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AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON JULY 9, 1998
REGISTRATION NO. 333-56063
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
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Amendment No. 2
to
Form S-1
REGISTRATION STATEMENT UNDER THE
SECURITIES ACT OF 1933
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CNA SURETY CORPORATION
(Exact Name of Registrant as Specified in Its Charter)
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DELAWARE 6331 36-4144905
(State or Other Jurisdiction (Primary Standard Industrial (IRS Employer Identification
of Classification Code Number) Number)
Incorporation or
Organization)
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CNA PLAZA, CHICAGO, ILLINOIS 60685 (312) 822-5000
(Address, Including Zip Code, and Telephone Number, Including Area Code,
of Registrant's Principal Executive Offices)
MARK C. VONNAHME, PRESIDENT AND CHIEF EXECUTIVE OFFICER
CNA SURETY CORPORATION, CNA PLAZA, CHICAGO, ILLINOIS 60685 (312) 822-5000
(Name, Address, Including Zip Code, and
Telephone Number, Including Area Code, of Agent for Service of Process)
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COPIES TO:
DAVID S. STONE, ESQ. GARY I. HOROWITZ, ESQ.
SEYFARTH, SHAW, FAIRWEATHER & GERALDSON SIMPSON THACHER & BARTLETT
55 EAST MONROE STREET, SUITE 4200 425 LEXINGTON AVENUE
CHICAGO, ILLINOIS 60603 (312) 346-8000 NEW YORK, NEW YORK 10017 (212) 455-2000
</TABLE>
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Approximate date of commencement of proposed sale to public: As soon as
practicable after this Registration Statement becomes effective.
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If any of the securities being registered on this form are to be offered on
a delayed or continuous basis pursuant to Rule 415 under the Securities Act of
1933, check the following box. [ ]
If this form is filed to register additional securities for any offering
pursuant to Rule 462(b) under the Securities Act of 1933, check the following
box and list the Securities Act registration statement number of the earlier
effective registration statement for the same offering. [ ]
If this form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act of 1933, check the following box and list the
Securities Act registration statement number of the earlier effective
registration statement for the same offering. [ ]
If this form is a post-effective amendment filed pursuant to Rule 462(d)
under the Securities Act of 1933, check the following box and list the
Securities Act registration statement number of the earlier effective
registration statement for the same offering. [ ]
If delivery of the prospectus is expected to be made pursuant to Rule 434,
please check the following box. [ ]
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PROSPECTUS [CNA SURETY LOGO]
JULY 9, 1998
4,188,129 SHARES
CNA SURETY CORPORATION
COMMON STOCK
All of the 4,188,129 shares of CNA Surety Corporation ("CNA Surety") common
stock, par value $0.01 per share (the "Common Stock"), are being offered for
sale (the "Offering") by certain stockholders of CNA Surety (such selling
stockholders are collectively referred to as the "Selling Stockholders"). See
"Principal and Selling Stockholders." Unless the over-allotment option granted
to the underwriters by CNA Surety is exercised, CNA Surety will not be selling
any of its Common Stock. CNA Surety will not receive any proceeds from the sale
of the shares offered hereunder by the Selling Stockholders.
The Common Stock is listed on the New York Stock Exchange (the "NYSE") and
trades under the symbol "SUR." The last reported sales price of the Common Stock
on July 8, 1998 was $14 1/8 per share. See "Price Range of Common Stock."
SEE "RISK FACTORS" COMMENCING ON PAGE 12 FOR CERTAIN INFORMATION WHICH
SHOULD BE CAREFULLY CONSIDERED BY PROSPECTIVE PURCHASERS OF THE COMMON STOCK.
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE
SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION
PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY
REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
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PRICE UNDERWRITING PROCEEDS TO
TO THE DISCOUNTS AND THE SELLING
PUBLIC COMMISSIONS(1) STOCKHOLDERS(2)(3)
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Per Share..................................... $ 13.75 $ 0.69 $ 13.06
Total......................................... $57,586,774 $2,889,809 $54,696,965
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(1) CNA Surety and the Selling Stockholders have agreed to indemnify the
Underwriters against certain liabilities, including liabilities under the
Securities Act of 1933, as amended (the "Securities Act"). See
"Underwriting" for indemnification arrangements with the Underwriters.
(2) Expenses, estimated at $700,000, will be paid by CNA Surety.
(3) CNA Surety has granted the Underwriters a 30-day option, exercisable in
whole or in part, from time to time, to purchase up to an additional 628,219
shares of Common Stock to cover over-allotments, if any (the "Over-Allotment
Option"). CNA Surety will receive the proceeds from the sale of shares of
Common Stock subject to the Over-Allotment Option. If all of such shares are
purchased, Proceeds to the Selling Stockholders will not be affected and the
total Price to the Public, Underwriting Discounts and Commissions, and
Proceeds to CNA Surety (before deducting expenses estimated at $700,000,
which will be paid by CNA Surety) will be $66,224,785, $3,323,280 and
$8,204,540, respectively. See "Underwriting."
The shares of Common Stock are offered by the several Underwriters, subject
to prior sale, when, as and if delivered to and accepted by the Underwriters and
subject to various prior conditions, including their right to reject orders in
whole or in part. It is expected that delivery of the shares of Common Stock
will be made in New York, New York on or about July 14, 1998.
DONALDSON, LUFKIN & JENRETTE SALOMON SMITH BARNEY
SECURITIES
CORPORATION
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CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS
THAT STABILIZE, MAINTAIN, OR OTHERWISE AFFECT THE PRICE OF THE COMMON STOCK.
SPECIFICALLY, THE UNDERWRITERS MAY OVER-ALLOT IN CONNECTION WITH THE OFFERING,
AND MAY BID FOR, AND PURCHASE, SHARES OF THE COMMON STOCK IN THE OPEN MARKET.
FOR A DESCRIPTION OF THESE ACTIVITIES, SEE "UNDERWRITING."
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The states in which CNA Surety's insurance subsidiaries are domiciled,
South Dakota and Texas, have enacted laws which require regulatory approval for
the acquisition of "control" of insurance companies. Under these laws, there
exists a presumption of "control" when an acquiring party acquires 10% or more
of the voting securities of an insurance company or of a company which itself
controls an insurance company. Therefore, any person acquiring 10% or more of
the Common Stock of CNA Surety would need the prior approval of the state
insurance regulators of South Dakota and Texas, or a determination from such
regulators that "control" has not been acquired.
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AVAILABLE INFORMATION
CNA Surety is subject to the informational requirements of the Securities
Exchange Act of 1934, as amended (the "Exchange Act"), and in accordance
therewith, files reports and other information with the Securities and Exchange
Commission (the "Commission"). Such reports and other information filed by CNA
Surety can be inspected and copied at the public reference facilities maintained
by the Commission in Room 1024, 450 Fifth Street, N.W., Judiciary Plaza,
Washington, D.C. 20549, where copies may be obtained at prescribed rates, as
well as at the following regional offices: Northeast Regional Office, 7 World
Trade Center, Suite 1300, New York, New York 10048; and Midwest Regional Office,
Citicorp Center, 500 West Madison Street, Suite 1400, Chicago, Illinois
60661-2511. This material may also be inspected at the offices of the NYSE, 20
Broad Street, New York, New York 10005. Certain information and reports are also
available electronically through the Commission's Electronic Data Gathering,
Analysis and Retrieval system database, which can be accessed through the
Commission's website located at http://www.sec.gov.
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION
When used in this Prospectus, the words "estimates," "targets," "projects,"
"intends," "expects," and similar expressions are intended to identify
forward-looking statements under the Private Securities Litigation Reform Act of
1995. The statements which are not historical facts contained in this Prospectus
are forward-looking statements that involve risks and uncertainties, including,
but not limited to, the impact of competitive products and other competitive
factors, the effect of controlling stockholders and conflicts of interest, the
effect of economic conditions, including interest rates, investment portfolio
developments and the reaction to market conditions, the impact of adverse
legislation, the effects of CNA Surety's holding company structure, rating
agency policies and practices, the ability of CNA Surety to effectively
integrate the businesses of the Predecessor Operations with Western Surety and
USA (as each term is hereinafter defined), regulatory changes and conditions,
development of claims and the effect on loss reserves, compliance with year 2000
issues by the Company and its suppliers, insureds, and bond obligees, risk of
insolvency of CNA Surety's insurance subsidiaries, limitations on change in
control of CNA Surety, the impact of shares eligible for future sale, product
and policy demand and market response risks, policies and pricing, product and
policy development, the performance of reinsurance companies under reinsurance
contracts with CNA Surety's insurance subsidiaries, the results of financing
efforts, the identification of potential transactions and the actual
consummation of contemplated transactions or agreements, and other risks. All
such statements are subject to risks and uncertainties that could cause actual
results to differ materially from those contemplated in such forward-looking
statements. For a discussion of such risks, see "Risk Factors." Readers are
cautioned not to place undue reliance on forward-looking statements. CNA Surety
does not undertake any obligation to publicly release any revisions to these
forward-looking statements to reflect events or circumstances after the date
hereof or to reflect the occurrence of unanticipated events.
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PROSPECTUS SUMMARY
The following summary is qualified in its entirety by, and should be read
in conjunction with, the more detailed information and financial statements,
including the notes thereto, appearing elsewhere in this Prospectus. All
financial information presented is in accordance with generally accepted
accounting principles ("GAAP"), unless otherwise specified. Financial
information presented in accordance with statutory accounting practices ("SAP")
is identified as such. Unless otherwise indicated, all information contained in
this Prospectus is based upon the assumption that the Underwriters'
Over-Allotment Option will not be exercised. Unless the context otherwise
requires, all references in this Prospectus to: (i) "CNA Surety" shall mean the
issuer, CNA Surety Corporation, and all references to the "Company" shall mean
CNA Surety Corporation together with its subsidiaries on a consolidated basis
and incorporating the combination of the respective insurance businesses in
connection with the Merger; (ii) "CNAF" shall mean CNA Financial Corporation and
its subsidiaries, each either individually or collectively; (iii) "Capsure"
shall mean Capsure Holdings Corp. and its property and casualty affiliates; (iv)
"CCC" shall mean Continental Casualty Company and its property and casualty
affiliates, each either individually or collectively; (v) "CIC" shall mean The
Continental Insurance Company and its property and casualty affiliates, each
either individually or collectively; (vi) "Predecessor Operations" shall refer
to the combined surety operations of CCC and CIC conducted prior to the Merger;
(vii) "Western Surety" shall mean Western Surety Company; (viii) "USA" shall
mean Universal Surety of America; (ix) the "Merger" shall mean the combination
of the Predecessor Operations with Capsure's principal insurance subsidiaries
pursuant to a reorganization agreement under which Capsure was merged with and
into a subsidiary of CNA Surety Corporation; and (x) "Merger Date" shall mean
the close of business on September 30, 1997 when the Merger was consummated.
THE COMPANY
BUSINESS OVERVIEW
CNA Surety is an insurance holding company that, through its subsidiaries,
develops, markets and underwrites primarily surety bonds. The Company is the
largest publicly-traded insurance holding company focused exclusively on the
surety business and is one of the leading providers of surety products in the
United States. During 1997, the insurance companies now owned by the Company
wrote over $266 million of gross written premiums, $244 million of which
consisted of surety premiums. For the three months ended March 31, 1998, the
Company wrote over $63 million of gross written premiums, $57 million of which
consisted of surety premiums.
The Company was formed to facilitate the merger of the surety business of
CNAF with Capsure's insurance subsidiaries, Western Surety and USA. Management
believes that the Merger, which occurred on September 30, 1997, resulted in the
combination of three complementary surety businesses, each with distinct
strengths, product focuses and marketing strategies. The combination of these
businesses resulted in a single, larger entity focused on serving the needs of
virtually all segments of the surety market, in terms of the types of products
offered and the size of bonds available. Based on management's knowledge of the
industry, management believes that the Company now offers the broadest range of
surety products available in the marketplace and that the Company's branch
system and independent agency network are the most extensive in the surety
industry, the combination of which provide the Company with a competitive
marketing advantage.
Surety products, unlike the standard two-party insurance policy, are
three-party agreements in which the Company as 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. Sureties are generally entitled to recover from the principal any
losses and expenses paid to third parties.
The Company, through its principal insurance subsidiaries, underwrites a
broad spectrum of surety bonds, including contract surety bonds, non-contract
bonds, referred to as commercial bonds, small fidelity bonds and errors and
omissions ("E&O") liability insurance. The Company also assumes, on a
reinsurance basis,
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international surety and credit insurance written by CNA Reinsurance Company,
Limited, a United Kingdom domiciled subsidiary of CNAF ("CNA Re (London)").
Management believes that the Company is the largest writer of smaller commercial
surety bonds, with strong capabilities in marketing, distribution and service.
Western Surety and USA, the Company's principal insurance subsidiaries, are
currently rated A+ (Superior) and A (Excellent), respectively, by A.M. Best,
Inc. ("A.M. Best"). A.M. Best ratings are based upon factors relevant to
policyholders, agents, insurance brokers and intermediaries and are not directed
to the protection of investors.
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, many of
whom belong to the National Association of Surety Bond Producers. The Company
enjoys broad national distribution of its products through approximately 36,000
of the approximately 44,000 independent property and casualty insurance agencies
in the United States.
The Company's primary focus is on evaluating the risk and determining if
the principal meets its underwriting requirements for the bond. Accordingly, the
Company's surety bond premiums primarily reflect the type and class of risk and
related costs associated with both processing the bond transaction and
investigating the applicant including, if necessary, an analysis of the
applicant's creditworthiness and ability to perform.
The Company is led by an experienced management team with an average of
over twenty years of experience, whose core expertise is in surety underwriting
and claims management. Management's underwriting philosophy is disciplined and
focused on consistent underwriting profitability. The extent and sophistication
of underwriting activity, including the amount of bonding authority granted to
independent agents, varies depending on the class of business and the type of
bond. For example, contractor accounts and large commercial surety customers
undergo extensive credit, financial and managerial review and analysis on a
regular basis. Similarly, certain classifications of bonds, such as fiduciary
and court appeal bonds, also receive extensive underwriting. On the other hand,
the Company requires comparatively little underwriting information for certain
low-exposure risks such as notary bonds. The Company's underwriting has resulted
in combined ratios of 79.7%, 81.0% and 87.4%, excluding the effects of favorable
loss reserve development, for the three months ended March 31, 1998 and on a pro
forma basis for the years ended December 31, 1997 and 1996, respectively. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations . . ."
CORPORATE STRATEGY
CNA Surety's corporate objective is to be the leading provider of surety
and surety-related products in the United States and in selected international
markets and to be the surety of choice for customers and independent agents and
brokers. The Merger was an integral step towards achieving this objective and,
in management's view, has enhanced the Company's position as a market leader in
addition to providing increased opportunities for long-term revenue and earnings
growth. Elements of management's operating strategy designed to achieve its
corporate objective include the following:
Leverage the Company's Broad Product Line and Distribution Network
Management intends to use the Company's expanded product offerings, and
extensive distribution network, to leverage its existing marketing capabilities.
For example, the Company has introduced Western Surety's small commercial
products and USA's small contractor products to the 41 CNA Surety branch offices
of the Company, which prior to the Merger, did not have access to these product
offerings. Similarly, the Company has introduced CNA Surety's larger contract
and commercial bond expertise and greater financial capacity to Western Surety's
and USA's broad independent agency distribution system. In addition, Western
Surety's and USA's marketing representatives now receive support, training and
education from CNA Surety branch office personnel. Management believes that,
over time, the development of more extensive relationships with its independent
agency force will enhance the Company's growth opportunities and operating
efficiencies.
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Pursue Cross-Marketing Opportunities between the Company and CNAF
Management believes that the Company's relationship with CNAF, its
principal stockholder, provides significant opportunities for the Company.
Management believes that CNAF's 100-year history, leading position in the
property and casualty insurance market, financial strength and name recognition
provide CNA Surety with a strong marketing advantage in the medium to large
surety marketplace. In addition, with a leading position in providing property
and casualty insurance to the construction sector, risk management services to
"Fortune 1000" clients and professional liability products to architects and
engineers, CNAF is well positioned to generate new business opportunities for
CNA Surety.
In an effort to capitalize on these cross-marketing opportunities, the
Company and CNAF have instituted various referral programs which will allow the
Company to access CNAF's clients that may have a need for surety products. These
referrals are transmitted to the Company's home and branch offices, allowing
Company representatives to pursue these leads.
Expand in the International Markets
The Company recently began its expansion into the European markets through
a relationship with CNA Re (London). Through this relationship, the Company
participates, on a 50% quota share basis, in an international book of
predominately credit insurance and surety business. While credit insurance is a
relatively small market in the United States, credit insurance has a far more
prominent role in Western Europe, where direct writers and reinsurers often
market surety-related products along with credit insurance. Therefore,
management believes that the relationship with CNA Re (London) will serve as an
entree into the large European credit market and, thereby, enhance CNA Surety's
ability to build a surety business in Western Europe.
The Company is also partnering with other members of CNAF's international
organization to establish an infrastructure to market surety bonds
internationally. CNA Surety management believes that these actions will build
name recognition in the international marketplace.
Promote the Company's Specialty and Service-Based Orientation
As a provider of specialty surety products, management believes that the
Company is better positioned than its competitors to deliver exceptional service
to its agents and customers. The Company has developed specialized technology
targeted specifically toward the surety market. For example, due to Western
Surety's historical focus on the small commercial surety market, which requires
immediate response, the Company has developed business systems and processing
expertise that efficiently supports the surety needs of smaller customers and
minimizes the handling costs associated with the low premium, high volume nature
of the small commercial surety business. The Company expects to utilize this
experience and service orientation to better compete in the broader commercial
surety market.
Expand in the Private Sector
Based upon the Company's extensive knowledge of the surety business, its
focus almost exclusively on one sector of the insurance market, the experience
of its management team and its long-standing relationships with insurance agents
producing surety premiums, management believes that it is well positioned to
develop surety-related products for market niches that it believes are
underserved with regard to surety products. For example, the Company has
identified private construction as a market largely untapped with respect to
surety products. While surety bonds are widely used in the public construction
market, surety bonds are not yet as frequently used in the private construction
sector. Potential opportunities for this sector include not only the use of
existing surety bond products but also the development of new product offerings
tailored to the specific requirements of the private construction sector.
Consider Strategic Acquisitions
Management will continue to consider strategic acquisitions, as part of its
long-term approach to growing its business. CNA Surety's focus will be primarily
on specialty providers of surety-related products that bring geographic
diversity or product expertise or expansion to the Company.
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RELATIONSHIP WITH CNAF
The Merger was effected pursuant to a reorganization agreement dated as of
December 19, 1996 and amended as of July 14, 1997 (the "Reorganization
Agreement"). In connection with the Merger, the Company assumed the surety
business written by CNAF's subsidiaries, CCC and CIC, and the statutory surplus
of Western Surety was increased by $73.25 million as a result of a capital
contribution from CNAF and the contribution of debt proceeds from CNA Surety.
Immediately following the Merger, certain CNAF subsidiaries owned, on a
fully-diluted basis, approximately 61.75% of CNA Surety's outstanding Common
Stock and former Capsure stockholders owned, on a fully-diluted basis, the
remaining approximately 38.25% of the Company.
In connection with the Merger, the Company and CNAF entered into various
reinsurance and other operating agreements designed to provide continuing and
expanded underwriting capacity for the combined operations, to protect against
adverse loss reserve development related to the Predecessor Operations' reserves
prior to the Merger, and to help preserve, through the year 2000, the
profitability of the Predecessor Operations and certain additional accounts. In
addition to certain ongoing covenants in the Reorganization Agreement and other
agreements described below, in connection with the Merger, the Company entered
into the following reinsurance agreements: (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"). Subsequent to the Merger, the Company
entered into the Surety Second Excess of Loss Reinsurance Contract (the "Second
Excess of Loss Contract"). A description of each of these agreements is set
forth below. See "Certain Relationships and Related Transactions" for a more
complete discussion of the foregoing agreements.
Surety Quota Share Treaty
The Quota Share Treaty effected the formal transfer of the reserves of the
Predecessor Operations to Western Surety and provided CNA Surety with a
guarantee of such reserves for a period of five years following the Merger. In
addition, in order to protect the Company's business for a period of five years
following the Merger, CNAF agreed to refrain from making a quote or bid, and to
refer any inquiry or request, for surety business to the Company so that the
Company could exclusively offer such products. Notwithstanding the foregoing,
CNAF agreed that it will cede any such business it may write to CNA Surety
through the Quota Share Treaty.
Aggregate Stop Loss Reinsurance Contract
The Stop Loss Contract protects the Company from the variability of the
contract surety business in the form of adverse loss experience on certain
business underwritten after the Merger. Accordingly, the Stop Loss Contract
assures a minimum level of profitability (to the extent expenses do not
increase) for at least three full fiscal years following the Merger by limiting
the Company's insurance subsidiaries' prospective net loss ratios to 24% for
both certain insureds that were accounts of the Predecessor Operations as of the
Merger Date and certain lines of insured business (excluding all miscellaneous
bonds and small contract surety previously underwritten by Capsure's insurance
subsidiaries) (the "Loss Ratio Cap").
Surety Excess of Loss Reinsurance Contract and Surety Second Excess of Loss
Reinsurance Contract
The Excess of Loss Contract and the Second Excess of Loss Contract provide
the Company with the underwriting capacity to continue to expand the Company's
large surety bond business by providing the Company's insurance subsidiaries
with reinsurance support from CNAF's insurance subsidiary, CCC. Historically,
CCC's substantial capital base has enabled it to underwrite and retain large
aggregate surety bond exposures. The Excess of Loss Contract and the Second
Excess of Loss Contract cede to CCC certain liabilities in excess of the
capacity provided by the Company's insurance subsidiaries' other reinsurance
program with third party reinsurers. Specifically, pursuant to the Excess of
Loss Contract CCC provides the Company's insurance subsidiaries with $75 million
of coverage per principal in excess of the $55 million of coverage provided to
such insurance subsidiaries by third party reinsurers, which is in turn in
excess of the $5 million of coverage per principal to be retained by the
Company's insurance subsidiaries. In addition, the
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Second Excess of Loss Contract provides the Company's insurance subsidiaries
with coverage from CCC for losses in excess of $135 million per principal.
The Excess of Loss Contract and the Second Excess of Loss Contract both
provide that, at the request of the Company's insurance subsidiaries, CCC will
act as a joint insurer, or "co-surety," for business covered by either the
Excess of Loss Contract or the Second Excess of Loss Contract.
Administrative Services Agreement
To allow for the continued use by CNA Surety of real and personal property
currently owned or leased by CCC, CNA Surety and CCC entered into the
Administrative Services Agreement. Specifically, the Administrative Services
Agreement provides CNA Surety with the flexibility to purchase many of the
services provided by CCC to the Predecessor Operations, including
telecommunications, computer access and support, human resource assistance,
accounting, legal, financial and administrative support, marketing, and various
other business services.
Trademark License Agreement
In order to maintain its ability to utilize the valuable "CNA" trademark,
CNAF and the Company entered into a Trademark License Agreement pursuant to
which the Company obtained the right to use the "CNA" mark or some derivation
thereof for an unlimited period of time, subject to a right of termination in
the event of a change in control of CNA Surety.
Services and Indemnity Agreement
The Services and Indemnity Agreement authorizes the Company's insurance
subsidiaries to perform certain underwriting, claims, agency and accounting
functions on behalf of CCC as they relate to the business assumed under the
Quota Share Treaty for a period of five years from the Merger Date. Thus,
together with the foregoing reinsurance arrangements, the Company has been
granted the authority to access the CCC capital pool and to issue surety bonds
utilizing CCC rates and forms.
Continuing Covenants of CNAF
The Reorganization Agreement contains certain ongoing agreements, including
an agreement by CCC and CNA Surety to cause the bylaws of CNA Surety to require
approval by 75% of the holders of Common Stock in order for CNA Surety to (i)
enter into certain business combinations, (ii) accept proposals to sell all or
substantially all of the Company's assets, (iii) amend the bylaw provisions
requiring such supermajority voting or (iv) amend the certificate of
incorporation.
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THE OFFERING
Common Stock Offered by the Selling
Stockholders(1)................... 4,188,129 shares
Common Stock Outstanding after the
Offering(1)(2).................... 43,446,119 shares
Use of Proceeds..................... The Company will not receive any of the
proceeds from the sales of Common Stock
by the Selling Stockholders offered
hereunder and will only receive
proceeds from the sale of Common Stock
hereunder if and only to the extent
that the Over-Allotment Option is
exercised. In the event the
Underwriters elect to exercise their
Over-Allotment Option, the Company
intends to use the proceeds from such
sales of Common Stock by the Company
for general corporate purposes. See
"Use of Proceeds."
Dividend Policy..................... CNA Surety currently pays no dividends.
The CNA Surety Board of Directors (the
"Board"), however, recently adopted a
new dividend policy and intends to pay
quarterly dividends beginning in the
fourth quarter of 1998. The timing and
declaration and payment of dividends
will be at the discretion of the Board
and will depend upon many factors. The
Company expects that the first
quarterly dividend, if declared and
paid, will be $0.08 per share. See
"Dividend Policy."
NYSE Symbol......................... "SUR"
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(1) Excludes up to 628,219 shares of Common Stock which may be sold by CNA
Surety upon exercise of the Underwriters' Over-Allotment Option. See
"Underwriting."
(2) Based on the number of shares of Common Stock outstanding as of May 27,
1998. Does not include 749,116 shares of Common Stock issuable upon exercise
of currently outstanding CNA Surety stock options.
RISK FACTORS
In connection with a prospective purchaser's decision to purchase any of
the Common Stock offered hereby, such prospective purchaser should evaluate
certain risk factors associated with such an investment, which are discussed
herein beginning on page 12. The principal risk factors include: (i) the impact
of competition; (ii) the effect of controlling stockholders and conflicts of
interest; (iii) susceptibility to interest rate changes and general economic
conditions; (iv) the impact of adverse legislation; (v) the effects of the CNA
Surety holding company structure; (vi) changes in insurance ratings; (vii) the
ability of CNA Surety to effectively integrate the companies; (viii) the impact
of regulation of insurance companies; (ix) adequacy of reserves; (x) year 2000
compliance by the Company and its suppliers, insureds and bond obligees; (xi)
consequences of insolvency; (xii) limitations on change in control; and (xiii)
shares eligible for future sale.
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SUMMARY CONSOLIDATED PRO FORMA AND HISTORICAL
FINANCIAL DATA OF CNA SURETY
The following summary financial information is provided for the operations
that combined to form CNA Surety for various time periods in 1996 and 1997 as if
the Merger had been consummated on January 1, 1996. Periods presented on this
basis are therefore marked "pro forma." This pro forma financial information
gives effect to the following: (i) adjustment to the Capsure statement of
operations, as reported, to reflect the income effects as if a $10 per share
special cash distribution paid on October 4, 1996 had been made on January 1,
1996; (ii) consummation of the Merger and the related transactions and the
contribution of capital to, and the incurrence of additional debt, by CNA
Surety; (iii) purchase accounting adjustments to reflect Capsure's assets and
liabilities at fair value; (iv) estimated indirect and overhead expenses for the
Predecessor Operations; and (v) estimated interest expense related to the
additional debt. The pro forma financial information does not include the
estimated net investment income resulting from investment of Merger-related cash
flows, including (i) the $50 million debt proceeds drawn by CNA Surety under the
Credit Facility (as hereinafter defined) and contributed to Western Surety; (ii)
the $52.25 million capital contribution from CCC; and (iii) collection of the
receivable in the amount of approximately $117 million from CCC. Information for
the three months ended March 31, 1998 is derived from the actual quarterly
financial statements of CNA Surety. This information is provided to assist in
understanding and evaluating the consolidated financial information of the
various entities that comprise CNA Surety and is not necessarily indicative of
the future results of operations of CNA Surety. The summary financial data set
forth below should be read in conjunction with the table of Summary Consolidated
Historical Financial Data of CNA Surety which immediately follows and the more
detailed financial information or financial statements and related notes
included in this Prospectus. See "Selected Consolidated Financial Data" and "Pro
Forma Condensed Statement of Consolidated Operations."
<TABLE>
<CAPTION>
THREE MONTHS ENDED
YEARS ENDED DECEMBER 31, MARCH 31,
------------------------- --------------------------
1996 1997 1997 1998
(PRO FORMA) (PRO FORMA) (PRO FORMA) (HISTORICAL)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C>
INCOME STATEMENT DATA:
Total revenues(1)(2)......................... $250,194 $258,682 $ 59,338 $65,534
======== ======== ======== =======
Gross written premiums....................... $251,414 $266,418 $ 59,779 $63,848
======== ======== ======== =======
Net written premiums......................... $235,186 $257,067 $ 56,128 $61,836
======== ======== ======== =======
Net earned premiums.......................... $238,330 $243,425 $ 56,125 $58,745
Net losses and LAE(3)........................ 41,450 5,648 (26,384) 11,218
Net commissions, brokerage and other......... 150,198 150,631 36,328 35,039
-------- -------- -------- -------
Underwriting income(3)....................... 46,682 87,146 46,181 12,488
Net investment income(2)..................... 10,796 14,534 3,126 6,789
Net investment gains......................... 1,068 723 87 --
Interest expense............................. 7,660 7,232 1,765 1,821
Non-recurring charges and Merger costs(4).... 8,565 12,087 -- --
Amortization of intangible assets............ 5,788 5,788 1,447 1,475
-------- -------- -------- -------
Income before income taxes(2)(3)............. 36,533 77,296 46,182 15,981
Income taxes................................. 14,101 42,921 16,771 6,166
-------- -------- -------- -------
Net income(2)(3)............................. $ 22,432 $ 34,375 $ 29,411 $ 9,815
======== ======== ======== =======
Basic and diluted net income per
share(2)(3)................................ $ 0.52 $ 0.79 $ 0.68 $ 0.23
======== ======== ======== =======
OPERATING DATA:
Loss ratio(3)................................ 17.4% 2.3% (47.0)% 19.1%
Expense ratio................................ 63.0 61.9 64.7 59.6
-------- -------- -------- -------
Combined ratio(3)............................ 80.4% 64.2% 17.7% 78.7%
======== ======== ======== =======
</TABLE>
(footnotes on following page)
9
<PAGE> 11
- ---------------
(1) Includes net earned premiums, net investment income and net investment
gains.
(2) Pro forma investment income for the years ended December 31, 1996 and 1997
and for the three months ended March 31, 1997 does not include the pro forma
effects of estimated investment income resulting from the investment of
Merger-related cash flows as described in the introduction to this table. If
proceeds from these sources of funds were assumed to be invested in
high-quality, taxable fixed income securities with an average duration of
approximately 3 years, yielding 6.4%, net investment income would increase
approximately $14,200 (approximately $9,200 net of income taxes, or $0.21 in
pro forma earnings per share) and approximately $11,300 (approximately
$7,300 net of income taxes, or $0.17 in pro forma earnings per share) for
the years ended December 31, 1996 and 1997, respectively, and approximately
$3,700 (approximately $2,400 net of income taxes, or $0.05 in pro forma
earnings per share) for the three months ended March 31, 1997.
(3) Includes the effect of recording releases of prior years' loss reserves. The
dollar amount and percentage point effect on the loss ratio of these reserve
reductions were $16,642 or 7.0 percentage points and $40,886 or 16.8
percentage points for the years ended December 31, 1996 and 1997,
respectively, and $36,900 or 65.7 percentage points and $581 or 1.0
percentage point for the three months ended March 31, 1997 and 1998,
respectively. The after tax per share effects of recording these reserve
reductions were $0.25 and $0.61 per share for the years ended December 31,
1996 and 1997, respectively, and $0.55 and $0.01 per share for the three
months ended March 31, 1997 and 1998, respectively.
(4) Capsure incurred approximately $2,200, after applicable income taxes, or
$0.51 per share, in Merger-related costs in 1997 compared to approximately
$5,700, after applicable income taxes, or $0.13 per share in non-recurring
charges and Merger costs in 1996. In the fourth quarter of 1996, Capsure
incurred approximately $1,100, after applicable income taxes, or $0.03 per
share, in non-recurring Merger costs.
10
<PAGE> 12
SUMMARY CONSOLIDATED HISTORICAL FINANCIAL DATA OF CNA SURETY
The following are summary consolidated historical financial data for CNA
Surety at and for the periods subsequent to the Merger. The summary consolidated
historical financial information for CNA Surety should be read in conjunction
with "Management's Discussion and Analysis of Financial Condition and Results of
Operations..." and the more detailed information or financial statements and
related notes included in this Prospectus. See "Selected Consolidated Financial
Data -- CNA Surety."
