM 1A.
RISK FACTORS
Our business faces many risks. Some of the more significant risks that we face are described below. There may be additional risks that we do not currently perceive to be significant or that we are not currently aware of that may also impact our business. Each of the risks and uncertainties described below could lead to events or circumstances that have a material adverse effect on our business, results of operations, financial condition or equity.
In addition, ownership of our common stock may be subject to risks associated with the liquidity of the investment. Approximately 61% of our common stock is owned by affiliates of CNAF. This concentration of ownership may reduce the number of market participants willing to purchase our stock and limit the ability of a minority owner to liquidate their position.
As previously discussed, the Company received an unsolicited proposal from CNAF to acquire all of the outstanding shares of common stock that are not currently owned by subsidiaries of CNAF at a purchase price of $22.00 per share in cash (the “CNAF Proposal”). Following public disclosure of the CNAF Proposal, the Company’s common stock has traded at levels substantially higher than prior to the CNAF Proposal. The price of the Company’s common stock is subject to significant risks associated with the CNAF Proposal including whether a transaction is completed, its financial terms and potential litigation.
We may determine that our loss reserves are insufficient to cover our estimated ultimate unpaid liability for claims and we may need to increase them.
We maintain loss reserves to cover our estimated ultimate unpaid liability for claims and claim adjustment expenses for reported and unreported claims. Reserves represent our best estimate at a given accounting date. Loss reserves are not an exact calculation of liability but instead are complex estimates derived by us, generally utilizing a variety of reserve estimation techniques from numerous assumptions and expectations about future events, many of which are highly uncertain, such as estimates of claims severity, frequency of claims, inflation, claims handling, case reserving policies and procedures, underwriting and pricing policies, changes in the legal and regulatory environment and the lag time between the occurrence of an insured event and the time of its ultimate settlement. Many of these uncertainties are not precisely quantifiable and require significant judgment on our part.
In light of the many uncertainties associated with establishing the estimates and making the assumptions necessary to establish reserve levels, we review and change our reserve estimates in a regular and ongoing process as experience develops and further claims are reported and settled. If estimated reserves are insufficient for any reason, the required increase in reserves would be recorded as a charge against our earnings for the period in which reserves are determined to be insufficient.
Surety losses and our results can be volatile.
In the past, our results have been adversely impacted by a relatively small number of large claims. In addition, our results have been significantly impacted by increases in corporate default rates. These past occurrences illustrate that our loss experience and results can be volatile.
We have a significant concentration of exposure to construction firms.
A significant portion of our business is guaranteeing the performance of construction firms. Therefore, we are exposed to the challenges that the construction industry faces. The last several years have been particularly challenging as significant issues in the home builder segment have spilled over into the non-residential segments of the construction industry. These challenges include a substantial reduction in the availability of new work and intense competition among contractors for the limited amount of new work. As a result of these challenges, we have experienced a lower demand for our bonds, and we may experience a higher frequency of claims and higher losses.
Our premium writings and profitability are impacted by the availability and cost of reinsurance and our reinsurance purchasing decisions.
Reinsurance coverage is an important component of our capital structure. Reinsurance allows us to meet certain regulatory restrictions that would otherwise limit the size of bonds that we write and limit the market segments in which we could compete. In addition, reinsurance reduces the potential volatility of earnings and protects our capital by limiting the amount of loss associated with any one bond principal. We have experienced periods where it was difficult for us to buy as much reinsurance as we desired and when reinsurance costs have risen substantially. The availability and cost of reinsurance protection depends on a number of factors such as our loss experience, the surety industry’s loss experience, the number of reinsurers willing to provide coverage and broader economic conditions. If sufficient reinsurance is not available or is too costly or if we purchase insufficient reinsurance, we may need to reduce our premium writings and may be susceptible to higher losses.
In addition, due to the nature of the reinsurance products we purchase, reinsurers may cover principals for whom the Company writes surety bonds in one year, but then exclude or provide only limited reinsurance for these same principals in subsequent years. As a result, we may continue to have exposure to these principals with limited or no reinsurance for bonds written during years that we had reinsurance covering these principals.
We may not be able to collect amounts owed to us by reinsurers.
Amounts recoverable from reinsurers are reported as receivables in our balance sheets and are estimated in a manner consistent with loss and loss adjustment expense reserves. The ceding of insurance does not, however, discharge our primary liability for claims. As a result, we are subject to credit risk relating to our ability to recover amounts due from reinsurers. It is possible that future financial deterioration of our reinsurers could result in certain balances becoming uncollectible.
We rely upon affiliated companies that we do not control to conduct certain aspects of our business.
Due to regulatory restrictions that limit the size of the bonds that our insurance subsidiaries can write, we utilize the capacity of affiliated companies to service some parts of our business. If this capacity is no longer available to us, no longer satisfies the regulatory requirements or no longer meets customer requirements, we may need to stop servicing parts of our business.
Rating agencies may downgrade their ratings for us or for affiliated companies that we rely on to write business. This would adversely affect our ability to write business.
Our customers often refer to the financial strength ratings assigned by A.M. Best, S&P and other similar companies when they are choosing a surety company. Because we use the underwriting capacity of CCC, an affiliate, to serve larger accounts, our financial strength ratings, as well as those of CCC, factor into customers’ decisions. If our ratings or CCC’s ratings are downgraded, we may experience a significant reduction in premium writings.
We face intense competition.
All aspects of the insurance industry are highly competitive and we must continuously allocate resources to refine and improve our products and services. Insurers compete on the basis of factors including products, price, services, ratings and financial strength. Although we seek pricing that will result in what we believe are adequate returns on the capital allocated to our business, we may lose business to competitors offering competitive products at lower prices. We compete with a large number of stock and mutual insurance companies and other entities for
both distributors and customers. We also compete against providers of substitute products such as letters of credit in certain markets.
Demand for our products is created by laws that could be changed.
We believe that the vast majority of the demand for our products results from federal, state and local laws that mandate the use of surety bonds. If these laws are relaxed or eliminated, our business would be severely impacted.
We are subject to capital adequacy requirements and, if we do not meet these requirements, regulatory agencies may restrict or prohibit us from operating our business.
Insurance companies are subject to Risk-Based Capital standards set by state regulators to help identify companies that merit further regulatory attention. These standards apply specified risk factors to various asset, premium and reserve components of our statutory capital and surplus reported in our statutory financial statements. Current rules require companies to maintain statutory capital and surplus at a specified minimum level determined using the Risk-Based Capital formula. If we do not meet these minimum requirements, state regulators may restrict or prohibit us from operating our business.
Our insurance subsidiaries, upon whom we depend for dividends and advances in order to fund our working capital needs, are limited by state regulators in their ability to pay dividends.
We are a holding company and are dependent upon dividends, advances, loans and other sources of cash from our subsidiaries in order to meet our obligations. Without specific approval by the subsidiaries’ domiciliary state department of insurance, dividend payments are generally limited to amounts determined by formula. If we are restricted, by regulatory rules or otherwise, from paying or receiving intercompany dividends, we may not be able to fund our working capital needs and debt service requirements from available cash. As a result, we would need to look to other sources of capital which may be more expensive or may not be available at all.
Some of the credit that may be extended to us requires ongoing compliance with conditions and limitations regarding our profitability and financial condition.
From time to time, the Company may borrow money from banks. Typically, this borrowing would include requirements that we meet certain tests of profitability and financial condition. If we did not meet these tests, we could be required to repay outstanding borrowings. If we are capable of repaying the borrowings, we may experience a reduction in capital strength that may hamper our ability to conduct business. If we cannot access this credit or are not capable of repaying the borrowings, we would need to look to other sources of capital which may be more expensive or may not be available at all.
Our investment portfolio may suffer reduced returns or losses.
Investment returns are an important part of our overall profitability. General economic conditions, fluctuations in interest rates and many other factors beyond our control can adversely affect the returns and the overall value of our investment portfolio. In addition, any defaults in the payments due to us for our investments, especially with respect to liquid corporate and municipal bonds, could reduce our investment income and realized investment gains or could cause us to incur investment losses. As a result of these factors, we may not realize an adequate return on our investments, may incur losses on sales of our investments and may be required to write down the value of our investments.
We rely on our information technology and telecommunications systems to conduct our business.
Our business is highly dependent upon the successful and uninterrupted functioning of our information technology and telecommunications systems. We rely on these systems to process new and renewal business, provide customer service, make claims payments and facilitate collections and cancellations, as well as to perform actuarial and other analytical functions necessary for pricing and product development.
ITEM 1B.
ITEM 1B.
UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2.
PROPERTIES
CNA Surety leases its executive offices and its shared branch locations with CCC under the Administrative Services Agreement (“ASA”) with CCC discussed in detail in Item 8., Note 14 of the Notes to the Consolidated Financial Statements, Related Party Transactions. CNA Surety currently uses approximately 89,000 square feet and related personal property at 35 branch locations and its home and executive offices (30,360 square feet) in Chicago, Illinois. In 2010, CNA Surety’s annual rent under the ASA was approximately $2.1 million. Annual rent for space leased through the ASA will be approximately $2.0 million beginning January 1, 2011.
CNA Surety leases approximately 83,550 square feet of office space for its primary processing and service center at 101 South Phillips Avenue, Sioux Falls, South Dakota, under a lease expiring in 2012. The annual rent, which is subject to annual adjustments, was $1.8 million as of December 31, 2010. On September 21, 2010, CNA Surety entered into a lease agreement for a new property to be occupied following the expiration of the current lease. The new lease includes various contingencies including completion of construction of the building and office space to be occupied. The lease term shall be ten years from its commencement date as defined in the agreement. Other specific lease terms such as final rental square feet and cost will be finalized upon satisfaction of the required contingencies.
CNA Surety also leased space for contract and commercial branch offices in San Juan, Puerto Rico and Rocklin, California. Annual rent for these offices was $0.1 million with leases terminating in 2011 and 2012, respectively. In 2011, CNA Surety will also lease space in San Antonio, Texas, with a lease terminating in 2016. Annual rent under this lease will be less than $0.1 million.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
The Company and its subsidiaries are parties to various lawsuits arising in the normal course of business. The Company believes the resolution of these lawsuits will not have a material adverse effect on its financial condition or its results of operations.
PART II.
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
The Company’s common stock (“Common Stock”) trades on the New York Stock Exchange under the symbol SUR. On February 8, 2011 the last reported sale price for the Common Stock was $25.16 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 2010 and 2009.
The following table and graph present the Company’s common stock market performance over the last five years compared to appropriate industry indices:
The number of stockholders of record of Common Stock on February 4, 2011 was approximately 2,300.
A summary of outstanding options and shares authorized for issuance under equity compensation plans as of December 31, 2010 follows:
Dividends
Effective November 21, 2002, the Company announced that its Board of Directors suspended its quarterly cash dividend. The reintroduction of a quarterly or annual dividend and the amount of any such dividend will be reassessed at future Board meetings.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
The following financial information for CNA Surety as of and for the years ended December 31, 2010, 2009, 2008, 2007 and 2006 has been derived from the Consolidated Financial Statements and Notes thereto.
(a)
Includes the effect of re-estimates of prior year reserves, known as reserve development. The dollar amount of these reserve reductions were $76.3 million, $54.3 million, $45.5 million, $5.1 million and $5.3 million for the years ended December 31, 2010, 2009, 2008, 2007 and 2006, respectively. The percentage point effect of these reserve reductions on the loss and combined ratios for these years were 18.3, 12.8, 10.6, 1.2 and 1.4 percentage points, respectively.
(b)
Includes expenses of $1.5 million incurred related to the evaluation of the CNAF Proposal. These expenses are shown as “Other expense” in the Consolidated Statements of Income and are not included in the expense or combined ratios.
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
CNA Surety Corporation is an insurance holding company in the United States. Through its insurance subsidiaries, CNA Financial Corporation (“CNAF”) owns approximately 61% of the outstanding common stock of CNA Surety Corporation. Loews Corporation owns approximately 90% of the outstanding common stock of CNAF. The following is a discussion and analysis of CNA Surety Corporation and its subsidiaries’ (collectively, “CNA Surety” or the “Company”) operating results, liquidity and capital resources and financial condition. The most significant risks and uncertainties impacting the operating performance and financial condition of the Company are discussed in Item 1A., Risk Factors, of this Form 10-K. This discussion should be read in conjunction with the Consolidated Financial Statements of CNA Surety and Notes thereto.
CNAF Proposal
In October 2010, the Company received an unsolicited proposal from CNAF to acquire all of the outstanding shares of common stock that are not currently owned by subsidiaries of CNAF at a purchase price of $22.00 per share in cash (the “CNAF Proposal”). The Company’s Board of Directors appointed a special committee (the “Special Committee”), comprised solely of the Company’s three independent directors, to review and evaluate the CNAF proposal. The Special Committee retained both legal and financial advisors to assist in their consideration of the CNAF Proposal.
On February 4, 201l, the Special Committee announced that it does not support the terms of the proposal and advised CNAF that it is open to alternate proposals.
Critical Accounting Policies
The Company’s accounting policies related to reserves and disclosures for unpaid losses and loss adjustment expenses and related estimates of reinsurance recoverables are particularly critical to an assessment of the Company’s financial results. Given the nature of the surety business, the determination of these balances is inherently a highly subjective exercise which requires management to analyze, weigh and balance numerous macroeconomic, customer specific and claim specific factors and trends, most of which, in and of themselves, are inherently uncertain and difficult to predict. In addition, management believes the other most critical accounting policies and related disclosures for purposes of understanding the Company’s results of operations and financial condition pertain to investments, goodwill and other intangible assets, recognition of premium revenue and the related unearned premium liability and deferred policy acquisition costs.
Reserves for Unpaid Losses and Loss Adjustment Expenses and Reinsurance
CNA Surety accrues liabilities for unpaid losses and loss adjustment expenses (“LAE”) under its surety and property and casualty insurance contracts based upon estimates of the ultimate amounts payable under the contracts related to losses occurring on or before the balance sheet date.
Reported claims are in various stages of the settlement process. Due to the nature of surety, which is the relationship among three parties whereby the surety guarantees the performance of the principal to a third party (the obligee), the investigation of claims and the establishment of case estimates on claim files can be a complex process that can occur over a period of time depending on the type of bond(s) and the facts and circumstances involving the particular bond(s), the claim(s) and the principal. Case reserves are typically established after a claim is filed and an investigation and analysis has been conducted as to the validity of the claim, the principal’s response to the claim and the principal’s financial viability. To the extent it is determined that there are no bona fide defenses to the claim and the principal is unwilling or financially unable to resolve the claim, a case reserve is established on the claim file for the amount the Company estimates it will have to pay to honor its obligations under the provisions of the bond(s).
While the Company intends to establish initial case reserve estimates that are sufficient to cover the ultimate anticipated loss on a claim file, some estimates need to be adjusted during the life cycle of the claim file as matters continue to develop. Factors that can necessitate case reserve increases or decreases are the complexity of the
bond(s) and/or underlying contract(s), if additional and/or unexpected claims are filed, if the financial condition of the principal or obligee changes or as claims develop and more information is discovered that was unknown and/or unexpected at the time the initial case reserve estimate was established. Ultimately, claims are resolved through payment and/or a determination that, based on the information available, a case reserve is no longer required.
As of any balance sheet date, not all claims have been reported and some claims may not be reported for many years. As a result, the liability for unpaid losses includes significant estimates for incurred-but-not-reported (“IBNR”) claims. The IBNR reserves also include provisions for losses in excess of the current case reserve for previously reported claims and for claims that may be reopened. The IBNR reserves also include offsets for anticipated indemnity recoveries.
The following table shows the estimated liability as of December 31, 2010 for unpaid claims applicable to reported claims and to IBNR (dollars in thousands) for each sub-line of business:
Periodic actuarial analyses of the Company’s loss reserves are performed. These analyses include a comprehensive review performed in the fourth quarter based on data as of September 30 and an update of the comprehensive review performed in January based on data as of December 31. In between these analyses, management monitors claim activity against benchmarks of expected claim activity prepared in connection with the comprehensive review and records adjustments as necessary.
The actuarial analyses are based upon multiple projection methodologies that involve detailed statistical analysis of past claim reporting, settlement activity, and indemnification activity, as well as claim frequency and severity data when sufficient information exists to lend statistical credibility to the analysis. The analysis may be based upon internal loss experience or industry experience. Methodologies may vary depending on the type of claim being estimated. While methodologies may vary, each employs significant judgments and assumptions.
In estimating the unpaid claim liabilities, the following projection methodologies are employed:
•
Historical development method, sometimes referred to as a link ratio method;
•
Bornhuetter-Ferguson method on both a paid and incurred basis;
•
Frequency-severity method; and
•
Loss ratio method.
The following provides a summary of these projection methodologies:
Historical Development Method
As a group of claims mature, their collective value changes. This change in value over time is referred to as loss development. The loss development method is a traditional actuarial approach which relies on the historical changes in losses from one evaluation point to another to project the current valuation of losses to ultimate settlement values. Development patterns which have been exhibited by more mature (older) years are used to estimate the expected development of the less mature (more recent) years. The strength of this method is that it is very responsive to emerging loss experience for each accident year. The weakness is that this method can become highly leveraged and volatile for less mature accident years.
Bornhuetter-Ferguson Method
The incurred Bornhuetter-Ferguson (“B-F”) method is commonly used to provide a more stable estimate of ultimate losses in situations where loss development is volatile, substantial and/or immature. The method calculates IBNR (or unpaid loss when conducting a paid B-F projection) directly as the product of: Expected Ultimate Losses multiplied by IBNR (or Unpaid) Percentage.
