SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

FORM 10-K

 

 

 

 

 

Commission File Number: 1-13277

 

 

 

 

CNA SURETY CORPORATION

(Exact name of registrant as specified in its charter)

 

 

(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 if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ.

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ.

 

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 þ     No o

 

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.  o

 

Indicate by a check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filers and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o     Accelerated filer þ     Non-accelerated filer o.

 

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act)  Yes o     No þ.

 

The aggregate market value of voting stock held by non-affiliates was $280.8 million based upon the closing price of $17.28 per share on June 30, 2006, 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 15, 2007, 43,901,478 shares of the Registrant’s Common Stock were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE:

 

Portions of the CNA Surety Corporation Proxy Statement prepared for the 2007 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

 

CNA SURETY CORPORATION AND SUBSIDIARIES

 

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 an 8.4% market share (based upon 2005 Surety Association of America (“SAA”) written premium data). CNA Surety’s wide selection of surety products range from very small commercial bonds to large contract bonds.

 

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 (“Universal Surety”), 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 63% of the outstanding common stock of CNA Surety. Loews Corporation (“Loews”) owns approximately 89% 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.

 

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 36,000 independent agencies. CNA Surety’s insurance subsidiaries are Western Surety, Surety Bonding, and Universal Surety. The insurance subsidiaries write, on a direct basis or as business assumed from CCC and CIC, small fidelity and non-contract surety bonds, referred to as commercial bonds; small, medium and large contract bonds; and errors and omissions (“E&O”) liability insurance. Western Surety is a licensed insurer in all 50 states, the District of Columbia and Puerto Rico. Surety Bonding is licensed in 28 states and the District of Columbia. Universal Surety is licensed in 44 states and the District of Columbia.

 

A.M. Best Company, Inc.

 

Western Surety, Surety Bonding and Universal Surety are currently rated A (Excellent) with a stable 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 inter-company reinsurance and related agreements, CNA Surety’s customers have access to CCC’s broader underwriting capacity. CCC is currently rated A (Excellent) with a stable outlook by A.M. Best. A.M. Best’s letter ratings range from A++ (Superior) to F (In Liquidation) with A++ being highest.

 

Standard and Poor’s (“S&P”)

 

CCC, Western Surety, Surety Bonding, and Universal Surety are currently rated A- (Stable), by S&P. S&P’s letter ratings range from AAA (Extremely Strong) to CC (Extremely Weak) with AAA being highest. Ratings from AA to CCC may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories. An insurer rated A has strong financial security characteristics, but is somewhat more likely to be affected by adverse business conditions than are insurers with higher ratings.

 

The United States surety market is represented by bonds required by federal statutes, state laws, and local ordinances. These bonding requirements range from federal construction projects, where the contractor is required to post performance and payment bonds which guarantee performance of contracts to the government as well as payment of bills to subcontractors and suppliers, to license and permit bonds which guarantee compliance with legal requirements for business operations.

 

Products and Policies

 

Unlike a standard, two-party insurance policy, surety bonds are three-party agreements in which the issuer of the bond (the surety) joins with a second party (the principal) in guaranteeing to a third party (the owner/obligee) the fulfillment of some obligation on the part of the principal. The surety is the party who guarantees fulfillment of the principal’s obligation to the obligee. In addition, sureties are generally entitled to recover from the principal any losses and expenses paid to third parties. The surety’s responsibility is to evaluate the risk and determine if the principal meets the underwriting requirements for the bond. Accordingly, surety bond premiums primarily reflect the type and class of risk and related costs associated with both processing the bond transaction and investigating the applicant including, if necessary, an analysis of the applicant’s credit-worthiness and ability to perform.

 

There are two broad types of surety products — contract surety and commercial surety bonds. Contract surety bonds secure a contractor’s performance and/or payment obligation generally with respect to a construction project. Contract surety bonds are generally required by federal, state and local governments for public works projects. Commercial surety bonds include all surety bonds other than contract and cover obligations typically required by law or regulation.

 

Contract bond guarantee obligations include the following:

 

Bid bonds: used by contractors submitting proposals on potential contracts. These bonds guarantee that a contractor will enter into a contract at the amount bid and post the appropriate performance bonds.

 

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

 

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

 

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

 

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

 

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

 

Judicial and Fiduciary bonds: required by statutes, courts or legal documents for the protection of those on whose behalf a fiduciary acts. Examples of such fiduciaries include executors and administrators of estates, and guardians of minors and incompetents.

 

Public Official bonds: required by statutes and ordinances to guarantee the lawful and faithful performance of the duties of office by public officials.

 

CNA Surety also 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):

 

 

 

 

 

In 2006, no individual agency generated more than 1.1% of aggregate gross written premiums. Approximately $61.9 million, or 13.7%, of gross written premiums were generated from national insurance brokers in 2006 with the single largest national broker production comprising $14.5 million, or 3.2%, of gross written premiums.

 

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 36,000 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 34 local branch offices.

 

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

 

 

 

 

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. 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.

 

Commercial Surety

 

A large portion of the commercial surety market is comprised of small obligations that are routine in nature and require minimal underwriting. Customers are focused principally on prompt and efficient service. These small transactional bonds and related fidelity bonds and E&O products represent approximately 80% of the Company’s non-contract gross written premiums and 30% 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 20% of the Company’s commercial gross written premiums and 7% of the Company’s total gross written premium.

 

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.

 

The surety and fidelity market is highly competitive. According to 2005 data from the SAA, the U.S. market aggregates approximately $5.9 billion in direct written premiums, comprised of approximately $4.5 billion in surety premiums and approximately $1.4 billion in fidelity premiums. The 20 largest surety companies account for approximately 77% of the domestic surety market and 95% of the domestic fidelity market. The large diversified insurance companies hold the largest market shares. In 2005, CNA Surety was the second largest surety provider with an 8.4% 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 2005, the surety industry’s underwriting performance began to be negatively 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.

 

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, 2006, the Company holds approximately $4.9 million of letters of credit as collateral for reinsurance receivables.

 

The Company’s reinsurance program is predominantly comprised of excess of loss reinsurance contracts that limit the Company’s retention on a per principal basis. The Company’s reinsurance coverage is provided by third party reinsurers and related parties. Refer to Item 7., Management’s Discussion and Analysis of Financial Condition and Results of Operations, and Item 8., Note 6 of the Notes to the Consolidated Financial Statements, Reinsurance, for further discussion.

