SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ FORM 10-K ------------------------ [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER: 1-13277 ------------------------ CNA SURETY CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 36-4144905 (STATE OR OTHER JURISDICTION OF INCORPORATION OR (I.R.S. EMPLOYER IDENTIFICATION NO.) ORGANIZATION) CNA CENTER, CHICAGO, ILLINOIS 60685 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) (312) 822-5000 (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) ------------------------ Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g)of the Act: COMMON STOCK, $0.01 PAR VALUE (Title of Class) ------------------------ Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [X] No [ ] The aggregate market value of voting stock held by non-affiliates was $209.0 million based upon the closing price of $13.33 per share on February 22, 2005, using beneficial ownership of stock rules adopted pursuant to Section 13 of the Securities Exchange Act of 1934 to exclude voting stock owned by Directors, Officers and Major Stockholders, some of whom may not be held to be affiliates upon judicial determination. At February 22, 2005, 43,104,070 shares of the Registrant's Common Stock were outstanding. DOCUMENTS INCORPORATED BY REFERENCE: Portions of the CNA Surety Corporation Proxy Statement prepared for the 2005 annual meeting of shareholders, pursuant to Regulation 14A, are incorporated by reference into Part III of this report. CNA SURETY CORPORATION AND SUBSIDIARIES TABLE OF CONTENTS PAGE ---- PART I Item 1. Business.................................................... 2 General................................................... 2 Formation of CNA Surety and Merger........................ 2 Description of Business................................... 2 Financial Strength Ratings................................ 2 Product Information....................................... 3 Marketing................................................. 5 Underwriting.............................................. 6 Competition............................................... 7 Reinsurance............................................... 7 Reserves for Unpaid Losses and Loss Adjustment Expenses... 7 Claims.................................................... 9 Environmental Claims...................................... 10 Regulation................................................ 10 Investments............................................... 11 Employees................................................. 11 Availability of SEC Reports............................... 12 Item 2. Properties.................................................. 12 Item 3. Legal Proceedings........................................... 12 Item 4. Submission of Matters to a Vote of Security Holders......... 12 PART II Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters and Issuer Purchases of Equity Securities.................................................. 13 Item 6. Selected Financial Data..................................... 14 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations................................... 15 Item 7A. Quantitative and Qualitative Discussions About Market Risk........................................................ 40 Item 8. Financial Statements and Supplementary Data................. 42 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.................................... 79 Item 9A. Controls and Procedures..................................... 79 Item 9B. Other Information........................................... 79 PART III Item 10. Directors and Executive Officers of the Registrant.......... 79 Item 11. Executive Compensation...................................... 79 Item 12. Security Ownership of Certain Beneficial Owners and Management.................................................. 79 Item 13. Certain Relationships and Related Transactions.............. 79 Item 14. Principal Accounting Fees and Services...................... 79 PART IV Item 15. Exhibits, Financial Statement Schedules..................... 80 1 CNA SURETY CORPORATION AND SUBSIDIARIES PART I. ITEM 1. BUSINESS GENERAL CNA Surety Corporation ("CNA Surety" or "Company") is an insurance holding company in the United States formed through the September 30, 1997 combination of the surety business of CNA Financial Corporation with Capsure Holdings Corp.'s ("Capsure") insurance subsidiaries. CNA Surety is currently one of the largest surety providers in the United States with approximately a 9.2% market share (based upon 2003 Surety Association of America ("SAA") written premium data). Its wide selection of surety products range from very small commercial bonds to large contract bonds. FORMATION OF CNA SURETY AND MERGER In December 1996, CNA Financial Corporation ("CNAF") and Capsure agreed to merge (the "Merger") the surety business of CNAF with Capsure's insurance subsidiaries, Western Surety Company ("Western Surety"), Surety Bonding Company of America ("Surety Bonding") and Universal Surety of America ("USA"), into CNA Surety. CNAF, through its operating subsidiaries, writes multiple lines of property and casualty insurance, including surety business that is reinsured by Western Surety. CNAF owns approximately 64% of the outstanding common stock of CNA Surety. Loews Corporation ("Loews") owns approximately 91% of the outstanding common stock of CNAF. The principal operating subsidiaries of CNAF that wrote the surety line of business for their own account prior to the Merger were Continental Casualty Company and its property and casualty affiliates (collectively, "CCC") and The Continental Insurance Company and its property and casualty affiliates (collectively, "CIC"). CIC was acquired by CNAF on May 10, 1995. The combined surety operations of CCC and CIC are referred to herein as CCC Surety Operations. DESCRIPTION OF BUSINESS The Company's corporate objective is to be the leading provider of surety and surety-related products in North America and to be the surety of choice for its customers and independent agents and brokers. CNA Surety's insurance subsidiaries write surety and fidelity bonds in all 50 states through a combined network of approximately 34,000 independent agencies. CNA Surety's principal insurance subsidiaries are Western Surety and Surety Bonding. The insurance subsidiaries write, on a direct basis or as business assumed from CCC and CIC, small fidelity and non-contract surety bonds, referred to as commercial bonds; small, medium and large contract bonds; and errors and omissions ("E&O") liability insurance. Western Surety is a licensed insurer in all 50 states, the District of Columbia and Puerto Rico. Surety Bonding is licensed in 28 states and the District of Columbia. USA is licensed in 44 states and the District of Columbia. FINANCIAL STRENGTH RATINGS A.M. BEST COMPANY, INC. Western Surety is currently rated A (Excellent) with a negative rating outlook, by A.M. Best Company, Inc. ("A.M. Best"). An A (Excellent) rating is assigned to those companies which A.M. Best believes have an excellent ability to meet their ongoing obligations to policyholders. A (Excellent) rated insurers have been shown to be among the strongest in ability to meet policyholder and other contractual obligations. The rating outlook indicates the potential direction of a company's rating for an intermediate period, generally defined as the next 12 to 36 months. Through intercompany reinsurance and related agreements, CNA Surety's customers have access to CCC's broader underwriting capacity. CCC is currently rated A (Excellent) with a negative outlook by A.M. Best. A.M. Best's letter ratings range from A++ (Superior) to F (In Liquidation) with A++ being highest. 2 STANDARD AND POOR'S ("S&P") CCC and Western Surety are both currently rated A- (Strong), by S&P. On August 7, 2003, S&P placed CCC and Western Surety on credit watch with negative implications. S&P's letter ratings range from AAA+ (Extremely Strong) to CC (Extremely Weak) with AAA+ being highest. Ratings from "AA" to "CCC" may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories. An insurer rated 'A' has strong financial security characteristics, but is somewhat more likely to be affected by adverse business conditions than are insurers with higher ratings. PRODUCT INFORMATION According to the SAA industry estimates for 2000, approximately 75% of the United States surety market is represented by bonds required by federal statutes, state laws, and local ordinances. These bonding requirements range from federal construction projects, where the contractor is required to post performance and payment bonds which guarantee performance of contracts to the government as well as payment of bills to subcontractors and suppliers, to license and permit bonds which guarantee compliance with legal requirements for business operations. PRODUCTS AND POLICIES Unlike a standard, two-party insurance policy, surety bonds are three-party agreements in which the issuer of the bond (the surety) joins with a second party (the principal) in guaranteeing to a third party (the owner/obligee) the fulfillment of some obligation on the part of the principal. The surety is the party who guarantees fulfillment of the principal's obligation to the obligee. In addition, sureties are generally entitled to recover from the principal any losses and expenses paid to third parties. The surety's responsibility is to evaluate the risk and determine if the principal meets the underwriting requirements for the bond. Accordingly, surety bond premiums primarily reflect the type and class of risk and related costs associated with both processing the bond transaction and investigating the applicant including, if necessary, an analysis of the applicant's creditworthiness and ability to perform. There are two broad types of surety products -- contract surety and commercial surety bonds. Contract surety bonds secure a contractor's performance and/or payment obligation generally with respect to a construction project. Contract surety bonds are generally required by federal, state and local governments for public works projects. Commercial surety bonds include all surety bonds other than contract and cover obligations typically required by law or regulation. Contract bond guarantee obligations include the following: Bid bonds: used by contractors submitting proposals on potential contracts. Performance bonds: guarantee to the owner the performance of the contractor's obligations according to the terms and conditions of the contract. Payment bonds: guarantee payment of the contractor's obligations under the contract for labor, subcontractors, and materials supplied to the project. Payment bonds are utilized in public projects where liens are not permitted. Other examples of contract bonds are completion, maintenance and supply bonds. Commercial surety business is comprised of bonds covering obligations typically required by law or regulation, such as the following: License and Permit bonds: required by statutes or ordinances for a number of purposes including guaranteeing the payment of certain taxes and fees and providing consumer protection as a condition to granting licenses related to selling real estate or motor vehicles and contracting services. Judicial and Fiduciary bonds: required by statutes, courts or legal documents for the protection of those on whose behalf a fiduciary acts. Examples of such fiduciaries include executors and administrators of estates, and guardians of minors and incompetents. 3 Public Official bonds: required by statutes and ordinances to guarantee the lawful and faithful performance of the duties of office by public officials. CNA Surety also writes direct contract and commercial surety bonds for international risks. Such bonds are written to satisfy the international bond requirements of domestic customers and for select foreign clients. In addition, the Company markets surety related products such as fidelity bonds and E&O insurance. Fidelity bonds cover losses arising from employee dishonesty. Examples of purchasers of fidelity bonds are law firms, insurance agencies and janitorial service companies. CNA Surety writes E&O policies for two classes of insureds: notaries public and tax preparers. The notary public E&O policy is marketed as a companion product to the notary public bond and the tax preparer E&O policy is marketed to small tax return preparation firms. Although all of its products are sold through the same independent insurance agent and broker distribution network, the Company's underwriting is organized by the two broad types of surety products -- contract surety and commercial surety, which also includes fidelity bonds and other insurance products for these purposes. These two operating segments have been aggregated into one reportable business segment for financial reporting purposes because of their similar economic and operating characteristics. The following tables set forth, for each principal class of bonds, gross written premiums, net written premiums and number of domestic bonds and policies in force and the respective percentages of the total for the past three years (amounts in thousands, except average bond amounts): GROSS WRITTEN PREMIUMS ------------------------------------------------------ % OF % OF % OF 2004 TOTAL 2003 TOTAL 2002 TOTAL -------- ----- -------- ----- -------- ----- Contract....................... $221,577 56.9% $208,472 56.1% $197,875 55.0% Commercial: License and permit........... 81,502 20.9 83,554 22.5 85,787 23.9 Judicial and fiduciary....... 22,590 5.8 24,075 6.5 25,358 7.0 Public official.............. 23,911 6.1 21,330 5.7 18,861 5.2 Other........................ 7,890 2.1 4,774 1.3 4,033 1.1 -------- ----- -------- ----- -------- ----- Total commercial............... 135,893 34.9 133,733 36.0 134,039 37.2 Fidelity and other............. 31,947 8.2 29,170 7.9 27,978 7.8 -------- ----- -------- ----- -------- ----- $389,417 100.0% $371,375 100.0% $359,892 100.0% ======== ===== ======== ===== ======== ===== Domestic....................... $381,655 98.0% $363,290 97.8% $348,010 96.7% International.................. 7,762 2.0 8,085 2.2 11,882 3.3 -------- ----- -------- ----- -------- ----- $389,417 100.0% $371,375 100.0% $359,892 100.0% ======== ===== ======== ===== ======== ===== NET WRITTEN PREMIUMS ------------------------------------------------------ % OF % OF % OF 2004 TOTAL 2003 TOTAL 2002 TOTAL -------- ----- -------- ----- -------- ----- Contract....................... $172,274 54.1% $184,449 57.8% $172,633 56.3% Commercial..................... 115,454 36.3 106,899 33.5 107,290 35.0 Fidelity and other............. 30,556 9.6 27,862 8.7 26,731 8.7 -------- ----- -------- ----- -------- ----- $318,284 100.0% $319,210 100.0% $306,654 100.0% ======== ===== ======== ===== ======== ===== Domestic....................... $311,620 97.9% $311,125 97.5% $297,385 97.0% International.................. 6,664 2.1 8,085 2.5 9,269 3.0 -------- ----- -------- ----- -------- ----- $318,284 100.0% $319,210 100.0% $306,654 100.0% ======== ===== ======== ===== ======== ===== 4 DOMESTIC BONDS/POLICIES IN FORCE ------------------------------------------------ % OF % OF % OF 2004 TOTAL 2003 TOTAL 2002 TOTAL ------ ----- ------ ----- ------ ----- Contract............................. $ 33 1.4% $ 36 1.6% $ 39 1.8% Commercial........................... 1,803 73.8 1,723 74.6 1,611 74.7 Fidelity and other................... 606 24.8 550 23.8 507 23.5 ------ ----- ------ ----- ------ ----- $2,442 100.0% $2,310 100.0% $2,157 100.0% ====== ===== ====== ===== ====== ===== AVERAGE BOND PENALTY/POLICY LIMIT(1) ------------------------------------ 2004 2003 2002 ---------- ---------- ---------- Contract............................................. $923,981 $834,798 $905,896 Commercial........................................... $ 14,673 $ 15,235 $ 19,493 Fidelity and other................................... $ 19,245 $ 17,660 $ 11,152 ------------------------- (1) The average bond penalty is a measure of the average limit of liability associated with bonds in force at each reporting period. In 2004, no individual agency generated more than 1.7% of aggregate gross written premiums. Approximately $68.1 million, or 17.5%, of gross written premiums were generated from national insurance brokers in 2004 with the single largest national broker production comprising $18.5 million, or 4.7%, of gross written premiums. MARKETING The Company principally markets its products in all 50 states, as well as the District of Columbia and Puerto Rico. Its products are marketed primarily through independent producers, including multi-line agents and brokers such as surety specialists, many of whom are members of the National Association of Surety Bond Producers. CNA Surety enjoys broad national distribution of its products, which are marketed through approximately 34,000 of the approximately 44,000 independent property and casualty insurance agencies in the United States. In addition, the Company employs 41 full-time salaried marketing representatives and 5 telemarketing representatives to continually service its vast producer network. Relationships with these independent producers are maintained through the Company's 35 local branch offices. The following table sets forth the distribution of the domestic business of CNA Surety, by state based upon gross written premiums in each of the last three years: YEARS ENDED DECEMBER 31, ------------------------ 2004 2003 2002 ------ ------ ------ Gross Written Premiums by State: California................................................ 10.4% 9.9% 10.8% Texas..................................................... 8.8 9.8 12.6 Florida................................................... 6.6 6.6 7.0 Illinois.................................................. 4.6 4.7 2.8 New York.................................................. 4.0 4.6 4.9 Pennsylvania.............................................. 3.1 3.0 4.5 Virginia.................................................. 3.0 2.3 2.5 Georgia................................................... 3.0 2.7 4.3 Michigan.................................................. 2.7 3.0 3.3 Massachusetts............................................. 2.7 2.7 3.2 All Other................................................. 51.1 50.7 44.1 ----- ----- ----- Total.................................................. 100.0% 100.0% 100.0% ===== ===== ===== 5 Contract Surety With respect to standard contract surety, the core target customers for the Company are contractors with less than $50 million in contracted work in progress. This segment is comprised of small contractors (less than $5 million in work in progress), medium contractors ($5-$30 million) and the lower end of the large contractors (greater than $30 million). These small and medium contractors, as a group, represent a significant portion of the United States construction market. The Company's marketing emphasis continues to be on small and medium contractors, however the Company does have exposure to larger contractors. These exposures are measured in terms of bonded backlog which is an indication of the Company's exposure in event of default before indemnification and salvage and subrogation recoveries. At December 31, 2004, the Company has 13 accounts each with a bonded backlog in excess of $150 million and 14 accounts each with a bonded backlog between $100 million and $150 million. The Company actively monitors both the number of these large accounts and the exposure on each account through a variety of underwriting methods. Some of these accounts are maintained on a "co-surety" or joint insurer basis with other sureties in order to manage aggregate exposure. The Company also fulfills the bond requirements of select small and emerging specialty contractors. For example, CNA Surety participates in the non-standard contract surety market through the federal government's Small Business Administration ("SBA") surety bond guarantee programs. Through these programs, the SBA assumes 70% to 90% of the coverage in exchange for 10% to 30% of the premium. Commercial Surety A large portion of the commercial surety market is comprised of small obligations that are routine in nature and require minimal underwriting. Customers are focused principally on prompt and efficient service. These small transactional bonds represent approximately 76% of the Company's commercial gross written premiums and 33% of the Company's total gross written premium. The Company continues to focus its marketing efforts on this small commercial bond market through its Sioux Falls, South Dakota service center. In this market segment, CNA Surety emphasizes one-day response service, easy-to-use forms and an extensive array of commercial bond products. In addition, independent agents are provided pre-executed bond forms, powers of attorney, and facsimile authorizations that allow them to issue many standard bonds in their offices. CNA Surety's insurance subsidiaries may also direct their marketing to particular industries or classes of bonds on a broad basis. For instance, the Company maintains programs directed at notary bonds, mortgage broker compliance bonds and grain warehouse dealer bonds (protecting funds associated with grain storage). CNA Surety also maintains a specific underwriting staff in Chicago dedicated to middle market and "Fortune 1000" accounts. The Company's large commercial account business is estimated to represent approximately 24% of the Company's commercial gross written premiums and 10% of the Company's total gross written premium. UNDERWRITING CNA Surety is focused on consistent underwriting profitability. The extent and sophistication of underwriting activity varies by type of risk. Contractor accounts and large commercial surety customers undergo credit, financial and managerial review and analysis on a regular basis. Certain classifications of bonds, such as fiduciary and court appeal bonds, also require more extensive underwriting. CNA Surety also targets various products in the surety and fidelity bond market which are characterized by relatively low-risk exposure and small bond amounts. The underwriting criteria, including the extent of bonding authority granted to independent agents, varies depending on the class of business and the type of bond. For example, relatively little underwriting information is typically required of certain low-exposure risks such as notary bonds. 6 COMPETITION The surety and fidelity market is highly competitive. According to 2003 data from the SAA, the U.S. market aggregates approximately $5.0 billion in direct written premiums, comprised of approximately $3.7 billion in surety premiums and approximately $1.3 billion in fidelity premiums. The large diversified insurance companies hold the largest market shares. For example, the 20 largest surety companies account for approximately 79% of the domestic surety market and 97% of the domestic fidelity market. In 2003, CNA Surety was the third largest surety provider with a 9.2% market share. Primary competitors of CNA Surety are approximately 20 national, multi-line companies participating in the surety market throughout the country. Management believes that its principal strengths are diverse product offerings, service and accessibility and long-term relationships with agents and accounts. Competition has increased as a result of ten years of profitable underwriting experience through 1999. This competition has typically manifested itself through reduced premium rates and greater tolerance for relaxation of underwriting standards. Beginning in 2000 and through the end of 2003, the surety industry's underwriting performance began to be impacted by the significant increases in corporate defaults. Although premium rates began firming in 2001, particularly on large accounts due to deteriorating underwriting performance throughout the surety industry, management believes such competition will continue and impact the Company's ability to raise rates further. REINSURANCE The Company's insurance subsidiaries, in the ordinary course of business, cede reinsurance to other insurance companies and affiliates. Reinsurance arrangements are used to limit maximum loss, provide greater diversification of risk and minimize exposure on larger risks. Reinsurance contracts do not ordinarily relieve the Company of its primary obligations to claimants. Therefore, a contingent liability exists with respect to reinsurance ceded to the extent that any reinsurer is unable to meet the obligations assumed under reinsurance contracts. The Company evaluates the financial condition of its reinsurers, monitors concentrations of credit risk and establishes allowances for uncollectible amounts when indicated. At December 31, 2004 the Company holds approximately $1.6 million of Letters of Credit as collateral for reinsurance receivables. The Company's reinsurance program is predominantly comprised of excess of loss reinsurance contracts that limit the Company's retention on a per principal basis. The Company's reinsurance coverage is provided by third party reinsurers and related parties. Refer to Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 6 of the Notes to the Consolidated Financial Statements, Reinsurance, for further discussion. CNA Surety's largest reinsurance receivable from an affiliate, CCC, an A rated company by A.M. Best, was approximately $5.4 million and $52.7 million at December 31, 2004 and 2003, respectively. In addition, due to the nature of the reinsurance products available to the Company and other sureties, reinsurers may cover principals for whom the Company writes surety bonds in one year, but then exclude or provide only limited reinsurance for these same principals in subsequent years. As a result, the Company may continue to have exposure to these principals with limited or no reinsurance for bonds written during years that the Company had reinsurance covering these principals. RESERVES FOR UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES The Company retains an independent actuarial firm of national standing to perform periodic actuarial analysis of the Company's loss reserves. This analysis is based on a variety of techniques that involve detailed statistical analysis of past reporting, settlement activity, and salvage and subrogation activity, as well as claim frequency and severity data when sufficient information exists to lend statistical credibility to the analysis. The analysis may be based upon internal loss experience or industry experience. Techniques may vary depending on the type of claim being estimated. While techniques may vary, each employs significant judgments and assumptions. The independent actuarial firm provides annually actuarial certification as to the reasonableness 7 of actuarial assumptions used and the sufficiency of year-end reserves for each of the Company's principal insurance subsidiaries. The estimated liability for unpaid losses and loss adjustment expenses includes, on an undiscounted basis, estimates of (a) the ultimate settlement value of reported claims, (b) incurred-but-not-reported ("IBNR") claims, (c) future expenses to be incurred in the settlement of claims and (d) claim recoveries, exclusive of reinsurance recoveries which are reported as an asset. These estimates are determined based on the Company's and surety industry loss experience as well as consideration of current trends and conditions. The estimated liability for unpaid losses and loss adjustment expenses is an estimate and there is the potential that actual future loss payments will differ significantly from initial estimates. The methods of determining such estimates and the resulting estimated liability are regularly reviewed and updated. Changes in the estimated liability are reflected in operating income in the period in which such changes are determined to be needed. A table is included in Note 7 of the Notes to the Consolidated Financial Statements, Reserves for Loss and Loss Adjustment Expenses, that presents the activity in the reserves for unpaid losses and loss adjustment expenses for the Company and is incorporated herein by reference. This table highlights the impact of revisions to the estimated liability established in prior years. The following table sets forth a reconciliation of the consolidated loss reserves reported in accordance with generally accepted accounting principles ("GAAP"), and the reserves reported to state insurance regulatory authorities in accordance with statutory accounting practices ("SAP") as of December 31, 2004 (dollars in thousands): Net reserves at end of year, GAAP basis..................... $ 246,556 Ceded reinsurance, net of salvage and subrogation........... 116,831 --------- Gross reserves at end of year, GAAP basis................... 363,387 Estimated reinsurance recoverable netted against gross reserves for SAP.......................................... (116,831) Net reserves on retroactive reinsurance assumed............. (10,492) --------- Net reserves at end of year, SAP basis...................... $ 236,064 ========= The following loss reserve development table illustrates the change over time of reserves established for the Company's estimated losses and loss adjustment expenses at the end of various calendar years. The first section shows the reserves as originally reported at the end of the stated year. The second section shows the cumulative amounts paid as of the end of successive years with respect to that reserve liability. The third section shows re-estimates of the original recorded reserve as of the end of each successive year which is the result of management's expanded awareness of additional facts and circumstances that pertain to the unsettled claims. The last section compares the latest re-estimated reserve to the reserve originally established, and indicates whether or not the original reserve was adequate or inadequate to cover the estimated costs of unsettled claims. The loss reserve development table is cumulative as of each December 31, and, therefore, ending balances should not be added since the amount at the end of each calendar year includes activity for both the current and prior years. The loss reserve development table reflects, on a pro forma basis, the reserves of the CCC Surety Operations and Capsure since 1994 and CIC since its acquisition in May of 1995. Such historical development is not necessarily indicative of the financial results that would have occurred under the ownership and management of CNA Surety or of future operating results. 8 AS OF DECEMBER 31, ------------------------------------------------------------------------------------ 1994 1995 1996 1997 1998 1999 2000 2001 ------- -------- -------- -------- -------- -------- -------- -------- (DOLLARS IN THOUSANDS) Gross reserves for losses and loss adjustment expenses..... $75,298 $153,843 $142,282 $130,381 $150,020 $157,933 $204,457 $315,811 Originally reported ceded recoverable.................. 4,900 5,932 5,218 7,656 7,986 20,464 70,159 166,318 ------- -------- -------- -------- -------- -------- -------- -------- Net reserves for losses and loss adjustment expenses..... 70,398 147,911 137,064 122,725 142,034 137,469 134,298 149,493 ======= ======== ======== ======== ======== ======== ======== ======== Net Paid (Cumulative) as of: One year later............... 12,018 42,552 9,866 19,595 32,428 35,825 44,763 64,832 Two years later.............. 18,149 43,179 20,171 30,775 52,524 47,795 75,825 98,885 Three years later............ 21,229 46,782 25,206 43,999 58,421 73,341 87,011 117,396 Four years later............. 22,313 48,960 32,918 47,144 67,451 81,788 93,154 -- Five years later............. 24,776 56,891 35,214 51,742 71,352 86,539 -- -- Six years later.............. 24,102 54,724 38,371 54,659 74,462 -- -- -- Seven years later............ 22,167 57,275 41,058 57,211 -- -- -- -- Eight years later............ 23,212 59,153 43,525 -- -- -- -- -- Nine years later............. 24,726 61,365 -- -- -- -- -- -- Ten years later.............. 27,126 -- -- -- -- -- -- -- Net Reserves re-estimated as of: End of initial year.......... 70,398 147,911 137,064 122,725 142,034 137,469 134,298 149,493 One year later............... 51,471 132,267 96,178 118,373 128,949 130,376 139,110 155,673 Two years later.............. 44,135 103,466 90,796 102,304 114,605 128,134 140,094 182,812 Three years later............ 38,829 101,745 77,086 87,321 110,462 130,280 132,504 169,340 Four years later............. 38,628 89,348 62,217 86,271 113,748 122,469 120,051 -- Five years later............. 31,362 77,477 60,882 86,320 105,797 110,055 -- -- Six years later.............. 27,327 72,879 61,443 79,029 93,768 -- -- -- Seven years later............ 24,497 73,428 57,375 69,923 -- -- -- -- Eight years later............ 25,024 71,844 51,857 -- -- -- -- -- Nine years later............. 33,302 68,321 -- -- -- -- -- -- Ten years later.............. 33,480 -- -- -- -- -- -- -- ======= ======== ======== ======== ======== ======== ======== ======== Total net (deficiency) redundancy................... $36,918 $ 79,590 $ 85,207 $ 52,802 $ 48,266 $ 27,414 $ 14,247 $(19,847) ======= ======== ======== ======== ======== ======== ======== ======== Cumulative redundancy (deficiency) as a percentage of original estimate......... 52.4% 53.8% 62.2% 43.0% 34.0% 19.9% 10.6% (13.3)% ======= ======== ======== ======== ======== ======== ======== ======== Net reserves re-estimated..... $33,480 $ 68,321 $ 51,857 $ 69,923 $ 93,768 $110,055 $120,051 $169,340 Re-estimated ceded recoverable.................. 2,970 3,123 5,418 8,979 14,046 71,274 107,460 120,578 ------- -------- -------- -------- -------- -------- -------- -------- Gross reserves re-estimated... $36,450 $ 71,444 $ 57,275 $ 78,902 $107,814 $181,239 $227,511 $227,511 ======= ======== ======== ======== ======== ======== ======== ======== AS OF DECEMBER 31, ------------------------------ 2002 2003 2004 -------- -------- -------- (DOLLARS IN THOUSANDS) Gross reserves for losses and loss adjustment expenses..... $303,433 $413,539 $363,387 Originally reported ceded recoverable.................. 137,301 158,357 116,831 -------- -------- -------- Net reserves for losses and loss adjustment expenses..... 166,132 255,182 246,556 ======== ======== ======== Net Paid (Cumulative) as of: One year later............... 59,567 88,857 -- Two years later.............. 100,595 -- -- Three years later............ -- -- -- Four years later............. -- -- -- Five years later............. -- -- -- Six years later.............. -- -- -- Seven years later............ -- -- -- Eight years later............ -- -- -- Nine years later............. -- -- -- Ten years later.............. -- -- -- Net Reserves re-estimated as of: End of initial year.......... 166,132 255,182 246,556 One year later............... 205,422 254,570 -- Two years later.............. 199,865 -- -- Three years later............ -- -- -- Four years later............. -- -- -- Five years later............. -- -- -- Six years later.............. -- -- -- Seven years later............ -- -- -- Eight years later............ -- -- -- Nine years later............. -- -- -- Ten years later.............. -- -- -- ======== ======== ======== Total net (deficiency) redundancy................... $(33,733) $ 612 -- ======== ======== ======== Cumulative redundancy (deficiency) as a percentage of original estimate......... (20.3)% 0.2% --% ======== ======== ======== Net reserves re-estimated..... $199,865 $254,570 Re-estimated ceded recoverable.................. 145,648 96,740 -------- -------- Gross reserves re-estimated... $345,513 $351,310 ======== ======== CLAIMS Proactive claims management is an important factor for the profitable underwriting of surety and fidelity products. The Company maintains an experienced and dedicated staff of in-house claim specialists. Claim handling for the Company's contract and large commercial account business is performed in Chicago. Claims for the Company's small commercial bonds and the related fidelity bonds and E&O insurance are handled in Sioux Falls. The disposition of claims and other claim-related activity is done in accordance with established policies, procedures and expense controls designed to minimize loss costs and maximize salvage and subrogation recoveries. Indemnity and subrogation rights exist on a significant portion of the business written, enabling the Company to pursue loss recovery from the principal. 