The IBNR (or unpaid) percentage is derived from the incurred (or paid) loss development patterns. Various approaches can be used to determine the expected ultimate losses (e.g., prior year estimates, pricing assumptions, etc.). An expected loss ratio (ultimate losses divided by earned premium) based on review of prior accident years’ loss ratio experience is utilized to obtain an estimate of expected ultimate losses. This estimate is then applied to the more recent accident years’ earned premium. The strength of the B-F method is that it is less leveraged than the historical development method and thus does not result in an overreaction to an unusual claim occurrence (or an unusual lack of claims). The weakness of the method is that it is reliant on an initial expectation of ultimate losses.
Frequency-Severity Method
This method first projects the expected number of claims for each accident year and then multiplies this estimate by the expected average cost of claims for the applicable accident year. The number of claims can be projected using the historical development technique or other methodology. The average cost of claims for the more recent accident years is estimated by observing the estimated average cost of claims for the older more mature accident years and trending those values to appropriate cost levels for the more recent accident years. The strength of this method is that it is not reliant on loss development factors for less mature accident years which can become highly leveraged and volatile. The weakness is that this method is slow to react to an abrupt change in claim severities.
Loss Ratio Method
This method relies on historical projected ultimate loss ratios for the more mature accident years to estimate the more recent, less mature accident years’ ultimate losses. Applying a selected loss ratio (by reviewing more mature years) to the more recent years’ earned premium results in an indication of the more recent years’ ultimate losses. The strength of this method is that it can be used in connection with a company’s pricing targets and can be used when the historical data has limited credibility. The weakness of this method is that it is slow to react to the emerging loss experience for a particular accident year.
Each of the projection methodologies employed rely to varying degrees on the basic assumption that the Company’s historical claim experience is indicative of the Company’s future claim development. The amount of weight given to any individual projection method is based on an assessment of the volatility of the historical data and development patterns, an understanding of the changes in the overall surety industry over time and the resultant potential impact of these changes on the Company’s prospective claims development, an understanding of the changes to the Company’s processes and procedures within its underwriting, claims handling and data systems functions, among other things. The decision as to how much weight to give to any particular projection methodology is ultimately a matter of experience and professional judgment.
Surety results, especially for contract and certain commercial products like insurance program bonds, workers compensation insurance bonds and reclamation bonds, tend to be impacted by fewer, but more severe, losses. With this type of loss experience, it is more difficult to estimate the required reserves, particularly for the most current accident years which may have few reported claims. Therefore, assumptions related to the frequency and magnitude of severe loss are key in estimating surety loss reserves.
The indicated reserve, or actuarial point estimate, was developed by reviewing the Company’s claims experience by accident year for individual sub-lines of business. Within each sub-line, the selection of the point estimate was made after consideration of the appropriateness of the various projection methodologies in light of the sub-line’s loss characteristics and historical data. In general, for the older, more mature, accident years the historical development method (i.e., link ratio method) was relied upon more heavily. For the more recent years, the indicated reserves were more heavily based on the Bornhuetter-Ferguson and loss ratio methods since these are not as reliant
on the Company’s large (i.e., leveraged) development factors and thus are believed to represent a more stable set of methods from which to select indicated reserves for the more recent years.
The actuarial analysis is the primary tool that management utilizes in determining its best estimate of loss reserves. However, the carried reserve may differ from the actuarial point estimate as a result of management’s consideration of the impact of factors such as the following, especially as they relate to the current accident year:
•
Current claim activity, including the frequency and severity of current claims;
•
Changes in underwriting standards and business mix such as the Company’s efforts to reduce exposures to large commercial bonds;
•
Changes in the claims handling process;
•
Potential changes in the Company’s reinsurance program; and
•
Current economic conditions, especially corporate default rates and the condition of the construction economy.
Management believes that the impact of the factors listed above, and others, may not be fully quantifiable through actuarial analysis. Accordingly, management applies its judgment of the impact of these factors, and others, to its selection of the recorded loss reserves.
The following table shows the point estimate as determined by the actuarial analysis as compared to the actual loss reserve established by management, both gross and net of reinsurance (dollars in thousands):
At December 31, 2010, management’s recorded gross and net reserves were higher than the actuarial point estimate. Management recorded reserves that were materially consistent with the actuarial point estimates for accident years 2008 and prior. For accident years 2009 and 2010, management recorded reserves that deviated from the actuarial indications due to the belief that the potential impact on losses of the economic recession and associated challenges facing construction firms was not fully reflected in the actuarial analyses. To determine the recorded reserves for accident years 2009 and 2010, management used the same methodology that was used in 2009. This methodology relied on an analysis of past experience for accident years that were impacted by periods of economic difficulties. This analysis was influenced by management’s assessment of key factors like the length and depth of the recession, the particular challenges facing construction firms, the financial strength of bonded contractors, the contractors’ responses to the economic challenges and the Company’s and the industry’s underwriting discipline. This analysis also included adjustments to historical results to reflect differences in premium rates, reinsurance coverage and changes in underwriting appetite, particularly related to large commercial risks.
At December 31, 2009, management’s recorded gross and net reserves were also higher than the actuarial point estimate primarily due to the factors and analysis described above as related to accident years 2008 and 2009. Recorded reserves for accident years 2007 and prior were materially consistent with the actuarial point estimates.
Receivables recorded with respect to insurance losses ceded to reinsurers under reinsurance contracts are estimated in a manner similar to liabilities for insurance losses and, therefore, are also subject to uncertainty. In addition to the factors cited above, assumptions are made regarding the impact of reinsurance programs to be in place in future periods. Estimates of reinsurance recoveries may prove uncollectible if the reinsurer is unable to perform under the contract. Reinsurance contracts do not relieve the ceding company of its obligations to indemnify its own policyholders.
Casualty insurance loss reserves are subject to a significant amount of uncertainty. Given the nature of surety losses with its low frequency, high severity characteristics, this is particularly true for surety loss reserves. As a result, the range of reasonable loss reserve estimates may be broader than that associated with traditional property/casualty insurance products. While the loss reserve estimates represent the best professional judgments, arrived at after careful actuarial analysis of the available data, it is important to note that variation from the estimates is not only possible but, in fact, probable. The sources of this inherent variability are numerous - future economic conditions, court decisions, legislative actions and individual large claim impacts, for example.
The range of reasonable reserve estimates is not intended to reflect the maximum and/or minimum possible outcomes; but rather reflects a range of reasonable estimates given the uncertainty in estimating unpaid claim liabilities for surety business. Further, there is no generally accepted method of estimating reserve ranges, but rather many concepts are currently being vetted within actuarial literature.
In developing the indicated range of reserve estimates, a bootstrapping based methodology was utilized in order to estimate the distribution of reserves. The bootstrap method is premised on the idea that the volatility in a company’s historical paid and incurred loss development is representative of the variability in a company’s future payments and thus can be used to estimate the variability within a company’s reserve estimate. Given the dispersion of the reserve indications, the 50th and 75th percentile were selected as representing a reasonable range of reserve estimates.
At December 31, 2010, the range of reasonable loss reserve estimates, net of reinsurance receivables, was from $313 million to $381 million. Ranges of reasonable loss reserve estimates are not calculated for the sub-lines of business. Management believes that the range calculated over total reserves provides the most meaningful information due to the importance of correlation of losses between the sub-lines of business related to the impact of general economic conditions.
The primary factors that would result in the Company’s actual losses being closer to either end of the reserve range are the number of large claims, as well as the number of large indemnification amounts. In other words, the primary factors that, if they were to occur, would result in the Company’s actual payments being at the high end of the indicated range are if the Company experiences an unusually high number of large claims and/or an unusually low number of large indemnification recoveries. Conversely, if the Company were to experience an unusually low number of large claims and/or an unusually high number of large indemnification recoveries, the Company’s actual payments would tend to be at the low end of the range. These variations in outcomes could be driven by broader issues such as the state of the construction economy or the level of corporate defaults, or by the specific facts and circumstances surrounding individual claims. Again, it is important to note that it is possible that the actual payments could fall outside of the estimated range.
Due to the inherent uncertainties in the process of establishing the liabilities for unpaid losses and loss adjustment expenses, the actual ultimate claims amounts will differ from the currently recorded amounts. This difference could have a material effect on reported earnings and financial condition. Future effects from changes in these estimates will be recorded in the period such changes are determined to be needed.
Investments
Management believes the Company has the ability to hold all fixed income securities to maturity. However, the Company may dispose of securities prior to their scheduled maturity due to changes in interest rates, prepayments, tax and credit considerations, liquidity or regulatory capital requirements, or other similar factors. As a result, the Company considers all of its fixed income securities (bonds) and equity securities as available-for-sale. These
securities are reported at fair value, with unrealized gains and losses, net of deferred income taxes, reported in stockholders’ equity as a separate component of accumulated other comprehensive income.
All securities transactions are recorded on the trade date. Investment gains or losses realized on the sale of securities are determined using the first-in, first-out method. Cash flows from purchases, sales and maturities of fixed income and equity securities are reported gross in the investing activities section of the Consolidated Statements of Cash Flows.
Fixed income securities in an unrealized loss position that the Company intends to sell, or it more likely than not will be required to sell before recovery of amortized cost, are considered to be other-than-temporarily impaired (“OTTI”). These securities are written down to fair value and the resulting losses are recognized in realized gains/losses in the Consolidated Statements of Income. Fixed income securities in an unrealized loss position for which management believes a credit loss exists are also considered to be other-than-temporarily impaired. For those securities, the Company bifurcates the impairment into a credit component and a non-credit component. The credit component, which represents the difference between discounted expected cash flows and the fixed income security’s amortized cost, is recognized in earnings and the non-credit component is recognized in other comprehensive income.
The amortized cost of fixed income securities is determined based on cost, adjustments for previously recorded OTTI losses and the cumulative effect of amortization of premiums and accretion of discounts using the interest method. Such amortization and accretion are included in investment income. For mortgage-backed and asset-backed securities, the Company considers estimates of future prepayments in the calculation of the effective yield used to apply the interest method. If a difference arises between the anticipated prepayments and the actual prepayments, the Company recalculates the effective yield based on actual prepayments and the currently anticipated future prepayments. The amortized costs of such securities are adjusted to the amount that would have resulted had the recalculated effective yields been applied since the acquisition of the securities with a corresponding charge or credit to investment income. Prepayment estimates are based on the structural elements of specific securities, interest rates and generally recognized prepayment speed indices.
Short-term investments, that generally include U.S. Treasury bills, corporate notes, money market funds and investment grade commercial paper equivalents, are carried at amortized cost, which approximates fair value.
Invested assets are exposed to various risks, such as interest rate risk, market risk and credit risk. Due to the level of risk associated with invested assets and the level of uncertainty related to changes in the value of these assets, it is possible that changes in risks in the near term may materially affect the amounts reported in the Consolidated Balance Sheets and Consolidated Statements of Income.
Goodwill and Other Intangible Assets
CNA Surety’s Consolidated Balance Sheets as of December 31, 2010 and 2009 include goodwill and intangible assets of approximately $138.8 million. This amount primarily represents goodwill and identified intangibles with indefinite useful lives arising from the acquisition of Capsure Holdings Corp.
A significant amount of judgment is required in performing intangible assets impairment tests. Such tests include periodically determining or reviewing the estimated fair value of CNA Surety’s reporting units. Under the relevant standard, fair value of a reporting unit refers to the price that would be received to sell the reporting unit as a whole in an orderly transaction between market participants. There are several methods of estimating fair value, including market quotations, asset and liability fair values and other valuation techniques, such as discounted cash flows and multiples of earnings or revenues. The Company uses a valuation technique based on discounted cash flows. Significant inputs to the Company’s discounted cash flow model include estimated capital requirements to support the business, expected cash flows from underwriting activity, required capital reinvestment to support growth and the selected discount rates. If the carrying amount of a reporting unit, including goodwill, exceeds the estimated fair value, then individual assets, including identifiable intangible assets, and liabilities of the reporting unit are estimated at fair value. The excess of the estimated fair value of the reporting unit over the estimated fair value of net assets would establish the implied value of intangible assets. The excess of the recorded amount of intangible assets over the implied value of intangible assets is recorded as an impairment loss.
Insurance Premiums
Insurance premiums are recognized as revenue ratably over the term of the related policies in proportion to the insurance protection provided. Contract bonds provide coverage for the length of the bonded project and not a fixed time period. As such, the Company uses estimates of the contract length as the basis for recognizing premium revenue on these bonds. Premium revenues are net of amounts ceded to reinsurers. Unearned premiums represent the portion of premiums written, before ceded reinsurance which is shown as an asset, applicable to the unexpired terms of policies in force determined on a pro rata basis.
Insurance premium receivables do not include financing costs or other fees and are presented net of an estimated allowance for doubtful accounts. This allowance is based on a periodic evaluation of the aging and collectibility of premium receivables. Premium receivables and any related allowance are written off after collection efforts have been exhausted.
Deferred Policy Acquisitions Costs
Policy acquisition costs, consisting of commissions, premium taxes and other underwriting expenses which vary with, and are primarily related to, the production of business, net of reinsurance commissions, are deferred and amortized as a charge to income as the related premiums are earned. The Company periodically tests that deferred policy acquisition costs are recoverable based on the expected profitability embedded in the reserve for unearned premium. If the expected profitability is less than the balance of deferred policy acquisition costs, a charge to net income is taken and the deferred policy acquisition cost balance is reduced to the amount determined to be recoverable. Anticipated investment income is considered in the determination of the recoverability of deferred policy acquisition costs.
Results of Operations
Financial Measures
The Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) discusses certain accounting principles generally accepted in the United States of America (“GAAP”) and non-GAAP financial measures in order to provide information used by management to monitor the Company’s operating performance. Management utilizes various financial measures to monitor the Company’s insurance operations and investment portfolio. Underwriting results, which are derived from certain income statement amounts, are considered a non-GAAP financial measure and are used by management to monitor performance of the Company’s insurance operations.
Underwriting results are computed as net earned premiums less net losses and loss adjustment expenses and net commissions, brokerage and other underwriting expenses. Management uses underwriting results to monitor its insurance operations’ results without the impact of certain factors, including net investment income, net realized investment gains (losses) and interest expense. Management excludes these factors in order to analyze the direct relationship between net earned premiums and the related net losses and loss adjustment expenses along with net commissions, brokerage and other underwriting expenses.
Operating ratios are calculated using insurance results and are widely used by the insurance industry and regulators such as state departments of insurance and the National Association of Insurance Commissioners for financial regulation and as a basis of comparison among companies. The ratios discussed in the Company’s MD&A are calculated using GAAP financial results and include the net loss and loss adjustment expense ratio (“loss ratio”) as well as the net commissions, brokerage and other underwriting expense ratio (“expense ratio”) and combined ratio. The loss ratio is the percentage of net incurred losses and loss adjustment expenses to net earned premiums. The expense ratio is the percentage of net commissions, brokerage and other underwriting expenses, including the
amortization of deferred policy acquisition costs, to net earned premiums. The combined ratio is the sum of the loss ratio and expense ratio.
While management uses various GAAP and non-GAAP financial measures to monitor various aspects of the Company’s performance, net income is the most directly comparable GAAP measure and represents a more comprehensive measure of operating performance. Management believes that its process of evaluating performance through the use of these non-GAAP financial measures provides a basis for enhanced understanding of the operating performance and the impact to net income as a whole. Management also believes that investors may find these widely used financial measures described above useful in interpreting the underlying trends and performance, as well as to provide visibility into the significant components of net income.
Comparison of CNA Surety Actual Results for the Years Ended December 31, 2010, 2009 and 2008
Analysis of Net Income
The Company had net income of $134.4 million for the year ended December 31, 2010 as compared to $117.9 million for the year ended December 31, 2009 and $110.4 million for the year ended December 31, 2008. The increase in net income in 2010 over 2009 reflects the higher levels of favorable loss development discussed below, lower underwriting expenses and higher investment income, partially offset by lower net earned premium. The increase in net income in 2009 over 2008 reflects the higher levels of favorable loss development discussed below and higher investment income, partially offset by lower net earned premium.
The components of net income are discussed in the following sections.
Results of Insurance Operations
Underwriting components for the Company for the years ended December 31, 2010, 2009 and 2008 are summarized in the following table (dollars in thousands):
Premiums Written/Earned
CNA Surety primarily markets contract and commercial surety bonds. Contract surety bonds generally secure a contractor’s performance and/or payment obligation with respect to a construction project. Contract surety bonds are generally required by federal, state and local governments for public works projects. The most common types include bid, performance and payment bonds. Commercial surety bonds include all surety bonds other than contract and cover obligations typically required by law or regulation. The commercial surety market includes numerous types of bonds categorized as court judicial, court fiduciary, public official, license and permit and many miscellaneous bonds that include guarantees of financial performance. The Company also writes fidelity bonds that cover losses arising from employee dishonesty and other insurance products that are generally companion products to certain surety bonds. For example, the Company writes surety bonds for notaries and also offers related errors and omissions insurance coverage.
Through one of its insurance subsidiaries, Western Surety Company (“Western Surety”), the Company assumes significant amounts of premiums primarily from affiliates. This includes surety business written or renewed, net of reinsurance, by Continental Casualty Company (“CCC”) and The Continental Insurance Company (“CIC”), and their affiliates, after September 30, 1997 that is reinsured by Western Surety pursuant to reinsurance and related agreements. Because of certain regulatory restrictions that limit the Company’s ability to write certain business on a direct basis, the Company continues to utilize the underwriting capacity available through these agreements. The Company is in full control of all aspects of the underwriting and claim management of the assumed business from CCC and CIC.
CNA Surety also assumes premium on contract and commercial surety bonds for international risks. Such premiums are assumed pursuant to the terms of reinsurance treaties or as a result of specific international bond requirements of domestic customers. For the years ended December 31, 2010, 2009, and 2008, assumed premiums written under such arrangements were $4.3 million, $2.4 million and $2.1 million, respectively.