<TABLE>
<CAPTION>
SEPTEMBER 30,
(DATE OF INCEPTION)
THROUGH THREE MONTHS ENDED
DECEMBER 31, MARCH 31,
------------------- ------------------
1997 1998
(AMOUNTS IN THOUSANDS, EXCEPT
PERCENTAGES AND PER SHARE DATA)
<S> <C> <C>
INCOME STATEMENT DATA:
Total revenues.............................................. $ 71,284 $ 65,534
======== ========
Gross written premiums...................................... $ 75,252 $ 63,848
======== ========
Net written premiums........................................ $ 73,989 $ 61,836
======== ========
Net earned premiums......................................... $ 65,433 $ 58,745
Net losses and LAE(1)....................................... 12,134 11,218
Net commissions, brokerage and other........................ 38,213 35,039
-------- --------
Underwriting income(1)...................................... 15,086 12,488
Net investment income....................................... 5,766 6,789
Net investment gains........................................ 85 --
Interest expense............................................ 1,831 1,821
Amortization of intangible assets........................... 1,447 1,475
-------- --------
Income before income taxes(1)............................... 17,659 15,981
Income taxes................................................ 6,663 6,166
-------- --------
Net income(1)............................................... $ 10,996 $ 9,815
======== ========
Basic weighted average shares outstanding................... 43,302 43,348
======== ========
Basic and diluted net income per share...................... $ 0.25 $ 0.23
======== ========
OPERATING DATA:
Loss ratio(1)............................................... 18.5% 19.1%
Expense ratio............................................... 58.4 59.6
-------- --------
Combined ratio(1)........................................... 76.9% 78.7%
======== ========
BALANCE SHEET DATA:
Invested assets and cash.................................... $419,667 $427,599
Intangible assets, net of amortization...................... 161,962 160,487
Total assets................................................ 727,180 740,871
Insurance reserves.......................................... 304,217 309,620
Long-term debt.............................................. 118,000 118,000
Total liabilities........................................... 470,448 474,348
Stockholders' equity........................................ 256,732 266,523
Statutory surplus........................................... 142,429 144,849
Book value per share........................................ 5.93 6.14
</TABLE>
- ---------------
(1) Includes the effect of recording releases of prior years' loss reserves. The
dollar amount and the percentage point effect on the loss ratio of these
reserve revisions was $647 or 1.0 percentage point for the period from
September 30, 1997 (date of inception) through December 31, 1997 and $581 or
1.0 percentage point for the three months ended March 31, 1998.
11
<PAGE> 13
RISK FACTORS
The following risk factors, in conjunction with and in addition to the
other information presented in this Prospectus, should be carefully considered
in evaluating the Company before making an investment in the Common Stock being
offered hereby.
COMPETITION
The surety market is highly competitive. Companies generally compete for
surety business on the basis of price, service, financial strength, ratings and
reputation of the company, as well as capabilities of the independent agents and
brokers who solicit the business. The small contract and commercial bond markets
in which the Company competes have seen additional competition as both large and
small insurance companies are competing and expanding in this area. The Company
does not have a direct sales force but instead relies on a nationwide network of
independent insurance agencies. In order to compete effectively in the market,
the Company will need to continue to maintain productive relationships with the
independent insurance agencies that offer its products. Since surety bonds may
account for only a small portion of an agency's revenues, an important factor
considered by agencies is the range of products and the services offered by a
surety company. Certain existing and potential competitors of the Company may be
larger, and may have greater financial resources and more extensive insurance
product lines than the Company. The businesses of CNA Surety's insurance
subsidiaries could be adversely affected by such competition.
U.S. House of Representatives Resolution No. 10, entitled "The Financial
Services Competition Act of 1998 ("HR 10"), was recently approved by the U.S.
House of Representatives. In the event that HR 10 is enacted into law, banking
and securities firms would be permitted to affiliate with insurance companies.
Such affiliations could expand the number and size of the competitors in the
insurance industry, which could have an adverse effect on CNA Surety's insurance
subsidiaries' ability to compete effectively in the market.
CONTROLLING STOCKHOLDER AND CONFLICTS OF INTEREST
Certain subsidiaries of CNAF own, on a fully diluted basis, an aggregate of
approximately 61.75% of the outstanding shares of Common Stock and have a number
of ongoing relationships with the Company. In light of CNAF's beneficial
ownership of stock, CNAF has the ability to elect the directors of the Board,
subject to CNAF's obligation under the Reorganization Agreement to elect certain
designees of Capsure until the 1999 annual meeting of CNA Surety stockholders.
In that regard, CNAF is able to control the policy decisions of CNA Surety,
including decisions regarding the issuance of securities, payment of dividends,
approval of acquisitions and the sale of its assets. CNAF also has the ability
to approve any action requiring majority stockholder approval, including
adopting amendments to CNA Surety's certificate of incorporation and approving
or disapproving mergers or sales of all or substantially all of the assets of
CNA Surety, subject to certain provisions of CNA Surety's bylaws which require
supermajority votes on certain matters for a period of two years following the
Merger. See "The Company -- Business Overview."
The Company is dependent upon its relationship with CNAF. The Company's
ability to write large contract surety business depends, to a certain extent, on
the Company's continuing relationship with CNAF, including the Company's
ability, through the various reinsurance and other agreements, to use CCC bond
rates and forms. See "Certain Relationships and Related Transactions." In
general, certain brokers and customers also may derive assurance from, and a
certain willingness to do business with the Company as a result of, the
Company's affiliation with CNAF. Further, significant administrative and service
functions necessary for the Company's operations are currently provided by CNAF.
Most of the contractual arrangements between CNAF and the Company were entered
into in connection with the Merger and have terms of not more than five years.
Although certain reinsurance agreements may be renewed, CNA Surety management
has no reason to believe that the reinsurance agreements will be extended at the
end of such periods or that, if extended, such agreements will be extended on
the same terms and conditions. In addition, no assurance can be given that the
other arrangements with CNAF will be renewed on the same terms and conditions
upon their respective dates of termination.
12
<PAGE> 14
CNAF has agreed not to write certain types of surety policies for its own
account for a period of five years from the Merger Date and, to the extent such
surety policies are written, to cede such policies to the Company. See "The
Company -- Business Overview." However, CNAF can continue to write other lines
of insurance, including fidelity and E&O, that the Company currently writes and
CNAF may expand such lines from time to time.
Conflicts of interest between CNA Surety and CNAF could arise with respect
to business dealings between them, including interpretation of existing
agreements between them, new products, potential acquisitions, the election of
new or additional directors, the payment of dividends and the amounts paid for
services provided pursuant to various agreements between the entities. There is
no formal plan or arrangement to resolve potential conflicts of interest that
may arise. CNA Surety intends to seek the approval of the audit committee of the
Board for any issues or future business transactions between the companies and
will refer to that committee any issues that arise with respect to those
transactions. See "Management of the Company" and "Certain Relationships and
Related Transactions."
SUSCEPTIBILITY TO CHANGES IN INTEREST RATES AND GENERAL ECONOMIC CONDITIONS
The Company's business is affected by fluctuations in interest rates and by
general economic conditions in the United States.
Approximately one-half of the Company's business is related to the contract
surety market, comprised of contract bonds typically required in construction
projects. The number of construction projects initiated from time to time is
directly related to general economic conditions at such time, the level of
interest rates, and the funding of public works projects by federal, state and
local governments. In the event of an increase in interest rates and/or an
economic downturn, the Company's business volume and claims experience could be
adversely affected.
The Company's investment portfolio consists primarily of investment grade
debt securities. The market value of those securities will vary depending upon
general economic and market conditions and the interest rate environment. From
time to time, the Company may be required for business or regulatory reasons to
sell certain of its investments at a time when their market value is less than
the cost of such investments.
The Company's portfolio includes collateralized mortgage obligations
("CMOs") and other asset-backed securities, which differ from traditional fixed
income securities in that they may expose the investor to yield variability and
even principal risk due to such factors as high mortgage prepayment rates and
defaults and delinquencies in the underlying asset pool. Management believes it
has reduced prepayment variability by investing only in short tranches and by
owning a substantial amount of planned amortization class ("PAC") tranches,
which have been structured largely to insulate the investor from prepayment
risk. A PAC tranche is structured to amortize in a predictable manner and
thereby shift the risk of prepayment of the underlying collateral to other
tranches. Although management believes it has reduced prepayment risk by
investing in PAC tranches, there can be no assurance that the Company will not
suffer a reduction in future investment income associated with prepayments.
ADVERSE LEGISLATION
A significant portion of the Company's insurance subsidiaries' business is
and will continue to be derived from the writing of small fidelity and
commercial surety bonds mandated by various state statutes and local ordinances
to cover acts of public officials and private businesses, such as realtors,
automobile dealers and others who generally interact with members of the public.
In recent years, several jurisdictions have repealed, or considered action to
repeal, legislation mandating use of various types of these bonds, often
replacing them with alternative protection mechanisms, such as recovery funds
administered by the states for the benefit of citizens who assert claims against
such officials or businesses. In addition, contract surety bonds are required
generally by federal, state and local governments for public works projects. If
numerous governments were to repeal the requirements for obtaining bonds of the
type written by the Company's insurance subsidiaries, the results of operations,
financial condition and cash flows of the Company's insurance subsidiaries would
be materially and adversely affected, and, consequently, CNA Surety's financial
condition could be materially and adversely affected.
13
<PAGE> 15
HOLDING COMPANY STRUCTURE
CNA Surety is a holding company which conducts substantially all of its
operations through its insurance subsidiaries and derives substantially all of
its operating income and operating cash flow from such subsidiaries. CNA Surety
relies on dividends from its insurance subsidiaries as well as returns on its
holding company cash and invested assets to generate the funds necessary to meet
its obligations and pay dividends, if any, on its capital stock. The ability of
the insurance subsidiaries to make such payments is subject to, among other
things, applicable state laws, rating agency requirements, and any restrictions
that may be contained in credit agreements or other financing arrangements
entered into by the insurance subsidiaries. Claims of creditors of the insurance
subsidiaries will generally have priority as to the assets of such subsidiaries
over the claims of CNA Surety and the holders of Common Stock.
The payment of dividends to CNA Surety by the insurance subsidiaries
without prior approval of the insurance subsidiaries' domiciliary state
insurance commissioners is limited to amounts determined by formula in
accordance with the accounting practices prescribed or permitted by the state's
insurance departments. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations . . . -- Liquidity and Capital Resources."
These formulae vary by state. All dividends must be reported to the appropriate
insurance departments prior to payment. No assurance can be given that there
will not be further regulatory actions restricting the ability of the insurance
subsidiaries to pay dividends and, accordingly, that funds held by the insurance
subsidiaries will be available to CNA Surety for payment of debt, expenses or
dividends.
INSURANCE RATINGS
CNA Surety's insurance subsidiaries compete with other insurance companies
on the basis of a number of factors, including the ratings assigned by A.M.
Best. A.M. Best's letter ratings range from A++ (Superior) to C- (Weak) with A++
being highest. A.M. Best ratings are based upon factors relevant to
policyholders, agents, insurance brokers and intermediaries and are not directed
to the protection of investors.
Western Surety and USA are currently rated A+ (Superior) and A (Excellent),
respectively, by A.M. Best. Through intercompany reinsurance and related
agreements, the Company's customers have access to CCC's broader underwriting
capacity. CCC has an A.M. Best rating of A (Excellent). There can be no
assurance that the ratings of Western Surety, USA or CCC will not be changed in
subsequent periodic reviews by A.M. Best. If such ratings were to be downgraded
below A-, such ratings downgrade could have a material adverse effect on the
results of operations of the Company and its ability to effectively compete in
the marketplace.
INTEGRATION OF THE COMPANIES
Capsure, CCC and CNA Surety entered into the Reorganization Agreement with
the expectation that the Merger would result in certain benefits. In order to
achieve such benefits, CNA Surety needs to continue to integrate the Predecessor
Operations with the businesses and operating systems of Western Surety and USA.
There can be no assurance that such integration process will continue to occur
in the desired manner. The transition to a fully combined company will continue
to require substantial attention from management, which could divert
management's attention and adversely effect the operating results of the
Company. In addition, the process of combining the organizations could cause the
interruption of, or disruption in, the activities of any or all of the
businesses, which could have a material adverse effect on the Company's combined
operations. There can be no assurance that the Company will realize all or any
of the anticipated benefits of the Merger.
REGULATION
CNA Surety's insurance subsidiaries are subject to varying degrees of
supervision and regulation in the jurisdictions in which they conduct business
under statutes which delegate regulatory, supervisory and administrative powers
to state insurance regulators. The nature of the regulation varies from
jurisdiction to jurisdiction but typically involves prior approval of the
acquisition of control of an insurance company or of any
14
<PAGE> 16
company controlling an insurance company, regulation of certain transactions
entered into by an insurance company with any of its affiliates, limitations on
dividends, approval or filing of premium rates and policy forms, solvency
standards, minimum amounts of capital and surplus that must be maintained,
limitations on amounts or types of investments, limitations on the size of risks
which may be insured by a single company, licensing of insurers and agents,
deposits of securities for the benefit of policy or surety bond holders,
reporting of financial condition and other matters. In addition, state insurance
regulators perform periodic financial and market conduct examinations of
insurance companies. All such regulation is intended generally to protect the
policy or surety bond holders, rather than equity holders. No assurance can be
given that future legislative or regulatory changes will not adversely affect
CNA Surety and its insurance subsidiaries.
Certain states in which CNA Surety's insurance subsidiaries conduct
business require insurers to participate in a guaranty association to provide
protection to policyholders against the insolvency of insurers licensed in such
states. In order to provide the association 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 have historically not been material to the combined
results of operations, but no assurance can be given that such assessments will
not be material in the future to the results of operations of CNA Surety's
insurance subsidiaries.
Although the federal government does not generally regulate the operations
of insurance companies, from time to time, the federal government considers
various bills which could expand its powers in the insurance industry. CNA
Surety cannot predict, however, whether such legislation will be enacted, what
the terms and conditions will be if enacted, or what effect, if any, such
legislation might have on CNA Surety and its insurance subsidiaries. If
regulation of CNA's businesses increases in the future at the federal and state
level, CNA Surety believes that the costs associated with compliance would also
increase.
The Company is currently bound by U.S. Department of Treasury regulations
which set underwriting limitations on sureties for federal and other public
works project bonds. The underwriting limitations of Western Surety and USA,
which are based on the amount of each insurer's statutory surplus, are currently
$12.5 million and $1.4 million per bond, respectively, which limits their
ability to underwrite certain large federal and other public works project
bonds. Through intercompany reinsurance and related agreements with CCC, CNA
Surety has access to CCC's $452.2 million per bond U.S. Treasury underwriting
limitation, enabling the Company to write larger bonds. However, there can be no
assurance that once the term of such reinsurance and related agreements expires,
that such reinsurance agreements will be extended, allowing CNA Surety to
continue to have access to the larger CCC U.S. Treasury underwriting limitation.
ADEQUACY OF RESERVES
CNA Surety's insurance subsidiaries' reserves for loss and loss adjustment
expenses ("LAE") may prove to be deficient in the future due to the inherent
uncertainties involved in the process of establishing reserves which relies on
estimates which may differ from actual future loss payments. The reserve
adjustments required to cure such deficiencies would be charged against future
operations and could have an adverse effect on CNA Surety's results of
operations and financial condition.
The Predecessor Operations transferred to CNA Surety by CNAF in the Merger
are subject to certain reinsurance agreements which provide certain guarantees
and protections against losses on such business. See "Certain Relationships and
Related Transactions." However, the Quota Share Treaty only guarantees and
protects the Company from losses incurred on the Predecessor Operations and does
not cover any business written by Capsure prior to the Merger Date or any surety
business written after the Merger Date. See "Business of the Company -- Reserves
for Unpaid Losses and LAE."
YEAR 2000 COMPLIANCE
As the year 2000 approaches, a critical business issue has emerged for
virtually all companies regarding how existing application software programs and
operating systems can accommodate this date field. In brief, many existing
application software products in the marketplace were designed to only
accommodate a two digit date position which represents the year (e.g., 95 is
stored on the system and represents the year 1995). As
15
<PAGE> 17
a result, the year 1999 (i.e., 99) could be the maximum date value these systems
will be able to accurately process. CNA Surety management is in the process of
replacing or upgrading its systems to accommodate business into and beyond the
year 2000. Based on information currently available, CNA Surety management
anticipates that by the end of 1998 it will have substantially completed its
program of replacement and upgrade. The Company anticipates that the cost of its
program of replacement and upgrade will be approximately $1 million in excess of
the cost of ordinary software upgrades and replacements. To the extent the
Company's systems are not fully year 2000 compliant or the Company's computer
systems must interact with the computer systems of other entities' computers
which are not year 2000 compliant, there can be no assurance that potential
systems interruptions or the resulting costs necessary to remediate systems and
to compensate for any losses would not have a material adverse effect on the
Company's business, financial condition, results of operations, cash flows and
business prospects.
Although the Company has not received any claims based on losses resulting
from the year 2000 issues, there can be no assurance that bond obligees or
insureds will not suffer losses of this type and seek compensation under the
Company's bonds or policies. If any claims are made, the Company's obligations,
if any, will depend on the facts and circumstances of the claim and provisions
of the bond or policy. At this time, the Company is unable to determine whether
the adverse impact, if any, in connection with the foregoing circumstances would
be material to the Company.
INSOLVENCY
In the event of insolvency, liquidation or other reorganization of CNA
Surety's insurance subsidiaries, the creditors and stockholders of CNA Surety
would have no right to proceed against CNA Surety's insurance subsidiaries or to
cause the liquidation or bankruptcy of such insurance subsidiaries under federal
or state bankruptcy laws. The insurance laws of the domiciliary state would
govern such proceedings and the relevant insurance commissioner would act as
liquidator or rehabilitator for the insurance subsidiary. Creditors and
policyholders of any such insurance subsidiary would be entitled to payment in
full from the assets of the insurance subsidiary before CNA Surety, as a
stockholder, would be entitled to receive any distribution therefrom.
In addition, insurance regulators have the authority in certain
circumstances to block payments by CNA Surety's insurance subsidiaries of
dividends and other amounts that would otherwise be permitted without prior
regulatory approval. See "Dividend Policy" and "Business of the
Company -- Regulation."
LIMITATIONS ON CHANGE IN CONTROL
CNA Surety's certificate of incorporation and bylaws contain a number of
provisions relating to corporate governance and the rights of stockholders.
Certain of these provisions may be deemed to have a potential "anti-takeover"
effect in that such provisions may delay, defer or prevent a change of control
of CNA Surety. These provisions include (i) the authority of the Board to issue
series of its preferred stock, $0.01 par value per share (the "Preferred
Stock"), with such voting rights and other powers as the Board may determine and
(ii) notice requirements in the bylaws relating to nominations to the Board and
to the raising of business matters at stockholders' meetings. For nominations or
other business to be properly brought before an annual meeting of stockholders
by a stockholder, CNA Surety's bylaws require such stockholder to deliver a
notice to the secretary, absent specified circumstances, not less than 50 days
nor more than 75 days prior to such meeting. This could have the effect of
discouraging a prospective acquiror from making a tender offer or otherwise
attempting to obtain control of CNA Surety.
In addition, certain provisions of Delaware law could have the effect of
delaying, deferring or preventing a change in control of CNA Surety, which could
adversely affect the market price of the Common Stock. CNA Surety is subject to
the anti-takeover provisions of Section 203 of the Delaware General Corporation
Law which prohibit CNA Surety from engaging in a "business combination" with an
"interested stockholder" for a period of three years after the date of the
transaction in which the person became an interested stockholder, unless the
combination is approved in the statutorily prescribed manner.
16
<PAGE> 18
Under applicable state insurance laws and regulations, no person may
acquire control of CNA Surety unless such person has filed a statement
containing specified information with appropriate regulatory authorities and has
obtained approval for such an acquisition. Under applicable laws and
regulations, any person acquiring, directly or indirectly, or holding proxies
with respect to, 10% or more of the voting stock of any other person is presumed
to have acquired "control of such person." Accordingly, any purchase resulting
in the purchaser owning 10% or more of the outstanding Common Stock, in the
Offering or otherwise, would require prior approval by applicable regulatory
authorities. Such prior approval requirement would also apply to an acquisition
of proxies to vote 10% or more of the outstanding Common Stock and, therefore,
could delay or prevent a stockholder from acquiring such proxies in a proxy
contest. No assurance can be given as to whether CNA Surety would seek to invoke
these laws and regulations in the event of a contested solicitation of proxies.
In addition, the Reorganization Agreement has certain covenants which could
have the effect of inhibiting a change of control, including certain
supermajority voting rights for a period of two years following the Merger. The
Reorganization Agreement contains an agreement whereby CCC and CNA Surety agreed
to cause the bylaws of CNA Surety to require approval by 75% of the holders of
Common Stock for CNA Surety in order to (i) enter into certain business
combinations, (ii) accept proposals to sell all or substantially all of the
Company's assets, (iii) amend the bylaw provisions requiring such supermajority
voting or (iv) amend the certificate of incorporation.
SHARES ELIGIBLE FOR FUTURE SALE
Sales of a substantial number of shares of the Common Stock in the public
market following this Offering, or the perception that such sales could occur,
could adversely affect the market price for the Common Stock. Based on the
number of shares of Common Stock outstanding on May 27, 1998, upon completion of
this Offering, CNA Surety will have 43,446,119 shares of Common Stock
outstanding, of which 16,177,426 shares will be freely tradeable without
restriction or future registration under the Securities Act (except those shares
acquired by affiliates of the Company). The remaining shares will be "restricted
securities" within the meaning of Rule 144 under the Securities Act. As of May
27, 1998, 749,116 shares of Common Stock were issuable upon the exercise of
outstanding stock options (111,516 of which are exercisable), which shares have
been registered by CNA Surety under the Securities Act and, subject to the
reoffer limitations for executive officers and directors of CNA Surety, are
freely tradeable without restriction upon issuance. The Company and certain of
its current stockholders, holding an aggregate of 27,268,693 shares of Common
Stock upon completion of this Offering, have agreed not to offer, sell, contract
to sell or otherwise dispose of, directly or indirectly, any Common Stock, or
any securities convertible into or exchangeable or exercisable for Common Stock,
until 180 days after the date of this Prospectus, without the prior consent of
Donaldson, Lufkin & Jenrette Securities Corporation, on behalf of the
Underwriters. Following the 180-day period, 27,268,693 of the restricted
securities will become immediately eligible for sale, subject to the manner of
sale, volume, notice and information requirements of Rule 144.
In addition, while management is not aware of any current intention on the
part of CNAF to reduce its ownership of Common Stock, there is no restriction,
other than the foregoing 180-day agreement, on CNAF's ability to sell a portion
or all of the Common Stock owned by it at some future date (subject to certain
limitations under tax and securities laws). Any such sale may have an adverse
effect on the market price of the Common Stock. In addition, sales of shares of
Common Stock by CNA Surety or CNAF which result in a change of control may
affect the relationship between CNA Surety and CNAF. For instance, the trademark
license agreement between CNAF and CNA Surety allowing CNA Surety to use the
"CNA" name or some derivation thereof, is subject to termination by CNAF if a
change of control in CNA Surety occurs. Purchases of additional shares of Common
Stock by CNA Surety or CNAF could also have an impact on the market price of the
Common Stock; although CNA Surety and CNAF are subject to certain restrictions
on such purchases for a period of 18 months following the Merger Date. See
"Business of the Company."
17
<PAGE> 19
THE COMPANY
CNA Surety is an insurance holding company that, through its subsidiaries,
develops, markets and underwrites primarily surety bonds. The Company is the
largest publicly-traded insurance holding company focused exclusively on the
surety business and is one of the leading providers of surety products in the
United States. During 1997, the insurance companies now owned by the Company
wrote over $266 million of gross written premiums, $244 million of which
consisted of surety premiums. For the three months ended March 31, 1998, the
Company wrote over $63 million of gross written premiums, $57 million of which
consisted of surety premiums.
The Company was formed to facilitate the merger of the surety business of
CNAF with Capsure's insurance subsidiaries, Western Surety and USA. Management
believes that the Merger, which occurred on September 30, 1997, resulted in the
combination of three complementary surety businesses, each with distinct
strengths, product focuses and marketing strategies. The combination of these
businesses resulted in a single, larger entity focused on serving the needs of
virtually all segments of the surety market, in terms of the types of products
offered and the size of bonds available. Based on management's knowledge of the
industry, management believes that the Company now offers the broadest range of
surety products available in the marketplace and that the Company's branch
system and independent agency network are the most extensive in the surety
industry, the combination of which provides the Company with a competitive
marketing advantage.
Surety products, unlike the standard two-party insurance policy, are
three-party agreements in which the Company as 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. Sureties are generally entitled to recover from the principal any
losses and expenses paid to third parties.
The Company, through its principal insurance subsidiaries, Western Surety
and USA, underwrites a broad spectrum of surety bonds. Western Surety writes
small fidelity and non-contract bonds and E&O liability insurance. Management
believes that Western Surety is the largest writer of smaller commercial surety
bonds and attributes Western Surety's volume to its strong capabilities in
marketing, distribution and service. In addition, Western Surety underwrites
contract surety bonds, primarily for mid to large sized contract accounts, and
assumes, on a reinsurance basis, international surety and credit insurance
written by CNA Re (London). USA specializes in the underwriting of small
contract and commercial surety bonds. Western Surety and USA are currently rated
A+ (Superior) and A (Excellent), respectively, by A.M. Best. A.M. Best ratings
are based upon factors relevant to policyholders, agents, insurance brokers and
intermediaries and are not directed to the protection of investors.
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, many of
whom belong to the National Association of Surety Bond Producers. The Company
enjoys broad national distribution of its products through approximately 36,000
of the approximately 44,000 independent property and casualty insurance agencies
in the United States.
The Company's primary focus is on evaluating the risk and determining if
the principal meets its underwriting requirements for the bond. Accordingly, the
Company's surety bond premiums primarily reflect the type and class of risk and
related costs associated with both processing the bond transaction and
investigating the applicant including, if necessary, an analysis of the
applicant's creditworthiness and ability to perform.
The Company is led by an experienced management team with an average of
over twenty years of experience, whose core expertise is in surety underwriting
and claims management. Management's underwriting philosophy is disciplined and
focused on consistent underwriting profitability. The extent and sophistication
of underwriting activity, including the amount of bonding authority granted to
independent agents, varies depending on the class of business and the type of
bond. For example, contractor accounts and large commercial surety customers
undergo extensive credit, financial and managerial review and analysis on a
regular basis. Similarly, certain classifications of bonds, such as fiduciary
and court appeal bonds, also receive
18
<PAGE> 20
extensive underwriting. On the other hand, the Company requires comparatively
little underwriting information for certain low-exposure risks, such as notary
bonds. The Company's underwriting has resulted in combined ratios of 79.7%,
81.0% and 87.4%, excluding the effects of favorable loss reserve development,
for the three months ended March 31, 1998 and on a pro forma basis for the years
ended December 31, 1997 and 1996, respectively. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations . . ."
CNA Surety is a Delaware corporation which was formed for the purpose of
the Merger. Prior to the Merger, CNA Surety did not conduct any activities. Its
insurance subsidiaries are Western Surety, a South Dakota insurance corporation,
USA, a Texas insurance corporation, and Surety Bonding Company of America, a
South Dakota insurance corporation. The mailing address for CNA Surety's
principal executive offices is CNA Plaza, Chicago, Illinois, 60685; its
telephone number is (312) 822-5000.
USE OF PROCEEDS
The Common Stock being offered hereunder is being sold by the Selling
Stockholders. The Company will not receive any of the proceeds from the sales of
Common Stock by the Selling Stockholders, and will only receive proceeds from
the sale of Common Stock hereunder if and to the extent that the Over-Allotment
Option is exercised. In the event that the Underwriters elect to exercise their
Over-Allotment Option, the Company will sell to the Underwriters up to 628,219
shares of its Common Stock. The net proceeds to the Company from the Offering,
assuming exercise of the entire Over-Allotment Option (but excluding expenses of
this Offering estimated at $700,000), will be approximately $8,204,540. The
Company intends to use such proceeds for general corporate purposes. See
"Principal and Selling Stockholders" and "Underwriting."
DIVIDEND POLICY
Since its formation, CNA Surety has not paid any dividends to its
stockholders. The Board, however, recently adopted a new dividend policy and
intends to pay quarterly dividends, beginning with the fourth quarter of 1998.
The declaration and payment of dividends to holders of Common Stock, including
the amount and frequency of such dividends, is at the discretion of the Board
and depends upon many factors, including CNA Surety's financial condition,
operating characteristics, projected earnings and growth, capital requirements
of its insurance subsidiaries, debt service obligations and such other factors
as the Board deems relevant. The Company expects that the first quarterly
dividend, if declared and paid, will be approximately $0.08 per share.
As an insurance holding company, CNA Surety is dependent upon dividends and
other permitted payments from its insurance subsidiaries in order to pay cash
dividends, if any, as well as to pay operating expenses and meet debt service
requirements. The payment of dividends by the insurance subsidiaries are subject
to varying degrees of supervision by the insurance regulatory authorities in
South Dakota and Texas. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations . . . -- Liquidity and Capital Resources"
and "Risk Factors -- Holding Company Structure" and "-- Regulation."
19
<PAGE> 21
PRICE RANGE OF COMMON STOCK
CNA Surety's Common Stock is traded on the NYSE under the symbol "SUR." The
following table shows the range of high and low sales prices for shares of the
Common Stock as reported on the NYSE during the periods indicated. Prior to
September 30, 1997, shares of Common Stock were not publicly traded. The
reported last sales price of the Common Stock on the NYSE on July 8, 1998 was
$14 1/8.
<TABLE>
<CAPTION>
PRICE RANGE
OF COMMON STOCK
----------------
HIGH LOW
------ ------
<S> <C> <C>
1997
4th Quarter................................................. $16 1/2 $12 7/8
1998
1st Quarter................................................. $16 3/8 $14 1/3
2nd Quarter................................................. $16 3/4 $13
3rd Quarter through July 8, 1998............................ $15 1/16 $13 15/16
</TABLE>
The number of stockholders of record of Common Stock on June 1, 1998 was
approximately 2,000.
20
<PAGE> 22
SELECTED CONSOLIDATED FINANCIAL DATA
Following are selected financial data for the operations which merged to
form CNA Surety, including information with respect to CNA Surety, the
Predecessor Operations and Capsure. This information is provided to assist in
understanding and evaluating the historical financial information of the various
entities that comprise CNA Surety and is not necessarily indicative of the
future results of operations of CNA Surety. In addition, selected financial
information for CNA Surety, as if the Merger had been consummated on January 1,
1996 (pro forma financial data), has been provided to further assist in
understanding and evaluating the consolidated financial information of the
various entities that comprise CNA Surety.
SELECTED CONSOLIDATED PRO FORMA AND HISTORICAL FINANCIAL DATA OF CNA SURETY
The following financial information is provided for the operations that
combined to form CNA Surety for various time periods in 1997 and 1996 as if the
Merger had been consummated on January 1, 1996. Periods presented on this basis
are therefore marked "pro forma." This pro forma financial information gives
effect to the following: (i) adjustment to the Capsure statement of operations,
as reported, to reflect the income effects as if the $10 per share special cash
distribution paid on October 4, 1996 had been made on January 1, 1996; (ii)
consummation of the Merger and the related transactions and the contribution of
capital to, and the incurrence of additional debt by, CNA Surety; (iii) purchase
accounting adjustments to reflect Capsure's assets and liabilities at fair
value; (iv) estimated indirect and overhead expenses for the Predecessor
Operations; and (v) estimated interest expense related to the additional debt.
The pro forma financial information does not include the estimated net
investment income resulting from investment of Merger-related cash flows,
including (i) the $50 million debt proceeds, (ii) the $52.25 million capital
contribution from CCC; and (iii) collection of the receivable in the amount of
approximately $117 million from CCC. Information for the three months ended
March 31, 1998 is derived from the actual quarterly financial statements of CNA
Surety. This information is provided to assist in understanding and evaluating
the consolidated financial information of the various entities that comprise CNA
Surety and is not necessarily indicative of future results of operations of CNA
Surety. The selected consolidated pro forma and historical financial data set
forth below should be read in conjunction with the more detailed financial
information or financial statements and related notes included in this
Prospectus. See "Pro Forma Condensed Statement of Consolidated Operations."