 

CNA Surety’s largest reinsurance recoverable from an affiliate, CCC, an A rated company by A.M. Best, was approximately $55.0 million and $53.0 million at December 31, 2006 and 2005, respectively. CNA Surety’s largest reinsurance recoverable from a third party, an A rated company by A.M. Best, was approximately $13.4 million and $14.1 million at December 31, 2006 and 2005, 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.

 

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 annually provides actuarial certification as to the reasonableness of actuarial assumptions used and the sufficiency of year-end reserves for each of the Company’s 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 income in the period in which such changes are determined to be needed. The determination of the Company’s reserves for unpaid losses

and loss adjustment expenses is inherently a subjective exercise, which requires management to analyze, weigh, and balance numerous macroeconomic, customer specific, and claims specific factors and trends, most of which, in themselves, are inherently uncertain and difficult to predict. A discussion of this process is included in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

A table is included in Item 8., Note 7 of the Notes to the Consolidated Financial Statements, Reserves for 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, 2006 (dollars in thousands):

 

 

The following loss reserve development table illustrates the change over time of reserves established for the Company’s estimated losses and loss adjustment expenses at the end of various calendar years. The first section shows the reserves as originally reported at the end of the stated year. The second section shows the cumulative amounts paid as of the end of successive years with respect to that reserve liability. The third section shows re-estimates of the original recorded reserve as of the end of each successive year which is the result of management’s expanded awareness of additional facts and circumstances that pertain to the unsettled claims. The last section compares the latest re-estimated reserve to the reserve originally established, and indicates whether the original reserve was adequate or inadequate to cover the estimated costs of unsettled claims.

 

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, CIC and Capsure since 1996. 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.

 

 

Proactive claims management is an important factor for the profitable underwriting of surety and fidelity products. The Company maintains an experienced and dedicated staff of in-house claim specialists. Claim handling for the Company’s contract and large commercial account business is performed in Chicago. Claims for the Company’s small commercial bonds and the related fidelity bonds and E&O insurance are handled in Sioux Falls. The disposition of claims and other claim-related activity is performed in accordance with established policies, procedures and expense controls designed to minimize loss costs and maximize 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.

 

The Company does not typically bond contractors that specialize in hazardous environmental remediation work. The Company does, however, provide bonding programs for several accounts that have incidental

environmental exposure. In the commercial surety market, the Company provides bonds to large corporations that are in the business of mining various minerals and are obligated to post reclamation bonds that guarantee that property which was disturbed during mining is returned to an acceptable condition when the mining is completed. The Company also provides court and other surety bonds for large corporations wherein the underlying action involves environmental-related issues. While no environmental responsibility is overtly provided by commercial or contract bonds, some risk of environmental exposure may exist if the surety were to assume certain rights in the completion of a defaulted project or through salvage recovery. The Company estimates its net case incurred losses on known claims of this nature to be $14.9 million as of December 31, 2006.

 

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. Universal Surety 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 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, and Item 8., Note 13 of the Notes to the Consolidated Financial Statements, Statutory Financial Data. Without prior regulatory approval in 2007, Western Surety may pay stockholder dividends of $87.7 million to CNA Surety. For the year ended December 31, 2006, CNA Surety received $10.5 million in dividends from its insurance subsidiaries.

 

CNA Surety’s insurance subsidiaries are subject to periodic financial and market conduct examinations. These examinations are generally performed by the domiciliary state insurance regulatory authorities, however, they may be performed by any jurisdiction in which the insurer transacts business. During 2006, the California Department of Insurance announced it will conduct a market conduct examination of Western Surety, Surety Bonding and Universal Surety, commencing in early 2007. During 2005, both the South Dakota Department of Commerce and Regulation-Insurance Division and the Texas Department of Insurance issued their respective reports of financial examination for the two-year period ended December 31, 2003. These exams were initiated in connection with an examination of the insurance subsidiaries of CNAF undertaken by the Illinois Department of Insurance. The examinations of Western Surety and Surety Bonding were completed on January 21, 2005. The examination of Universal Surety was completed on August 3, 2005. The matters noted in these examination reports were largely administrative in nature and have been addressed by management. The matters noted did not have a material impact on the insurance subsidiaries’ statutory surplus, nor did they result in any fines or penalties to CNA Surety or any of its subsidiaries. The examination report for Western Surety did address the Company’s exposure to the large national contractor that had previously been discussed with the regulators.

 

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 2006.

 

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 $24.6 million and $0.7 million, respectively, for the twelve-month period ended June 30, 2006. Effective July 1, 2006 through June 30, 2007, the underwriting limitations of Western Surety and Surety Bonding are $26.8 million and $0.7 million, respectively. Through a surety quota share treaty (the “Quota Share Treaty”) between CCC and Western Surety Company, discussed in both Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, and Item 8., Note 6 of the Notes to the Consolidated Financial Statements, Reinsurance, CNA Surety has access to CCC and its affiliates’ U.S. Department of Treasury underwriting limitations. Effective July 1, 2006 through June 30, 2007, the underwriting limitations of CCC and its affiliates utilized under the Quota Share Treaty total $549.0 million. CNA Surety management believes that the foregoing U.S. Treasury underwriting limitations are sufficient for the conduct of its business.

 

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.

 

As of December 31, 2006, the Company employed 736 persons. CNA Surety has not experienced any work stoppages. Management of CNA Surety believes its relations with its employees are good.

 

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 100 F Street, NE, Washington, DC 20549. Information regarding the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. This reference to 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.

 

Our business faces many risks. Some of the more significant risks that we face are described below. There may be additional risks that we do not currently perceive to be significant or that we are not currently aware of that may also impact our business. Each of the risks and uncertainties described below could lead to events or circumstances that have a material adverse effect on our business, results of operations, financial condition or equity.

 

In addition, ownership of our common stock may be subject to risks associated with the liquidity of the investment. Approximately 63% of our common stock is owned by affiliates of CNAF. This concentration of ownership may reduce the number of market participants willing to purchase our stock and limit the ability of a minority owner to liquidate their position.

 

We may determine that our loss reserves are insufficient to cover our estimated ultimate unpaid liability for claims and we may need to increase them.