Gross written premium, which is the aggregate of direct written premiums and assumed written premiums, for the years ended December 31, 2010, 2009 and 2008 are shown in the table below (dollars in thousands) for each sub-line of business:
For 2010, gross written premiums increased 0.4 percent to $440.2 million as compared to 2009. Gross written premiums for contract surety increased 1.3 percent to $278.4 million despite continued challenges in the construction industry. For 2010, commercial surety gross written premiums decreased 1.7 percent compared to 2009 due to a modest decline in the small commercial market, partially offset by selective growth in the corporate commercial market. Fidelity and other premiums increased 1.9 percent to $30.5 million.
For 2009, gross written premiums decreased 6.2 percent to $438.3 million as compared to 2008. Gross written premiums for contract surety decreased 8.5 percent to $274.8 million primarily due to lower demand resulting from fewer new construction projects. For 2009, commercial surety gross written premiums decreased 1.8 percent compared to 2008 due, in part, to continued adverse economic conditions. Commercial surety gross written premiums for 2008 included a non-recurring premium recognition from a single account of $1.1 million. Fidelity and other premiums decreased 3.2 percent to $29.9 million.
The Company’s insurance subsidiaries purchase reinsurance from other insurance companies and affiliates. Reinsurance arrangements are used to limit maximum loss, provide greater diversification of risk and minimize exposure on larger risks. The cost of this reinsurance is recorded as ceded written premium. Ceded written premiums decreased from $27.3 million to $23.9 million for 2010 compared to 2009 primarily due to the lower cost of the Company’s 2010 third party excess of loss treaty.
Ceded written premium in 2009 decreased compared to 2008 from $35.5 million to $27.3 million. The Company’s decision to increase the per principal retention from $10.0 million to $15.0 million resulted in lower ceded premiums on the 2009 third party excess of loss treaty. Further, 2008 ceded written premium included $4.2 million recorded as a result of additional losses ceded under the 2007 excess of loss treaty as compared to $0.5 million recorded in 2009 as the result of additional losses ceded under the 2007 third party excess of loss treaty.
Net written premiums, which is gross written premiums less ceded written premiums, for the years ended December 31, 2010, 2009 and 2008 are shown in the table below (dollars in thousands) for each sub-line of business:
Net written premiums are recognized as revenue over the policy term as net earned premiums. Net earned premiums for the years ended December 31, 2010, 2009 and 2008 are shown in the table below (dollars in thousands) for each sub-line of business:
Net earned premiums were $418.0 million in 2010 compared to $421.9 million in 2009. While net written premiums for the current year increased, the impact of adverse economic conditions on prior year net written premium is reflected in this $3.9 million decrease. Net earned premiums for contract surety business decreased 1.0 percent to $256.7 million for 2010 compared to 2009. Net earned premiums for commercial surety decreased 0.7 percent to $131.0 million for 2010 compared to 2009. Net earned premium for fidelity and other premiums decreased 1.0 percent to $30.3 million for 2010 compared to 2009.
For 2009, net earned premiums decreased by $9.8 million to $421.9 million as compared to 2008 reflecting continued adverse economic conditions, partially offset by the decrease in ceded written premiums discussed above. Ceded earned premiums decreased $8.1 million to $27.5 million for 2009 compared to 2008. Net earned premiums for contract surety business decreased 2.7 percent to $259.3 million for 2009 compared to 2008. Net earned premiums for commercial surety decreased 1.3 percent to $131.9 million for 2009 compared to 2008. Net earned premium for fidelity and other premiums decreased 2.6 percent to $30.6 million for 2009 compared to 2008.
Net Loss Ratio
The loss ratios for the years ended December 31, 2010, 2009 and 2008 were 10.8%, 16.5% and 18.7%, respectively. These loss ratios include re-estimates of prior accident year reserves, known as reserve development. The dollar amount and percentage point effect of these reserve reductions were $76.3 million, or 18.3 percentage points, $54.3 million, or 12.8 percentage points, and $45.5 million, or 10.6 percentage points, for the years ended December 31, 2010, 2009, and 2008, respectively.
The favorable development for 2010 was primarily related to accident years 2008, 2007 and 2006. Loss experience for the 2007 and 2006 accident years continued to be lower than expected, particularly for large losses.
Beginning in 2008, the Company began recording higher loss provisions for the current accident year in response to the severe deterioration in economic conditions that began in 2008. The results of subsequent actuarial reviews indicated redundancies for accident year 2008, but management believed that the potential impacts of the economic downturn were not fully recognized by the actuarial methodologies and maintained their higher loss estimates. The actuarial review performed in 2010 indicated a larger redundancy for accident year 2008 than at December 31, 2009. At December 31, 2010, management believed that the experience for the 2008 accident year was sufficiently mature to make the actuarial indication credible and adjusted the reserves to the actuarial indication. In retrospect, it appears that this deterioration in economic conditions did not begin to impact loss
activity until the 2009 accident year. The Company’s estimates of losses for accident years 2010 and 2009 continue to reflect the impact of the difficult economic conditions.
The favorable development in 2009 resulted primarily from a level of loss activity substantially below expectations for accident years 2006 and 2007. This level of loss activity was particularly influenced by a lower than expected emergence of large claims. Significant case reserve reductions and better than expected indemnification recoveries for accident years 2005 and prior also contributed to the favorable development in 2009. The Company’s initial estimates of losses for accident year 2009 and the estimate for accident year 2008 continued to reflect the expected impact of less favorable economic conditions.
The favorable development in 2008 primarily resulted from several significant case reserve reductions, favorable indemnity recoveries and a low level of new loss activity for accident years 2006 and prior. These favorable developments were somewhat offset by adverse development related to the 2007 accident year which was recorded in response to economic conditions at December 31, 2008. Also, the initial estimates of losses for accident year 2008 reflected the Company’s expectations of the impact of continued deterioration of these economic conditions.
Expense Ratio
The expense ratio for the year ended December 31, 2010 decreased to 54.5% from 55.3% in 2009. The expense ratio for 2009 included impairments of capitalized software development costs related to in-development projects that the Company decided to terminate. These impairments totaled $4.9 million, which added 1.1 percentage points to the expense ratio for 2009.
In 2009, the expense ratio increased to 55.3% from 54.5% in 2008 due to these impairments.
Other Expense
As previously discussed, in October 2010, the Company received an unsolicited proposal from CNAF to acquire all of the outstanding shares of common stock that are not currently owned by subsidiaries of CNAF. The Special Committee appointed to review and evaluate the CNAF Proposal retained both legal and financial advisors to assist in their consideration of the CNAF Proposal. The Company incurred expenses of $1.5 million in 2010 related to the evaluation of the CNAF Proposal. These expenses are shown as “Other expense” in the Consolidated Statements of Income and are not included in the expense ratio discussed above.
Investment Income and Realized Investment Gains/Losses
For 2010, net investment income was $53.6 million compared to net investment income for 2009 and 2008 of $50.4 million and $47.3 million, respectively. The annualized pre-tax yield was 4.0%, 4.2% and 4.4% for 2010, 2009 and 2008, respectively. The annualized after-tax yield was 3.2%, 3.5% and 3.6% for 2010, 2009 and 2008, respectively. The increase in net investment income for 2010 and 2009 is primarily attributable to higher overall invested assets resulting from significant cash flow from operations, partially offset by a decline in yields.
The following summarizes net realized investment gains (losses) activity (dollars in thousands):
The Company’s investment portfolio is generally managed to maximize after-tax investment return, while minimizing credit risk with investments concentrated in high quality fixed income securities. CNA Surety’s portfolio is managed to provide diversification by limiting exposures to any one industry, issue or issuer, and to provide liquidity by investing in the public securities markets. The portfolio is structured to support CNA Surety’s insurance underwriting operations and to consider the expected duration of liabilities and short-term cash needs. In achieving these goals, assets may be sold to take advantage of market conditions or other investment opportunities or regulatory, credit and tax considerations. These activities will produce realized gains and losses.
Interest Expense
The benchmark interest rate for the Company’s variable interest rate debt is the London Interbank Offered Rate (“LIBOR”). Due to lower three-month LIBOR rates, interest expense decreased $0.2 million, or 16.3 percent, for 2010 compared to 2009. Interest expense also decreased $0.8 million, or 35.2 percent for 2009 compared to 2008 due to lower interest rates. Weighted average debt outstanding was $30.9 million for each of these periods. The weighted average interest rate for 2010, 2009 and 2008 was 3.7%, 4.3% and 6.4%, respectively.
Income Taxes
The Company’s income tax expense was $62.7 million for 2010, $51.3 million for 2009 and $48.8 million for 2008. The effective income tax rates were 31.8%, 30.3% and 30.7% for 2010, 2009 and 2008, respectively. The effective tax rates are lower than the statutory tax rates primarily due to the Company’s ability to exclude interest income from its significant investments in tax-exempt securities. Investment income included income from tax-exempt securities of $24.9 million, $25.5 million and $23.8 million in 2010, 2009 and 2008, respectively.
Exposure Management
The Company’s business is subject to certain risks and uncertainties associated with the current economic environment and corporate credit conditions. In response to these risks and uncertainties, the Company has enacted
various exposure management initiatives. With respect to risks on large commercial accounts, the Company generally limits its exposure to $50.0 million per account, but will selectively accept higher exposures.
With respect to contract surety, the Company’s portfolio is predominantly comprised of contractors with bonded backlog of less than $30.0 million. Bonded backlog is an estimate of the Company’s exposure in the event of default before indemnification. The Company does have accounts with bonded backlogs significantly greater than $30.0 million.
The Company manages its exposure on each account and aggressively looks for co-surety, shared accounts and other means to support or reduce larger exposures. Reinsurance and indemnification rights, including rights to contract proceeds on construction projects in the event of default, exist that substantially reduce CNA Surety’s exposure to loss.
Excess of Loss Reinsurance
The Company’s ceded reinsurance program is predominantly comprised of excess of loss reinsurance contracts that limit the Company’s retention on a per principal basis. The Company’s reinsurance coverage is provided by third party reinsurers and related parties. Due to the terms of these excess of loss treaties, reinsurers may cover some principals in one year but then exclude these same principals in subsequent years. As a result, the Company may have exposures to these principals that have limited or no reinsurance coverage.
At December 31, 2010, Munich Reinsurance America, Inc., Hannover Rückversicherung AG, Odyssey America Reinsurance Corporation, Endurance Reinsurance Corp. of America and Renaissance Reinsurance Ltd. were the five unaffiliated reinsurers from which the Company had its largest reinsurance receivables. Each of these reinsurers was rated at least A by A.M. Best Company, Inc. (“A.M. Best”). There were no amounts past due under reinsurance contracts and no allowances were established for uncollectible reinsurance receivables at December 31, 2010 or 2009.
Third Party Reinsurance
Effective January 1, 2009, CNA Surety entered into an excess of loss treaty (“2009 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the excess of loss treaty effective in 2008. Under the 2009 Excess of Loss Treaty, the Company’s net retention per principal was $15 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company’s retention. The contract provided aggregate coverage of $185 million and included an optional extended discovery period, which was not exercised. The contract also included a provision for additional premiums of up to $13.8 million based on losses ceded under the contract. The actual ceded premiums for the 2009 Excess of Loss Treaty were $26.6 million.
Third Party Reinsurance
Effective January 1, 2010, CNA Surety entered into an excess of loss treaty (“2010 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the 2009 Excess of Loss Treaty. Under the 2010 Excess of Loss Treaty, the Company’s net retention per principal was $15 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company’s retention. The contract provided aggregate coverage of $185 million and included an optional extended discovery period, which was not exercised. The contract also included a provision for additional premiums of up to $12.3 million based on losses ceded under the contract. The actual ceded premiums for the 2010 Excess of Loss Treaty were $23.7 million.
Third Party Reinsurance
Effective January 1, 2011, CNA Surety entered into an excess of loss treaty (“2011 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the 2010 Excess of Loss Treaty. Under the 2011 Excess of Loss Treaty, the Company’s net retention per principal remains at $15 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company’s retention. The contract provides aggregate coverage of $185 million and includes an optional extended discovery period, for an additional premium (a percentage of the original premium based on any unexhausted aggregate limit by layer), which will provide
coverage for losses discovered beyond 2011 on bonds that were in force during 2011. The contract also includes a provision for additional premiums of up to $10.7 million based on losses ceded under the contract. The base annual premium for the 2011 Excess of Loss Treaty is $21.7 million.
Related Party Reinsurance
Reinsurance agreements together with the Services and Indemnity Agreement described below provide for the transfer of the surety business written by CCC and CIC to Western Surety. Many of these agreements originally were entered into on September 30, 1997 (the “Merger Date”) and include: (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. Although the contracts entered on the Merger Date have expired, some have been renewed on different terms as described below.
Through the Quota Share Treaty, CCC and CIC transfer to Western Surety surety business written or renewed by CCC and CIC after the Merger Date. The Quota Share Treaty was renewed on January 1, 2010 and expired on December 31, 2010. The Quota Share treaty was renewed on substantially the same terms on January 1, 2011 and expires on December 31, 2011 and is annually renewable thereafter. CCC and CIC transfer the related liabilities of such business and pay to Western Surety an amount in cash equal to CCC’s and CIC’s net written premiums written on all such business, minus a quarterly ceding commission to be retained by CCC and CIC equal to $50,000 plus 25% of net written premiums written on all such business. For 2010 and 2009 this resulted in an override commission on their actual direct acquisition costs of 4.7% and 4.8%, respectively, to CCC and CIC.
Under the terms of the Quota Share Treaty, CCC has guaranteed the loss and loss adjustment expense reserves transferred to Western Surety as of the Merger Date by agreeing to pay Western Surety, within 30 days following the end of each calendar quarter, the amount of any adverse development on such reserves, as re-estimated as of the end of such calendar quarter. There was no adverse reserve development for the period from the Merger Date through December 31, 2010.
Through the Stop Loss Contract, the Company’s insurance subsidiaries were protected from adverse loss development on certain business underwritten after the Merger Date. The Stop Loss Contract between the Company’s insurance subsidiaries and CCC limited the insurance subsidiaries’ prospective net loss ratios with respect to certain accounts and lines of insured business for three full accident years following the Merger Date. In the event the insurance subsidiaries’ accident year net loss ratio exceeds 24% in any of the accident years 1997 through 2000 on certain insured accounts (the “Loss Ratio Cap”), the Stop Loss Contract requires CCC at the end of each calendar quarter following the Merger Date, to pay to the insurance subsidiaries a dollar amount equal to (i) the amount, if any, by which the Company’s 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 Company’s insurance subsidiaries paid CCC an annual premium of $20,000. The CNA Surety insurance subsidiaries have paid CCC all required annual premiums. Through December 31, 2010, losses incurred under the Stop Loss Contract were $47.2 million. Through December 31, 2009, losses incurred under the Stop Loss Contract were $49.1 million. The net amount settled in 2010 under this contract was $1.9 million paid to CCC as a result of favorable development on claims subject to the Stop Loss Contract. At December 31, 2010, the amount received under the Stop Loss Contract included $2.7 million held by the Company for losses covered under this contract that were incurred but not paid.
The Services and Indemnity Agreement provides the Company’s insurance subsidiaries with the authority to perform various administrative, management, underwriting and claim functions in order to conduct the surety business of CCC and CIC and to be reimbursed by CCC for services rendered. In consideration for providing the foregoing services, CCC has agreed to pay Western Surety a quarterly fee of $50,000. In 2009, this agreement was amended so that the Company’s authority to conduct administrative, management, underwriting and claim functions for bonds written for the large national contractor discussed below shall continue until CCC’s bonds for such contractor have expired and claims have been settled or closed. This agreement was renewed on January 1, 2010 and expired on December 31, 2010. As of December 31, 2010 and 2009, there were no amounts due to the CNA Surety insurance subsidiaries under this agreement. This agreement was renewed with the same terms on January 1, 2011 and expires on December 31, 2011 and is annually renewable thereafter.
From January 1, 2005 to June 30, 2009, the Company and CCC were parties to an excess of loss contract, and extensions to that contract, that provided unlimited reinsurance coverage in excess of $60 million retention for the life of bonds either in force or written during the contract periods exclusively for one large national contractor excluded from the Company’s third party reinsurance. Premiums for these contracts totaled $8.6 million and included an initial premium of $7.0 million and premiums of $1.6 million based on the level of premiums written on bonds for the large national contractor.
In 2009, the Company and CCC terminated the excess of loss contract discussed in the preceding paragraph. Related to the termination of this contract, the Company and CCC also commuted the Quota Share Treaty as regards the premium and losses for the large national contractor. The impact of this commutation was a decrease of gross loss reserves of $51.8 million. Under the terms of the agreements effecting this commutation, the Company paid CCC $1.8 million. This settlement reflected the difference between the Company’s $60.0 million retention under the excess of loss contract and the $58.2 million paid by the Company for losses of the large national contractor through 2009.
On January 1, 2010, the Company and CCC entered into separate agreements that provide for the transfer of the Canadian surety business of CCC to Western Surety. These agreements, which include a quota share treaty (the “Canadian Quota Share Treaty”) and a services and indemnity agreement (the “Canadian Services and Indemnity Agreement”), are substantially similar to the Quota Share Treaty and the Services and Indemnity Agreement discussed above. The Canadian Services and Indemnity Agreement provides Western Surety with the authority to supervise various administrative, underwriting and claim functions associated with the surety business written by CCC, through its Canadian branch, on behalf of the Company. Through the Canadian Quota Share Treaty, this Canadian surety business is transferred to Western Surety. Pursuant to these agreements, CCC will transfer the subject premium and related liabilities of such business and pay to Western Surety an amount equal to CCC’s net written premiums on all such business, minus a ceding commission of 33.5% of net written premiums. Further, Western Surety will pay an additional ceding commission to CCC in the amount of actual direct expense in producing such premium. These agreements expired on December 31, 2010. These agreements renewed with the same terms on January 1, 2011 and expire on December 31, 2011 and are annually renewable thereafter.