21
<PAGE> 23
SELECTED CONSOLIDATED PRO FORMA AND HISTORICAL FINANCIAL DATA OF CNA SURETY
<TABLE>
<CAPTION>
THREE MONTHS ENDED
YEARS ENDED DECEMBER 31, MARCH 31,
------------------------- --------------------------
1996 1997 1997 1998
(PRO FORMA) (PRO FORMA) (PRO FORMA) (HISTORICAL)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C>
INCOME STATEMENT DATA:
Total revenues(1)(2)......................... $250,194 $258,682 $ 59,338 $65,534
======== ======== ======== =======
Gross written premiums....................... $251,414 $266,418 $ 59,779 $63,848
======== ======== ======== =======
Net written premiums......................... $235,186 $257,067 $ 56,128 $61,836
======== ======== ======== =======
Net earned premiums.......................... $238,330 $243,425 $ 56,125 $58,745
Net losses and LAE(3)........................ 41,450 5,648 (26,384) 11,218
Net commissions, brokerage and other......... 150,198 150,631 36,328 35,039
-------- -------- -------- -------
Underwriting income(3)....................... 46,682 87,146 46,181 12,488
Net investment income(2)..................... 10,796 14,534 3,126 6,789
Net investment gains......................... 1,068 723 87 --
Interest expense............................. 7,660 7,232 1,765 1,821
Non-recurring charges and Merger costs(4).... 8,565 12,087 -- --
Amortization of intangible assets............ 5,788 5,788 1,447 1,475
-------- -------- -------- -------
Income before income taxes(2)(3)............. 36,533 77,296 46,182 15,981
Income taxes................................. 14,101 42,921 16,771 6,166
-------- -------- -------- -------
Net income(2)(3)............................. $ 22,432 $ 34,375 $ 29,411 $ 9,815
======== ======== ======== =======
Basic and diluted net income per
share(2)(3)................................ $ 0.52 $ 0.79 $ 0.68 $ 0.23
======== ======== ======== =======
OPERATING DATA:
Loss ratio(3)................................ 17.4% 2.3% (47.0)% 19.1%
Expense ratio................................ 63.0 61.9 64.7 59.6
-------- -------- -------- -------
Combined ratio(3)............................ 80.4% 64.2% 17.7% 78.7%
======== ======== ======== =======
</TABLE>
- ---------------
(1) Includes net earned premiums, net investment income and net investment
gains.
(2) Pro forma investment income for the years ended December 31, 1996 and 1997
and for the three months ended March 31, 1997 does not include the pro forma
effects of estimated investment income resulting from the investment of
Merger-related cash flows as described in the introduction to this table. If
proceeds from these sources of funds were assumed to be invested in
high-quality, taxable fixed income securities with an average duration of
approximately 3 years, yielding 6.4%, net investment income would increase
approximately $14,200 (approximately $9,200 net of income taxes, or $0.21 in
pro forma earnings per share) and approximately $11,300 (approximately
$7,300 net of income taxes, or $0.17 in pro forma earnings per share) for
the years ended December 31, 1996 and 1997, respectively, and approximately
$3,700 (approximately $2,400 net of income taxes, or $0.05 in pro forma
earnings per share) for the three months ended March 31, 1997.
(3) Includes the effect of recording releases of prior years' loss reserves. The
dollar amount and percentage point effect on the loss ratio of these reserve
reductions were $16,642 or 7.0 percentage points and $40,886 or 16.8
percentage points for the years ended December 31, 1996 and 1997,
respectively, and $36,900 or 65.7 percentage points and $581 or 1.0
percentage point for the three months ended March 31, 1997 and 1998,
respectively. The after tax per share effects of recording these reserve
reductions were $0.25 and $0.61 per share for the years ended December 31,
1996 and 1997, respectively, and $0.55 and $0.01 per share for the three
months ended March 31, 1997 and 1998, respectively.
(4) Capsure incurred approximately $2,200, after applicable income taxes, or
$0.51 per share, in Merger-related costs in 1997 compared to approximately
$5,700, after applicable income taxes, or $0.13 per share in non-recurring
charges and Merger costs in 1996. In the fourth quarter of 1996, Capsure
incurred approximately $1,100, after applicable income taxes, or $0.03 per
share, in non-recurring Merger costs.
22
<PAGE> 24
SELECTED CONSOLIDATED HISTORICAL FINANCIAL DATA OF CNA SURETY
The following selected consolidated historical financial information for
CNA Surety at and for periods subsequent to the Merger should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations . . ." and the more detailed information or financial
statements of CNA Surety included elsewhere in this Prospectus.
<TABLE>
<CAPTION>
SEPTEMBER 30,
(DATE OF INCEPTION)
THROUGH THREE MONTHS ENDED
DECEMBER 31, MARCH 31,
------------------- ------------------
1997 1998
(AMOUNTS IN THOUSANDS, EXCEPT
PERCENTAGES AND PER SHARE DATA)
<S> <C> <C>
INCOME STATEMENT DATA:
Total revenues.............................................. $ 71,284 $ 65,534
======== ========
Gross written premiums...................................... $ 75,252 $ 63,848
======== ========
Net written premiums........................................ $ 73,989 $ 61,836
======== ========
Net earned premiums......................................... $ 65,433 $ 58,745
Net losses and LAE(1)....................................... 12,134 11,218
Net commissions, brokerage and other........................ 38,213 35,039
-------- --------
Underwriting income(1)...................................... 15,086 12,488
Net investment income....................................... 5,766 6,789
Net investment gains........................................ 85 --
Interest expense............................................ 1,831 1,821
Amortization of intangible assets........................... 1,447 1,475
-------- --------
Income before income taxes(1)............................... 17,659 15,981
Income taxes................................................ 6,663 6,166
-------- --------
Net income(1)............................................... $ 10,996 $ 9,815
======== ========
Basic weighted average shares outstanding................... 43,302 43,348
======== ========
Basic and diluted net income per share...................... $ 0.25 $ 0.23
======== ========
OPERATING DATA:
Loss ratio(1)............................................... 18.5% 19.1%
Expense ratio............................................... 58.4 59.6
-------- --------
Combined ratio(1)........................................... 76.9% 78.7%
======== ========
BALANCE SHEET DATA:
Invested assets and cash.................................... $419,667 $427,599
Intangible assets, net of amortization...................... 161,962 160,487
Total assets................................................ 727,180 740,871
Insurance reserves.......................................... 304,217 309,620
Long-term debt.............................................. 118,000 118,000
Total liabilities........................................... 470,448 474,348
Stockholders' equity........................................ 256,732 266,523
Statutory surplus........................................... 142,429 144,849
Book value per share........................................ 5.93 6.14
</TABLE>
- ---------------
(1) Includes the effect of recording releases of prior years' loss reserves. The
dollar amount and the percentage point effect on the loss ratio of these
reserve revisions was $647 or 1.0 percentage point for the period from
September 30, 1997 (date of inception) through December 31, 1997 and $581 or
1.0 percentage point for the three months ended March 31, 1998.
23
<PAGE> 25
SELECTED CONSOLIDATED FINANCIAL DATA OF PREDECESSOR OPERATIONS
The following selected consolidated financial information for the
Predecessor Operations is derived from and should be read in conjunction with
the more detailed information or interim and annual financial statements of the
Predecessor Operations included elsewhere in this Prospectus. The selected
financial information of the Predecessor Operations does not include data with
respect to assets, liabilities (other than insurance reserves) and equity
because CNAF did not customarily allocate the investment portfolio or equity of
its operating subsidiaries to business units like the Predecessor Operations.
<TABLE>
<CAPTION>
THREE
MONTHS NINE MONTHS
ENDED ENDED
YEARS ENDED DECEMBER 31, MARCH 31, SEPTEMBER 30,
----------------------------------------- --------- -------------
1993 1994 1995(1) 1996 1997 1997
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
INCOME STATEMENT DATA:
Total revenues............................. $ 72,632 $ 77,981 $130,603 $149,069 $ 33,829 $108,564
======== ======== ======== ======== ======== ========
Gross written premiums..................... $ 88,040 $ 94,182 $136,605 $155,208 $ 33,042 $116,075
======== ======== ======== ======== ======== ========
Net written premiums....................... $ 73,005 $ 82,064 $122,012 $143,904 $ 30,480 $108,630
======== ======== ======== ======== ======== ========
Net earned premiums........................ $ 72,632 $ 77,981 $130,603 $149,069 $ 33,829 $108,564
Net losses and LAE(2)...................... 12,508 8,580 32,440 33,006 (27,612) (11,516)
Amortization of deferred policy acquisition
costs.................................... 27,928 34,202 58,243 66,382 14,753 48,075
Other direct expenses(3)................... 6,029 6,716 11,840 13,268 3,996 10,173
Policyholders' dividends................... 1,005 1,009 1,508 1,965 814 1,426
-------- -------- -------- -------- -------- --------
Excess of net earned premiums over direct
operating expenses before income
taxes(2)(3).............................. $ 25,162 $ 27,474 $ 26,572 $ 34,448 $ 41,878 $ 60,406
======== ======== ======== ======== ======== ========
OPERATING DATA:
Loss ratio(2).............................. 17.2% 11.0% 24.8% 22.1% (81.6)% (10.6)%
Expense ratio(3)........................... 48.2 53.8 54.8 54.8 57.8 55.0
-------- -------- -------- -------- -------- --------
Combined ratio(2)(3)....................... 65.4% 64.8% 79.6% 76.9% (23.8)% 44.4%
======== ======== ======== ======== ======== ========
BALANCE SHEET DATA:
Insurance reserves(4)...................... $112,764 $111,695 $239,716 $214,828 $177,586 $183,491
</TABLE>
- ---------------
(1) CNAF acquired CIC in May 1995. Results include the surety operations of CIC
since its acquisition in May 1995 which affects the comparability of
financial information.
(2) Includes the effect of recording releases of prior year loss reserves. The
dollar amount and the percentage point effect on the loss ratio of these
reserve reductions, were $8,454 or 10.8 percentage points, $10,846 or 8.3
percentage points and $9,742 or 6.5 percentage points for the years ended
December 31, 1994, 1995 and 1996, respectively, $35,000 or 103.5 percentage
points for the three months ended March 31, 1997 and $35,000 or 32.2
percentage points for the nine months ended September 30, 1997.
(3) Does not include the effects of certain general and administrative expenses,
which are indirect or overhead in nature, since such costs were not
historically allocated to the Predecessor Operations by CNAF or its
subsidiaries. Accordingly, the comparability of this data or other data that
include such costs is affected.
(4) The insurance reserves include both loss and LAE and unearned premium
reserves. These reserves are shown before the effects of ceded reinsurance.
In accordance with the Reorganization Agreement and related reinsurance
agreements, these reserves, as of the Merger Date, were transferred to
Western Surety, net of reinsurance which totaled $28,362, $21,098, $31,060
and $21,779 at December 31, 1993, 1994, 1995 and 1996, respectively, $20,848
for the three months ended March 31, 1998 and $9,979 for the nine months
ended September 30, 1997.
24
<PAGE> 26
SELECTED CONSOLIDATED FINANCIAL DATA OF CAPSURE
The following financial information should be read in conjunction with
Capsure's consolidated financial statements and the notes thereto, for each of
the three years in the period ended December 31, 1996, included elsewhere in
this Prospectus.
<TABLE>
<CAPTION>
THREE
MONTHS
ENDED
YEARS ENDED DECEMBER 31, MARCH 31,
---------------------------------------------- ---------
1993 1994(1)(2) 1995 1996(3) 1997
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
INCOME STATEMENT DATA:
Total revenues........................................ $107,915 $112,555 $117,510 $110,650 $ 25,509
======== ======== ======== ======== ========
Gross written premiums................................ $100,775 $102,356 $111,398 $107,269 $ 26,737
======== ======== ======== ======== ========
Net written premiums.................................. $ 88,306 $ 90,578 $ 97,728 $ 95,109 $ 25,648
======== ======== ======== ======== ========
Net earned premiums................................... $ 86,029 $ 92,481 $ 98,692 $ 92,491 $ 22,296
Underwriting income................................... $ 15,224 $ 15,233 $ 44,831 $ 19,233 $ 5,691
Net investment income................................. 19,815 19,129 20,471 16,444 3,126
Net investment gains (losses)......................... 2,071 945 (1,653) 1,715 87
Interest expense...................................... 6,280 4,726 4,103 1,717 1,003
Write-off of unamortized deferred loan fees(4)........ -- 1,556 -- 700 --
Non-recurring compensation and Merger costs(5)........ -- -- -- 7,865 --
Amortization and impairment of goodwill and
intangibles(6)...................................... 3,407 3,365 16,853 2,761 698
Other expenses, net................................... 1,905 1,881 2,442 2,789 668
-------- -------- -------- -------- --------
Income before income taxes............................ 25,518 23,779 40,251 21,560 6,535
Income taxes.......................................... 9,234 9,401 19,721 8,181 2,722
-------- -------- -------- -------- --------
Net income (loss)..................................... $ 16,284 $ 14,378 $ 20,530 $ 13,379 $ 3,813
======== ======== ======== ======== ========
OPERATING DATA:
Loss ratio(7)......................................... 23.2% 25.2% (7.5)% 10.9% 5.5%
Expense ratio......................................... 59.1 58.3 62.1 68.3 69.0
-------- -------- -------- -------- --------
Combined ratio(7)..................................... 82.3% 83.5% 54.6% 79.2% 74.5%
======== ======== ======== ======== ========
BALANCE SHEET DATA:
Invested assets and cash(2)........................... $317,077 $305,898 $307,556 $165,268 $166,381
Intangible assets, net of amortization................ 85,566 102,130 84,158 75,956 75,253
Total assets.......................................... 530,075 553,370 514,768 313,139 315,489
Insurance reserves.................................... 205,188 225,671 202,842 108,444 111,327
Long-term debt........................................ 85,214 71,000 25,000 60,000 59,000
Total liabilities..................................... 322,450 328,505 257,464 190,556 190,358
Stockholders' equity(2)(3)............................ 207,625 224,865 257,304 122,583 125,131
</TABLE>
- ---------------
(1) Capsure acquired USA in September 1994. The inclusion of the results of USA
since the date of its acquisition affects the comparability of financial
information.
(2) Effective January 1, 1994, Capsure adopted Statement of Financial Accounting
Standards ("FAS") No. 115.
(3) Capsure disposed of United Capitol Holding Company and its subsidiaries
(collectively, "United Capitol") on May 22, 1996. The inclusion of the
results of United Capitol through May 22, 1996 and the payment of a $10.00
per share ($156,248) special cash distribution on October 4, 1996 effects
the comparability of financial information.
(4) Capsure incurred a $700 charge in 1996 related to the refinancing of its
revolving credit facility and a similar charge of $1,556 in 1994 for the
early retirement of bank term loans.
(5) Capsure incurred a non-recurring compensation charge of $6,341 in 1996 for
the repricing of all outstanding common stock options in connection with a
$10.00 per share special cash distribution paid on October 4, 1996 and an
additional $1,524 in non-recurring Merger-related expenses.
(6) Amortization and impairment of goodwill and intangibles for 1995 included a
write-down of approximately $13,200 of goodwill associated with the 1990
United Capitol acquisition to reflect the estimated net realizable value on
the sale of those operations.
(7) Capsure's incurred losses and LAE in 1995 were reduced by approximately
$29,100, net of reinsurance, as a result of favorable claim settlements and
certain changes in estimates relating to insured events of prior years, of
which approximately $23,200, net of reinsurance, related to United Capitol.
25
<PAGE> 27
PRO FORMA CONDENSED STATEMENT OF CONSOLIDATED OPERATIONS
BASIS OF PREPARATION
The following Pro Forma Condensed Statement of Consolidated Operations for
the year ended December 31, 1997 reflects the effects of the Merger and various
transactions related to the Merger as if the Merger had been consummated on
January 1, 1996. This pro forma financial statement gives effect to the
following, all of which are set forth in greater detail in the explanatory notes
to the pro forma financial statements: (i) adjustment to the Capsure statement
of operations, as reported, to reflect the income effects as if a $10 per share
($156.2 million) special cash distribution paid on October 4, 1996 had been made
on January 1, 1996; (ii) consummation of the Merger and the related transactions
and the contribution of capital to, and the incurrence of additional debt by,
CNA Surety; (iii) purchase accounting adjustments to reflect Capsure's assets
and liabilities at fair value; (iv) estimated indirect and overhead expenses for
the Predecessor Operations; and (v) estimated interest expense related to the
additional debt. This Pro Forma Condensed Statement of Consolidated Operations
is the source for the pro forma financial data for the year ended December 31,
1997 which is set forth in the Summary Consolidated Pro Forma and Historical
Financial Data and the Selected Consolidated Pro Forma Historical Financial Data
which are included elsewhere in this Prospectus. The adjustments necessary for
deriving the pro forma results of operations for the year ended December 31,
1996 and the three months ended March 31, 1997 are similar to the adjustments
described above and, therefore, pro forma condensed statements of operations for
these periods are not presented herein.
The accompanying Pro Forma Condensed Statement of Consolidated Operations
does not include the estimated net investment income resulting from investment
of Merger-related cash flow, including (i) the $50 million debt proceeds drawn
by CNA Surety under the Credit Facility and contributed to Western Surety, (ii)
the $52.25 million capital contribution from CCC, and (iii) collection of the
receivable in the amount of approximately $117 million from CCC. Investment
earnings are an integral part of an insurance entity's operations. If proceeds
from these sources of funds were assumed to be invested in high-quality, taxable
fixed income securities with an average duration of approximately 3 years,
yielding 6.4%, net investment income would increase approximately $11.3 million
($7.3 million net of tax, or $0.17 in pro forma earnings per share) for the year
ended December 31, 1997.
PURCHASE ACCOUNTING
The Merger has been accounted for by CNA Surety as an acquisition of
Capsure, using purchase accounting. Accordingly, the assets and liabilities of
Capsure which form the basis of measuring subsequent results of operations were
reflected at their estimated fair value as of the assumed acquisition date. The
purchase price was $182.1 million, which is based on the traded market price of
shares of Capsure common stock of $11.00 per share, the estimated fair market
value of the Capsure Options and the estimated Merger-related costs of the
Predecessor Operations.
LIMITATIONS AND INSTRUCTIONS
The Pro Forma Condensed Statement of Consolidated Operations should be read
in conjunction with the accompanying explanatory notes, the financial statements
of Capsure and Predecessor Operations and the notes thereto, and the other
financial information pertaining to Capsure and Predecessor Operations included
in this Prospectus. The Pro Forma Condensed Statement of Consolidated Operations
is intended for information purposes only and is not necessarily indicative of
the results of operations which would have been achieved and reported had the
Merger and related transactions been consummated on the date assumed, nor is it
necessarily indicative of the future consolidated operating results of CNA
Surety.
26
<PAGE> 28
CNA SURETY
PRO FORMA CONDENSED STATEMENT OF CONSOLIDATED OPERATIONS
YEAR ENDED DECEMBER 31, 1997
(UNAUDITED)
<TABLE>
<CAPTION>
CNA SURETY
------------------------------------------
SEPTEMBER 30,
NINE MONTHS ENDED (DATE OF
SEPTEMBER 30, 1997 INCEPTION)
---------------------- THROUGH PRO FORMA PRO FORMA
PREDECESSOR DECEMBER 31, ACCOUNTING CONDENSED
CAPSURE OPERATIONS 1997 ADJUSTMENTS CONSOLIDATED
-------- ----------- ------------- ----------- ------------
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
Revenues:
Net earned premiums.............. $ 69,428 $108,564 $65,433 $ -- $243,425
Net investment income............ 8,768 -- 5,766 -- 14,534*
Net investment gains............. 638 -- 85 -- 723
-------- -------- ------- ------- --------
Total revenues................ 78,834 108,564 71,284 -- 258,682
-------- -------- ------- ------- --------
Expenses:
Net losses and LAE............... 5,030 (11,516) 12,134 -- 5,648
Net commissions, brokerage and
other underwriting............ 50,585 59,392 38,213 2,441a 150,631
Interest expense................. 2,961 -- 1,831 2,440b 7,232
Non-recurring charges and Merger-
related costs................. 12,087 -- -- -- 12,087
Amortization of intangible
assets........................ 2,094 282 1,447 1,965c 5,788
-------- -------- ------- ------- --------
Total expenses................ 72,757 48,158 53,625 6,846 181,386
-------- -------- ------- ------- --------
Income before income taxes......... 6,077 60,406 17,659 (6,846) 77,296
Income taxes....................... 16,995 21,241 6,663 (1,978)a,b 42,921
-------- -------- ------- ------- --------
Net income (loss).................. $(10,918) $ 39,165 $10,996 $(4,868)* $ 34,375*
======== ======== ======= ======= ========
Basic weighted average shares
outstanding...................... 43,302 43,302
======= ========
Diluted weighted average shares
outstanding...................... 43,552 43,552
======= ========
Basic net income per share......... $ 0.25 $ 0.79*
======= ========
Diluted net income per share....... $ 0.25 $ 0.79*
======= ========
</TABLE>
- ---------------
* Amounts do not include the estimated investment income that would have been
earned by the Predecessor Operations. See Note 2 to Pro Forma Condensed
Statement of Consolidated Operations.
SEE BASIS OF PREPARATION, PURCHASE ACCOUNTING, LIMITATIONS AND INSTRUCTIONS,
AND NOTES TO PRO FORMA CONDENSED STATEMENT OF CONSOLIDATED OPERATIONS.
27
<PAGE> 29
NOTES TO PRO FORMA CONDENSED STATEMENT OF CONSOLIDATED OPERATIONS
NOTE 1. MERGER AND PURCHASE ACCOUNTING ADJUSTMENTS
The Predecessor Operations and Capsure merged their operations on September
30, 1997 into CNA Surety according to terms and conditions discussed elsewhere
in this Prospectus.
This transaction has been accounted for by CNA Surety as an acquisition of
Capsure, using purchase accounting. The purchase price for Capsure has been
allocated to Capsure's assets that were acquired and to Capsure's liabilities
that were assumed based on the estimated fair value of such assets and
liabilities at the Merger Date. The purchase price for the outstanding shares of
Capsure common stock was determined as follows (dollars in thousands, except per
share data):
<TABLE>
<S> <C>
Traded value of Capsure shares to be exchanged at $11.00 per
share..................................................... $178,177
Value of Capsure options.................................... 2,527
Predecessor Operations' Merger-related costs................ 1,358
--------
Total purchase price........................................ $182,062
========
</TABLE>
The purchase price was allocated as follows (dollars in thousands):
<TABLE>
<S> <C>
Capsure net assets at historical cost....................... $100,875
Fair value adjustments:
Purchased intangibles..................................... (73,844)
Intangibles arising from Merger........................... 155,031
--------
Purchase price.............................................. $182,062
========
</TABLE>
Pro Forma Condensed Statement of Consolidated Operations
The Pro Forma Condensed Statement of Consolidated Operations gives effect
to the adjustments necessary to reflect the Merger and other transactions as if
the Merger and the other transactions had occurred on January 1, 1997. Those
adjustments and their effects on revenues, expenses, income taxes and net income
for the nine months ended September 30, 1997 which preceded the Merger are
summarized and explained below (dollars in following table and footnotes in
thousands, except per share amounts). Results of operations from September 30,
1997 through December 31, 1997 which comprise the remainder of 1997 are derived
from the actual financial statements of CNA Surety.
<TABLE>
<CAPTION>
INCOME NET
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 REVENUES EXPENSES TAXES INCOME
- -------------------------------------------- -------- -------- ------- -------
ADD (SUBTRACT)
<S> <C> <C> <C> <C>
Pro forma adjustments:
(a) Record the expense effects of estimated indirect and
overhead expenses allocable to the Predecessor
Operations.(1)...................................... $ -- $2,441 $ (854) $(1,587)
(b) Record the estimated interest expense adjustment(2)
related to the total pro forma debt................. -- 2,440 (854) (1,586)
(c) Record additional amortization of intangible assets
resulting from the Merger and related transactions,
using useful lives of 20 to 30 years................ -- 1,965 (270) (1,695)
------- ------ ------- -------
Total pro forma adjustments................... $ -- $6,846 $(1,978) $(4,868)
======= ====== ======= =======
</TABLE>
(1) The estimate of overhead and other indirect expenses of $2,441 for the nine
months ended September 30, 1997 (Merger Date) was determined pursuant to the
terms of the Administrative Services Agreement and assumes that all services
offered thereunder were purchased by CNA Surety. The estimated cost of such
services was based on the rates set forth in the Administrative Services
Agreement and
28
<PAGE> 30
NOTES TO PRO FORMA CONDENSED STATEMENT OF CONSOLIDATED OPERATIONS (CONTINUED)
management's best estimate of usage of each of the services to be provided,
without giving effect to any potential savings resulting from the Merger.
CNA Surety is under no obligation to purchase any services under the
Administrative Services Agreement.
(2) The estimated interest expense adjustment is comprised of (i) the interest
expense on the additional $63,000 of debt and (ii) the adjustment to
interest expense on Capsure's pre-Merger debt, based on the terms of the
Credit Facility. Based on the terms of the Credit Facility, the average
interest rates for the nine months ended September 30, 1997 (Merger Date)
would have been 5.86%.
NOTE 2. INVESTMENT INCOME
The accompanying Pro Forma Condensed Statement of Consolidated Operations
does not include the estimated net investment income resulting from investment
of Merger-related cash flow, including (i) the $50 million debt proceeds drawn
by CNA Surety under the Credit Facility and contributed to Western Surety, (ii)
the $52.25 million capital contribution from CCC, and (iii) collection of the
receivable in the amount of approximately $117 million from CCC. Investment
earnings are an integral part of an insurance entity's operations. If proceeds
from these sources of funds were assumed to be invested in high-quality, taxable
fixed income securities with an average duration of approximately 3 years,
yielding 6.4%, net investment income would increase by approximately $11.3
million ($7.3 million net of tax, or $0.17 in pro forma earnings per share) for
the year ended December 31, 1997.
NOTE 3. SIGNIFICANT NON-RECURRING CHARGES
Capsure incurred $22.0 million, after applicable income taxes, or $0.51 per
share, in Merger-related costs during the nine months ended September 30, 1997.
Income tax expense for this nine month period for Capsure includes the effects
of the limitations placed on CNA Surety's ability to utilize Capsure's NOL
carryforwards to offset future taxable income.
29
<PAGE> 31
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS OF CNA SURETY AND OF THE STATEMENT OF CERTAIN
ASSETS AND LIABILITIES AND THE STATEMENTS OF CERTAIN REVENUES AND
DIRECT OPERATING EXPENSES OF THE PREDECESSOR OPERATIONS
GENERAL
The following is a discussion and analysis of CNA Surety and its insurance
subsidiaries' operating results, financial condition, liquidity and capital
resources as well as a discussion of the Predecessor Operations' special purpose
Statement of Certain Assets and Liabilities and special purpose Statements of
Certain Revenues and Direct Operating Expenses. This discussion should be read
in conjunction with the Consolidated Financial Statements of CNA Surety and
notes thereto and the Statement of Certain Assets and Liabilities and Statements
of Certain Revenues and Direct Operating Expenses and the related notes thereto
of the Predecessor Operations.
FORMATION OF CNA SURETY AND MERGER
Pursuant to the Merger, CNAF and Capsure combined the surety business of
CNAF, referred to herein as the Predecessor Operations, with Capsure's principal
insurance subsidiaries, Western Surety and USA, under the control of a
newly-formed holding company, CNA Surety. CIC and CCC were the principal
operating subsidiaries of CNAF that wrote the surety line of business for their
own account prior to the Merger. CIC was acquired by CNAF on May 10, 1995.
Pursuant to the Reorganization Agreement, the Predecessor Operations and
Capsure's insurance businesses were merged on the Merger Date. CNAF, through its
property and casualty subsidiaries, CCC and CIC, contributed $52.25 million of
capital to CNA Surety. Through reinsurance agreements, CCC and CIC ceded to
Western Surety all of their net unearned premiums and loss and LAE reserves, as
of the Merger Date, and will cede to Western Surety all surety business written
or renewed by CCC or CIC for a period of five years thereafter. Further, CCC and
CIC have assumed or agreed to assume the obligation for any adverse development
on recorded reserves for the Predecessor Operations as of the Merger Date, to
limit the loss ratio on certain defined business written by CNA Surety through
December 31, 2000 and to provide certain additional excess of loss reinsurance.
CCC also agreed to provide certain administrative services at specified rates,
subject to inflationary increases, for the three years after the Merger if CNA
Surety elects to purchase such services. See "Certain Relationships and Related
Transactions."
FINANCIAL STATEMENT PRESENTATION
As set forth in Note 1 to the Consolidated Financial Statements, the
results of the Predecessor Operations did not reflect investment income and
investment gains and losses. Additionally, certain general and administrative
expenses, which were indirect or overhead in nature, were not allocated to the
Predecessor Operations by CNAF. As a result of these factors and because the
Merger with Capsure significantly affected the combined organization, it is not
useful to compare CNA Surety results for the first quarter of 1998 to
Predecessor Operations results for the first quarter of 1997, and the CNA Surety
results from September 30, 1997 (date of inception) through December 31, 1997 to
Predecessor Operations results for the fourth quarter ended December 31, 1996.
Also, a comparison of the results of operations of the Predecessor Operations
for the nine months ended September 30, 1997 to the year ended December 31, 1996
would not be useful due to the different reporting periods of nine and twelve
months.
Accordingly, the remainder of this discussion and analysis is formatted to
compare information for CNA Surety for various time periods as if the Merger had
been consummated on January 1, 1996. Periods presented on this basis are
therefore marked "pro forma." This pro forma financial information gives effect
to the following: (i) adjustment to the Capsure statement of operations, as
reported, to reflect the income effects as if the $10 per share ($156.2 million)
special cash distribution paid on October 4, 1996 had been made on January 1,
1996; (ii) consummation of the Merger and the related transactions and the
contribution of capital to, and the incurrence of additional debt by, CNA
Surety; (iii) purchase accounting adjustments to reflect Capsure's assets and
liabilities at fair value; (iv) estimated indirect and overhead expenses for the
Predecessor
30
<PAGE> 32
Operations; and (v) estimated interest expense related to the additional debt.
The pro forma financial information does not include the estimated net
investment income resulting from investment of Merger-related cash flows,
including (i) the $50 million debt proceeds, (ii) the $52.25 million capital
contribution from CCC and (iii) collection of the receivable from CCC. See
"Selected Consolidated Pro Forma and Historical Financial Data of CNA Surety"
and "Pro Forma Condensed Statement of Consolidated Operations."
RESULTS OF OPERATIONS
ANALYSIS OF CNA SURETY RESULTS FOR THE THREE MONTHS ENDED MARCH 31, 1998
COMPARED TO THE PRO FORMA THREE MONTHS ENDED MARCH 31, 1997
The components of income for the Company for the three months ended March
31, 1998 and 1997 are summarized as follows:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
---------------------
1998 1997
(PRO FORMA)
(DOLLARS IN
THOUSANDS, EXCEPT PER
SHARE DATA)
<S> <C> <C>
Total revenues(1)........................................... $65,534 $59,338
======= =======
Underwriting income(2)...................................... $12,488 $46,181
Net investment income(1).................................... 6,789 3,126
Net investment gains........................................ -- 87
Interest expense............................................ 1,821 1,765
Amortization of intangible assets........................... 1,475 1,447
------- -------
Income before income taxes.................................. 15,981 46,182
Income taxes................................................ 6,166 16,771
------- -------
Net income.................................................. $ 9,815 $29,411
======= =======
Basic net income per share.................................. $ 0.23 $ 0.68
======= =======
</TABLE>
- ---------------
(1) Pro forma revenues and net investment income for the three months ended
March 31, 1997 do not include the pro forma effects of estimated investment
income resulting from investment of Merger-related cash flows. If proceeds
from these sources of funds were assumed to be invested in high-quality,
taxable fixed income securities with an average duration of approximately 3
years, yielding 6.4%, net investment income would increase approximately
$14,200 (approximately $9,200 net of income taxes, or $0.21 in pro forma
earnings per share) and approximately $11,300 (approximately $7,300 net of
income taxes, or $0.17 in pro forma earnings per share) for the years ended
December 31, 1996 and 1997, respectively, and approximately $3,700
(approximately $2,400 net of income taxes, or $0.05 in pro forma earnings
per share) for the three months ended March 31, 1997.
(2) Includes $581 of favorable reserve development for the three months ended
March 31, 1998. Includes $36,900 of favorable reserve development for the
three months ended March 31, 1997 of which $35,000 is related to the
Predecessor Operations and is principally related to accident years prior to
1996.
31
<PAGE> 33
Insurance Underwriting
Underwriting results for the Company for the three months ended March 31,
1998 and 1997 are summarized in the following table:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
----------------------
1998 1997
(PRO FORMA)
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Gross written premiums...................................... $ 63,848 $ 59,779
======== ========
Net written premiums........................................ $ 61,836 $ 56,128
======== ========
Net earned premiums......................................... $ 58,745 $ 56,125
Net losses and LAE(1)....................................... 11,218 (26,384)
Net commissions, brokerage and other........................ 35,039 36,328
-------- --------
Underwriting income......................................... $ 12,488 $ 46,181
======== ========
Loss ratio(1)............................................... 19.1% (47.0)%
Expense ratio............................................... 59.6 64.7
-------- --------
Combined ratio(1)........................................... 78.7% 17.7%
======== ========
</TABLE>
- ---------------
(1) Includes $581 of favorable reserve development for the three months ended
March 31, 1998. Includes $36,900 of favorable reserve development for the
three months ended March 31, 1997 of which $35,000 is related to the
Predecessor Operations and is principally related to accident years prior to
1996.
Premiums Written
CNA Surety primarily markets contract and commercial surety bonds. Contract
bonds guarantee obligations covered by a written agreement between two parties.