 

We maintain loss reserves to cover our estimated ultimate unpaid liability for claims and claim adjustment expenses for reported and unreported claims. Reserves represent our best estimate at a given accounting date. Loss reserves are not an exact calculation of liability but instead are complex estimates derived by us, generally utilizing a variety of reserve estimation techniques from numerous assumptions and expectations about future events, many of which are highly uncertain, such as estimates of claims severity, frequency of claims, inflation, claims handling, case reserving policies and procedures, underwriting and pricing policies, changes in the legal and regulatory environment and the lag time between the occurrence of an insured event and the time of its ultimate settlement. Many of these uncertainties are not precisely quantifiable and require significant judgment on our part.

 

In light of the many uncertainties associated with establishing the estimates and making the assumptions necessary to establish reserve levels, we review and change our reserve estimates in a regular and ongoing process as experience develops and further claims are reported and settled. If estimated reserves are insufficient for any reason, the required increase in reserves would be recorded as a charge against our earnings for the period in which reserves are determined to be insufficient.

 

Surety losses and our results can be volatile.

 

In the past, our results have been adversely impacted by a relatively small number of large claims. In addition, our results have been significantly impacted by increases in corporate default rates. These past occurrences illustrate that our loss experience and results can be volatile.

 

We have a significant concentration of exposure to construction firms.

 

A significant portion of our business is guaranteeing the performance of construction firms. Therefore, we are exposed to the challenges that the construction industry faces. Over the recent past, the construction industry has enjoyed very strong demand for its services. However, if the construction economy encounters difficulties, we may experience a higher frequency of claims and higher losses.

 

Our premium writings and profitability are impacted by the availability and cost of reinsurance and our reinsurance purchasing decisions.

 

Reinsurance coverage is an important component of our capital structure. Reinsurance allows us to meet certain regulatory restrictions that would otherwise limit the size of bonds that we write and limit the market segments in which we could compete. In addition, reinsurance reduces the potential volatility of earnings and protects our capital by limiting the amount of loss associated with any one bond principal. We have experienced periods where it was difficult for us to buy as much reinsurance as we desired and when reinsurance costs have risen substantially. The availability and cost of reinsurance protection depends on a number of factors such as our loss experience, the surety industry’s loss experience, the number of reinsurers willing to provide coverage, and broader economic conditions. If sufficient reinsurance is not available or is too costly or if we purchase insufficient reinsurance, we may need to reduce our premium writings and may be susceptible to higher losses.

 

We may not be able to collect amounts owed to us by reinsurers.

 

Amounts recoverable from reinsurers are reported as receivables in our balance sheets and are estimated in a manner consistent with loss and loss adjustment expense reserves. The ceding of insurance does not, however, discharge our primary liability for claims. As a result, we are subject to credit risk relating to our ability to recover amounts due from reinsurers. It is possible that future financial deterioration of our reinsurers could result in certain balances becoming uncollectible.

 

We rely upon affiliated companies that we do not control to conduct certain aspects of our business.

 

Due to regulatory restrictions that limit the size of the bonds that our insurance subsidiaries can write, we utilize the capacity of affiliated companies to service some parts of our business. If this capacity is no longer available to us, no longer satisfies the regulatory requirements, or no longer meets customer requirements, we may need to stop servicing parts of our business.

 

Rating agencies may downgrade their ratings for us or for affiliated companies that we rely on to write business. This would adversely affect our ability to write business.

 

Our customers often refer to the financial strength ratings assigned by A.M. Best, S&P and other similar companies when they are choosing a surety company. Because we use the underwriting capacity of CCC, an affiliate, to serve larger accounts, our financial strength ratings, as well as those of CCC, factor into customers’ decisions. If our ratings or CCC’s ratings are downgraded, we may experience a significant reduction in premium writings.

 

We face intense competition.

 

All aspects of the insurance industry are highly competitive and we must continuously allocate resources to refine and improve our products and services. Insurers compete on the basis of factors including products, price, services, ratings and financial strength. Although we seek pricing that will result in what we believe are adequate returns on the capital allocated to our business, we may lose business to competitors offering competitive products at lower prices. We compete with a large number of stock and mutual insurance companies and other entities for both distributors and customers. We also compete against providers of substitute products such as letters of credit in certain markets.

 

Demand for our products is created by laws that could be changed.

 

We believe that the vast majority of the demand for our products results from federal, state and local laws that mandate the use of surety bonds. If these laws are loosened or eliminated, our business would be severely impacted.

 

We are subject to capital adequacy requirements and, if we do not meet these requirements, regulatory agencies may restrict or prohibit us from operating our business.

 

Insurance companies are subject to risk-based capital standards set by state regulators to help identify companies that merit further regulatory attention. These standards apply specified risk factors to various asset, premium and reserve components of our statutory capital and surplus reported in our statutory financial statements. Current rules require companies to maintain statutory capital and surplus at a specified minimum level determined using the risk-based capital formula. If we do not meet these minimum requirements, state regulators may restrict or prohibit us from operating our business.

 

Our insurance subsidiaries, upon whom we depend for dividends and advances in order to fund our working capital needs, are limited by state regulators in their ability to pay dividends.

 

We are a holding company and are dependent upon dividends, advances, loans and other sources of cash from our subsidiaries in order to meet our obligations. Dividend payments, however, must be approved by the subsidiaries’ domiciliary state departments of insurance and are generally limited to amounts determined by formula which varies by state. If we are restricted, by regulatory rule or otherwise, from paying or receiving inter-

company dividends, we may not be able to fund our working capital needs and debt service requirements from available cash. As a result, we would need to look to other sources of capital which may be more expensive or may not be available at all.

 

Some of the credit extended to us requires ongoing compliance with conditions and limitations regarding our profitability and financial condition.

 

We borrow money from banks under a credit facility that requires that we meet certain tests of profitability and financial condition. If we do not meet these tests, we may be required to repay outstanding borrowings. If we are capable of repaying the borrowings, we may experience a reduction in capital strength that may hamper our ability to conduct business. If we are not capable of repaying the borrowings, we would need to look to other sources of capital which may be more expensive or may not be available at all.

 

Our investment portfolio may suffer reduced returns or losses.

 

Investment returns are an important part of our overall profitability. General economic conditions, fluctuations in interest rates, and many other factors beyond our control can adversely affect the returns and the overall value of our investment portfolio. In addition, any defaults in the payments due to us for our investments, especially with respect to liquid corporate and municipal bonds, could reduce our investment income and realized investment gains or could cause us to incur investment losses. As a result of these factors, we may not realize an adequate return on our investments, may incur losses on sales of our investments and may be required to write down the value of our investments.

 

We rely on our information technology and telecommunications systems to conduct our business.