9 ENVIRONMENTAL CLAIMS The Company does not typically bond contractors that specialize in hazardous environmental remediation work. The Company does however bond several accounts that have incidental environmental exposure with respect to which the Company provides bonding programs. In the commercial surety market, the Company provides bonds to large corporations that are in the business of mining various minerals and are obligated to post reclamation bonds that guarantee that property which was disturbed during mining is returned to an acceptable condition when the mining is completed. The Company also provides court and other surety bonds for large corporations wherein the underlying action involves environmental related issues. While no environmental responsibility is overtly provided by commercial or contract bonds, some risk of environmental exposure may exist if the surety were to assume certain rights in the completion of a defaulted project or through salvage recovery. The Company estimates its net case incurred losses on known claims of this nature to be $12.0 million as of December 31, 2004. REGULATION The Company's insurance subsidiaries are subject to varying degrees of regulation and supervision in the jurisdictions in which they transact business under statutes that delegate regulatory, supervisory and administrative powers to state insurance regulators. In general, an insurer's state of domicile has principal responsibility for such regulation which is designed generally to protect policyholders rather than investors and relates to matters such as the standards of solvency which must be maintained; the licensing of insurers and their agents; the examination of the affairs of insurance companies, including periodic financial and market conduct examinations; the filing of annual and other reports, prepared on a statutory basis, on the financial condition of insurers or for other purposes; establishment and maintenance of reserves for unearned premiums and losses; and requirements regarding numerous other matters. Licensed or admitted insurers generally must file with the insurance regulators of such states, or have filed on its behalf, the premium rates and bond and policy forms used within each state. In some states, approval of such rates and forms must be received from the insurance regulators in advance of their use. Western Surety is domiciled in South Dakota and licensed in all 50 states and the District of Columbia and Puerto Rico. Surety Bonding is domiciled in South Dakota and licensed in 28 states and the District of Columbia. USA is domiciled in Texas and licensed in 44 states and the District of Columbia. Insurance regulations generally also require registration and periodic disclosure of certain information concerning ownership, financial condition, capital structure, general business operations and any material transactions or agreements by or among affiliates. Such regulation also typically restricts the ability of any one person to acquire 10% or more, either directly or indirectly, of a company's stock without prior approval of the applicable insurance regulatory authority. In addition, dividends and other distributions to stockholders generally may be paid only out of unreserved and unrestricted statutory earned surplus. Such distributions may be subject to prior regulatory approval, including a review of the implications on Risk-Based Capital requirements. A discussion of Risk-Based Capital requirements for property and casualty insurance companies is included in both Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 13 of the Notes to the Consolidated Financial Statements, Statutory Financial Data. Without prior regulatory approval in 2005, CNA Surety's insurance subsidiaries may pay stockholder dividends of $46.8 million in the aggregate. For the year ended December 31, 2004, CNA Surety received no dividends from its insurance subsidiaries. CNA Surety's insurance subsidiaries are subject to periodic financial and market conduct examinations. These examinations are generally performed by the domiciliary state insurance regulatory authorities. During 2003, both the South Dakota Department of Commerce and Regulation-Insurance Division and the Texas Department of Insurance issued their respective reports of examination for the five-year period ended December 31, 2001. The points noted in their reviews were largely administrative in nature and have been addressed by management. In connection with an examination of the insurance subsidiaries of CNAF undertaken by the Illinois Department of Insurance in 2004, both the South Dakota Department of Commerce and Regulation-Insurance Division and the Texas Department of Insurance initiated financial 10 examinations as of December 31, 2003 of Western Surety, Surety Bonding, and USA. The review of USA is currently in progress. The review of Western Surety and Surety Bonding was completed on January 21, 2005. The points noted in these reviews were largely administrative in nature and are being addressed by management. The points noted do not have a material impact on the insurance subsidiaries' statutory surplus, nor have they resulted in any fines or penalties to CNA Surety or any of its subsidiaries. The report did address the Company's exposure to the large national contractor (discussed later) that had previously been discussed with the regulators. The Company has agreed to provide the regulators with an ongoing update and review of this exposure. Certain states in which CNA Surety's insurance subsidiaries conduct their business require insurers to join a guaranty association. Guaranty associations provide protection to policyholders of insurers licensed in such states against the insolvency of those insurers. In order to provide the associations with funds to pay certain claims under policies issued by insolvent insurers, the guaranty associations charge members assessments based on the amount of direct premiums written in that state. Such assessments were not material to CNA Surety's results of operations in 2004. Western Surety and Surety Bonding each qualifies as an acceptable surety for federal and other public works project bonds pursuant to U.S. Department of Treasury regulations. U.S. Treasury underwriting limitations are based on an insurer's statutory surplus. The underwriting limitations of Western Surety and Surety Bonding, based on each insurer's statutory surplus, were $21.9 million and $0.5 million, respectively, for the twelve-month period ended June 30, 2004. Effective July 1, 2004 through June 30, 2005, the underwriting limitations of Western Surety and Surety Bonding are $18.5 million and $0.5 million, respectively. Through the Surety Quota Share Treaty between CCC and Western Surety Company, CNA Surety has access to CCC and its affiliates' U.S. Department of Treasury underwriting limitations. The Surety Quota Share Treaty had an original term of five years from the Merger Date and was renewed on October 1, 2002 and on January 1, 2004 on substantially the same terms. Effective July 1, 2004 through June 30, 2005, the underwriting limitations of CCC and its affiliates total $591.1 million. CNA Surety management believes that the foregoing U.S. Treasury underwriting limitations are sufficient for the conduct of its business. INVESTMENTS CNA Surety insurance subsidiaries' investment practices must comply with insurance laws and regulations and must also comply with certain covenants under CNA Surety's credit facility. Generally, insurance laws and regulations prescribe the nature and quality of, and set limits on, the various types of investments that may be made by CNA Surety's insurance subsidiaries. The Company's investment portfolio generally is managed to maximize after-tax investment return, while minimizing credit risk with investments concentrated in high quality income securities. CNA Surety's portfolio is managed to provide diversification by limiting exposures to any one industry, issue or issuer, and to provide liquidity by investing in the public securities markets. The portfolio is structured to support CNA Surety's insurance underwriting operations and to consider the expected duration of liabilities and short-term cash needs. An investment committee of CNA Surety's Board of Directors establishes investment policy and oversees the management of each portfolio. A professional independent investment adviser has been engaged to assist in the management of each insurance subsidiary investment portfolio pursuant to established investment committee guidelines. The insurance subsidiaries pay an advisory fee based on the market value of the assets under management. EMPLOYEES As of December 31, 2004, the Company employed 724 persons. CNA Surety has not experienced any work stoppages. Management of CNA Surety believes its relations with its employees are good. 11 AVAILABILITY OF SEC REPORTS A copy of this Annual Report on Form 10-K, as well as CNA Surety's subsequent Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to such reports are available, free of charge, on the Internet at CNA Surety's website (www.cnasurety.com) as soon as reasonably practicable after being filed with or submitted to the Securities and Exchange Commission (the "SEC"). Prior to the filing of this Form 10-K, CNA Surety provided links to the SEC's website (www.sec.gov) which contained the equivalent of the reports described above. Any materials the Company files with the SEC may be read and obtained at the SEC's Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. Information regarding the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. This reference to the CNA Surety's website or the SEC's address does not constitute incorporation by reference of the information contained on the website and should not be considered part of this document. ITEM 2. PROPERTIES CNA Surety leases its executive offices and its shared branch locations with Continental Casualty Company ("CCC") under the Administrative Services Agreement. CNA Surety currently uses approximately 91,800 square feet and related personal property at 33 branch locations and its home and executive offices (20,484 square feet), in Chicago, Illinois. CNA Surety's annual rent for this space is approximately $2.8 million. CNA Surety may terminate its use of these locations as set forth in the Administrative Services Agreement, without material penalty, by providing CCC with 30 days written notice. In 2005, CNA Surety intends to enter into separate lease or sub-lease agreements with CCC for these shared locations. CNA Surety leases approximately 81,100 square feet of office space for its primary processing and service center at 101 South Phillips Avenue, Sioux Falls, South Dakota, under a lease expiring in 2012. The annual rent, which is subject to annual adjustments, was $0.9 million as of December 31, 2004. CNA Surety also leases space for contract and commercial branch offices in Tallahassee, Florida, New York, New York; Troy, Michigan; Roseville, California; Houston, Texas; and San Juan, Puerto Rico. Annual rent for these offices was $0.5 million with leases terminating in 2005, 2007, 2005, 2005, 2006, and 2006, respectively. ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are parties to various lawsuits arising in the normal course of business, some seeking material damages. The Company believes the resolution of these lawsuits will not have a material adverse effect on its financial condition or its results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 12 PART II. ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The Company's common stock ("Common Stock") trades on the New York Stock Exchange under the symbol SUR. On February 22, 2005, the last reported sale price for the Common Stock was $13.33 per share. The following table shows the range of high and low sales prices for shares of the Common Stock as reported on the New York Stock Exchange during 2004 and 2003. HIGH LOW ---- --- 2004 1st Quarter............................................... $11.50 $ 9.46 2nd Quarter............................................... $12.93 $ 9.99 3rd Quarter............................................... $11.05 $ 9.99 4th Quarter............................................... $13.96 $10.38 2003 1st Quarter............................................... $ 8.68 $ 6.10 2nd Quarter............................................... $10.23 $ 7.89 3rd Quarter............................................... $10.70 $ 9.30 4th Quarter............................................... $11.08 $ 8.60 The number of stockholders of record of Common Stock on February 22, 2005, was approximately 404. DIVIDENDS Effective November 21, 2002, the Company announced that its Board of Directors suspended its quarterly cash dividend. The Board reassessed the level of dividends which would be appropriate based upon a number of factors, including CNA Surety's financial condition, operating characteristics, projected earnings and growth, capital requirements of its insurance subsidiaries and debt service obligations. The reintroduction of a quarterly or annual dividend and the amount of any such dividend will be reassessed at future Board meetings. 13 ITEM 6. SELECTED FINANCIAL DATA The following financial information has been derived from the Consolidated Financial Statements and Notes thereto. The following information presented for CNA Surety is as of and for the years ended December 31, 2004, 2003, 2002, 2001 and 2000. 2004 2003 2002 2001 2000 ---------- ---------- ---------- ---------- -------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) Total revenues.................... $ 350,789 $ 332,576 $ 318,487 $ 350,471 $332,273 ========== ========== ========== ========== ======== Gross written premiums............ $ 389,417 $ 371,375 $ 359,892 $ 333,003 $316,667 ========== ========== ========== ========== ======== Net written premiums.............. $ 318,284 $ 319,210 $ 306,654 $ 315,804 $304,468 ========== ========== ========== ========== ======== Net earned premium................ $ 317,857 $ 304,449 $ 298,319 $ 320,910 $301,819 Net losses and loss adjustment expenses........................ 87,356 172,476 94,198 80,836 55,683 Net commissions, brokerage and other underwriting expenses..... 207,166 190,740 179,827 202,877 181,655 Net investment income............. 30,181 26,301 27,754 29,515 29,897 Net realized investment gains (losses)........................ 2,751 1,826 (7,586) 46 557 Interest expense.................. 2,260 1,523 1,708 3,925 6,956 Non-recurring charges............. -- -- -- -- 500 Amortization of intangible assets(2)....................... -- -- -- 6,097 6,097 ---------- ---------- ---------- ---------- -------- Income (loss) before income taxes........................... 54,007 (32,163) 42,754 56,736 81,382 Income taxes...................... 14,297 (18,102) 12,635 19,828 27,780 ---------- ---------- ---------- ---------- -------- Net income........................ $ 39,710 $ (14,151) $ 30,119 $ 36,908 $ 53,602 ========== ========== ========== ========== ======== Basic and diluted earnings per common share.................... $ 0.92 $ (0.33) $ 0.70 $ 0.86 $ 1.25 ========== ========== ========== ========== ======== Loss ratio(1)..................... 27.5% 56.7% 31.6% 25.2% 18.4% Expense ratio..................... 65.2 62.6 60.3 63.2 60.2 ---------- ---------- ---------- ---------- -------- Combined ratio(1)................. 92.7% 119.3% 91.9% 88.4% 78.6% ========== ========== ========== ========== ======== Invested assets and cash.......... $ 766,387 $ 654,072 $ 638,204 $ 579,657 $555,975 Intangible assets, net of amortization.................... 138,785 138,785 143,785 143,785 149,882 Total assets...................... 1,174,494 1,169,123 1,093,380 1,061,598 950,568 Insurance reserves................ 589,406 637,607 519,646 516,190 406,636 Debt.............................. 65,720 50,418 60,816 76,195 101,556 Total liabilities................. 728,123 758,982 672,819 673,170 576,536 Stockholders' equity.............. 446,371 410,141 420,561 388,428 374,032 Book value per share.............. $ 10.38 $ 9.54 $ 9.79 $ 9.08 $ 8.76 Dividends paid per share.......... $ -- $ -- $ 0.45 $ 0.54 $ 0.32 ------------------------- (1) Includes the effect of recording revisions of prior year reserves. The dollar amount and the percentage point effect on the loss ratio of these reserve revisions were a reduction of $613, or 0.2%, for the year ended December 31, 2004, an addition of $39,290, or 12.9% for the year ended December 31, 2003, an addition of $6,180, or 2.1%, for the year ended December 31, 2002, an addition of $4,812, or 1.5%, for the year ended December 31, 2001, and a reduction of $7,093, 2.4%, for the year ended December 31, 2000. (2) As of January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142 concerning the accounting for goodwill and other intangible assets. The adoption of this standard eliminated the Company's amortization of goodwill and intangibles after December 31, 2001 and therefore, increased the Company's reported 2002 net income by $5.7 million, or 13 cents per share, respectively, as compared to the same period in 2001. If the provisions of this standard were applied to prior periods, net income for the years ended December 31, 2001 and 2000 would have been $42.6 million or $0.99 per share, and $59.3 million or $1.38 per share, respectively. 14 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is a discussion and analysis of CNA Surety Corporation ("CNA Surety" or "Company") and its subsidiaries' operating results, liquidity and capital resources, and financial condition. This discussion should be read in conjunction with the Consolidated Financial Statements of CNA Surety and Notes thereto. INTRODUCTION Management believes that the following areas represent the most significant risks and uncertainties impacting the operating performance and financial condition of the Company. The financial impacts of these issues would affect gross and net written premium, incurred losses and reserves for unpaid losses. Each of these issues is discussed in greater detail later in this section. Exposure to Loss on Principals Excluded from Reinsurance Programs Beginning in 2002, the Company's unaffiliated reinsurers excluded certain accounts (for which the Company had continuing exposure from bonds written in prior years) from the reinsurance programs. For these accounts, the Company would retain up to $60 million of loss. Due to the improved financial condition of some of these accounts and the Company's efforts to have these accounts covered, only one remains excluded from the 2005 reinsurance program. This account is a large national contractor that is discussed in detail on page 25. Availability and Cost of Reinsurance Reinsurance coverage is an important component of the Company's capital structure. Reinsurance allows the Company to meet certain regulatory restrictions that would otherwise limit the size of bonds that the Company writes and limit the market segments in which the Company could compete. In addition, reinsurance reduces the potential volatility of earnings and protects the Company's capital by limiting the amount of loss associated with any one bond principal. Due to increased loss frequency and severity for both the Company and within the surety industry in general that began emerging in 1999, the Company, beginning in 2002, paid substantially higher reinsurance premiums and was required to retain higher amounts of its per principal exposure. Through aggressive exposure reduction efforts and continued underwriting discipline, the Company has been able to purchase additional limits and more expansive reinsurance protection for 2004 and 2005, with substantial cost savings achieved for 2005 relative to 2004. The availability and cost of reinsurance protection for 2006 and beyond will depend on a number of factors such as the Company's loss experience, the surety industry's loss experience, the number of reinsurers willing to provide coverage, and broader economic conditions. Financial Strength Ratings Surety bond principals and obligees often refer to the financial strength ratings assigned by A.M. Best Company, Inc. ("A.M. Best"), Standard and Poor's ("S&P") and other similar companies when they are choosing a surety company. Because the Company uses the underwriting capacity of Continental Casualty Company ("CCC") to serve larger accounts, the insurer financial strength rating of both the Company and CCC factor into customers' decisions. After reporting a significant net loss in the third quarter of 2003, the Company's A.M. Best rating was lowered from A+ to A with a negative outlook. CCC also reported a significant net loss in the third quarter of 2003, but A.M. Best affirmed CCC's rating of A with a negative outlook. Management believes that the current ratings are sufficient for the Company to conduct all aspects of its business. Management also believes that a one level reduction in ratings would have only a minimal impact on operations. A further decrease beyond one level would likely have a material adverse impact on the Company's ability to write business. Management believes that the likelihood of further ratings downgrades has been reduced by ongoing efforts to reduce large exposures, lower per principal retentions under the 2004 15 and 2005 reinsurance programs, the reduction in the number of principals excluded from reinsurance programs and increased statutory surplus and capital. Economic Conditions The Company's results of operations are impacted by general corporate credit conditions, as well as by the condition of the public construction segment of the economy. Corporate credit default rates have improved from the historically high levels of 2002 and 2003, and the amount of new public construction spending appears to be strong. An improvement in overall corporate default rates could be expected to have a favorable impact on the Company's loss costs. Strong public construction spending could be expected to benefit the Company's written premium production and loss costs. Changes in these factors could have a material impact on the Company's financial condition and results of operations. Management believes that the diversification of the Company's book of business, with approximately 40% of premium from products that are less sensitive to economic conditions, mitigates the impact of these economic factors. Bond Premium Rates The premium rates that the Company charges for its bonds have a direct impact on the amount of revenue generated and on the ratio of incurred losses to earned premium. Over the last several years, the Company has charged higher rates for its bonds, particularly in the large commercial and contract segments. These two segments demonstrated the greater rate need due to the emergence of increased loss frequency and severity as noted above. Based on analysis of current competitive factors in the marketplace, the Company does not expect to achieve significant rate increases, particularly in the small and middle market contract segments. CRITICAL ACCOUNTING POLICIES Management believes the most significant accounting policies and related disclosures for purposes of understanding the Company's results of operations and financial condition pertain to reserves for unpaid losses and loss adjustment expenses and reinsurance, investments, goodwill and other intangible assets, and deferred policy acquisition costs. The Company's accounting policies related to reserves for unpaid losses and loss adjustment expenses and related estimates of reinsurance recoverables, are particularly critical to an assessment of the Company's financial results. These balances are highly subjective and require management's most complex judgments because of the need to make estimates about the effects of matters that are inherently uncertain. Reserves for Unpaid Losses and Loss Adjustment Expenses and Reinsurance CNA Surety accrues liabilities for unpaid losses and loss adjustment expenses under its surety and property and casualty insurance contracts based upon estimates of the ultimate amounts payable under the contracts related to losses occurring on or before the balance sheet date. Reported claims are in various stages of the settlement process. Due to the nature of surety, which is the relationship among three parties whereby the surety guarantees the performance of the principal to a third party (the obligee), the investigation of claims and the establishment of case estimates on claim files can be a complex process that can occur over a period of time depending on the type of bond(s) and the facts and circumstances involving the particular bond(s), the claim(s) and the principal. Case reserves are typically established after a claim is filed and an investigation and analysis has been conducted as to the validity of the claim, the principal's response to the claim and the principal's financial viability. To the extent it is determined that there are no bona fide defenses to the claim and the principal is unwilling or financially unable to resolve the claim, a case estimate is established on the claim file for the amount the Company estimates it will have to pay to honor its obligations under the provisions of the bond(s). 16 While the Company intends to establish initial case reserve estimates that are sufficient to cover the ultimate anticipated loss on a file, some estimates need to be adjusted during the life cycle of the file as matters continue to develop. Factors that can necessitate case estimate increases or decreases are the complexity of the bond(s) and/or underlying contract(s), if additional and/or unexpected claims are filed, if the financial condition of the principal or obligee changes or as claims develop and more information is discovered that was unknown and/or unexpected at the time the initial case reserve estimate was established. Ultimately, claims are resolved through payment and/or a determination that, based on the information available, a case reserve is no longer required. As of any balance sheet date, not all claims have been reported and some claims may not be reported for many years. As a result, the liability for unpaid losses includes significant estimates for incurred-but-not-reported ("IBNR") claims. The following table shows the estimated liability as of December 31, 2004 for unpaid claims applicable to reported claims and to IBNR (dollars in thousands) for each sub-line of business: GROSS CASE LOSS GROSS IBNR LOSS TOTAL GROSS AND LAE RESERVES AND LAE RESERVES RESERVES ---------------- ---------------- ----------- Contract.................................. $ 55,362 $ 87,224 $142,586 Commercial................................ 108,636 99,233 207,869 Fidelity and other........................ 4,716 8,216 12,932 -------- -------- -------- Total..................................... $168,714 $194,673 $363,387 ======== ======== ======== The Company retains an independent actuarial firm of national standing to perform periodic actuarial analysis of the Company's loss reserves. This analysis is based on a variety of techniques that involve detailed statistical analysis of past claim reporting, settlement activity, and salvage and subrogation activity, as well as claim frequency and severity data when sufficient information exists to lend statistical credibility to the analysis. The analysis may be based upon internal loss experience or industry experience. Techniques may vary depending on the type of claim being estimated. While techniques may vary, each employs significant judgments and assumptions. This analysis results in both a range of reasonable loss reserve estimates as well as a point estimate of the indicated loss reserves. Surety results, especially for contract and certain commercial products like insurance program bonds, workers compensation insurance bonds and reclamation bonds, tend to be impacted by fewer, but more severe, losses. With this type of loss experience, it is more difficult to estimate the required reserves, particularly for the most current accident years which may have few reported claims. As a result, the range of reasonable loss reserve estimates may be broader than that associated with traditional property/casualty insurance products. The independent actuarial firm's analysis is the primary tool that management utilizes in determining its best estimate of loss reserves. However, the carried reserve may differ from the independent actuarial firm's point estimate as a result of management's consideration of the impact of factors such as the following, especially as they relate to the current accident year: - Current claim activity, including the frequency and severity of current claims - Changes in underwriting standards and business mix such as the Company's efforts to reduce exposures to large commercial bonds - Changes in the claims handling process - Current economic conditions, especially corporate default rates and the condition of the construction economy Management believes that the impact of the factors listed above, and others, may not be fully quantifiable through actuarial analysis. Accordingly, management may apply its judgment of the impact of these factors, and others, to its selection of the recorded loss reserves. Receivables recorded with respect to insurance losses ceded to reinsurers under reinsurance contracts are estimated in a manner similar to liabilities for insurance losses and, therefore, are also subject to uncertainty. In addition to the factors cited above, estimates of reinsurance recoveries may prove uncollectible if the 17 reinsurer is unable to perform under the contract. Reinsurance contracts do not relieve the ceding company of its obligations to indemnify its own policyholders. The Company's Consolidated Balance Sheet includes estimated liabilities for unpaid losses and loss adjustment expenses of $363.4 million and reinsurance receivables related to unpaid losses of $116.8 million at December 31, 2004 compared to estimates of $413.5 million and $158.4 million, respectively, at December 31, 2003. At December 31, 2004, the range of reasonable loss reserve estimates, net of reinsurance receivables, calculated by the independent actuarial firm and adopted by management was from $199 million to $305 million. Ranges of reasonable loss reserve estimates are not calculated for the sub-lines of business. Management believes that the range calculated over total reserves provides the most meaningful information due to the importance of correlation of losses between the sub-lines of business related to the impact of general economic conditions. Due to the inherent uncertainties in the process of establishing the liabilities for unpaid losses and loss adjustment expenses, the actual ultimate claims amounts will differ from the currently recorded amounts. This difference could have a material effect on reported earnings and financial condition. Future effects from changes in these estimates will be recorded as a component of losses incurred in the period such changes are determined to be needed. Investments Management believes the Company has the ability to hold all fixed income securities to maturity. However, the Company may dispose of securities prior to their scheduled maturity due to changes in interest rates, prepayments, tax and credit considerations, liquidity or regulatory capital requirements, or other similar factors. As a result, the Company considers all of its fixed income securities (bonds and redeemable preferred stocks) and equity securities as available-for-sale. These securities are reported at fair value, with unrealized gains and losses, net of deferred income taxes, reported as a separate component of stockholders' equity. Cash flows from purchases, sales and maturities are reported gross in the investing activities section of the cash flow statement. The amortized cost of fixed income securities is determined based on cost and the cumulative effect of amortization of premiums and accretion of discounts to maturity. Such amortization and accretion are included in investment income. For mortgage-backed and certain asset-backed securities, the Company recognizes income using the effective-yield method based on estimated cash flows. All securities transactions are recorded on the trade date. Investment gains or losses realized on the sale of securities are determined using the specific identification method. Investments with an other-than-temporary decline in value are written down to fair value, resulting in losses that are included in realized investment gains and losses. Short-term investments that generally include U.S. Treasury bills, corporate notes, money market funds and investment grade commercial paper equivalents, are carried at amortized cost which approximates fair value. Invested assets are exposed to various risks, such as interest rate risk, market risk and credit risk. Due to the level of risk associated with invested assets and the level of uncertainty related to changes in the value of these assets, it is possible that changes in risks in the near term may materially affect the amounts reported in the Consolidated Balance Sheets and Consolidated Statements of Income. Intangible Assets CNA Surety's Consolidated Balance Sheet as of December 31, 2004 includes intangible assets of $138.8 million. These amounts represent goodwill and identified intangibles with indefinite useful lives arising from the acquisition of Capsure. Prior to 2002, goodwill from this and other acquisitions were generally amortized as a charge to earnings over periods not exceeding 30 years. Under Statement of Financial Accounting Standards ("SFAS") No. 142 entitled "Goodwill and Other Intangible Assets" ("SFAS 142"), which was adopted by CNA Surety as of January 1, 2002, periodic amortization ceased, in accordance with an impairment-only accounting model. 18 A significant amount of judgment is required in performing goodwill impairment tests. Such tests include periodically determining or reviewing the estimated fair value of CNA Surety's reporting units. Under SFAS 142, fair value refers to the amount for which the entire reporting unit may be bought or sold. There are several methods of estimating fair value, including market quotations, asset and liability fair values and other valuation techniques, such as discounted cash flows and multiples of earnings or revenues. If the carrying amount of a reporting unit, including goodwill, exceeds the estimated fair value, then individual assets, including identifiable intangible assets, and liabilities of the reporting unit are estimated at fair value. The excess of the estimated fair value of the reporting unit over the estimated fair value of net assets would establish the implied value of goodwill. The excess of the recorded amount of intangible assets over the implied value of intangible assets is recorded as an impairment loss. Deferred Policy Acquisition Costs Policy acquisition costs, consisting of commissions, premium taxes and other underwriting expenses which vary with, and are primarily related to, the production of business, net of reinsurance commissions, are deferred and amortized as a charge to income as the related premiums are earned. The Company periodically tests that deferred acquisition costs are recoverable based on the expected profitability embedded in the reserve for unearned premium. If the expected profitability is less than the balance of deferred acquisition costs, a charge to net income is taken and the deferred acquisition cost balance is reduced to the amount determined to be recoverable. Anticipated investment income is considered in the determination of the recoverability of deferred acquisition costs. RESULTS OF OPERATIONS Financial Measures The Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") discusses certain generally accepted accounting principles ("GAAP") and non-GAAP financial measures in order to provide information used by management to monitor the Company's operating performance. Management utilizes various financial measures to monitor the Company's insurance operations and investment portfolio. Underwriting results, which are derived from certain income statement amounts, are considered a non-GAAP financial measure and are used by management to monitor performance of the Company's insurance operations. The Company's investment portfolio is monitored through analysis of various quantitative and qualitative factors and certain decisions related to the sale or impairment of investments produce realized gains and losses, which is also a component used in the calculation of net income and is a non-GAAP financial measure. Underwriting results are computed as net earned premiums less net loss and loss adjustment expenses and net commissions, brokerage and other underwriting expenses. Management uses underwriting results to monitor the results of its insurance operations without the impact of certain factors, including net investment income, net realized investment gains (losses) and interest expense. Management excludes these factors in order to analyze the direct relationship between net earned premiums and the related net loss and loss adjustment expenses along with net commissions, brokerage and other underwriting expenses. Operating ratios are calculated using insurance results and are widely used by the insurance industry and regulators such as state departments of insurance and the National Association of Insurance Commissioners for financial regulation and as a basis of comparison among companies. The ratios discussed in the Company's MD&A are calculated using GAAP financial results and include the net loss and loss adjustment expense ratio ("loss ratio") as well as the net commissions, brokerage and other underwriting expense ratio ("expense ratio") and combined ratio. The loss ratio is the percentage of net incurred claim and claim adjustment expenses to net earned premiums. The expense ratio is the percentage of net commissions, brokerage and other underwriting expenses, including the amortization of deferred acquisition costs, to net earned premiums. The combined ratio is the sum of the loss and expense ratios. 19 The Company's investment portfolio is monitored by management through analyses of various factors including unrealized gains and losses on securities, portfolio duration, and exposure to interest rate, market and credit risk. Based on such analyses, the Company may impair an investment security in accordance with its policy, or sell a security. Such activities will produce net realized investment gains and losses. While management uses various GAAP and non-GAAP financial measures to monitor various aspects of the Company's performance, net income is the most directly comparable GAAP measure and represents a more comprehensive measure of operating performance. Management believes that its process of evaluating performance through the use of these non-GAAP financial measures provides a basis for enhanced understanding of its operating performance and the impact to net income as a whole. Management also believes that investors may find these widely used financial measures described above useful in interpreting the underlying trends and performance, as well as to provide visibility into the significant components of net income. COMPARISON OF CNA SURETY ACTUAL RESULTS FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002 Analysis of Net Income (Loss) The Company had net income of $39.7 million for the year ended December 31, 2004 as compared to a net loss of $14.2 million for the year ended December 31, 2003, and net income of $30.1 million for the year ended December 31, 2002. The increase in 2004 reflects the absence of material adverse loss development which occurred during the third quarter of 2003, higher net earned premium and higher net investment income, partially offset by higher expenses. The decrease in 2003 compared to 2002 was driven by higher incurred losses and lower investment income. Analysis of the components of net income are discussed in the following sections. Results of Insurance Operations Underwriting components for the Company for the years ended December 31, 2004, 2003 and 2002 are summarized in the following table (dollars in thousands): YEARS ENDED DECEMBER 31, ------------------------------ 2004 2003 2002 -------- -------- -------- Gross written premium................................ $389,417 $371,375 $359,892 ======== ======== ======== Net written premium.................................. $318,284 $319,210 $306,654 ======== ======== ======== Net earned premium................................... $317,857 $304,449 $298,319 ======== ======== ======== Net losses and loss adjustment expenses.............. $ 87,356 $172,476 $ 94,198 ======== ======== ======== Net commissions, brokerage and other underwriting expenses........................................... $207,166 $190,740 $179,827 ======== ======== ======== Loss ratio........................................... 27.5% 56.7% 31.6% Expense ratio........................................ 65.2 62.6 60.3 -------- -------- -------- Combined ratio....................................... 