The most common types include bid, performance and payment bonds. The commercial
surety market includes numerous types of bonds categorized as court judicial,
court fiduciary, public official, license and permit, and many miscellaneous
bonds that include guarantees of financial performance. The Company also writes
fidelity bonds that cover losses arising from employee dishonesty and E&O
liability insurance.
Gross written premiums are shown in the table below:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
---------------------
1998 1997
(PRO FORMA)
(DOLLARS IN
THOUSANDS)
<S> <C> <C>
Commercial.................................................. $30,689 $28,166
Contract.................................................... 26,200 25,120
Fidelity.................................................... 4,434 4,241
E&O and other............................................... 2,525 2,252
------- -------
$63,848 $59,779
======= =======
</TABLE>
Gross written premiums increased 6.8%, or $4.1 million, in the first
quarter ended March 31, 1998 compared to the pro forma first quarter of 1997.
Commercial surety gross written premiums were up 9.0% in the first quarter of
1998 compared to pro forma first quarter 1997. The increase in commercial surety
premium was largely due to the Company's continued international expansion which
began in 1997. The Company assumed $2.5 million of international surety and
credit premiums in the first quarter of 1998 under a quota share reinsurance
treaty with CNA Re (London), an affiliate of CCC. Exclusive of the international
surety and credit business, commercial surety gross written premiums were
comparable to first quarter 1997. The
32
<PAGE> 34
contract business increased by 4.3% over first quarter 1997 results. The
fidelity and other business, primarily written by Western Surety, increased 7.2%
in the first quarter of 1998. These increases were primarily due to growth in
the small contract surety and other businesses marketed through the Western
Surety agency force.
Net written premiums are shown in the table below:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
---------------------
1998 1997
(PRO FORMA)
(DOLLARS IN
THOUSANDS)
<S> <C> <C>
Commercial.................................................. $30,257 $26,213
Contract.................................................... 25,240 23,963
Fidelity.................................................... 4,411 4,230
E&O and other............................................... 1,928 1,722
------- -------
$61,836 $56,128
======= =======
</TABLE>
For the quarter ended March 31, 1998, net written premiums increased 10.2%,
or $5.7 million, over the comparable period in 1997. Net written premiums were
up primarily due to a 15.4% increase in commercial surety business in the first
quarter of 1998. The increase in commercial net written premiums included the
aforementioned $2.5 million of assumed international surety and credit business
as well as the effects of increased net retentions of commercial surety risks
effective October 1, 1997. Net written premiums, exclusive of the international
business, increased 5.7% for the three months ended March 31, 1998. Net written
premiums for contract surety increased 5.3%, or $1.3 million, for the first
quarter of 1998. Net written premiums for fidelity and other lines increased
6.5% for the first quarter of 1998 to $6.3 million. These increases are
primarily due to growth in the small contract surety and other businesses
marketed through the Western Surety agency force.
Underwriting Income
Underwriting income was $12.5 million in the first quarter of 1998 compared
to $46.2 million in the pro forma first quarter of 1997. The first quarter 1997
results included a significant amount of favorable loss reserve development as
more fully described below.
Loss Ratio
The loss ratio for the first quarter 1998 was 19.1% compared to (47.0)% for
the pro forma first quarter of 1997. Excluding the impact of the favorable
reserve development of $0.6 million and $36.9 million in the first quarter of
1998 and 1997, respectively, the loss ratios would have been 20.1% and 18.7%,
respectively. The increase in the adjusted loss ratio was primarily associated
with the addition of the international surety and credit business, which is
characterized by relatively higher loss ratios than the Company's domestic
surety business. Approximately $35.0 million in favorable reserve development in
the first quarter of 1997 related to the Predecessor Operations. Based on the
Predecessor Operations' study of reserves, management determined that it had
been overly cautious in interpreting claim data and had discounted favorable
trends. Consistent with the Predecessor Operations' regular study of reserve
levels, the Predecessor Operations released $35.0 million of prior year reserves
in the first quarter of 1997. Approximately $33.0 million of this reserve
development related to CIC and principally to accident years prior to 1996.
Expense Ratio
The expense ratio decreased to 59.6% in the first quarter of 1998 compared
to 64.7% in the pro forma first quarter of 1997. The decline in the Company's
expense ratio for the quarter was largely due to the larger scale of the
combined organization as net earned premiums increased 4.7% for the quarter
while total underwriting expenses decreased 3.5%. The $1.3 million decline in
underwriting expenses on a pro forma basis for the quarter is not necessarily
indicative of a trend management expects to continue near term.
33
<PAGE> 35
Investment Income
Net investment income was $6.8 million for the first quarter of 1998
compared to $3.1 million for the pro forma first quarter of 1997. The increase
in investment income for the first quarter of 1998 was the result of higher
invested cash balances in the first quarter of 1998 which reflects the
investment of Merger-related cash flows. As described below, pro forma
investment income for the first quarter of 1997 does not include any estimate of
net investment income resulting from investment of Merger-related cash flows.
The average pretax yield was 6.5% for the three months ended March 31, 1998.
The unaudited pro forma financial information for the first quarter of 1997
does not include the estimated net investment income resulting from investment
of Merger-related cash flows, including (i) the $50 million of debt proceeds,
(ii) the $52.25 million capital contribution from CCC, and (iii) collection of
the receivable from CCC. Investment earnings are an integral part of an
insurance entity's operations. If proceeds from these sources of funds were
assumed to be invested in high-quality, taxable fixed income securities with an
average duration of approximately 3 years, yielding 6.4%, net investment income
would increase approximately $3.7 million ($2.4 million net of income taxes, or
$0.05 in pro forma earnings per share) for the three months ended March 31,
1997.
Analysis of Other Operations
Amortization of intangible assets was $1.5 million for the first quarter of
1998, compared to $1.4 million for pro forma first quarter ended March 31, 1997.
Intangible assets represent goodwill and identified intangibles arising from the
acquisition of Capsure and goodwill arising from the May 1995 acquisition of CIC
by CNAF that was allocated to the surety business of CIC. Intangible assets are
generally amortized over 30 years.
Interest expense for the first quarter of 1998 increased 3.2% compared to
the pro forma first quarter 1997. The weighted average interest rate was 5.8%
compared to 5.7% in the first quarter of 1997.
Income Taxes
Income tax expense was $6.2 million for the first quarter ended March 31,
1998 compared to $16.8 million for the pro forma first quarter of 1997 (which
includes approximately $12.9 million of income tax expense related to the $36.9
million favorable reserve development). The effective income tax rates for the
three months ended March 31, 1998 and 1997 were 38.6% and 36.3%, respectively.
ANALYSIS OF CNA SURETY RESULTS FOR THE PERIOD FROM SEPTEMBER 30, 1997 (DATE OF
INCEPTION) THROUGH DECEMBER 31, 1997 AND THE PRO FORMA THREE MONTHS ENDED
DECEMBER 31, 1996 AND PRO FORMA YEARS ENDED DECEMBER 31, 1997 AND 1996
A discussion of CNA Surety's results for the period from September 30, 1997
(date of inception) through December 31, 1997 compared to pro forma results of
operations for the comparative period in 1996 and a discussion of pro forma
results of operations for the years ended December 31, 1997 and 1996 follows.
The operating results of CNA Surety for the period from September 30, 1997 (date
of inception) through December 31, 1997 are hereinafter referred to as the
customarily subscribed terms "Three Months Ended" or "Fourth Quarter."
34
<PAGE> 36
The components of income for the Company for the three months and years
ended December 31, 1997 and 1996 are summarized as follows:
<TABLE>
<CAPTION>
THREE MONTHS ENDED YEARS ENDED
DECEMBER 31, DECEMBER 31,
--------------------- -------------------
1997 1996 1997 1996
(PRO FORMA) (PRO FORMA)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE
DATA)
<S> <C> <C> <C> <C>
Total revenues....................................... $71,284 $62,754 $258,682 $250,194
======= ======= ======== ========
Underwriting income.................................. $15,086 $ 8,989 $ 87,146 $ 46,682
Net investment income................................ 5,766 2,866 14,534 10,796
Net investment gains................................. 85 19 723 1,068
Interest expense..................................... 1,831 1,807 7,232 7,660
Non-recurring charges and Merger costs............... -- 1,524 12,087 8,565
Amortization of intangible assets.................... 1,447 1,447 5,788 5,788
------- ------- -------- --------
Income before income taxes........................... 17,659 7,096 77,296 36,533
Income taxes......................................... 6,663 2,751 42,921 14,101
------- ------- -------- --------
Net income........................................... $10,996 $ 4,345 $ 34,375 $ 22,432
======= ======= ======== ========
Basic and diluted net income per share............... $ 0.25 $ 0.10 $ 0.79 $ 0.52
======= ======= ======== ========
</TABLE>
Insurance Underwriting
Underwriting results for the Company for the three months and years ended
December 31, 1997 and 1996 are summarized in the following table:
<TABLE>
<CAPTION>
THREE MONTHS ENDED YEARS ENDED
DECEMBER 31, DECEMBER 31,
--------------------- -------------------
1997 1996 1997 1996
(PRO FORMA) (PRO FORMA)
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Gross written premiums............................... $75,252 $64,126 $266,418 $251,414
======= ======= ======== ========
Net written premiums................................. $73,989 $59,808 $257,067 $235,186
======= ======= ======== ========
Net earned premiums.................................. $65,433 $59,869 $243,425 $238,330
Net losses and LAE................................... 12,134 11,237 5,648 41,450
Net commissions, brokerage and other................. 38,213 39,643 150,631 150,198
------- ------- -------- --------
Underwriting income.................................. $15,086 $ 8,989 $ 87,146 $ 46,682
======= ======= ======== ========
Loss ratio........................................... 18.5% 18.8% 2.3% 17.4%
Expense ratio........................................ 58.4 66.2 61.9 63.0
------- ------- -------- --------
Combined ratio....................................... 76.9% 85.0% 64.2% 80.4%
----- ------- ------ ------
----- ------- ------ ------
</TABLE>
35
<PAGE> 37
Premiums Written
Gross written premiums are shown in the table below:
<TABLE>
<CAPTION>
THREE MONTHS ENDED YEARS ENDED
DECEMBER 31, DECEMBER 31,
--------------------- -------------------
1997 1996 1997 1996
(PRO FORMA) (PRO FORMA)
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Commercial........................................... $40,638 $27,490 $120,660 $105,401
Contract............................................. 29,185 31,639 123,014 124,477
Fidelity............................................. 3,495 3,404 15,762 15,134
E&O and other........................................ 1,934 1,593 6,982 6,402
------- ------- -------- --------
$75,252 $64,126 $266,418 $251,414
======= ======= ======== ========
</TABLE>
Gross written premiums increased 17.4%, or $11.1 million, in the fourth
quarter ended December 31, 1997 compared to the fourth quarter of 1996 and gross
written premiums increased 6.0%, or $15.0 million, for the year ended December
31, 1997 compared to 1996. These increases were primarily attributable to $10.1
million of international surety and credit business assumed in the fourth
quarter of 1997, as a result of the Company's initiative to more aggressively
expand its products and services into the international markets. In 1997, CNA
Surety expanded into the international surety and credit insurance market
through a quota share reinsurance treaty with CNA Re (London), an affiliate of
CCC. Commercial surety, exclusive of international surety and credit business,
increased 11.0% for the fourth quarter and 4.9% for the year ended December 31,
1997, respectively. The fidelity and other book of business, primarily written
by Western Surety, increased 8.6% and 5.6% in the fourth quarter and year ended
December 31, 1997, respectively. These increases in commercial surety and
fidelity and other business were offset by a decrease in contract surety
business of 7.8% in the fourth quarter and 1.2% for the full year ended December
31, 1997. The decreases in contract surety reflected the competitive pressures
primarily in the medium to large contract segment of the market and, to a lesser
extent, the timing of contractor accounts being awarded new business by their
customers.
Net written premiums are shown in the table below:
<TABLE>
<CAPTION>
THREE MONTHS ENDED YEARS ENDED
DECEMBER 31, DECEMBER 31,
--------------------- -------------------
1997 1996 1997 1996
(PRO FORMA) (PRO FORMA)
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Commercial........................................... $41,272 $25,157 $118,160 $ 97,407
Contract............................................. 27,836 30,170 118,138 118,268
Fidelity............................................. 3,516 3,395 15,750 15,090
E&O and other........................................ 1,365 1,086 5,019 4,421
------- ------- -------- --------
$73,989 $59,808 $257,067 $235,186
======= ======= ======== ========
</TABLE>
For the three months ended December 31, 1997, net written premiums
increased 23.7%, or $14.2 million, over the comparable period in 1996. For the
year ended December 31, 1997, net written premiums increased 9.3%, or $21.9
million, over the comparable period in 1996. Net written premiums were up
primarily due to a 21.3% increase in commercial surety business in 1997. The
increase in commercial net written premiums included the addition of the
aforementioned international surety and credit business as well as relatively
strong growth in Western Surety's core small commercial surety business
throughout 1997. Net written premiums, exclusive of the international business,
increased 6.8% and 5.0% for the three months and year ended December 31, 1997,
respectively. The rise in commercial net written premiums was offset by a
decrease in contract surety net written premiums as a result of the competitive
market conditions that exist in the contract surety market. Net written premiums
for contract surety decreased 7.7%, or $2.3 million, for the quarter and
36
<PAGE> 38
were down slightly for the year ended December 31, 1997. The Company also
renegotiated its reinsurance agreements with its reinsurers, increasing the
Company's net retention to $5.0 million per principal (e.g., the contractor on
contract surety bonds) on its commercial surety business. In the fourth quarter
of 1997, the Company received $3.8 million in previously ceded reinsurance
premiums from its reinsurers. Absent these returned premiums, domestic
commercial surety net written premiums were up 8.6% for the quarter and 7.0% for
the year.
Underwriting Income
Underwriting income increased 67.8% to $15.1 million from $9.0 million in
the fourth quarter of 1997 and increased 86.7% to $87.1 million from $46.7
million for the year ended December 31, 1997 as compared to the similar periods
in 1996. The period to period change in underwriting income and combined ratios
was due to fluctuations in both the loss and expense ratios as more fully
described below.
Loss Ratio
The loss ratio for the fourth quarter 1997 was 18.5% compared to 18.8% for
the pro forma fourth quarter of 1996. The loss ratio included approximately $0.6
million and $4.9 million, respectively, in favorable reserve development for the
three months ended December 31, 1997 and 1996, respectively.
The loss ratios for the years ended December 31, 1997 and 1996 were 2.3%
and 17.4%, respectively. Excluding the impact of the favorable reserve
development of $40.9 million and $16.6 million in 1997 and 1996, respectively,
the loss ratios would have been 19.1% and 24.4%, respectively. The decrease in
the adjusted loss ratio was due to the ongoing favorable economic trends that
continue to benefit the surety business in addition to the more disciplined
underwriting practices the Company applied to the book of business acquired from
CIC in May of 1995. Approximately $35.0 million in favorable reserve development
in 1997 related to the Predecessor Operations. Based on the Predecessor
Operations' study of reserves, management determined that it had been overly
cautious in interpreting claim data and had discounted favorable trends.
Consistent with the Predecessor Operations' regular study of reserve levels, the
Predecessor Operations released $35.0 million of prior year reserves in the
first quarter of 1997. Approximately $33.0 million of this reserve development
related to CIC and principally to accident years prior to 1996.
Expense Ratio
The expense ratio decreased to 58.4% in the fourth quarter of 1997 compared
to 66.2% in the pro forma fourth quarter of 1996. The decline in the Company's
expense ratio for the quarter was largely due to the larger scale of the
combined organization as net earned premiums advanced 9.3% for the quarter while
total underwriting expenses decreased 3.6%. The $1.4 million decline in
underwriting expenses on a pro forma basis for the quarter is not necessarily
indicative of a trend management expects to continue near term.
The expense ratio for the year ended December 31, 1997 decreased to 61.9%
from 63.0% for 1996. This decline in the Company's expense ratio was also
primarily due to the increased scale of the Company as net earned premiums
increased 2.1% and underwriting expenses increased only 0.3%.
Investment Income
Net investment income was $5.8 million for the fourth quarter of 1997
compared to $2.9 million for the pro forma fourth quarter of 1996. The average
pretax yield was 5.7% for the three months ended December 31, 1997. Pro forma
net investment income for the years ended December 31, 1997 and 1996 was $14.5
million and $10.8 million, respectively. Increases in investment income for the
quarter and in pro forma investment income for the year ended December 31, 1997
were the direct result of higher actual invested cash balances in the fourth
quarter of 1997 which reflected the investment of Merger-related cash flows.
However, pro forma investment income for periods prior to the Merger do not
include the pro forma effects of estimated net investment income resulting from
investment of Merger-related cash flows as described below.
37
<PAGE> 39
The foregoing pro forma financial information does not include the
estimated net investment income resulting from investment of Merger-related cash
flows, including (i) $50 million of debt proceeds, (ii) a $52.25 million capital
contribution from CCC and (iii) collection of the receivable from CCC.
Investment earnings are an integral part of an insurance entity's operations. If
proceeds from these sources of funds were assumed to be invested in
high-quality, taxable fixed income securities with an average duration of
approximately 3 years, yielding 6.4%, net investment income would increase
approximately $11.3 million ($7.3 million net of income taxes, or $0.17 in pro
forma earnings per share) for the year ended December 31, 1997, and
approximately $3.8 million ($2.5 million net of income taxes, or $0.06 in pro
forma earnings per share) and approximately $14.2 million ($9.2 million net of
income taxes, or $0.21 in pro forma earnings per share) for the three months and
year ended December 31, 1996, respectively.
Net realized investment gains were $0.1 million in the fourth quarter of
1997 and pro forma net realized investment gains were $0.7 million and $1.1
million for the years ended December 31, 1997 and 1996, respectively. Net
realized investment gains on securities held at Capsure's parent company were
$0.8 million for the year ended December 31, 1996.
Analysis of Other Operations
Amortization expense was $1.4 million for the fourth quarter of 1997 and
the pro forma fourth quarter of 1996 and was $5.8 million for the years ended
December 31, 1997 and 1996. Intangible assets represent goodwill and identified
intangibles arising from the acquisition of Capsure and goodwill arising from
the May 1995 acquisition of CIC by CNAF that was allocated to the surety
business of CIC. Intangible assets are generally amortized over 30 years.
Interest expense for the fourth quarter of 1997 increased 1.3% compared to
the pro forma fourth quarter 1996. While the average outstanding debt was down
to $117.3 million in the fourth quarter of 1997, the weighted average interest
rate was 5.9% compared to 5.6% in the pro forma fourth quarter of 1996. Pro
forma interest expense decreased 5.6%, or $0.4 million, for the year ended
December 31, 1997 compared to the prior year. This decrease was primarily due to
lower average outstanding debt of $119.2 million in 1997 compared to $124.7
million in 1996. The weighted average interest rate for the year ended December
31, 1997 was 5.8% compared to 5.7% for the year ended December 31, 1996.
Capsure incurred $22.0 million, after applicable income taxes, or $0.51 per
share, in Merger costs in 1997 compared to $5.7 million, after applicable income
taxes, or $0.13 per share in non-recurring charges and Merger costs in 1996. In
the fourth quarter of 1996, Capsure incurred $1.1 million, after applicable
income taxes, or $0.03 per share, in non-recurring Merger costs.
Income Taxes
Income tax expense was $6.7 million for the fourth quarter ended December
31, 1997. The effective income tax rate for the three months ended December 31,
1997 was 37.7%. Income taxes were $42.9 million and $14.1 million and the
effective income tax rates were 55.5% and 38.6% for the years ended December 31,
1997 and 1996, respectively. The effective rate for the full year 1997 reflects
the effects of limitations placed on CNA Surety's ability to utilize Capsure's
available net operating loss tax carryforwards ("NOLs") to offset future taxable
income.
38
<PAGE> 40
ANALYSIS OF PREDECESSOR OPERATIONS RESULTS FOR THE YEARS ENDED DECEMBER 31,
1996 AND 1995
Premiums Written
Net written premiums for the years ended December 31, 1996 and 1995 of the
Predecessor Operations throughout the period and of CIC subsequent to May 10,
1995 (the date of acquisition) are shown in the table below:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
----------------------------------
1996 1995
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Commercial.................................................. $ 40,459 $ 33,446
Contract.................................................... 103,445 88,566
--------------- ---------------
$ 143,904 $ 122,012
=============== ===============
</TABLE>
Changes in net written premiums during this period were primarily due to
the acquisition of CIC in May of 1995 and, in 1996, also due to changes in the
reinsurance programs. CIC net written premiums have been included for
approximately seven and one-half months in the 1995 results and have been
included for the full year in the 1996 results. The more significant changes in
the reinsurance programs were that contract surety retentions increased from
$3.0 million to $5.0 million per principal effective January 1, 1996. Similarly,
commercial bond retentions increased from $0.8 million to $3.0 million effective
January 1, 1996. These changes in the reinsurance arrangements were made as a
result of the larger capital base of the combined operations, and allowed the
Predecessor Operations to lower reinsurance costs and retain additional amounts
of surety premiums. The increase in retentions in 1996 accounted for
approximately 25% of the total 1996 increase in net written premiums.
Correspondingly, the increased retention by the Predecessor Operations, in part,
contributed to the reduction of ceded loss reserves which decreased from $24.5
million at December 31, 1995 to $15.5 million at December 31, 1996. Although the
Predecessor Operations' potential exposure increased as a result of the
increased retentions, the Predecessor Operations' management believed that,
based upon the favorable loss experience with respect to such business, the
retention of potentially profitable business offset such increased exposure.
Due to the significant effect of the CIC acquisition on premiums and
changes in the reinsurance programs, it is more meaningful to review gross
written premiums (premiums written before ceded premiums) during the periods
ended December 31, 1996 and 1995, for CCC and CIC, as if they had been combined
throughout this period:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
--------------------------------------
1996 1995
(PRO FORMA)
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Commercial............................................ $ 47,078 30.3% $ 50,588 30.9%
Contract.............................................. 108,130 69.7 113,255 69.1
-------- ----- -------- -----
$155,208 100.0% $163,843 100.0%
======== ===== ======== =====
</TABLE>
Gross written premiums in 1996 declined from the pro forma combined 1995
level by $8.6 million. This decrease was attributable in part to the continued
program that commenced in 1995 to re-underwrite the CIC book of business on an
account-by-account basis and remove business with unsatisfactory profit
potential and risk. To a lesser extent, a portion of the decrease is believed to
be due to considerable management attention focused on effecting and completing
the integration of CIC and CCC. The decrease in gross written premiums in 1996
was 5.3%; this percentage decline was less than half of the 1995 percentage
decrease.
39
<PAGE> 41
OPERATING RESULTS
The following table is a summary of the pretax operating results of the
Predecessor Operations and certain operating ratios for the years ended December
31, 1996 and 1995. These pretax operating results do not include investment
income, realized capital gains and losses, and certain indirect or overhead type
expenses.
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
1996 1995
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Net earned premiums......................................... $149,069 $130,603
Net losses and LAE.......................................... 33,006 32,440
Other direct costs and expenses(1).......................... 81,615 71,591
-------- --------
Excess of net earned premiums over direct
operating expenses before income taxes(1)................. $ 34,448 $ 26,572
======== ========
Large losses................................................ $ 14,900 $ 13,900
======== ========
Loss ratio.................................................. 22.1% 24.8%
Expense ratio(1)............................................ 54.8 54.8
-------- --------
Combined ratio(1)........................................... 76.9% 79.6%
======== ========
Effect of large losses on combined ratio.................... 10.0% 10.6%
======== ========
</TABLE>
- ---------------
(1) Does not include the effects of certain general and administrative expenses,
which are indirect or overhead in nature, since such costs were not
historically allocated to the Predecessor Operations by CNAF or its
subsidiaries.
The year-over-year change in the combined ratio was due to fluctuations in
the loss ratio as more fully discussed under "Loss Ratio" below.
Loss Ratio
The loss ratio was 22.1% in 1996, compared to 24.8% in 1995. Prior to the
CIC acquisition, the average loss ratio was approximately 17% for the last ten
years and 19% for the last 15 years. This decrease in the loss ratio in 1996
compared to 1995 was attributable in part to the continued program that
commenced in 1995 to re-underwrite the CIC book of business on an
account-by-account basis and remove business with unsatisfactory profit
potential and risk, in addition to more disciplined underwriting practices the
Company applied to the book of business acquired from CIC by CNAF in May of
1995. Also in 1996, large losses (individual claims which are in excess of $2.5
million, net of reinsurance) were $14.9 million in aggregate compared to $13.9
million in 1995. These large losses had the effect of increasing loss ratios for
1996 and 1995 by 10.0% and 10.6%, respectively.
Expense Ratio
The expense ratio was 54.8% in 1996, unchanged from 1995.
LIQUIDITY AND CAPITAL RESOURCES
The liquidity requirements of the Company are met primarily by funds
generated from operations. The principal cash flow sources are premiums,
investment income, and sales and maturities of investments. CNA Surety also may
generate funds from additional borrowings under the Credit Facility (as
hereinafter defined). The primary cash flow uses are payments for claims,
operating expenses, debt service on the Credit Facility, as well as dividends,
if any, to CNA Surety stockholders. In general, surety operations generate
premium collections from customers in advance of cash outlays for claims.
Premiums are invested until such time as funds are required to pay losses and
LAE.
40
<PAGE> 42
The Company believes that total invested assets, including cash and
short-term investments, are sufficient in the aggregate and have suitably
scheduled maturities to satisfy all policy claims and other operating
liabilities, including income tax sharing payments of its insurance
subsidiaries. At March 31, 1998, the carrying value of the Company's insurance
subsidiaries' invested assets and cash was $418.8 million, comprised of $389.4
million of fixed income securities, $19.9 million of short-term investments,
$6.0 million of other investments and $3.4 million of cash.
Cash flow at the CNA Surety level is derived principally from dividend and
tax sharing payments from its insurance subsidiaries. The principal obligations
at the parent company level are to service debt and pay operating expenses. At
March 31, 1998, the parent company's invested assets and cash were $8.8 million.
The Company's consolidated net cash flow provided by operating activities
was $12.5 million for the three months ended March 31, 1998. Consolidated
operating cash flow (pretax income excluding net investment gains and
amortization of intangibles assets) for the three months ended March 31, 1998
was $17.5 million.
The Company's consolidated net cash flow provided by operating activities
was $29.0 million for the three months ended December 31, 1997. Consolidated
operating cash flow (pretax income excluding net investment gains and
amortization of intangible assets) for the three months ended December 31, 1997
was $19.0 million.
The Company received $116.9 million in cash from CNAF on October 1, 1997.
This payment from CNAF reflects the effects of the reinsurance agreement whereby
CCC and CIC ceded all of their net unearned premiums and loss and LAE reserves
for their surety business to Western Surety as of the Merger Date.
CNA Surety's bank borrowings are under a five-year unsecured revolving
credit facility pursuant to a Credit Agreement, dated as of September 30, 1997,
among CNA Surety, the lender parties thereto and Chase Manhattan Bank, as
Administrative Agent (the "Credit Facility") which provides for borrowings of up
to $130 million. CNA Surety borrowed $105 million as of September 30, 1997 and
used the proceeds to retire the existing Capsure debt of approximately $54
million and to make a $50 million capital contribution to Western Surety. On
October 6, 1997, CNA Surety borrowed an additional $13 million to pay the $10.6
million closing dividend to Capsure stockholders and other Merger-related costs.
The interest rate on borrowings under the Credit Facility may be fixed, at
CNA Surety's option, for a period of one, two, three, or six months and is based
on, among other rates, the London Interbank Offered Rate ("LIBOR"), plus the
applicable margin. The margin, including the facility fee, varies based on CNA
Surety's leverage ratio (debt to total capitalization) and ranges from 0.25% to
0.40%. At March 31, 1998, the weighted average interest rate was 5.9% on the
$118.0 million of outstanding borrowings.
The Credit Facility contains, among other conditions, limitations on CNA
Surety with respect to the incurrence of additional indebtedness and requires
the maintenance of certain financial ratios. As of March 31, 1998, the Company
was in compliance with all restrictions and covenants contained in the Credit
Facility agreement. The Credit Facility provides for the payment of all
outstanding principal balances after five years with no required principal
payments prior to such time. Principal prepayments, if any, and interest
payments are expected to be funded primarily through dividends from CNA Surety's
insurance subsidiaries.
As an insurance holding company, CNA Surety is dependent upon dividends and
other permitted payments from its insurance subsidiaries to pay cash dividends,
if any, as well as to pay operating expenses and meet debt service requirements.
The payment of dividends by the insurance subsidiaries are subject to varying
degrees of supervision by the insurance regulatory authorities in South Dakota
and Texas. In South Dakota, where Western Surety is domiciled, insurance
companies may pay dividends only from earned surplus excluding surplus arising
from unrealized capital gains or revaluation of assets. In Texas, where USA is
domiciled, an insurance company may declare or pay dividends to stockholders
only from the insurer's earned surplus. The insurance subsidiaries may pay
dividends without obtaining prior regulatory approval only if such dividend or
distribution (together with dividends or distributions made within the preceding
12-month period) is less than, as of the end of the immediately preceding year,
the greater of (i) 10% of the insurer's surplus to policyholders and (ii)
statutory net income. In South Dakota, net income includes net realized capital
gains in
41
<PAGE> 43
an amount not to exceed 20% of net unrealized capital gains. All dividends must
be reported to the appropriate insurance department prior to payment.
The dividends that may be paid without prior regulatory approval are
determined by formulas established by the applicable insurance regulations, as
described above. The formulae that determine dividend capacity in the current
year are dependent on, among other items, the prior year's ending statutory
surplus and statutory net income. Accordingly, dividend capacity for 1998 does
not fully reflect the effects of the Merger. Dividend capacity for 1998 is based
on statutory surplus and income at and for the year ended December 31, 1997
which will only include the results of the Predecessor Operations for the period
from September 30, 1997 (date of inception) through December 31, 1997. Dividend
capacity for 1999 will be based on statutory surplus and income at and for the
year ended December 31, 1998 which will include the effects of the Predecessor
Operations for all of 1998. Without prior regulatory approval in 1998, CNA
Surety's insurance subsidiaries may pay dividends to the Company of $16.3
million in the aggregate. CNA Surety received $4.4 million and $5.0 million in
dividends from its insurance subsidiaries in the first quarter of 1998 and the
period from September 30, 1997 through December 31, 1997, respectively. Because
the Predecessor Operations were conducted through several wholly-owned insurance
subsidiaries of CNAF, and the surety business only represented a small portion
of the business of such subsidiaries, dividends paid by the insurance
subsidiaries to CNAF were not allocated among lines of insurance. Accordingly,
the amounts of dividends paid by the insurance subsidiaries to CNAF attributable
to the Predecessor Operations cannot be determined for years prior to the
Merger.
In accordance with the provisions of intercompany tax sharing agreements
between CNA Surety and its subsidiaries, the tax of each subsidiary shall be
determined based upon each subsidiary's separate return liability, as calculated
in accordance with the Internal Revenue Code of 1986, as amended (the "Code").
Intercompany tax payments are made at such times as estimated tax payments would
be required by the Internal Revenue Service ("IRS"). CNA Surety received tax
sharing payments from its subsidiaries of $1.6 million and $2.4 million in the
first quarter of 1998 and the period from September 30, 1997 through December
31, 1997, respectively.
CNA Surety management believes that it will have sufficient available
resources to meet its present capital needs.
FINANCIAL CONDITION
Investment Portfolio
The Company's policy is to invest primarily in fixed income securities with
high quality credit ratings. As of March 31, 1998, 100% of the Company's fixed
income securities were considered investment grade by The Standard & Poors
Corporation ("S&P") or Moody's Investor Services, Inc. ("Moody's"), and
approximately 84% were rated at least AA by those agencies. In addition, the
Company's investments in fixed income securities did not contain any significant
geographic or industry concentration of credit risk.
The following table sets forth the ratings assigned by S&P or Moody's of
the fixed income securities portfolio of the Company as of March 31, 1998.
<TABLE>
<CAPTION>
MARCH 31, 1998
-----------------------
CREDIT RATING FAIR VALUE PERCENT
------------- ----------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
AAA/Aaa..................................................... $302,482 77.7%
AA/Aa....................................................... 23,557 6.0
A/A......................................................... 51,286 13.2
BBB......................................................... 12,071 3.1
-------- -----
Total............................................. $389,396 100.0%
======== =====
</TABLE>
As of March 31, 1998, approximately 33% of the investment portfolio was
held in high-quality, short-duration mortgage pass-through instruments, CMOs and
other asset-backed securities. CMOs differ from
42
<PAGE> 44
traditional fixed income securities in that they may expose the investor to
yield variability and even principal risk due to such factors as high mortgage
prepayment rates and defaults and delinquencies in the underlying asset pool.