 

Our business is highly dependent upon the successful and uninterrupted functioning of our information technology and telecommunications systems. We rely on these systems to process new and renewal business, provide customer service, make claims payments and facilitate collections and cancellations, as well as to perform actuarial and other analytical functions necessary for pricing and product development.

 

None.

 

CNA Surety leases its executive offices and its shared branch locations with Continental Casualty Company (“CCC”) under the Administrative Services Agreement with CCC discussed in detail in Item 8., Note 14 of the Notes to the Consolidated Financial Statements, Related Party Transactions. CNA Surety currently uses approximately 92,463 square feet and related personal property at 29 branch locations and its home and executive offices (30,360 square feet) in Chicago, Illinois. CNA Surety’s annual rent for this space is approximately $3.0 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 2007, CNA Surety intends to enter into separate lease or sub-lease agreements with CCC for several of these shared locations.

 

CNA Surety leases approximately 83,551 square feet of office space for its primary processing and service center at 101 South Phillips Avenue, Sioux Falls, South Dakota, under a lease expiring in 2012. The annual rent, which is subject to annual adjustments, was $1.5 million as of December 31, 2006. CNA Surety also leased space for contract and commercial branch offices in Tallahassee, Florida, New York, New York; Roseville, California; Houston, Texas; and San Juan, Puerto Rico. Annual rent for these offices was $0.4 million with leases terminating in 2006, 2007, 2007, 2006, and 2011, respectively. The leases that expired in 2006 were not renewed.

 

The Company and its subsidiaries are parties to various lawsuits arising in the normal course of business. The Company believes the resolution of these lawsuits will not have a material adverse effect on its financial condition or its results of operations.

 

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 25, 2007, not later than 120 days after the end of the fiscal year covered by this Form 10-K. Information required by Item 4 will appear in the Proxy Statement and is incorporated herein by reference.

 

The Company’s common stock (“Common Stock”) trades on the New York Stock Exchange under the symbol SUR. On February 15, 2007, the last reported sale price for the Common Stock was $20.55 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 2006 and 2005.

 

The following table and graph present the Company’s common stock market performance over the last five years compared to appropriate industry indices:

 

 

 

The number of stockholders of record of common stock on February 15, 2007, was approximately 4,400.

 

A summary of outstanding options and shares authorized for issuance under equity compensation plans as of December 31, 2006 follows:

 

 

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.

 

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, 2006, 2005, 2004, 2003 and 2002.

 

 

 

 

 

 

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. The most significant risk and uncertainties impacting the operating performance and financial condition of the Company are discussed in Item 1A, Risk Factors of this Form 10-K. This discussion should be read in conjunction with the Consolidated Financial Statements of CNA Surety and Notes thereto.

 

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, recognition of premium revenue and the related unearned premium liability, 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. Given the nature of the surety business, the determination of these balances is inherently a highly subjective exercise, which requires management to analyze, weigh, and balance numerous macroeconomic, customer specific, and claim specific factors and trends, most of which, in themselves, are inherently uncertain and difficult to predict.

 

Reserves for Unpaid Losses and Loss Adjustment Expenses and Reinsurance

 

CNA Surety accrues liabilities for unpaid losses and loss adjustment expenses (“LAE”) under its surety and property and casualty insurance contracts based upon estimates of the ultimate amounts payable under the contracts related to losses occurring on or before the balance sheet date.

 

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

 

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 may not be reported for many years. As a result, the liability for unpaid losses includes significant estimates for incurred-but-not-reported (“IBNR”) claims. The IBNR reserves also include provisions for losses in excess of the current case reserve for previously reported claims and for claims that may be reopened. The IBNR reserves also include offsets for anticipated salvage and subrogation recoveries. The following table shows the estimated liability as of December 31, 2006 for unpaid claims applicable to reported claims and to IBNR (dollars in thousands) for each sub-line of business:

 

 

The Company retains an independent actuarial firm of national standing to perform periodic actuarial analyses of the Company’s loss reserves. These analyses typically include a comprehensive review performed in the third quarter based on data as of June 30 and an update of the comprehensive review performed in January based on data as of December 31. In between these analyses, management monitors claim activity against benchmarks prepared by the independent actuarial firm based on expected claim activity and consults with the actuarial firm as necessary.

 

The independent actuarial firm’s analyses are based upon multiple projection methodologies 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. Methodologies may vary depending on the type of claim being estimated. While methodologies may vary, each employs significant judgments and assumptions.

 

In estimating the unpaid claim liabilities, the independent actuarial firm employed the following projection methodologies:

 

 

The following provides a summary of these projection methodologies:

 

Historical Development Method

 

As a group of claims mature, their collective value changes. This change in value over time is referred to as loss development. The loss development method is a traditional actuarial approach which relies on the historical changes in losses from one evaluation point to another to project the current valuation of losses to ultimate settlement values. Development patterns which have been exhibited by more mature (older) years are used to estimate the expected development of the less mature (more recent) years. The strength of this method is that it is

very responsive to emerging loss experience for each accident year. The weakness is that this method can become highly leveraged and volatile for less mature accident years.

 

Bornhuetter-Ferguson Method

 

The incurred Bornhuetter-Ferguson (“B-F”) method is commonly used to provide a more stable estimate of ultimate losses in situations where loss development is volatile, substantial and/or immature. The method calculates IBNR (or unpaid loss when conducting a paid B-F projection) directly as the product of:

 

Expected Ultimate Losses multiplied by IBNR (or Unpaid) Percentage

 

The IBNR (or unpaid) percentage is derived from the incurred (or paid) loss development patterns. Various approaches can be used to determine the expected ultimate losses (e.g., prior year estimates, pricing assumptions, etc.). To obtain an estimate of expected ultimate losses, the independent actuarial firm utilized an expected loss ratio (ultimate losses divided by earned premium) based on review of prior accident years’ loss ratio experience. This estimate was then applied to the more recent accident years’ earned premium. The strength of the B-F method is that it is less leveraged than the historical development method and thus does not result in an overreaction to an unusual claim occurrence (or an unusual lack of claims). The weakness of the method is that it is reliant on an initial expectation of ultimate losses.

 

Average Hindsight Outstanding Method

 

This method relies on the older, more mature accident years’ ultimate loss estimates to restate what the outstanding losses should have been, with hindsight, by accident year by stage of development. These restated hindsight outstanding losses are then trended to the appropriate cost levels for the accident years being projected and added to the paid to date losses in order to generate indicated ultimate losses for the more recent accident years. The strength of this method is that it is relatively unaffected by changes in a company’s case reserving practices. The weaknesses of this method are that it is sensitive to payment pattern shifts and that the average hindsight severities can become highly variable for certain datasets.