92.7% 119.3% 91.9% ======== ======== ======== Premiums Written CNA Surety primarily markets contract and commercial surety bonds. Contract surety bonds generally secure a contractor's performance and/or payment obligation with respect to a construction project. Contract surety bonds are generally required by federal, state and local governments for public works projects. The most common types include bid, performance and payment bonds. Commercial surety bonds include all surety bonds other than contract and cover obligations typically required by law or regulation. The commercial surety market includes numerous types of bonds categorized as court judicial, court fiduciary, public official, license and permit and many miscellaneous bonds that include guarantees of financial performance. The Company 20 also writes fidelity bonds that cover losses arising from employee dishonesty and other insurance products that are generally companion products to certain surety bonds. For example, the Company writes surety bonds for notaries and also offers related errors and omissions ("E&O") insurance coverage. The Company assumes significant amounts of premiums primarily from affiliates. This includes all surety business written or renewed, net of reinsurance, by CCC and CIC, and their affiliates, after the Merger Date that is reinsured by Western Surety pursuant to reinsurance and related agreements. Because of certain regulatory restrictions that limit the Company's ability to write business on a direct basis, the Company continues to utilize the underwriting capacity available through these agreements. The Company is in full control of all aspects of the underwriting and claim management of the assumed business. Gross written premiums for the years ended December 31, 2004, 2003 and 2002 are shown in the table below (dollars in thousands) for each sub-line of business: YEARS ENDED DECEMBER 31, ------------------------------ 2004 2003 2002 -------- -------- -------- Contract............................................. $221,577 $208,472 $197,875 Commercial........................................... 135,893 133,733 134,039 Fidelity and other................................... 31,947 29,170 27,978 -------- -------- -------- $389,417 $371,375 $359,892 ======== ======== ======== Gross written premiums for the year ended December 31, 2004 increased 4.9% to $389.4 million as compared to 2003. Gross written premiums for contract surety increased 6.3% to $221.6 million, due primarily to improving rates on large contract bonds. Commercial surety premiums increased 1.6% to $135.9 million as continued strong volume growth in small commercial products more than offset the volume decline due to the Company's ongoing efforts to reduce aggregate exposures to large commercial accounts. Fidelity and other premiums increased by 7.7% in 2004 primarily due to the volume growth of related small commercial products. Gross written premiums for the year ended December 31, 2003 increased 3.2%, or $11.5 million, over the comparable period in 2002. Gross written premiums for contract surety increased 5.4%, or $10.6 million, reflecting improving rates. Gross written premiums for commercial surety decreased 0.2%, or $0.3 million, for the year ended December 31, 2003 reflecting the Company's ongoing effort to reduce aggregate exposures to large commercial accounts that was offset by continued volume growth of small commercial products and improving rates on large commercial bonds. Fidelity and other products increased 4.3% or $1.2 million, for the year ended December 31, 2003 as compared to the same period in 2002 due primarily to volume growth in fidelity and E&O products that are related to small commercial surety bonds. Net written premiums for the years ended December 31, 2004, 2003 and 2002 are shown in the table below (dollars in thousands) for each sub-line of business: YEARS ENDED DECEMBER 31, ------------------------------ 2004 2003 2002 -------- -------- -------- Contract............................................. $172,274 $184,449 $172,633 Commercial........................................... 115,454 106,899 107,290 Fidelity and other................................... 30,556 27,862 26,731 -------- -------- -------- $318,284 $319,210 $306,654 ======== ======== ======== For the year ended December 31, 2004, net written premiums decreased slightly to $318.3 million as compared to 2003, reflecting higher reinsurance costs. Ceded written premiums increased $19.0 million to $71.1 million for the year ended December 31, 2004 compared to 2003 primarily due to the Company's decision to reduce its per principal retention by purchasing additional reinsurance protection. Net written premiums for contract surety business decreased 6.6% to $172.3 million due to a higher allocation of reinsurance costs in 2004. Because of the significant reductions in exposures to large commercial bonds, a 21 greater share of the reinsurance protection is related to contract bonds. Net written premiums for commercial surety increased 8.0% to $115.5 million for the year ended December 31, 2004. Fidelity and other products increased 9.7% to $30.5 million for the year 2004 as compared to 2003. For the year ended December 31, 2003 net written premiums increased 4.1% to $319.2 million as compared to the same period in 2002, reflecting the aforementioned gross production. Ceded written premiums decreased $1.0 million to $52.2 million for the year ended December 31, 2003. Net written premiums for contract surety business increased 6.8% to $184.4 million. Net written premiums for commercial surety decreased 0.4% to $106.9 million for the year ended December 31, 2003. Fidelity and other products increased 4.2% to $27.9 million for the year 2003 as compared to 2002 primarily due to the aforementioned gross production. Excess of Loss Reinsurance The Company's reinsurance program is predominantly comprised of excess of loss reinsurance contracts that limit the Company's retention on a per principal basis. At December 31, 2004, American Reinsurance Company, General Reinsurance Corporation, Swiss Reinsurance America Corporation, and XL Reinsurance Corporation (all rated at least A by A.M. Best) were the four reinsurers from which the Company had its largest reinsurance receivables. 2004 Third Party Reinsurance Compared to 2003 Third Party Reinsurance Effective January 1, 2004, CNA Surety entered into a new excess of loss treaty ("2004 Excess of Loss Treaty") with a group of third party reinsurers that reduced its net retention per principal to $10 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company's retention. This new excess of loss treaty replaced the $45 million excess of $15 million per principal coverage, as well as the $40 million excess of $60 million per principal and the $3 million excess of $12 million coverage that had been provided by CCC. The material differences between the 2004 Excess of Loss Treaty excess of loss reinsurance program and the Company's 2003 Excess of Loss Treaty are as follows. The annual aggregate coverage increased from $110 million in 2003 to $157 million in 2004. The premium for the 2004 Excess of Loss Treaty was $50.6 million (net of expected return premium) compared to a total of $42.0 million of reinsurance premiums paid in 2003 (net of expected return premium) for the $45 million excess of $15 million, the $40 million excess of $60 million and the $3 million excess of $12 million treaties. The contract also included an optional twelve month extended discovery period, for an additional premium (a percentage of the original premium based on any unexhausted aggregate limit by layer), which would provide coverage for losses discovered in 2005 on bonds that were in force during 2004. The Company did not elect to purchase the extended discovery period because it obtained coverage for 2005 under a new treaty. The 2004 Excess of Loss Treaty also provided for somewhat less restrictive special acceptance provisions for larger contract accounts than those contained in the 2003 Excess of Loss Treaty. In addition to the one large contract principal (described later) and the two commercial principals excluded (based upon class of business), the Company's reinsurers had excluded three other contract principals from the 2003 Excess of Loss Treaty, for a total of six excluded principals. The one large contract principal and the two commercial principals remained excluded from the 2004 Excess of Loss Treaty. Of the two commercial principals, one is a domestic electric utility with an estimated bonded exposure of $38 million and is currently rated B- by S&P. This rating was increased from CCC+ during the third quarter of 2004 due to significant recapitalization efforts by the principal. The bonded exposure will decline over the term of the bond which extends until 2007. The other commercial principal is a foreign industrial enterprise that fulfilled its bonded obligations in the second quarter of 2004, so the Company no longer has any exposure. With respect to the three contract principals other than the large national contractor, two contract principals that have completed asset sales and other reorganization efforts have been accepted into the 2004 Excess of Loss Treaty. The Company received claims related to the third contract principal in 2003, making it ineligible for inclusion in the 2004 Excess of Loss Treaty. The Company believes it is adequately reserved for any exposure related to this principal and is not currently providing bonds to this contractor. 22 2005 Third Party Reinsurance Compared to 2004 Third Party Reinsurance Effective January 1, 2005, CNA Surety entered into a new excess of loss treaty ("2005 Excess of Loss Treaty") with a group of third party reinsurers on terms similar to the 2004 Excess of Loss Treaty. Under the 2005 Excess of Loss Treaty, the Company's net retention per principal remains at $10 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company's retention. The material differences between the 2005 Excess of Loss Treaty and the Company's 2004 Excess of Loss Treaty are as follows. The annual aggregate coverage increases from $157 million in 2004 to $185 million in 2005. The base annual premium for the 2005 Excess of Loss Treaty is $40.7 million compared to the actual cost of the 2004 Excess of Loss Treaty of $50.6 million (net of expected return premium). The contract again includes an optional twelve month extended discovery period, for an additional premium (a percentage of the original premium based on any unexhausted aggregate limit by layer) which will provide coverage for losses discovered in 2006 on bonds that were in force during 2005. In addition, the 2005 Excess of Loss Treaty provides coverage for one commercial principal that had been excluded from the 2004 Excess of Loss Treaty. The Company no longer has exposure to a second commercial principal that was excluded from the 2004 Excess of Loss Treaty. Only the large national contractor (described later) that was excluded from the 2004 Excess of Loss Treaty remains excluded from the 2005 Excess of Loss Treaty. Related Party Reinsurance Reinsurance agreements together with the Services and Indemnity Agreement that are described below provide for the transfer of the surety business written by CCC and CIC to Western Surety. All of these agreements originally were entered into on September 30, 1997 (the "Merger Date"): (i) the Surety Quota Share Treaty (the "Quota Share Treaty"); (ii) the Aggregate Stop Loss Reinsurance Contract (the "Stop Loss Contract"); and (iii) the Surety Excess of Loss Reinsurance Contract (the "Excess of Loss Contract"). All of these contracts have expired. Some have been renewed on different terms as described below. The Services and Indemnity Agreement provides the Company's insurance subsidiaries with the authority to perform various administrative, management, underwriting and claim functions in order to conduct the business of CCC and CIC and to be reimbursed by CCC for services rendered. In consideration for providing the foregoing services, CCC has agreed to pay Western Surety a quarterly fee of $50,000. This agreement was renewed on January 1, 2005 and expires on December 31, 2005; and is annually renewable thereafter. There was no amount due to the CNA Surety insurance subsidiaries as of December 31, 2004. Through the Quota Share Treaty, CCC and CIC transfer to Western Surety all surety business written or renewed by CCC and CIC after the Merger Date. CCC and CIC transfer the related liabilities of such business and pay to Western Surety an amount in cash equal to CCC's and CIC's net written premiums written on all such business, minus a quarterly ceding commission to be retained by CCC and CIC equal to $50,000 plus 28% of net written premiums written on such business. Under the terms of the Quota Share Treaty, CCC has guaranteed the loss and loss adjustment expense reserves transferred to Western Surety as of September 30, 1997 by agreeing to pay Western Surety, within 30 days following the end of each calendar quarter, the amount of any adverse development on such reserves, as re-estimated as of the end of such calendar quarter. There has not been any adverse reserve development for the period from September 30, 1997 (date of inception) through December 31, 2004. The Quota Share Treaty had an original term of five years from the Merger Date and was renewed on October 1, 2002 on substantially the same terms with an expiration date of December 31, 2003. The Quota Share Treaty was again renewed on January 1, 2004 on substantially the same terms with an expiration date of December 31, 2004; and is annually renewable thereafter. The ceding commission paid to CCC and CIC by Western Surety remained at 28% of net written premiums and contemplates an approximate 4% override commission for fronting fees to CCC and CIC on their actual direct acquisition costs. Due to lower commissions paid to producers on the business covered by the Quota Share Treaty, the actual override commission paid to CCC and CIC for 2004 was approximately 7%. The Quota Share Treaty was renewed for one year on January 1, 2005 on substantially the same terms except that the ceding commission to CCC and CIC was reduced to 25% in order to provide an approximate 4% override commission to CCC and CIC. 23 The Stop Loss Contract terminated on December 31, 2000 and was not renewed. The Stop Loss Contract protected the insurance subsidiaries from adverse loss experience on certain business underwritten after the Merger Date. The Stop Loss Contract between the insurance subsidiaries and CCC limited the insurance subsidiaries' prospective net loss ratios with respect to certain accounts and lines of insured business for three full accident years following the Merger Date. In the event the insurance subsidiaries' accident year net loss ratio exceeds 24% in any of the accident years 1997 through 2000 on certain insured accounts (the "Loss Ratio Cap"), the Stop Loss Contract requires CCC at the end of each calendar quarter following the Merger Date, to pay to the insurance subsidiaries a dollar amount equal to (i) the amount, if any, by which their actual accident year net loss ratio exceeds the applicable Loss Ratio Cap, multiplied by (ii) the applicable net earned premiums. In consideration for the coverage provided by the Stop Loss Contract, the insurance subsidiaries paid to CCC an annual premium of $20,000. The CNA Surety insurance subsidiaries have paid CCC all required annual premiums. As of December 31, 2004, the Company had billed $54.9 million under the Stop Loss Contract which has been paid by CCC, including $29.9 million received in 2004. The Excess of Loss Contract provided the insurance subsidiaries of CNA Surety with the capacity to underwrite large surety bond exposures by providing reinsurance support from CCC. The Excess of Loss Contract provided $75 million of coverage for losses in excess of the $60 million per principal. Subsequent to the Merger Date, the Company entered into a second excess of loss contract with CCC ("Second Excess of Loss Contract"). The Second Excess of Loss Contract provided unlimited additional coverage for principal losses that exceed the foregoing coverage of $75 million per principal provided by the Excess of Loss Contract, or aggregate losses per principal in excess of $135 million. In consideration for the reinsurance coverage provided by the Excess of Loss Contracts, the insurance subsidiaries paid to CCC, on a quarterly basis, a premium equal to 1% of the net written premiums applicable to the Excess of Loss Contract, subject to a minimum premium of $20,000 and $5,000 per quarter under the Excess of Loss Contract and Second Excess of Loss Contract, respectively. The two Excess of Loss Contracts collectively provided coverage for losses discovered on surety bonds in force as of the Merger Date and for losses discovered on new and renewal business written during the term of the Excess of Loss Contracts. Both Excess of Loss Contracts commenced following the Merger Date and continued until September 30, 2002. The discovery period for losses covered by the Excess of Loss Contracts originally extended until September 30, 2005. On January 1, 2005, CCC agreed to extend the discovery period to September 30, 2006 in return for an additional premium of $75,000. Effective October 1, 2002, the Company secured replacement excess of loss protection from CCC for per principal losses that exceed $60 million in two parts -- a) $40 million excess of $60 million and b) $50 million excess of $100 million. This excess of loss protection is primarily necessary to support contract surety accounts with bonded backlogs or work-in-process in excess of $60 million. The Company generally limits support for new large commercial surety accounts to $25 million. In addition to the foregoing structural changes in its high layer excess of loss reinsurance programs, the cost for these protections increased significantly as compared to the cost of the previous two Excess of Loss Contracts. The $40 million excess of $60 million contract is for a three year term beginning October 1, 2002 and provides annual aggregate coverage of $80 million and $120 million aggregate coverage for the entire three year term. The Company paid annual reinsurance premiums of $3.8 million (net of expected return premium) in year one to CCC. Effective January 1, 2004, the Company obtained replacement coverage from third party reinsurers as part of the 2004 Excess of Loss Treaty. Accordingly, the $40 million excess of $60 million contract with CCC was commuted effective January 1, 2004. As part of this commutation, the Company was entitled to a commutation payment of $10.9 million from CCC that was received in the first quarter of 2004. As of December 31, 2003, the full amount of the commutation payment had been recognized as a receivable. The Company and CCC entered into a new $40 million excess of $60 million reinsurance contract providing coverage exclusively for the one large national contractor that is excluded from the Company's third party reinsurance. This contract was effective from January 1, 2004 to December 31, 2004. The premium for this contract was $3.0 million. If a loss is ceded under this contract, an additional premium of $6.0 million is due. The Company and CCC entered into a new contract covering the one large national contractor effective January 1, 2005 to December 31, 2005 on the same terms as the 2004 contract. 24 The reinsurance premium for the coverage provided by the $50 million excess of $100 million contract was $6.0 million. This contract expired on December 31, 2003. The Company and CCC entered into a new $50 million excess of $100 million contract for the period of January 1, 2004 to December 31, 2004. The premium for this contract was $6.0 million plus an additional premium of $14.0 million if a loss is ceded under this contract. Effective January 1, 2005, the Company and CCC entered into a new $50 million excess of $100 million contract in force through December 31, 2005. The premium for this contract is $4.75 million plus an additional premium of $14.0 million if a loss is ceded under this contract. The reduction in premium for 2005 reflects the reduction in the Company's exposures, particularly large commercial exposures. The Company and CCC are presently discussing a possible restructuring of the reinsurance arrangements described in the preceding two paragraphs under which all bonds written for the large national contractor would be reinsured by CCC under an excess of $60 million treaty and other CNA Surety accounts would be covered by a separate $50 million excess of $100 million treaty. Effective October 1, 2003, the Company entered into a $3 million excess of $12 million excess of loss contract with CCC. The reinsurance premium for the coverage provided by the $3 million excess of $12 million contract was $0.3 million plus, if applicable, additional premiums based on paid losses. The contract provided for aggregate coverage of $12 million. This contract effectively lowered the Company's net retention per principal for the remainder of 2003 to $12 million plus a 5% co-participation in the $45 million layer of excess reinsurance with third party reinsurers. This contract was to expire on December 31, 2004, but was commuted effective January 1, 2004, when the Company obtained replacement coverage from third party reinsurers as part of the 2004 Excess of Loss Treaty. As of December 31, 2004 and December 31, 2003, CNA Surety had an insurance receivable balance from CCC and CIC of $16.4 million and $71.1 million, respectively. CNA Surety had reinsurance payables to CCC and CIC of $0.3 million as of December 31, 2004. CNA Surety had no reinsurance payables to CCC and CIC as of December 31, 2003. Large National Contractor The Company has provided significant surety bond protection guaranteeing projects undertaken by the large national contract principal that is excluded from the Company's third party insurance. The related party reinsurance available to the Company for this principal and the credit extended to the principal by affiliates of the Company are described below. Reinsurance If the Company should suffer any losses that are discovered prior to September 30, 2006 arising from bonds issued to the large national contractor with effective dates of September 30, 2002 and prior, the Company would retain the first $60 million of losses on bonds written, and CCC would incur 100% of losses above $60 million pursuant to the extended discovery provisions of the two Excess of Loss treaties that expired on September 30, 2002. Any losses discovered after September 30, 2006 on bonds with effective dates of September 30, 2002 and prior would be covered up to $150 million pursuant to the $50 million excess of $100 million contract with CCC described above and a twelve month contract with CCC effective January 1, 2005 that provides $40 million excess of $60 million reinsurance coverage exclusively for the large national contractor. For bonds that the Company has written after September 30, 2002, in addition to the coverage provided by excess of loss reinsurance treaties described above ($40 million excess of $60 million and $50 million excess of $100 million) the Company and CCC have entered into facultative reinsurance in connection with larger bonds. The Company's exposure on bonds written from October 1, 2002 through October 31, 2003 was limited to $20 million per bond. For bonds written subsequent to November 1, 2003 through December 31, 2004, the Company's exposure is limited to $14.7 million per bond. For bonds the Company may write in 2005, the Company's exposure will be limited to 10% of its statutory surplus. 25 CNAF Credit Facility Commencing in 2003, CNAF has provided loans through a credit facility in order to help the large national contractor meet its liquidity needs and complete projects which had been bonded by CNA Surety. In December of 2004, the credit facility was amended to increase the maximum available loans to $106 million from $86 million at December 31, 2003. The amendment also provides that CNAF may in its sole discretion further increase the amounts available for loans under the credit facility, up to an aggregate maximum of $126 million. As of December 31, 2004 and 2003, $99 million and $80 million had been advanced under the credit facility. Loews, through a participation agreement with CNAF, provided funds for and owned a participation of $29 million and $26 million of the loans outstanding as of December 31, 2004 and 2003, respectively, and has agreed to a participation of one-third of any additional loans which may be made above the original $86 million credit facility limit up to the $126 million maximum available line. Loans under the credit facility are secured by a pledge of substantially all of the assets of the contractor and certain of its affiliates. In connection with the credit facility, CNAF has also guaranteed or provided collateral for letters of credit which are charged against the maximum available line and, if drawn upon, would be treated as loans under the credit facility. As of December 31, 2004 and 2003, these guarantees and collateral obligations aggregated $13 million and $7 million. The contractor implemented a restructuring plan intended to reduce costs and improve cash flow, and appointed a chief restructuring officer to manage execution of the plan. In the course of addressing various expense, operational and strategic issues, however, the contractor has decided to substantially reduce the scope of its original business and to concentrate on those segments determined to be potentially profitable. As a consequence, operating cash flow, and in turn the capacity to service debt, has been reduced below previous levels. Restructuring plans have also been extended to accommodate these circumstances. In light of these developments, CNAF recorded an impairment charge of $56 million pretax ($36 million after-tax) for the fourth quarter of 2004, net of the participation by Loews, with respect to amounts loaned under the credit facility. Any draws under the credit facility beyond $106 million or further changes in the large national contractor's business plan or projections may necessitate further impairment charges. The Company intends to continue to provide surety bonds on behalf of the contractor during the restructuring period, subject to the contractor's initial and ongoing compliance with the Company's underwriting standards. Indemnification and subrogation rights, including rights to contract proceeds on construction projects in the event of default, exist that reduce CNA Surety's exposure to loss. While the Company believes that the contractor's restructuring efforts will be successful and provide sufficient cash flow for its operations, the contractor's failure to achieve its extended restructuring plan or perform its contractual obligations under the Company's surety bonds could have a material adverse effect on CNA Surety's results of operations, cash flow and equity. If such failures occur, the Company estimates that possible losses, net of indemnification and subrogation recoveries, but before recoveries under reinsurance contracts, to be approximately $200 million pretax. However, the related party reinsurance treaties discussed above should limit the Company's per principal loss exposure to approximately $60 million. After consideration of the additional premium due in the event of losses under the reinsurance treaties discussed above, the Company estimates that the financial statement impact of a failure by this contractor would be approximately $52 million after tax. The Company has had discussions with its insurance regulatory authorities regarding the level of bonds provided for this principal and will continue to keep the insurance regulators informed of its ongoing exposure to this account. Net Loss Ratio The loss ratios for the years ended December 31, 2004, 2003 and 2002 were 27.5%, 56.7% and 31.6%, respectively. The loss ratios reflect $0.6 million of favorable loss reserve development for the year ended December 31, 2004, and $39.3 million and $6.2 million in net unfavorable loss reserve development for the years ended December 31, 2003 and 2002, respectively. The improvement in the loss ratio from 2003 to 2004 is primarily due to the absence of both the adverse development on prior accident years that was recorded in 2003 and other large losses related to accident year 2003. Past changes in the Company's business mix and reinsurance program along with increased corporate 26 default rates were the primary drivers of the need to substantially increase reserve levels in 2003. Beginning in the late 1990's, the Company began writing more bonds for large corporate clients. Shortly thereafter, corporate default rates increased dramatically. These exposures proved to be more volatile than the Company's more traditional contract and small commercial surety products, and began resulting in a higher frequency of severe losses. As a result, the Company's reinsurers significantly increased rates, reduced the amount of coverage available to the Company and excluded certain accounts from the reinsurance program. For 2002, the Company's per principal retention increased from $5 million to $20 million. Although the Company reduced its per principal retention to $15 million for 2003, these higher retentions, at a time of continuing higher frequency of severe losses, further increased the volatility of results. Reported claim activity improved dramatically in 2004. Management believes that this is a result of ongoing efforts to reduce its exposures to large corporate clients, continued underwriting discipline in its traditional contract and small commercial products and a reduction in corporate default rates. Management anticipates that these factors, along with a further reduction in the Company's per principal retention for most accounts to $10 million for the 2004 and 2005 reinsurance programs will reduce the volatility of the Company's results. The favorable loss development recorded in 2004 for prior accident years resulted from loss adjustment expense payments related to prior years that were lower than previously expected. The adverse development on prior accident years that occurred in 2003 was directly related to a significant increase in large claim activity. Management concluded that this claim activity exceeded the assumptions regarding the frequency of severe losses used in determining the then existing reserves. First, additional contract bond claims were received during the third quarter of 2003 on a contractor that had filed for bankruptcy in February, 2003. Upon review and verification of these new claims, the existing case reserve was increased by $7.2 million, net of applicable reinsurance. Second, a demand was made during the third quarter of 2003 against a $45 million insurance program bond issued on behalf of a national trucking concern that was now in bankruptcy. This demand was in contradiction of previous information provided by the obligee on the bond. Based on this new information, management reserved the full remaining limits on this bond which resulted in $15 million of net adverse development after the application of available reinsurance. Third, claims were also received in the third quarter of 2003 on worker's compensation self insurance bonds written between 1975 and 1986 on behalf of two principals. After verifying coverage and obtaining supporting actuarial information on the underlying workers' compensation claims, the Company increased the case reserves on these bonds by $8.4 million, net of applicable reinsurance. Fourth, after receiving a demand on another insurance program bond in the third quarter of 2003, management identified an outstanding insurance program bond written on behalf of a contractor now in bankruptcy. Based on recent experience with this type of bond, which typically has few defenses available to the surety, and in particular with the obligee on this bond, management recorded a loss provision on this bond of $6 million. Finally, management determined that the case reserve on a particular claim was insufficient due to the amount of legal fees that the Company was incurring on the case. Based on their estimate of future legal expenses, management increased the reserve on this bond by $3 million. In addition to the net unfavorable loss reserve development, the higher net loss ratio in 2003 primarily relates to net reserve additions of approximately $49.0 million for the 2003 accident year due to material adverse loss severity on the Company's branch commercial and contract business. The net additions to reserves for the 2003 accident year resulted from three large contract bond claims totaling $28 million incurred in 2003, an approximately $15 million net loss on an insurance program bond for a now bankrupt large commercial account, and changes in estimates of large losses resulting from this significant adverse claim activity. The net adverse loss reserve development in 2002 includes $2.4 million associated with the assumed international credit and surety business from CNA Re that the Company ceased writing in 2000. The remainder is primarily related to increased claim frequency in the Company's small and specialty contract business. In addition to the net unfavorable loss reserve development, the loss ratio for the 2002 accident year was adversely impacted by the occurrence of a $12.0 million loss resulting from the bankruptcy of a national trucking concern. Due to the occurrence of this loss, other adverse loss trends and the uncertain outlook for 27 the economy and credit markets at that time, the Company increased the 2002 accident year loss ratio assumption on contract and large commercial business. On January 2, 2003, CNA Surety settled litigation brought by J.P. Morgan Chase & Co. ("Chase") in connection with three surety bonds issued on behalf of Enron Corporation subsidiaries. The penal sums of the three bonds totaled approximately $78 million. The Company paid Chase approximately $40.7 million and assigned its recovery rights in the Enron bankruptcy to Chase in exchange for a full release of its obligations under the bonds. The Company has no other exposure related to the Enron Corporation. CNA Surety's net loss related to the settlement, after anticipated recoveries under excess of loss reinsurance treaties, was previously fully reserved. Immediately upon execution of the settlement documents, the Company sent written notice for reimbursement to its reinsurers. As of December 31, 2004, the Company has billed a total of $37.1 million to its reinsurers. Seven reinsurers responsible for payment of 63% of the treaty proceeds either have paid their portions of the claim or have reached agreement with the Company and paid the Company to commute the entire reinsurance treaty under which the Enron claim was made. Pursuant to the treaty, the Company demanded and began arbitration proceedings against the two other reinsurers who have not paid their portions of the claim or commuted their treaties. Management believes that these reinsurers do not have valid defenses under the reinsurance treaties to avoid payment, and that the Company will fully recover all reinsurance recoverables recorded related to this settlement. As such, the Company has not recorded a reduction with respect to the remaining reinsurance recoverables of $13.7 million as of December 31, 2004. The surety business assumed from CCC and CIC is subject to an aggregate stop loss reinsurance contract between CCC and the Company that limits the Company's accident year net loss ratio on this business to 24% for accident years 1997 (October 1, 1997 to December 31, 1997), 1998, 1999 and 2000. The Company recorded estimated reinsurance recoveries from CCC of $29.9 in 2003, $2.5 million in 2002, $16.6 million in 2001 and $5.8 million in 2000 under this contract. No reinsurance recoveries from CCC were recorded in 2004. As of December 31, 2004, there was no unpaid balance related to amounts due under the Stop Loss Contract. Exposure Management As the foregoing results indicate, the Company's business is subject to certain risks and uncertainties associated with the current economic environment and corporate credit conditions. In response to these risks and uncertainties, the Company has enacted various exposure management initiatives, particularly to reduce its risks on large commercial accounts. As the following table depicts, the Company has reduced its exposure, before the effects of reinsurance, by 43% in 2004 on large commercial accounts, which are defined as accounts with exposures in excess of $10 million: NUMBER OF ACCOUNTS AS OF TOTAL EXPOSURE DECEMBER 31, AS OF DECEMBER 31, ------------- ------------------------- COMMERCIAL ACCOUNT EXPOSURE 2004 2003 2004 2003 % REDUCTION --------------------------- ----- ----- ---- ---- ----------- (DOLLARS IN BILLIONS) $100 million and larger......................... 2 7 $0.2 $0.9 77.8% $50 to $100 million............................. 7 8 0.5 0.6 16.7% $25 to $50 million.............................. 11 13 0.4 0.5 20.0% $10 to $25 million.............................. 39 66 0.6 1.0 40.0% -- -- ---- ---- Total........................................... 59 94 $1.7 $3.0 43.3% == == ==== ==== With respect to contract surety, the Company's portfolio is predominantly comprised of contractors with bonded backlog of less than $30 million. Bonded backlog is a measure of the Company's exposure in the event of default before indemnification, salvage and subrogation recoveries. The Company does have a number of accounts with higher bonded backlogs. For example, the Company has 13 accounts each with a bonded backlog in excess of $150 million and 14 accounts each with a bonded backlog of between $100 million and $150 million. 28 The Company will manage its exposure to any one contract credit and aggressively looks for co-surety, shared accounts and other means to support or reduce larger exposures. Reinsurance, indemnification and subrogation rights, including rights to contract proceeds on construction projects in the event of default, exist that substantially reduce CNA Surety's exposure to loss. Expense Ratio The expense ratio increased to 65.2% for the year ended December 31, 2004 as compared to 62.6% for 2003. The increase in the expense ratio for the year ended December 31, 2004 primarily reflects the impact of higher reinsurance costs on net earned premiums and higher operating expenses. Ceded earned premium increased by $10.5 million in 2004, primarily due to the Company's decision to reduce its per principal retention from $15 million in 2003 to $10 million in 2004. The higher ceded earned premium increased the 2004 expense ratio by 2.1 percentage points. Operating expenses increased 8.6% for the year ended December 31, 2004 primarily due to a 6.6% increase in gross earned premium. 2004 operating expenses were impacted by a $4.9 million increase to the accrual for policyholder dividends. This increase added approximately 1.5 percentage points to the 2004 expense ratio. The Company streamlined its field office structure during 2004 in order to add consistency to operations and to reduce expenses. No significant expense impact occurred in 2004 due to severance costs associated with this effort. The expense ratio increased to 62.6% for the year ended December 31, 2003 as compared to 60.3% for 2002. The increase in the expense ratio for the year ended December 31, 2003 primarily reflects the impact of higher reinsurance costs on net earned premiums and higher operating expenses. Ceded earned premium increased by $13.3 million in 2003, due to the Company's decision to reduce its per principal retention from $20 million in 2002 to $15 million in 2003 and costs associated with the purchase of an extended discovery period on a 2001 treaty. The higher ceded earned premium increased the 2003 expense ratio by 2.6 percentage points. Operating expenses increased 6.1% for the year ended December 31, 2003 primarily due to a 5.6% increase in gross earned premium. 