Management believes it has reduced prepayment variability by investing only in
short tranches and by owning a substantial amount of PAC tranches which have
been structured largely to insulate the investor from prepayment risk. A PAC
tranche is structured to amortize in a predictable manner and, thereby shift the
risk of prepayment of the underlying collateral to other tranches, whose owners
are willing to accept such risk. Further, management believes it has minimized
credit risk by generally purchasing securities rated "A" or better on the date
of acquisition and which are collateralized or guaranteed by U.S. Government
agencies or have substantial credit enhancement in the form of financial
guarantees, mortgage insurance, letters of credit, over-collateralization,
subordinated structures and excess servicing spreads. Management monitors the
investment portfolio of the insurance subsidiaries and the current rating of
each security owned on a monthly basis. See "Risk Factors -- Susceptibility to
Changes in Interest Rates and General Economic Conditions."
Reserves for Unpaid Losses and LAE
CNA Surety's insurance subsidiaries employ accepted reserving approaches in
establishing the estimated liability for unpaid losses and LAE that give
consideration to the inherent difficulty and variability in the estimation
process. In addition, CNA Surety utilizes independent actuarial firms of
national standing to conduct periodic reviews of claim procedures and loss
reserving practices, and annually obtains actuarial certification as to the
reasonableness of actuarial assumptions used and the sufficiency of year-end
reserves for each of its principal insurance subsidiaries.
The estimated liability for unpaid losses and LAE 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 LAE 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, known as
reserve development, are reflected in operating income in the year in which such
changes are determined to be needed. See "Business of the Company -- Reserves
for Unpaid Losses and LAE" and Note 8 of "Notes to Consolidated Financial
Statements."
Risk Based Capital and Other Regulatory Ratios
The National Association of Insurance Commissioners ("NAIC") has
promulgated Risk Based Capital ("RBC") requirements for property and casualty
insurance companies to evaluate on an annual basis the adequacy of statutory
capital and surplus in relation to investment and insurance risks such as asset
quality, loss reserve adequacy, and other business factors. The RBC information
is used by state insurance regulators as an early warning mechanism to identify
insurance companies that potentially are inadequately capitalized. In addition,
the formula defines new minimum capital standards that supplement the current
system of fixed minimum capital and surplus requirements on a state-by-state
basis. Regulatory compliance is determined by a ratio (the "Ratio") of the
enterprise's regulatory total adjusted capital, as defined by the NAIC, to its
authorized control level RBC, as defined by the NAIC. Generally, a Ratio in
excess of 200% of authorized control level RBC requires no corrective actions on
behalf of the company or regulators. As of December 31, 1997, each of CNA
Surety's insurance subsidiaries had a Ratio that was in excess of the minimum
RBC requirements.
CNA Surety's insurance subsidiaries require capital to support premium
writings. In accordance with industry and regulatory guidelines, the net written
premiums to surplus ratio of a property and casualty insurer should not exceed 3
to 1 (the terms of the Credit Facility also limit this ratio to 3 to 1 for
Western Surety and USA). On December 31, 1997, the Company had a combined
statutory surplus of $142.4 million. Western Surety's statutory surplus was
$128.7 million and its net written premiums to surplus ratio was 1.8 to 1. USA's
statutory surplus was $13.7 million and its net written premiums to surplus
ratio was 1.6 to 1. The Company
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<PAGE> 45
believes that each of its insurance subsidiary's statutory surplus is sufficient
to support its current and anticipated premium levels.
The NAIC has also developed a rating system, the Insurance Regulatory
Information System ("IRIS"), primarily intended to assist state insurance
departments in overseeing the financial condition of all insurance companies
operating within their respective states. IRIS consists of eleven key financial
ratios that address various aspects of each insurer's financial condition and
stability. In 1997, USA's IRIS ratios fell within all of the "usual" ranges. Due
to the Merger that occurred on September 30, 1997, and related reinsurance
transactions, Western Surety's net writings, surplus and agents balances
increased significantly, causing the applicable IRIS ratios to be outside the
"usual" ranges. All of the remaining IRIS ratios for Western Surety were within
the "usual" ranges.
IMPACT OF YEAR 2000 ON THE COMPANY
The widespread use of computer programs, both in the United States and
internationally, that rely on two digit fields to perform computations and
decision making functions may cause computer systems to malfunction when
processing information involving dates after 1999. Such malfunction could lead
to business delays and disruptions. The Company is in the process of replacing
or upgrading its systems to accommodate business for the year 2000, and
anticipates that by December 31, 1998 it will have substantially completed its
program of replacements and the necessary upgrades to accommodate year 2000
processing of its business. However, due to the interdependent nature of
computer systems, the Company may be adversely impacted depending upon whether
it or other entities not affiliated with the Company (vendors and business
partners) address this issue successfully. The cost to the Company of achieving
year 2000 compliance is estimated to be less than $1.0 million in excess of the
cost of normal software upgrades and replacements and will primarily be incurred
in 1998 and funded through working capital. See "Risk Factors -- Year 2000
Compliance."
IMPACT OF ADOPTING STATEMENTS OF FINANCIAL ACCOUNTING STANDARDS ("SFAS")
In February 1997, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 128, "Earnings Per Share". SFAS No. 128 is effective for both interim
and annual periods ending after December 15, 1997 SFAS No. 128 replaces
Accounting Principles Board ("APB") Opinion No. 15, "Earnings Per Share." APB
Opinion No. 15 required that entities with simple capital structures present a
single earnings per common share ("EPS") on the face of the income statement,
whereas those with complex capital structures had to present both primary and
fully diluted EPS. SFAS No. 128 simplifies the computation of EPS by replacing
the presentation of primary EPS with a presentation of basic EPS and requires
dual presentation of basic and diluted EPS by entities with complex capital
structures. Basic EPS includes no dilution and is computed by dividing income
available to common stockholders by the weighted average number of common shares
outstanding for the period, whereas primary EPS includes the dilutive effect of
common stock equivalents, such as stock options. Diluted EPS reflects the
potential dilution of securities that could share in the earnings of an entity,
similar to fully diluted EPS. The Company has adopted SFAS No. 128 in the
accompanying Consolidated Financial Statements.
In February 1997, the FASB issued SFAS No. 129, "Disclosure of Information
about Capital Structure," which establishes standards for disclosing information
about an entity's capital structure. The Statement consolidates existing
disclosure requirements for ease of retrieval and greater visibility to
nonpublic entities. The new Statement contains no change in disclosure
requirements for companies previously subject to the requirements of APB No. 10,
"Omnibus Opinion -- 1966" APB Opinion No. 15, "Earnings per Share" and FASB
Statement No. 47 "Disclosure of Long-Term Obligations" and as such the adoption
of SFAS No. 129 did not have any effect on the Company's financial reporting.
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income" which establishes accounting standards for reporting and display of
comprehensive income and its components (revenues, expenses, gains, and losses)
in a full set of general-purpose financial statements. This Statement requires
that an enterprise (a) classify items of other comprehensive income by their
nature in a financial statement and
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<PAGE> 46
(b) display the accumulated balance of other comprehensive income separately
from retained earnings and additional paid-in capital in the equity section of a
statement of financial position.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information" which establishes accounting standards
about the way public enterprises report information about operating segments in
its annual financial statements and requires that those enterprises report
selected information about operating segments in interim financial reports
issued to stockholders. It also establishes standards for related disclosures
about products and services, geographic areas and major customers. SFAS No. 131
replaces SFAS No. 14, "Financial Reporting for Segments of a Business
Enterprise."
In February 1998, the FASB issued SFAS No. 132, "Employers' Disclosures
about Pensions and Other Postretirement Benefits" which revises employers'
disclosures about pensions and other postretirement benefit plans. SFAS No. 132
does not change the measurement or recognition requirements of those plans under
the previous accounting standards. The new standardized disclosures require
additional information on changes in the benefit obligations and fair value of
plan assets as well as eliminate certain disclosures from prior accounting
standards that are no longer as useful. Restatement of disclosures of prior
periods for comparative purposes is required.
Each of SFAS Nos. 130, 131 and 132 is effective for fiscal years beginning
after December 15, 1997. Each Statement was adopted by CNA Surety in its
Condensed Consolidated Financial Statements as of and for the three months ended
March 31, 1998. Any necessary changes in disclosures and reporting requirements
from the adoption of such statements are reflected in the Company's Consolidated
Financial Statements.
In December 1997, the American Institute of Certified Public Accountants'
Accounting Executives Standards Committee issued Statement of Position ("SOP")
97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related
Assessments" which provides guidance on accounting by all entities that are
subject to insurance-related assessments. It requires that entities should
recognize liabilities for insurance-related assessments when all of the
following criteria have been met: an assessment has been imposed or a probable
assessment will be imposed; the event obligating an entity to pay an imposed or
probable assessment has occurred on or before the date of the financial
statements; and the amount of the assessment can be reasonably estimated. This
SOP is effective for financial statements for fiscal years beginning after
December 15, 1998. The Company does not expect the adoption of this SOP to have
a material effect on the Company's results of operations.
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<PAGE> 47
BUSINESS OF THE COMPANY
BUSINESS OVERVIEW
CNA Surety is an insurance holding company that, through its subsidiaries,
develops, markets and underwrites primarily surety bonds. The Company is the
largest publicly-traded insurance holding company focused exclusively on the
surety business and is one of the leading providers of surety products in the
United States. During 1997, the insurance companies now owned by the Company
wrote over $266 million of gross written premiums, $244 million of which
consisted of surety premiums. For the three months ended March 31, 1998, the
Company wrote over $63 million of gross written premiums, $57 million of which
consisted of surety premiums.
The Company was formed to facilitate the merger of the surety business of
CNAF with Capsure's insurance subsidiaries, Western Surety and USA. Management
believes that the Merger, which occurred on September 30, 1997, resulted in the
combination of three complementary surety businesses, each with distinct
strengths, product focuses and marketing strategies. The combination of these
businesses resulted in a single, larger entity focused on serving the needs of
virtually all segments of the surety market, in terms of the types of products
offered and the size of bonds available. Based on management's knowledge of the
industry, management believes that the Company's branch system and independent
agency network are the most extensive in the surety industry, the combination of
which provides the Company with a competitive marketing advantage.
Surety products, unlike the standard two-party insurance policy, are
three-party agreements in which the Company as 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. Sureties are generally entitled to recover from the principal any
losses and expenses paid to third parties.
The Company, through its principal insurance subsidiaries, Western Surety
and USA, underwrites a broad spectrum of surety bonds. Western Surety writes
small fidelity and commercial bonds and E&O liability insurance. Management
believes that Western Surety is the largest writer of smaller commercial surety
bonds and attributes Western Surety's volume to its strong capabilities in
marketing, distribution and service. In addition, Western Surety underwrites
contract surety bonds, primarily for mid to large sized contract accounts, and
assumes, on a reinsurance basis, international surety and credit insurance
written by CNA Re (London). USA specializes in the underwriting of small
contract and commercial surety bonds. Western Surety and USA are currently rated
A+ (Superior) and A (Excellent), respectively, by A.M. Best. A.M. Best ratings
are based upon factors relevant to policyholders, agents, insurance brokers and
intermediaries and are not directed to the protection of investors.
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, many of
whom belong to the National Association of Surety Bond Producers. The Company
enjoys broad national distribution of its products through approximately 36,000
of the approximately 44,000 independent property and casualty insurance agencies
in the United States.
The Company's primary focus is on evaluating the risk and determining if
the principal meets its underwriting requirements for the bond. Accordingly, the
Company's surety bond premiums primarily reflect the type and class of risk and
related costs associated with both processing the bond transaction and
investigating the applicant including, if necessary, an analysis of the
applicant's creditworthiness and ability to perform.
The Company is led by an experienced management team with an average of
over twenty years of experience, whose core expertise is in surety underwriting
and claims management. Management's underwriting philosophy is disciplined and
focused on consistent underwriting profitability. The extent and sophistication
of underwriting activity, including the amount of bonding authority granted to
independent agents, varies depending on the class of business and the type of
bond. For example, contractor accounts and large commercial surety customers
undergo extensive credit, financial and managerial review and analysis on a
regular basis. Similarly, certain classifications of bonds, such as fiduciary
and court appeal bonds, also receive extensive underwriting. On the other hand,
the Company requires comparatively little underwriting
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<PAGE> 48
information for certain low-exposure risks such as notary bonds. The Company's
underwriting has resulted in combined ratios of 79.7%, 81.0% and 87.4%,
excluding the effects of favorable loss reserve development, for the three
months ended March 31, 1998 and on a pro forma basis for the years ended
December 31, 1997 and 1996, respectively. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations . . ."
CORPORATE STRATEGY
CNA Surety's corporate objective is to be the leading provider of surety
and surety-related products in the United States and in selected international
markets and to be the surety of choice for customers and independent agents and
brokers. The Merger was an integral step towards achieving this objective and,
in management's view, has enhanced the Company's position as a market leader in
addition to providing increased opportunities for long-term revenue and earnings
growth. Elements of management's operating strategy designed to achieve its
corporate objective include the following:
Leverage the Company's Broad Product Line and Distribution Network
Management intends to use the Company's expanded product offerings, and
extensive distribution network, to leverage its existing marketing capabilities.
For example, the Company has introduced Western Surety's small commercial
products and USA's small contractor products to the 41 CNA Surety branch offices
of the Company, which prior to the Merger did not have access to these product
offerings. Similarly, the Company has introduced CNA Surety's larger contract
and commercial bond expertise and greater financial capacity to Western Surety's
and USA's broad independent agency distribution system. In addition, Western
Surety's and USA's marketing representatives now receive support, training, and
education from CNA Surety branch office personnel. Management believes that,
over time, the development of more extensive relationships with its independent
agency force will enhance the Company's growth opportunities and operating
efficiencies.
Pursue Cross-Marketing Opportunities between the Company and CNAF
Management believes that the Company's relationship with CNAF, its
principal stockholder, provides significant opportunities for the Company.
Management believes that CNAF's 100-year history, leading position in the
property and casualty insurance market, financial strength and name recognition
provide CNA Surety with a strong marketing advantage in the medium to large
surety marketplace. In addition, with a leading position in providing property
and casualty insurance to the construction sector, risk management services to
"Fortune 1000" clients and professional liability products to architects and
engineers, CNAF is well positioned to generate new business opportunities for
CNA Surety.
In an effort to capitalize on these cross-marketing opportunities, the
Company and CNAF have instituted various referral programs which will allow the
Company to access CNAF's clients that may have a need for surety products. These
referrals are transmitted to the Company's home and branch offices, allowing the
Company's representatives to pursue these leads.
Expand in the International Markets
The Company recently began its expansion into the European markets through
a relationship with CNA Re (London). Through this relationship, the Company
participates, on a 50% quota share basis, in an international book of
predominately credit insurance and surety business. While credit insurance is a
relatively small market in the United States, credit insurance has a far more
prominent role in Western Europe, where direct writers and reinsurers often
market surety-related products along with credit insurance. Therefore,
management believes that the relationship with CNA Re (London) will serve as an
entree into the large European credit market and, thereby, enhance CNA Surety's
ability to build a surety business in Western Europe.
The Company is also partnering with other members of CNAF's international
organization to establish an infrastructure to market surety bonds
internationally. CNA Surety management believes that these actions will build
name recognition in the international marketplace.
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<PAGE> 49
Promote the Company's Specialty and Service-Based Orientation
As a provider of specialty surety products, management believes that the
Company is better positioned than its competitors to deliver exceptional service
to its agents and customers. The Company has developed specialized technology
targeted specifically toward the surety market. For example, due to Western
Surety's historical focus on the small commercial surety market, which requires
immediate response, the Company has developed business systems and processing
expertise that efficiently supports the surety needs of smaller customers and
minimizes the handling costs associated with the low premium, high volume nature
of the small commercial surety business. The Company expects to utilize this
experience and service orientation to better compete in the broader commercial
surety market.
Expand in the Private Sector
Based upon the Company's extensive knowledge of the surety business, its
focus almost exclusively on one sector of the insurance market, the experience
of its management team and its long-standing relationships with insurance agents
producing surety premiums, management believes that it is well positioned to
develop surety-related products for market niches that it believes are
underserved with regard to surety products. For example, the Company has
identified private construction as a market largely untapped with respect to
surety products. While surety bonds are widely used in the public construction
market, surety bonds are not yet as frequently used in the private construction
sector. Potential opportunities for this sector include not only the use of
existing surety bond products but also the development of new product offerings
tailored to the specific requirements of the private construction sector.
Consider Strategic Acquisitions
Management will continue to consider strategic acquisitions, as part of its
long-term approach to growing its business. CNA Surety's focus will be primarily
on specialty providers of surety-related products that bring geographic
diversity or product expertise or expansion to the Company.
PRODUCT INFORMATION
According to the SAA industry estimates, approximately 80% of the
approximately $2.7 billion United States surety market is represented by bonds
required by federal statutes, state laws, and local ordinances. These bonding
requirements range from federal construction projects, where the contractor is
required to post performance and payment bonds which guarantee performance of
contracts to the government as well as payment of bills to subcontractors and
suppliers, to license and permit bonds which guarantee compliance with legal
requirements for business operations.
Products and Policies
Unlike a standard, two-party insurance policy, surety bonds are three-party
agreements in which the issuer of the bond (the surety) joins with a second
party (the principal) in guaranteeing to a third party (the owner/obligee) the
fulfillment of some obligation on the part of the principal. The surety is the
party who guarantees fulfillment of the principal's obligation to the obligee.
In addition, sureties are generally entitled to recover from the principal any
losses and expenses paid to third parties. The surety's responsibility is to
evaluate the risk and determine if the principal meets the underwriting
requirements for the bond. Accordingly, surety bond premiums primarily reflect
the type and class of risk and related costs associated with both processing the
bond transaction and investigating the applicant including, if necessary, an
analysis of the applicant's creditworthiness and ability to perform.
The surety business is comprised of contract surety business and commercial
surety business, although the products comprising each are sold through the same
distribution system.
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<PAGE> 50
Contract bond guarantee obligations include the following:
Bid bonds: used by contractors submitting proposals on potential contracts.
Performance bonds: guarantee to the owner the performance of the
contractor's obligations according to the terms and conditions of the contract.
Payment bonds: guarantee payment of the contractor's obligations under the
contract for labor, subcontractors, and materials supplied to the project.
Payment bonds are utilized in public projects where liens are not permitted.
Other examples of contract bonds are completion, maintenance and supply
bonds.
Commercial surety business is comprised of bonds covering obligations
typically required by law or regulation, such as the following:
License and Permit bonds: required by statutes or ordinances for a number
of purposes, including guaranteeing the payment of certain taxes and fees and
providing consumer protection as a condition to granting licenses related to
selling real estate or motor vehicles and contracting services.
Judicial and Fiduciary bonds: required by statutes, courts or legal
documents for the protection of those on whose behalf a fiduciary acts. Examples
of such fiduciaries include executors and administrators of estates, and
guardians of minors and incompetents.
Public Official bonds: required by statutes and ordinances to guarantee the
lawful and faithful performance of the duties of office by public officials.
Fidelity bonds: cover losses arising from employee dishonesty. Examples of
purchasers of fidelity bonds are law firms, insurance agencies and janitorial
service companies.
In 1997, the Company expanded into the international surety and credit
insurance market through a 50% U.S. dollar denominated quota share treaty with
CNA Re (London), an affiliate of CCC. Western Surety assumed $10.1 million of
premium through this relationship in the fourth quarter of 1997 and $2.5 million
in the first quarter of 1998. The assumed business is predominately
European-based risks, a substantial portion of which is credit insurance and the
remainder of which is surety and fidelity.
The following table sets forth the pro forma gross written premiums for
1997 and 1996 by type of commercial surety bond and the percentage of each type
to total pro forma gross written premiums for the Company for such years:
<TABLE>
<CAPTION>
PRO FORMA GROSS WRITTEN PREMIUMS
---------------------------------------------
YEARS ENDED DECEMBER 31,
---------------------------------------------
1997 % OF TOTAL 1996 % OF TOTAL
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
License and permit.................................... $ 64,614 24.3% $ 61,163 24.3%
Judicial and fiduciary................................ 26,555 10.0 25,512 10.1
Public official....................................... 17,703 6.6 16,819 6.7
International and other............................... 11,788 4.4 1,907 0.8
-------- ---- -------- ----
Total Commercial............................ $120,660 45.3% $105,401 41.9%
======== ==== ======== ====
</TABLE>
The Company also writes E&O policies through its subsidiary Western Surety
for three classes of insureds: notaries public, tax preparers and insurance
agents and brokers. The notary public E&O policy is marketed as a companion
product to the notary public bond and the tax preparer E&O policy is marketed to
small tax return preparation firms. Western Surety introduced an insurance
agents' and brokers' E&O insurance product in 1994 and had expanded this product
to 39 states as of December 31, 1997.
The following tables set forth, for each principal class of bonds, gross
written premiums and net written premiums, and the respective percentages of the
total for the first quarter of 1998 and 1997 and for the years ended December
31, 1997 and 1996. All tables in this section contain information reflecting the
pro forma
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<PAGE> 51
combined operations of CNA Surety, including Western Surety and USA results
prior to the Merger Date. As such, the financial information is not necessarily
indicative of the financial results that would have occurred under the ownership
and management of CNA Surety:
<TABLE>
<CAPTION>
GROSS WRITTEN PREMIUMS
-------------------------------------------------------------------------------------------
(DOLLARS IN THOUSANDS)
THREE MONTHS ENDED MARCH 31, YEARS ENDED DECEMBER 31,
------------------------------------------- ---------------------------------------------
1998 % OF TOTAL 1997 % OF TOTAL 1997 % OF TOTAL 1996 % OF TOTAL
(PRO FORMA) (PRO FORMA) (PRO FORMA)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Commercial........... $30,689 48.1% $28,166 47.1% $120,660 45.3% $105,401 41.9%
Contract............. 26,200 41.0 25,120 42.0 123,014 46.2 124,477 49.6
Fidelity............. 4,434 6.9 4,241 7.1 15,762 5.9 15,134 6.0
E&O and other........ 2,525 4.0 2,252 3.8 6,982 2.6 6,402 2.5
------- ----- ------- ----- -------- ----- -------- -----
$63,848 100.0% $59,779 100.0% $266,418 100.0% $251,414 100.0%
======= ===== ======= ===== ======== ===== ======== =====
</TABLE>
<TABLE>
<CAPTION>
NET WRITTEN PREMIUMS
-------------------------------------------------------------------------------------------
(DOLLARS IN THOUSANDS)
THREE MONTHS ENDED MARCH 31, YEARS ENDED DECEMBER 31,
------------------------------------------- ---------------------------------------------
1998 % OF TOTAL 1997 % OF TOTAL 1997 % OF TOTAL 1996 % OF TOTAL
(PRO FORMA) (PRO FORMA) (PRO FORMA)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Commercial........... $30,257 49.0% $26,213 46.7% $118,160 46.0% $ 97,407 41.4%
Contract............. 25,240 40.8 23,963 42.7 118,138 45.9 118,268 50.3
Fidelity............. 4,411 7.1 4,230 7.5 15,750 6.1 15,090 6.4
E&O and other........ 1,928 3.1 1,722 3.1 5,019 2.0 4,421 1.9
------- ----- ------- ----- -------- ----- -------- -----
$61,836 100.0% $56,128 100.0% $257,067 100.0% $235,186 100.0%
======= ===== ======= ===== ======== ===== ======== =====
</TABLE>
The following table sets forth for each principal class of bonds, the
number of bonds and policies in force and the respective percentage of the total
for the past two years:
<TABLE>
<CAPTION>
DOMESTIC BONDS/POLICIES IN FORCE
------------------------------------------------
(AMOUNTS IN THOUSANDS, AVERAGE LIMIT IN DOLLARS)
------------------------------------------------
AS OF DECEMBER 31,
------------------------------------------------
1997 % OF TOTAL 1996 % OF TOTAL
(PRO FORMA)
<S> <C> <C> <C> <C>
Commercial.................................... 1,475 82.2% 1,470 84.1%
Contract...................................... 30 1.7 26 1.5
Fidelity...................................... 95 5.3 94 5.4
E&O and other................................. 193 10.8 157 9.0
-------- ----- -------- -----
Total Bonds......................... 1,793 100.0% 1,747 100.0%
======== ===== ======== =====
Average domestic bond penalty/policy
limit(1).................................... $ 25,082 $ 24,883
======== ========
</TABLE>
- ---------------
(1) The average bond penalty is a measure of the average limit of liability
associated with contract and commercial surety bonds in force at each
reporting period.
In 1997, the agency with which the Company did the most business generated
approximately $2.8 million of gross written premiums, or 1.1% of aggregate gross
written premiums. The ten agencies which did the most business with the Company
produced a total of $15.3 million or 5.8% of aggregate gross written premiums.
MARKETING
The Company 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.
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<PAGE> 52
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 61 full-time salaried marketing representatives to continually
service its vast producer network. Relationships with these independent
producers are maintained through the Company's 49 local branch offices.
The following table sets forth the distribution of the pro forma combined
domestic business of the Company by state, based upon gross written premiums in
each of the last two years:
<TABLE>
<CAPTION>
YEARS ENDED
DECEMBER 31,
----------------
1997 1996
---- ----
<S> <C> <C>
Pro Forma Gross Written Premiums by State:
Texas..................................................... 12.7% 13.3%
California................................................ 7.0 7.8
Florida................................................... 5.6 5.8
New York.................................................. 4.5 4.8
Illinois.................................................. 4.0 4.1
Pennsylvania.............................................. 3.8 3.6
Michigan.................................................. 3.3 3.1
Louisiana................................................. 3.2 3.5
All Other................................................. 55.9 54.0
----- -----
Total....................................................... 100.0% 100.0%
===== =====
</TABLE>
Contract Surety
With respect to the contract surety business, the core focus for the
Company is contractors with less than $50 million in contracted work in
progress. This segment is comprised of small contractors (less than $5 million
in work in progress), medium contractors ($5-$25 million) and the lower end of
the large contractors ($25-$150 million). These small and medium contractors, as
a group, represent a significant portion of the United States construction
market. The Company has a small number of accounts with contracted work in
progress in excess of $150 million, the majority of which have been clients of
the Predecessor Operations for more than ten years. Some of these accounts are
maintained on a "co-surety" or joint insurer basis with other sureties in order
to manage aggregate exposure.
The Company's USA subsidiary expects to continue to focus its marketing
efforts on serving the needs of the small contractor. Contract bonds
underwritten by USA are primarily contractor performance and payment bonds in
amounts under $3.0 million. CNA Surety intends to leverage Western Surety's
diverse agency relationships and its nationwide branch structure to expand the
geographic and agency distribution of USA's small contract surety business.
CNA Surety also participates in the non-standard contract surety market,
utilizing the federal government's Small Business Administration ("SBA") surety
bond guarantee programs. The SBA programs provide 70%-90% coverage in exchange
for 10%-30% of the premium.
Commercial Surety
A large portion of the commercial surety market is comprised of small
obligations represented by licenses and permits that are routine in nature and
require minimal underwriting. Customers are focused principally on prompt and
efficient service. Western Surety will continue to focus its marketing efforts
on this small commercial bond market. Western Surety emphasizes one-day response
service, easy-to-use forms and an extensive array of commercial bond products.
In addition, independent agents are provided pre-executed bond forms, powers of
attorney, and facsimile authorizations that allow them to issue many standard
bonds in their offices.
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<PAGE> 53
While a large portion of the commercial surety market is represented by
small entities, the Company also intends to seek to service the bonding needs of
larger, "Fortune 1000" firms, where a high level of technical and underwriting
skill is required. These larger customers are sophisticated, professional buyers
of commercial surety bonds who demand exceptional service and business expertise
at a reasonable cost. The Company maintains a specific underwriting staff in its
Chicago home office and other underwriting centers across the country dedicated
to the "Fortune 1000" market.
CNA Surety's insurance subsidiaries also will direct their marketing to
particular industries or classes of bonds on a broad basis. For instance, the
Company maintains programs directed at notary bonds, mortgage broker compliance
bonds, games of chance bonds (guaranteeing payment of prizes from promotional
games) and grain warehouse dealers bonds (protecting funds associated with grain
storage).
UNDERWRITING
The underwriting philosophy of the Company is disciplined and focused on
consistent underwriting profitability. The extent and sophistication of
underwriting activity varies by type of risk. Contractor accounts and large
commercial surety customers undergo extensive credit, financial and managerial
review and analysis on a regular basis. Certain classifications of bonds, such
as fiduciary and court appeal bonds, also require more extensive underwriting.
The Company also targets various products in the surety and fidelity bond
market which are characterized by relatively low-risk exposure and small bond
amounts. The underwriting criteria, including the extent of bonding authority
granted to independent agents, will vary depending on the class of business and
the type of bond. For example, relatively little underwriting information is
typically required of certain low-exposure risks such as notary bonds.
REINSURANCE
CNA Surety's insurance subsidiaries, in the ordinary course of business,
cede insurance to other insurance companies to limit their exposure to loss,
provide greater diversification of risk and minimize aggregate exposures.
Because the ceding of insurance does not ordinarily discharge the primary
liability of the original insurer, CNA Surety management only places their
reinsurance with qualified carriers after conducting a detailed review of the
nature of the obligation and a thorough assessment of the reinsurers' credit
qualifications and claims settlement performance and capabilities. The
reinsurance coverages and terms are tailored to the specific risk
characteristics of the underlying products of the Company.
For contract and commercial surety business, exclusive of USA business, an
excess of loss reinsurance program is in effect. It provides for coverage on a
per principal basis, equal to $55 million in excess of a $5 million retention.
For the USA business only, the Company has per principal reinsurance coverage of
85% of losses up to $4.9 million in excess of $100,000. The Company is party to
the Excess of Loss Contract and the Second Excess of Loss Contract (collectively
referred to herein as the "Excess of Loss Contracts") with CCC which together
provide coverage in excess of $60 million, on a per principal basis. See
"Certain Relationships and Related Transactions." The Company limits its net
retention on its insurance agents and brokers E&O liability insurance product to
20% through a third party quota share reinsurance agreement. At March 31, 1998,
CNA Surety had a reinsurance receivable balance from CCC of $46.8 million. This
balance was primarily comprised of direct premium receivables of CCC with
respect to the surety business ceded to Western Surety.
At March 31, 1998, CNA Surety's largest non-affiliate reinsurance
receivable, including prepaid reinsurance premiums of $1.1 million, was
approximately $3.0 million with Transatlantic Reinsurance Company, which is
rated A+ (Superior) by A.M. Best.
RESERVES FOR UNPAID LOSSES AND LAE
The estimated liability for unpaid losses and LAE includes, on an
undiscounted basis, estimates of (a) the ultimate settlement value of reported
claims, (b) IBNR claims, (c) future expenses to be incurred in
52
<PAGE> 54
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 LAE
is an estimate and there is the potential that actual future loss payments will
differ significantly from initial estimates. The methods of determining such
estimates and the resulting estimated liability are regularly reviewed and
updated. Changes in the estimated liability are reflected in operating income in
the year in which such changes are determined to be needed.
CNA Surety's insurance subsidiaries employ accepted reserving approaches in
establishing the estimated liability for unpaid losses and LAE that give
consideration to the inherent difficulty and variability in the estimation
process. In addition, CNA Surety utilizes independent actuarial firms of
national standing to conduct periodic reviews of claim procedures and loss
reserving practices, and annually obtains actuarial certification as to the
reasonableness of actuarial assumptions used and the sufficiency of year-end
reserves for each of its principal insurance subsidiaries.
The following table sets forth activity in the reserves for unpaid losses
and LAE and highlights the impact of favorable development of the estimated
liability established in prior periods:
<TABLE>
<CAPTION>
PREDECESSOR OPERATIONS
SEPTEMBER 30 -----------------------
(DATE OF INCEPTION) NINE MONTHS ENDED YEARS ENDED
THROUGH DECEMBER 31, SEPTEMBER 30, DECEMBER 31,
-------------------- ----------------- -----------------------
1997 1997(1) 1996 1995
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Reserves at beginning of period:
Gross................................ $122,281 $119,151 $138,657 $ 48,818
Ceded reinsurance.................... 7,273 15,467 24,531 13,770
-------- -------- -------- --------
Net reserves at beginning of period.... 115,008 103,684 114,126 35,048
Net reserves of CIC at May 10, 1995,
date of acquisition.................. -- -- -- 64,780
-------- -------- -------- --------
Total net reserves..................... 115,008 103,684 114,126 99,828
-------- -------- -------- --------
Net incurred loss and LAE:
Provision for insured events of
current period.................... 12,781 23,484 42,748 43,286
Decrease in provision for insured
events of prior periods........... (647) (35,000) (9,742) (10,846)
-------- -------- -------- --------
Total net incurred losses.............. 12,134 (11,516) 33,006 32,440
-------- -------- -------- --------
Net payments attributable to:
Current period events................ 4,256 4,307 7,728 1,648
Prior periods events................. 161 3,780 35,720 16,494
-------- -------- -------- --------
Total net payments..................... 4,417 8,087 43,448 18,142
-------- -------- -------- --------
Net reserves of Capsure at the Merger
Date................................. -- 30,927 -- --
Net reserves at end of period.......... 122,725 115,008 103,684 114,126
Ceded reinsurance at end of period..... 7,656 7,273 15,467 24,531
-------- -------- -------- --------
Gross reserves at end of period........ $130,381 $122,281 $119,151 $138,657
======== ======== ======== ========
</TABLE>
- ---------------
(1) Amounts are for Predecessor Operations except for the net reserves of
Capsure and ceded reinsurance and gross reserves at the end of the period,
which are for CNA Surety.