 

Frequency-Severity Method

 

This method first projects the expected number of claims for each accident year and then multiplies this estimate by the expected average cost of claims for the applicable accident year. The number of claims can be projected using the historical development technique or other methodology. The average cost of claims for the more recent accident years is estimated by observing the estimated average cost of claims for the older more mature accident years and trending those values to appropriate cost levels for the more recent accident years. The strength of this method is that it is not reliant on loss development factors for less mature accident years which can become highly leveraged and volatile. The weakness is that this method is slow to react to an abrupt change in claim severities.

 

Loss Ratio Method

 

This method relies on historical projected ultimate loss ratios for the more mature accident years to estimate the more recent, less mature accident years’ ultimate losses. Applying a selected loss ratio (by reviewing more mature years) to the more recent years’ earned premium results in an indication of the more recent years’ ultimate losses. The strength of this method is that it can be used in connection with a company’s pricing targets and can be used when the historical data has limited credibility. The weakness of this method is that it is slow to react to the emerging loss experience for a particular accident year.

 

Each of the projection methodologies employed rely to varying degrees on the basic assumption that the Company’s historical claim experience is indicative of the Company’s future claim development. The amount of weight given to any individual projection method is based on an assessment of the volatility of the historical data and development patterns, an understanding of the changes in the overall surety industry over time and the resultant potential impact of these changes on the Company’s prospective claims development, an understanding of the changes to the Company’s processes and procedures within its underwriting, claims handling and data systems

functions, among other things. The decision as to how much weight to give to any particular projection methodology is ultimately a matter of experience and professional judgment.

 

Surety results, especially for contract and certain commercial products like insurance program bonds, workers compensation insurance bonds and reclamation bonds, tend to be impacted by fewer, but more severe, losses. With this type of loss experience, it is more difficult to estimate the required reserves, particularly for the most current accident years which may have few reported claims. Therefore, assumptions related to the frequency and magnitude of severe loss are key in estimating surety loss reserves. The Company experienced a period of unusually high frequency of severe loss in accident years 2002 and 2003. In response to this activity, the independent actuarial firm included higher expectations of severe losses in its analysis for 2004. The Company’s claim experience improved dramatically since 2004. As a result, the independent actuarial firm’s current analysis places less reliance on the severe loss experience in accident years 2002 and 2003.

 

The indicated reserve was developed by reviewing the Company’s claims experience by accident year for several individual sub-lines of business. Within each sub-line, the selection of the point estimate was made after consideration of the appropriateness of the various projection methodologies in light of the sub-line’s loss characteristics and historical data. In general, for the older, more mature, accident years the historical development method (i.e., link ratio method) was relied upon more heavily. For the more recent years, the indicated reserves were more heavily based on the Bornhuetter-Ferguson and loss ratio methods since these are not as reliant on the Company’s large (i.e., leveraged) development factors and thus are believed to represent a more stable set of methods from which to select indicated reserves for the more recent years.

 

The 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:

 

 

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.

 

The following table shows the point estimate as determined by the Company’s independent actuarial firm, compared to the actual loss reserve established by management, both gross and net of reinsurance (dollars in thousands):

 

 

At December 31, 2006, management’s recorded gross and net reserves were slightly lower than the point estimate determined by the independent actuarial firm, with the percentage difference being somewhat larger on a net basis. At December 31, 2006, management believed continued improvement in economic conditions, lower corporate default rates and fewer reported severe claims indicated a lower provision for severe losses was appropriate. Management believed that the actuarial point estimates included provisions in the most recent accident year for severe losses that continue to be influenced by the Company’s experience in accident years 2002 and 2003 and did not fully reflect the favorable economic conditions, changes in the Company’s exposures and favorable claim experience during the most recent accident years.

 

At December 31, 2005, management’s recorded reserves were also lower than the point estimates determined by the independent actuarial firm. The independent actuarial firm’s analyses conducted during the third quarter of 2006, with data as of June 30, 2006, resulted in lower point estimates, confirming the positive loss trends noted by management and considered in management’s recorded reserves at December 31, 2005. These positive loss trends included improvement in the 2005 accident year primarily due to fewer reported severe claims. During 2006, management recorded favorable development on prior accident years of $5.3 million on a net basis based on the redundancy indicated by the actuarial analysis and the continuation of positive loss experience.

 

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

 

Casualty insurance loss reserves are subject to a significant amount of uncertainty. Given the nature of surety losses with its low frequency, high severity characteristics, this is particularly true for surety loss reserves. As a result, the range of reasonable loss reserve estimates may be broader than that associated with traditional property/casualty insurance products. While the loss reserve estimates represent the best professional judgments, arrived at after careful actuarial analysis of the available data, it is important to note that variation from the estimates is not only possible but, in fact, probable. The degree of such variation could be significant and in either direction from the estimates and could result in actual losses outside of the estimated reserve range. The sources of this inherent variability are numerous — future economic conditions, court decisions, legislative actions, and individual large claim impacts, for example.

 

The range of reasonable reserve estimates is not intended to reflect the maximum and/or minimum possible outcomes; but rather reflects a range of reasonable estimates given the uncertainty in estimating unpaid claim liabilities for surety business. Further, there is no generally accepted method of estimating reserve ranges, but rather many concepts are currently being vetted within actuarial literature.

 

In developing the indicated range of reserve estimates for the Company, the independent actuarial firm utilized the Mack methodology and their point estimate analysis in order to estimate the requisite reserve distribution parameters. The Mack methodology is premised on the idea that the volatility in a company’s historical paid loss development is representative of the variability in a company’s future payments and thus can be used to estimate the variability within a company’s reserve estimate. Given the dispersion of the reserve indications, along with its experience and professional judgment, the independent actuarial firm selected the 50th and 75th percentile as representing a reasonable range of reserve estimates.

 

At December 31, 2006, the range of reasonable loss reserve estimates, net of reinsurance receivables, calculated by the independent actuarial firm and adopted by management was from $247 million to $353 million. Ranges of reasonable loss reserve estimates are not calculated for the sub-lines of business. Management believes that the range calculated over total reserves provides the most meaningful information due to the importance of correlation of losses between the sub-lines of business related to the impact of general economic conditions.