2003 operating expenses were impacted by a $1.9 million accrual for post-employment benefits for three former senior executives that increased the 2003 expense ratio by 0.6 percentage points. Investment Income For 2004, net investment income was $30.2 million compared to net investment income for 2003 and 2002 of $26.3 million and $27.8 million, respectively. The annualized pretax yield was 4.5%, 4.4% and 4.8% for 2004, 2003 and 2002, respectively. The annualized after-tax yield was 3.7%, 3.6% and 3.8% for 2004, 2003 and 2002, respectively. The increase in investment income for 2004 is attributable to higher overall invested assets resulting primarily from significant cash flow from operations. The decrease in investment income for 2003 is attributable to the impact of lower investment yields in part due to increased investment in tax-exempt securities. Net realized investment gains/losses were $2.8 million and $1.8 million in gains for 2004 and 2003, respectively, and $7.6 million in losses for 2002. The net gains realized in 2004 and 2003 resulted from opportunities to sell securities that the Company believed would maximize the total return on its portfolio. The net realized investment losses in 2002 reflect the Company's insurance subsidiaries' decision to liquidate their common equity portfolios during 2002. The volatility of the equity markets was adversely impacting the Company's reported regulatory capital. The following summarizes net realized investment gains (losses) for the years ended December 31, 2004, 2003, and 2002: YEARS ENDED DECEMBER 31, ------------------------- 2004 2003 2002 ------ ------ ------- Gross realized investment gains........................... $2,765 $2,368 $11,183 Gross realized investment losses.......................... (14) (542) (18,769) ------ ------ ------- Net realized investment gain (losses)..................... $2,751 $1,826 $(7,586) ====== ====== ======= 29 The Company's investment portfolio generally is managed to maximize after-tax investment return, while minimizing credit risk with investments concentrated in high quality fixed income securities. CNA Surety's portfolio is managed to provide diversification by limiting exposures to any one industry, issue or issuer, and to provide liquidity by investing in the public securities markets. The portfolio is structured to support CNA Surety's insurance underwriting operations and to consider the expected duration of liabilities and short-term cash needs. In achieving these goals, assets may be sold to take advantage of market conditions or other investment opportunities or regulatory, credit and tax considerations. These activities will produce realized gains and losses. Invested assets are exposed to various risks, such as interest rate, market and credit. Due to the level of risk associated with certain of these invested assets and the level of uncertainty related to changes in the value of these assets, it is possible that changes in risks in the near term may significantly affect the amounts reported in the Consolidated Balance Sheets and Consolidated Statements of Income. The Company's Quantitative and Qualitative Discussion about Market Risk is contained in Item 7A of this Form 10-K. Interest Expense Interest expense increased $0.7 million, or 48.4%, for 2004 compared to 2003, primarily due to higher outstanding debt levels and the higher interest rate associated with long-term debt issued in 2004. The weighted average interest rate for 2004 was 3.6% compared to 2.4% and 2.2% for the periods ended December 31, 2003 and 2002, respectively. Interest expense decreased $0.2 million, or 10.8%, for 2003 compared to the same period in 2002, due primarily to lower outstanding debt levels. Average debt outstanding was $60.9 million in 2004 compared to $55.6 million and $73.4 million in 2003 and 2002, respectively. Income Taxes The Company's income tax expense was $14.3 million for the year ended December 31, 2004, as compared to an income tax benefit of $18.0 million for 2003 and income tax expense of $12.6 million for 2002. The effective income tax rates were 26.5%, (56.0)% and 29.6% for the years ended December 31, 2004, 2003 and 2002, respectively. The 2004 effective tax rate is impacted by the Company's significant investments in tax-exempt securities. The change in the effective tax rate in 2003 primarily relates to taxable losses from insurance underwriting and greater investments in tax-exempt securities as compared 2002. LIQUIDITY AND CAPITAL RESOURCES It is anticipated that the liquidity requirements of CNA Surety will be met primarily by funds generated from operations. The principal sources of operating cash flows are premiums, investment income, recoveries under reinsurance contracts and sales and maturities of investments. CNA Surety also may generate funds from additional borrowings under the credit facility described below. The primary cash flow uses are payments for claims, operating expenses, federal income taxes, debt service, as well as dividends to CNA Surety stockholders. In general, surety operations generate premium collections from customers in advance of cash outlays for claims. Premiums are invested until such time as funds are required to pay claims and claims adjusting expenses. The Company believes that total invested assets, including cash and short-term investments, are sufficient in the aggregate and have suitably scheduled maturities to satisfy all policy claims and other operating liabilities, including dividend and income tax sharing payments of its insurance subsidiaries. If cash requirements unexpectedly exceed cash inflows, the Company may raise additional cash by liquidating fixed income securities ahead of their scheduled maturity. Depending on the interest rate environment at that time, the Company could generate realized gains or losses that would increase or decrease net income for the period. The extent of these gains or losses would depend on a number of factors such as the prevailing interest rates and credit spreads, the duration of the assets sold, and the marketability of the assets. The need to liquidate fixed income securities would be expected to cause a reduction in future investment income. 30 The Company might also access available or new credit facilities to meet cash needs. This would increase interest expense by increasing the amount of debt outstanding and potentially increasing the interest rate on previously outstanding debt. The Company currently has $5 million of borrowing capacity on existing facilities. The Company's ability to enter into new facilities is limited by covenants in the existing facility. At December 31, 2004, the carrying value of the Company's insurance subsidiaries' invested assets was comprised of $722.0 million of fixed income securities, $22.7 million of short-term investments, $1.1 million of other investments and $5.6 million of cash. At December 31, 2003, the carrying value of the Company's insurance subsidiaries' invested assets was comprised of $573.7 million of fixed income securities, $49.8 million of short-term investments, $1.1 million of other investments and $2.0 million of cash. During the fourth quarter of 2004, the Company reached agreement with the obligee on a bond in claim regarding certain aspects of the claim resolution. As part of this agreement, the Company will place approximately $34 million of government securities in trust to fund future payments under the bond. This claim was previously fully reserved. Cash flow at the parent company level is derived principally from dividend and tax sharing payments from its insurance subsidiaries, and to a lesser extent, investment income. The principal obligations at the parent company level are to service debt, pay operating expenses, including income taxes, and pay dividends to stockholders. At December 31, 2004, the parent company's invested assets consisted of $6.3 million of fixed income securities, $1.2 million of equity securities, $5.8 million of short-term investments and $1.7 million of cash. At December 31, 2003, the parent company's invested assets consisted of $6.3 million of fixed income securities, $1.1 million of equity securities, $14.1 million of short-term investments and $6.0 million of cash. As of December 31, 2004 and December 31, 2003, parent company short-term investments and cash included $5.1 million and $6.6 million, respectively, of restricted cash primarily related to premium receipt collections ultimately due to the Company's insurance subsidiaries. The Company's consolidated net cash flow provided by operating activities was $108.0 million, $25.2 million and $85.5 million for 2004, 2003 and 2002, respectively. The increase in net cash flow provided by operating activities in 2004 primarily relates to higher premiums received, lower loss payments, receipts from reinsurers and an income tax refund related to the operating loss of 2003. The decrease in cash flow provided in 2003 is primarily due to increased loss payments. In May of 2004, the Company, through a wholly-owned trust, privately issued $30 million of preferred securities through two pooled transactions. These securities bear interest at a rate of the London Interbank Offered Rate ("LIBOR") plus 337.5 basis points with a 30-year term and are redeemable after five years. The securities were issued by CNA Surety Capital Trust I (the "Issuer Trust"). The sole asset of the Issuer Trust consists of $30.9 million junior subordinated debenture issued by the Company to the Issuer Trust. The subordinated debentures bear interest at a rate of LIBOR plus 337.5 basis points and mature in April of 2034. As of December 31, 2004 the interest rate on the junior subordinated debentures was 5.665%. The proceeds from the debt issuance were used to reduce the outstanding balance of a revolving credit facility of $30 million (the "Revolving Credit Facility") by $10.0 million and to increase the statutory surplus of the Company's insurance subsidiaries by $20.0 million. On September 30, 2002, the Company refinanced $65 million in outstanding borrowings under its previous credit facility with a new credit facility (the "2002 Credit Facility"). The 2002 Credit Facility, as amended September 30, 2003, provides an aggregate of up to $50 million in borrowings divided between the Revolving Credit Facility of $30 million and a term loan facility (the "Term Loan Facility") of $20 million. The Revolving Credit Facility matures on September 30, 2005. The Revolving Credit Facility may be increased from time to time by the amount of repayments under the Term Loan Facility up to an additional $10 million. Such increase is subject to consent by each Revolving Credit Bank, and will take place upon receipt by the banks of the respective installment payments under the Term Loan Facility. Effective January 30, 2003, the Company entered into an interest rate swap on the Term Loan Facility. As a result, the current effective interest rate on the term loan as of December 31, 2004 was 2.77%. 31 In June 2004, the Company reduced the outstanding Revolving Credit Facility by $10.0 million to $20 million. In September of 2004, the Company increased the outstanding Revolving Credit Facility by $5.0 million. At December 31, 2004, the amount outstanding under the Revolving Credit Facility was $25.0 million. The Term Loan Facility balance was reduced by $20 million through December 31, 2004 to $10 million according to scheduled repayment. Further repayment of the Term Loan Facility will take place in equal semi-annual installments of $5 million on the following dates: DATE SCHEDULED REPAYMENT OUTSTANDING BALANCE ---- ------------------- ------------------- March 31, 2005................................... $5,000,000 $5,000,000 September 30, 2005............................... 5,000,000 -- The Company has a total of $35 million of debt maturing in 2005. No other debt matures in the next five years. The interest rate on borrowings under the 2002 Credit Facility may be fixed, at CNA Surety's option, for a period of one, two, three, or nine months and is based on, among other rates, LIBOR, plus the applicable margin. The margin, including a facility fee and utilization fee on the Revolving Credit Facility, was 1.30% at December 31, 2004 and can vary based on CNA Surety's leverage ratio (debt to total capitalization) from 1.15% to 1.45%. The margin on the Term Loan Facility was 0.625% at December 31, 2004 and can vary based on CNA Surety's leverage ratio (debt to total capitalization) from 0.48% to 0.80%. As of December 31, 2004, the weighted average interest rate was 3.2825% on the $35.0 million of outstanding borrowings. As of December 31, 2003, the weighted average interest rate on the 2002 Credit Facility was 2.4% on the $50.0 million of outstanding borrowings. The 2002 Credit Facility contains, among other conditions, limitations on CNA Surety with respect to the incurrence of additional indebtedness and maintenance of a rating of at least "A" by A.M. Best for each of the Company's insurance subsidiaries. The 2002 Credit Facility also requires the maintenance of certain financial ratios as follows: a) maximum funded debt to total capitalization ratio of 25%, b) minimum net worth of $350.0 million and c) minimum fixed charge coverage ratio of 2.5 times. Due to the net loss reported for the third quarter of 2003, the Company was in violation of the minimum fixed charge coverage test. The lenders granted the Company a waiver for this violation and amended the 2002 Credit Facility to replace the fixed charge coverage ratio requirement for the next three quarters with a minimum earnings requirement. At March 31, 2004, the Company was in violation of this minimum earnings requirement and received a waiver for this requirement in the second quarter of 2004. The Company is in compliance with the debt covenants as of and for the quarter ended December 31, 2004. A summary of the Company's commitments as of December 31, 2004 is presented in the following table: COMMITMENTS DECEMBER 31, 2004 2005 2006 2007 2008 2009 THEREAFTER TOTAL ----------------- ------ ------ ----- ----- ----- ---------- ------ (IN MILLIONS) Debt....................... $ 37.7 $ 1.8 $ 1.8 $ 1.8 $ 1.8 $ 73.6 $118.5 Operating leases........... 1.6 1.4 1.1 1.0 1.0 2.7 8.8 Loss and loss adjustment expense reserves......... 137.5 115.2 42.3 16.1 13.4 38.9 363.4 Other long-term liabilities(a)........... 1.7 0.3 0.4 0.4 0.4 5.8 9.0 ------ ------ ----- ----- ----- ------ ------ Total...................... $178.5 $118.7 $45.6 $19.3 $16.6 $121.0 $499.7 ====== ====== ===== ===== ===== ====== ====== ------------------------- (a) reflects post-employment obligations to former executives and unfunded post-retirement benefit plans As an insurance holding company, CNA Surety is dependent upon dividends and other permitted payments from its insurance subsidiaries to pay operating expenses, meet debt service requirements, as well as to pay cash dividends. The payment of dividends by the insurance subsidiaries is subject to varying degrees of supervision by the insurance regulatory authorities in South Dakota and Texas. In South Dakota, where 32 Western Surety and Surety Bonding are domiciled, insurance companies may only pay dividends from earned surplus excluding surplus arising from unrealized capital gains or revaluation of assets. In Texas, where USA is domiciled, an insurance company may only declare or pay dividends to stockholders from the insurer's earned surplus. The insurance subsidiaries may pay dividends without obtaining prior regulatory approval only if such dividend or distribution (together with dividends or distributions made within the preceding 12-month period) is less than, as of the end of the immediately preceding year, the greater of (i) 10% of the insurer's surplus to policyholders or (ii) statutory net income. In South Dakota, net income includes net realized capital gains in an amount not to exceed 20% of net unrealized capital gains. All dividends must be reported to the appropriate insurance department prior to payment. The dividends that may be paid without prior regulatory approval are determined by formulas established by the applicable insurance regulations, as described above. The formulas that determine dividend capacity in the current year are dependent on, among other items, the prior year's ending statutory surplus and statutory net income. Dividend capacity for 2005 is based on statutory surplus and income at and for the year ended December 31, 2004. Without prior regulatory approval in 2005, CNA Surety's insurance subsidiaries may pay to CNA Surety dividends of $46.8 million in the aggregate. CNA Surety received no dividends from its insurance subsidiaries in 2004. CNA Surety received dividends of $28.5 million from its insurance subsidiaries in 2003. Combined statutory surplus totaled $252.4 million at December 31, 2004, resulting in a net written premium to statutory surplus ratio of 1.3 to 1. Insurance regulations restrict Western Surety's maximum net retention on a single surety bond to 10 percent of statutory surplus. Under the 2005 Excess of Loss Treaty, the Company's net retention on new bonds would generally be $10 million plus a 5% co-participation in the $90 million layer of excess reinsurance above the Company's retention and this regulation would require minimum statutory surplus of $145.0 million at Western Surety. This surplus requirement may limit the amount of future dividends Western Surety could otherwise pay to CNA Surety. In accordance with the provisions of inter-company tax sharing agreements between CNA Surety and its subsidiaries, the tax of each subsidiary shall be determined based upon each subsidiary's separate return liability. Intercompany tax payments are made at such times when estimated tax payments would be required by the Internal Revenue Service ("IRS"). CNA Surety received tax-sharing payments from its subsidiaries of $10.9 million for 2004 and $7.4 million for 2003. Western Surety and Surety Bonding each qualify as an acceptable surety for federal and other public works project bonds pursuant to U.S. Department of Treasury regulations. U.S. Treasury underwriting limitations are based on an insurer's statutory surplus. Effective July 1, 2004 through June 30, 2005, the underwriting limitations of Western Surety and Surety Bonding are $18.5 million and $0.5 million, respectively. Through the Surety Quota Share Treaty between CCC and Western Surety Company, CNA Surety has access to CCC and its affiliates' U.S. Department of Treasury underwriting limitations. The Surety Quota Share Treaty had an original term of five years from the Merger Date and was renewed on October 1, 2002 and on January 1, 2004 on substantially the same terms. Effective July 1, 2004 through June 30, 2005, the underwriting limitations of CCC and its affiliates total $591.1 million. CNA Surety management believes that the foregoing U.S. Treasury underwriting limitations are sufficient for the conduct of its business. Subject to the aforementioned uncertainties concerning the Company's per principal net retentions, CNA Surety management believes that the Company has sufficient available resources, including capital protection against large losses provided by the Company's excess of loss reinsurance arrangements, to meet its present capital needs. 33 FINANCIAL CONDITION Investment Portfolio The following table summarizes the distribution of the Company's fixed income and equity portfolios at estimated fair values as of December 31, 2004 and 2003 (dollars in thousands): DECEMBER 31, DECEMBER 31, 2004 2003 ESTIMATED % OF ESTIMATED % OF FAIR VALUE TOTAL FAIR VALUE TOTAL ------------ ----- ------------ ----- Fixed income securities: U.S. Treasury securities and obligations of U.S. Government and agencies: U.S. Treasury............................ $ 56,034 7.7% $ 21,764 3.7% U.S. Agencies............................ 4,557 0.6 4,535 0.8 Collateralized mortgage obligations...... 18,745 2.6 8,195 1.4 Mortgage pass-through securities......... 56,772 7.8 7,993 1.4 Obligations of states and political subdivisions............................. 454,617 62.3 402,411 69.2 Corporate bonds............................ 99,069 13.6 103,802 17.9 Non-agency collateralized mortgage obligations.............................. 2,081 0.3 727 0.1 Other asset-backed securities: Second mortgages/home equity loans....... 21,114 2.8 6,147 1.1 Credit card receivables.................. 867 0.1 5,051 0.9 Other.................................... 8,185 1.1 4,798 0.8 Redeemable preferred stock................. 6,297 0.9 14,633 2.5 -------- ----- -------- ----- Total fixed income securities.............. 728,338 99.8% 580,056 99.8% Equity securities.......................... 1,198 0.2 1,061 0.2 -------- ----- -------- ----- Total...................................... $729,536 100.0% $581,117 100.0% ======== ===== ======== ===== The Company's investment portfolio generally is managed to maximize after-tax investment return, while minimizing credit risk with investments concentrated in high quality income securities. CNA Surety's portfolio is managed to provide diversification by limiting exposures to any one industry, issue or issuer, and to provide liquidity by investing in the public securities markets. The portfolio is structured to support CNA Surety's insurance underwriting operations and to consider the expected duration of liabilities and short-term cash needs. CNA Surety classifies its fixed income securities and its equity securities as available-for-sale, and as such, they are carried at fair value. The amortized cost of fixed income securities is adjusted for amortization of premiums and accretion of discounts to maturity, which is included in net investment income. Changes in fair value are reported as a component of other comprehensive income. 34 The estimated fair value and amortized cost of fixed income and equity securities held by CNA Surety by investment category, were as follows (dollars in thousands): GROSS UNREALIZED LOSSES GROSS ----------------------- AMORTIZED COST UNREALIZED LESS THAN MORE THAN ESTIMATED FAIR DECEMBER 31, 2004 OR COST GAINS 12 MONTHS 12 MONTHS VALUE ----------------- -------------- ---------- ---------- ---------- -------------- Fixed income securities: U.S. Treasury securities and obligations of U.S. Government and agencies: U.S. Treasury........... $ 55,818 $ 255 $ (39) $ -- $ 56,034 U.S. Agencies........... 4,576 39 (9) (49) 4,557 Collateralized mortgage obligations.......... 18,260 590 (105) -- 18,745 Mortgage pass-through securities........... 56,696 325 (249) -- 56,772 Obligations of states and political subdivisions............ 431,624 23,467 (387) (87) 454,617 Corporate bonds........... 94,363 4,735 (27) (2) 99,069 Non-agency collateralized mortgage obligations.... 2,078 3 -- -- 2,081 Other asset-backed securities: Second mortgages/home equity loans......... 20,942 241 (69) -- 21,114 Credit card receivables.......... 867 -- -- -- 867 Other................... 7,794 391 -- -- 8,185 Redeemable preferred stock................... 5,356 941 -- -- 6,297 -------- ------- ----- ----- -------- Total fixed income securities.............. 698,374 30,987 (885) (138) 728,338 Equity securities......... 1,084 114 -- -- 1,198 -------- ------- ----- ----- -------- Total................... $699,458 $31,101 $(885) $(138) $729,536 ======== ======= ===== ===== ======== Invested assets are exposed to various risks, such as interest rate, market and credit. Due to the level of risk associated with certain of these invested assets and the level of uncertainty related to changes in the value of these assets, it is possible that changes in risks in the near term may significantly affect the amounts reported in the Consolidated Balance Sheets and Consolidated Statements of Income. The Company's Quantitative and Qualitative Discussion about Market Risk is contained in Item 7A of this Form 10-K. The following table sets forth the ratings assigned by S&P or Moody's Investor Services, Inc. ("Moody's") of the fixed income securities portfolio of the Company as of December 31, 2004 and 2003 (dollars in thousands): 2004 2003 ----------------------- ----------------------- CREDIT RATING FAIR VALUE % OF TOTAL FAIR VALUE % OF TOTAL ------------- ---------- ---------- ---------- ---------- AAA/Aaa.................................... $508,309 69.8% $340,374 58.7% AA/Aa...................................... 109,736 15.1 116,051 20.0 A/Aa....................................... 62,342 8.6 45,187 7.8 BBB........................................ 39,640 5.4 69,853 12.0 Not Rated.................................. 8,311 1.1 8,591 1.5 -------- ----- -------- ----- Total...................................... $728,338 100.0% $580,056 100.0% 35 As of December 31, 2004 and 2003, 99% of the Company's fixed income securities were considered investment grade by S&P or Moody's and 85% and 79% were rated at least AA by those agencies for 2004 and 2003, respectively. The Company's investments in fixed income securities do not contain any industry concentration of credit risk. As of December 31, 2004, municipal securities of the State of Florida, the State of Texas, the State of Illinois, and the State of Michigan and each state's related political subdivisions each represent 4.2%, 4.1%, 3.5% and 3.4%, respectively, of the estimated fair value of the Company's fixed income securities. Municipal securities of each other state individually represent less than 3.3% of the Company's fixed income portfolio. The following table provides the composition of fixed income securities with an unrealized loss at December 31, 2004 in relation to the total of all fixed maturity securities by contractual maturities: % OF % OF MARKET UNREALIZED CONTRACTUAL MATURITY VALUE LOSS -------------------- ------ ---------- Due in one year or less..................................... 1% --% Due after one year through five years....................... 5 4 Due after five years through ten years...................... 24 27 Due after ten years......................................... 29 28 Asset-backed securities..................................... 41 41 --- --- Total....................................................... 100% 100% === === The following table summarizes for fixed income securities in an unrealized loss position at December 31, 2004 and 2003, the aggregate fair value and gross unrealized loss by length of time those securities have been continuously in an unrealized loss position (dollars in thousands): DECEMBER 31, 2004 DECEMBER 31, 2003 ---------------------------- ---------------------------- ESTIMATED GROSS ESTIMATED GROSS UNREALIZED LOSS AGING FAIR VALUE UNREALIZED LOSS FAIR VALUE UNREALIZED LOSS --------------------- ---------- --------------- ---------- --------------- Fixed income securities: Investment grade: 0-12 months......................... $107,401 $ 885 $21,074 $284 Greater than 12 months.............. 5,484 138 2,224 49 -------- ------ ------- ---- Total investment grade.............. $112,885 $1,023 $23,298 $333 ======== ====== ======= ==== A significant judgment in the valuation of investments is the determination of when an other-than-temporary decline in value has occurred. The Company follows a consistent and systematic process for impairing securities that sustain other-than-temporary declines in value. The Company has established a watch list that is reviewed by the Chief Financial Officer and one other executive officer on at least a quarterly basis. The watch list includes individual securities that fall below certain thresholds or that exhibit evidence of impairment indicators including, but not limited to, a significant adverse change in the financial condition and near term prospects of the investment or a significant adverse change in legal factors, the business climate or credit ratings. When a security is placed on the watch list, it is monitored for further market value changes and additional news related to the issuer's financial condition. The focus is on objective evidence that may influence the evaluation of impairment factors. The decision to record an impairment loss incorporates both quantitative criteria and qualitative information. The Company considers a number of factors including, but not limited to: (a) the length of time and the extent to which the market value has been less than book value, (b) the financial condition and near term prospects of the issuer, (c) the intent and ability of the Company to retain its investment for a period of time sufficient to allow for any anticipated recovery in value, (d) whether the debtor is current on interest and principal payments and (e) general market conditions and industry or sector specific factors. 36 For securities for which an impairment loss has been recorded, the security is written down to fair value and the resulting losses are recognized in net realized gains/losses in the Consolidated Statements of Operations. For the years ended December 31, 2004, 2003, and 2002, the Company had no other-than-temporary declines in the value of its investment securities. Reserves for Unpaid Losses and Loss Adjustment Expenses The Company retains an independent actuarial firm of national standing to perform periodic actuarial analysis of the Company's loss reserves. This analysis is based on a variety of techniques that involve detailed statistical analysis of past claim reporting, settlement activity, and salvage and subrogation activity, as well as claim frequency and severity data when sufficient information exists to lend statistical credibility to the analysis. The analysis may be based upon internal loss experience or industry experience. Techniques may vary depending on the type of claim being estimated. While techniques may vary, each employs significant judgments and assumptions. The independent actuarial firm provides annually actuarial certification as to the reasonableness of actuarial assumptions used and the sufficiency of year-end reserves for each of its principal insurance subsidiaries. The estimated liability for unpaid losses and loss adjustment expenses includes, on an undiscounted basis, estimates of (a) the ultimate settlement value of reported claims, (b) incurred-but-not-reported ("IBNR") claims, (c) future expenses to be incurred in the settlement of claims and (d) claim recoveries, exclusive of reinsurance recoveries which are reported as an asset. These estimates are determined based on the Company's and surety industry loss experience as well as consideration of current trends and conditions. The estimated liability for unpaid losses and loss adjustment expenses is an estimate and there is the potential that actual future loss payments will differ significantly from initial estimates. The methods of determining such estimates and the resulting estimated liability are regularly reviewed and updated. The independent actuarial firm's analysis is the primary tool that management utilizes in determining its best estimate of loss reserves. However, the carried reserve may differ from the independent actuarial firm's point estimate as a result of management's consideration of the impact of factors such as the following, especially as they relate to the current accident year: - Current claim activity, including the frequency and severity of current claims - Changes in underwriting standards and business mix such as the Company's efforts to reduce exposures to large commercial bonds - Changes in the claims handling process - Current economic conditions, especially corporate default rates and the condition of the construction economy Management believes that the impact of the factors listed above, and others, may not be fully quantifiable through actuarial analysis. Accordingly, management may apply its judgment of the impact of these factors, and others, to its selection of the recorded loss reserves. Due to the inherent uncertainties in the process of establishing the liabilities for unpaid losses and loss adjustment expenses, the actual ultimate claims amounts will differ from the currently recorded amounts. This difference could have a material effect on reported earnings and financial condition. Future effects from changes in these estimates will be recorded as a component of losses incurred in the period such changes are determined to be needed. The Company recorded net loss reserve development which resulted in a decrease in the estimated liability of $0.6 million in the year ended December 31, 2004 and increases of $39.3 million and $6.2 million for the years ended December 31, 2003 and 2002, respectively. Note 7 to the accompanying Consolidated Financial Statements presents a table of the activity in the reserves for unpaid losses and loss adjustment 37 expenses for the Company. This table highlights the impact of revisions to the estimated liability established in prior years. Risk Based Capital ("RBC") and Other Regulatory Ratios The National Association of Insurance Commissioners ("NAIC") has promulgated RBC requirements for property and casualty insurance companies to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks such as asset quality, loss reserve adequacy, and other business factors. The RBC information is used by state insurance regulators as an early warning mechanism to identify insurance companies that potentially are inadequately capitalized. In addition, the formula defines minimum capital standards that supplement the current system of fixed minimum capital and surplus requirements on a state-by-state basis. Regulatory compliance is determined by a ratio (the "Ratio") of the enterprise's regulatory total adjusted capital, as defined by the NAIC, to its authorized control level RBC, as defined by the NAIC. Generally, a Ratio in excess of 200% of authorized control level RBC requires no corrective actions on behalf of a company or regulators. As of December 31, 2004, each of CNA Surety's insurance subsidiaries had a Ratio that was in compliance with minimum RBC requirements. CNA Surety's insurance subsidiaries require capital to support premium writings. In accordance with industry and regulatory guidelines, the net written premiums to surplus ratio of a property and casualty insurer generally should not exceed 3 to 1. On December 31, 2004, Western Surety and its insurance subsidiaries had a combined statutory surplus of $252.4 million and a net written premiums to surplus ratio of 1.3 to 1. On December 31, 2003, CNA Surety had a combined statutory surplus of $190.4 million and a net written premium to surplus ratio of 1.7 to 1. The Company believes that each insurance company's statutory surplus is sufficient to support its current and anticipated premium levels. The NAIC has also developed a rating system, the Insurance Regulatory Information System ("IRIS"), primarily intended to assist state insurance departments in overseeing the financial condition of all insurance companies operating within their respective states. IRIS consists of twelve financial ratios that address various aspects of each insurer's financial condition and stability. In 2004 and 2003, most of the ratios for Western Surety, USA and Surety Bonding were within the "usual" ranges as defined by the NAIC, except as noted. In 2004, Western Surety's Investment Yield was outside the usual range due to a concentration of short-term and tax-exempt investments. Also, the Two Year Reserve Development to Policyholders' Surplus was outside the usual range due to adverse claim development in the third quarter of 2003. In 2003, Western Surety's Investment Yield was outside the usual range due to greater investment in tax-exempt securities. Also, the One-Year Reserve Development to Policyholders' Surplus was outside the usual range due to prior year adverse claim development. In 2003, USA's Change in Net Writings was outside the usual range due to decreased writings of contract surety bonds. In 2003, USA's Two-Year Overall Operating ratio was outside of the usual range, primarily due to increases in the loss and expense ratios. Surety Bonding's Investment Yield for 2003 was outside of the usual range primarily due to generally lower investment rates along with a concentration of short-term investments. IMPACT OF PENDING ACCOUNTING STANDARDS In March of 2004, the Emerging Issues Task Force (EITF) reached consensus on the guidance provided in EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments (EITF 03-1), as applicable to debt and equity securities that are within the scope of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (SFAS 115) and equity securities that are accounted for using the cost method specified in Accounting Principles Board Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock. Under EITF 03-1 an investment is impaired if the fair value of the investment is less than its cost including adjustments for amortization, accretion, foreign exchange, and hedging. An impairment would be considered other-than-temporary unless a) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for the recovery of the fair value up to (or beyond) the cost of the investment and b) evidence indicating that the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. This new guidance for determining whether impairment is other-than-temporary was to be 38 effective for reporting periods beginning after June 15, 2004. In September of 2004, the Financial Accounting Standards Board ("FASB") issued FASB Staff Position EITF Issue 03-1-1, which delayed the effective date for the measurement and recognition guidance included in EITF Issue 03-1 related to other-than-temporary impairment until additional implementation guidance is provided. As a result of the delay, during 2004, the Company continued to apply existing accounting literature for determining when a decline in fair value is other-than-temporary. The Company continues to evaluate the impact of this new accounting standard on its process for determining other-than-temporary impairment of equity and fixed maturity securities, including the potential impacts from any revisions to the original guidance issued. Adoption of this standard as originally issued may cause the Company to recognize impairment losses in the Consolidated Statements of Operations which would not have been recognized under the current guidance or to recognize such losses in earlier periods, especially those due to increases in interest rates, and could also impact the recognition of investment income on impaired securities. Such an impact would likely increase earnings volatility in future periods. However, since fluctuations in the fair value for available-for-sale securities are already recorded in Accumulated Other Comprehensive Income, adoption of this standard is not expected to have a significant impact on equity. In December of 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment ("SFAS 123R"), that amends SFAS No. 123 ("SFAS 123"), as originally issued in May of 1995. SFAS 123R addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise's equity instruments or that may be settled by the issuance of such equity instruments. SFAS 123R supercedes APB No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25"). After the effective date of this standard, entities will not be permitted to use the intrinsic value method specified in APB 25 to measure compensation expense and generally would be required to measure compensation expense using a fair-value based method. Public companies are to apply this standard using either the modified prospective method or the modified retrospective method. The modified prospective method requires a company to (a) record compensation expense for all awards it grants after the date it adopts the standard and (b) record compensation expense for the unvested portion of previously granted awards that remain outstanding at the date of adoption. The modified retrospective method requires companies to record compensation expense to either (a) all prior years for which SFAS 123 was effective (i.e. for all fiscal years beginning after December 15, 2004) or (b) only to prior interim periods in the year of initial adoption if the effective date of SFAS 123R does not coincide with the beginning of the fiscal year. SFAS 123R is effective for interim or annual periods beginning after June 15, 2005. Adoption of this standard is not expected to have a material impact on the Company's results of operations and/or equity. FORWARD-LOOKING STATEMENTS This report includes a number of statements which relate to anticipated future events (forward-looking statements) rather than actual present conditions or historical events. Forward-looking statements generally include words such as "believes," "expects," "intends," "anticipates," "estimates," and similar expressions. Forward-looking statements in this report include expected developments in the Company's insurance business, including incurred losses and loss and loss adjustment expense reserves; the impact of routine ongoing insurance reserve reviews being conducted by the Company; the ongoing state regulatory examinations of the Company's primary insurance company subsidiaries, and the Company's responses to the results of those reviews and examinations; the Company's expectations concerning its revenues, earnings, expenses and investment activities; expected cost savings and other results from the Company's expense reduction and restructuring activities; and the Company's proposed actions in response to trends in its business. Forward-looking statements, by their nature, are subject to a variety of inherent risks and uncertainties that could cause actual results to differ materially from the results projected. Many of these risks and uncertainties cannot be controlled by the Company. Some examples of these risks and uncertainties are: - general economic and business conditions; - changes in financial markets such as fluctuations in interest rates, long-term periods of low interest rates, credit conditions and currency, commodity and stock prices; 39 - the ability of the Company's contract principals to fulfill their bonded obligations; - the effects of corporate bankruptcies on surety bond claims, as well as on capital markets; - changes in foreign or domestic political, social and economic conditions; - regulatory initiatives and compliance with governmental regulations, judicial decisions, including interpretation of policy provisions, decisions regarding coverage, trends in litigation and the outcome of any litigation involving the Company, and rulings and changes in tax laws and regulations; - regulatory limitations, impositions and restrictions upon the Company, including the effects of assessments and other surcharges for guaranty funds and other mandatory pooling arrangements; - the impact of competitive products, policies and pricing and the competitive environment in which the Company operates, including changes in the Company's books of business; - product and policy availability and demand and market responses, including the level of ability to obtain rate increases and decline or non-renew underpriced accounts, to achieve premium targets and profitability and to realize growth and retention estimates; - development of claims and the impact on loss reserves, including changes in claim settlement practices; - the performance of reinsurance companies under reinsurance contracts with the Company; - results of financing efforts, including the availability of bank credit facilities; - changes in the Company's composition of operating segments; - the sufficiency of the Company's loss reserves and the possibility of future increases in reserves; - the risks and uncertainties associated with the Company's loss reserves as outlined in the Reserves section of this MD&A; and, - the possibility of further changes in the Company's ratings by ratings agencies, including the inability to access certain markets or distribution channels and the required collateralization of future payment obligations as a result of such changes, and changes in rating agency policies and practices. Any forward-looking statements made in this report are made by the Company as of the date of this report. The Company does not have any obligation to update or revise any forward-looking statement contained in this report, even if the Company's expectations or any related events, conditions or circumstances change. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCUSSIONS ABOUT MARKET RISK CNA Surety's investment portfolio is subject to economic losses due to adverse changes in the fair value of its financial instruments, or market risk. Interest rate risk represents the largest market risk factor affecting the Company's consolidated financial condition due to its significant level of investments in fixed income securities. Increases and decreases in prevailing interest rates generally translate into decreases and increases in the fair value of the Company's fixed income portfolio. The fair value of these interest rate sensitive instruments may also be affected by the credit worthiness of the issuer, prepayment options, relative value of alternative investments, the liquidity of the instrument, income tax considerations and general market conditions. The Company manages its exposure to interest rate risk primarily through an asset/liability matching strategy. The Company's exposure to interest rate risk is mitigated by the relative short-term nature of its insurance and other liabilities. The targeted effective duration of the Company's investment portfolio is approximately 5 years, consistent with the expected duration of its insurance and other liabilities. The tables below summarize the estimated effects of certain hypothetical increases and decreases in interest rates. It is assumed that the changes occur immediately and uniformly across each investment category. The hypothetical changes in market interest rates selected reflect the Company's expectations of the reasonably possible best or worst-case scenarios over a one-year period. The hypothetical fair values are based upon the same prepayment assumptions that were utilized in computing fair values as of December 31, 2004. Significant variations in market interest rates could produce changes in the timing of repayments due to 40 prepayment options available. The fair value of such instruments could be affected and therefore actual results might differ from those reflected in the following table. HYPOTHETICAL ESTIMATED FAIR PERCENTAGE HYPOTHETICAL VALUE AFTER INCREASE FAIR VALUE AT CHANGE IN HYPOTHETICAL (DECREASE) IN DECEMBER 31, INTEREST RATE CHANGE IN STOCKHOLDERS' 2004 (BP=BASIS POINTS) INTEREST RATE EQUITY ------------- ----------------- -------------- ------------- (DOLLARS IN THOUSANDS) U.S. Government and government agencies and authorities........... $136,108 200 bp increase $123,990 (1.8)% 100 bp increase 130,255 (0.9) 100 bp decrease 141,248 0.7 200 bp decrease 145,997 1.4 States, municipalities and political subdivisions....................... 454,617 200 bp increase 398,451 (8.2) 100 bp increase 426,163 (4.1) 100 bp decrease 484,149 4.3 200 bp decrease 515,785 8.9 Corporate bonds and all other........ 137,613 200 bp increase 122,449 (2.2) 100 bp increase 128,147 (1.4) 100 bp decrease 141,072 0.5 200 bp decrease 148,431 1.6 Total fixed income securities........ $728,338 200 bp increase 644,890 (12.2) 100 bp increase 684,565 (6.4) 100 bp decrease 766,469 5.6 200 bp decrease 810,213 11.9 HYPOTHETICAL ESTIMATED FAIR PERCENTAGE HYPOTHETICAL VALUE AFTER INCREASE FAIR VALUE AT CHANGE IN HYPOTHETICAL (DECREASE) IN DECEMBER 31, INTEREST RATE CHANGE IN STOCKHOLDERS' 2003 (BP=BASIS POINTS) INTEREST RATE EQUITY ------------- ----------------- -------------- ------------- (DOLLARS IN THOUSANDS) U.S. Government and government agencies and authorities........... $ 42,487 200 bp increase $ 37,563 (0.8)% 100 bp increase 40,119 (0.4) 100 bp decrease 44,471 0.3 200 bp decrease 46,343 0.6 States, municipalities and political subdivisions....................... 402,411 200 bp increase 349,291 (8.4) 100 bp increase 375,189 (4.3) 100 bp decrease 430,247 4.4 200 bp decrease 459,412 9.0 Corporate bonds and all other........ 135,158 200 bp increase 124,301 (1.7) 100 bp increase 129,346 (0.9) 100 bp decrease 140,486 0.8 200 bp decrease 146,629 1.8 Total fixed income securities........ $580,056 200 bp increase 511,155 (10.9) 100 bp increase 544,654 (5.6) 100 bp decrease 615,204 5.6 200 bp decrease 652,384 11.5 41 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of CNA Surety Corporation Chicago, Illinois We have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that CNA Surety Corporation and subsidiaries (the "Company") maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions. A company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management's assessment that the Company maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedules as of and for the year ended December 31, 2004 of the Company and our report dated February 25, 2005 expressed an unqualified opinion on the consolidated financial statements and financial statement schedules. Deloitte & Touche LLP Chicago, Illinois February 25, 2005 42 MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING The management of CNA Surety Corporation (CNAS) and subsidiaries is responsible for establishing and maintaining adequate internal control over financial reporting. CNAS' internal control system was designed to provide reasonable assurance to the Company's management, its Audit Committee and Board of Directors regarding the preparation and fair presentation of published financial statements. There are inherent limitations to the effectiveness of any internal control or system of control, however well designed, including the possibility of human error and the possible circumvention or overriding of such controls or systems. Moreover, because of changing conditions the reliability of internal controls may vary over time. As a result even effective internal controls can provide no more than reasonable assurance with respect to the accuracy and completeness of financial statements and their process of preparation. CNAS management assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2004. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control -- Integrated Framework. Based on our assessment we believe that, as of December 31, 2004, the Company's internal control over financial reporting is effective based on those criteria. CNAS' independent registered public accountant, Deloitte & Touche LLP, has issued an audit report covering our assessment of the Company's internal control over financial reporting. This report appears on page 42. CNA Surety Corporation Chicago, Illinois February 25, 2005 43 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of CNA Surety Corporation Chicago, Illinois We have audited the accompanying consolidated balance sheets of CNA Surety Corporation and subsidiaries (the "Company") as of December 31, 2004 and 2003, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedules listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of CNA Surety Corporation and subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company's internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 25, 2005 expressed an unqualified opinion on management's assessment of the effectiveness of the Company's internal control over financial reporting and an unqualified opinion on the effectiveness of the Company's internal control over financial reporting. Deloitte & Touche LLP Chicago, Illinois February 25, 2005 44 CNA SURETY CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, ----------------------- 2004 2003 ---------- ---------- (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA) ASSETS Invested assets and cash: Fixed income securities, at fair value (amortized cost: $698,374 and $544,201)................................. $ 728,338 $ 580,056 Equity securities, at fair value (cost: $1,084 and $992).................................................. 1,198 1,061 Short-term investments, at cost (approximates fair value)................................................. 28,457 63,871 Other investments, at fair value (cost: $1,058 and $1,119)................................................ 1,058 1,119 ---------- ---------- Total invested assets.................................. 759,051 646,107 Cash........................................................ 7,336 7,965 Deferred policy acquisition costs........................... 102,128 104,674 Insurance receivables: Premiums, including $11,012 and $18,394 from affiliates (net of allowance for doubtful accounts: $2,153 and $1,575)................................................ 32,340 39,455 Reinsurance, including $5,364 and $52,704 from affiliates............................................. 98,874 177,775 Intangible assets (net of accumulated amortization: $25,523 and $25,523).............................................. 138,785 138,785 Current income taxes receivable............................. -- 21,315 Property and equipment, at cost (less accumulated depreciation and amortization: $21,600 and $18,944)....... 15,358 16,556 Prepaid reinsurance premiums................................ 7,955 6,432 Accrued investment income................................... 8,891 8,031 Other assets................................................ 3,776 2,028 ---------- ---------- Total assets......................................... $1,174,494 $1,169,123 ========== ========== LIABILITIES Reserves: Unpaid losses and loss adjustment expenses................ $ 363,387 $ 413,539 Unearned premiums......................................... 226,019 224,068 ---------- ---------- Total reserves......................................... 589,406 637,607 Debt........................................................ 65,488 50,418 Deferred income taxes, net.................................. 27,024 30,738 Current income taxes payable................................ 3,491 -- Reinsurance and other payables to affiliates................ 461 191 Accrued expenses............................................ 17,090 14,854 Other liabilities........................................... 25,163 25,174 ---------- ---------- Total liabilities...................................... $ 728,123 $ 758,982 Commitments and contingencies (See Note 6, 7, & 8) STOCKHOLDERS' EQUITY Preferred stock, par value $0.01 per share, 20,000 shares authorized; none issued and outstanding................... -- -- Common stock, par value $.01 per share, 100,000 shares authorized; 44,423 shares issued and 43,015 shares outstanding at December 31, 2004 and 44,401 shares issued and 42,980 shares outstanding at December 31, 2003........ 444 444 Additional paid-in capital.................................. 255,996 255,816 Retained earnings........................................... 185,496 145,786 Accumulated other comprehensive income...................... 19,551 23,351 Treasury stock, at cost..................................... (15,116) (15,256) ---------- ---------- Total stockholders' equity............................. 446,371 410,141 ---------- ---------- Total liabilities and stockholders' equity........... $1,174,494 $1,169,123 ========== ========== The accompanying notes are an integral part of these consolidated financial statements. 45 CNA SURETY CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME YEARS ENDED DECEMBER 31, ------------------------------ 2004 2003 2002 -------- -------- -------- (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA) Revenues: Net earned premium................................... $317,857 $304,449 $298,319 Net investment income................................ 30,181 26,301 27,754 Net realized investment gains (losses)............... 2,751 1,826 (7,586) -------- -------- -------- Total revenues.................................... 350,789 332,576 318,487 -------- -------- -------- Expenses: Net losses and loss adjustment expenses.............. 87,356 172,476 94,198 Net commissions, brokerage and other underwriting expenses.......................................... 207,166 190,740 179,827 Interest expense..................................... 2,260 1,523 1,708 -------- -------- -------- Total expenses.................................... 296,782 364,739 275,733 Income (loss) before income taxes...................... 54,007 (32,163) 42,754 Income tax expense (benefit)........................... 14,297 (18,012) 12,635 -------- -------- -------- Net income (loss)...................................... $ 39,710 $(14,151) $ 30,119 ======== ======== ======== Earnings (loss) per common share....................... $ 0.92 $ (0.33) $ 0.70 ======== ======== ======== Earnings (loss) per common share, assuming dilution.... $ 0.92 $ (0.33) $ 0.70 ======== ======== ======== Weighted average shares outstanding.................... 42,998 42,967 42,910 ======== ======== ======== Weighted average shares outstanding, assuming dilution............................................. 43,143 42,989 43,028 ======== ======== ======== The accompanying notes are an integral part of these consolidated financial statements. 46 CNA SURETY CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY ACCUMULATED COMMON COMPREHENSIVE OTHER STOCK SHARES COMMON ADDITIONAL INCOME RETAINED COMPREHENSIVE OUTSTANDING STOCK PAID-IN CAPITAL (LOSS) EARNINGS INCOME ------------ ------ --------------- ------------- -------- ------------- (AMOUNTS IN THOUSANDS) Balance, December 31, 2001..................... 42,780 $442 $254,133 $149,128 $ 278 ====== ==== ======== ======== ======= Comprehensive income: Net income................. -- -- -- 30,119 30,119 -- Other comprehensive income: Change in unrealized gains on securities (after income taxes of $10,609), net of reclassification adjustment of $(16,627) after income taxes of $2,730................... -- -- -- 19,583 -- 19,583 -------- Total comprehensive income............... $ 49,702 ======== Issuance of treasury stock to employee stock purchase program......... 10 -- 15 -- -- Stock options exercised and other.................... 157 2 1,617 -- -- Dividends paid to stockholders............. -- -- -- (19,310) -- ------ ---- -------- -------- ------- Balance, December 31, 2002..................... 42,947 $444 $255,765 $159,937 $19,861 ====== ==== ======== ======== ======= Comprehensive income: Net income................. -- -- -- (14,151) (14,151) -- Other comprehensive income: Change in unrealized gains on securities (after income taxes of $1,380), net of reclassification adjustment of $1,618 after income taxes of ($869)................... -- -- -- 3,490 -- 3,490 -------- Total comprehensive income............... $(10,661) ======== Issuance of treasury stock to employee stock purchase program......... 18 -- (71) -- -- Stock options exercised and other.................... 15 -- 122 -- -- ------ ---- -------- -------- ------- Balance, December 31, 2003..................... 42,980 $444 $255,816 $145,786 $23,351 ====== ==== ======== ======== ======= Comprehensive income: Net income................. -- -- -- 39,710 39,710 -- Other comprehensive income: Change in unrealized gains on securities (after income taxes of $2,046), net of reclassification adjustment of $1,753 after income taxes of ($944)................... -- -- -- (3,800) -- (3,800) -------- Total comprehensive income............... $ 35,910 ======== Issuance of treasury stock to employee stock purchase program......... 13 -- (34) -- -- Stock options exercised and other.................... 22 -- 214 -- -- ------ ---- -------- -------- ------- Balance, December 31, 2004..................... 43,015 $444 $255,996 $185,496 $19,551 ====== ==== ======== ======== ======= TREASURY TOTAL STOCK STOCKHOLDERS' (AT COST) EQUITY --------- ------------- (AMOUNTS IN THOUSANDS) Balance, December 31, 2001..................... $(15,553) $388,428 ======== ======== Comprehensive income: Net income................. -- 30,119 Other comprehensive income: Change in unrealized gains on securities (after income taxes of $10,609), net of reclassification adjustment of $(16,627) after income taxes of $2,730................... -- 19,583 Total comprehensive income............... Issuance of treasury stock to employee stock purchase program......... 107 122 Stock options exercised and other.................... -- 1,619 Dividends paid to stockholders............. -- (19,310) -------- -------- Balance, December 31, 2002..................... $(15,446) $420,561 ======== ======== Comprehensive income: Net income................. -- (14,151) Other comprehensive income: Change in unrealized gains on securities (after income taxes of $1,380), net of reclassification adjustment of $1,618 after income taxes of ($869)................... -- 3,490 Total comprehensive income............... Issuance of treasury stock to employee stock purchase program......... 190 119 Stock options exercised and other.................... -- 122 -------- -------- Balance, December 31, 2003..................... $(15,256) $410,141 ======== ======== Comprehensive income: Net income................. -- 39,710 Other comprehensive income: Change in unrealized gains on securities (after income taxes of $2,046), net of reclassification adjustment of $1,753 after income taxes of ($944)................... -- (3,800) Total comprehensive income............... Issuance of treasury stock to employee stock purchase program......... 140 106 Stock options exercised and other.................... -- 214 -------- -------- Balance, December 31, 2004..................... $(15,116) $446,371 ======== ======== The accompanying notes are an integral part of these consolidated financial statements. 47 CNA SURETY CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, -------------------------------- 2004 2003 2002 --------- -------- --------- (AMOUNTS IN THOUSANDS) CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss).......................................... $ 39,710 $(14,151) $ 30,119 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation and amortization......................... 4,551 4,197 3,866 Accretion of bond discount, net....................... 2,930 2,093 1,028 Net realized investment (gains) losses................ (2,751) (1,826) 7,586 Changes in: Insurance receivables.................................... 86,016 (41,846) 37,774 Reserve for unearned premiums............................ 1,951 7,855 15,834 Reserve for unpaid losses and loss adjustment expenses... (50,151) 110,106 (12,378) Deferred policy acquisition costs........................ 2,546 (8,288) (6,598) Deferred income taxes, net............................... (1,667) (1,872) 171 Reinsurance and other payables to affiliates............. 270 (22,811) 15,614 Prepaid reinsurance premiums............................. (1,523) 6,905 (7,499) Other assets and liabilities............................. 26,073 (15,141) 21 --------- -------- --------- Net cash provided by operating activities.................. 107,955 25,221 85,538 --------- -------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Fixed income securities: Purchases................................................ (270,679) (88,311) (239,019) Maturities............................................... 22,686 30,251 29,303 Sales.................................................... 93,558 53,394 142,322 Purchases of equity securities............................. (313) (439) (22,870) Proceeds from the sale of equity securities................ 280 294 48,900 Changes in short-term investments.......................... 35,437 (13,193) 2,942 Purchases of property and equipment........................ (3,527) (3,903) (3,881) Changes in receivables/payables for securities sold/purchased........................................... -- -- (11,409) Other, net................................................. (1,353) (57) 3,147 --------- -------- --------- Net cash (used in) provided by investing activities...... (123,911) (21,964) (50,565) --------- -------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from long-term debt............................... 30,930 -- 71,000 Principal payments on debt................................. (15,417) (10,398) (86,379) Debt issuance costs........................................ (506) -- -- Dividends to stockholders.................................. -- -- (19,310) Issuance of treasury stock to employee stock purchase plan..................................................... 140 119 122 Employee stock option exercises and other.................. 180 8 1,414 --------- -------- --------- Net cash provided by (used in) financing activities........ 15,327 (10,271) (33,153) --------- -------- --------- Increase (decrease) in cash................................ (629) (7,014) 1,820 Cash at beginning of period................................ 7,965 14,979 13,159 --------- -------- --------- Cash at end of period...................................... $ 7,336 $ 7,965 $ 14,979 ========= ======== ========= Supplemental Disclosure of Cash Flow Information: Cash paid (received) during the period for: Interest................................................... $ 2,066 $ 1,260 $ 2,136 Income taxes............................................... $ (8,840) $ 5,816 $ 8,000 The accompanying notes are an integral part of these consolidated financial statements. 48 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SIGNIFICANT ACCOUNTING POLICIES Formation of CNA Surety Corporation and Merger In December 1996, CNA Financial Corporation ("CNAF") and Capsure Holdings Corp. ("Capsure") agreed to merge (the "Merger") the surety business of CNAF with Capsure's insurance subsidiaries, Western Surety Company ("Western Surety") Surety Bonding Company of America ("Surety Bonding") and Universal Surety of America ("USA"), into CNA Surety Corporation ("CNA Surety" or "Company"). CNAF, through its operating subsidiaries, writes multiple lines of property and casualty insurance, including surety business that is reinsured by Western Surety. CNAF owns approximately 64% of the outstanding common stock of CNA Surety. Loews Corporation ("Loews") owns approximately 91% of the outstanding common stock of CNAF. The principal operating subsidiaries of CNAF that wrote the surety line of business for their own account prior to the Merger were Continental Casualty Company and its property and casualty affiliates (collectively, "CCC") and The Continental Insurance Company and its property and casualty affiliates (collectively, "CIC"). Principles of Consolidation The consolidated financial statements include the accounts of CNA Surety and all majority-owned subsidiaries. Estimates The preparation of financial statements in conformity with generally accepted accounting principles ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Investments Management believes the Company has the ability to hold all fixed income securities to maturity. However, the Company may dispose of securities prior to their scheduled maturity due to changes in interest rates, prepayments, tax and credit considerations, liquidity or regulatory capital requirements, or other similar factors. As a result, the Company considers all of its fixed income securities (bonds and redeemable preferred stocks) and equity securities as available-for-sale. These securities are reported at fair value, with unrealized gains and losses, net of deferred income taxes, reported as a separate component of stockholders' equity. The amortized cost of fixed income securities is determined based on cost and the cumulative effect of amortization of premiums and accretion of discounts to maturity. Such amortization and accretion are included in investment income. For mortgage-backed and certain asset-backed securities, the Company recognizes income using the effective-yield method based on estimated cash flows. All securities transactions are recorded on the trade date. Investment gains or losses realized on the sale of securities are determined using the specific identification method. Investments with an other-than-temporary decline in value are written down to fair value, resulting in losses that are included in net realized investment gains/losses. Short-term investments that generally include U.S. Treasury bills, corporate notes, money market funds and investment grade commercial paper equivalents, are carried at amortized cost which approximates fair value. 49 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Deferred Policy Acquisition Costs Policy acquisition costs, consisting of commissions, premium taxes and other underwriting expenses that vary with, and are primarily related to, the production of business, net of reinsurance commissions, are deferred and amortized as the related premiums are earned. The Company periodically tests that deferred acquisition costs are recoverable based on the expected profitability embedded in the reserve for unearned premium. If the expected profitability is less than the balance of deferred acquisition costs, a charge to net income is taken and the deferred acquisition cost balance is reduced to the amount determined to be recoverable. Anticipated investment income is considered in the determination of the recoverability of deferred acquisition costs. Intangible Assets CNA Surety's Consolidated Balance Sheet as of December 31, 2004 includes intangible assets of $138.8 million. These amounts represent goodwill and identified intangibles with indefinite useful lives arising from the acquisition of Capsure. Prior to 2002, goodwill from this and other acquisitions were generally amortized as a charge to earnings over periods not exceeding 30 years. Under Statement of Financial Accounting Standards ("SFAS") No. 142 entitled "Goodwill and Other Intangible Assets" ("SFAS 142"), which was adopted by CNA Surety as of January 1, 2002, periodic amortization ceased, in accordance with an impairment-only accounting model. A significant amount of judgment is required in performing intangible asset impairment tests. Such tests include periodically determining or reviewing the estimated fair value of CNA Surety's reporting units. Under SFAS 142, fair value refers to the amount for which the entire reporting unit may be bought or sold. There are several methods of estimating fair value, including market quotations, asset and liability fair values and other valuation techniques, such as discounted cash flows and multiples of earnings or revenues. If the carrying amount of a reporting unit, including goodwill, exceeds the estimated fair value, then individual assets, including identifiable intangible assets, and liabilities of the reporting unit are estimated at fair value. The excess of the estimated fair value of the reporting unit over the estimated fair value of net assets would establish the implied value of intangible assets. The excess of the recorded amount of intangible assets over the implied value of intangible assets is charged-off as an impairment loss. The Company completed its annual intangible asset impairment test as of October 1, 2004, whereby no impairment was indicated. Reserves for Unpaid Losses and Loss Adjustment Expenses The estimated liability for unpaid losses and loss adjustment expenses includes, on an undiscounted basis, estimates of (a) the ultimate settlement value of reported claims, (b) incurred-but-not-reported ("IBNR") claims, (c) future expenses to be incurred in the settlement of claims and (d) claim recoveries, before reinsurance recoveries which are reported as an asset. These estimates are determined based on the Company's loss experience as well as consideration of industry experience, current trends and conditions. The estimated liability for unpaid losses and loss adjustment expenses is an estimate and there is the potential that actual future loss payments will differ significantly from recorded amounts. The methods of determining such estimates and the resulting estimated liability are regularly reviewed and updated. Changes in the estimated liability are reflected in the Statement of Income in the period in which such changes are determined to be needed. Insurance Premiums Insurance premiums are recognized as revenue ratably over the terms of the related policies in proportion to the insurance protection provided. Premium revenues are net of amounts ceded to reinsurers. Unearned 50 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) premiums represent the portion of premiums written, before ceded reinsurance which is shown as an asset, applicable to the unexpired terms of policies in force determined on a pro rata basis. Reinsurance The Company assumes and cedes insurance with other insurers and reinsurers to limit maximum loss, provide greater diversification of risk and minimize exposure on larger risks. Premiums and loss and loss adjustment expenses that are ceded under reinsurance arrangements reduce the respective revenues and expenses. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy and are reported as reinsurance receivables. Stock-Based Compensation As allowed under SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), the Company accounts for its stock option plans in accordance with Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). The Company has not issued stock options where the exercise price is less than the fair market value of the Company's common stock on the date of grant and, accordingly, no compensation expense has been recognized. Income Taxes The Company accounts for income taxes under the liability method. Under the liability method, deferred income taxes are established for the future tax effects of temporary differences between the tax and financial reporting bases of assets and liabilities using currently enacted tax rates. Such temporary differences primarily relate to unearned premium reserves and deferred policy acquisition costs. The effect on deferred taxes of a change in tax rates is recognized in income in the period of enactment. Property and Equipment Property and equipment are carried at cost less accumulated depreciation. Depreciation is based on the estimated useful lives of the various classes of property and equipment and determined principally on a straight-line basis. Depreciation expense for 2004, 2003, and 2002 was $4.5 million, $4.2 million, and $3.9 million, respectively. The cost of maintenance and repairs is charged to income as incurred; major improvements are capitalized. Earnings Per Share Basic earnings per common share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per common share is computed based on the weighted average number of shares outstanding plus the dilutive effect of common stock equivalents which is computed using the treasury stock method. 51 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The computation of earnings (loss) per share is as follows (amounts in thousands, except for per share data): YEARS ENDED DECEMBER 31, ---------------------------- 2004 2003 2002 ------- -------- ------- Net income (loss)...................................... $39,710 $(14,151) $30,119 ======= ======== ======= Shares: Weighted average shares outstanding.................... 42,980 42,947 42,780 Weighted average shares of options exercised........... 18 20 130 ------- -------- ------- Total weighted average shares outstanding.............. 42,998 42,967 42,910 Effect of dilutive options............................. 145 -- 118 ------- -------- ------- Total weighted average shares outstanding, assuming dilution............................................. 