53
<PAGE> 55
The following table sets forth a reconciliation of the consolidated loss
reserves reported in accordance with GAAP, and the reserves reported to state
insurance regulatory authorities in accordance with SAP for the year ended
December 31, 1997 (dollars in thousands):
<TABLE>
<S> <C>
Net reserves at end of year, GAAP basis..................... $122,725
Ceded reinsurance, net of salvage and subrogation........... 7,656
--------
Gross reserves at end of year, GAAP basis................... 130,381
Estimated salvage and subrogation recoverable (gross of
reinsurance), not anticipated under SAP................... 8,070
Estimated reinsurance recoverable netted against gross
reserves for SAP.......................................... (8,692)
--------
Net reserves at end of year, SAP basis...................... $129,759
========
</TABLE>
54
<PAGE> 56
The loss reserve development table below illustrates the change over time
of reserves established for the Company's estimated losses and LAE at the end of
various calendar years. The first section shows the reserves as originally
reported at the end of the stated year. The second section shows the cumulative
amounts paid as of the end of successive years with respect to that reserve
liability. The third section shows re-estimates of the original recorded reserve
as of the end of each successive year which is the result of management's
expanded awareness of additional facts and circumstances that pertain to the
unsettled claims. The last section compares the latest re-estimated reserve to
the reserve originally established, and indicates whether or not the original
reserve was adequate or inadequate to cover the estimated costs of unsettled
claims.
The loss reserve development table is cumulative as of each December 31,
and, therefore, ending balances should not be added since the amount at the end
of each calendar year includes activity for both the current and prior years.
The loss reserve development table reflects, on a pro forma basis, the reserves
of the Predecessor Operations and Capsure since 1987 and CIC since its
acquisition in May of 1995. Such historical development is not necessarily
indicative of the financial results that would have occurred under the ownership
and management of CNA Surety nor of future operating results.
<TABLE>
<CAPTION>
AS OF DECEMBER 31,
----------------------------------------------------------------------------------------
1987 1988 1989 1990 1991 1992 1993 1994 1995
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Net reserves for losses and
LAE....................... $50,609 $60,959 $58,685 $69,733 $60,425 $61,998 $64,627 $70,398 $147,911
Net Paid (cumulative) as of:
One year later.............. 12,532 11,700 7,618 13,456 16,287 17,636 12,923 12,018 42,552
Two years later............. 20,510 15,221 13,540 22,330 24,295 25,854 19,671 18,149 43,179
Three years later........... 22,251 17,823 18,033 26,835 29,857 29,495 21,990 21,229 --
Four years later............ 23,928 20,723 20,758 31,591 31,273 30,582 23,070 -- --
Five years later............ 26,152 22,575 22,089 32,133 31,909 30,817 -- -- --
Six years later............. 27,312 23,271 25,441 32,352 32,354 -- -- -- --
Seven years later........... 27,717 24,515 23,457 32,993 -- -- -- -- --
Eight years later........... 28,616 24,529 23,849 -- -- -- -- -- --
Nine years later............ 28,606 24,877 -- -- -- -- -- -- --
Ten years later............. 29,013 -- -- -- -- -- -- -- --
Net Reserves Re-estimated
as of:
End of initial year......... 50,609 60,959 58,685 69,733 60,425 61,998 64,627 70,398 147,911
One year later.............. 48,426 49,285 53,486 50,822 58,644 58,603 54,568 51,471 132,267
Two years later............. 43,530 44,495 39,131 51,330 51,511 54,585 44,749 44,135 103,466
Three years later........... 41,032 36,635 39,978 46,439 46,826 47,911 38,972 38,829 --
Four years later............ 38,256 37,200 34,357 42,946 42,212 42,542 28,094 -- --
Five years later............ 38,006 32,134 31,405 40,747 39,945 33,699 -- -- --
Six years later............. 34,184 29,816 31,777 38,131 36,164 -- -- -- --
Seven years later........... 33,899 29,392 26,646 36,179 -- -- -- -- --
Eight years later........... 32,932 26,831 25,464 -- -- -- -- -- --
Nine years later............ 30,634 25,514 -- -- -- -- -- -- --
Ten years later............. 29,580 -- -- -- -- -- -- -- --
------- ------- ------- ------- ------- ------- ------- ------- --------
Total net (deficiency)
redundancy................ $21,029 $35,445 $33,221 $33,554 $24,261 $28,299 $36,533 $31,569 $44,445
======= ======= ======= ======= ======= ======= ======= ======= ========
Cumulative redundancy
(deficiency) as a
percentage of original
estimate.................. 41.6% 58.1% 56.6% 48.1% 40.2% 45.6% 56.5% 44.8% 30.0%
======= ======= ======= ======= ======= ======= ======= ======= ========
<CAPTION>
AS OF DECEMBER 31,
-------------------
1996 1997
<S> <C> <C>
Net reserves for losses and
LAE....................... $137,064 $122,725
Net Paid (cumulative) as of:
One year later.............. 9,866 --
Two years later............. -- --
Three years later........... -- --
Four years later............ -- --
Five years later............ -- --
Six years later............. -- --
Seven years later........... -- --
Eight years later........... -- --
Nine years later............ -- --
Ten years later............. -- --
Net Reserves Re-estimated
as of:
End of initial year......... 137,064 122,725
One year later.............. 96,178 --
Two years later............. -- --
Three years later........... -- --
Four years later............ -- --
Five years later............ -- --
Six years later............. -- --
Seven years later........... -- --
Eight years later........... -- --
Nine years later............ -- --
Ten years later............. -- --
-------- --------
Total net (deficiency)
redundancy................ $ 40,886(1) --
======== ========
Cumulative redundancy
(deficiency) as a
percentage of original
estimate.................. 29.8% --
======== ========
</TABLE>
- ---------------
(1) The $40,886 release of prior year reserves is comprised of $35,000 of
Predecessor Operations favorable reserve development and $5,239 of Capsure
favorable reserve development in the nine month period of 1997 prior to the
Merger and $647 of CNA Surety favorable reserve development for the period
from September 30, 1997 (date of inception) through December 31, 1997.
55
<PAGE> 57
CLAIMS
The Company maintains a dedicated staff of in-house claim specialists. All
claim handling is centralized in the three home office underwriting
locations -- Chicago, Sioux Falls and Houston. The disposition of claims and
other claim-related activity is done in accordance with established policies,
procedures and expense controls. Indemnity and subrogation rights exist on a
significant portion of the business written, enabling the Company to pursue loss
recovery.
ASBESTOS AND ENVIRONMENTAL MATTERS
The Company does not bond contractors that specialize in environmental
remediation work. The Company does, however, bond several accounts that have
incidental environmental exposure with respect to which the Company provides
limited bonding programs. In the commercial surety market, the Company provides
bonds to large corporations that are in the business of mining various minerals
and are obligated to post reclamation bonds that guarantee that property which
was disturbed during mining is returned to an acceptable condition when the
mining is completed. While no environmental responsibility is overtly provided
by commercial or contract bonds, some risk of environmental exposure may exist
if the surety were to assume certain rights of ownership in the property in the
completion of a defaulted project or through salvage recovery.
To date, the Company has not received any environmental claim notices nor
is management aware of any potential environmental claims.
COMPETITION
The surety and fidelity market is highly competitive. According to 1997
data published by the SAA, the U.S. market aggregates approximately $3.6 billion
in direct written premiums, comprised of approximately $2.7 billion in surety
premiums and approximately $0.9 billion in fidelity premiums. The large
diversified insurance companies hold the largest market shares. For example, the
20 largest surety companies account for nearly 73% of the surety market. On a
pro forma basis for 1997, according to such data, CNA Surety was the largest
direct writer of surety products.
Primary competitors of CNA Surety are approximately 20 national, multi-line
companies participating in the surety market throughout the country. Management
believes that its principal strengths are capacity, diverse product offering,
service and accessibility and long-term relationships with agents and accounts.
While the surety industry has experienced slow premium growth, competition has
increased as a result of ten years of profitable underwriting experience. This
competition has typically manifested itself through reduced premium rates and
greater tolerance for relaxation of underwriting standards. Management believes
such competition will continue.
A.M. BEST RATINGS
A.M. Best ratings are based on an evaluation of a company's financial
strength (leverage/capitalization, capital structure/holding company, quality
and appropriateness of reinsurance program, adequacy of loss/policy reserves,
and quality and diversification of assets), operating performance
(profitability, revenue composition, and management experience and objectives)
and market profile (market risk, competitive market position, spread of risk,
and event risk) as compared to A.M. Best's quantitative and qualitative
standards. Western Surety and USA are currently rated A+ (Superior) and A
(Excellent), respectively, by A.M. Best. CCC is currently rated A (Excellent) by
A.M. Best. A.M. Best's letter ratings range from A++ (Superior) to C- (Weak)
with A++ being highest. An A+ (Superior) rating is assigned to those companies
which A.M. Best believes, on balance, have superior financial strength,
operating performance and market profile when compared to the standards
established by A.M. Best. A+ (Superior) rated insurers have been shown to be
among the strongest in ability to meet policyholder and other contractual
obligations. A rating of A (Excellent) is assigned to those companies which A.M.
Best believes have, on balance, excellent financial strength, operating
performance and market profile when compared to the standards established by
A.M. Best.
56
<PAGE> 58
REGULATION
CNA Surety's insurance subsidiaries are subject to varying degrees of
regulation and supervision in the jurisdictions in which they transact business
under statutes which delegate regulatory, supervisory and administrative powers
to state insurance regulators. In general, an insurer's state of domicile has
principal responsibility for such regulation which is designed generally to
protect policyholders rather than investors and relates to matters such as the
standards of solvency which must be maintained; the licensing of insurers and
their agents; the examination of the affairs of insurance companies, including
periodic financial and market conduct examinations; the filing of annual and
other reports, prepared on a statutory basis, on the financial condition of
insurers or for other purposes; establishment and maintenance of reserves for
unearned premiums and losses; and requirements regarding numerous other matters.
Licensed or admitted insurers generally must file with the insurance regulators
of such states, or have filed on its behalf, the premium rates and bond and
policy forms used within each state. In some states, approval of such rates and
forms must be received from the insurance regulators in advance of their use.
Western Surety is domiciled in South Dakota and licensed in all 50 states
and the District of Columbia. SBCA is domiciled in South Dakota and licensed in
23 states. USA is domiciled in Texas and licensed in 42 states and the District
of Columbia.
Insurance regulations also generally 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 RBC requirements. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations... -- Liquidity and Capital Resources."
CNA Surety's insurance subsidiaries are subject to periodic financial and
market conduct examinations. These examinations are generally performed by the
domiciliary state insurance regulatory authorities. The South Dakota Department
of Commerce and Regulation -- Division of Insurance (the "South Dakota
Department") recently concluded its financial and market conduct examination of
Western Surety for the five year period ended December 31, 1996. The South
Dakota Department made a finding of non-compliance with respect to the Company's
practices regarding return of premiums and recommended that Western Surety
change its current procedures regarding the return of premium. The Company is
disputing the South Dakota Department's interpretation of the applicable
statutes and intends to seek an agreement with the South Dakota Department not
to take action against the Company until remedial legislation can be passed
regarding the applicable statutes, which would eliminate any non-compliance by
the Company with such statutes. Although CNA Surety management disputes such
recommendation, management does not believe that such changes in procedures, if
ultimately required, will have a material adverse effect on the Company.
The South Dakota Department's previous examination of Western Surety was as
of December 31, 1991 covering both financial and market conduct procedures. The
Texas Department of Insurance conducted its last examination of USA as of
December 31, 1996. This examination included financial matters. There were no
significant issues noted which required corrective action by any of the
insurance subsidiaries.
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 the
Predecessor Operations nor to Capsure's results of operations.
Western Surety and USA each qualifies as an acceptable surety for federal
and other public works project bonds pursuant to U.S. Department of Treasury
regulations. The underwriting limitations of Western Surety and USA, based on
each insurer's statutory surplus, are currently $12.5 million and $1.4 million
per bond, respectively. Pursuant to the Quota Share Treaty and the Services and
Indemnity Agreement with CCC, the
57
<PAGE> 59
Company is permitted to issue bonds utilizing CCC's $452.2 million per bond U.S.
Treasury underwriting limitation. See "Certain Relationships and Related
Transactions."
INVESTMENTS
CNA Surety's insurance company investment practices must comply with
insurance laws and regulations and must also comply with certain covenants under
CNA Surety's $130 million Credit Facility. Generally, insurance laws and
regulations prescribe the nature and quality of, and set limits on, the various
types of investments which may be made by CNA Surety's insurance subsidiaries.
See "Regulation" in this Section.
The Company's investment portfolios generally are managed to maximize after
tax investment returns, while minimizing credit risks with investments
concentrated in high quality, fixed income securities. The Company's portfolios
are managed to provide diversification by limiting exposures to any one issue or
issuer, and to provide liquidity by investing in the public securities markets.
The portfolios are structured to support the Company's operations and consider
the expected duration of liabilities and short-term cash needs.
An investment committee of the Board establishes investment policy and
oversees the management of each portfolio. A professional independent investment
adviser has been engaged to assist in the management of each of the Company's
insurance subsidiaries investment portfolio pursuant to established investment
committee guidelines. The insurance subsidiaries pay an advisory fee based on
the market value of the assets under management.
The estimated fair value and amortized cost of fixed income securities held
by the Company as March 31, 1998, by investment category, and the gross
unrealized gains and losses were as follows:
<TABLE>
<CAPTION>
AMORTIZED GROSS GROSS ESTIMATED
COST OR UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
--------- ---------- ---------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
FIXED INCOME SECURITIES:
U.S. Treasury securities and obligations of U.S.
Government corporations and agencies:
U.S. Treasury....................................... $ 59,060 $ 220 $ -- $ 59,280
U.S. Agency......................................... 63,701 388 (148) 63,941
CMOs................................................ 34,551 103 (70) 34,584
Mortgage pass-through securities.................... 32,198 61 (3) 32,256
Obligations of states and political subdivisions...... 79,784 206 (525) 79,465
Corporate bonds....................................... 58,706 331 (362) 58,675
Non-agency CMOs....................................... 29,391 40 (120) 29,311
Asset-backed securities:
Second mortgages/home equity loans.................. 20,101 206 (5) 20,302
Credit card receivables............................. 6,483 24 -- 6,507
Other underlying assets............................. 5,075 4 (4) 5,075
-------- ------ ------- --------
Total fixed income securities....................... $389,050 $1,583 $(1,237) $389,396
======== ====== ======= ========
</TABLE>
Short-term investments are generally comprised of U.S. Treasury bills,
corporate notes, money market funds and investment grade commercial paper
equivalents.
58
<PAGE> 60
The amortized cost and estimated fair value of fixed income securities at
March 31, 1998, by contractual maturity, are shown below. Actual maturities will
differ from contractual maturities as securities may be called or prepaid with
or without call or prepayment penalties:
<TABLE>
<CAPTION>
AMORTIZED ESTIMATED
COST FAIR VALUE
--------- ----------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
FIXED INCOME SECURITIES:
Due within one year......................................... $ 2,732 $ 2,733
Due after one year but within five years.................... 110,156 110,750
Due after five years but within ten years................... 76,281 75,847
Due after ten years......................................... 72,083 72,032
-------- --------
261,252 261,362
Mortgage pass-through securities, CMOs and
asset-backed securities................................... 127,798 128,034
-------- --------
$389,050 $389,396
======== ========
</TABLE>
The following table sets forth the rating assigned by S&P or Moody's of the
fixed income securities portfolio of the Company as of March 31, 1998:
<TABLE>
<CAPTION>
CREDIT RATING FAIR VALUE PERCENT
------------- ----------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
AAA/Aaa..................................................... $302,482 77.7%
AA/Aa....................................................... 23,557 6.0
A/A......................................................... 51,286 13.2
BBB......................................................... 12,071 3.1
-------- -----
Total............................................. $389,396 100.0%
======== =====
</TABLE>
As of March 31, 1998, 100% of the Company's fixed income securities were
considered investment grade by S&P and/or Moody's, and 84% were rated at least
AA by those agencies. In addition, the Company's investments in fixed income
securities did not contain any significant geographic or industry concentration
of credit risk.
NET OPERATING LOSS TAX CARRYFORWARDS
In July 1986, Capsure emerged from voluntary bankruptcy proceedings under
Chapter 11 of the United States Bankruptcy Code. Prior to its emergence, Capsure
was primarily involved in oil and gas production, exploration and development
and providing supplies to the oil and gas industry. Due to a significant
downturn in the oil and gas industry in the early 1980s, Capsure generated
significant losses and was unable to meet its obligations, resulting in its
voluntary bankruptcy filing. Upon emergence from bankruptcy, Capsure had
approximately $300 million in NOLs. The IRS has not audited Capsure's tax
returns for the years in which it reported net operating losses.
Capsure had approximately $100.7 million of these NOLs available at the
Merger Date to reduce its future federal taxable income, of which $50.7 million
expired on December 31, 1997. Under Section 382 of the Code, significant
restrictions on CNA Surety's ability to utilize Capsure's NOL carryovers apply
because of the ownership change as a result of the Merger.
EMPLOYEES
As of December 31, 1997, the Company employed approximately 840 persons.
Since its emergence from bankruptcy in 1986 through the time of the Merger,
Capsure did not experience any work stoppages nor had the Predecessor Operations
ever experienced a work stoppage. Since the formation of CNA Surety and the
59
<PAGE> 61
Merger, CNA Surety has not experienced any work stoppages and CNA Surety
believes its relations with its employees are good.
LEGAL PROCEEDINGS
The Company is a party to numerous 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, results of operations or
cash flows.
PROPERTIES
CNA Surety leases its executive offices and its shared branch locations
with CCC under an Administrative Services Agreement. CNA Surety currently uses
approximately 72,500 square feet and related personal property at 41 branch
locations and its home and executive offices (15,243 square feet), in Chicago,
Illinois. CNA Surety's annual rent for this space is approximately $1.6 million.
CNA Surety may terminate its use of these locations as set forth in the
Administrative Services Agreement, without penalty, by providing CCC with 60
days written notice.
Western Surety leases office space for its executive offices at 101 South
Phillips Avenue, Sioux Falls, South Dakota 57104, under a lease expiring in
2002. Western Surety's office space, consisting of approximately 81,600 square
feet, is leased from a partnership in which Western Surety owns a 50% interest.
The annual rent, which is subject to annual adjustments, was $1.5 million as of
December 31, 1997. Western Surety also leases a 7,900 square foot branch office
in Dallas, Texas. Annual rent for the branch office was $0.2 million and the
lease expires in 1999. USA leases office space for its executive offices at 950
Echo Lane, Suite 250, Houston, Texas 77024, under a lease terminating in the
year 2000 with an annual rent of $0.2 million. USA also leases space for 7
branch offices for an additional annual rent of approximately $0.1 million.
60
<PAGE> 62
MANAGEMENT OF THE COMPANY
The directors and executive officers of the Company are as follows:
<TABLE>
<CAPTION>
NAME AGE POSITION
---- --- --------
<S> <C> <C>
Giorgio Balzer............................ 58 Director
Philip H. Britt........................... 52 Director
David T. Cumming.......................... 54 Director
Rod F. Dammeyer........................... 58 Director
Melvin Gray............................... 65 Director
Joe P. Kirby.............................. 44 Director
Roy E. Posner............................. 65 Director
Adrian M. Tocklin......................... 46 Director
Robert T. Van Gieson...................... 53 Director and Chairman of the Board
Mark C. Vonnahme.......................... 49 President, Chief Executive Officer and Director
Robert E. Ayo............................. 57 Vice President and Chief Underwriting Officer -
Contract Surety
Michael Dougherty......................... 39 Vice President and Chief Marketing Officer
Melita Geoghegan.......................... 51 Vice President and Chief Human Resources Officer
Thomas P. Greasel......................... 59 Vice President and Chief Claims Officer
John S. Heneghan.......................... 36 Vice President and Chief Financial Officer
Dan L. Kirby.............................. 51 Executive Vice President - Legislative Affairs
Paul T. Lively............................ 49 Vice President - Business Development and Secretary
John L. McReynolds........................ 57 President and Chief Operating Officer of USA
Stephen T. Pate........................... 51 President and Chief Operating Officer of Western
Surety
Thomas A. Pottle.......................... 38 Vice President and Chief Operations Officer
Sharon A. Sartori......................... 42 Vice President and Chief Underwriting Officer -
Commercial Surety
William Pate.............................. 34 Director-Designee
</TABLE>
The following is certain additional information concerning each director
and executive officer of the Company, including positions and offices with the
Company, present principal occupation or employment and material occupations and
employment for the past five years.
GIORGIO BALZER, Director of CNA Surety since September 30, 1997. Chairman and
Chief Executive Officer, Businessmen's Assurance Company of America since 1990;
U.S. representative for Assicurazioni Generali, S.p.A. Director of Commerce
Bancshares, Inc.
PHILIP H. BRITT, Director of CNA Surety since March 1998. Senior Vice President,
Insurance Industry Division of First Chicago NBD Corporation since April 1988;
various other positions with First Chicago NBD Corporation - The First National
Bank of Chicago from 1982 through April 1988. Member of the Association of
Insurance and Financial Analysts.
DAVID T. CUMMING, Director of CNA Surety since December 1996. Secretary of the
Company from December 1996 until September 30, 1997; Executive Vice President -
Mergers and Acquisitions, CNA Commercial Insurance, a business unit of CNAF,
since January 1998; Deputy General Counsel of all insurance subsidiaries of
CNAF, including CCC and CIC, from 1993 until January 1998.
ROD F. DAMMEYER, Director of CNA Surety since September 30, 1997. Managing
Partner of EGI Corporate Investments, a division of Equity Group Investments,
Inc. ("EGI"), since January 1996; Director since 1985 and Vice Chairman of
Anixter International, Inc. ("Anixter") since February 1998; President from 1985
until February 1998 and Chief Executive Officer from 1993 until February 1998 of
Anixter. Director of ANTEC Corporation, Groupo Azucarero Mexico, IMC Global
Inc., Jacor Communications, Inc., Metal Management,
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<PAGE> 63
Inc., Stericycle, Inc., TeleTech Holdings, Inc., Transmedia Network, Inc., and
Trustee of several Van Kampen American Capital, Inc. closed-end mutual funds.
MELVIN GRAY, Director of CNA Surety since September 30, 1997. Chairman and Chief
Executive Officer since 1982 and various other positions since 1962 of Graycor,
Inc. Member Board of Advisors of the Construction Industry Institute.
JOE P. KIRBY, Director of CNA Surety since September 30, 1997. Director of
Western Surety since 1979; President from 1979 until 1995 and Chief Executive
Officer of Western Surety from 1979 until September 30, 1997. Mr. Kirby is the
brother of Dan L. Kirby.
ROY E. POSNER, Retired. Director of CNA Surety since September 30, 1997. Chief
Financial Officer and Senior Vice President of Loews Corporation, the parent
corporation of CNAF, from 1985 until February 1997.
ADRIAN M. TOCKLIN, Director of CNA Surety since September 30, 1997 and Chairman
of the Board from September 30, 1997 until March 1998. President, CNA
Diversified Operations, a business unit of CNAF, from May 1995 until April 1998.
President and Chief Operating Officer of The Continental Corporation
("Continental") and all of its insurance subsidiaries from June 1994 until May
1995; Executive Vice President of Continental from September 1992 until June
1994; various other positions with Continental since December 1974; Director of
SONAT, Inc. and Trustee of George Washington University.
ROBERT T. VAN GIESON, Director of CNA Surety and Chairman of the Board since
March 1998. President and Chief Executive Officer, CNA Global Operations, a
business unit of CNAF, since December 1997; President and Chief Executive
Officer, CNA Global Operations Group, from July 1996 until December 1997;
Chairman and Chief Executive Officer of Chubb Insurance Co. of Europe from 1990
until 1996; Director of First Insurance Company of Hawaii, Associated Aviation
Underwriters, and International Insurance Society.
MARK C. VONNAHME, Director, President and Chief Executive Officer of CNA Surety
since September 1997. Group Vice President and Senior Surety Officer of all CNAF
insurance subsidiaries, including CCC and CIC, from August 1993 until September
30, 1997. Vice President, Contract Surety Division of CCC from January 1993
until August 1993; and Assistant Vice President, Contract Surety Division of
CCC, from 1991 until January 1993. Director of Surety Association of America.
ROBERT E. AYO, Vice President and Chief Underwriting Officer - Contract Surety
of CNA Surety since September 30, 1997. Vice President and Chief Contract
Underwriting Officer, Surety of all insurance subsidiaries of CNAF, including
CCC and CIC, from March 1995 until September 30, 1997; Assistant Vice President
and Underwriting Manager, Contract Surety of CCC, from January 1993 until March
1995; Underwriting Manager, Contract Surety of CCC from 1985 until January 1993.
MICHAEL A. DOUGHERTY, Vice President and Chief Marketing Officer of CNA Surety
since November 1997. Senior Vice President Aon Risk Services of Illinois from
April 1992 until November 1997.
MELITA H. GEOGHEGAN, Vice President and Chief Human Resources Officer of CNA
Surety since September 30, 1997. Assistant Vice President of Human Resources,
Surety Division of CCC from 1996 until September 30, 1997, and various positions
with CCC from 1993 to 1996.
THOMAS P. GREASEL, Vice President and Chief Claims Officer of CNA Surety since
September 30, 1997. Vice President and Director of Surety Claims for CCC from
1993 until September 30, 1997.
JOHN S. HENEGHAN, Vice President and Chief Financial Officer of CNA Surety since
September 30, 1997. Vice President of Capsure from December 1995 and Controller
of Capsure from June 1994 until September 30, 1997; and various positions,
including Senior Audit Manager, with Deloitte & Touche LLP from 1984 until June
1994.
DAN L. KIRBY, Executive Vice President - Legislative Affairs of CNA Surety since
September 30, 1997. Vice President, General Counsel and Secretary of Western
Surety from 1974 until September 30, 1997. Mr. Kirby is the brother of Joe P.
Kirby.
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<PAGE> 64
PAUL T. LIVELY, Vice President - Business Development of CNA Surety since March
1998 and Secretary of CNA Surety since May 1998. Assistant Secretary from March
1998 until May 1998. Practicing attorney from 1988 until 1997 with Querrey &
Harrow, Ltd.
JOHN L. MCREYNOLDS, President and Chief Operating Officer of USA since January
1, 1998. Executive Vice President of USA from 1984 until December 31, 1997.
STEPHEN T. PATE, President and Chief Operating Officer of Western Surety since
June 1995. Executive Vice President of Western Surety from October 1994 until
June 1995; President, Surety Profit Center of CIC from April 1993 until October
1994; and Regional Vice President, Surety of CIC from June 1991 until April
1993.
THOMAS A. POTTLE, Vice President and Chief Operations Officer of CNA Surety
since September 1997. Secretary of CNA Surety from September 30, 1997 until May
1998. Assistant Vice President and Surety Controller of CNA from 1996 until
September 1997; Surety Controller of CCC from September 1994 until 1996; and
various positions with CCC from 1986 until September 1994.
SHARON A. SARTORI, Vice President and Chief Underwriting Officer - Commercial
Surety of CNA Surety since November 1997. Commercial Surety Territorial
Underwriting Officer of CNA Surety from September 30, 1997 until November 1997;
and various positions, including Assistant Vice President and Territorial
Underwriting Officer, of CCC from 1993 until September 30, 1997.
WILLIAM PATE, Director - Designee. Director - Mergers and Acquisitions of EGI
since February 1994 and Associate, Credit Suisse First Boston prior to February
1994. Mr. Pate has been designated and has consented to become a Director
immediately after the effectiveness of the Registration Statement of which this
Prospectus forms a part.
BOARD AND COMMITTEES
The Board has an Executive Committee which consists of Ms. Tocklin and
Messrs. Van Gieson and Vonnahme. The Executive Committee possesses and may
exercise the full and complete authority of the Board in the management and
business affairs of the Company during the intervals between the meetings of the
Board. All action by the Executive Committee is reported to the Board at its
next meeting and such action is subject to revision and alteration by the Board,
provided that no rights of third persons can be prejudicially affected by the
subsequent action of the Board. Vacancies on the Executive Committee are filled
by the Board. However, during the temporary absence of a member of the Executive
Committee, due to illness or inability to attend a meeting or for other cause,
the remaining member(s) of the Executive Committee may appoint a member of the
Board to act in the place and with all the authority of such absent member.
CNA Surety also has an Audit Committee which consists of Messrs. Dammeyer,
Gray and Posner (Chair). The Audit Committee is authorized and has the power to
review such procedures of the Company and its subsidiaries regarding the
appointment of the independent auditors, the scope and fees of prospective
annual audits and results thereof, compliance with the accounting and financial
policies of the Company, management's procedures and policies relative to the
adequacy of CNA Surety's internal accounting controls and review of any and all
related party agreements and arrangements between CNA Surety and its affiliates,
as well as any disputes that may arise thereunder.
CNA Surety also has a Compensation Committee which consists currently of
Messrs. Balzer, Britt and J. Kirby (Chair). The Compensation Committee reviews
and administers all compensation matters for the five most highly compensated
executive officers of the Company as well as its stock option plans.
Finally, CNA Surety also has an Investment Committee which consists of
Messrs. J. Kirby, Posner, Van Gieson, and Vonnahme and Ms. Tocklin. The
Investment Committee establishes investment policies and oversees the management
of the Company's investment portfolios.
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<PAGE> 65
EXECUTIVE COMPENSATION
The following tables show information with respect to the annual
compensation (including option grants) for services rendered to CNA Surety (or
its predecessors) for the year ended December 31, 1997 by the chief executive
officer and those persons who were, at December 31, 1997, the four other most
highly compensated executive officers of CNA Surety. CNA Surety began operations
following the Merger which was consummated on September 30, 1997. Accordingly,
compensation for prior years has been omitted.
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
NUMBER OF
SECURITIES
OTHER ANNUAL UNDERLYING ALL OTHER
SALARY(1) BONUS(1) COMPENSATION(1) OPTIONS COMPENSATION(1)
NAME AND PRINCIPAL POSITION YEAR ($) ($) ($) GRANTED(#) ($)
- --------------------------- ---- --------- --------- --------------- ---------- ---------------
<S> <C> <C> <C> <C> <C> <C>
Mark C. Vonnahme............ 1997 264,519 114,700(2) 13,646(3) 30,000 27,260(4)
President and Chief
Executive Officer of CNA
Surety
John T. Knox................ 1997 253,120 300,000(5) 0 20,000 705,577(6)
Former President and Chief
Executive Officer of USA and
Former Director of the
Company
Dan L. Kirby................ 1997 239,807 125,000 444(7) 15,000 524,557(8)
Vice President, Legislative
Affairs of CNA Surety
Stephen T. Pate............. 1997 262,500 312,500(5) 5,970(9) 20,000 4,800(10)
President and Chief
Operating Officer of Western
Surety
Robert E. Ayo............... 1997 165,384 99,100(2) 326(11) 20,000 12,984(12)
Vice President and Chief
Underwriting Officer,
Contract Surety of CNA
Surety
</TABLE>
- ---------------
(1) Includes salary, bonus, other annual and all other compensation paid prior
to the Merger, on September 30, 1997, by CCC and Capsure for Messrs.
Vonnahme and Ayo and for Messrs. Knox, Kirby and Pate, respectively.
(2) Includes transaction completion bonus of $4,700 for Mr. Vonnahme and $3,000
for Mr. Ayo.
(3) Includes $11,646 for health club and country club dues and $2,000 for income
tax preparation.
(4) Includes $15,173 of CCC distributions from the CNAF supplemental savings
plan, $6,720 of 401(k) plan company matching contributions to both the CNA
and CNA Surety sponsored plans, $3,610 CCC paid automobile lease, $721 of
CCC paid contributions on a life insurance policy owned by him and a $1,036
CCC paid retirement gift.
(5) Includes transaction and retention bonuses paid by Capsure of $250,000 for
Mr. Knox and $312,500 for Mr. Pate.
(6) Includes $671,216 paid by the Company in connection with the termination of
his employment contract, $22,782 for Company paid automobile lease, $6,959
for Company paid contributions on a life insurance policy owned by him and
$4,620 of 401(k) plan company matching contributions.
(7) Includes $444 of reimbursements of health club dues.
(8) Includes $519,757 in connection with the exercise of Capsure stock options
and $4,800 for 401(k) plan company matching contributions.
(9) Includes $384 of reimbursements of health club dues and $5,586 for Company
paid country club membership dues.
(10) For 401(k) plan Company matching contributions.
(11) For CCC reimbursement of health club dues.