As of December 31, 2010 and December 31, 2009, CNA Surety had an insurance receivable balance from CCC and CIC of $10.8 million and $9.8 million, respectively, comprised of premiums receivable. CNA Surety had no reinsurance payables to CCC or CIC as of December 31, 2010.
The Company’s Consolidated Balance Sheets also include a “Deposit with affiliated ceding company” of $23.4 million and $26.9 million at December 31, 2010 and December 31, 2009, respectively. In 2005, pursuant to an agreement with the claimant on a bond regarding certain aspects of the claim resolution, the Company deposited $32.7 million with an affiliate to enable the affiliate to establish a trust to fund future payments under the bond. The bond was written by the affiliate and assumed by one of the Company’s insurance subsidiaries pursuant to the Quota Share Treaty. The Company is entitled to the interest income earned by the trust. Prior to the establishment of the trust, the Company had fully reserved its obligation under the bond and the claim remains fully reserved.
Liquidity and Capital Resources
It is anticipated that the liquidity requirements of CNA Surety will be met primarily by funds generated from operations. The principal sources of operating cash flows are premiums, investment income and recoveries under reinsurance contracts. The primary cash flow uses are payments for claims, operating expenses, federal income taxes and debt service. In general, surety operations generate premium collections from customers in advance of cash outlays for claims. Premiums are invested until such time as funds are required to pay claims and claims adjusting expenses.
The Company believes that total invested assets, including cash and short-term investments, are sufficient in the aggregate and have suitably scheduled maturities to satisfy all policy claims and other operating liabilities, including dividend and income tax sharing payments of its insurance subsidiaries. If cash requirements unexpectedly exceed cash inflows, the Company may raise additional cash by liquidating fixed income securities ahead of their scheduled maturity. Depending on the interest rate environment at that time, the Company could generate realized gains or losses that would increase or decrease net income for the period. The extent of these gains or losses
would depend on a number of factors such as the prevailing interest rates and credit spreads, the duration of the assets sold and the marketability of the assets. The need to liquidate fixed income securities would be expected to cause a reduction in future investment income.
At December 31, 2010, the carrying value of the Company’s insurance subsidiaries’ invested assets was comprised of $1,404.4 million of fixed income securities, $39.7 million of short-term investments and $3.4 million of cash. At December 31, 2009, the carrying value of the Company’s insurance subsidiaries’ invested assets was comprised of $1,266.2 million of fixed income securities, $36.9 million of short-term investments and $2.9 million of cash.
Cash flow at the parent company level is derived principally from dividend and tax sharing payments from its insurance subsidiaries, and to a lesser extent, investment income. In 2010, parent company cash flows included significant cash flows from the exercise of stock options under the Company’s stock-based compensation plan. The principal obligations at the parent company level are to service debt and pay operating expenses, including income taxes. At December 31, 2010, the parent company’s invested assets consisted of $1.9 million of equity securities and $16.7 million of short-term investments and cash. At December 31, 2009, the parent company’s invested assets consisted of $1.6 million of equity securities and $14.0 million of short-term investments and cash. At December 31, 2010 and December 31, 2009, parent company short-term investments and cash included $11.5 million and $11.1 million, respectively, of cash and short-term investments primarily related to premium receipt collections ultimately due to the Company’s insurance subsidiaries.
The Company’s consolidated net cash flow provided by operating activities was $142.1 million, $158.0 million and $124.2 million for 2010, 2009 and 2008, respectively. The decrease in net cash flow provided by operating activities in 2010 primarily relates to higher income tax payments partially offset by lower claim payments. The increase in net cash flow provided by operating activities in 2009 compared to 2008 primarily relates to the absence of the payment of $23.6 million, net of reinsurance recoveries, in 2008 in settlement of a large claim that had been fully reserved. This increase also reflects the impact of lower ceded premiums and lower federal income tax payments.
In May 2004, the Company, through a wholly-owned trust, privately issued $30.0 million of preferred securities through two pooled transactions. These securities, issued by CNA Surety Capital Trust I (the “Issuer Trust”), bear interest at the LIBOR plus 337.5 basis points with a 30-year term. As of May 2009, the Company may redeem these securities, in whole or in part, at par value at any scheduled quarterly interest payment date. As of December 31, 2010, none of these preferred securities have been redeemed.
The Company’s investment of $0.9 million in the Issuer Trust is carried at cost in “Other assets” in the Company’s Consolidated Balance Sheets. The sole asset of the Issuer Trust consists of a $30.9 million junior subordinated debenture issued by the Company to the Issuer Trust. Due to the underlying characteristics of this debt, the carrying value of the debenture approximates its estimated fair value.
The Company has also guaranteed the dividend payments and redemption of the preferred securities issued by the Issuer Trust. The maximum amount of undiscounted future payments the Company could make under the guarantee is approximately $55.7 million, consisting of annual dividend payments of approximately $1.1 million until maturity and the redemption value of the preferred securities of $30.0 million. Because payment under the guarantee would only be required if the Company does not fulfill its obligations under the debentures held by the Issuer Trust, the Company has not recorded any additional liabilities related to this guarantee.
The junior subordinated debenture bears interest at a rate of LIBOR plus 337.5 basis points and matures in April 2034. As of December 31, 2010 and 2009, the interest rate on the junior subordinated debenture was 3.66% and 3.65%, respectively.
The Company does not have any material off-balance sheet arrangements as defined by Item 303 of Regulation S-K under the Securities Act of 1933 and the Securities Exchange Act of 1934.
A summary of the Company’s contractual obligations as of December 31, 2010 is presented in the following table:
(a)
Reflects expected principal and interest payments.
(b)
Reflects unfunded postretirement benefit plans and long-term incentive plan payments to certain executives.
In addition to the operating lease obligations included in the table above, on September 21, 2010, CNA Surety entered into a lease agreement for a new property to be occupied following the 2012 expiration of the lease for its primary processing and service center in Sioux Falls, South Dakota. The new lease includes various contingencies including completion of construction of the building and office space to be occupied. The lease term shall be ten years from its commencement date as defined in the agreement. Other specific lease terms such as final rental square feet and cost will be finalized upon satisfaction of the required contingencies.
As an insurance holding company, CNA Surety is dependent upon dividends and other permitted payments from its insurance subsidiaries to pay operating expenses and meet debt service requirements, as well as to potentially pay cash dividends. The payment of dividends by the insurance subsidiaries is subject to varying degrees of supervision by the insurance regulatory authorities in the insurance subsidiaries’ states of domicile. Western Surety, Surety Bonding Company of America (“Surety Bonding”) and Universal Surety of America (“Universal Surety”) are domiciled in South Dakota. In South Dakota, insurance companies may only pay dividends from earned surplus excluding surplus arising from unrealized capital gains or revaluation of assets. The insurance subsidiaries may pay dividends without obtaining prior regulatory approval only if such dividend or distribution (together with dividends or distributions made within the preceding 12-month period) is less than, as of the end of the immediately preceding year, the greater of (i) 10% of the insurer’s surplus to policyholders or (ii) statutory net income. In South Dakota, net income includes net realized capital gains in an amount not to exceed 20% of net unrealized capital gains. All dividends must be reported to the South Dakota Division of Insurance prior to payment.
The dividends that may be paid without prior regulatory approval are determined by formulas established by the applicable insurance regulations, as described above. The formulas that determine dividend capacity in the current year are dependent on, among other items, the prior year’s ending statutory surplus and statutory net income. Dividend capacity for 2011 is based on statutory surplus and income at and for the year ended December 31, 2010. Without prior regulatory approval in 2011, Western Surety may pay dividends of $140.2 million to CNA Surety. CNA Surety received no dividends from its insurance subsidiaries in 2010. CNA Surety received dividends of $5.0 million and $3.0 million from its insurance subsidiaries during 2009 and 2008, respectively. CNA Surety received dividends of $0.5 million from its non-insurance subsidiaries during 2010. CNA Surety did not receive any dividends from its non-insurance subsidiaries during 2009 and 2008.
Combined statutory surplus totaled $825.6 million at December 31, 2010, resulting in a net written premium to statutory surplus ratio of 0.5 to 1. Insurance regulations restrict the insurance subsidiaries’ maximum net retention on a single surety bond to 10 percent of statutory surplus. Under the 2011 Excess of Loss Treaty, the Company’s net retention on new bonds would generally be $15 million plus a 5% co-participation in the $90 million layer of excess reinsurance above the Company’s retention. Based on statutory surplus as of December 31, 2010, this regulation would limit Western Surety’s largest gross risk to $168.1 million. This surplus requirement may limit the amount of future dividends Western Surety could otherwise pay to CNA Surety.
In accordance with the provisions of intercompany tax sharing agreements between CNA Surety and its subsidiaries, the income tax of each subsidiary shall be determined based upon each subsidiary’s separate return
liability. Intercompany tax payments are made at such times when estimated tax payments would be required by the Internal Revenue Service. CNA Surety received tax-sharing payments of $61.9 million from its subsidiaries for 2010, $41.3 million for 2009 and $48.6 million for 2008.
Western Surety and Surety Bonding each qualify as an acceptable surety for federal and other public works project bonds pursuant to U.S. Department of Treasury regulations. U.S. Treasury underwriting limitations, the maximum net retention on a single federal surety bond, are based on an insurer’s statutory surplus. Effective July 1, 2009 through June 30, 2010, the underwriting limitations of Western Surety and Surety Bonding were $54.7 million and $0.7 million, respectively. Effective July 1, 2010 through June 30, 2011, the underwriting limitations of Western Surety and Surety Bonding are $67.1 million and $0.8 million, respectively. Through the Quota Share Treaty previously discussed, CNA Surety has access to CCC and its affiliates’ U.S. Department of Treasury underwriting limitations. Effective July 1, 2010 through June 30, 2011, the underwriting limitations of CCC and its affiliates utilized under the Quota Share Treaty total $892.1 million. CNA Surety management believes that the foregoing U.S. Treasury underwriting limitations are sufficient for the conduct of its business.
CNA Surety management believes that the Company has sufficient available resources, including capital protection against large losses provided by the Company’s excess of loss reinsurance arrangements, to meet its present capital needs.
Insurance Regulation and Supervision
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, however, they may be performed by any jurisdiction in which the insurer transacts business. During 2008, the South Dakota Division of Insurance began its financial examination of Western Surety, Surety Bonding and Universal Surety as of and for the period January 1, 2004 through December 31, 2008. The final financial examination report was filed with the South Dakota Division of Insurance on December 11, 2009. On January 13, 2010, the Company was notified that the final examination report was adopted by the Director of the South Dakota Division of Insurance as filed. No adverse findings were included in the final examination report.
Financial Condition
Investment Portfolio
The following table summarizes the distribution of the Company’s fixed income and equity portfolios at estimated fair values as of December 31, 2010 and 2009 (dollars in thousands):
The Company’s investment portfolio generally is managed to maximize after-tax investment return, while minimizing credit risk with investments concentrated in high-quality income securities. CNA Surety’s portfolio is managed to provide diversification by limiting exposures to any one industry, issue or issuer, and to provide liquidity by investing in the public securities markets. The portfolio is structured to support CNA Surety’s insurance underwriting operations and to consider the expected duration of liabilities and short-term cash needs. In achieving these goals, assets may be sold to take advantage of market conditions or other investment opportunities or regulatory, credit and tax considerations. These activities will produce realized gains and losses.
The amortized cost, gross unrealized gains, gross unrealized losses, estimated fair value and unrealized OTTI losses of fixed income securities and the cost, gross unrealized gains, gross unrealized losses and estimated fair value of equity securities held by CNA Surety at December 31, 2010, by investment category, were as follows (dollars in thousands):
(a)
The unrealized loss position of this security was $0.3 million at December 31, 2010.
The amortized cost, gross unrealized gains, gross unrealized losses, estimated fair value and unrealized OTTI losses of fixed income securities and the cost, gross unrealized gains, gross unrealized losses and estimated fair value of equity securities held by CNA Surety at December 31, 2009, by investment category, were as follows (dollars in thousands):
(a)
The unrealized loss position of this security was $0.5 million at December 31, 2009.
Invested assets are exposed to various risks, such as interest rate, market and credit. Due to the level of risk associated with certain of these invested assets and the level of uncertainty related to changes in the value of these assets, it is possible that changes in risks in the near term may significantly affect the amounts reported in the Consolidated Balance Sheets and Consolidated Statements of Income. The Company’s Quantitative and Qualitative Disclosures about Market Risk is contained in Item 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
CNA Surety’s investment portfolio is subject to economic losses due to adverse changes in the fair value of its financial instruments, or market risk. Interest rate risk represents the largest market risk factor affecting the Company’s consolidated financial condition due to its significant level of investments in fixed income securities. Increases and decreases in prevailing interest rates generally translate into decreases and increases in the fair value of the Company’s fixed income portfolio. The fair value of these interest rate sensitive instruments may also be affected by the credit-worthiness of the issuer, prepayment options, relative value of alternative investments, the liquidity of the instrument, income tax considerations and general market conditions. The Company manages its exposure to interest rate risk primarily through an asset/liability matching strategy. The Company’s exposure to interest rate risk is mitigated by the relative short-term nature of its insurance and other liabilities. The targeted effective duration of the Company’s investment portfolio is approximately 5, consistent with the expected duration of its insurance and other liabilities.
The tables below summarize the estimated effects of certain hypothetical changes in interest rates. It is assumed that the changes occur immediately and uniformly across each investment category. The selected hypothetical changes in market interest rates reflect the Company’s expectations of the reasonably possible scenarios over a one-year period and the hypothetical fair values are based upon the same prepayment assumptions that were utilized in computing fair values at December 31, 2010 and December 31, 2009. Significant variations in market interest rates could produce changes in the timing of repayments due to prepayment options available. The fair value of such instruments could be affected and therefore actual results might differ from those reflected in the following tables.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders of
CNA Surety Corporation
Chicago, Illinois
We have audited the internal control over financial reporting of CNA Surety Corporation and subsidiaries (the “Company”) as of December 31, 2010, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedules as of and for the year ended December 31, 2010 of the Company and our report dated February 18, 2011 expressed an unqualified opinion on those financial statements and financial statement schedules and included an explanatory paragraph relating to a change in method of accounting for the recognition and presentation of other-than-temporary impairments in 2009.
/s/ Deloitte & Touche LLP
Chicago, Illinois
February 18, 2011
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The management of CNA Surety Corporation and subsidiaries (“CNA Surety” or the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting. CNA Surety’s internal control system was designed to provide reasonable assurance to the Company’s management, its Audit Committee and Board of Directors regarding the preparation and fair presentation of published financial statements.
There are inherent limitations to the effectiveness of any internal control or system of control, however well designed, including the possibility of human error and the possible circumvention or overriding of such controls or systems. Moreover, because of changing conditions the reliability of internal controls may vary over time. As a result, even effective internal controls can provide no more than reasonable assurance with respect to the accuracy and completeness of financial statements and their process of preparation.
CNA Surety management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2010. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control - Integrated Framework. Based on our assessment we believe that, as of December 31, 2010, the Company’s internal control over financial reporting is effective based on those criteria.
CNA Surety’s independent registered public accounting firm, Deloitte & Touche LLP, has issued an audit report covering the Company’s internal control over financial reporting. Their report appears immediately prior to this Management’s Report on Internal Control Over Financial Reporting as the first item of Item 8, Financial Statements and Supplementary Data of this Form 10-K.
CNA Surety Corporation
Chicago, Illinois
February 18, 2011
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders of
CNA Surety Corporation
Chicago, Illinois
We have audited the accompanying consolidated balance sheets of CNA Surety Corporation and subsidiaries (the “Company”) as of December 31, 2010 and December 31, 2009, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2010. Our audits also included the financial statement schedules listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of CNA Surety Corporation and subsidiaries as of December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2010, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for the recognition and presentation of other-than-temporary impairments in 2009.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2010, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 18, 2011 expressed an unqualified opinion on the Company’s internal control over financial reporting.
/s/ Deloitte & Touche LLP
Chicago, Illinois
February 18, 2011
CNA SURETY CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these consolidated financial statements.
CNA SURETY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
The accompanying notes are an integral part of these consolidated financial statements.
CNA SURETY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
The accompanying notes are an integral part of these consolidated financial statements.
CNA SURETY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these consolidated financial statements.
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1.
Significant Accounting Policies
Formation of CNA Surety Corporation and Merger
In December 1996, CNA Financial Corporation (“CNAF”) and Capsure Holdings Corp. (“Capsure”) agreed to merge (the “Merger”) the surety business of CNAF with Capsure’s insurance subsidiaries, Western Surety Company (“Western Surety”), Surety Bonding Company of America (“Surety Bonding”) and Universal Surety of America (“Universal Surety”), into CNA Surety Corporation (“CNA Surety” or the “Company”). CNAF, through its operating subsidiaries, writes multiple lines of property and casualty insurance, including surety business that is reinsured by Western Surety. 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”). Through its insurance subsidiaries, CNAF owns approximately 61% of the outstanding common stock of CNA Surety. Loews Corporation owns approximately 90% of the outstanding common stock of CNAF.