43,143 42,967 43,028 ======= ======== ======= Earnings (loss) per share.............................. $ 0.92 $ (0.33) $ 0.70 ======= ======== ======= Earnings (loss) per share, assuming dilution........... $ 0.92 $ (0.33) $ 0.70 ======= ======== ======= No adjustments were made to reported net income (loss) in the computation of earnings per share. Accounting Pronouncements In August 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 143 entitled "Accounting for Asset Retirement Obligations" ("SFAS 143"). SFAS 143 addresses accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The Company adopted the provisions of SFAS 143 effective January 1, 2003. The adoption of SFAS 143 did not have an impact on the Company's financial position or results of operations. In November 2002, the FASB issued FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (an interpretation of FASB SFAS Nos. 5, 57, and 107 and rescission of FASB Interpretation No. 34)" ("FIN 45"). FIN 45 clarifies the requirements of FASB SFAS No. 5, "Accounting for Contingencies" relating to a guarantor's accounting for, and disclosure of, the issuance of certain types of guarantees. FIN 45 provided for additional disclosure requirements related to guarantees, effective for financial periods ended after December 15, 2002. Additionally, FIN 45 outlined provisions for initial recognition and measurement of the liability incurred in providing a guarantee. These provisions are applied to guarantees issued or modified after December 31, 2002. The Company has adopted the disclosure requirements of FIN 45 and the provisions for initial recognition and measurement for all guarantees issued or modified after December 31, 2002. The adoption of FIN 45 did not have a significant impact on the Company's financial position or results of operations. In January 2003, FASB issued FASB Interpretation ("FIN") No. 46, "Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin ("ARB") No. 51" ("ARB No. 51") ("FIN No. 46"). In December of 2003, the FASB issued a revision to FIN No. 46 ("FIN No. 46R"), which superceded FIN No. 46 and further clarified the application of ARB No. 51. Per ARB No. 51, as a general rule, ownership by the parent, either directly or indirectly, of over fifty percent of the outstanding voting shares of a subsidiary is a condition pointing toward preparation of consolidated financial statements of the parent and its subsidiary. However, application of the majority voting interest requirement of ARB No. 51 to certain types of entities may not identify the party with a controlling financial interest because the controlling financial interest may be achieved through arrangements that do not involve voting interest. FIN No. 46R clarifies the applicability of ARB No. 51 to entities in which the equity investors do not have the characteristics of a 52 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support. FIN No. 46R requires an entity to consolidate a variable interest entity ("VIE") in which it is the primary beneficiary even though the entity does not, either directly or indirectly, own over fifty percent of the outstanding voting shares. FIN 46R defines a VIE as one in which a) the equity investment is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties which is provided through other interests that will absorb some or all of the expected losses of the entity or b) the equity investors lack one or more of the following essential characteristics of a controlling financial interest i) direct or indirect ability to make decisions about the entity's activities through voting rights or similar rights or ii) the obligation to absorb the expected losses of the entity, if they occur or receive residual returns of the entity, if they occur or iii) the right to receive the expected residual returns of the entity if they occur. The primary beneficiary of a VIE is required to consolidate the results of operations of the VIE. Financial statements issued are required to disclose the nature, purpose, activities and size of the VIE and maximum exposure to loss as a result of its involvement with the VIE. The Company has adopted FIN 46R. The Company is neither a primary beneficiary of a VIE nor does it have a significant involvement with a VIE. In December 2002, the FASB issued SFAS No. 148 entitled "Accounting for Stock-Based Compensation, Transition and Disclosure" ("SFAS 148"). SFAS 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS 148 also amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company adopted this disclosure standard beginning with the 2002 annual financial statements. The Company has not adopted fair value accounting. The Company applies APB 25 and related interpretations, in accounting for its plans as allowed for under the provisions of SFAS 123. Accordingly, no compensation cost has been recognized for its stock-based incentive plans as the exercise price of the granted options equals the market price at the grant date. In April 2003, the FASB issued SFAS No. 149 entitled "Amendment of Statement 133 on Derivative Instruments and Hedging Activities" ("SFAS 149"). SFAS 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133 entitled "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). SFAS 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. Adoption of SFAS 149 did not have a significant impact on the Company's financial position or results of operations. In May 2003, the FASB issued SFAS No. 150 entitled "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity" ("SFAS 150"). SFAS 150 establishes standards for how an issuer of financial instruments classifies and measures in its statement of financial position certain instruments with characteristics of both liabilities and equity. SFAS 150 modifies the accounting and financial statement disclosures of certain financial instruments that, under previous guidance, issuers could account for as equity. SFAS 150 affects the issuer's accounting for three types of financial instruments that are required to be accounted for as liabilities. SFAS 150 is effective for all financial instruments entered into or modified after May 31, 2003. For all financial instruments entered into prior to May 31, 2003, SFAS 150 was effective at the beginning of the first interim period beginning after June 15, 2003, which for CNA Surety began July 1, 2003. The Company does not have any financial instruments outstanding to which provisions of SFAS 150 apply, therefore the adoption of SFAS 150 did not have any impact on the Company's financial position or results of operations. In March 2004, the Emerging Issues Task Force ("EITF") reached consensus on the disclosure guidance provided in EITF Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and its 53 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Application to Certain Investments" ("EITF 03-1"). Under EITF 03-1 an investment is impaired if the fair value of the investment is less than its cost including adjustments for amortization, accretion, foreign exchange, and hedging. An impairment would be considered other-than-temporary unless a) the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for the recovery of the fair value up to (or beyond) the cost of the investment and b) evidence indicating that the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. This new guidance for determining whether the decline in the fair value of the investment is other-than-temporary was to be effective for reporting periods beginning after June 15, 2004. In September of 2004, the FASB issued FSP EITF Issue 03-1-1, which delayed the effective date for the measurement and recognition guidance included in EITF Issue 03-1 related to other-than-temporary impairment pending additional implementation guidance. As a result of the delay the Company continues to apply existing accounting literature for determining when a decline in fair value is other-than-temporary. In May of 2004, the FASB revised FASB Staff Position ("FSP") 106-1, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003" and issued FSP 106-2, "Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003" (FSP 106-2). The FSP provides accounting guidance to employers who sponsor postretirement health care plans that provide prescription drug benefits and the prescription drug benefit provided by the employer is "actuarially equivalent" to Medicare Part D and hence qualifies for the subsidy under the Medicare amendment act. This FSP was effective for the Company as of July 1, 2004, and its adoption did not have a material impact on the Company's results of operations or equity. In December of 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment ("SFAS 123R"), that amends SFAS No. 123 ("SFAS 123"), as originally issued in May of 1995. SFAS 123R addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise's equity instruments or that may be settled by the issuance of such equity instruments. SFAS 123R supercedes APB No. 25, "Accounting for Stock Issued to Employees" ("APB No. 25"). After the effective date of this standard, entities will not be permitted to use the intrinsic value method specified in APB 25 to measure compensation expense and generally would be required to measure compensation expense using a fair-value based method. Public companies are to apply this standard using either the modified prospective method or the modified retrospective method. The modified prospective method requires a company to (a) record compensation expense for all awards it grants after the date it adopts the standard and (b) record compensation expense for the unvested portion of previously granted awards that remain outstanding at the date of adoption. The modified retrospective method requires companies to record compensation expense to either (a) all prior years for which SFAS 123 was effective (i.e. for all fiscal years beginning after December 15, 2004) or (b) only to prior interim periods in the year of initial adoption if the effective date of SFAS 123R does not coincide with the beginning of the fiscal year. SFAS 123R is effective for interim or annual periods beginning after June 15, 2005. Adoption of this standard is not expected to have a material impact on the Company's results of operations and/or equity. Reclassifications Certain amounts in 2003 and 2002 have been reclassified to conform with the current year presentation. 54 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 2. INVESTMENTS The estimated fair value and amortized cost of fixed income and equity securities held by investment category, were as follows (dollars in thousands): GROSS UNREALIZED LOSSES GROSS ----------------------- AMORTIZED COST UNREALIZED LESS THAN MORE THAN ESTIMATED DECEMBER 31, 2004 OR COST GAINS 12 MONTHS 12 MONTHS FAIR VALUE ----------------- -------------- ---------- ---------- ---------- ---------- Fixed income securities: U.S. Treasury securities and obligations of U.S. Government and agencies: U.S. Treasury............... $ 55,818 $ 255 $ (39) $ -- $ 56,034 U.S. Agencies............... 4,576 39 (9) (49) 4,557 Collateralized mortgage obligations............... 18,260 590 (105) -- 18,745 Mortgage pass-through securities................ 56,696 325 (249) -- 56,772 Obligations of states and political subdivisions......... 431,624 23,467 (387) (87) 454,617 Corporate bonds.................. 94,363 4,735 (27) (2) 99,069 Non-agency collateralized mortgage obligations........... 2,078 3 -- -- 2,081 Other asset-backed securities: Second mortgages/home equity loans....................... 20,942 241 (69) -- 21,114 Credit card receivables........ 867 -- -- -- 867 Other.......................... 7,794 391 -- -- 8,185 Redeemable preferred stock....... 5,356 941 -- -- 6,297 -------- ------- ----- ----- -------- Total fixed income securities.... 698,374 30,987 (885) (138) 728,338 Equity securities................ 1,084 114 -- -- 1,198 -------- ------- ----- ----- -------- Total....................... $699,458 $31,101 $(885) $(138) $729,536 ======== ======= ===== ===== ======== 55 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) GROSS UNREALIZED LOSSES GROSS ----------------------- AMORTIZED COST UNREALIZED LESS THAN MORE THAN ESTIMATED DECEMBER 31, 2003 OR COST GAINS 12 MONTHS 12 MONTHS FAIR VALUE ----------------- -------------- ---------- ---------- ---------- ---------- Fixed income securities: U.S. Treasury securities and obligations of U.S. Government and agencies: U.S. Treasury.................. $ 21,267 $ 497 $ -- $ -- $ 21,764 U.S. Agencies.................. 4,587 47 (99) -- 4,535 Collateralized mortgage obligations................. 7,770 425 -- -- 8,195 Mortgage pass-through securities.................. 7,607 386 -- -- 7,993 Obligations of states and political subdivisions......... 376,961 25,604 (127) (27) 402,411 Corporate bonds.................. 96,525 7,322 (45) -- 103,802 Non-agency collateralized mortgage obligations........... 749 -- -- (22) 727 Other asset-backed securities: Second mortgages/home equity loans....................... 5,721 426 -- -- 6,147 Credit card receivables........ 5,000 51 -- -- 5,051 Other.......................... 4,619 192 (13) -- 4,798 Redeemable preferred stock....... 13,395 1,238 -- -- 14,633 -------- ------- ----- ---- -------- Total fixed income securities.... 544,201 36,188 (284) (49) 580,056 Equity securities................ 992 69 -- -- 1,061 -------- ------- ----- ---- -------- Total....................... $545,193 $36,257 $(284) $(49) $581,117 ======== ======= ===== ==== ======== The Company's insurance subsidiaries, as required by state law, deposit certain securities with state insurance regulatory authorities. At December 31, 2004, securities on deposit had an aggregate carrying value of $3.4 million. Short-term investments are generally comprised of U.S. Treasury bills, corporate notes, money market funds and investment grade commercial paper equivalents. The amortized cost and estimated fair value of fixed income securities, by contractual maturity, at December 31, 2004 and 2003 are shown below. Actual maturities may differ from contractual maturities as borrowers may have the right to call or prepay obligations with or without call or prepayment penalties (dollars in thousands): 2004 2003 -------------------------- -------------------------- AMORTIZED ESTIMATED FAIR AMORTIZED ESTIMATED FAIR COST VALUE COST VALUE --------- -------------- --------- -------------- Fixed Income Securities: Due within one year.................. $ 52,045 $ 52,186 $ 1,006 $ 1,016 Due after one year but within five years.............................. 44,305 45,513 70,709 74,381 Due after five years but within ten years.............................. 350,909 371,964 267,010 286,356 Due after ten years.................. 144,478 150,911 174,010 185,392 -------- -------- -------- -------- 591,737 620,574 512,735 547,145 Mortgage pass-through securities, collateralized mortgage obligations and asset-backed securities........ 106,637 107,764 31,466 32,911 -------- -------- -------- -------- $698,374 $728,338 $544,201 $580,056 ======== ======== ======== ======== 56 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Major categories of net investment income of available-for-sale securities were as follows (dollars in thousands): YEARS ENDED DECEMBER 31, --------------------------- 2004 2003 2002 ------- ------- ------- Investment income: Fixed income securities............................... $29,682 $26,152 $25,764 Equity securities..................................... 87 306 1,213 Short-term investments................................ 1,396 556 1,359 Other investments..................................... (17) 25 135 ------- ------- ------- Total investment income............................... 31,148 27,039 28,471 Investment expenses..................................... (967) (738) (717) ------- ------- ------- Net investment income................................... $30,181 $26,301 $27,754 ======= ======= ======= Net unrealized investment gains and losses and the net change in unrealized gains and losses of available-for-sale securities were as follows (dollars in thousands): YEARS ENDED DECEMBER 31, --------------------------- 2004 2003 2002 ------- ------ -------- Net realized investment gains (losses): Fixed income securities: Gross realized investment gains.................... $ 2,702 $2,276 $ 9,515 Gross realized investment losses................... (10) (5) (608) ------- ------ -------- Net realized investment gains (losses) on fixed income securities............................. $ 2,692 $2,271 $ 8,907 ------- ------ -------- Equity securities: Gross realized investment gains.................... $ 63 $ 4 $ 1,672 Gross realized investment losses................... (4) (9) (17,405) ------- ------ -------- Net realized investment gains (losses) on equity securities.................................... $ 59 $ (5) $ 15,733) ------- ------ -------- Other.............................................. $ -- $ (440) $ (760) ------- ------ -------- Net realized investment gains (losses)................ $ 2,751 $1,826 $ (7,586) ======= ====== ======== Net change in unrealized gains (losses): Fixed income securities............................ $(5,891) $4,681 $ 23,435 Equity securities.................................. $ 45 $ 160 $ 6,769 Other.............................................. $ -- $ 527 $ (76) ------- ------ -------- Total net change in unrealized gains (losses).... $(5,846) $5,368 $ 30,128 ------- ------ -------- Net realized gains (losses) and change in unrealized gains (losses)..................................... $(3,095) $7,194 $ 22,542 ======= ====== ======== 57 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following table provides the composition of fixed income securities with an unrealized loss at December 31, 2004 in relation to the total of all fixed income securities by contractual maturities: % OF % OF MARKET UNREALIZED CONTRACTUAL MATURITY VALUE LOSS -------------------- ------ ---------- Due in one year or less..................................... 1% --% Due after one year through five years....................... 5 4 Due after five years through ten years...................... 24 27 Due after ten years......................................... 29 28 Asset-backed securities..................................... 41 41 --- --- Total....................................................... 100% 100% === === The following table summarizes for fixed income securities in an unrealized loss position at December 31, 2004 and 2003, the aggregate fair value and gross unrealized loss by length of time those securities have been continuously in an unrealized loss position (dollars in thousands): DECEMBER 31, 2004 DECEMBER 31, 2003 ----------------------- ----------------------- GROSS GROSS ESTIMATED UNREALIZED ESTIMATED UNREALIZED UNREALIZED LOSS AGING FAIR VALUE LOSS FAIR VALUE LOSS --------------------- ---------- ---------- ---------- ---------- Fixed income securities: Investment grade: 0-12 months................................ $107,401 $ 885 $21,074 $284 Greater than 12 months..................... 5,484 138 2,224 49 -------- ------ ------- ---- Total investment grade..................... $112,885 $1,023 $23,298 $333 ======== ====== ======= ==== There were no non-investment grade fixed income or equity securities in an unrealized loss position at December 31, 2004 or 2003. 3. DEBT In May 2004, the Company, through a wholly-owned trust, privately issued $30 million of preferred securities through two pooled transactions. These securities bear interest at a rate London Interbank Offered Rate ("LIBOR") plus 337.5 basis points with a 30-year term and are redeemable after five years. The securities were issued by CNA Surety Capital Trust I (the "Issuer Trust"). The sole asset of the Issuer Trust consists of a $30.9 million junior subordinated debenture issued by the Company to the Issuer Trust. The Company has also guaranteed the dividend payments and redemption of the preferred securities issued by the Issuer Trust. The maximum amount of undiscounted future payments the Company could make under the guarantee is $75.0 million, consisting of annual dividend payments of $1.5 million over 30 years and the redemption value of $30.0 million. Because payment under the guarantee would only be required if the Company does not fulfill its obligations under the debentures held by the Issuer Trust, the Company has not recorded any additional liabilities related to this guarantee. The subordinated debenture bears interest at a rate of LIBOR plus 337.5 basis points and matures in April of 2034. As of December 31, 2004, the interest rate on the junior subordinated debenture was 5.665%. On September 30, 2002, the Company refinanced $65 million in outstanding borrowings under its previous credit facility with a new credit facility (the "2002 Credit Facility"). The 2002 Credit Facility, as amended September 30, 2003, provides an aggregate of up to $50.0 million in borrowings divided between a revolving credit facility (the "Revolving Credit Facility") of $30.0 million and a term loan facility (the "Term 58 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Loan Facility") of $20.0 million. The Revolving Credit Facility matures on September 30, 2005. The Revolving Credit Facility may be increased from time to time by the amount of repayments under the Term Loan Facility up to an additional $10.0 million. Such increase is subject to consent by each bank participating in the Revolving Credit Facility, and will take place upon receipt by the banks of the respective installment payments under the Term Loan Facility. Effective January 30, 2003, the Company entered into an interest rate swap on the Term Loan Facility which fixed the previously floating interest rate. As a result, the effective interest rate on the term loan as of December 31, 2004 was 2.77%. In June 2004, the Company reduced the outstanding Revolving Credit Facility by $10.0 million to $20 million. In September of 2004, the Company increased the outstanding Revolving Credit Facility by $5.0 million. The Term Loan Facility balance was reduced by $20 million through December 31, 2004 according to the scheduled repayments and payment schedules. Further repayments and payment of the Term Loan Facility will take place in equal semi-annual installments of $5.0 million on the following dates: DATE SCHEDULED REPAYMENTS OUTSTANDING BALANCE ---- -------------------- ------------------- March 31, 2005................................... $5,000,000 $5,000,000 September 30, 2005............................... 5,000,000 -- The Company has a total of $35 million of debt maturing in 2005. No other debt matures in the next five years. The interest rate on borrowings under the 2002 Credit Facility may be fixed, at CNA Surety's option, for a period of one, two, three, or nine months and is based on, among other rates, LIBOR, plus the applicable margin. The margin, including a facility fee and utilization fee on the Revolving Credit Facility, was 1.30% at December 31, 2004 and can vary based on CNA Surety's leverage ratio (debt to total capitalization) from 1.15% to 1.45%. The margin on the Term Loan Facility was 0.625% at December 31, 2004 and can vary based on CNA Surety's leverage ratio (debt to total capitalization) from 0.48% to 0.80%. As of December 31, 2004, the weighted average interest rate was 3.2825% on the $35.0 million of outstanding borrowings. As of December 31, 2003, the weighted average interest rate on the 2002 Credit Facility was 2.4% on the $50.0 million of outstanding borrowings. The 2002 Credit Facility contains, among other conditions, limitations on CNA Surety with respect to the incurrence of additional indebtedness and maintenance of a rating of at least "A" by A.M. Best for each of the Company's insurance subsidiaries. The 2002 Credit Facility also requires the maintenance of certain financial ratios as follows: a) maximum funded debt to total capitalization ratio of 25%, b) minimum net worth of $350.0 million and c) minimum fixed charge coverage ratio of 2.5 times. Due to the net loss reported for the third quarter of 2003, the Company was in violation of the minimum fixed charge coverage test. The lenders granted the Company a waiver for this violation and amended the 2002 Credit Facility to replace the fixed charge coverage ratio requirement for the next three quarters with a minimum earnings requirement. At March 31, 2004, the Company was in violation of this minimum earnings requirement and received a waiver for this requirement in the second quarter of 2004. The Company is in compliance with the debt covenants as of and for the quarter ended December 31, 2004. 59 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 4. FAIR VALUE OF FINANCIAL INSTRUMENTS The following table summarizes fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values may be based on estimates using present value or other valuation techniques. These techniques are significantly affected by the assumptions used, including the discount rates and estimates of future cash flows. Potential taxes and other transaction costs have not been considered in estimating fair value. Accordingly, the estimates presented herein are subjective in nature and are not necessarily indicative of the amounts that the Company could realize in a current market exchange. This information excludes certain financial instruments such as insurance contracts and all non-financial instruments from fair value disclosure. Therefore, these fair value amounts cannot be aggregated to determine the underlying economic value of the Company. The carrying amounts and estimated fair values of financial instruments at December 31, 2004 and 2003 were as follows (dollars in thousands): 2004 2003 --------------------- --------------------- CARRYING ESTIMATED CARRYING ESTIMATED AMOUNT FAIR VALUE AMOUNT FAIR VALUE -------- ---------- -------- ---------- Fixed income securities.................... $728,338 $728,338 $580,056 $580,056 Equity securities.......................... 1,198 1,198 1,061 1,061 Short-term investments..................... 28,457 28,457 63,871 63,871 Other investments.......................... 1,058 1,058 1,119 1,119 Cash....................................... 7,336 7,336 7,965 7,965 Debt....................................... 65,488 65,488 50,418 50,418 The following methods and assumptions were used by the Company in estimating fair values of financial instruments: Investments -- The estimated fair values for the fixed income securities and equity securities are based upon quoted market prices, where available. For fixed income securities not actively traded, the estimated fair values are determined using values obtained from independent pricing services or, in the case of private placements, by discounting expected future cash flows using a current market rate applicable to the yield, credit quality and maturity of the investments. Cash, Short-term Investments and Other Investments -- The carrying value for these instruments approximates their estimated fair values. Debt -- The estimated fair value of the Company's debt is based on the quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of the same remaining maturity. 5. DEFERRED POLICY ACQUISITION COSTS AND OTHER OPERATING EXPENSES Policy acquisition costs deferred and the related amortization of deferred policy acquisition costs were as follows (dollars in thousands): YEARS ENDED DECEMBER 31, --------------------------------- 2004 2003 2002 --------- --------- --------- Balance at beginning of period.................... $ 104,674 $ 96,386 $ 89,788 Costs deferred.................................. 147,925 149,938 145,589 Amortization.................................... (150,471) (141,650) (138,991) --------- --------- --------- Balance at end of period.......................... $ 102,128 $ 104,674 $ 96,386 ========= ========= ========= 60 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Net commissions, brokerage and other underwriting expenses were comprised as follows (dollars in thousands): YEARS ENDED DECEMBER 31, ------------------------------ 2004 2003 2002 -------- -------- -------- Amortization of deferred policy acquisition costs.... $150,471 $141,650 $138,991 Other operating expenses............................. 56,695 49,090 40,836 -------- -------- -------- Net commissions, brokerage and other underwriting expenses........................................ $207,166 $190,740 $179,827 ======== ======== ======== 6. REINSURANCE The Company's insurance subsidiaries, in the ordinary course of business, cede insurance to other insurance companies and affiliates. Reinsurance arrangements are used to limit maximum loss, provide greater diversification of risk and minimize exposure on larger risks. Reinsurance contracts do not relieve the Company of its primary obligations to claimants. Therefore, a contingent liability exists with respect to insurance ceded to the extent that any reinsurer is unable to meet the obligations assumed under the reinsurance contracts. The Company evaluates the financial condition of its reinsurers, assesses the need for allowances for uncollectible amounts and monitors concentrations of credit risk. At December 31, 2004, CNA Surety's largest reinsurance receivable from an affiliate, CCC, an A (Excellent) rated company by A.M. Best Company, Inc. ("A.M. Best"), was approximately $5.4 million. At December 31, 2004, CNA Surety's largest reinsurance receivable from a non-affiliate reinsurer was approximately $16.9 million with a company rated A+ (Superior) by A.M. Best. The effect of reinsurance on premiums written and earned was as follows (dollars in thousands): YEARS ENDED DECEMBER 31, --------------------------------------------------------------- 2004 2003 2002 ------------------- ------------------- ------------------- WRITTEN EARNED WRITTEN EARNED WRITTEN EARNED -------- -------- -------- -------- -------- -------- Direct................ $267,371 $238,309 $195,786 $168,510 $148,186 $137,957 Assumed............... 122,046 149,158 175,589 195,004 211,706 206,146 Ceded................. (71,133) (69,610) (52,165) (59,065) (53,238) (45,784) -------- -------- -------- -------- -------- -------- Net Premiums.......... $318,284 $317,857 $319,210 $304,449 $306,654 $298,319 ======== ======== ======== ======== ======== ======== Assumed premiums primarily includes all surety business written or renewed, net of reinsurance, by CCC and CIC, and their affiliates, after the Merger Date that is reinsured by Western Surety pursuant to inter-company reinsurance and related agreements. Because of certain regulatory restrictions that limit the Company's ability to write business on a direct basis, the Company continues to utilize the underwriting capacity available through these agreements. The Company is in full control of all aspects of the underwriting and claim management of the assumed business. 61 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The effect of reinsurance on the Company's provision for loss and loss adjustment expenses and the corresponding ratio to earned premium was as follows (dollars in thousands): YEARS ENDED DECEMBER 31, ------------------------------------------------------- 2004 2003 2002 --------------- ----------------- --------------- $ RATIO $ RATIO $ RATIO ------- ----- -------- ------ ------- ----- Gross losses and loss adjustment expenses.......... $65,550 16.9% $257,016 70.7% $76,199 22.1% (Increase) decrease in reinsurance recoverables..... 21,806 31.3% (84,540) (143.1)% 17,999 39.3% ------- -------- ------- Net losses and loss adjustment expenses..................... $87,356 27.5% $172,476 56.7% $94,198 31.6% ======= ======== ======= During 2004, the Company reduced certain gross reserves, with corresponding reductions in ceded reserves, reflecting changes in estimates of incurred-but-not-reported reserves for large losses and the associated estimates of reinsurance recoverables. Although there is no impact to net losses and loss adjustment expenses, these actions did result in unusual fluctuations in the gross and ceded amounts shown above. The reduction in reinsurance recoverables in 2002 resulted from the settlement of claims related to the bankruptcy of Enron Corporation. This settlement resulted in the reduction of previously established gross loss reserves and a corresponding reduction to previously established reinsurance recoverables. The Company's reinsurance program is predominantly comprised of excess of loss reinsurance contracts that limit the Company's retention on a per principal basis. The Company's reinsurance coverage is provided by third party reinsurers and related parties. Due to the terms of conditions of these excess of loss treaties, reinsurers may cover some principals in one year but then exclude these same principals in subsequent years. As a result the Company may have exposures to these principals that have limited or no reinsurance coverage. Excess of Loss Reinsurance 2004 Third Party Reinsurance Compared to 2003 Third Party Reinsurance Effective January 1, 2004, CNA Surety entered into a new excess of loss treaty ("2004 Excess of Loss Treaty") with a group of third party reinsurers that reduced its net retention per principal to $10 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company's retention. This new excess of loss treaty replaces the $45 million excess of $15 million per principal coverage, as well as the $40 million excess of $60 million per principal and the $3 million excess of $12 million coverage that had been provided by CCC. The significant differences between the 2004 Excess of Loss Treaty and the Company's 2003 Excess of Loss Treaty are as follows. The annual aggregate coverage increased from $110 million in 2003 to $157 million in 2004. The premium for the 2004 Excess of Loss Treaty was $50.6 million (net of expected return premium) compared to a total of $42.0 million of reinsurance premiums paid in 2003 (net of expected return premium) for the $45 million excess of $15 million, the $40 million excess of $60 million and the $3 million excess of $12 million treaties. The contract also included an optional twelve-month extended discovery period, for an additional premium (a percentage of the original premium based on any unexhausted aggregate limit by layer), which will provide coverage for losses discovered in 2005 on bonds that were in force during 2004. The Company did not elect to purchase the extended discovery period because it obtained coverage for 2005 under a new treaty. The 2004 Excess of Loss Treaty also provided for somewhat less restrictive special acceptance provisions for larger contract accounts than those contained in the 2003 Excess of Loss Treaty and somewhat less restrictive special acceptance provisions for larger contract accounts than those contained in the 2003 Excess of Loss Treaty. In addition to the one large contract principal (described later as the "large national contractor") and the two commercial principals excluded (based upon class of business), the Company's reinsurers had excluded three other contract principals from the 2003 Excess of Loss Treaty, for a total of six excluded principals. The 62 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) large national contractor and the two commercial principals remain excluded from the 2004 Excess of Loss Treaty. Of the two commercial principals, one is a domestic electric utility with an estimated bonded exposure of $38 million as of December 31, 2004 and is currently rated B- by Standard and Poor's ("S&P"). This rating was increased from CCC+ during the third quarter of 2004 due to significant recapitalization efforts by the principal. The bonded exposure will decline over the term of the bond that extends until 2007. The other is a foreign industrial enterprise that fulfilled its bonded obligations in the second quarter of 2004, so the Company no longer has any exposure. With respect to the three excluded contract principals other than the large national contractor, two contract principals have completed asset sales and other reorganization efforts and have been accepted into the 2004 Excess of Loss Treaty. The Company received claims related to the third contract principal in 2003, making it ineligible for inclusion in the 2004 Excess of Loss Treaty. The Company believes it is adequately reserved for any exposure related to this principal and is currently not providing bonds to this principal. Related Party Reinsurance Reinsurance agreements together with the Services and Indemnity Agreement that are described below provide for the transfer of the surety business written by CCC and CIC to Western Surety. All of these agreements originally were entered into on September 30, 1997 (the "Merger Date"): (i) the Surety Quota Share Treaty (the "Quota Share Treaty"); (ii) the Aggregate Stop Loss Reinsurance Contract (the "Stop Loss Contract"); and (iii) the Surety Excess of Loss Reinsurance Contract (the "Excess of Loss Contract"). All of these contracts have expired. Some have been renewed on different terms as described below. The Services and Indemnity Agreement provides the Company's insurance subsidiaries with the authority to perform various administrative, management, underwriting and claim functions in order to conduct the business of CCC and CIC and to be reimbursed by CCC for services rendered. In consideration for providing the foregoing services, CCC has agreed to pay Western Surety a quarterly fee of $50,000. This agreement was renewed on January 1, 2004 and expires on December 31, 2004 and is annually renewable thereafter. There was no amount due to the CNA Surety insurance subsidiaries as of December 31, 2004. Through the Quota Share Treaty, CCC and CIC transfer to Western Surety all surety business written or renewed by CCC and CIC after the Merger Date. CCC and CIC transfer the related liabilities of such business and pay to Western Surety an amount in cash equal to CCC's and CIC's net written premiums written on all such business, minus a quarterly ceding commission to be retained by CCC and CIC equal to $50,000 plus 28% of net written premiums written on such business. Under the terms of the Quota Share Treaty, CCC has guaranteed the loss and loss adjustment expense reserves transferred to Western Surety as of September 30, 1997 by agreeing to pay Western Surety, within 30 days following the end of each calendar quarter, the amount of any adverse development on such reserves, as re-estimated as of the end of such calendar quarter. There has been no adverse reserve development for the period from September 30, 1997 (date of inception) through December 31, 2004. The Quota Share Treaty had an original term of five years from the Merger Date and was renewed on October 1, 2002 on substantially the same terms with an expiration date of December 31, 2003. The Quota Share Treaty was again renewed on January 1, 2004 on substantially the same terms with an expiration date of December 31, 2004; and is annually renewable thereafter. The ceding commission paid to CCC and CIC by Western Surety remained at 28% of net written premiums and contemplates an approximate 4% override commission for fronting fees to CCC and CIC on their actual direct acquisition costs. The Stop Loss Contract terminated on December 31, 2000 and was not renewed. The Stop Loss Contract protected the insurance subsidiaries from adverse loss experience on certain business underwritten after the Merger Date. The Stop Loss Contract between the insurance subsidiaries and CCC limited the insurance subsidiaries' prospective net loss ratios with respect to certain accounts and lines of insured business for three 63 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) full accident years following the Merger Date. In the event the insurance subsidiaries' accident year net loss ratio exceeded 24% in any of the accident years 1997 through 2000 on certain insured accounts (the "Loss Ratio Cap"), the Stop Loss Contract requires CCC at the end of each calendar quarter following the Merger Date, to pay to the insurance subsidiaries a dollar amount equal to (i) the amount, if any, by which their actual accident year net loss ratio exceeds the applicable Loss Ratio Cap, multiplied by (ii) the applicable net earned premiums. In consideration for the coverage provided by the Stop Loss Contract, the insurance subsidiaries paid to CCC an annual premium of $20,000. The CNA Surety insurance subsidiaries have paid CCC all required annual premiums. As of December 31, 2004, the Company had billed and received $54.9 million under the Stop Loss Contract, of which $29.9 million was received in 2004. The Excess of Loss Contract provided the insurance subsidiaries of CNA Surety with the capacity to underwrite large surety bond exposures by providing reinsurance support from CCC. The Excess of Loss Contract provided $75 million of coverage for losses in excess of the $60 million per principal. Subsequent to the Merger Date, the Company entered into a second excess of loss contract with CCC ("Second Excess of Loss Contract"). The Second Excess of Loss Contract provided unlimited coverage for principal losses that exceed the foregoing coverage of $75 million per principal provided by the Excess of Loss Contract, or aggregate losses per principal in excess of $135 million. In consideration for the reinsurance coverage provided by the Excess of Loss Contracts, the insurance subsidiaries paid to CCC, on a quarterly basis, a premium equal to 1% of the net written premiums applicable to the Excess of Loss Contract, subject to a minimum premium of $20,000 and $5,000 per quarter under the Excess of Loss Contract and Second Excess of Loss Contract, respectively. The two Excess of Loss Contracts collectively provided coverage for losses discovered on surety bonds in force as of the Merger Date and for losses discovered on new and renewal business written during the term of the Excess of Loss Contracts. Both Excess of Loss Contracts commenced following the Merger Date and continued until September 30, 2002. The discovery period for losses covered by the Excess of Loss Contracts extends until September 30, 2006. Effective October 1, 2002, the