(12) Includes $6,219 of 401(k) plan company matching contributions to both the
CNA and CNA Surety sponsored plans, $3,691 CCC paid automobile lease,
$2,038 of CCC paid contributions on a life insurance policy owned by him
and a $1,036 CCC paid retirement gift.
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<PAGE> 66
OPTION GRANTS IN LAST FISCAL YEAR
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS POTENTIAL REALIZABLE VALUE
-------------------------------- AT ASSUMED ANNUAL RATES
NUMBER OF % OF TOTAL OF STOCK PRICE
SECURITIES GRANTED TO APPRECIATION FOR OPTION
UNDERLYING EMPLOYEES EXERCISE OR TERM
OPTIONS GRANTED DURING BASE PRICE EXPIRATION --------------------------
NAME (#)(1) FISCAL YEAR(2) ($/SH) DATE 5%($) 10%($)
---- --------------- -------------- ----------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C>
Mark C. Vonnahme......... 30,000 6.5% 15.875 10/03/07 299,550 758,550
Robert E. Ayo............ 20,000 4.3% 15.875 10/03/07 199,700 505,700
Dan L. Kirby............. 15,000 3.2% 15.875 10/03/07 149,775 379,275
John T. Knox............. 20,000(3) 4.3% 15.875 10/03/07 0(3) 0
Stephen T. Pate.......... 20,000 4.3% 15.875 10/03/07 199,700 505,700
</TABLE>
- ---------------
(1) The options granted during 1997 are exercisable after October 3, 2000.
(2) 463,500 non-qualified stock options were granted to employees of the Company
during the three month period ending December 31, 1997.
(3) These options were forfeited as a result of Mr. Knox's resignation as
President and Chief Executive Officer of USA effective December 31, 1997.
AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR
AND FISCAL YEAR-END OPTION VALUE
<TABLE>
<CAPTION>
VALUE OF
UNEXERCISED
NUMBER OF IN-THE-MONEY
UNEXERCISED OPTIONS OPTIONS AT
AT FY-END (#) FY-END ($)
SHARES ACQUIRED VALUE (1)EXERCISABLE/ (1)EXERCISABLE/
NAME ON EXERCISE (#) REALIZED($) UNEXERCISABLE UNEXERCISABLE
---- --------------- ----------- ------------------- ---------------
<S> <C> <C> <C> <C>
Mark C. Vonnahme..................... 0 0 0/30,000 0/0
Robert E. Ayo........................ 0 0 0/20,000 0/0
Dan L. Kirby......................... 39,190 519,757 15,000/15,000 169,064/0
John T. Knox......................... 0 0 40,718/0 511,520/0
Stephen T. Pate...................... 0 0 11,250/23,750 139,922/46,641
</TABLE>
- ---------------
(1)Exercisable options for Messrs. D. Kirby, Knox and Pate relate to options
issued under CNA Surety's Replacement Stock Option Plan in connection with
the Merger. The Replacement Stock Option Plan reserved shares for issuance to
former Capsure option holders with the same price, rights, benefits, terms
and conditions as the Capsure options replaced.
COMPENSATION OF DIRECTORS
Directors, except for employees of the Company or its affiliates, are
compensated at the annual rate of $25,000, paid in quarterly installments, and
receive $1,500 for each meeting of the Board and committees of the Board which
they attend. The CNA Surety Corporation Non-Employee Directors Deferred
Compensation Plan (the "Plan") provides that non-employee Directors may elect
under the Plan to defer receipt of their annual compensation and have such
compensation deemed invested in stock units, which may then be distributed under
certain circumstances in the form of Common Stock.
EMPLOYMENT CONTRACTS
The Company entered into an employment agreement with Mark C. Vonnahme on
October 3, 1997. The agreement runs from October 1, 1997 through December 31,
1999, with automatic one-year renewals unless the Company or Mr. Vonnahme
provides the other party with thirty days written notice of intent not to renew.
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<PAGE> 67
The agreement provides for a minimum annual base salary of $300,000 that may be
adjusted annually by the Board, an annual bonus, a long-term incentive
compensation program, and stock options. As part of the agreement, Mr. Vonnahme
has agreed to certain confidentiality, non-competition, and non-solicitation
provisions.
The Company also entered into a two-year employment agreement with Dan L.
Kirby, effective October 1, 1997. The agreement provides for an annual base
salary of $200,000 and provides for additional compensation in the form of an
annual bonus, a long-term incentive compensation program, and stock options. The
agreement also provides a severance payment, equal to the discounted present
value of the salary that Mr. Kirby would have received through the term of the
agreement, if the Company terminates his employment without cause. As part of
the agreement, Mr. Kirby has agreed to certain confidentiality, non-
competition, and non-solicitation provisions.
The Company also maintained predecessor employment agreements with John T.
Knox, Jr. and Stephen T. Pate, entitling each to annual base salaries of
$262,500. Mr. Knox resigned as President and Chief Executive Officer of USA,
effective December 31, 1997 and received payment in the amount of $671,216 for
the discounted value of the base salary on the remaining term of his employment
contract. Although Mr. Pate's employment agreement expired on April 14, 1998,
Mr. Pate continues to be employed by the Company in the same capacities without
the benefit of an employment agreement.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
The members of CNA Surety's Compensation Committee are Messrs. Balzer,
Britt and J. Kirby.
Mr. J. Kirby is a director of CNA Surety and was a former officer and
director of Capsure. Mr. J. Kirby is the brother of D. Kirby, who is currently
an officer of CNA Surety and was a director of Capsure.
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<PAGE> 68
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
CCC and the CNA Surety insurance subsidiaries have entered into various
reinsurance agreements designed to protect against adverse loss reserve
development related to the Predecessor Operations' reserves at the Merger Date,
and to help preserve, through the year 2000, the profitability of the
Predecessor Operations and certain additional accounts. The reinsurance
agreements, together with the Services and Indemnity Agreement that is described
below, also effected the transfer of the Predecessor Operations to CNA Surety's
insurance subsidiaries. The reinsurance agreements entered into in connection
with the Merger are: (i) the Quota Share Treaty; (ii) the Stop Loss Contract;
and (iii) the Excess of Loss Contract.
Surety Quota Share Treaty
Through the Quota Share Treaty, CCC and CIC as of the Merger Date (i)
transferred the Predecessor Operations from CCC to Western Surety, including the
net loss reserves, allocated and unallocated LAE reserves, and the reserves for
IBNR losses (collectively, the "Reserves") and unearned premium reserves as of
the Merger Date as well as cash and other statutorily admitted assets equal to
such Reserves plus unearned premium reserves and (ii) provided a guarantee to
Western Surety regarding the adequacy of the Reserves transferred to Western
Surety on the Merger Date.
Specifically, CCC transferred to Western Surety 100% of the net liabilities
of then existing Predecessor Operations under surety bonds written or renewed by
CCC prior to the Merger Date. CCC effected the transfer of the existing
Predecessor Operations by paying Western Surety an amount in cash and other
statutorily net admitted assets (insurance premium receivables minus expenses
accrued for statutory reporting purposes) equal to (i) CCC's net unearned
premium reserves relating to the in-force Predecessor Operations as of the
Merger Date, plus (ii) the Reserves for all Predecessor Operations' business
written or assumed prior to the Merger Date, and minus (iii) a ceding commission
of $29 million to be retained by CCC, which reimbursed CCC for acquisition
expenses incurred by CCC in connection with the net unearned premium reserves
being transferred. CCC transferred to Western Surety all of the Predecessor
Operations' business written or renewed by CCC after the Merger Date by
transferring the related liabilities of such business and paying to Western
Surety an amount in cash equal to CCC's net written premiums on all such
business, minus a quarterly ceding commission to be retained by CCC equal to
$50,000 plus 28% of net written premiums on such business. For the quarter ended
March 31, 1998, CCC and CIC paid Western Surety, net of commissions and
reinsurance loss payments, $22.5 million under the Quota Share Treaty and the
Company had a reinsurance receivable balance from CCC and CIC of $46.8 million.
This balance is primarily comprised of direct premium receivables of CCC and CIC
with respect to the surety business ceded to Western Surety.
CCC also agreed to guarantee the Reserves transferred to Western Surety by
agreeing to pay to Western Surety within 30 days following the end of each
calendar quarter the amount of any adverse development on such Reserves, as
reestimated as of the end of such calendar quarter.
The Quota Share Treaty has a term of five years from the Merger Date.
Notwithstanding the Quota Share Treaty's term, the provisions of the Quota Share
Treaty shall continue to apply until all obligations of the parties have been
performed, including the guarantee with respect to the adequacy of the Reserves.
CCC shall be responsible for losses on business covered by the Quota Share
Treaty which are discovered within three years after its termination.
Aggregate Stop Loss Reinsurance Contract
The Stop Loss Contract entered into on the Merger Date will protect CNA
Surety from adverse loss experience on certain business underwritten after the
Merger Date. The Stop Loss Contract between CNA Surety's insurance subsidiaries
and CCC limits the CNA Surety insurance subsidiaries' prospective net loss
ratios with respect to certain accounts and lines of insured business for at
least three fiscal years following the Merger Date. In the event the CNA Surety
insurance subsidiaries' accident year net loss ratio exceeds the Loss Ratio Cap
of 24% in each of 1997 through 2000 on certain insured accounts, the Stop Loss
Contract requires CCC at the end of each calendar quarter following the Merger
Date, to pay to the CNA Surety
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<PAGE> 69
insurance subsidiaries a dollar amount equal to (i) the amount, if any, by which
their actual accident year net loss ratio exceeds the applicable Loss Ratio Cap,
multiplied by (ii) the applicable net earned premiums.
The Loss Ratio Cap only applies to the results of insureds that were
accounts of the Predecessor Operations as of the Merger Date as well as similar
accounts at any time following the Merger Date but prior to the termination of
the Stop Loss Contract. Although the Stop Loss Contract remains in effect until
December 31, 2000, the provisions shall continue until all obligations of the
parties have been performed. In consideration for the coverage provided by the
Stop Loss Contract, the CNA Surety insurance subsidiaries must pay to CCC an
annual premium equal to $20,000. The CNA Surety insurance subsidiaries paid CCC
the initial annual premium. There was no amount due to the CNA Surety insurance
subsidiaries from CCC under the Stop Loss Contract as of March 31, 1998.
Surety Excess of Loss Reinsurance Contract and Surety Second Excess of Loss
Contract
The Excess of Loss Contracts collectively provide CNA Surety with the
capacity to underwrite large surety bond exposures by providing the insurance
subsidiaries with reinsurance support from CCC. Historically, CCC's substantial
capital base has enabled it to underwrite and retain large aggregate surety bond
exposures. The Excess of Loss Contract executed by CCC and the CNA Surety
insurance subsidiaries on the Merger Date and the Second Excess of Loss Contract
subsequently entered into by such parties retroactive to October 1, 1997, cede
to CCC certain liabilities in excess of the capacity provided by the CNA Surety
insurance subsidiaries' reinsurance program.
Specifically, under the Excess of Loss Contract, CCC provides the insurance
subsidiaries with $75 million of coverage in excess of the $55 million of
coverage provided to the insurance subsidiaries by third party reinsurers, which
is in turn in excess of the $5 million of coverage per principal to be retained
by the insurance subsidiaries. The Second Excess of Loss Contract is structured
to commence additional coverage immediately after the foregoing coverage of $75
million per principal, in excess of $60 million, provided by the Excess of Loss
Contract. Consequently, under the Excess of Loss Contracts, CCC will be
obligated to pay to the CNA Surety insurance subsidiaries, on a quarterly basis,
the amount of any loss in excess of the $5 million per principal retained by CNA
Surety's insurance subsidiaries. Over the last five years, no more than ten
Predecessor Operations' accounts have had exposures that would have been
reinsured under the Excess of Loss Contract.
The Excess of Loss Contracts collectively provide coverage for losses
discovered on surety bonds in force as of the Merger Date and for losses
discovered on new and renewal business written, renewed or assumed during the
term of the Excess of Loss Contracts. CCC is also obligated to act as a joint
insurer, or "co-surety," for business covered by the Excess of Loss Contracts
when requested by the CNA Surety insurance subsidiaries.
The term of the Excess of Loss Contract commenced immediately following the
Merger Date and continues for a period of five years. Although executed
subsequent to the Excess of Loss Contract, the term of the Second Excess of Loss
Contract has been structured to provide retroactive effectiveness in order to
parallel the term of the Excess of Loss Contract. For a period of three years
following the termination of the Excess of Loss Contracts, CCC will be liable
for applicable losses discovered with respect to business covered prior to the
date of termination of the Excess of Loss Contracts. In consideration for the
reinsurance coverage provided by the Excess of Loss Contracts, the insurance
subsidiaries will pay to CCC, on a quarterly basis, a premium equal to 1% of the
net written premiums applicable to the Excess of Loss Contracts, subject to a
minimum premium of $20,000 and $5,000 per quarter under the Excess of Loss
Contract and the Second Excess of Loss Contract, respectively. The CNA Surety
insurance subsidiaries have paid CCC $80,000 for all minimum quarterly premiums
due under the Excess of Loss Contract through September 30, 1998. Although fully
executed, as a related party transaction, the Second Excess of Loss Contract is
subject to ratification by the Audit Committee of the Board. CNA Surety
management has no reason to believe that such ratification will not be obtained.
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Services and Indemnity Agreement
The Services and Indemnity Agreement between CCC and CNA Surety's insurance
subsidiaries authorizes CNA Surety's insurance subsidiaries to perform certain
underwriting, claims, agency and accounting functions on behalf of CCC as they
relate to the business assumed under the Quota Share Treaty for a period of five
years from the Merger Date. In consideration for the provision of the foregoing
services, CCC agreed to pay the insurance subsidiaries a quarterly fee of
$50,000. CCC has paid Western Surety $100,000 for services rendered under the
Services and Indemnity Agreement for the period from September 30, 1997 through
March 31, 1998.
In addition, the Services and Indemnity Agreement prohibits any changes or
modifications to it or any of the reinsurance agreements without the written
approval of CCC and the audit committee of the CNA Surety Board.
Administrative Services Agreement
Pursuant to the Reorganization Agreement, CNA Surety entered into an
Administrative Services Agreement with CCC to allow for the continued use by CNA
Surety of real and personal property currently owned or leased by CCC. In
addition, CNA Surety may purchase many of the services provided by CCC to the
Predecessor Operations. The Administrative Services Agreement has a three-year
term and commenced as of the Merger Date.
The Administrative Services Agreement provides that the rental and service
fees charged by CCC thereunder can be no less favorable than that charged to the
Predecessor Operations. Such charges may be increased annually in an amount not
more than the increase in the consumer price index during the previous 12
months. CNA Surety has the authority to choose, at its discretion, to receive
any or all of the services offered under the Administrative Services Agreement.
CNA Surety, however, is under no obligation to purchase any services under the
Administrative Services Agreement. The aggregate maximum annual cost for the use
of the real and personal property and for services available under the agreement
is approximately $7.9 million. Administrative services are provided at specified
rates, subject to inflationary increases. For the quarter ended March 31, 1998,
the Company incurred $2.3 million for rents and services provided under the
agreement. The Company paid CCC $2.3 million during the quarter ended March 31,
1998 and $1.1 million of accrued expenses was reflected in other liabilities in
CNA Surety's Consolidated Balance Sheet at March 31, 1998.
Services provided and offered under the Administrative Services Agreement
include the following: telecommunications, computer access and support, human
resource assistance, accounting, legal, financial and administrative support,
marketing, strategic management and direction, investment advice and various
other business services.
The Company currently uses approximately 72,500 square feet of space and
related personal property in CCC's 41 branch locations and home office in
Chicago, Illinois. CNA Surety may terminate its use of these locations as set
forth in the Administrative Services Agreement, without penalty, by providing
CCC with 60 days written notice.
The Administrative Services Agreement also provides for prior notice of any
termination of the underlying leases of real property from third parties and an
option to CNA Surety to purchase the personal property owned by CCC and leased
to CNA Surety under the Administrative Services Agreement at the end of three
years for the price of $1.
Reinsurance Arrangement with CNA Re (London)
In the fourth quarter of 1997, an affiliate of CCC entered into a 50% U.S.
dollar quota share reinsurance treaty with CNA Re (London), a subsidiary of
CNAF. The treaty was effective as of January 1, 1997 and provides facultative or
treaty reinsurance cover on credit insurance, surety and guarantee, and fidelity
and computer crime classes of business, predominantly on European risks. The
business assumed by CCC under this treaty was retroceded to Western Surety under
terms of the Quota Share Treaty. For the three months ended March 31, 1998, the
Company assumed $2.5 million in international premiums.
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Trademark License Agreement
In connection with the Merger, CNAF and the Company entered into a
Trademark License Agreement pursuant to which the Company obtained the right to
use the "CNA" mark or some derivation thereof for an unlimited period of time,
subject to termination in the event of a change in control of CNA Surety. The
license is a royalty-free license to CNA Surety and may not be assigned by CNA
Surety.
Continuing Covenants of CNAF
The Reorganization Agreement contains certain ongoing agreements, including
an agreement by CCC and CNA Surety to cause the bylaws of CNA Surety to require
approval by 75% of the holders of Common Stock for CNA Surety in order to (i)
enter into certain business combinations, (ii) accept proposals to sell all or
substantially all of the Company's assets, (iii) amend the bylaw provisions
requiring such supermajority voting or (iv) amend the certificate of
incorporation.
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PRINCIPAL AND SELLING STOCKHOLDERS
In connection with the Merger, CNA Surety entered into a registration
rights agreement with Equity Capsure Limited Partnership ("Equity Capsure"), the
major stockholder of Capsure, granting certain registration rights. Pursuant to
the exercise of such registration rights, CNA Surety is registering for sale
shares of Common Stock held by the former partners of Equity Capsure. The
Selling Stockholders consist of (i) certain trusts, partnerships or other
entities that hold shares of Common Stock following the distribution of shares
of Common Stock by Equity Capsure to its partners; (ii) Samuel Zell, the former
Chief Executive Officer and Chairman of the Board of Directors of Capsure; and
(iii) Bruce A. Esselborn, the former President of Capsure. The Selling
Stockholders will pay all underwriting discounts, commissions and transfer taxes
relating to the shares of Common Stock offered for sale by the Selling
Stockholders hereunder, as well as the fees and disbursement of their legal
counsel. All other fees and expenses in connection with the registration of the
shares of Common Stock hereunder shall be borne by CNA Surety.
The following table sets forth, as of May 22, 1998, the beneficial
ownership of Common Stock of (i) each of the Selling Stockholders, (ii) each
stockholder who is known by the Company to beneficially own more than 5% of such
outstanding Common Stock, (iii) each of CNA Surety's directors, those executive
officers named in the Summary Compensation Table and all executive officers and
directors of CNA Surety as a group. Information regarding the directors and
executive officers and their security holdings has been furnished by them to CNA
Surety. The table also sets forth the number of shares of Common Stock being
offered by the Selling Stockholders and the number and percentage of outstanding
shares to be owned by each person and group after adjustment for completion of
the Offering.
<TABLE>
<CAPTION>
AMOUNT AND NATURE OF AMOUNT AND NATURE OF
BENEFICIAL OWNERSHIP BENEFICIAL OWNERSHIP
PRIOR TO OFFERING(1) SHARES OF AFTER THE OFFERING
-------------------- COMMON STOCK --------------------
NAME AND ADDRESS OF BENEFICIAL OWNERS SHARES PERCENT OFFERED SHARES PERCENT
------------------------------------- ---------- ------- ------------ ---------- -------
<S> <C> <C> <C> <C> <C>
CNAF(2)................................. 27,096,337(3) 62.5%(3) -- 27,096,337 62.5%
Samstock, L.L.C.(4)..................... 1,988,769 4.6% 1,988,769 0 --
Alpha/ZFT General Partnership(5)........ 578,649 1.3% 578,649 0 --
Anda Partnership(6)..................... 498,684 1.1% 498,684 0 --
LFT Partnership(7)...................... 486,760 1.1% 486,760 0 --
Samuel Zell............................. 65,000 * 65,000 0 --
The Ann and Robert H. Lurie Family
Foundation(8)......................... 486,760 1.1% 486,760 0 --
Bruce A. Esselborn(9)................... 83,507(10) * 83,507(10) 0 --
Philip H. Britt......................... 3,000 * -- 3,000 --
David T. Cumming........................ 3,500(11) * -- 3,500 *
Melvin Gray............................. 1,000(12) * -- 1,000 *
Joe P. Kirby............................ 76,910 * -- 76,910 *
Roy Posner.............................. 250 * -- 250 *
Adrian M. Tocklin....................... 1,000 * -- 1,000 *
Robert T. Van Gieson.................... 300 * -- 300 *
Mark C. Vonnahme........................ 1,100(13) * -- 1,100 *
Robert E. Ayo........................... 100 * -- 100 *
Dan L. Kirby............................ 78,252 * -- 78,252 *
Stephen T. Pate......................... 11,450 * -- 11,450 *
All directors and executive officers as
a group (21 persons) including the
above named persons................... 635,976 1.5% 635,976 1.5%
</TABLE>
- ---------------
* Less than 1%
(footnotes continued on next page)
71
<PAGE> 73
(1) The number of shares of the Common Stock indicated as beneficially owned
are reported on the basis of regulations of the Commission governing the
determination of beneficial ownership of securities.
(2) CNAF is an 84% owned subsidiary of Loews Corporation. The address for CNAF
is: CNA Plaza, Chicago, Illinois, 60685. CNAF and Loews Corporation each
disclaim beneficial ownership of these shares.
(3) The Reorganization Agreement provided that CCC and its affiliates would
have beneficial ownership of 61.75% of the outstanding Common Stock on a
fully-diluted basis immediately following the Merger. Although CCC and its
affiliates have not increased their ownership in CNA Surety, the beneficial
ownership for CCC reported in this table is higher than 61.75% because the
rules under the Exchange Act require disclosure of ownership on other than
a fully-diluted basis.
(4) Samstock, L.L.C., a Delaware limited liability company ("Samstock"), is
wholly owned by SZ Investments, L.L.C., a Delaware limited liability
company ("SZ Investments"). SZ Investments is owned by Zell General
Partnership, Inc., an Illinois corporation, as the sole managing member,
which is wholly owned by the Samuel Zell Revocable Trust of which Mr. Zell
is trustee and beneficiary ("Zell Trust") and Alphabet Partners and ZFT
Partnership, as non-managing members. The business address for Samstock is
Two N. Riverside Plaza, Chicago, IL 60606.
(5) Alpha/ZFT General Partnership, an Illinois general partnership
("Alpha/ZFT"), is wholly owned by Alphabet Partners and ZFT Partnership,
each of which is composed of various trusts for the benefit of Mr. Zell and
his family. The business address for Alpha/ZFT is Two N. Riverside Plaza,
Chicago, IL 60606.
(6) Anda Partnership, a Nevada general partnership ("Anda"), is composed of ten
trusts created for the benefit of Ann Lurie and her family which share
equally in the partnership. Mrs. Lurie and Mark Slezak are co-trustees of
the ten trusts. The business address for Anda is Two N. Riverside Plaza,
Chicago, IL 60606.
(7) LFT Partnership, an Illinois general partnership ("LFT"), is composed of
six trusts created for the benefit of Mrs. Lurie's six children which share
equally in the partnership. Mrs. Lurie is the sole trustee of the six
trusts. The business address of LFT is Two N. Riverside, Chicago, IL 60606.
(8) The Ann and Robert H. Lurie Family Foundation is an Illinois not-for-profit
corporation with Ann Lurie as the President, Treasurer and one of the
directors. The address for the Ann and Robert H. Lurie Family Foundation is
Two N. Riverside Plaza, Chicago, Illinois, 60606.
(9) Mr. Esselborn was a Director of the Company from September 30, 1997 until
May 1998. Mr. Esselborn was President of Capsure from June 1992 until
September 30, 1997.
(10) Includes 8,500 shares of Common Stock held by Mr. Esselborn's wife, which
shares are being sold in this Offering.
(11) Includes 1,000 shares beneficially owned by Mr. Cumming's daughter and 500
shares beneficially owned by his wife.
(12) Shares are held in trust in Mr. Gray's name.
(13) Includes 1,000 shares owned jointly by Mr. Vonnahme and his wife with whom
he shares voting and investment power.
72
<PAGE> 74
DESCRIPTION OF CAPITAL STOCK
CNA Surety is authorized to issue two classes of shares: common and
preferred.
COMMON STOCK
The number of shares of Common Stock authorized by CNA Surety's certificate
of incorporation is 100 million, $.01 par value per share. As of May 27, 1998,
43,446,119 shares of Common Stock were issued and outstanding. All issued and
outstanding shares of Common Stock offered hereby are validly issued, fully paid
and non-assessable. The holders of Common Stock are entitled to one vote for
each share held of record on each matter submitted to a vote of stockholders and
are not entitled to cumulative voting. Holders of Common Stock have no
preemptive rights and have no rights to convert their Common Stock into any
other securities. Holders of Common Stock are entitled to such dividends if,
when and as declared by the Board out of funds legally available therefore. See
"Dividend Policy."
The shares of Common Stock being offered in the Offering are to be listed
on the NYSE, subject to official notice of issuance.
Certain of CNAF's operating subsidiaries' ownership of approximately 62.5%
of the outstanding Common Stock may permit it to elect the members of the Board
who will control the future direction and operations of the Company, including
decisions regarding the issuance of securities, dividends, acquisitions and the
sale of the Company.
Upon liquidation or dissolution of the Company, after satisfaction of any
liquidation preferences of any outstanding preferred stock, holders of Common
Stock are entitled to receive, pro rata in accordance with their full
liquidation interests, all assets remaining available for distribution to
stockholders.
The Company has appointed Boston EquiServe, LLP as its transfer agent and
registrar.
PREFERRED STOCK
The Board has the authority to issue up to 20 million shares of preferred
stock of CNA Surety, $0.01 par value per share, and to determine the price,
rights, preferences, privileges and restrictions, including voting rights, of
such stock without further stockholder approval. As of May 27, 1998, no shares
of preferred stock had been issued or were outstanding.
73
<PAGE> 75
UNDERWRITING
Subject to certain terms and conditions contained in the Underwriting
Agreement, the syndicate of Underwriters named below, for whom Donaldson, Lufkin
& Jenrette Securities Corporation and Smith Barney Inc. are acting as
representatives (the "Representatives"), have severally agreed to purchase from
the Selling Stockholders, and if the Over-Allotment Option is exercised, from
CNA Surety, an aggregate of 4,188,129 shares of Common Stock. The number of
shares of Common Stock that each Underwriter has agreed to purchase is set forth
opposite its name below:
<TABLE>
<CAPTION>
UNDERWRITERS NUMBER OF SHARES
------------ ----------------
<S> <C>
Donaldson, Lufkin & Jenrette Securities
Corporation..................................... 1,664,576
Smith Barney Inc. ................................ 1,664,575
ABN AMRO Chicago Corporation...................... 95,442
Chatsworth Securities LLC......................... 95,442
Cochran, Caronia & Co., Inc. ..................... 95,442
Conning & Company................................. 95,442
Dowling & Partners Securities LLC................. 95,442
Fox-Pitt, Kelton Incorporated..................... 95,442
Janney Montgomery Scott Inc. ..................... 95,442
Keefe, Bruyette & Woods, Inc. .................... 95,442
Kelton International.............................. 95,442
---------
Total........................................ 4,188,129
=========
</TABLE>
The Underwriting Agreement provides that the obligations of the several
Underwriters to purchase shares of Common Stock are subject to the approval of
certain legal matters by counsel and to certain other conditions. If any of the
shares of Common Stock are purchased by the Underwriters pursuant to the
Underwriting Agreement, all such shares of Common Stock (other than the shares
of Common Stock covered by the Over-Allotment Option) must be so purchased.
CNA Surety and the Selling Stockholders have agreed to indemnify the
Underwriters against certain liabilities, including liabilities under the
Securities Act, or to contribute to payments that the Underwriters may be
required to make in respect thereof.
CNA Surety has been advised by the Representatives that the Underwriters
propose to offer the Common Stock to the public initially at the price set forth
on the cover page of this Prospectus and to certain dealers (who may include the
Underwriters) at such price less a concession not to exceed $0.41 per share. The
Underwriters may allow, and such dealers may reallow, discounts not in excess of
$0.10 per share to any other Underwriter and certain other dealers.
CNA Surety has granted to the Underwriters an option to purchase up to
628,219 additional shares of Common Stock, at the public offering price less
underwriting discounts and commissions, solely to cover over-allotments. Such
option may be exercised at any time until 30 days after the effective date of
the Registration Statement of which this Prospectus is part. To the extent that
the Underwriters exercise such option each of the Underwriters will be
committed, subject to certain conditions, to purchase a number of option shares
proportionate to such Underwriter's initial commitment as indicated in the
preceding table.
CNAF, CNA Surety, the Selling Stockholders, and the directors and the
executive officers of CNA Surety have agreed that they will not directly or
indirectly offer, sell, contract to sell, or otherwise dispose of or transfer
any shares of Common Stock owned by them without the prior written consent of
Donaldson, Lufkin & Jenrette Securities Corporation, for a period of 180 days
after the date of this Prospectus except in certain non-public transactions in
which the acquiror or acquirors of such shares agree(s) to such restrictions. In
addition, CNA Surety has agreed that for a period of 180 days after the date of
this Prospectus it will not, without the prior written consent of Donaldson,
Lufkin & Jenrette Securities Corporation, offer, sell, contract to sell, grant
any option to purchase or otherwise dispose of any shares of Common Stock or any
securities convertible into or exercisable or exchangeable for such Common Stock
or in any other manner transfer all or a portion of the economic consequences
associated with such Common Stock, except for (i) shares of Common Stock offered
hereby, (ii) shares of Common Stock issued pursuant to the exercise of options
outstanding on the date of this Prospectus, (iii) options or other stock-based
awards granted or shares of
74
<PAGE> 76
Common Stock after the date of this Prospectus pursuant to CNA Surety's employee
stock plans and other plans and (iv) shares or options issued in acquisitions in
which the acquiror or acquirors of such shares agree(s) to such restrictions.
In connection with the Offering, the Underwriters may engage in
transactions that stabilize, maintain or otherwise affect the price of the
Common Stock. Specifically, the Underwriters may overallot the Offering,
creating a syndicate short position. In addition, the Underwriters may bid for,
and purchase, shares of Common Stock in the open market to cover syndicate
shorts or to stabilize the price of the Common Stock. Finally, the underwriting
syndicate may reclaim selling concessions allowed for distributing the Common
Stock in the Offering, if the syndicate repurchases previously distributed
Common Stock in syndicate covering transactions, in stabilization transactions
or otherwise. Any of these activities may stabilize or maintain the market price
of the Common Stock above independent market levels. The Underwriters are not
required to engage in these activities and may end any of these activities at
any time.
EXPERTS
The consolidated financial statements of CNA Surety Corporation and
subsidiaries as of December 31, 1997 and for the period from September 30, 1997
(date of inception) through December 31, 1997 and related financial statement
schedules and the special purpose Statement of Certain Assets and Liabilities of
Predecessor Operations as of December 31, 1996 and the special-purpose
Statements of Certain Revenues and Direct Operating Expenses for each of the two
years in the period ended December 31, 1996 and for the nine-month period ended
September 30, 1997, have been audited by Deloitte & Touche LLP, independent
auditors, as set forth in their report thereon and included herein. The Deloitte
& Touche LLP report on the special purpose financial statements expresses an
unqualified opinion and includes an explanatory paragraph with respect to the
basis of presentation. Such financial statements and related financial statement
schedules are included in this Prospectus in reliance upon such report given
upon the authority of such firm as experts in accounting and auditing.
The consolidated financial statements for Capsure as of December 31, 1996
and 1995 and for each of the three years in the period ended December 31, 1996
have been audited by Coopers & Lybrand L.L.P., independent auditors, as set
forth in their report thereon and as included herein. Such financial statements
and related financial statement schedules are included in this Prospectus in
reliance upon such report given upon the authority of such firm as experts in
accounting and auditing.
LEGAL MATTERS
The validity of the Common Stock to be offered hereby, including shares
issuable in the event that the Underwriters exercise the Over-Allotment Option,
and certain matters in connection herewith will be passed upon for the Company
by Seyfarth, Shaw, Fairweather & Geraldson, Chicago, Illinois, counsel for the
Company. Certain legal matters in connection with this Offering are being passed
upon for the Underwriters by Simpson Thacher & Bartlett, New York, New York.
75
<PAGE> 77
GLOSSARY OF SELECTED INSURANCE TERMS
The following terms when used in this Prospectus have the following
meanings:
Bid Bonds.................. Contract bonds used by owners to prequalify
contractors submitting proposals on potential
contracts.
Combined Ratio............. The sum of the Loss Ratio and the Expense Ratio.
Commercial Surety Bonds.... Surety bonds that are not contract bonds.
Contract Bonds............. Bonds which secure the payment and/or performance
of an obligation under a written contract.