CNAF Proposal
In October 2010, the Company received an unsolicited proposal from CNAF to acquire all of the outstanding shares of common stock that are not currently owned by subsidiaries of CNAF at a purchase price of $22.00 per share in cash (the “CNAF Proposal”). The Company’s Board of Directors appointed a special committee (the “Special Committee”), comprised solely of the Company’s three independent directors, to review and evaluate the CNAF Proposal. The Special Committee retained both legal and financial advisors to assist in their consideration of the CNAF Proposal. During 2010, the Company incurred expenses of $1.5 million directly related to the consideration of the proposal. These expenses are shown as “Other expense” in the Consolidated Statements of Income.
CNAF Proposal - Subsequent Event
On February 4, 201l, the Special Committee announced that it does not support the terms of the proposal and advised CNAF that it is open to alternate proposals.
Principles of Consolidation
The Consolidated Financial Statements include the accounts of CNA Surety and all majority-owned subsidiaries.
Estimates
The preparation of financial statements in conformity with generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Investments
Management believes the Company has the ability to hold all fixed income securities to maturity. However, the Company may dispose of securities prior to their scheduled maturity due to changes in interest rates, prepayments, tax and credit considerations, liquidity or regulatory capital requirements or other similar factors. As a result, the Company considers all of its fixed income securities (bonds) and equity securities as available-for-sale, and as such, they are carried at fair value.
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
All securities transactions are recorded on the trade date. Investment gains or losses realized on the sale of securities are determined using the first-in, first-out method. Cash flows from purchases, sales and maturities of fixed income and equity securities are reported gross in the investing activities section of the Consolidated Statements of Cash Flows.
The amortized cost of fixed income securities is determined based on cost, adjustments for previously recorded other-than-temporary impairment (“OTTI”) losses and the cumulative effect of amortization of premiums and accretion of discounts using the interest method. Such amortization and accretion are included in net investment income in the Consolidated Statements of Income. For mortgage-backed and asset-backed securities, the Company considers estimates of future prepayments in the calculation of the effective yield used to apply the interest method. If a difference arises between the anticipated prepayments and the actual prepayments, the Company recalculates the effective yield based on actual prepayments and the currently anticipated future prepayments. The amortized costs of such securities are adjusted to the amount that would have resulted had the recalculated effective yields been applied since the acquisition of the securities with a corresponding charge or credit to net investment income in the Consolidated Statements of Income. Prepayment estimates are based on the structural elements of specific securities, interest rates and generally recognized prepayment speed indices.
In April 2009, the Financial Accounting Standards Board (“FASB”) issued updated accounting guidance, which amended the OTTI loss model for fixed income securities. A fixed income security is impaired if the fair value of the security is less than its amortized cost basis, which is its cost adjusted for accretion, amortization and previously recorded OTTI losses. The updated accounting guidance requires an OTTI loss equal to the difference between fair value and amortized cost to be recognized in earnings if the Company intends to sell the fixed income security or if it is more likely than not that the Company will be required to sell the fixed income security before recovery of its amortized cost basis.
The remaining fixed income securities in an unrealized loss position are evaluated to determine if a credit loss exists. If the Company does not expect to recover the entire amortized cost basis of a fixed income security, the security is deemed to be other-than-temporarily impaired for credit reasons. For these securities, the bifurcation of OTTI losses into a credit component and a non-credit component is required by the updated accounting guidance. The credit component is recognized in earnings and represents the difference between the present value of the future cash flows that the Company expects to collect and a fixed income security’s amortized cost basis. The non-credit component is recognized in other comprehensive income and represents the difference between fair value and the present value of the future cash flows that the Company expects to collect.
Prior to the adoption of the updated accounting guidance, OTTI losses were not bifurcated between credit and non-credit components. The difference between fair value and amortized cost was recognized in earnings for all securities for which the Company did not expect to recover the amortized cost basis, or for which the Company did not have the ability and intent to hold until recovery of fair value to amortized cost.
Short-term investments, that generally include U.S. Treasury bills, corporate notes, money market funds and investment grade commercial paper equivalents, are carried at amortized cost which approximates fair value.
Deferred Policy Acquisition Costs
Policy acquisition costs, consisting of commissions, premium taxes and other underwriting expenses which vary with, and are primarily related to, the production of business, net of reinsurance commissions, are deferred and amortized as a charge to income as the related premiums are earned. The Company tests that deferred policy acquisition costs are recoverable based on the expected profitability embedded in the reserve for unearned premium. If the expected profitability is less than the balance of deferred policy acquisition costs, a charge to income is taken and the deferred policy acquisition cost balance is reduced to the amount determined to be recoverable. Anticipated investment income is considered in the determination of the recoverability of deferred policy acquisition costs.
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Intangible Assets
CNA Surety’s Consolidated Balance Sheet as of December 31, 2010 includes intangible assets of $138.8 million, comprised of $122.7 million of goodwill and $16.1 million of identified intangibles with indefinite useful lives arising from the acquisition of Capsure. The Company performs impairment tests of these intangible assets annually, or when certain conditions are present.
A significant amount of judgment is required in performing intangible assets impairment tests. Such tests include periodically determining or reviewing the estimated fair value of CNA Surety’s reporting units. Under the relevant standard, fair value of a reporting unit refers to the price that would be received to sell the reporting unit as a whole in an orderly transaction between market participants. There are several methods of estimating fair value, including market quotations, asset and liability fair values and other valuation techniques, such as discounted cash flows and multiples of earnings or revenues. The Company uses a valuation technique based on discounted cash flows. Significant inputs to the Company’s discounted cash flow model include estimated capital requirements to support the business, expected cash flows from underwriting activity, required capital reinvestment to support growth and the selected discount rates. If the carrying amount of a reporting unit, including goodwill and other intangible assets, exceeds the estimated fair value, then individual assets, including identifiable intangible assets, and liabilities of the reporting unit are estimated at fair value. The excess of the estimated fair value of the reporting unit over the estimated fair value of net assets would establish the implied value of intangible assets. The excess of the recorded amount of intangible assets over the implied value of intangible assets is recorded as an impairment loss.
The Company used a valuation technique based on discounted cash flows to complete its annual intangible asset impairment test as of October 1, 2010. No impairment was indicated. The Company also evaluated the indefinite-lived intangible and determined that no events or circumstances have occurred that warrant a re-categorization of this intangible to a finite-lived intangible.
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, including provisions for losses in excess of the current case reserve for previously reported claims and for claims that may be reopened, as well as offsets for anticipated indemnification recoveries and (c) future expenses to be incurred in the settlement of claims, before reinsurance recoveries, which are reported as an asset. These estimates are determined based on the facts and circumstances of each claim and the Company’s loss experience as well as consideration of industry experience, current trends and conditions. The estimated liability for unpaid losses and loss adjustment expenses is an estimate and there is the potential that actual future loss payments will differ significantly from recorded amounts. The methods of determining such estimates and the resulting estimated liability are regularly reviewed and updated. Changes in the estimated liability are reflected in income in the period in which such changes are determined to be needed.
Insurance Premiums
Insurance premiums are recognized as revenue ratably over the term of the related policies in proportion to the insurance protection provided. Contract bonds provide coverage for the length of the bonded project and not a fixed time period. As such, the Company uses estimates of the contract length as the basis for recognizing premium revenue on these bonds. Premium revenues are net of amounts ceded to reinsurers. Unearned premiums represent the portion of premiums written, before ceded reinsurance which is shown as an asset, applicable to the unexpired terms of policies in force determined on a pro rata basis.
Insurance premium receivables do not include financing costs or other fees and are presented net of an estimated allowance for doubtful accounts. This allowance is based on a periodic evaluation of the aging and
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
collectibility of premium receivables. Premium receivables and any related allowance are written off after collection efforts have been exhausted.
Reinsurance
The Company assumes and cedes insurance with other insurers and reinsurers to limit maximum loss, provide greater diversification of risk, minimize exposure on larger risks and to meet certain regulatory restrictions that would otherwise limit the size of bonds the Company can write. Premiums and losses and loss adjustment expenses that are ceded under reinsurance arrangements reduce the respective revenues and expenses. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy and are reported as reinsurance receivables. Reinsurance receivables include unpaid amounts related to paid losses and loss adjustment expenses. These amounts are considered past due based on the reinsurance contract terms. The Company evaluates the financial condition of its reinsurers, monitors concentrations of credit risk and establishes allowances for uncollectible amounts when indicated.
Stock-Based Compensation
The Company measures and records stock-based compensation expense using a fair-value based method. The Company applies the alternative transition method in calculating its pool of excess tax benefits available to absorb future tax deficiencies and accounts for graded vesting using the accelerated method.
Income Taxes
The Company accounts for income taxes under the liability method. Under the liability method, deferred income taxes are established for the future tax effects of temporary differences between the tax and financial reporting bases of assets and liabilities using currently enacted tax rates. Such temporary differences primarily relate to unearned premium reserves, deferred policy acquisition costs and net unrealized gains/losses on securities. The effect on deferred taxes of a change in tax rates is recognized in income in the period of enactment. Future tax benefits are recognized to the extent that realization of such benefits are more likely than not.
Effective in 2007, the Company adopted guidance which prescribed a comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return. The Company has elected to classify interest, if any, recognized in accordance with this guidance as interest expense. Likewise, penalties, if any, recognized in accordance with this guidance will be classified as miscellaneous expense.
Property and Equipment
Property and equipment are carried at cost less accumulated depreciation. The Company records depreciation using the straight-line method based on the estimated useful lives of the various classes of property and equipment ranging from 3 years to 20 years. Depreciation and amortization expense for 2010, 2009 and 2008 was $6.2 million, $6.0 million and $5.7 million, respectively. The cost of maintenance and repairs is charged to income as incurred; major improvements are capitalized.
Earnings Per Share
Basic earnings per common share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per common share is computed based on the weighted average number of shares outstanding plus the dilutive effect of common stock equivalents which is computed using the treasury stock method.
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The computation of earnings per share is as follows (amounts in thousands, except for per share data):
No adjustments were made to reported net income in the computation of earnings per share. Options to purchase shares of common stock of 0.4 million, 0.7 million and 0.6 million for the years ending December 31, 2010, 2009 and 2008, respectively, were excluded from the calculation of diluted earnings per share because the exercise price of the options was greater than the average market price of CNA Surety’s common stock.
Adopted Accounting Pronouncements
In June 2009, the FASB issued Accounting Standards Update (“ASU”) No. 2009-16, “Transfers and Servicing (Topic 860) - Accounting for Transfers of Financial Assets.” This guidance removed the concept of a qualifying special-purpose entity and eliminated it from exceptions under the guidance for consolidation of variable interest entities. It also modified the de-recognition conditions related to legal isolation and effective control and added additional disclosure requirements for transfers of financial assets. This guidance was effective for annual reporting periods beginning after November 15, 2009. The adoption of this guidance did not have an impact on the Company’s financial condition or results of operations.
In June 2009, the FASB issued ASU No. 2009-17, “Consolidations (Topic 810) - Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities.” This guidance amended existing consolidation guidance applicable for variable interest entities as well as requirements for determination of the primary beneficiary of a variable interest entity, required an ongoing assessment of whether an entity is the primary beneficiary and required enhanced disclosures that will provide users of financial statements information regarding an enterprise’s involvement in a variable interest entity. This guidance was effective for annual reporting periods beginning after November 15, 2009. The Company evaluated its trust preferred security arrangement discussed further in Note 3., Debt, to these Consolidated Financial Statements and determined the issuer trust should remain unconsolidated under this guidance. As such, the adoption of this guidance did not have an impact on the Company’s financial condition or results of operations.
Pending Accounting Pronouncements
In October 2010, the FASB issued ASU No. 2010-26, “Financial Services - Insurance (Topic 944) - Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts.” This updated accounting guidance modifies the definition of the types of costs incurred to acquire or renew insurance contracts that may be capitalized. Under the new guidance, these costs include those costs that are incremental direct costs and certain costs that are directly related to successful contract acquisitions. This accounting guidance is effective for fiscal years, and interim periods within those
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
fiscal years, beginning after December 15, 2011 with prospective or retrospective application allowed. The Company is currently assessing the available application methods as well as the impact this accounting guidance will have on its financial condition and results of operations.
In December 2010, the FASB issued ASU No. 2010-28, “Intangibles - Goodwill and Other (Topic 350) - When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts.” This guidance clarifies application of Step 2 of the goodwill impairment tests. When Step 1 of the goodwill impairment test results in a zero or negative amount, some entities had concluded that Step 2 of the test was unnecessary because the fair value of their reporting unit would be greater than zero. The guidance requires an entity to perform Step 2 if it is more likely than not that an impairment exists. This accounting guidance is effective for fiscal years beginning after December 15, 2010. The Company does not expect the adoption of this guidance to have an impact on the Company’s financial condition or results of operations.
2.
Investments
Major categories of net investment income were as follows (dollars in thousands):
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Net realized investment gains and losses and the net change in unrealized gains and losses of available-for-sale securities were as follows (dollars in thousands):
Net realized investment gains were $1.1 million for 2010. Realized gains on sales of fixed income securities were partially offset by the recognition of additional other-than-temporary impairment losses on a fixed income security for which OTTI losses were first recognized in 2009. The OTTI losses on this security and OTTI losses on equity securities related to the Company’s nonqualified deferred compensation plan partially offset realized gains on sales of fixed income securities resulting in net realized investment gains of $1.2 million for 2009. Net realized investment losses were $1.4 million for 2008 due to the recognition of an OTTI loss on a fixed income security and OTTI losses on equity securities related to the Company’s nonqualified deferred compensation plan.
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The amortized cost, gross unrealized gains, gross unrealized losses, estimated fair value and unrealized OTTI losses of fixed income securities and the cost, gross unrealized gains, gross unrealized losses and estimated fair value of equity securities held by CNA Surety at December 31, 2010, by investment category, were as follows (dollars in thousands):
(a)
The unrealized loss position of this security was $0.3 million at December 31, 2010.
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The amortized cost, gross unrealized gains, gross unrealized losses, estimated fair value and unrealized OTTI losses of fixed income securities and the cost, gross unrealized gains, gross unrealized losses and estimated fair value of equity securities held by CNA Surety at December 31, 2009, by investment category, were as follows (dollars in thousands):
(a)
The unrealized loss position of this security was $0.5 million at December 31, 2009.
The Company did not hold any non-income producing fixed income securities as of December 31, 2010 or 2009. As of December 31, 2010 and December 31, 2009, no investments in any single issuer exceeded 10% of stockholders’ equity.
A security is in an unrealized loss position, or impaired, if the fair value of the security is less than its amortized cost, which includes adjustments for accretion, amortization and previously recorded other-than-temporary impairment losses. When a security is impaired, the impairment is evaluated to determine whether it is temporary or other-than-temporary.
A significant judgment in the valuation of investments is the determination of when an other-than-temporary decline in value has occurred. The Company follows a consistent and systematic process for identifying securities that sustain other-than-temporary declines in value. The Company has established a watch list that is reviewed by the Chief Financial Officer and one other executive officer on at least a quarterly basis. The watch list includes individual securities that fall below certain thresholds or that exhibit evidence of impairment indicators including, but not limited to, a significant adverse change in the financial condition and near-term prospects of the investment or a significant adverse change in legal factors, the business climate or credit ratings.
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
When a security is placed on the watch list, it is monitored for further market value changes and additional news related to the issuer’s financial condition. The focus is on objective evidence that may influence the evaluation of impairment factors. The decision to record an other-than-temporary impairment loss incorporates both quantitative criteria and qualitative information.
In determining whether an equity security is other-than-temporarily impaired, the Company considers a number of factors including, but not limited to: (a) the length of time and the extent to which the market value has been less than book value, (b) the financial condition and near-term prospects of the issuer, (c) the intent and ability of the Company to retain its investment for a period of time sufficient to allow for any anticipated recovery in value and (d) general market conditions and industry or sector specific factors. Currently, the Company’s equity portfolio is comprised solely of mutual funds related to the Company’s deferred compensation plan, which is an unfunded, nonqualified deferred compensation plan for a select group of management or highly compensated employees. Due to the nature of the plan, the Company does not assert the ability to hold these securities until an anticipated recovery in value. As such, if any of these securities are in an unrealized loss position, they are considered to be other-than-temporarily impaired.
For equity securities for which an other-than-temporary impairment loss has been identified, the security is written down to fair value and the resulting losses are recognized in realized gains/losses in the Consolidated Statements of Income.
Based on the Company’s evaluation of this quantitative criteria and qualitative information, the Company recorded no OTTI losses on equity securities in 2010. In 2009 and 2008, the Company recorded other-than-temporary impairment losses of less than $0.1 million and $0.4 million, respectively, on the equity securities that are related to the Company’s nonqualified deferred compensation plan.
Fixed income securities in an unrealized loss position that the Company intends to sell, or it more likely than not will be required to sell before any anticipated recovery of amortized cost, are considered to be other-than-temporarily impaired. These securities are written down to fair value and the resulting losses are recognized in realized gains/losses in the Consolidated Statements of Income.
The remaining fixed income securities in an unrealized loss position are evaluated to determine if a credit loss exists. To determine if a credit loss exists, the Company considers a number of factors including, but not limited to: (a) the financial condition and near-term prospects of the issuer, (b) credit ratings of the securities, (c) whether the debtor is current on interest and principal payments, (d) the length of time and the extent to which the market value has been less than book value and (e) general market conditions and industry or sector specific factors.
In addition to these factors, the Company considers the results of discounted cash flow modeling using assumptions representative of current market conditions as well as those specific to the Company’s particular security holdings. For asset-backed and mortgage-backed securities, the focus of this analysis is on assessing the sufficiency and quality of underlying collateral and timing of cash flows. Significant assumptions considered by the Company in its cash flow projections include delinquency rates, probable risk of default, over collateralization and credit support from lower level tranches. If the discounted expected cash flows for a security equal or exceed the amortized cost of that security, no credit loss exists and the security is deemed to be temporarily impaired.