Company secured replacement excess of loss protection from CCC for per principal losses that exceed $60 million in two parts -- a) $40 million excess of $60 million and b) $50 million excess of $100 million. This excess of loss protection is primarily necessary to support contract surety accounts with bonded backlogs or work-in-process in excess of $60 million. The Company generally limits exposure on new large commercial surety accounts to $25 million. In addition to the foregoing structural changes in its high layer excess of loss reinsurance programs, the cost for these protections increased significantly as compared to the cost of the two previous Excess of Loss Contracts. The $40 million excess of $60 million contract is for a three year term beginning October 1, 2002 and provides annual aggregate coverage of $80 million and $120 million aggregate coverage for the entire three year term. Effective October 1, 2003, the Company entered into a $3 million excess of $12 million contract with CCC. The reinsurance premium for the coverage provided by the $3 million excess of $12 million contract was $0.3 million plus, if applicable, additional premiums based on paid losses. The contract provided for aggregate coverage of $12 million. This contract effectively lowered the Company's net retention per principal for the remainder of 2003 to $12 million plus a 5% co-participation in the $45 million layer of excess reinsurance with third party reinsurers. This contract was to expire on December 31, 2004. Effective January 1, 2004, the Company obtained replacement coverage from third party reinsurers as part of the 2004 Excess of Loss Treaty. Accordingly, the $40 million excess of $60 million contract with CCC was commuted effective January 1, 2004. As part of this commutation, the Company has received a commutation payment of $10.9 million from CCC. As of December 31, 2003 the full amount of the commutation payment had been recognized as a receivable. The Company and CCC entered into a new $40 million excess of $60 million reinsurance contract providing coverage exclusively for the one large national contractor that is excluded from the Company's third party reinsurance. This contract is effective from 64 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) January 1, 2004 to December 31, 2004. The premium for this contract is $3.0 million plus an additional premium of $6 million if a loss is ceded under this contract. The reinsurance premium for the coverage provided by the $50 million excess of $100 million contract was $6.0 million. This contract expired on December 31, 2003. The Company and CCC entered into a new $50 million excess of $100 million contract for the period of January 1, 2004 to December 31, 2004. The premium for this contract is $6.0 million plus an additional premium of $14 million if a loss is ceded under this contract. As of December 31, 2004 and December 31, 2003, CNA Surety had an insurance receivable balance from CCC and CIC of $16.4 million and $71.1 million. CNA Surety had reinsurance payables to CCC and CIC of $0.3 million as of December 31, 2004. CNA Surety had no reinsurance payables to CCC and CIC as of December 31, 2003. Large National Contractor The Company has provided significant surety bond protection guaranteeing projects undertaken by the large national contract principal that is excluded from the Company's third party reinsurance. The related party reinsurance available to the Company for this principal and the credit extended to the principal by affiliates of the Company are described below. If the Company should suffer any losses that are discovered prior to September 30, 2006 arising from bonds issued to the contractor with effective dates of September 30, 2002 and prior, the Company would retain the first $60 million of losses on bonds written, and CCC would incur 100% of losses above $60 million pursuant to the extended discovery provisions of the two Excess of Loss treaties that expired on September 30, 2002. Any losses discovered after September 30, 2006 on bonds with effective dates prior to September 30, 2002 would be covered up to $150 million pursuant to the $50 million excess of $100 million contract with CCC described above and a twelve month contract with CCC effective January 1, 2004 that provides $40 million excess of $60 million reinsurance coverage exclusively for the national contractor. For bonds that the Company has written after September 30, 2003, in addition to the coverage provided by excess of loss reinsurance treaties described above ($40 million excess of $60 million and $50 million excess of $100 million) the Company and CCC have entered into facultative reinsurance in connection with larger bonds. The Company's exposure on bonds written from October 1, 2002 through October 31, 2003 was limited to $20 million per bond. For bonds written between November 1, 2003 and December 31, 2004, the Company's exposure was $14.7 million. For bonds written subsequent to December 31, 2004, the Company's exposure will be limited to 10% of policyholders' surplus. CNAF Credit Facility Commencing in 2003, CNAF has provided loans through a credit facility in order to help the large national contractor meet its liquidity needs and complete projects which had been bonded by CNA Surety. In December of 2004, the credit facility was amended to increase the maximum available loans to $106 million from $86 million at December 31, 2003. The amendment also provides that CNAF may in its sole discretion further increase the amounts available for loans under the credit facility, up to an aggregate maximum of $126 million. As of December 31, 2004 and 2003, $99 million and $80 million had been advanced under the credit facility. Loews, through a participation agreement with CNAF, provided funds for and owned a participation of $29 million and $26 million of the loans outstanding as of December 31, 2004 and 2003, respectively, and has agreed to a participation of one-third of any additional loans which may be made above the original $86 million credit facility limit up to the $126 million maximum available line. Loans under the credit facility are secured by a pledge of substantially all of the assets of the contractor and certain of its affiliates. In connection with the credit facility, CNAF has also guaranteed or provided 65 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) collateral for letters of credit which are charged against the maximum available line and, if drawn upon, would be treated as loans under the credit facility. As of December 31, 2004 and 2003, these guarantees and collateral obligations aggregated $13 million and $7 million. The contractor implemented a restructuring plan intended to reduce costs and improve cash flow, and appointed a chief restructuring officer to manage execution of the plan. In the course of addressing various expense, operational and strategic issues, however, the contractor has decided to substantially reduce the scope of its original business and to concentrate on those segments determined to be potentially profitable. As a consequence, operating cash flow, and in turn the capacity to service debt, has been reduced below previous levels. Restructuring plans have also been extended to accommodate these circumstances. In light of these developments, CNAF has recorded an impairment charge of $56 million pretax ($36 million after-tax) in the fourth quarter of 2004, net of the participation by Loews, with respect to amounts loaned under the credit facility. Any draws under the credit facility beyond $106 million or further changes in the large national contractor's business plan or projections may necessitate further impairment charges. The Company intends to continue to provide surety bonds on behalf of the contractor during the restructuring period, subject to the contractor's initial and ongoing compliance with the Company's underwriting standards. Indemnification and subrogation rights, including rights to contract proceeds on construction projects in the event of default, exist that reduce CNA Surety's exposure to loss. While the Company believes that the contractor's restructuring efforts will be successful and provide sufficient cash flow for its operations, the contractor's failure to achieve its extended restructuring plan or perform its contractual obligations under the Company's surety bonds could have a material adverse effect on CNA Surety's results of operations, cash flow and equity. If such failures occur, the Company estimates that possible losses, net of indemnification and subrogation recoveries, but before recoveries under reinsurance contracts, to be approximately $200 million pretax. However, the related party reinsurance treaties discussed above should limit the Company's per principal loss exposure to approximately $60 million. 66 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 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): YEARS ENDED DECEMBER 31, ------------------------------ 2004 2003 2002 -------- -------- -------- Reserves at beginning of period: Gross................................................ $413,539 $303,433 $315,811 Ceded reinsurance.................................... 158,357 137,301 166,318 -------- -------- -------- Net reserves at beginning of period.................. 255,182 166,132 149,493 -------- -------- -------- Net incurred loss and loss adjustment expenses: Provision for insured events of current period..... 87,969 133,186 88,018 Increase (decrease) in provision for insured events of prior periods................................ (613) 39,290 6,180 -------- -------- -------- Total net incurred.............................. 87,356 172,476 94,198 -------- -------- -------- Net payments attributable to: Current period events.............................. 7,125 23,859 12,727 Prior period events................................ 88,857 59,567 64,832 -------- -------- -------- Total net payments.............................. 95,982 83,426 77,559 -------- -------- -------- Net reserves at end of period........................ 246,556 255,182 166,132 Ceded reinsurance at end of period................... 116,831 158,357 137,301 -------- -------- -------- Gross reserves at end of period................. $363,387 $413,539 $303,433 ======== ======== ======== The Company recorded net loss reserve development which resulted in a decrease of the estimated liability of $0.6 million for the year ended December 31, 2004 and increases in the estimated liability of $39.3 million, $6.2 million for the years ended December 31, 2003 and 2002, respectively. The decrease in the estimated liability recorded in 2004 for prior accident years resulted from loss adjustment expense payments related to prior accident years that were lower than previously expected. Adverse claim trends in the 2001 and 2002 accident years, particularly increased claim severity on large commercial accounts, had resulted in increased gross and net incurred loss and loss adjustment expenses for the two years ended December 31, 2003. Incurred loss and loss adjustment expenses for the year ended December 31, 2003 included net adverse development on prior accident years of $39.3 million that primarily relates to accident years 2001 and 2002 and changes in estimates of large losses resulting from the material adverse claim activity in the third quarter of 2003. The $39.3 million of net adverse development recorded in 2003 was a result of previously unexpected claim activity reported during the third quarter of 2003. First, additional contract bond claims were received during the third quarter of 2003 on a contractor that had filed for bankruptcy in February, 2003. Upon review and verification of these new claims, the existing case reserve was increased by $7.2 million, net of applicable reinsurance. Second, a demand was made during the third quarter of 2003 against a $45 million insurance program bond issued on behalf of a national trucking concern that was now in bankruptcy. This demand was in contradiction of previous information provided by the obligee on the bond. Based on this new information, management reserved the full remaining limits on this bond which resulted in $15 million of net adverse development after the application of available reinsurance. Third, claims were also received in the third quarter of 2003 on worker's compensation self insurance bonds written between 1975 and 1986 on behalf of two principals. After verifying coverage and obtaining supporting actuarial information on the underlying 67 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) workers' compensation claims, the Company increased the case reserves on these bonds by $8.4 million, net of applicable reinsurance. Fourth, after receiving a demand on another insurance program bond in the third quarter of 2003, management identified an outstanding insurance program bond written on behalf of a contractor now in bankruptcy. Based on recent experience with this type of bond, which typically has few defenses available to the surety, and in particular with the obligees on this bond, management recorded a loss provision on this bond of $6 million. Finally, management determined that the case reserve on a particular claim was insufficient due to the amount of legal fees that the Company was incurring on the case. Based on their estimate of future legal expenses, management increased the reserve on this bond by $3 million. In addition to the net unfavorable loss reserve development, the higher net loss ratio in 2003 primarily relates to net reserve additions of approximately $49.0 million for the 2003 accident year due to material adverse loss severity on the Company's branch commercial and contract business. The net additions to reserves for the 2003 accident year resulted from three large contract bond claims totaling $28 million incurred in 2003, an approximately $15 million net loss on an insurance program bond for a now bankrupt large commercial account, and changes in estimates of large losses resulting from this significant adverse claim activity. Incurred loss and loss adjustment expenses for the year ended December 31, 2002 included $17 million on a gross basis and $12 million on a net basis (after reinsurance) related to the September 2002 bankruptcy of a large national trucking concern. On January 2, 2003, CNA Surety settled litigation brought by J.P. Morgan Chase & Co. ("Chase") in connection with three surety bonds issued on behalf of Enron Corporation ("Enron") subsidiaries. The penal sums of the three bonds totaled approximately $78 million. The Company paid Chase approximately $40.7 million and assigned its recovery rights in the Enron bankruptcy to Chase in exchange for a full release of its obligations under the bonds. The Company has no other exposure related to the Enron Corporation. CNA Surety's net loss related to the settlement, after anticipated recoveries under excess of loss reinsurance treaties, was previously fully reserved. Immediately upon execution of the settlement documents, the Company sent written notice for reimbursement to its reinsurers. As of December 31, 2004, the Company has billed a total of $37.1 million to its reinsurers. Seven reinsurers responsible for payment of 63% of the treaty proceeds either have paid their portions of the claim or have reached agreement with the Company and paid the Company to commute the entire reinsurance treaty under which the Enron claim was made. Pursuant to the treaty, the Company demanded and began arbitration proceedings against the two other reinsurers who have not paid their portions of the claim or commuted their treaties. Management believes that these reinsurers do not have valid defenses under the reinsurance treaties to avoid payment, and that the Company will fully recover all reinsurance recoverable recorded related to this settlement. As such, the Company has not recorded a reduction with respect to these reinsurance recoverable of $13.7 million as of December 31, 2004. 8. COMMITMENTS AND CONTINGENCIES At December 31, 2004 the future minimum commitment under operating leases was as follows: 2005 -- $1.6 million; 2006 -- $1.4 million; 2007 -- $1.1 million, 2008 -- $1.0 million and 2009 -- $1.0 million and thereafter -- $2.7 million. Total rental expense for 2004, 2003 and 2002 was $5.1 million, $4.6 million, and $4.0 million, respectively. The Company is party to various lawsuits arising in the normal course of business, some seeking material damages. The Company believes the resolution of these lawsuits will not have a material adverse effect on its financial condition or its results of operations. 68 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 9. INCOME TAXES The components of deferred income taxes as of December 31, 2004 and 2003 were as follows (dollars in thousands): 2004 2003 ------- ------- Deferred tax assets related to: Unearned premium reserve.................................. $14,416 $14,568 Loss and loss adjustment expense reserve.................. 4,286 5,355 Accrued expenses.......................................... 1,663 1,646 Other..................................................... 8,632 3,885 ------- ------- Total deferred tax assets.............................. 28,997 25,454 ------- ------- Deferred tax liabilities related to: Deferred policy acquisition costs......................... 35,745 36,636 Intangible assets......................................... 5,650 5,650 Unrealized gains on securities............................ 10,527 12,573 Other..................................................... 4,099 1,333 ------- ------- Total deferred tax liabilities......................... 56,021 56,192 ------- ------- Net deferred tax liability.................................. $27,024 $30,738 ======= ======= CNA Surety and its subsidiaries file a consolidated federal income tax return. The income tax provisions consisted of the following (dollars in thousands): YEARS ENDED DECEMBER 31, ---------------------------- 2004 2003 2002 ------- -------- ------- Federal current........................................ $15,672 $(16,218) $12,210 Federal deferred....................................... (1,667) (1,872) 171 State.................................................. 292 78 254 ------- -------- ------- Total income tax expense (benefit)..................... $14,297 $(18,012) $12,635 ======= ======== ======= A reconciliation from the federal statutory tax rate to the effective tax rate is as follows: YEARS ENDED DECEMBER 31, -------------------- 2004 2003 2002 ---- ----- ---- Federal statutory rate...................................... 35.0% (35.0)% 35.0% Tax exempt income deduction................................. (9.4) (14.9) (9.4) Non-deductible expenses..................................... 0.3 0.5 0.5 State income tax, net of federal income tax benefit......... 0.5 0.2 0.4 Other....................................................... 0.1 (6.8) 3.1 ---- ----- ---- Total income tax expense (benefit).......................... 26.5% (56.0)% 29.6% ==== ===== ==== 10. EMPLOYEE BENEFITS CNA Surety sponsors a tax deferred savings plan ("401(k) plan") covering substantially all of its employees. Prior to December 31, 1999, the Company matched 70% of the participating employee's 69 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) contribution up to 6% of eligible compensation (4.2% maximum matching). Effective January 1, 2000, the Company match was increased to 100% of the participating employee's contribution up to 3% of eligible compensation and 50% of the participating employee's contribution between 3% and 6% of eligible compensation (4.5% maximum matching). Effective January 1, 2004, the Company implemented an additional basic contribution for eligible 401(k) plan participants of 3% (if under age 45) or 5% (if 45 or older) of eligible compensation. In addition, the Company may also make an annual discretionary profit sharing contribution to the 401(k) plan, subject to the approval of the Company's Board of Directors. The profit sharing contribution may be restricted by plan and regulatory limitations. The Company contribution, including profit sharing, to the 401(k) plan was $3.5 million, $2.3 million, and $2.9 million for the years ended December 31, 2004, 2003 and 2002, respectively. CNA Surety established the CNA Surety Corporation Deferred Compensation Plan, effective April 1, 2000. The Company established and maintains the Plan as an unfunded, nonqualified deferred compensation plan for a select group of management or highly compensated employees. The purpose of the Plan is to permit designated employees of the Company and participating affiliates to accumulate additional retirement income through a nonqualified deferred compensation plan that enables them to defer compensation to which they will become entitled in the future. The Company holds equity securities with a fair value of $1.2 million as of December 31, 2004 in respect of this deferred compensation plan. The post retirement benefit plan that provides medical benefits has been determined to be actuarially equivalent to Medicare Part D on an estimated basis under the rules provided in final regulations issued January 21, 2005. As such, the federal subsidy to plan sponsors under the Medicare Modernization Act ("MMA") has been recognized in the accounting for that plan. Western Surety sponsors two post-retirement benefit plans covering certain employees. One plan provides medical benefits, and the other plan provides sick leave termination payments. The post-retirement health care plan is contributory and the sick leave plan is non-contributory. Western Surety uses a December 31 measurement date for both of its post-retirement benefit plans. The following table sets forth the plans' combined accumulated postretirement benefit obligation at the beginning and end of the last two fiscal years (dollars in thousands): 2004 2003 ------- ------ Reconciliation of benefit obligation Benefit obligation at beginning of the year............... $ 5,992 $5,398 Service cost.............................................. 149 195 Interest cost............................................. 339 337 Plan amendment............................................ -- (63) Effect of Medicare Modernization Act...................... (1,241) -- Curtailment............................................... -- 57 Actuarial loss............................................ 129 283 Benefits and expenses paid................................ (183) (215) ------- ------ Benefit obligation at end of year......................... $ 5,185 $5,992 ======= ====== 70 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following table sets forth the plans' combined funded status reconciled with the amount shown in the Company's statement of financial position at December 31, 2004 and December 31, 2003 (dollars in thousands): 2004 2003 ------- ------- Reconciliation of funded status Funded status............................................. $(5,185) $(5,992) Unrecognized prior service cost........................... (996) (967) Unrecognized net loss..................................... (372) 546 ------- ------- Accrued benefit cost...................................... $(6,553) $(6,413) ======= ======= The Company expects to contribute $0.2 million to the post-retirement benefit plans to pay benefits in 2005. The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid. These amounts are shown both gross and net of the federal subsidy to plan sponsors under the MMA. BEFORE IMPACT OF FEDERAL SUBSIDY NET OF FEDERAL SUBSIDY -------------------------------- ---------------------- 2005................................... $ 186 $ 186 2006................................... 208 178 2007................................... 236 206 2008................................... 273 240 2009................................... 311 277 2010-2014.............................. 1,595 1,354 The Company's post-retirement health care plan is unfunded; the accumulated post-retirement benefit obligation and plan assets for that plan are $4.6 million and $0, respectively. The Company's post-retirement sick leave plan is unfunded; the accumulated post-retirement benefit obligation and plan assets for that plan are $0.6 million and $0, respectively. The plans' combined net periodic post-retirement benefit cost for the last three fiscal years included the following components (dollars in thousands): 2004 2003 2002 ---- ---- ---- Net periodic benefit cost Service cost at end of year............................... $149 $195 $137 Interest cost............................................. 340 337 302 Expected return on assets................................. -- -- -- Prior service cost........................................ (162) (154) (131) Curtailment............................................... -- -- (44) Recognized net actuarial (gain)........................... (4) (8) (10) ---- ---- ---- Net periodic benefit cost................................. $323 $370 $254 ==== ==== ==== The 2005 benefit cost is expected to be reduced by approximately $.2 million as a result of the MMA. 2004 2003 2002 ----- ---- ---- Key Assumptions Discount rate............................................. 5.875% 6.5% 6.5% Initial health care cost trend, pre-Medicare.............. 8.0% 8.0% 7.0% Initial health care cost trend, post-Medicare............. 10.0% 10.0% 9.0% Ultimate health care cost trend........................... 5.0% 5.0% 5.0% Year in which ultimate trend is reached................... 2010 2009 2006 71 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The health care cost trend rate assumption has an effect on the amounts reported. To illustrate, increasing the assumed health care cost trend rates by 1 percentage point in each year would increase the benefit obligation as of December 31, 2004 by $0.8 million and increase the aggregate of service cost and interest cost for the year then ended by $0.1 million. Decreasing the assumed health care cost trend rates by 1 percentage point in each year would decrease the benefit obligation as of December 31, 2004 by $0.7 million and decrease the aggregate of service cost and interest cost for the year then ended by $0.1 million. 11. STOCKHOLDERS' EQUITY The Company has reserved shares of its common stock for issuance to directors, officers, employees and certain advisors of the Company through incentive stock options, non-qualified stock options and stock appreciation rights ("SARs") to be granted under the CNA Surety 1997 Long-Term Equity Compensation Plan ("CNA Surety Plan"). The Company has also reserved shares of its common stock for issuance to Capsure option holders under the CNA Surety Corporation Replacement Stock Option Plan ("Replacement Plan"). The CNA Surety Plan and Replacement Plan are collectively referred to as the "Plan". The aggregate number of shares initially available for which options may be granted under the Plan is 3,000,000. Options issued under the Replacement Plan have the same exercise price, rights, benefits, terms and conditions as the Capsure options replaced. The number of unexercised and outstanding Capsure options issued to the holders under the Replacement Plan on September 30, 1997 was 335,235. The exercise prices of the replacement options ranged between $0.05 and $8.00 per share on September 30, 1997. The Compensation Committee (the "Committee") of the Board of Directors, consisting of independent members of the Board of Directors, administers the Plan. The Committee determines the option prices. Prices may not be less than the fair market value of the Company's common stock on the date of grant for incentive stock options and may not be less than the par value of the Company's common stock for non-qualified stock options. The Plan provides for the granting of incentive stock options as defined under Section 382 of the Internal Revenue Code of 1986, as amended. All non-qualified stock options and incentive stock options granted under the Plan expire ten years after the date of grant and in the case of the Replacement Plan the options expire ten years from the original Capsure grant date. The following table summarizes stock option activity for 2004, 2003 and 2002. WEIGHTED AVERAGE OPTION SHARES SUBJECT PRICE PER TO OPTION SHARE -------------- -------------- Balance at December 31, 2001.............................. 1,663,287 $13.18 Options granted......................................... 325,800 $ 9.35 Options cancelled....................................... (172,419) $13.03 Options exercised....................................... (146,725) $ 9.63 --------- Balance at December 31, 2002.............................. 1,669,943 $12.76 Options granted......................................... 344,500 $ 9.52 Options cancelled....................................... (277,051) $12.96 Options exercised....................................... (3,000) $ 2.56 --------- Balance at December 31, 2003.............................. 1,734,392 $12.11 Options granted......................................... 356,425 $12.04 Options cancelled....................................... (369,263) $12.23 Options exercised....................................... (22,313) $ 9.73 --------- Balance at December 31, 2004.............................. 1,699,241 $12.09 ========= 72 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) As of December 31, 2004, the number of shares available for granting of options under the Plan was 741,502. ]The following table summarizes information about stock options outstanding at December 31, 2004: OPTIONS OUTSTANDING ------------------------------------------------- OPTIONS EXERCISABLE WEIGHTED AVERAGE ------------------------------ NUMBER REMAINING WEIGHTED AVERAGE NUMBER WEIGHTED AVERAGE RANGE OF EXERCISE PRICES OUTSTANDING CONTRACTUAL LIFE EXERCISE PRICE EXERCISABLE EXERCISE PRICE ------------------------ ----------- ---------------- ---------------- ----------- ---------------- $2.875 to $3.50....... 3,950 0.7 years $ 3.50 3,950 $ 3.50 $9.35 to $11.50....... 823,798 7.0 years $10.22 508,398 $10.68 $13.05 to $15.875..... 871,493 6.7 years $13.91 468,822 $15.23 The weighted average fair market value (at grant date) per option granted was $3.82, $3.72 and $3.69 respectively, for options granted during 2004, 2003 and 2002. The fair value of these options was estimated at grant date using a Black-Scholes option pricing model with the following weighted average assumptions for the year ended December 31, 2004: risk free interest rate of 1.1%; dividend yield of 0.0%; expected option life of six years; and volatility of 30.4%. Similar assumptions for the years ended December 31, 2003 and 2002 were: risk free interest rate of 1.10% and 1.50%; dividend yield of 0.0%; expected option life of 6 years; and volatility of 39.8%. The Company applies the intrinsic value method per APB 25 and related interpretations, in accounting for its plans as allowed for under the provisions of SFAS 123 with respect to its stock-based incentive plans. Accordingly, no compensation cost has been recognized for its stock-based incentive plans as the exercise price of the granted options equals the market price at the grant date. The following table illustrates the effect on net income and earnings per share data if the Company had applied the fair value recognition provisions of SFAS 123 to stock based compensation under the Company's stock-based compensation plan. YEARS ENDED DECEMBER 31, ------------------------------------- 2004 2003 2002 ---------- ----------- ---------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Net income (loss)...................................... $39,710 $(14,151) $30,119 Less: Total stock based compensation cost determined under the fair value method, net of tax.............. (616) (118) (12) ------- -------- ------- Pro forma net income (loss)............................ $39,094 $(14,269) $30,107 ======= ======== ======= Basic and diluted earnings (loss) per share, as reported............................................. $ 0.92 $ (0.33) $ 0.70 ======= ======== ======= Basic and diluted earnings (loss) per share, pro forma................................................ $ 0.91 $ (0.33) $ 0.70 ======= ======== ======= Effective January 1, 1998, the Company established the CNA Surety Corporation Non-Employee Directors Deferred Compensation Plan. Under this plan, each director who is not a full-time employee of the Company or any of its affiliates may defer all or a portion of the annual retainer fee that would otherwise be paid to such director. The deferral amount, which must be in multiples of 10% of the retainer fee, will be credited to a deferred compensation account and will be deemed invested in Common Stock Units equal to the deferred fees divided by the fair market value of CNA Surety common stock as of each quarterly meeting date. Each director will be fully vested in his or her deferred compensation amount. Aggregate common stock units outstanding as of December 31, 2004 and 2003 were 15,079 and 12,932, respectively. Common Stock Units are convertible into CNA Surety common stock at the election of the director. 12. SEGMENT INFORMATION The Company is a leading provider of surety and fidelity bonds in the United States. According to the Surety Association of America ("SAA"), the surety and fidelity segment of the domestic property and 73 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) casualty insurance industry aggregates approximately $5.0 billion in direct written premiums, comprised of approximately $3.7 billion in surety premiums and $1.3 billion in fidelity premiums. Surety bonds are three-party agreements in which the issuer of the bond (the surety) joins with a second party (the principal) in guaranteeing to a third party (the owner/obligee) the fulfillment of some obligation on the part of the principal. The surety is the party who guarantees fulfillment of the principal's obligation to the obligee. There are two broad types of surety products -- contract surety and commercial surety bonds. Contract surety bonds secure a contractor's performance and/or payment obligation generally with respect to a construction project. Contract surety bonds are generally required by federal, state, and local governments for public works projects. Commercial surety bonds include all surety bonds other than contract and cover obligations typically required by law or regulation. Fidelity bonds cover losses arising from employee dishonesty. Although all of its products are sold through the same independent insurance agent and broker distribution network, the Company's underwriting is organized by the two broad types of surety products -- contract surety and commercial surety, which also includes fidelity bonds and other insurance products for these purposes. These two operating segments have been aggregated into one reportable business segment for financial reporting purposes because of their similar economic and operating characteristics. The following tables set forth gross and net written premiums, dollars in thousands, by product and between domestic and international risks and the respective percentage of the total for the past three years. GROSS WRITTEN PREMIUMS FOR THE YEARS ENDED ------------------------------------------------------ % OF % OF % OF 2004 TOTAL 2003 TOTAL 2002 TOTAL -------- ----- -------- ----- -------- ----- Contract....................... $221,577 56.9% $208,472 56.1% $197,875 55.0% Commercial: License and permit........... 81,502 20.9 83,554 22.5 85,787 23.9 Judicial and fiduciary....... 22,590 5.8 24,075 6.5 25,358 7.0 Public official.............. 23,911 6.2 21,330 5.7 18,861 5.2 Other........................ 7.890 2.0 4,774 1.3 4,033 1.1 -------- ----- -------- ----- -------- ----- Total commercial............... 135,893 34.9 133,733 36.0 134,039 37.2 Fidelity and other............. 31,947 8.2 29,170 7.9 27,978 7.8 -------- ----- -------- ----- -------- ----- $389,417 100.0% $371,375 100.0% $359,892 100.0% ======== ===== ======== ===== ======== ===== Domestic....................... $381,655 98.0% $363,290 97.8% $348,010 96.7% International.................. 7.762 2.0 8,085 2.2 11,882 3.3 -------- ----- -------- ----- -------- ----- $389,417 100.0% $371,375 100.0% $359,892 100.0% ======== ===== ======== ===== ======== ===== 74 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NET WRITTEN PREMIUMS FOR THE YEARS ENDED ------------------------------------------------------ % OF % OF % OF 2004 TOTAL 2003 TOTAL 2002 TOTAL -------- ----- -------- ----- -------- ----- Contract....................... $172,274 54.1% $184,449 57.8% $172,633 56.3% Commercial..................... 115,454 36.3 106,899 33.5 107,290 35.0 Fidelity and other............. 30,556 9.6 27,862 8.7 26,731 8.7 -------- ----- -------- ----- -------- ----- $318,284 100.0% $319,210 100.0% $306,654 100.0% ======== ===== ======== ===== ======== ===== Domestic....................... $311,620 97.9 $311,125 97.5% $297,385 97.0% International.................. 6,664 2.1 8,085 2.5 9,269 3.0 -------- ----- -------- ----- -------- ----- $318,284 100.0% $319,210 100.0% $306,654 100.0% ======== ===== ======== ===== ======== ===== Approximately $68.1 million, or 17.5%, of gross written premiums were generated from national insurance brokers in 2004 with the single largest national broker production comprising $18.5 million, or 4.7%, of gross written premiums. In 2003, approximately $61.2 million, or 16.5%, of gross written premiums were generated from national insurance brokers with the single largest national broker production comprising $19.2 million, or 5.2%, of gross written premiums. In 2002, approximately $72.4 million, or 20.1%, of gross written premiums were generated from national insurance brokers with the single largest national broker production comprising $28.3 million, or 7.9%, of gross written premiums. 13. STATUTORY FINANCIAL DATA (UNAUDITED) CNA Surety's insurance subsidiaries file financial statements prepared in accordance with statutory accounting practices prescribed or permitted by applicable insurance regulatory authorities. Prescribed statutory accounting practices include state laws, regulations and general administrative rules, as well as guidance provided in a variety of publications of the National Association of Insurance Commissioners ("NAIC"). Permitted statutory accounting practices encompass all accounting practices that are not prescribed. The Company's insurance subsidiaries follow three permitted accounting practices which did not have a material effect on reported statutory surplus or income. The Company was given permission to report activity in the Small Business Administration's Surety Bond Guarantee program as a reinsurance program and to report all salvage and subrogation recoveries as recoveries of loss rather than allocating recoveries between loss and loss adjustment expenses. Also, Surety Bonding has been given permission to report ceding commissions received from Western Surety that exceed the acquisition costs related to the business ceded as a reduction to commission expense. Historically, the principal differences between statutory financial statements and financial statements prepared in accordance with generally accepted accounting principles are that statutory financial statements do not reflect deferred policy acquisition costs, deferred income taxes are recorded but there are limitations as to the amount of deferred tax assets that may be reported as "admitted" assets and fixed income securities are generally carried at amortized cost in statutory financial statements. The following table reconciles consolidated stockholders' equity at December 31, 2004 and 2003 as reported herein in conformity with GAAP with total statutory capital and surplus of CNA Surety's insurance 75 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) subsidiaries, determined in accordance with statutory accounting practices prescribed or permitted by insurance regulatory authorities (dollars in thousands): 2004 2003 --------- --------- Consolidated equity per GAAP................................ $ 446,371 $ 410,141 Less: Impact of non-insurance companies and eliminations.... (53,151) (28,921) --------- --------- Insurance company equity per GAAP........................... 499,522 439,062 Intangible assets........................................... (133,361) (133,361) Net unrealized gain on fixed income securities.............. (28,412) (34,178) Deferred policy acquisition costs........................... (102,128) (104,674) Deferred income taxes, net.................................. 40,478 45,159 Non-admitted assets and statutory reserves.................. (23,453) (21,586) Other....................................................... (232) -- --------- --------- Balance per statutory accounting practices.................. $ 252,414 $ 190,422 ========= ========= The NAIC has promulgated Risk Based Capital ("RBC") requirements for property and casualty insurance companies to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks such as asset quality, loss reserve adequacy, and other business factors. The RBC information is used by state insurance regulators as an early warning mechanism to identify insurance companies that potentially are inadequately capitalized. In addition, the formula defines new minimum capital standards that supplement the current system of fixed minimum capital and surplus requirements on a state-by-state basis. Regulatory compliance is determined by a ratio (the "Ratio") of the enterprise's regulatory total adjusted capital, as defined by the NAIC, to its authorized control level RBC, as defined by the NAIC. Generally, a Ratio in excess of 200% of authorized control level RBC requires no corrective actions by a company or regulators. As of December 31, 2004 each of CNA Surety's insurance subsidiaries had a Ratio that was in compliance with the minimum RBC requirements. CNA Surety's insurance subsidiaries are subject to regulation and supervision by the various state insurance regulatory authorities in which they conduct business. Such regulation is generally designed to protect policyholders and includes such matters as maintenance of minimum statutory surplus and restrictions on the payment of dividends. Generally, statutory surplus of each insurance subsidiary in excess of a statutorily prescribed minimum is available for payment of dividends to the parent company. However, such distributions as dividends may be subject to prior regulatory approval. Without prior regulatory approval in 2005, CNA Surety's insurance subsidiaries may pay dividends of $46.8 million in the aggregate. Combined statutory surplus for the insurance subsidiaries at December 31, 2004 was $252.4 million. 14. RELATED PARTY TRANSACTIONS The Company has the following related party transactions not previously described in Note 6. Reinsurance. Effective January 1, 2001, CNA Surety renewed an Administrative Services Agreement with CCC. The agreement allows the Company to purchase and/or have access to certain services provided by CNAF. The Company will also pay CNAF a management fee for its proportionate share of administrative and overhead costs incurred in supporting the services provided pursuant to this agreement. The management fee for the year 2005 is $1.9 million that shall be paid by CNA Surety to CNAF in equal monthly installments by the last day of each month. The amounts paid were $1.8 million, $1.7 million, and $1.6 million for 2004, 2003, and 2002, respectively. The management fee shall be increased as of January 1, the "adjustment date", of each year this Administrative Services Agreement is in force by the greater of 5% or the amount of the increase in 76 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) the Consumer Price Index for All Urban Consumers for the Chicago, Illinois area as reported by the Bureau of Labor Statistics for the 12 month period immediately preceding the adjustment date. The agreement was amended in 2003 to allow CCC to purchase services from the Company. In 2004 and 2003, CCC paid the Company $0.5 million for services in connection with licensing and appointing CCC's insurance producers as required by state insurance laws. This agreement shall be effective so long as CNAF or their affiliates or shareholders shall continue to own a majority interest in CNA Surety. This agreement may be terminated by either party upon the provision of 30 days prior notice of such termination to the other party. The Company was charged $7.4 million, $6.1 million, and $5.2 million for the years ended December 31, 2004, 2003 and 2002, respectively, for rents and services provided under the Administrative Services Agreement. In addition, the Company was charged $0.8 million, $1.4 million and $1.0 million for direct costs incurred by CCC on the Company's behalf during 2004, 2003 and 2002, respectively. The Company had no payable balance to CCC related to the Administrative Services Agreement as of December 31, 2004. Western Surety has entered into a series of business transactions with entities in which an affiliate of CCC has an interest. The first series involves five separate real estate residual value insurance policies issued by R.V.I. America Insurance Company ("RVI -- America") reinsured by Western Surety through the Quota Share Treaty. RVI America is a wholly owned subsidiary of R.V.I. America Corporation, which is a wholly owned subsidiary of R.V.I. Guaranty Company Ltd. of Bermuda ("RVI -- Bermuda"), an unconsolidated affiliate of CCC. The transactions involve policies with limits totaling approximately $11.5 million. CCC is reinsuring the full extent of RVI -- America's exposure on the policies. Pursuant to the Quota Share Treaty, Western Surety is, in turn, reinsuring all of CCC's exposures on the policies. Western Surety is reinsuring all of its exposure on the policies with RVI-Bermuda, a non-admitted reinsurer. The policy limits range from $1,665,077 to $2,954,164 with an average policy limit of approximately $2.3 million and total limits of all policies of $11,539,510. Net premium amounts retained in 2000 relative to these reinsurance transactions totaled $519,278 as follows: RVI -- America, $51,928; CCC, $130,858; Western Surety, $67,298; and RVI -- Bermuda, $269,194. In addition from time to time Western Surety provided surety bonds guaranteeing insurance payments of certain companies to CCC and its affiliates under retrospectively rated insurance policies underwritten by CCC and its affiliates. Under the terms of these bonds, referred to as insurance program bonds, if the principal, the insured company, failed to make required a required premium payment, CCC and its affiliates would have a claim against the Company under the bond. The Company now has a policy not to issue such bonds to companies insured by CCC and its affiliates. The last such bond was written in 2001 and currently bonds with $13.9 million of total penal sums remain as of December 31, 2004. Western Surety from time to time provides license and permit bonds and appeal bonds to CCC and its affiliates and to clients of CCC and its affiliates. Under procedures established by the Audit Committee, the Company may issue appeal bonds for CCC and its affiliates and their clients with penal sums of $10 million or less without prior Audit Committee approval as long as those bonds meet the Company's normal underwriting standards, the rates charged are market rates and that the Company has received the indemnity of CCC. Bonds greater than $10 million require the prior approval of the Audit Committee. As of December 31, 2004, the total amount of the outstanding appeal and license and permit bonds written on behalf of CCC and its affiliates was approximately $65.3 million, which was comprised of 42 bonds. Western Surety has entered into indemnity agreements with CCC and its affiliates indemnifying Western Surety for any loss arising from the issuance of appeal bonds for CCC and its affiliates. The premium for these bonds was approximately $503,000 in 2004 and $440,000 in 2003. 77 CNA SURETY CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 15. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) The following is a summary of the quarterly results of operations for the years ended December 31, 2004, 2003, and 2002 (dollars in thousands, except per share amounts): FIRST SECOND THIRD FOURTH QUARTER QUARTER QUARTER QUARTER ------- ------- -------- ------- 2004 Revenues...................................... $84,404 $84,667 $ 90,950 $90,768 ======= ======= ======== ======= Income before income taxes.................... $ 8,119 $13,884 $ 15,194 $16,810 Income taxes.................................. 1,745 3,699 4,220 4,633 ------- ------- -------- ------- Net income.................................... $ 6,374 $10,185 $ 10,974 $12,177 ======= ======= ======== ======= Basic and diluted earnings per common share... $ 0.15 $ 0.24 $ 0.25 $ 0.28 ======= ======= ======== ======= 2003 Revenues...................................... $78,635 $84,596 $ 84,162 $85,183 ======= ======= ======== ======= Income (loss) before income taxes............. $15,380 $15,966 $(77,507) $13,998 Income taxes.................................. 4,391 4,283 (30,088) 3,402 ------- ------- -------- ------- Net income (loss)............................. $10,989 $11,683 $(47,419) $10,596 ======= ======= ======== ======= Basic and diluted earnings per common share... $ 0.26 $ 0.27 $ (1.10) $ 0.24 ======= ======= ======== ======= 2002 Revenues...................................... $74,049 $84,464 $ 85,529 $74,445 ======= ======= ======== ======= Income before income taxes.................... $15,392 $18,819 $ 3,715 $ 4,828 Income taxes.................................. 4,835 5,917 1,098 785 ------- ------- -------- ------- Net income.................................... $10,557 $12,902 $ 2,617 $ 4,043 ======= ======= ======== ======= Basic and diluted earnings per common share... $ 0.25 $ 0.30 $ 0.06 $ 0.09 ======= ======= ======== ======= 16. SUBSEQUENT EVENT On October 27, 2004, the Company announced that it had tentatively agreed to sell all of its financial interest in United Kingdom ("UK") based DeMontfort Group, Ltd. to HCC Insurance Holdings, Inc. The agreement covers CNA Surety's 34% ownership in the common shares and certain preferred shares and indebtedness of the DeMontfort Group. The transaction settled on January 5, 2005. The Company expects to realize a gain of approximately $2.0 million before the effect of income taxes in the first quarter 2005, however the decision to sell the investment is not otherwise expected to have a material impact on the Company's ongoing operations or financial position. 78 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES As of December 31, 2004, the Company's management, including the Company's Chief Executive Officer (CEO) and Chief Financial Officer (CFO) have conducted an evaluation of the effectiveness of its disclosure controls and procedures (as such term is defined in Rules 13a-15 (e) and 15d-15 (e) under the Securities Exchange Act of 1934, as amended ("the Exchange Act"). Based on their evaluation, the CEO and CFO concluded that the Company's disclosure controls and procedures are effective in ensuring that all material information required to be filed in this Annual Report has been made to them in a timely manner. Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, the Company included a report of management's assessment of the design and effectiveness of its internal controls as part of this Annual Report on Form 10-K for the fiscal year ended December 31, 2004. The independent registered public accounting firm of the Company also attested to, and reported on, management's assessment of the effectiveness of internal control over financial reporting. Management's report and the independent registered public accounting firm's attestation report are included in the Company's 2004 Financial Statements under the captions entitled "Management's Report on Internal Control Over Financial Reporting" and "Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting" and are incorporated herein by reference. There were no changes in the Company's internal control over financial reporting (as defined in Rules 13a-15 (f) and 15d-15 (f) under the Exchange Act) during the quarter ended December 31, 2004 that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. ITEM 9B. OTHER INFORMATION PART III. ITEMS 10, 11, 12, 13, AND 14. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT, EXECUTIVE COMPENSATION, SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS, CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND PRINCIPAL ACCOUNTANT FEES AND SERVICES The Company will file a definitive proxy statement with the Securities and Exchange Commission pursuant to Regulation 14A under the Securities Exchange Act of 1934 (the "Proxy Statement") relating to the Company's Annual Meeting of Stockholders to be held on April 26, 2005, not later than 120 days after the end of the fiscal year covered by this Form 10-K. Information required by Items 10 through 14 will appear in the Proxy Statement and is incorporated herein by reference. 79 PART IV. ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES PAGE ---- Financial Statement Schedules: Schedule I -- Summary of Investments........................ 81 Schedule II -- Condensed Financial Information of Registrant................................................ 82 Schedule III -- Supplementary Insurance Information......... 86 Schedule IV -- Reinsurance.................................. 87 Schedule V -- Valuation and Qualifying Accounts............. 88 Schedule VI -- Supplemental Information Concerning Property -- Casualty Insurance Operations................. 89 (a)(3) Exhibits............................................. 90 80 SCHEDULE I CNA SURETY CORPORATION AND SUBSIDIARIES SUMMARY OF INVESTMENTS OTHER THAN INVESTMENTS IN RELATED PARTIES AS OF DECEMBER 31, 2004 AND 2003 AS OF DECEMBER 31, 2004 ------------------------------- COST OR AMORTIZED FAIR CARRYING COST VALUE VALUE --------- -------- -------- (AMOUNTS IN THOUSANDS) Fixed Income Securities: U.S. Government and government agencies and authorities... $135,350 $136,108 $136,108 States, municipalities and political subdivisions......... 431,624 454,617 454,617 All other corporate bonds................................. 126,044 131,316 131,316 Redeemable preferred stock................................ 5,356 6,297 6,297 -------- -------- -------- Total fixed income securities.......................... 698,374 728,338 728,338 -------- ======== -------- Equity securities........................................... 1,084 1,198 1,198 Short-term investments...................................... 28,457 28,457 Other investments........................................... 1,058 1,058 -------- -------- Total investments...................................... $728,973 $759,051 ======== ======== AS OF DECEMBER 31, 2003 ------------------------------- COST OR AMORTIZED FAIR CARRYING COST VALUE VALUE --------- -------- -------- (AMOUNTS IN THOUSANDS) Fixed Income Securities: U.S. Government and government agencies and authorities... $ 41,231 $ 42,487 $ 42,487 States, municipalities and political subdivisions......... 376,961 402,411 402,411 All other corporate bonds................................. 112,614 120,525 120,525 Redeemable preferred stock................................ 13,395 14,633 14,633 -------- -------- -------- Total fixed income securities.......................... 544,201 580,056 580,056 -------- ======== -------- Equity securities........................................... 992 1,061 1,061 Short-term investments...................................... 63,871 63,871 Other investments........................................... 1,119 1,119 -------- -------- Total investments...................................... $610,183 $646,107 ======== ======== 81 SCHEDULE II CNA SURETY CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY) BALANCE SHEETS DECEMBER 31 ----------------------- 2004 2003 ---------- ---------- (AMOUNTS IN THOUSANDS) ASSETS Investments in and advances to subsidiaries................. $510,844 $448,162 Fixed income securities (amortized cost: $4,803 and $5,175)................................................... 6,358 6,347 Equity investments (cost: $1,080 and $991).................. 1,198 1,061 Short-term investments, at cost (which approximates fair value).................................................... 5,798 14,089 Cash (restricted: $1,761 and $5,971)........................ 1,762 5,973 Other assets................................................ 544 -- -------- -------- Total assets.............................................. $526,504 $475,632 ======== ======== LIABILITIES Debt........................................................ $ 65,720 $ 50,002 Other liabilities........................................... 14,413 15,489 -------- -------- Total liabilities......................................... 80,133 65,491 -------- -------- STOCKHOLDERS' EQUITY Common stock................................................ 444 444 Additional paid-in capital.................................. 255,997 255,816 Retained earnings........................................... 185,495 145,786 Accumulated other comprehensive income...................... 19,551 23,351 Treasury stock, at cost..................................... (15,116) (15,256) -------- -------- Total stockholders' equity................................ 446,371 410,141 -------- -------- Total liabilities and stockholders' equity............. $526,504 $475,632 ======== ======== The accompanying note is an integral part of these condensed financial statements. 82 SCHEDULE II CNA SURETY CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY) -- (CONTINUED) STATEMENTS OF INCOME YEARS ENDED DECEMBER 31, ---------------------------- 2004 2003 2002 ------- -------- ------- (AMOUNTS IN THOUSANDS) Revenues: Net investment income..................................... $ 1,262 $ 923 $ 713 Net realized investment gains (losses).................... 40 81 (4) ------- -------- ------- Total revenues......................................... 1,302 1,004 709 ------- -------- ------- Expenses: Interest expense.......................................... 2,248 1,491 1,656 Corporate expense......................................... 6,419 6,781 3,706 ------- -------- ------- Total expenses......................................... 8,667 8,272 5,362 ------- -------- ------- Loss from operations before income taxes and equity in net income of subsidiaries.................................... (7,365) (7,268) (4,653) Income taxes................................................ (2,573) (2,867) (1,629) ------- -------- ------- Net loss before equity in net income of subsidiaries........ (4,792) (4,401) (3,024) Equity in net income (loss) of subsidiaries................. 44,502 (9,750) 33,143 ------- -------- ------- Net income (loss)........................................... $39,710 $(14,151) $30,119 ======= ======== ======= The accompanying note is an integral part of these condensed financial statements. 83 SCHEDULE II CNA SURETY CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY) -- (CONTINUED) STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, ------------------------------ 2004 2003 2002 -------- -------- -------- (AMOUNTS IN THOUSANDS) OPERATING ACTIVITIES: Net income................................................ $ 39,710 $(14,151) $ 30,119 Cash dividends from subsidiaries....................... -- 28,012 31,162 Tax payments received from (paid to) subsidiaries...... (6,172) 7,362 9,894 Federal and state income tax (payments) receipts....... 8,988 (5,816) (8,000) Adjustments to reconcile net income to net cash provided by operating activities: Equity in net income of subsidiaries................. (44,502) 9,750 (33,143) Change in other assets and liabilities............... (4,100) (5,878) (759) -------- -------- -------- Net cash provided by operating activities................... (6,076) 19,279 29,273 -------- -------- -------- INVESTING ACTIVITIES: Net advances from (to) subsidiaries....................... (496) 2,423 (9,713) Capital contributions to subsidiaries..................... (20,350) (4,898) -- Net sales of fixed income securities...................... 180 507 19 Net purchases of equity securities........................ (92) (231) (853) Changes in short-term investments......................... 8,291 (5,328) 5,900 Other..................................................... (1,414) (134) (62) -------- -------- -------- Net cash provided by (used in) investing activities......... (13,881) (7,661) (4,709) -------- -------- -------- FINANCING ACTIVITIES: Proceeds from debt........................................ 30,930 -- 71,000 Principal payments on debt................................ (15,000) (10,000) (86,000) Debt issuance costs....................................... (506) -- -- Dividends to stockholders................................. -- -- (19,310) Issuance of treasury stock to employee stock purchase plan................................................... 140 119 122 Employee stock option exercises........................... 181 8 1,414 -------- -------- -------- Net cash used in financing activities....................... 15,745 (9,873) (32,774) -------- -------- -------- Increase (decrease) in cash................................. (4,211) 1,745 (8,210) Cash at beginning of period................................. 5,973 4,228 12,438 -------- -------- -------- Cash at end of period....................................... $ 1,762 $ 5,973 $ 4,228 ======== ======== ======== The accompanying note is an integral part of these condensed financial statements. 84 CNA SURETY CORPORATION CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY) -- (CONTINUED) SCHEDULE II NOTE TO CONDENSED FINANCIAL INFORMATION 1. RESTRICTED CASH AND SHORT TERM INVESTMENTS As of December 31, 2004 and December 31, 2003, short-term investments and cash included $5.1 million and $6.6 million, respectively, of restricted cash related to premium receipt collections ultimately due to the Company's insurance subsidiaries. 85 SCHEDULE III CNA SURETY CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002 YEARS ENDED DECEMBER 31, ------------------------------ 2004 2003 2002 -------- -------- -------- (AMOUNTS IN THOUSANDS) Deferred policy acquisition costs........................... $102,128 $104,674 ======== ======== Unpaid losses and loss adjustment expense reserves.......... $363,387 $413,539 ======== ======== Unearned premiums........................................... $226,019 $224,068 ======== ======== Other policy claims and benefits payable.................... $ -- $ -- ======== ======== Net premium revenue......................................... $317,857 $304,449 $298,319 ======== ======== ======== Net investment income....................................... $ 30,181 $ 26,301 $ 27,754 ======== ======== ======== Benefits, claims, losses and settlement expenses............ $ 87,356 $172,476 $ 94,198 ======== ======== ======== Amortization of deferred policy acquisition costs........... $150,471 $141,650 $138,991 ======== ======== ======== Other operating expenses.................................... $ 56,695 $ 49,090 $ 40,836 ======== ======== ======== Net premiums written........................................ $318,284 $319,210 $306,654 ======== ======== ======== 86 SCHEDULE IV CNA SURETY CORPORATION AND SUBSIDIARIES REINSURANCE FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002 PERCENTAGE CEDED TO ASSUMED OF AMOUNT GROSS OTHER FROM OTHER NET ASSUMED AMOUNT COMPANIES COMPANIES(1) AMOUNT TO NET -------- --------- ------------ -------- ---------- (AMOUNTS IN THOUSANDS) YEAR ENDED DECEMBER 31, 2004 Premiums written: Property and casualty insurance..... $267,371 $71,133 $122,046 $318,284 38.3% -------- ------- -------- -------- ---- Total premiums written........... $267,371 $71,133 $122,046 $318,284 38.3% ======== ======= ======== ======== ==== Premiums earned: Property and casualty insurance..... $238,309 $69,610 $149,158 $317,857 46.9% -------- ------- -------- -------- ==== Total premiums earned............ $238,309 $69,610 $149,158 $317,857 46.9% ======== ======= ======== ======== ==== YEAR ENDED DECEMBER 31, 2003 Premiums written: Property and casualty insurance..... $195,786 $52,165 $175,589 $319,210 55.0% -------- ------- -------- -------- ---- Total premiums written........... $195,786 $52,165 $175,589 $319,210 55.0% ======== ======= ======== ======== ==== Premiums earned: Property and casualty insurance..... $168,510 $59,065 $195,004 $304,449 64.1% -------- ------- -------- -------- ---- Total premiums earned............ $168,510 $59,065 $195,004 $304,449 64.1% ======== ======= ======== ======== ==== YEAR ENDED DECEMBER 31, 2002 Premiums written: Property and casualty insurance..... $148,186 $53,238 $211,706 $306,654 69.0% -------- ------- -------- -------- ---- Total premiums written........... $148,186 $53,238 $211,706 $306,654 69.0% ======== ======= ======== ======== ==== Premiums earned: Property and casualty insurance..... $137,957 $45,784 $206,146 $298,319 69.1% -------- ------- -------- -------- ---- Total premiums earned............ $137,957 $45,784 $206,146 $298,319 69.1% ======== ======= ======== ======== ==== ------------------------- (1) Primarily from affiliates. 87 SCHEDULE V CNA SURETY CORPORATION AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002 ADDITIONS ----------------------- BALANCE AT CHARGED TO CHARGED TO BALANCE AT BEGINNING COSTS AND OTHER END OF OF PERIOD EXPENSES ACCOUNTS DEDUCTIONS(1) PERIOD ---------- ---------- ---------- ------------- ---------- (AMOUNTS IN THOUSANDS) YEAR ENDED DECEMBER 31, 2004 Allowance for possible losses on premiums receivable.............. $1,575 $ 910 $ -- $ 332 $2,153 ====== ===== ===== ===== ====== Allowance for possible losses on reinsurance receivable........... $ -- $ -- $ -- $ -- $ -- ====== ===== ===== ===== ====== YEAR ENDED DECEMBER 31, 2003 Allowance for possible losses on premiums receivable.............. $1,365 $ 963 $ -- $(753) $1,575 ====== ===== ===== ===== ====== Allowance for possible losses on reinsurance receivable........... $ -- $ -- $ -- $ -- $ -- ====== ===== ===== ===== ====== YEAR ENDED DECEMBER 31, 2002 Allowance for possible losses on premiums receivable.............. $2,614 $(363) $ -- $(886) $1,365 ====== ===== ===== ===== ====== Allowance for possible losses on reinsurance receivable........... $ -- $ -- $ -- $ -- $ -- ====== ===== ===== ===== ====== ------------------------- (1) Write-offs charged against allowance. 88 SCHEDULE VI CNA SURETY CORPORATION AND SUBSIDIARIES SUPPLEMENTAL INFORMATION CONCERNING PROPERTY-CASUALTY INSURANCE OPERATIONS AS OF AND FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002 YEARS ENDED DECEMBER 31, ---------------------------------- 2004 2003 2002 -------- ---------- ---------- (AMOUNTS IN THOUSANDS) Deferred policy acquisition costs........................... $102,128 $104,674 ======== ======== Reserves for unpaid claims and claim adjustment expenses.... $363,387 $413,539 ======== ======== Discount (if any) deducted.................................. $ -- $ -- ======== ======== Unearned premiums........................................... $226,019 $224,068 ======== ======== Net premium revenue......................................... $317,857 $304,449 $298,319 ======== ======== ======== Net investment income....................................... $ 30,181 $ 26,301 $ 27,754 ======== ======== ======== Net claims and claim expenses incurred related to: Current year.............................................. $ 87,969 $133,186 $ 88,018 ======== ======== ======== Prior years............................................... $ (613) $ 39,290 $ 6,180 ======== ======== ======== Amortization of deferred policy acquisition costs........... $150,471 $141,650 $138,991 ======== ======== ======== Net paid claims and claim adjustment expenses............... $ 95,982 $ 83,426 $ 77,559 ======== ======== ======== Net premiums written........................................ $318,284 $319,210 $306,654 ======== ======== ======== 89 (a)(3) EXHIBITS EXHIBIT NUMBER DESCRIPTION ------- ----------- 2(1) Reorganization Agreement dated as of December 19, 1996 among Capsure Holdings Corp., Continental Casualty Company, CNA Surety Corporation, Surety Acquisition Company and certain affiliates of Continental Casualty Company (filed on December 27, 1996 as Exhibit 2 to Capsure Holdings Corp.'s Form 8-K, and incorporated herein by reference.) 2(2) First Amendment to the Reorganization Agreement dated as of July 14, 1997 among Capsure Holdings Corp., Continental Casualty Company, CNA Surety Corporation, Surety Acquisition Company and certain affiliates of Continental Casualty Company (filed on July 16, 1997 as Exhibit 2 to Capsure Holdings Corp.'s Form 8-K, and incorporated herein by reference.) 3(1) Certificate of Incorporation of CNA Surety Corporation dated December 10, 1996 (filed on August 15, 1997 as Exhibit 3(1)to CNA Surety Corporation's Registration Statement on Form S-4 (Registration No. 333-33753), and incorporated herein by reference.) 3(2) Amendment to Certificate of Incorporation of CNA Surety Corporation dated May 27, 1997 (filed on August 15, 1997 as Exhibit 3(2) to CNA Surety Corporation's Registration Statement on Form S-4 (Registration No. 333-33753), and incorporated herein by reference.) 3(3) Bylaws of CNA Surety Corporation (filed on August 15, 1997 as Exhibit 3(3) to CNA Surety Corporation's Registration Statement on Form S-4 (Registration No. 333-33753), and incorporated herein by reference.) 3(4) Amendment to Bylaws of CNA Surety Corporation (filed on September 23, 1998 as Exhibit 4(3) to CNA Surety Corporation's Registration Statement on Form S-8(Registration No. 333-64135), and incorporated herein by reference.) 4(1) Specimen certificate of CNA Surety Corporation (filed on August 15, 1997 as Exhibit 4(1) to CNA Surety Corporation's Registration Statement on Form S-4 (Registration No. 333-33753), and incorporated herein by reference.) 9 Not applicable. 10(1) Form of The CNA Surety Corporation Replacement Stock Option Plan (filed on August 15, 1997 as Exhibit 10(12) to CNA Surety Corporation's Registration Statement on Form S-4(Registration No. 333-33753), and incorporated herein by reference.) 10(2) Form of CNA Surety Corporation 1997 Long-Term Equity Compensation Plan (filed on August 15, 1997 as Exhibit 10(13) to CNA Surety Corporation's Registration Statement on Form S-4 (Registration No. 333-33753), and incorporated herein by reference.) 10(3) Form of Aggregate Stop Loss Reinsurance Contract by and between Western Surety Company, Universal Surety of America, Surety Bonding Company of America and Continental Casualty Company (filed on December 27, 1996 as Exhibit 2 to Capsure Holdings Corp.'s Form 8-K, and incorporated herein by reference.) 10(4) Form of Surety Excess of Loss Reinsurance Contract by and between Western Surety Company, Universal Surety of America, Surety Bonding Company of America and Continental Casualty Company (filed on December 27, 1996 as Exhibit 2 to Capsure Holdings Corp.'s Form 8-K, and incorporated herein by reference.) 10(5) Surety Second Excess of Loss Reinsurance Contract by and between Western Surety Company, Universal Surety of America, Surety Bonding Company of America and Continental Casualty Company (filed on July 9, 1998 as Exhibit 10(14) to CNA Surety Corporation's Registration Statement on Form S-1(Registration No. 333-56063), and incorporated herein by reference.) 10(6) Form of 10% Quota Share Treaty by and between Western Surety Company and Continental Casualty Company (filed on November 14, 2002 as Exhibit 10(1) to CNA Surety Corporation's Form 10-Q, and incorporated herein by reference.) 10(7) Form of Surety Quota Share Treaty by and between Western Surety Company and Continental Casualty Company. 90 EXHIBIT NUMBER DESCRIPTION ------- ----------- 10(8) Revised Form of Surety Excess of Loss Reinsurance Contract by and between Western Surety Company, Universal Surety of America, Surety Bonding Company of America and Continental Casualty Company (filed on May 14, 2003 as Exhibit 10(1) to CNA Surety Corporation's Form 10-Q, and incorporated herein by reference.) 10(9) Placement Slip for Surety Excess of Loss Reinsurance Contract by and between Western Surety Company, Universal Surety of America, Surety Bonding Company of America and Continental Casualty Company (filed on March 26, 2003 as Exhibit 10(12) to CNA Surety Corporation's Form 10-K, and incorporated herein by reference.) 10(10) Endorsement No. 1 to the Surety Excess of Loss Reinsurance Contract by and between Western Surety Company, Universal Surety of America, Surety Bonding Company of America and Continental Casualty Company (filed on November 13, 2003 to CNA Surety Corporation's Form 10-Q, and incorporated herein by reference.) 10(11) Form of Surety Excess of Loss Reinsurance Contract by and between Western Surety Company, Universal Surety of America, Surety Bonding Company of America and Continental Casualty Company (filed on March 15, 2004 as Exhibit 10(12) to CNA Surety Corporation's Form 10-K, and incorporated herein by reference.) 10(12) Endorsement to 10(11) Form of Surety Excess of Loss Reinsurance Contract by and between Western Surety Company, Universal Surety of America, Surety Bonding Company of America and Continental Casualty Company (filed on March 15, 2004 as Exhibit 10(12) to CNA Surety Corporation's Form 10-K, and incorporated herein by reference.) 10(13) Form of Surety Excess of Loss Reinsurance Contract by and between Western Surety Company, Universal Surety of America, Surety Bonding Company of America and Continental Casualty Company. 10(14) Form of Surety Excess of Loss Reinsurance Contract by and between Western Surety Company, Universal Surety of America, Surety Bonding Company of America and Continental Casualty Company. 10(15) Credit Agreement between CNA Surety Corporation and LaSalle Bank National Association Surety (filed on November 14, 2002 as Exhibit 10(3) to CNA Surety Corporation's Form 10-Q, and incorporated herein by reference.) 10(16) Amendment to Credit Agreement between CNA Surety Corporation and LaSalle Bank National Association (filed on March 26, 2003 as Exhibit 10(9) to CNA Surety Corporation's Form 10-K, and incorporated herein by reference.) 10(17) Second Amendment to Credit Agreement between CNA Surety Corporation and LaSalle Bank National Association (filed on November 13, 2003 as Exhibit 10(2) to CNA Surety Corporation's Form 10-Q, and incorporated herein by reference.) 10(18) Third Amendment to Credit Agreement between CNA Surety Corporation and LaSalle Bank National Association (filed on November 13, 2003 as Exhibit 10(2) to CNA Surety Corporation's Form 10-Q, and incorporated herein by reference.) 10(19) Form of Services and Indemnity Agreement by and between Western Surety Company and Continental Casualty Company. 10(20) Employment Agreement dated as of June 30, 2003 by and between CNA Surety Corporation and John F. Welch (filed on August 12, 2003 as Exhibit 10(1) to CNA Surety Corporation's Form 10-Q, and incorporated herein by reference.) 10(21) Form of CNA Surety Corporation Non-Employee Directors Deferred Compensation Plan (filed on July 9, 1998 as Exhibit 10(15) to CNA Surety Corporation's Registration Statement on Form S-1 (Registration No. 333-56063), and incorporated herein by reference.) 10(22) Form of CNA Surety Corporation Deferred Compensation Plan (filed on March 24, 2000 as Exhibit 10(18) to CNA Surety Corporation's Annual Report on Form 10-K, and incorporated herein by reference.) 91 EXHIBIT NUMBER DESCRIPTION ------- ----------- 10(23) Form of CNA Surety Corporation 2000 Employee Stock Purchase Plan (filed on January 26, 2001 (incorporated by reference) to CNA Surety Corporation's Registration Statement on Form S-8 (Registration No. 333-54440), and incorporated herein by reference.) 10(24) Deferred Bonus Agreement dated as of January 13, 2003 by and between CNA Surety Corporation and Michael Dougherty (filed on March 26, 2003 as Exhibit 10(9) to CNA Surety Corporation's Form 10-K, and incorporated herein by reference.) 10(25) Deferred Bonus Agreement dated as of December 19, 2002 by and between CNA Surety Corporation and Enid Tanenhaus (filed on March 26, 2003 as Exhibit 10(9) to CNA Surety Corporation's Form 10-K, and incorporated herein by reference.) 10(26) Deferred Bonus Agreement dated as of January 13, 2003 by and between CNA Surety Corporation and Thomas Pottle (filed on March 15, 2004 as Exhibit 10(26) to CNA Surety Corporation's Form 10-K, and incorporated herein by reference). 11 Not Applicable. 12 Not Applicable. 13 Not Applicable. 16 Not Applicable. 18 Not Applicable. 21 Subsidiaries of the Registrant. 22 Not Applicable. 23 Consent of Deloitte & Touche LLP dated February 25, 2005. 24 Not Applicable. 31(1) Certification pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002-Chief Executive Officer. 31(2) Certification pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002-Chief Financial Officer 32(1) Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32(2) Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 92 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CNA SURETY CORPORATION /s/ JOHN F. WELCH -------------------------------------- John F. Welch President and Chief Executive Officer (Principal Executive Officer) /s/ JOHN F. CORCORAN -------------------------------------- John F. Corcoran. Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) Dated: March 1, 2005 Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. DATE TITLE SIGNATURE ---- ----- --------- March 1, 2005 Chairman of the Board /s/ JAMES LEWIS and Director --------------------------------------------- James Lewis March 1, 2005 Director /s/ PHILIP H. BRITT --------------------------------------------- Philip H. Britt March 1, 2005 Director /s/ ROBERT TINSTMAN --------------------------------------------- Robert Tinstman March 1, 2005 Director /s/ LORI KOMSTADIUS --------------------------------------------- Lori Komstadius March 1, 2005 Director /s/ ROY E. POSNER --------------------------------------------- Roy E. Posner March 1, 2005 Director /s/ ADRIAN M. TOCKLIN --------------------------------------------- Adrian M. Tocklin March 1, 2005 Director /s/ JOHN F. WELCH --------------------------------------------- John F. Welch 93