 

The primary factors that would result in the Company’s actual losses being closer to either end of the reserve range is the emergence of (or lack thereof) a small number of large claims, as well as the recovery of (or lack thereof) a small number of large salvage/subrogation amounts. In other words, the primary factors that, if they were to occur, would result in the Company’s actual payments being at the high end of the indicated range are if the Company experiences an unusually high number of large claims and/or an unusually low number of large salvage and subrogation recoveries. Conversely, if the Company were to experience an unusually low number of large claims and/or an unusually high number of large salvage and subrogation recoveries, the Company’s actual payments would tend to be at the low end of the range. These variations in outcomes could be driven by broader issues such as the state of the construction economy or the level of corporate defaults, or by the specific facts and circumstances surrounding individual claims. Again, it is important to note that it is possible that the actual net payments could fall outside of the estimated range.

 

Due to the inherent uncertainties in the process of establishing the liabilities for unpaid losses and loss adjustment expenses, the actual ultimate claims amounts will differ from the currently recorded amounts. This difference could have a material effect on reported earnings and financial condition. Future effects from changes in these estimates will be recorded in the period such changes are determined to be needed.

 

Investments

 

Management believes the Company has the ability to hold all fixed income securities to maturity. However, the Company may dispose of securities prior to their scheduled maturity due to changes in interest rates, prepayments, tax and credit considerations, liquidity or regulatory capital requirements, or other similar factors. As a result, the Company considers all of its fixed income securities (bonds and 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 in stockholders’ equity as a separate component of accumulated other comprehensive income. Cash flows from purchases, sales and maturities are reported gross in the investing activities section of the Consolidated Statements of Cash Flows.

 

The amortized cost of fixed income securities is determined based on cost and the cumulative effect of amortization of premiums and accretion of discounts. 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, 2006 includes intangible assets of $138.8 million. This amount represents goodwill and identified intangibles with indefinite useful lives arising from the acquisition of Capsure Holdings Corp. (“Capsure”).

 

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 the relevant standard, 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. The Company uses a valuation technique based on discounted cash flows. 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.

 

Insurance Premiums

 

Insurance premiums are recognized as revenue ratably over the term of the related policies in proportion to the insurance protection provided. Contract bonds provide coverage for the length of the bonded project and not a fixed time period. As such, the Company uses estimates of the contract length as the basis for recognizing premium revenue on these bonds. Premium revenues are net of amounts ceded to reinsurers. Unearned premiums represent the portion of premiums written, before ceded reinsurance which is shown as an asset, applicable to the unexpired terms of policies in force determined on a pro rata basis.

 

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.

 

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.

 

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, 2006, 2005 and 2004

 

Analysis of Net Income

 

The Company had net income of $82.8 million for the year ended December 31, 2006 as compared to $38.4 million for the year ended December 31, 2005, and $39.7 million for the year ended December 31, 2004. The increase in net income in 2006 over 2005 primarily reflects the absence of a $60.0 million pre-tax ($39.0 million after-tax) charge in 2005 to establish a reserve for contract surety losses related to the large national contractor discussed in the Net Loss Ratio section. Other positive impacts included higher earned premium, higher investment income, and a lower expense ratio. These impacts were partially offset by lower favorable reserve development in 2006. The decrease in 2005 over 2004 reflects higher losses in large part due to the establishment of the $60.0 million net loss reserve related to the large national contractor, partially offset by increased favorable loss development on prior accident years of $22.7 million. The higher losses were also offset by higher net earned premium, higher net investment income, and lower expenses.

 

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, 2006, 2005 and 2004 are summarized in the following table (dollars in thousands):

 

 

Premiums Written/Earned

 

CNA Surety primarily markets contract and commercial surety bonds. Contract surety bonds generally secure a contractor’s performance and/or payment obligation with respect to a construction project. Contract surety bonds are generally required by federal, state and local governments for public works projects. The most common types

include bid, performance and payment bonds. Commercial surety bonds include all surety bonds other than contract and cover obligations typically required by law or regulation. The commercial surety market includes numerous types of bonds categorized as court judicial, court fiduciary, public official, license and permit and many miscellaneous bonds that include guarantees of financial performance. The Company also writes fidelity bonds that cover losses arising from employee dishonesty and other insurance products that are generally companion products to certain surety bonds. For example, the Company writes surety bonds for notaries and also offers related errors and omissions (“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 September 30, 1997 that is reinsured by Western Surety pursuant to reinsurance and related agreements. Because of certain regulatory restrictions that limit the Company’s ability to write 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, 2006, 2005 and 2004 are shown in the table below (dollars in thousands) for each sub-line of business:

 

 

For 2006, gross written premiums increased 8.1% to $451.4 million as compared to 2005. Gross written premiums for contract surety increased 14.7% to $285.2 million primarily due to increased demand as a result of the strong construction economy and growth in contract size due to cost inflation within the construction industry. Commercial surety and related fidelity and other gross written premiums decreased 1.6% to $166.2 million as a decline in production of notary bonds and notary E&O policies resulting from a loss of a large notary program offset growth in other commercial and related products.

 

For 2005, gross written premiums increased 7.2% to $417.5 million as compared to 2004. Gross written premiums for contract surety increased 12.2% to $248.7 million due to volume growth, some of which is attributed to several competitors exiting the contract surety market. Commercial surety premiums decreased 1.6% to $133.7 million as continued strong volume growth in small commercial products was more than offset by declining premium volume on large commercial accounts due to the Company’s efforts to reduce aggregate exposures to large commercial accounts. Fidelity and other products increased 10.0% to $35.1 million, for the year ended December 31, 2005 as compared to the same period in 2004 due primarily to volume growth in related small commercial products.

 

Net written premiums for the years ended December 31, 2006, 2005 and 2004 are shown in the table below (dollars in thousands) for each sub-line of business:

 

 

For 2006, net written premiums increased by $43.7 million to $409.6 million as compared to 2005 reflecting the increase in gross written premiums discussed previously and a decrease of $9.9 million of ceded written premiums to $41.7 million for 2006. The reduction in ceded written premiums was due to the Company’s decision not to renew a high-level excess of loss reinsurance treaty and cost savings on the core reinsurance program. Net

written premiums for contract surety business increased 22.3% to $248.0 million for 2006 compared to 2005. Net written premiums for commercial surety increased 1.8% to $130.3 million for 2006 compared to 2005. Fidelity and other products decreased 10.8% to $31.3 million for the year 2006 compared to 2005 reflecting the decline in production of notary E&O policies resulting from a loss of the large notary program discussed previously.