Fixed income securities in an unrealized loss position for which management believes a credit loss exists are considered to be other-than-temporarily impaired. For these fixed income securities, the Company bifurcates OTTI losses into a credit component and a non-credit component. The credit component, which represents the difference between the discounted expected cash flows and the fixed income security’s amortized cost, is recognized in earnings. The non-credit component is recognized in other comprehensive income and represents the difference between fair value and the discounted cash flows that the Company expects to collect.
Based on the Company’s evaluation of this quantitative criteria and qualitative information, the Company recorded credit-related OTTI losses of $0.1 million on fixed income securities during 2010. These credit-related
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
OTTI losses were recorded on a security collateralized by sub-prime home loans that is rated below investment grade by Standard & Poor’s (“S&P”). The Company also recorded credit-related OTTI losses of $0.1 million on this security during 2009.
The following table presents a roll-forward of the Company’s cumulative credit losses recognized in net realized gains/losses on the Consolidated Statements of Income on fixed income securities held as of December 31, 2010 (in thousands of dollars):
The following table presents a roll-forward of the Company’s cumulative credit losses recognized in net realized gains/losses on the Consolidated Statements of Income on fixed income securities held as of December 31, 2009 (in thousands of dollars):
In 2008, the Company recorded other-than-temporary impairment losses of $1.0 million on one fixed income security. The security was issued by the financing subsidiary of a large domestic automaker and was rated below investment grade by S&P and Moody’s Investor Services (“Moody’s”). The Company determined that this previously recorded OTTI loss was credit-related.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The amortized cost and estimated fair value of fixed income securities, by contractual maturity, at December 31, 2010 and 2009 are shown below. Actual maturities may differ from contractual maturities as borrowers may have the right to call or prepay obligations with or without call or prepayment penalties (dollars in thousands):
The following table provides the composition of fixed income securities with an unrealized loss at December 31, 2010 in relation to the total of all fixed income securities by contractual maturities:
The following table summarizes for fixed income securities in an unrealized loss position at December 31, 2010 and 2009, the aggregate fair value and gross unrealized loss by length of time those securities have been continuously in an unrealized loss position (dollars in thousands):
(a)
Investment grade is determined by using the S&P rating. If a security is not rated by S&P, the Moody’s rating is used. As of December 31, 2010 and December 31, 2009, all of the Company’s fixed income securities were rated by S&P or Moody’s.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
At December 31, 2010, the Company holds 276 fixed income securities with a total estimated fair value of $1,149.9 million in a gross unrealized gain position of $59.5 million in the aggregate.
The following table summarizes securities in a gross unrealized loss position by investment category and by credit rating. The table also discloses the corresponding count of securities in an unrealized loss position and estimated fair value by category (in thousands of dollars):
(a)
Securities are categorized using the S&P rating. If a security is not rated by S&P, the Moody’s rating is used. At December 31, 2010, all of the Company’s fixed income securities were rated by S&P or Moody’s.
(b)
The unrealized loss on this AAA-rated U.S. Government agency security is negligible and does not result in an amount when rounded to thousands of dollars.
The unrealized losses on the Company’s investments in obligations of states and political subdivisions are due to changes in credit spreads and rising interest rates. Of the thirty-two investment grade obligations of states and political subdivisions in an unrealized loss position at December 31, 2010, only seven were in an unrealized loss position exceeding 5% of the security’s amortized cost. The largest unrealized loss, $0.7 million, or 11.9% of the security’s amortized cost, was on a security issued by a governmental utility authority. The unrealized loss position of this security has deteriorated slightly compared to December 31, 2009 when it was $0.6 million, or 11.3% of the security’s amortized cost. While the overall unrealized loss position of obligations of states and political subdivisions grew from $2.6 million, or 2.9% of their amortized cost, at December 31, 2009 to $5.8 million, or 3.4% of their amortized cost, at December 31, 2010 the Company continues to believe that all interest and principal will be paid according to their contractual terms. The Company has no current intent to sell these securities, nor is it more likely than not that it will be required to sell prior
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
to recovery of amortized cost. The Company does not believe the unrealized losses on these securities are indicative of credit losses and, as such, has not recorded an OTTI loss on these securities at December 31, 2010.
Of the Company’s thirteen investment grade corporate bond investments with an unrealized loss at December 31, 2010, none was in an unrealized loss position that exceeded 5% of the security’s amortized cost. Although interest rate increases in the fourth quarter of 2010 increased the unrealized loss position of these investments, the overall unrealized loss position on the Company’s corporate bond holdings improved $0.3 million at December 31, 2010 compared to December 31, 2009. The Company has no current intent to sell these securities, nor is it more likely than not that it will be required to sell prior to recovery of amortized cost. The Company does not believe the unrealized losses on these securities are indicative of credit losses and, as such, has not recorded any OTTI losses on these securities at December 31, 2010.
Two investment grade asset-backed securities, including one with exposure to sub-prime home loans, held by the Company were in an unrealized loss position at December 31, 2010. Neither of these securities was in an unrealized loss position that exceeded 5% of the security’s amortized cost. The Company has no current intent to sell these securities, nor is it more likely than not that it will be required to sell prior to recovery of amortized cost. The Company does not believe the unrealized losses on these securities are indicative of credit losses and, as such, has not recorded any OTTI losses on these securities at December 31, 2010.
One of the Company’s investments in obligations of states and political subdivisions is rated below investment grade at December 31, 2010 and is in an unrealized loss position of $1.1 million, or 10.0% of its amortized cost. This security, issued by a governmental utility authority, was in an unrealized loss position of $0.9 million, or 8.4% of amortized cost, at December 31, 2009. The Company believes that the security is rated below investment grade because an inconsequential contingency amount is insured with one of the major monoline insurers which is rated B by S&P. The Company believes that this insurer is the lowest rated source of security involved in the transaction and, despite the fact that the amount of security provided by this insurer is inconsequential, the entire transaction is rated to the lowest rated component. Based on the Company’s analysis of the sources of debt service on this bond and the fact that the security is current on all interest payments due through December 31, 2010, the Company continues to believe that all interest and principal will be paid according to their contractual terms. The Company has no current intent to sell this security, nor is it more likely than not that it will be required to sell prior to recovery of amortized cost. The Company does not believe the unrealized loss on this security is indicative of credit loss and, as such, has not recorded an OTTI loss on this security at December 31, 2010.
During 2010, the Company purchased fifteen non-investment grade corporate bonds. These bonds had an estimated fair value of $22.5 million at December 31, 2010. Eight of these securities were in an unrealized loss position at December 31, 2010. In the aggregate, these eight securities had an unrealized loss of $0.1 million as of December 31, 2010. Each of these securities was in an unrealized loss position representing less than 1.2% of that security’s amortized cost. The Company has no current intent to sell these securities, nor is it more likely than not that it will be required to sell prior to recovery of amortized cost. The Company does not believe the unrealized losses on these securities are indicative of credit losses and, as such, has not recorded any OTTI losses on these securities at December 31, 2010.
At December 31, 2010 the Company’s exposure to sub-prime home loans was limited to two asset-backed securities collateralized by sub-prime home loans which originated prior to 2005. The estimated fair value of these securities was $3.5 million at December 31, 2010. Both of these securities are in an unrealized loss position at December 31, 2010. One of these securities was rated below investment grade at December 31, 2010. The investment grade security was discussed previously. The non-investment grade security is in an unrealized loss position of $0.3 million, or 13.4% of its amortized cost. During 2010, the Company received repayments on this security of $0.7 million, or approximately 25% of the par value outstanding at December 31, 2009. As discussed previously, this security was determined to have credit losses totaling $0.1 million during 2010. The non-credit component of this security’s OTTI recognized in accumulated other
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
comprehensive income at December 31, 2010 was $0.2 million. The Company believes the non-credit component of the unrealized loss on this security is primarily attributable to this asset class being out of favor with investors and is not indicative of the quality of the underlying collateral. The Company has no current intent to sell this security, nor is it more likely than not that it will be required to sell prior to recovery of the adjusted amortized cost.
Based on the current facts and circumstances discussed above for the Company’s securities in an unrealized loss position, the Company has determined that no additional OTTI losses related to the securities in an unrealized loss position are required to be recorded at December 31, 2010.
The Company’s insurance subsidiaries, as required by state law, deposit certain securities with state insurance regulatory authorities. At December 31, 2010, securities on deposit had an aggregate estimated fair value of $5.2 million.
Invested assets are exposed to various risks, such as interest rate, market and credit risks. Due to the level of risk associated with certain of these invested assets and the level of uncertainty related to changes in the value of these assets, it is possible that changes in risks in the near term may significantly affect the amounts reported in the Consolidated Balance Sheets and Consolidated Statements of Income.
3.
Debt
In May 2004, the Company, through a wholly-owned trust, privately issued $30.0 million of preferred securities through two pooled transactions. These securities, issued by CNA Surety Capital Trust I (the “Issuer Trust”), bear interest at the London Interbank Offered Rate (“LIBOR”) plus 337.5 basis points with a 30-year term. As of May 2009, the Company may redeem these securities, in whole or in part, at par value at any scheduled quarterly interest payment date. As of December 31, 2010, none of these preferred securities have been redeemed.
The Company’s investment of $0.9 million in the Issuer Trust is carried at cost in “Other assets” in the Company’s Consolidated Balance Sheets. The sole asset of the Issuer Trust consists of a $30.9 million junior subordinated debenture issued by the Company to the Issuer Trust. Due to the underlying characteristics of this debt, the carrying value of the debenture approximates its estimated fair value.
The Company has also guaranteed the dividend payments and redemption of the preferred securities issued by the Issuer Trust. The maximum amount of undiscounted future payments the Company could make under the guarantee is approximately $55.7 million, consisting of annual dividend payments of approximately $1.1 million until maturity and the redemption value of the preferred securities of $30.0 million. Because payment under the guarantee would only be required if the Company does not fulfill its obligations under the debentures held by the Issuer Trust, the Company has not recorded any additional liabilities related to this guarantee.
The junior subordinated debenture bears interest at a rate of LIBOR plus 337.5 basis points and matures in April 2034. As of December 31, 2010 and 2009, the interest rate on the junior subordinated debenture was 3.66% and 3.65%, respectively.
4.
Fair Value of Financial Instruments
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Company uses the following fair value hierarchy in selecting inputs, with the highest priority given to Level 1, as these are the most transparent or reliable:
•
Level 1 - Quoted prices for identical instruments in active markets.
•
Level 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs are observable in active markets.
•
Level 3 - Valuations derived from valuation techniques in which one or more significant inputs are unobservable.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company utilizes a pricing service for the valuation of the majority of securities held. This pricing service is an independent, third party vendor recognized to be an industry leader with access to market information who obtains or computes fair market values from quoted market prices, pricing for similar securities, recently executed transactions, cash flow models with yield curves and other pricing models. For valuations obtained from the pricing service, the Company performs due diligence to understand how the valuation was calculated or derived, focusing on the valuation technique used and the nature of the inputs.
The following section describes the valuation methodologies used to measure different financial instruments at fair value, including an indication of the level in the fair value hierarchy in which the instrument is generally classified.
Fixed Income Securities
Securities valued using Level 1 inputs include highly liquid government bonds for which quoted market prices are available. Securities using Level 2 inputs are valued using pricing for similar securities, recently executed transactions, cash flow models with yield curves and other pricing models utilizing observable inputs. Most fixed income securities are valued using Level 2 inputs. Level 2 includes corporate bonds, municipal bonds, asset-backed securities and mortgage pass-through securities.
Equity Securities
Level 1 includes publicly traded securities valued using quoted market prices.
Short-Term Investments
The valuation of securities that are actively traded and have quoted prices are classified as Level 1. These securities include money market funds and U.S. Treasury bills. Level 2 includes commercial paper, for which all significant inputs are observable.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Assets measured at fair value on a recurring basis as of December 31, 2010 and December 31, 2009 are summarized below (dollars in thousands):
(a)
Includes commercial paper, U.S. Government agency discount notes and money market funds.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
(a)
Includes commercial paper, U.S. Government agency discount notes and money market funds.
5.
Deferred Policy Acquisition Costs and Other Operating Expenses
Policy acquisition costs deferred and the related amortization of deferred policy acquisition costs were as follows (dollars in thousands):
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Net commissions, brokerage and other underwriting expenses were comprised as follows (dollars in thousands):
6.
Reinsurance
The Company’s insurance subsidiaries, in the ordinary course of business, cede insurance to other insurance companies and affiliates. Reinsurance arrangements are used to limit maximum loss, provide greater diversification of risk, minimize exposure on larger risks and to meet certain regulatory restrictions that would otherwise limit the size of bonds the Company can write. Reinsurance contracts do not relieve the Company of its primary obligations to claimants. Therefore, a contingent liability exists with respect to insurance ceded to the extent that any reinsurer is unable to meet the obligations assumed under the reinsurance contracts. The Company evaluates the financial condition of its reinsurers, assesses the need for allowances for uncollectible amounts and monitors concentrations of credit risk.
There were no amounts past due under reinsurance contracts and no allowances were established for uncollectible reinsurance receivables at December 31, 2010 or 2009. At both December 31, 2010 and 2009, receivables from five reinsurers individually comprised 10% or more of the Company’s reinsurance receivable balance. At December 31, 2010, these receivables, $7.8 million, $5.6 million, $5.5 million, $4.6 million and $4.2 million, respectively, were from non-affiliated reinsurers rated at least A (Excellent) by A.M. Best. At December 31, 2009, these receivables, $9.0 million, $7.6 million, $6.8 million, $6.1 million and $5.8 million, respectively, were also due from non-affiliated reinsurers rated at least A by A.M. Best. At December 31, 2010 and 2009, CNA Surety had no reinsurance receivable from affiliates.
The effect of reinsurance on premiums written and earned was as follows (dollars in thousands):
Assumed premiums primarily include surety business written or renewed, net of reinsurance, by CCC and CIC after September 30, 1997 that is reinsured by Western Surety pursuant to reinsurance and related agreements. Because of certain regulatory restrictions that limit Western Surety’s ability to write certain business on a direct basis, the Company utilizes the underwriting capacity available through these agreements while retaining control of the underwriting and claim management of the assumed business.
Assumed premium also includes surety business written by another affiliate, First Insurance Company of Hawaii, Ltd. and its subsidiaries First Indemnity Insurance of Hawaii, Inc., First Fire and Casualty Insurance of Hawaii, Inc. and First Security Insurance of Hawaii, Inc. (collectively, “FICOH”). Through its insurance subsidiaries, CNAF owns approximately 50% of the outstanding common stock of First Insurance Company of Hawaii, Ltd. Under the terms of this excess of loss agreement effective January 1, 2010 through December 31, 2010 that covers certain contract surety business, FICOH retains losses of $2 million per principal and Western Surety
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
assumes 80% of $5 million per principal in excess of $2 million subject to an aggregate annual limit of $8 million. Premiums assumed by Western Surety under this agreement were $0.1 million for 2010 and 2009. In 2008, premiums assumed by Western Surety under this agreement were $0.2 million. This treaty was renewed with the same terms on January 1, 2011 and expires on December 31, 2011.
CNA Surety also assumes premium on contract and commercial surety bonds for international risks. Such premiums are assumed pursuant to the terms of reinsurance treaties or as a result of specific international bond requirements of domestic customers. For the years ended December 31, 2010, 2009 and 2008, assumed premiums written under such arrangements were $4.3 million, $2.4 million and $2.1 million, respectively.
The effect of reinsurance on the Company’s provision for losses and loss adjustment expenses and the corresponding ratio to earned premium was as follows (dollars in thousands):
The unusual relationship in the gross and ceded amounts shown above for the year ended December 31, 2010 resulted from adjustments to the estimated loss and loss adjustment expense reserves during the year ended December 31, 2010. The Company reduced gross reserves related to prior accident years by $92.5 million reflecting changes in estimates of incurred-but-not-reported reserves. The corresponding change in ceded reserves was such that net reserves related to prior accident years were reduced by $76.3 million for the year ended December 31, 2010.
Excess of Loss Reinsurance
The Company’s ceded reinsurance program is predominantly comprised of excess of loss reinsurance contracts that limit the Company’s retention on a per principal basis. The Company’s reinsurance coverage is provided by third party reinsurers and related parties. Due to the terms of these excess of loss treaties, reinsurers may cover some principals in one year but then exclude these same principals in subsequent years. As a result, the Company may have exposures to these principals that have limited or no reinsurance coverage.
Third Party Reinsurance
Effective January 1, 2009, CNA Surety entered into an excess of loss treaty (“2009 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the excess of loss treaty effective in 2008. Under the 2009 Excess of Loss Treaty, the Company’s net retention per principal was $15 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company’s retention. The contract provided aggregate coverage of $185 million and included an optional extended discovery period, which was not exercised. The contract also included a provision for additional premiums of up to $13.8 million based on losses ceded under the contract. The actual ceded premiums for the 2009 Excess of Loss Treaty were $26.6 million.
Third Party Reinsurance
Effective January 1, 2010, CNA Surety entered into an excess of loss treaty (“2010 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the 2009 Excess of Loss Treaty. Under the 2010 Excess of Loss Treaty, the Company’s net retention per principal was $15 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company’s retention. The contract provided
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
aggregate coverage of $185 million and included an optional extended discovery period, which was not exercised. The contract also included a provision for additional premiums of up to $12.3 million based on losses ceded under the contract. The actual ceded premiums for the 2010 Excess of Loss Treaty were $23.7 million.
Third Party Reinsurance
Effective January 1, 2011, CNA Surety entered into an excess of loss treaty (“2011 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the 2010 Excess of Loss Treaty. Under the 2011 Excess of Loss Treaty, the Company’s net retention per principal remains at $15 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company’s retention. The contract provides aggregate coverage of $185 million and includes an optional extended discovery period, for an additional premium (a percentage of the original premium based on any unexhausted aggregate limit by layer), which will provide coverage for losses discovered beyond 2011 on bonds that were in force during 2011. The contract also includes a provision for additional premiums of up to $10.7 million based on losses ceded under the contract. The base annual premium for the 2011 Excess of Loss Treaty is $21.7 million.
Related Party Reinsurance
Reinsurance agreements together with the Services and Indemnity Agreement described below provide for the transfer of the surety business written by CCC and CIC to Western Surety. Many of these agreements originally were entered into on September 30, 1997 (the “Merger Date”) and include: (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. Although the contracts entered on the Merger Date have expired, some have been renewed on different terms as described below.
Through the Quota Share Treaty, CCC and CIC transfer to Western Surety surety business written or renewed by CCC and CIC after the Merger Date. The Quota Share Treaty was renewed on January 1, 2010 and expired on December 31, 2010. The Quota Share treaty was renewed on substantially the same terms on January 1, 2011 and expires on December 31, 2011 and is annually renewable thereafter. CCC and CIC transfer the related liabilities of such business and pay to Western Surety an amount in cash equal to CCC’s and CIC’s net written premiums written on all such business, minus a quarterly ceding commission to be retained by CCC and CIC equal to $50,000 plus 25% of net written premiums written on all such business. For 2010 and 2009 this resulted in an override commission on their actual direct acquisition costs of 4.7% and 4.8%, respectively, to CCC and CIC.
Under the terms of the Quota Share Treaty, CCC has guaranteed the loss and loss adjustment expense reserves transferred to Western Surety as of the Merger Date by agreeing to pay Western Surety, within 30 days following the end of each calendar quarter, the amount of any adverse development on such reserves, as re-estimated as of the end of such calendar quarter. There was no adverse reserve development for the period from the Merger Date through December 31, 2010.
Through the Stop Loss Contract, the Company’s insurance subsidiaries were protected from adverse loss development on certain business underwritten after the Merger Date. The Stop Loss Contract between the Company’s insurance subsidiaries and CCC limited the insurance subsidiaries’ prospective net loss ratios with respect to certain accounts and lines of insured business for three full accident years following the Merger Date. In the event the insurance subsidiaries’ accident year net loss ratio exceeds 24% in any of the accident years 1997 through 2000 on certain insured accounts (the “Loss Ratio Cap”), the Stop Loss Contract requires CCC at the end of each calendar quarter following the Merger Date, to pay to the insurance subsidiaries a dollar amount equal to (i) the amount, if any, by which the Company’s 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 Company’s insurance subsidiaries paid CCC an annual premium of $20,000. The CNA Surety insurance subsidiaries have paid CCC all required annual premiums. Through December 31, 2010, losses incurred under the Stop Loss Contract were $47.2 million. Through December 31, 2009, losses incurred under the Stop Loss
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Contract were $49.1 million. The net amount settled in 2010 under this contract was $1.9 million paid to CCC as a result of favorable development on claims subject to the Stop Loss Contract. At December 31, 2010, the amount received under the Stop Loss Contract included $2.7 million held by the Company for losses covered under this contract that were incurred but not paid.
The Services and Indemnity Agreement provides the Company’s insurance subsidiaries with the authority to perform various administrative, management, underwriting and claim functions in order to conduct the surety business of CCC and CIC and to be reimbursed by CCC for services rendered. In consideration for providing the foregoing services, CCC has agreed to pay Western Surety a quarterly fee of $50,000. In 2009, this agreement was amended so that the Company’s authority to conduct administrative, management, underwriting and claim functions for bonds written for the large national contractor discussed below shall continue until CCC’s bonds for such contractor have expired and claims have been settled or closed. This agreement was renewed on January 1, 2010 and expired on December 31, 2010. As of December 31, 2010 and 2009, there were no amounts due to the CNA Surety insurance subsidiaries under this agreement. This agreement was renewed with the same terms on January 1, 2011 and expires on December 31, 2011 and is annually renewable thereafter.
From January 1, 2005 to June 30, 2009, the Company and CCC were parties to an excess of loss contract, and extensions to that contract, that provided unlimited reinsurance coverage in excess of $60 million retention for the life of bonds either in force or written during the contract periods exclusively for one large national contractor excluded from the Company’s third party reinsurance. Premiums for these contracts totaled $8.6 million and included an initial premium of $7.0 million and premiums of $1.6 million based on the level of premiums written on bonds for the large national contractor.
In 2009, the Company and CCC terminated the excess of loss contract discussed in the preceding paragraph. Related to the termination of this contract, the Company and CCC also commuted the Quota Share Treaty as regards the premium and losses for the large national contractor. The impact of this commutation was a decrease of gross loss reserves of $51.8 million. Under the terms of the agreements effecting this commutation, the Company paid CCC $1.8 million. This settlement reflected the difference between the Company’s $60.0 million retention under the excess of loss contract and the $58.2 million paid by the Company for losses of the large national contractor through 2009.
On January 1, 2010, the Company and CCC entered into separate agreements that provide for the transfer of the Canadian surety business of CCC to Western Surety. These agreements, which include a quota share treaty (the “Canadian Quota Share Treaty”) and a services and indemnity agreement (the “Canadian Services and Indemnity Agreement”), are substantially similar to the Quota Share Treaty and the Services and Indemnity Agreement discussed above. The Canadian Services and Indemnity Agreement provides Western Surety with the authority to supervise various administrative, underwriting and claim functions associated with the surety business written by CCC, through its Canadian branch, on behalf of the Company. Through the Canadian Quota Share Treaty, this Canadian surety business is transferred to Western Surety. Pursuant to these agreements, CCC will transfer the subject premium and related liabilities of such business and pay to Western Surety an amount equal to CCC’s net written premiums on all such business, minus a ceding commission of 33.5% of net written premiums. Further, Western Surety will pay an additional ceding commission to CCC in the amount of actual direct expense in producing such premium. These agreements expired on December 31, 2010. These agreements were renewed with the same terms on January 1, 2011 and expire on December 31, 2011 and are annually renewable thereafter.
As of December 31, 2010 and December 31, 2009, CNA Surety had an insurance receivable balance from CCC and CIC of $10.8 million and $9.8 million, respectively, comprised of premiums receivable. CNA Surety had no reinsurance payables to CCC or CIC as of December 31, 2010 or 2009.
The Company’s Consolidated Balance Sheets also include a “Deposit with affiliated ceding company” of $23.4 million and $26.9 million at December 31, 2010 and December 31, 2009, respectively. In 2005, pursuant to an agreement with the claimant on a bond regarding certain aspects of the claim resolution, the Company deposited
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
$32.7 million with an affiliate to enable the affiliate to establish a trust to fund future payments under the bond. The bond was written by the affiliate and assumed by one of the Company’s insurance subsidiaries pursuant to the Quota Share Treaty. The Company is entitled to the interest income earned by the trust. Prior to the establishment of the trust, the Company had fully reserved its obligation under the bond and the claim remains fully reserved.
7.
Reserves for Losses and Loss Adjustment Expenses
Activity in the reserves for unpaid losses and loss adjustment expenses was as follows (dollars in thousands):
The Company recorded net loss reserve development for prior accident years which resulted in a decrease of the estimated liability of $76.3 million, $54.3 million and $45.5 million in 2010, 2009 and 2008, respectively.
Favorable development in 2010 was primarily related to accident years 2008, 2007 and 2006. Loss experience for the 2007 and 2006 accident years continued to be lower than expected, particularly for large losses.
Beginning in 2008, the Company began recording higher loss provisions for the current accident year in response to the severe deterioration in economic conditions that began in 2008. The results of subsequent actuarial reviews indicated redundancies for accident year 2008, but management believed that the potential impacts of the economic downturn were not fully recognized by the actuarial methodologies and maintained their higher loss estimates. The actuarial review performed in 2010 indicated a larger redundancy for accident year 2008 than at December 31, 2009. At December 31, 2010, management believed that the experience for the 2008 accident year was sufficiently mature to make the actuarial indication credible and adjusted the reserves to the actuarial indication. In retrospect, it appears that this deterioration in economic conditions did not begin to impact loss activity until the 2009 accident year. The Company’s estimates of losses for accident years 2010 and 2009 continue to reflect the impact of the difficult economic conditions.
The favorable development in 2009 resulted primarily from a level of loss activity substantially below expectations for accident years 2006 and 2007. This level of loss activity was particularly influenced by a lower than
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
expected emergence of large claims. Significant case reserve reductions and better than expected indemnification recoveries for accident years 2005 and prior also contributed to the favorable development in 2009. At December 31, 2009, the Company’s initial estimates of losses for accident year 2009 and the estimate for accident year 2008 reflected the impact of less favorable economic conditions.
The favorable development in 2008 primarily resulted from several significant case reserve reductions, favorable indemnity recoveries and a low level of loss activity for accident years 2006 and prior. These favorable developments were somewhat offset by adverse development related to the 2007 accident year, which, along with the initial estimates of the 2008 accident year, reflected the impact of deterioration of economic conditions.
8.
Commitments and Contingencies
At December 31, 2010 the future minimum commitments under operating leases were as follows: 2011 - $2.0 million; 2012 - $1.1 million; 2013 - $0.2 million; 2014 - $0.2 million; 2015 - $0.2 million. Total rental expense was $4.3 million, $5.3 million and $5.2 million for 2010, 2009, and 2008, respectively.
In addition to these operating lease commitments, in September 2010, CNA Surety entered into a lease agreement for a new property to be occupied following the 2012 expiration of the lease for its primary processing and service center in Sioux Falls, South Dakota. The new lease includes various contingencies including completion of construction of the building and office space to be occupied. The lease term shall be ten years from its commencement date as defined in the agreement. Other specific lease terms such as final rental square feet and cost will be finalized upon satisfaction of the required contingencies.
The Company is party to various lawsuits arising in the normal course of business. The Company believes the resolution of these lawsuits will not have a material adverse effect on its financial condition or its results of operations.
9.
Income Taxes
The components of deferred income taxes as of December 31, 2010 and 2009 were as follows (dollars in thousands):
CNA Surety and its subsidiaries file a consolidated federal income tax return. The income tax allocation between the Company and its subsidiaries is subject to written agreement, approved by the Audit Committee of the
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Board of Directors. Allocation is based upon separate return calculations in accordance with the Internal Revenue Code of 1986 with current credit being given to separate company net losses.
The income tax provisions consisted of the following (dollars in thousands):
A reconciliation from the federal statutory tax rate to the effective tax rate is as follows:
The Company is subject to taxation in the United States, Puerto Rico and various state jurisdictions. The Company’s tax years 2007 through 2010 remain open as to the applicable statute of limitations and are subject to examination by the Internal Revenue Service.
The Company has not recognized any liabilities for uncertain income taxes as of December 31, 2010 or December 31, 2009. Also, the Company does not anticipate any material change in the total amount of unrecognized tax benefits to occur within the next twelve months.
10.
Employee Benefits
CNA Surety sponsors a tax-deferred savings plan (“401(k) plan”) covering substantially all of its employees. The Company matches 100% of the participating employee’s contribution up to 3% of eligible compensation and 50% of the participating employee’s contribution between 3% and 6% of eligible compensation (4.5% maximum matching). The Company also makes an additional basic contribution to eligible 401(k) plan participants of 3% (if under age 45) or 5% (if 45 or older) of eligible compensation. In addition, the Company may also make an annual discretionary profit sharing contribution to the 401(k) plan, subject to the approval of the Company’s Board of Directors. The profit sharing contribution may be restricted by plan and regulatory limitations. The Company contribution, including profit sharing, to the 401(k) plan was $4.8 million, $4.8 million and $4.6 million for the years ended December 31, 2010, 2009 and 2008, respectively.
CNA Surety established the CNA Surety Corporation Deferred Compensation Plan (the “2000 Plan”), effective April 1, 2000. The Company established and maintains the 2000 Plan as an unfunded, nonqualified deferred compensation plan for a select group of management or highly compensated employees. The purpose of the CNA Surety Corporation Deferred Compensation Plan is to permit designated employees of the Company and participating affiliates to accumulate additional retirement income through a nonqualified deferred compensation plan that enables them to defer compensation to which they will become entitled in the future.
On April 25, 2005, the Board of Directors of CNA Surety Corporation approved the CNA Surety Corporation 2005 Deferred Compensation Plan (the “2005 Plan”) and the CNA Surety Corporation 2005 Deferred
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Compensation Plan Trust (the “2005 Trust”). The 2005 Plan and 2005 Trust were adopted in connection with the enactment of Section 409A of the Internal Revenue Code of 1986, as amended, which was implemented under the American Jobs Creation Act of 2004. The 2005 Plan and 2005 Trust will be used in lieu of the 2000 Plan and the CNA Surety Corporation Deferred Compensation Plan Trust (the “2000 Trust”) for all amounts deferred on or after January 1, 2005. Amounts deferred under the 2000 Plan prior to January 1, 2005 will continue to be covered by and paid out in accordance with the terms of the 2000 Plan, the 2000 Trust and the elections made by participants under the 2000 Plan.
Western Surety sponsors two postretirement benefit plans covering certain employees. One plan provides medical benefits and the other plan provides sick leave termination payments. The medical benefit plan provides coverage for employees, and their eligible dependents, hired by Western Surety before November 1, 1992 and who retire at age 55 or later with at least 15 years of service. Only employees hired by Western Surety prior to 1988 are eligible for the sick leave plan. Further, benefits for the sick leave plan are based on unused accrued sick leave as of December 31, 2003, the date the accruals were frozen. The postretirement medical benefit plan is contributory and the sick leave plan is non-contributory. Western Surety uses a December 31 measurement date for both of its postretirement benefit plans. There were no plan assets for either of the postretirement benefit plans at December 31, 2010 or December 31, 2009.
The postretirement benefit plan that provides medical benefits has been determined to be actuarially equivalent to Medicare Part D on an estimated basis under the rules provided in final regulations issued in 2005. As such, the federal subsidy to plan sponsors under the Medicare Modernization Act (“MMA”) has been recognized in the accounting for that plan. In 2010, enactment of the Patient Protection and Affordable Care Act (the “Act”) and the Healthcare and Education Affordability Reconciliation Act (the “Reconciliation Measure”), which modifies certain provisions of the Act, repeal the current rule permitting deduction, for tax purposes, of the entire cost of providing prescription drug benefits even though a portion is offset by the federal subsidy. The impact of these provisions has been recognized in the accounting for this postretirement benefit plan. The impact included recognition of additional tax expense of $0.5 million in 2010.
The following table sets forth the plans’ combined accumulated postretirement benefit obligation at the beginning and end of the last two fiscal years (dollars in thousands):
The Company’s postretirement medical benefit plan’s accumulated postretirement benefit obligation as of December 31, 2010 is $11.6 million.
The Company’s postretirement sick leave plan’s accumulated postretirement benefit obligation as of December 31, 2010 is $0.7 million.
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following tables set forth the combined plans’ pre-tax adjustment to accumulated other comprehensive income/loss (“AOCI”) (dollars in thousands):
The net actuarial loss in 2010 was driven primarily by the lower discount rate used to measure the accumulated postretirement benefit obligation. The net actuarial loss in 2009 was driven by higher claim costs for the medical benefit plan. The net actuarial gain in 2008 resulted primarily from lower per capita claim costs as a result of the change in the plan provider.
The amounts recognized in the Consolidated Balance Sheets for postretirement benefit obligations at December 31, 2010 and 2009 were as follows (dollars in thousands):
The liabilities for postretirement benefits at December 31, 2010 and 2009 were as follows (dollars in thousands):
The plans’ combined net periodic postretirement benefit cost for the last three fiscal years included the following components (dollars in thousands):
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
At December 31, 2010 and 2009, respectively, the Company selected a discount rate of 5.56% and 5.96% to measure the accumulated postretirement benefit obligation. The Company’s analysis is based on projecting cash outflows for the postretirement benefit plans and discounting those cash outflows using published spot rates corresponding to the time period that the cash outflow is expected. As a result of this analysis, the Company selected 5.56% as the discount rate at December 31, 2010. This rate remains consistent with the Citigroup Pension Liability Index (“CPLI”) which was 5.54% at December 31, 2010. In 2009, the weighted average resulting from the analysis was nearly identical to the CPLI, which was used as the discount rate in 2009 for measurement of the postretirement benefit obligation.
The health care cost trend rate assumption has a significant effect on the amounts reported. To illustrate, increasing the assumed health care cost trend rates by 1 percentage point in each year would increase the benefit obligation as of December 31, 2010 by $2.4 million and increase the aggregate of service cost and interest cost for the year then ended by $0.2 million. Decreasing the assumed health care cost trend rates by 1 percentage point in each year would decrease the benefit obligation as of December 31, 2010 by $1.9 million and decrease the aggregate of service cost and interest cost for the year then ended by $0.1 million.
Estimated cost expected to be recognized from AOCI into net periodic benefit cost in 2011 (dollars in thousands):
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The Company expects to contribute $0.2 million to the postretirement benefit plans to pay benefits in 2011. The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid. These amounts are shown both gross and net of the federal subsidy to plan sponsors under the MMA in the following table (dollars in thousands):
11.
Stockholders’ Equity
The compensation expense recorded for the Company’s stock-based compensation plan in 2010, 2009 and 2008 was $1.8 million, $2.0 million and $1.7 million, respectively. The total income tax benefit recognized in the income statement for stock-based compensation arrangements was $0.6 million, $0.7 million and $0.6 million in 2010, 2009 and 2008, respectively. The amount of cash received from the exercise of stock options was $8.1 million, $1.2 million and $0.5 million in 2010, 2009 and 2008, respectively.