 

For 2005, net written premiums increased by $47.7 million to $365.9 million as compared to 2004 reflecting the increase in gross written premiums discussed previously and the reduction in the cost of the Company’s 2005 reinsurance program. Ceded written premiums decreased $19.6 million to $51.6 million for 2005 compared to 2004. Net written premiums for contract surety business increased 17.7% to $202.8 million. Net written premiums for commercial surety increased 10.9% to $128.0 million for 2005. Significant reductions in exposures to large commercial bonds caused a greater share of reinsurance protection to be allocated to contract bonds. Fidelity and other products increased 15.0% to $35.1 million for the year 2005 as compared to 2004 reflecting the increase in gross written premiums discussed previously.

 

Net earned premiums for the years ended December 31, 2006, 2005 and 2004 are shown in the table below (dollars in thousands) for each sub-line of business:

 

 

For 2006, net earned premiums increased by $45.3 million to $393.6 million as compared to 2005 reflecting the increase in gross written premiums discussed above. Ceded earned premiums decreased $9.2 million due to the Company’s decision not to renew a high-level excess of loss reinsurance treaty and cost savings on the core reinsurance program. Net earned premiums for contract surety business increased 19.9% to $230.9 million for 2006 compared to 2005. Net earned premiums for commercial surety increased 5.1% to $129.2 million for 2006 compared to 2005. Earned premium for fidelity and other products increased 1.9% to $33.6 million for the year 2006 compared to 2005.

 

For 2005, net earned premiums increased by $30.5 million to $348.4 million as compared to 2004 reflecting the increase in gross written premiums discussed above and the reduction in the cost of the Company’s 2005 reinsurance program. Ceded earned premiums decreased $15.5 million to $54.1 million for 2005 compared to 2004. Net earned premiums for contract surety business increased 11.1% to $192.5 million. Net earned premiums for commercial surety increased 6.6% to $122.9 million for 2005. Earned premium for fidelity and other products increased 12.6% to $33.0 million for the year 2005 as compared to 2004 reflecting the increase in gross written premiums discussed above.

 

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, 2006, Munich Reinsurance America, Inc., Renaissance Reinsurance Ltd., Odyssey America Reinsurance Corporation, and XL Reinsurance America Inc. (all rated at least A by A.M. Best) were the four unaffiliated reinsurers from which the Company had its largest reinsurance receivables.

 

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 remained at $10 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company’s retention. The significant differences

between the 2005 Excess of Loss Treaty and the Company’s 2004 Excess of Loss Treaty were as follows. The annual aggregate coverage increased from $157 million in 2004 to $185 million in 2005. The actual annual premium for the 2005 Excess of Loss Treaty was $41.5 million compared to the actual cost of the 2004 Excess of Loss Treaty of $50.6 million. 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 that was excluded from the 2004 Excess of Loss Treaty remained excluded from the 2005 Excess of Loss Treaty.

 

2006 Third Party Reinsurance Compared to 2005 Third Party Reinsurance

 

Effective January 1, 2006, CNA Surety entered into a new excess of loss treaty (“2006 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the 2005 Excess of Loss Treaty. Under the 2006 Excess of Loss Treaty, the Company’s net retention per principal remained at $10 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company’s retention. The significant differences between the 2006 Excess of Loss Treaty and the Company’s 2005 Excess of Loss Treaty were as follows. The actual cost for the 2006 Excess of Loss Treaty was $39.9 million compared to the actual cost of the 2005 Excess of Loss Treaty of $41.5 million. The contract included an optional extended discovery period, for an additional premium (a percentage of the original premium based on any unexhausted aggregate limit by layer), which will provide coverage for losses discovered beyond 2006 on bonds that were in force during 2006. Only the large national contractor that was excluded from the 2005 treaty remained excluded from the 2006 Excess of Loss Treaty.

 

2007 Third Party Reinsurance Compared to 2006 Third Party Reinsurance

 

Effective January 1, 2007, CNA Surety entered into a new excess of loss treaty (“2007 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the 2006 Excess of Loss Treaty. Under the 2007 Excess of Loss Treaty, the Company’s net retention per principal remained at $10 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company’s retention. The contract includes an optional extended discovery period, for an additional premium (a percentage of the original premium based on any unexhausted aggregate limit by layer), which will provide coverage for losses discovered beyond 2007 on bonds that were in force during 2007. The primary difference between the 2007 Excess of Loss Treaty and the Company’s 2006 Excess of Loss Treaty is as follows. The base annual premium for the 2007 Excess of Loss Treaty is $36.6 million compared to the actual cost of the 2006 Excess of Loss Treaty of $39.9 million. Only the large national contractor that was excluded from the 2006 treaty remained excluded from the 2007 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, 2006 and expired on December 31, 2006. There was no amount due to the CNA Surety insurance subsidiaries as of December 31, 2006. This agreement was renewed on January 1, 2007 and expires on December 31, 2007 and is annually renewable thereafter.

 

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. The Quota Share Treaty was renewed on January 1, 2006 and expired on December 31, 2006 and is annually renewable thereafter. CCC and CIC transfer the related liabilities of such business and pay to Western Surety an amount in cash equal to CCC’s and CIC’s net written premiums written

on all such business, minus a quarterly ceding commission to be retained by CCC and CIC equal to $50,000 plus 25% of net written premiums written on all such business. This contemplates an approximate 4% override commission for fronting fees to CCC and CIC on their actual direct acquisition costs. Prior to renewal of the Quota Share Treaty on January 1, 2005, this ceding commission was $50,000 plus 28% of net written premiums which resulted in an actual override commission of approximately 7% paid to CCC and CIC.

 

Under the terms of the Quota Share Treaty, CCC has guaranteed the loss and loss adjustment expense reserves transferred to Western Surety as of the Merger Date by agreeing to pay Western Surety, within 30 days following the end of each calendar quarter, the amount of any adverse development on such reserves, as re-estimated as of the end of such calendar quarter. There was no adverse reserve development for the period from the Merger Date through December 31, 2006. The Quota Share Treaty was renewed for one year on January 1, 2007, on substantially the same terms as 2006.

 

Through the Stop Loss Contract, the Company’s insurance subsidiaries were protected 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 the Company’s actual accident year net loss ratio exceeds the applicable Loss Ratio Cap, multiplied by (ii) the applicable net earned premiums. In consideration for the coverage provided by the Stop Loss Contract, the 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, 2005, the Company had billed and received $45.9 million under the Stop Loss Contract, which included a return of $9.0 million in 2005 due to a reduction of net loss ratios for years covered by the contract. This amount received under the Stop Loss Contract includes $28.2 million held by the Company for losses covered by this contract that are incurred but not paid as of December 31, 2006. Also, as of December 31, 2006, the Company billed CCC $2.0 million for additional estimated unpaid losses under the Stop Loss Contract.

 

The Company and CCC previously participated in a $40 million excess of $60 million reinsurance contract effective from January 1, 2005 to December 31, 2005 providing coverage exclusively for the one large national contractor excluded from the Company’s third party reinsurance. The premium for this contract was $3.0 million plus an additional premium of $6.0 million if a loss is ceded under this contract. In the second quarter of 2005, this contract was amended to provide unlimited coverage in excess of the $60 million retention, to increase the premium to $7.0 million, and to eliminate the additional premium provision. This treaty provides coverage for the life of bonds either in force or written during the term of the treaty which was from January 1, 2005 to December 31, 2005. In November 2005, the Company and CCC agreed by addendum to extend this contract for twelve months. This extension, which expired on December 31, 2006, was for an additional minimum premium of $0.8 million, subject to adjustment based on the level of actual premiums written on bonds for the large national contractor. In January 2007, the Company and CCC agreed by addendum to extend this contract for another twelve months. This extension, which will expire on December 31, 2007, was for an additional premium subject to the level of actual premiums written on bonds for the large national contractor. As of December 31, 2006 and 2005, the Company had ceded losses of $50.0 million under the terms of this contract.

 

The Company and CCC entered into a $50 million excess of $100 million contract for the period of January 1, 2005 to December 31, 2005. The premium for this contract was $4.8 million plus an additional premium of $14.0 million if a loss was ceded under this contract. In the second quarter of 2005, this contract was amended to exclude coverage for the large national contractor, to reduce the premium to $3.0 million, and to reduce the additional premium to $7.0 million. As of December 31, 2005, no losses were ceded under this contract, which was not renewed for 2006.

 

As of December 31, 2006 and December 31, 2005, CNA Surety had an insurance receivable balance from CCC and CIC of $61.9 million and $61.0 million, respectively. CNA Surety had no reinsurance payables to CCC and CIC as of December 31, 2006 and December 31, 2005.

Net Loss Ratio

 

The loss ratios for the years ended December 31, 2006, 2005 and 2004 were 24.3%, 36.7% and 27.5%, respectively. The loss ratios reflect $5.3 million, $23.3 million and $0.6 million of net favorable loss reserve development for the years ended December 31, 2006, 2005 and 2004, respectively.

 

The favorable development in 2006 resulted from lower than expected emergence of additional large claims primarily in the 2005 and 2004 accident years, partially offset by adverse development primarily in the 2003 and 2002 accident years. The adverse development in the 2003 accident year was due to an increase in loss adjustment expense reserves resulting from payments in 2006 that exceeded previous expectations. The adverse development in the 2002 accident year was primarily due to unfavorable development of a large contract claim. Establishment of the case reserve on this claim had been particularly difficult due to on-going litigation that severely hampered the Company’s ability to assess the amount of work required to complete the bonded project and the availability of remaining contract funds.

 

The lower loss ratio in 2006 compared to 2005 reflects the absence of the reserve charge related to the large national contractor excluded from the Company’s third party reinsurance. The higher loss ratio in 2005 compared to 2004 reflects the net reserve increase of $60.0 million related to the large national contractor, which added approximately 17 percentage points to this ratio. In June 2005, discussions with the large national contractor revealed significant deterioration of the contractor’s operations and cash flow. This deterioration was concentrated in an operating division of the contractor that had previously been placed into run off. As a result of these developments, the Company determined that the large national contractor would likely be unable to meet its obligations covered under the surety bonds. Accordingly, in the second quarter of 2005, the Company established a $40.0 million loss reserve based on an initial estimate of loss. In the third quarter of 2005, the Company began a re-evaluation of the contractor’s restructuring efforts. Through this re-evaluation that was completed in the fourth quarter of 2005, the Company determined that there had been further deterioration of the contractor’s actual and projected cash flows. As a result, the Company increased its gross loss reserves for this account by $70.0 million in the fourth quarter of 2005. After applying expected reinsurance recoveries from CCC, the Company’s net incurred loss is $60.0 million, which is the Company’s maximum exposure, net of reinsurance, on this account.

 

The Company intends to continue to provide limited surety bonds on behalf of the contractor to support the continuing restructuring efforts. However, existing reinsurance agreements limit the Company’s net loss exposure to the $60.0 million that has already been recorded.

 

In 2005, the impact on the loss ratio of the reserve charge related to the large national contractor was partially offset by increased favorable development from prior accident years and an increase in net earned premium that resulted from the reduction in the cost of the Company’s 2005 reinsurance program.

 

Reported claim activity improved dramatically in 2004 and continued at lower levels through 2005. 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. In 2005, the Company was able to achieve favorable settlements on several large claims that resulted in claim payments that were substantially less than had been previously expected. Two of these favorable settlements were on cases that were part of the adverse loss development recorded in 2003. In one of these cases, the Company’s negotiating position turned out to be stronger than expected. In the other case, the Company was able to negotiate a settlement that included significant recoveries that were not previously expected. In addition, the Company was able to reduce reserves on several large open claims based on new information that emerged in 2005. The independent actuarial review conducted in 2005 confirmed that the favorable claim settlements, the lower reserves on open claims and the reduced level of new claim activity had resulted in a reserve redundancy. Accordingly, the Company recorded favorable loss development of $23.3 million in 2005, primarily for accident years 2002 and 2003.

 

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 surety business assumed from CCC and CIC is subject to the Stop Loss 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. In 2006, the Company recorded an increase in estimated recoveries from CCC of $2.0 million. The Company previously recorded the following increases (decreases) in estimated recoveries under this contract: 2005 — ($9.0) million; 2003 — $29.9 million; 2002 — $2.5 million; 2001 — $16.6 million; and 2000 — $5.8 million. As of December 31, 2006, the unpaid balance related to amounts due under the Stop Loss Contract was $2.0 million.

 

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. Large commercial accounts are defined as accounts with exposures in excess of $10.0 million. As the following table depicts, the Company has reduced its exposure, before the effects of reinsurance, to large commercial accounts within certain exposure ranges. However, total large commercial account exposure has increased 1.8% in 2006.