Equity Compensation Plans
The Company reserved shares of its common stock for issuance to directors, officers, employees and certain advisors of the Company through incentive stock options, nonqualified stock options, restricted stock, bonus shares or stock appreciation rights to be granted under the CNA Surety 2006 Long-Term Equity Compensation Plan (the “2006 Plan”), approved by shareholders on April 25, 2006. The aggregate number of shares initially available for which options may be granted under the 2006 Plan was 3,000,000. Option exercises under the 2006 Plan are settled in newly issued common shares.
The 2006 Plan is administered by the Compensation Committee of the Board of Directors (the “Committee”), consisting of two or more directors of the Company. Subject to the provisions set forth in the 2006 Plan, all of the members of the Committee shall be independent members of the Board of Directors. The Committee determines the option exercise prices. Exercise 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 nonqualified stock options.
The 2006 Plan provides for the granting of incentive stock options as defined under Section 409A of the Internal Revenue Code of 1986, as amended. All nonqualified stock options and incentive stock options granted under the 2006 Plan expire ten years after the date of grant and vest ratably over the four-year period following the date of grant.
On February 5, 2010, 281,260 options were granted under the 2006 Plan. The fair market value (at grant date) per option granted was $7.25 for these options. The fair value of these options was estimated at the grant date using a Black-Scholes option pricing model with the following weighted average assumptions: risk free interest rate of 2.32%; dividend yield of 0.0%; expected option life of 5.3 years and volatility of 55.5%, which was based on historical volatility. The Company estimated the expected option life of the 2010 grant based on its analysis of past exercise patterns for similar options. As of December 31, 2010, the number of shares available for granting of options under the 2006 Plan was 2,009,145.
On February 6, 2009, 217,960 options were granted under the 2006 Plan. The fair market value (at grant date) per option granted was $8.95 for these options. The fair value of these options was estimated at the grant date using a
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Black-Scholes option pricing model with the following weighted average assumptions: risk free interest rate of 1.95%; dividend yield of 0.0%; expected option life of 5.3 years and volatility of 51.8%, which was based on historical volatility. The Company estimated the expected option life of the 2009 grant based on its analysis of past exercise patterns for similar options. As of December 31, 2009, the number of shares available for granting of options under the 2006 Plan was 2,252,920.
On February 8, 2008, 259,380 options were granted under the 2006 Plan. The fair market value (at grant date) per option granted was $6.32 for these options. The fair value of these options was estimated at the grant date using a Black-Scholes option pricing model with the following weighted average assumptions: risk free interest rate of 2.7%; dividend yield of 0.0%; expected option life of 5.3 years and volatility of 38.3%, which was based on historical volatility. The Company estimated the expected option life of the 2008 grant based on its analysis of past exercise patterns for similar options.
A summary of option activity for the year ended December 31, 2010 is presented below:
A summary of the status of the Company’s non-vested options as of December 31, 2010 and changes during the year then ended is presented below:
The total fair value of stock options vested was $1.5 million in 2010 and $1.4 million in both 2009 and 2008.
The following table summarizes information about stock options outstanding at December 31, 2010:
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
A summary of the options vested or expected to vest and options exercisable as of December 31, 2010 is presented below:
The total intrinsic value of options exercised was $3.3 million, $0.6 million and $0.2 million for 2010, 2009 and 2008, respectively. The tax benefits recognized by the Company for these exercises were $1.2 million for 2010, $0.2 million for 2009 and less than $0.1 million for 2008.
As of December 31, 2010, there was $1.4 million of total unrecognized compensation cost related to non-vested stock-based compensation arrangements granted under the Company’s equity compensation plans. That cost is expected to be recognized as follows: 2011 - $0.9 million; 2012 - $0.4 million; 2013 - $0.1 million.
Effective January 1, 1998, the Company established the CNA Surety Corporation Non-Employee Directors Deferred Compensation Plan. Under this plan, which was terminated on December 31, 2004, each director who was not a full-time employee of the Company or any of its affiliates could defer all or a portion of the annual retainer fee that would otherwise be paid to such director. The deferral amount was credited to a deferred compensation account and deemed invested in common stock units. Each director was fully vested in his or her deferred compensation amount. Common stock units are convertible into CNA Surety common stock at the election of the director. Aggregate common stock units outstanding as of December 31, 2010 and 2009 were 11,401 and 11,771, respectively.
12.
Segment Information
The Company is a leading provider of surety and fidelity bonds in the United States. According to the Surety and Fidelity Association of America (“SFAA”), the surety and fidelity segment of the domestic property and casualty insurance industry aggregates approximately $6.3 billion in direct written premiums, comprised of approximately $5.2 billion in surety premiums and $1.1 billion in fidelity premiums.
Surety bonds are three-party agreements in which the issuer of the bond (the surety) joins with a second party (the principal) in guaranteeing to a third party (the owner/obligee) the fulfillment of some obligation on the part of the principal. The surety is the party who guarantees fulfillment of the principal’s obligation to the obligee. There are two broad types of surety products - contract surety and commercial surety bonds.
Contract surety bonds secure a contractor’s performance and/or payment obligation generally with respect to a construction project. Contract surety bonds are generally required by federal, state, and local governments for public works projects. Commercial surety bonds include all surety bonds other than contract and cover obligations typically required by law or regulation. Fidelity bonds cover losses arising from employee dishonesty.
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Although all of its products are sold through the same independent insurance agent and broker distribution network, the Company’s underwriting is organized by the two broad types of surety products - contract surety and commercial surety, which also includes fidelity bonds and other insurance products for these purposes. These two operating segments have been aggregated into one reportable business segment for financial reporting purposes because of their similar economic and operating characteristics. The following tables set forth gross and net written premiums, dollars in thousands, by product and between domestic and international risks and the respective percentage of the total for the past three years.
In 2010, approximately $93.3 million, or 21.2%, of gross written premiums were generated from national insurance brokers, with the single largest national broker production comprising $22.9 million, or 5.2%, of gross written premiums. In 2009, approximately $86.1 million, or 19.7%, of gross written premiums were generated from national insurance brokers, with the single largest national broker production comprising $20.6 million, or 4.7%, of gross written premiums. In 2008, approximately $85.3 million, or 18.3%, of gross written premiums were generated from national insurance brokers, with the single largest national broker production comprising $14.3 million, or 3.1%, of gross written premiums.
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
13.
Statutory Financial Data (unaudited)
CNA Surety’s insurance subsidiaries file financial statements prepared in accordance with statutory accounting practices prescribed or permitted by applicable insurance regulatory authorities. Prescribed statutory accounting practices include state laws, regulations and general administrative rules, as well as guidance provided in a variety of publications of the National Association of Insurance Commissioners (“NAIC”). Permitted statutory accounting practices encompass all accounting practices that are not prescribed.
The Company’s insurance subsidiaries follow three permitted accounting practices which did not have a material effect on reported statutory surplus or income at and for the years ended December 31, 2010 and 2009. The Company’s insurance subsidiaries were given permission to report activity in the Small Business Administration’s Surety Bond Guarantee program as a reinsurance program and to report all indemnification recoveries as recoveries of loss rather than allocating recoveries between loss and loss adjustment expenses. Also, Surety Bonding has been given permission to report ceding commissions received from Western Surety that exceed the acquisition costs related to the business ceded as a reduction to commission expense.
Historically, the principal differences between statutory financial statements and financial statements prepared in accordance with GAAP are that statutory financial statements do not reflect deferred policy acquisition costs or intangible assets, deferred income taxes are recorded but there are limitations as to the amount of deferred tax assets that may be reported as “admitted” assets and fixed income securities are generally carried at amortized cost in statutory financial statements.
The following table reconciles consolidated stockholders’ equity at December 31, 2010 and 2009 as reported herein in conformity with GAAP with total statutory capital and surplus of CNA Surety’s insurance subsidiaries, determined in accordance with statutory accounting practices prescribed or permitted by insurance regulatory authorities (dollars in thousands):
The NAIC has promulgated Risk-Based Capital (“RBC”) requirements for property and casualty insurance companies to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks such as asset quality, loss reserve adequacy and other business factors. The RBC information is used by state insurance regulators as an early warning mechanism to identify insurance companies that potentially are inadequately capitalized. In addition, the formula defines minimum capital standards that supplement the system of fixed minimum capital and surplus requirements on a state-by-state basis. Regulatory compliance is determined by a ratio (the “Ratio”) of the enterprise’s regulatory total adjusted capital, as defined by the NAIC, to its authorized control level RBC, as defined by the NAIC. Generally, a Ratio in excess of 200% of authorized control level RBC requires no corrective actions by a company or regulators. As of December 31, 2010 each of CNA Surety’s insurance subsidiaries had a Ratio that was in compliance with the minimum RBC requirements.
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
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, Western Surety may pay dividends of $140.2 million to CNA Surety in 2011. Combined statutory surplus for the insurance subsidiaries at December 31, 2010 was $825.6 million.
14.
Related Party Transactions
In addition to those described in Note 6. Reinsurance, the Company has the following related party transactions.
CNA Surety and CCC are parties to an Administrative Services Agreement (“ASA”), which has been in effect since July 1, 2004, that allows the Company to purchase and/or have access to certain services provided by CCC and its affiliates, including the leasing of executive and branch offices. Pursuant to the ASA, the Company paid CCC $4.6 million for leased office space and services for 2010. For both 2009 and 2008, the Company paid CCC $6.9 million for leased office space and services in addition to an annual management fee of $2.1 million. The Company was also charged $0.2 million for the years ended December 31, 2010, 2009 and 2008 for direct costs incurred by CCC on the Company’s behalf. As provided by the ASA, CCC paid the Company $1.3 million, $1.4 million and $1.3 million for the years ended December 31, 2010, 2009 and 2008, respectively, for insurance agent licensing services provided by the Company. This agreement shall remain in effect until CNAF or its affiliates or shareholders cease being a majority shareholder of CNA Surety unless otherwise terminated by either party. This agreement is approved annually by the Audit Committee of the Company’s Board of Directors (“Audit Committee”). The Company had a payable balance to CCC related to the ASA of less than $0.1 million at December 31, 2010. At December 31, 2009, the Company had a $0.4 million payable balance to CCC related to the ASA.
Pursuant to procedures approved by the Audit Committee, the Company from time to time provides license and permit bonds and appeal bonds for CCC and its affiliates as well as for clients of CCC and its affiliates. As of December 31, 2010, the aggregate outstanding liability of these bonds was approximately $27.8 million. The premium for all such bonds written was $0.3 million in 2010 and 2009. The premium for all such bonds written was $0.6 million in 2008.
From time to time, Western Surety also has liability, either directly or through assumed reinsurance, under bonds written for Loews and certain of its subsidiaries. As of December 31, 2010, the aggregate liability under all such bonds was approximately $79.9 million. This is comprised of the liability for bonds written for Mexdrill Offshore, S. DE R.L. DE C. V., which is a subsidiary of Diamond Offshore Drilling, Inc. (“Diamond Offshore”). As of December 31, 2010, Loews owns 50.4% of Diamond Offshore. Premiums for bonds written for Loews and its subsidiaries were less than $0.1 million in 2010, $0.2 million in 2009 and less than $0.1 million in 2008. All bonds were written with the approval of the Audit Committee.
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
15.
Selected Quarterly Financial Data (unaudited)
The following is a summary of the quarterly results of operations for the years ended December 31, 2010 and 2009 (dollars in thousands, except per share amounts):
During the fourth quarter of 2010, the Company recorded net loss reserve development for prior accident years which resulted in a decrease of the estimated liability for unpaid loss and loss adjustment expense of $54.3 million with a corresponding increase to income before income taxes.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
As of December 31, 2010, the Company’s management, including the Company’s Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”) have conducted an evaluation of the effectiveness of its disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (“the Exchange Act”)). Based on their evaluation, the CEO and CFO concluded that the Company’s disclosure controls and procedures are effective in ensuring that all material information required to be filed in this Annual Report has been made known to them in a timely manner.
Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, the Company included a report of management’s assessment of the design and effectiveness of its internal controls as part of this Annual Report on Form 10-K for the fiscal year ended December 31, 2010. Management’s report and the independent registered public accounting firm’s attestation report are included in the Company’s 2010 Financial Statements under the captions entitled “Management’s Report on Internal Control Over Financial Reporting” and “Report of Independent Registered Public Accounting Firm” and are incorporated herein by reference.
There were no changes in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended December 31, 2010 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
ITEM 9B.
ITEM 9B.
OTHER INFORMATION
None.
PART III.
ITEMS 10, 11, 12, 13, and 14.
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE, EXECUTIVE COMPENSATION, SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS, CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE, AND PRINCIPAL ACCOUNTING FEES AND SERVICES
The Company will file a definitive proxy statement with the Securities and Exchange Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934 (the “Proxy Statement”) relating to the Company’s Annual Meeting of Stockholders to be held not later than 120 days after the end of the fiscal year covered by this Form 10-K. Information required by Items 10 through 14 will appear in the Proxy Statement and is incorporated herein by reference.
PART IV.
ITEM 15.
ITEM 15.
EXHIBITS, FINANCIAL STATEMENT SCHEDULES
SCHEDULE I
CNA SURETY CORPORATION AND SUBSIDIARIES
SUMMARY OF INVESTMENTS
OTHER THAN INVESTMENTS IN RELATED PARTIES
As of December 31, 2010 and 2009
SCHEDULE II
CNA SURETY CORPORATION
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
(PARENT COMPANY)
BALANCE SHEETS
The accompanying notes are an integral part of these condensed financial statements.
SCHEDULE II
CNA SURETY CORPORATION
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
(PARENT COMPANY) - (Continued)
STATEMENTS OF INCOME
The accompanying notes are an integral part of these condensed financial statements.
SCHEDULE II
CNA SURETY CORPORATION
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
(PARENT COMPANY) - (Continued)
STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these condensed financial statements.
SCHEDULE II
CNA SURETY CORPORATION
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
(PARENT COMPANY) - (Continued)
NOTES TO CONDENSED FINANCIAL INFORMATION
1.
Basis of Presentation
The condensed financial information of CNA Surety Corporation (“CNAS” or the “Company”) should be read in conjunction with the Consolidated Financial Statements of CNA Surety and Notes thereto included in Part II, Item 8, Financial Statements and Supplementary Data of this Form 10-K. CNAS’s subsidiaries are accounted for using the equity method of accounting. Equity in net income of these affiliates is presented in the Condensed Statements of Income. CNA Financial Corporation owned approximately 61% of the outstanding common stock of CNAS as of December 31, 2010.
2.
Cash and Short-Term Investments
As of December 31, 2010 and 2009, cash included $3.2 million and $1.9 million, respectively, and short-term investments included $8.3 million and $9.2 million, respectively, of cash and short-term investments ultimately due to the Company’s insurance subsidiaries related to premium collections and claim payments.
3.
Debt
In May 2004, the Company, through a wholly-owned trust, privately issued $30.0 million of preferred securities through two pooled transactions. These securities, issued by CNA Surety Capital Trust I (the “Issuer Trust”), bear interest at the London Interbank Offered Rate (“LIBOR”) plus 337.5 basis points with a 30-year term. As of May 2009, the Company may redeem these securities, in whole or in part, at par value at any scheduled quarterly interest payment date. As of December 31, 2010, none of these preferred securities have been redeemed.
The Company’s investment of $0.9 million in the Issuer Trust is carried at cost in “Other assets” in the Company’s Condensed Balance Sheets. The sole asset of the Issuer Trust consists of a $30.9 million junior subordinated debenture issued by the Company to the Issuer Trust. Due to the underlying characteristics of this debt, the carrying value of the debenture approximates its estimated fair value.
The Company has also guaranteed the dividend payments and redemption of the preferred securities issued by the Issuer Trust. The maximum amount of undiscounted future payments the Company could make under the guarantee is approximately $55.7 million, consisting of annual dividend payments of approximately $1.1 million until maturity and the redemption value of the preferred securities of $30.0 million. Because payment under the guarantee would only be required if the Company does not fulfill its obligations under the debentures held by the Issuer Trust, the Company has not recorded any additional liabilities related to this guarantee.
The junior subordinated debenture bears interest at a rate of LIBOR plus 337.5 basis points and matures in April 2034. As of December 31, 2010 and 2009, the interest rate on the junior subordinated debenture was 3.66% and 3.65%, respectively.
4.
Commitments and Contingencies
The Company is party to various lawsuits arising in the normal course of business. The Company believes the resolution of these lawsuits will not have a material adverse effect on its financial condition or its results of operations.
SCHEDULE III
CNA SURETY CORPORATION AND SUBSIDIARIES
SUPPLEMENTARY INSURANCE INFORMATION
As of and for the Years Ended
December 31, 2010, 2009 and 2008
SCHEDULE IV
CNA SURETY CORPORATION AND SUBSIDIARIES
REINSURANCE
For the Years Ended December 31, 2010, 2009 and 2008
(1)
Primarily from affiliates.
SCHEDULE V
CNA SURETY CORPORATION AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS
As of and for the Years Ended December 31, 2010, 2009 and
(1)
Write-offs charged against allowance.
SCHEDULE VI
CNA SURETY CORPORATION AND SUBSIDIARIES
SUPPLEMENTAL INFORMATION CONCERNING PROPERTY-CASUALTY
INSURANCE OPERATIONS
As of and for the Years Ended December 31, 2010, 2009 and
(a)(3) Exhibits
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CNA SURETY CORPORATION
/s/ JOHN F. WELCH
John F. Welch
President and Chief Executive Officer
(Principal Executive Officer)
/s/ JOHN F. CORCORAN
John F. Corcoran
Senior Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)
Dated February 18, 2011
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.