Expense Ratio.............. The percentage of premium income that goes to cover
acquisition and underwriting costs and is computed
as acquisition and underwriting expenses divided by
earned premiums.
Fidelity Bonds............. Bonds which cover losses arising from employee
dishonesty.
Judicial and Fiduciary
Bonds...................... Bonds required by statutes, courts or legal
documents for the protection of those on whose
behalf a fiduciary acts.
LAE........................ Loss adjustment expenses, including both allocated
and unallocated adjustment expenses.
License and Permit Bonds... 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.
Loss Ratio................. The percentage of incurred loss and loss adjustment
expenses to earned premiums.
Non-Standard Contract
Market................... Bonds that have higher risks or special exposures,
such as bonds written through the Small Business
Administration programs.
Notary Public Bonds........ Bonds required by statutes to protect against
losses resulting from the improper actions of
notaries public.
Payment Bonds.............. Contract bonds which guarantee payment of the
contractor's obligation under the contract for
labor, subcontractors and materials supplied to the
project. Because liens may not be placed on public
jobs, the payment bond may be the only protection
for those supplying labor or materials to a public
job.
Performance Bonds.......... Contract bonds which guarantee to the owner the
obligations of the contractor according to the
terms and conditions of the contract.
Public Official Bonds...... Bonds required by statutes and ordinances to
guarantee the lawful and faithful performance of
the duties of office by public officials.
Surety Bonds............... Three party agreements where the issuer of the bond
(the surety) joins with the second party (the
principal) in guaranteeing to a third party (the
obligee) the fulfillment of some obligation on the
part of the principal.
76
<PAGE> 78
INDEX TO FINANCIAL STATEMENT SCHEDULES.
<TABLE>
<CAPTION>
PAGE
----
<S> <C> <C>
PART I. YEAR ENDED DECEMBER 31, 1997:
(A) FINANCIAL:
Independent Auditors' Report................................ F-3
Consolidated Balance Sheet as of December 31, 1997 and
Statement of Certain Assets and Liabilities of Predecessor
as of December 31, 1996................................... F-4
Consolidated Statement of Income for the Period from
September 30, 1997 (date of inception) through December
31, 1997 and Statements of Certain Revenues and Direct
Operating Expenses of Predecessor for the Nine Months
Ended September 30, 1997 and Years Ended December 31, 1996
and 1995.................................................. F-5
Consolidated Statement of Changes in Stockholders' Equity
for the Period from September 30, 1997 (date of inception)
through December 31, 1997................................. F-6
Consolidated Statement of Cash Flows for the Period from
September 30, 1997 (date of inception) through December
31, 1997.................................................. F-7
Notes to Consolidated Financial Statements.................. F-8
(B) FINANCIAL STATEMENT SCHEDULES:
Schedule I -- Summary of Investments........................ F-26
Schedule II -- Condensed Financial Information of
Registrant................................................ F-27
Schedule III -- Supplementary Insurance Information......... F-31
Schedule IV -- Reinsurance.................................. F-32
Schedule V -- Valuation and Qualifying Accounts............. F-33
Schedule VI -- Supplemental Information Concerning
Property-Casualty Insurance Operations.................... F-34
PART II. THREE MONTHS ENDED MARCH 31, 1998 (UNAUDITED):
(A) FINANCIAL:
Independent Accountants' Review Report...................... F-35
Condensed Consolidated Balance Sheets as of March 31, 1998
and December 31, 1997..................................... F-36
Condensed Consolidated Statement of Income for the Three
Months Ended March 31, 1998 and Condensed Statement of
Certain Revenues and Direct Operating Expenses of
Predecessor for the Three Months Ended March 31, 1997..... F-37
Condensed Consolidated Statement of Stockholders' Equity for
the Three Months Ended March 31, 1998..................... F-38
Condensed Consolidated Statement of Cash Flows for the Three
Months Ended March 31, 1998............................... F-39
Notes to Condensed Consolidated Financial Statements as of
March 31, 1998............................................ F-40
</TABLE>
F-1
<PAGE> 79
<TABLE>
<CAPTION>
PAGE
----
<S> <C> <C>
PART III. CAPSURE FINANCIAL STATEMENTS:
(A) YEAR ENDED DECEMBER 31, 1996
(a)(1) Financial:
Report of Independent Accountants........................... F-44
Consolidated Balance Sheets as of December 31, 1996 and
1995...................................................... F-45
Consolidated Statements of Income for the Years Ended
December 31, 1996, 1995 and 1994.......................... F-46
Consolidated Statements of Changes in Stockholders' Equity
for the Years Ended December 31, 1996, 1995 and 1994...... F-47
Consolidated Statements of Cash Flows for the Years Ended
December 31, 1996, 1995 and 1994.......................... F-48
Notes to Consolidated Financial Statements.................. F-49
(a)(2) Financial Statement Schedules:
Schedule I -- Summary of Investments........................ F-66
Schedule II -- Condensed Financial Information of
Registrant................................................ F-67
Schedule III -- Supplementary Insurance Information......... F-71
Schedule IV -- Reinsurance.................................. F-72
Schedule V -- Valuation and Qualifying Accounts............. F-73
Schedule VI -- Supplemental Information Concerning
Property -- Casualty Insurance Operations................. F-74
(B) SIX MONTHS ENDED JUNE 30, 1997:
(b)(1) Financials:
Consolidated Balance Sheets at June 30, 1997 and December
31, 1996.................................................. F-75
Consolidated Statements of Income for the Periods Ended June
30, 1997 and 1996......................................... F-76
Consolidated Statements of Cash Flows for the Six Months
Ended June 30, 1997 and 1996.............................. F-77
Notes to Consolidated Financial Statements at June 30,
1997...................................................... F-78
</TABLE>
F-2
<PAGE> 80
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders of
CNA Surety Corporation
We have audited the consolidated balance sheet of CNA Surety Corporation
and subsidiaries as of December 31, 1997, and the related consolidated
statements of income, changes in stockholders' equity, and cash flows from
September 30, 1997 (date of inception) through December 31, 1997. We have also
audited the accompanying special-purpose statement of certain assets and
liabilities of CCC Surety Operations (Predecessor), a business unit of CNA
Financial Corporation, as of December 31, 1996 and the special-purpose
statements of certain revenues and direct operating expenses for each of the two
years in the period ended December 31, 1996 and for the nine month period ended
September 30, 1997. Our audit also included the financial statement schedules
listed in the Index at Item 16, Part I. These financial statements and financial
statement schedules are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements and
financial statement schedules based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
The accompanying special-purpose financial statements were prepared to
present certain assets and liabilities and certain revenues and direct operating
expenses of CCC Surety Operations and are not intended to be a complete
presentation of CCC Surety Operations. Note 1 to the consolidated financial
statements describes the basis of presentation of these special-purpose
financial statements.
In our opinion, such consolidated financial statements present fairly, in
all material respects, the financial position of CNA Surety Corporation and
subsidiaries as of December 31, 1997, and the results of their operations and
their cash flows from September 30, 1997 (date of inception) through December
31, 1997, in conformity with generally accepted accounting principles.
Furthermore, in our opinion, such special-purpose financial statements present
fairly, in all material respects, certain assets and liabilities of CCC Surety
Operations as of December 31, 1996, and certain revenues and direct operating
expenses for each of the two years in the period ended December 31, 1996 and for
the nine month period ended September 30, 1997, in conformity with generally
accepted accounting principles. Also, in our opinion, such financial statement
schedules, when considered in relation to the basic consolidated financial
statements taken as a whole, present fairly in all material respects the
information set forth therein.
Deloitte & Touche LLP
Chicago, Illinois
February 27, 1998
F-3
<PAGE> 81
CNA SURETY CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET AND STATEMENT
OF CERTAIN ASSETS AND LIABILITIES OF PREDECESSOR
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------
PREDECESSOR
1997 1996
-------- -----------
<S> <C> <C>
ASSETS
Invested assets and cash:
Fixed income securities, at fair value (amortized cost:
$265,545).............................................. $266,301 $ --
Short-term investments, at cost (approximates fair
value)................................................. 147,235 --
Other investments, at fair value.......................... 6,001 --
Cash...................................................... 130 --
-------- --------
419,667 --
Deferred policy acquisition costs........................... 64,144 37,689
Receivable from affiliates.................................. -- 131,478
Insurance receivables:
Premiums.................................................. 9,683 30,379
Reinsurance, including $47,856 from affiliates in 1997
(See Note 14).......................................... 55,151 20,069
Intangible assets, net of accumulated amortization of $1,447
and $619 at December 31, 1997 and 1996, respectively...... 161,962 6,897
Prepaid reinsurance premiums................................ 4,150 6,312
Other assets................................................ 12,423 --
-------- --------
Total assets........................................... $727,180 $232,824
======== ========
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses................ $130,381 $119,151
Unearned premiums......................................... 173,836 95,677
-------- --------
304,217 214,828
Long-term debt.............................................. 118,000 --
Deferred income taxes, net.................................. -- 4,540
Payable for securities purchased............................ 10,609 --
Other liabilities........................................... 37,622 13,456
-------- --------
Total liabilities...................................... 470,448 232,824
-------- --------
Commitments and contingencies (See Note 9)
STOCKHOLDERS' EQUITY
Preferred stock, par value $0.01 per share, 20,000 shares
authorized; none issued and outstanding................... -- --
Common stock, par value $0.01 per share, 100,000 shares
authorized; none issued at December 31, 1996 and 43,320
shares issued and outstanding at December 31, 1997........ 433 --
Additional paid-in capital.................................. 244,829 --
Retained earnings........................................... 10,996 --
Unrealized gain on securities, net of deferred income
taxes..................................................... 474 --
-------- --------
Total stockholders' equity............................. 256,732 --
-------- --------
Total liabilities and stockholders' equity............. $727,180 $232,824
======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-4
<PAGE> 82
CNA SURETY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF INCOME AND STATEMENTS OF
CERTAIN REVENUES AND DIRECT OPERATING EXPENSES OF PREDECESSOR
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
SEPTEMBER 30, PREDECESSOR
DATE OF -------------------------------------
INCEPTION, NINE YEARS ENDED
THROUGH MONTHS ENDED DECEMBER 31,
DECEMBER 31, SEPTEMBER 30, --------------------
1997 1997 1996 1995
------------- ------------- -------- --------
<S> <C> <C> <C> <C>
Revenues:
Net earned premiums.................... $65,433 $108,564 $149,069 $130,603
Net investment income.................. 5,766 -- -- --
Net realized investment gains.......... 85 -- -- --
------- -------- -------- --------
71,284 108,564 149,069 130,603
------- -------- -------- --------
Expenses:
Net losses and loss adjustment
expenses............................ 12,134 (11,516) 33,006 32,440
Net commissions, brokerage and other
underwriting........................... 38,213 59,674 81,615 71,591
Interest expense....................... 1,831 -- -- --
Amortization of intangible assets...... 1,447 -- -- --
------- -------- -------- --------
53,625 48,158 114,621 104,031
------- -------- -------- --------
Income before income taxes (Excess of net
earned premiums over direct operating
expenses, before income taxes for
Predecessor)........................... 17,659 60,406 34,448 26,572
Income taxes............................. 6,663 21,241 12,188 9,385
------- -------- -------- --------
Net income (Excess of net earned premiums
over direct operating expenses, net of
income taxes for Predecessor).......... $10,996 $ 39,165 $ 22,260 $ 17,187
======= ======== ======== ========
Earnings per share....................... $ 0.25
=======
Earnings per share, assuming dilution.... $ 0.25
=======
Weighted average shares outstanding...... 43,302
=======
Weighted average shares outstanding,
assuming dilution...................... 43,552
=======
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-5
<PAGE> 83
CNA SURETY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
SEPTEMBER 30,
DATE OF
INCEPTION,
THROUGH
DECEMBER 31,
1997
-------------
<S> <C>
Common Stock:
Beginning Balance......................................... $ --
Common stock issued for Capsure acquisition and as part of
the Merger............................................. 433
--------
Balance, December 31...................................... $ 433
========
Additional Paid-In Capital:
Beginning Balance......................................... $ --
Increase due to Capsure acquisition (See Note 2).......... 181,629
Capital contribution and the effects of reinsurance
agreements (See Note 2)................................ 62,859
Other..................................................... 341
--------
Balance, December 31...................................... $244,829
========
Retained Earnings:
Beginning Balance......................................... $ --
Net income................................................ 10,996
--------
Balance, December 31...................................... $ 10,996
========
Change in Net Unrealized Gain/(Loss) on Securities,
Net of Deferred Income Taxes:
Beginning Balance...................................... $ --
Change from September 30, 1997 (date of inception)
through December 31, 1997............................. 474
--------
Balance, December 31...................................... $ 474
========
</TABLE>
<TABLE>
<CAPTION>
COMMON STOCK
----------------------
ISSUED IN TREASURY
------- -----------
<S> <C> <C>
Shares:
Beginning Balance......................................... -- --
Increase due to common stock issued for Capsure
acquisition
and as part of the Merger.............................. 43,294 --
Issued through exercise of stock options.................. 26 --
------- -------
Balance, December 31, 1997................................ 43,320 --
======= =======
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-6
<PAGE> 84
CNA SURETY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
SEPTEMBER 30,
DATE OF
INCEPTION,
THROUGH
DECEMBER 31,
1997
-------------
<S> <C>
OPERATING ACTIVITIES:
Net income................................................ $ 10,996
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation and amortization.......................... 1,915
Accretion of bond discount, net........................ 172
Net realized investment gains.......................... (85)
Changes in:
Reinsurance receivables................................ (12,930)
Reserve for unearned premiums.......................... 9,233
Reserve for unpaid losses and loss adjustment
expenses.............................................. 8,100
Deferred income taxes, net............................. 4,038
Other assets and liabilities........................... 7,559
---------
Net cash provided by operating activities................... 28,998
---------
INVESTING ACTIVITIES:
Securities available-for-sale:
Purchases -- fixed income securities................... (149,580)
Maturities -- fixed income securities.................. 8,654
Sales -- fixed income securities....................... 5,146
Change in short-term investments.......................... (117,919)
Other, net................................................ (586)
---------
Net cash used in investing activities....................... (254,285)
---------
FINANCING ACTIVITIES:
Proceeds from long-term debt.............................. 118,000
Collection of receivable from affiliates, net............. 116,939
Principal payments on long-term debt...................... (54,000)
Capital contribution from CCC............................. 52,250
Closing dividend to Capsure stockholders.................. (10,591)
Other..................................................... 126
---------
Net cash provided by financing activities................... 222,724
---------
Increase (decrease) in cash................................. (2,563)
Cash at beginning of period................................. 2,693
---------
Cash at end of period....................................... $ 130
=========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest............................................... $ 1,704
Income taxes........................................... $ --
Non-cash investing activities:
Common stock and options issued in connection with
Capsure acquisition................................... $ 182,062
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-7
<PAGE> 85
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
Formation of CNA Surety Corporation and Merger
In December 1996, CNA Financial Corporation ("CNAF") and Capsure Holdings
Corp. ("Capsure") agreed to merge (the "Merger") the surety business of CNAF
with Capsure's insurance subsidiaries, Western Surety Company ("Western Surety")
and Universal Surety of America ("USA"), which are owned by a newly-formed
holding company, CNA Surety Corporation ("CNA Surety" or the "Company"). CNAF,
through its operating subsidiaries, writes multiple lines of property and
casualty insurance, including surety business that is reinsured by Western
Surety. Loews Corporation owns approximately 84% of the outstanding common stock
of CNAF. The principal operating subsidiaries of CNAF that wrote the surety line
of business for their own account prior to the Merger were Continental Casualty
Company and its property and casualty affiliates (collectively, "CCC") and The
Continental Insurance Company and its property and casualty affiliates
(collectively, "CIC"). CIC was acquired by CNAF on May 10, 1995. The combined
surety operations of CCC and CIC are referred to herein as CCC Surety Operations
("Predecessor").
Pursuant to a reorganization agreement, CCC Surety Operations and Capsure
merged their respective operations at the close of business on September 30,
1997 ("Merger Date"). CNAF, through its property and casualty subsidiaries, CCC
and CIC contributed $52.25 million of capital to CNA Surety. Through reinsurance
agreements, CCC and CIC ceded to Western Surety all of their net unearned
premiums and loss and loss adjustment expense reserves, as of the Merger Date,
and will cede to Western Surety all surety business written or renewed by CCC
and CIC for a period of five years thereafter. Further, CCC and CIC have agreed
to assume the obligation for any adverse development on recorded reserves for
CCC Surety Operations as of the Merger Date, to limit the loss ratio on certain
defined business written by CNA Surety through December 31, 2000 and to provide
certain additional excess of loss reinsurance. CCC also agreed to provide
certain administrative services at specified rates, subject to inflationary
increases, for three years after the Merger, if CNA Surety chooses to purchase
such services.
Immediately after the Merger, CCC and CIC owned, on a diluted basis, 61.75%
of CNA Surety's common stock and the stockholders and option holders of Capsure
owned 38.25% of CNA Surety's common stock on a diluted basis. The reorganization
agreement provides for a mechanism, referred to as the "Lookback Adjustment",
which could adjust the number of shares of CNA Surety common stock owned by CCC
in the event that either or both of Capsure's and the CCC Surety Operations'
actual net written premiums for 1997 vary from certain targets. See Note 16 for
a discussion of the Lookback Adjustment.
Principles of Consolidation
The consolidated financial statements include the accounts of CNA Surety
Corporation and all majority-owned subsidiaries. The consolidated financial
statements include the actual combined consolidated operating results of CCC
Surety Operations and Capsure since the Merger Date.
CNA Surety's insurance subsidiaries write surety and fidelity bonds in all
50 states through a combined network of approximately 37,000 independent
agencies. CNA Surety's principal insurance subsidiaries are Western Surety and
USA. Western Surety writes, on a direct basis or as business assumed from CCC
and CIC, small fidelity and noncontract surety bonds, referred to as commercial
bonds; small, medium and large contract bonds; international surety and credit
insurance; and errors and omissions ("E&O") liability insurance, as a licensed
insurer in all 50 states and the District of Columbia. Western Surety's
affiliated company, Surety Bonding Company of America ("SBCA"), writes
principally small commercial surety business and is licensed in 22 states. USA
specializes in the underwriting of small contract and commercial surety bonds.
USA is licensed in 41 states and the District of Columbia with most of its
business generated in Texas.
F-8
<PAGE> 86
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Predecessor Financial Information
The accompanying Statement of Certain Assets and Liabilities as of December
31, 1996 reflects assets and liabilities identified as being attributable to the
business of CCC Surety Operations, the Predecessor. Because CNAF did not
customarily allocate the investment portfolio or capital of its operating
subsidiaries to its business units like CCC Surety Operations, the Statement of
Certain Assets and Liabilities does not include investments or capital. The
receivable from affiliates is calculated at an amount necessary to balance all
other identified assets with the total of all identified liabilities.
The accompanying Statements of Certain Revenues and Direct Operating
Expenses for the years ended December 31, 1996 and 1995, reflect premiums
earned, losses incurred, loss adjustment expenses (allocated and unallocated)
and other direct operating expenses of CCC Surety Operations. Such operating
revenues and costs as investment income, realized gains and losses on
investments and certain general and administrative expenses, which are indirect
or overhead in nature, are not reflected in operating results since such items
were not historically allocated to CCC Surety Operations by CNAF or its
subsidiaries.
Since the accompanying Predecessor financial statements exclude certain
assets, liabilities, revenues, and expenses, as described in the preceding two
paragraphs, these financial statements are not intended to be a complete
presentation of CCC Surety Operations. Those assets, liabilities, revenues and
costs that are reflected in the accompanying financial statements have been
determined in accordance with generally accepted accounting principles.
Investments
The Company has the ability to hold all fixed income securities to
maturity. However, the Company may dispose of securities prior to their
scheduled maturity due to changes in interest rates, prepayments, tax and credit
considerations, liquidity or regulatory capital requirements, or other similar
factors. As a result, the Company considers all of its fixed income securities
(bonds and redeemable preferred stocks) and equity securities as
available-for-sale. These securities are reported at fair value, with unrealized
gains and losses, net of deferred income taxes, reported as a separate component
of stockholders' equity. Cash flows from purchases, sales and maturities are
reported gross in the investing activities section of the cash flow statement.
The amortized cost of fixed income securities is determined based on cost
and the cumulative effect of amortization of premiums and accretion of discounts
to maturity. Such amortization and accretion is included in investment income.
For mortgage-backed and certain asset-backed securities, the Company recognizes
income using the effective yield method based on estimated cash flows.
Investment gains or losses realized on the sale of securities are determined
using the specific identification method. Investments with an other than
temporary decline in value are written down to fair value, resulting in losses
that are included in investment gains and losses.
Short-term investments are carried at amortized cost which approximates
fair value.
Deferred Policy Acquisition Costs
Policy acquisition costs, consisting of commissions and other underwriting
expenses which vary with, and are directly related to, the production of
business, net of reinsurance commission income, are deferred and amortized as a
charge to income as the related premiums are earned.
F-9
<PAGE> 87
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Intangible Assets
The Merger of CCC Surety Operations and Capsure has been accounted for by
CNA Surety as an acquisition of Capsure, using purchase accounting. Intangible
assets represent goodwill and identified intangibles arising from the
acquisition of Capsure and goodwill arising from the May 1995 acquisition of CIC
by CNAF that was allocated to the surety business of CIC. Intangible assets are
amortized on a straight line basis generally over 30 years.
Management assesses the recoverability of intangible assets based upon
estimates of undiscounted future operating cash flows whenever significant
events or changes in circumstances suggest that the carrying amount of an asset
may not be recoverable.
Reserves for Unpaid Losses and Loss Adjustment Expenses
The estimated liability for unpaid losses and loss adjustment expenses
includes, on an undiscounted basis, estimates of (a) the ultimate settlement
value of reported claims, (b) incurred but not reported ("IBNR") claims, (c)
future expenses to be incurred in the settlement of claims and (d) claim
recoveries, exclusive of reinsurance recoveries which are reported as an asset.
These estimates are determined based on the Company's and surety industry loss
experience as well as consideration of current trends and conditions. The
estimated liability for unpaid losses and loss adjustment expenses is an
estimate and there is the potential that actual future loss payments will differ
significantly from initial estimates. The methods of determining such estimates
and the resulting estimated liability are regularly reviewed and updated.
Changes in the estimated liability are reflected in operating income in the year
in which such changes are determined to be needed.
Insurance Premiums
Insurance premiums are recognized as revenue ratably over the terms of the
related policies. Unearned premiums represent the portion of premiums written,
before ceded reinsurance, applicable to the unexpired terms of policies in force
calculated on a daily pro rata basis. Premium revenues are net of amounts ceded
to reinsurers.
Reinsurance
The Company assumes and cedes insurance with other insurers and reinsurers.
Premiums and loss and loss adjustment expenses that are ceded under reinsurance
arrangements reduce the respective revenues and expenses. Amounts recoverable
from reinsurers are estimated in a manner consistent with the claim liability
associated with the reinsured policy and are reported as reinsurance receivable
rather than netted against the estimated liability for unpaid losses and loss
adjustment expenses. Losses and loss adjustment expenses incurred are net of
estimated recoveries under reinsurance contracts.
Stock-Based Compensation
As allowed under Statement of Financial Accounting Standards ("SFAS") No.
123, "Accounting for Stock-Based Compensation," the Company accounts for its
stock option plans in accordance with Accounting Principles Board ("APB")
Opinion No. 25, "Accounting for Stock Issued to Employees." The Company has not
issued stock options where the exercise price is less than the fair market value
of the Company's common stock on the date of grant and, accordingly, no
compensation expense has been recognized.
F-10
<PAGE> 88
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Income Taxes
Deferred income taxes are established for the future tax effects of
temporary differences between the tax and financial reporting bases of assets
and liabilities using currently enacted tax rates. Such temporary differences
primarily relate to net operating tax loss carryforwards ("NOLs"), deferred
policy acquisition costs and intangible assets. The effect on deferred taxes of
a change in tax rates is recognized in income in the period of enactment. In
addition, deferred tax assets are valued based upon the expectation of future
realization on a "more likely than not" basis.
Earnings Per Share
Earnings per common share is computed based on the weighted average number
of shares outstanding during the period. Diluted earnings per common share is
computed based on the weighted average number of shares outstanding plus the
dilutive effect of common stock equivalents which is computed using the treasury
stock method.
Accounting Changes
In February 1997, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 128, "Earnings Per Share." SFAS No. 128 is effective for both interim
and annual periods ending after December 15, 1997. SFAS No. 128 replaces APB
Opinion No. 15, "Earnings Per Share." APB Opinion No. 15 required that entities
with simple capital structures present a single earnings per common share
("EPS") on the face of the income statement, whereas those with complex capital
structures had to present both primary and fully diluted EPS. SFAS No. 128
simplifies the computation of EPS by replacing the presentation of primary EPS
with a presentation of basic EPS and requires dual presentation of basic and
diluted EPS by entities with complex capital structures. Basic EPS includes no
dilution and is computed by dividing income available to common stockholders by
the weighted average number of common shares outstanding for the period, whereas
primary EPS includes the dilutive effect of common stock equivalents, such as
stock options. Diluted EPS reflects the potential dilution of securities that
could share in the earnings of an entity, similar to fully diluted EPS. The
Company has adopted SFAS No. 128 in the accompanying consolidated financial
statements issued for periods ending after December 15, 1997.
In February 1997, the FASB issued SFAS No. 129, "Disclosure of Information
about Capital Structure," which establishes standards for disclosing information
about an entity's capital structure. The Statement consolidates existing
disclosure requirements for ease of retrieval and greater visibility to
nonpublic entities. The new Statement contains no change in disclosure
requirements for companies previously subject to the requirements of APB Opinion
No. 10, "Omnibus Opinion -- 1966," APB Opinion No. 15, "Earnings per Share," and
FASB Statement No. 47 "Disclosure of Long-Term Obligations," and as such the
adoption of SFAS No. 129 did not have any effect on the Company's reporting.
SFAS No. 129 applies to all entities and is effective for financial statements
issued for periods ending after December 15, 1997.
Reclassifications
Certain reclassifications have been made to the Predecessor financial
statements to conform with the presentation in the 1997 Consolidated Financial
Statements.
F-11
<PAGE> 89
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
2. CAPSURE ACQUISITION
The purchase price for Capsure has been allocated to Capsure's assets that
were acquired and to Capsure's liabilities that were assumed based on the
estimated fair value of such assets and liabilities at the Merger Date. The
purchase price for the outstanding shares of Capsure common stock was determined
as follows (dollars in thousands):
<TABLE>
<S> <C>
Traded value of Capsure shares to be exchanged at $11.00 per
share..................................................... $178,177
Value of Capsure options.................................... 2,527
CCC Surety Operations merger-related costs.................. 1,358
--------
Total purchase price........................................ $182,062
========
The purchase price was allocated as follows (dollars in
thousands):
Capsure net assets at historical cost....................... $100,875
Fair value adjustments:
Purchased intangibles..................................... (73,844)
Intangibles arising from Merger........................... 155,031
--------
Purchase price.............................................. $182,062
========
CNA Surety's beginning stockholders' equity was comprised of
the following (dollars in thousands):
Purchase price.............................................. $182,062
Capital contribution of $52,250 from CCC and
the effects of reinsurance agreements..................... 62,859
--------
Stockholders' equity........................................ $244,921
========
</TABLE>
Unaudited Pro Forma Results
The following table of unaudited pro forma information has been prepared as
if the acquisition of Capsure had been consummated on January 1, 1996. This
unaudited pro forma financial information gives effect to the following: (i)
adjustment to the Capsure statement of operations, as reported, to reflect the
income effects as if the $10 per share special distribution was made on January
1, 1996; (ii) consummation of the Merger and the related transactions and the
contribution of capital to and the incurrence of additional debt by CNA Surety;
(iii) purchase accounting adjustments to reflect Capsure's assets and
liabilities at fair value; (iv) estimated indirect and overhead expenses for the
CCC Surety Operations; and (v) estimated interest expense related to the
additional debt (dollars are in thousands, except per share amounts):
<TABLE>
<CAPTION>
THREE MONTHS ENDED YEARS ENDED
DECEMBER 31, DECEMBER 31,
------------------- --------------------
UNAUDITED UNAUDITED
1997 1996 1997 1996
------- --------- -------- --------
ACTUAL PRO FORMA PRO FORMA
<S> <C> <C> <C> <C>
Revenues........................... $71,284 $62,754 $258,682 $250,194
Net income......................... $10,996 $ 4,345 $ 34,375 $ 22,432
Earnings per share................. $ 0.25 $ 0.10 $ 0.79 $ 0.52
</TABLE>
F-12
<PAGE> 90
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The foregoing unaudited pro forma operating results include non-recurring
charges, primarily merger-related costs of Capsure, of $22.0 million, net of tax
(or $0.51 per share) for the year ended December 31, 1997 and $1.1 million, net
of tax (or $0.03 per share) and $5.7 million, net of tax (or $0.13 per share) of
non-recurring charges and merger-related costs of Capsure for the three and
twelve month periods ended December 31, 1996, respectively.
This unaudited pro forma financial information is intended for information
purposes only and is not necessarily indicative of the results of operations
which would have been achieved and reported had the Merger and related
transactions been consummated on the dates assumed, nor is it necessarily
indicative of the future consolidated operating results of CNA Surety.
The Company paid a closing dividend on October 6, 1997 to the former
Capsure stockholders of record as of September 29, 1997. The dividend was
conditioned upon the consummation of the Merger in accordance with the
reorganization agreement. The $10.6 million ($0.65 per common share) closing
dividend was the aggregate amount of $3.5 million plus $58,600 per day from and
including June 1, 1997 through and including the day immediately preceding the
Merger Date.
3. INVESTMENTS
The estimated fair value and amortized cost of fixed income securities held
by CNA Surety at December 31, 1997, by investment category, were as follows
(dollars in thousands):
<TABLE>
<CAPTION>
AMORTIZED GROSS GROSS ESTIMATED
COST OR UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
--------- ---------- ---------- ---------
<S> <C> <C> <C> <C>
Fixed income securities:
U.S. Treasury securities and obligations of
U.S.
Government corporations and agencies:
U.S. Treasury............................ $ 59,140 $ 218 $ (3) $ 59,355
U.S. Agency.............................. 51,331 298 -- 51,629
Collateralized mortgage obligations...... 37,550 151 (134) 37,567
Mortgage pass-through securities......... 34,217 42 (89) 34,170
Obligations of states and political
subdivisions................................ 3,556 14 -- 3,570
Corporate bonds............................... 26,644 350 (154) 26,840
Non-agency collateralized mortgage
obligations................................. 19,654 41 (69) 19,626
Asset-backed securities:
Second mortgages/home equity loans....... 21,678 80 (16) 21,742
Credit card receivables.................. 6,498 15 -- 6,513
Other underlying assets.................. 5,277 18 (6) 5,289
-------- ------ ----- --------
Total fixed income securities.......... $265,545 $1,227 $(471) $266,301
======== ====== ===== ========
</TABLE>
The Company's insurance subsidiaries, as required by state law, deposit
certain securities with state insurance regulatory authorities. At December 31,
1997, fixed income securities on deposit had an aggregate carrying value of $6.3
million.
Short-term investments are generally comprised of U.S. Treasury bills,
corporate notes, money market funds and investment grade commercial paper
equivalents.
F-13
<PAGE> 91
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The amortized cost and estimated fair value of fixed income securities at
December 31, 1997, by contractual maturity, are shown below. Actual maturities
will differ from contractual maturities as borrowers may have the right to call
or prepay obligations with or without call or prepayment penalties (dollars in
thousands):
<TABLE>
<CAPTION>
AMORTIZED ESTIMATED
COST FAIR VALUE
--------- ----------
<S> <C> <C>
FIXED INCOME SECURITIES:
Due within one year......................................... $ -- $ --
Due after one year but within five years.................... 112,097 112,616
Due after five years but within ten years................... 1,000 1,015
Due after ten years......................................... 27,574 27,763
-------- --------
140,671 141,394
Mortgage pass-through securities, collateralized mortgage,
obligations and asset-backed securities................... 124,874 124,907
-------- --------
$265,545 $266,301
======== ========
</TABLE>
Major categories of net investment income and net realized investment gains
(losses) for the period from September 30, 1997 (date of inception) through
December 31, 1997 were as follows (dollars in thousands):
<TABLE>
<CAPTION>
<S> <C>
Investment income:
Fixed income securities................................... $3,061
Short-term investments.................................... 2,707
Other..................................................... 112
------
Total investment income................................... 5,880
Investment expenses......................................... (114)
------
Net investment income....................................... $5,766
======
Gross realized investment gains:
Fixed income securities................................... $ 90
Other..................................................... 11
Gross realized investment losses:
Other (16)
------
Net realized investment gain................................ $ 85
======
</TABLE>
Net unrealized gain on securities included in stockholders' equity at
December 31, 1997 was comprised of the follow (dollars in thousands):
<TABLE>
<CAPTION>
GAINS LOSSES NET
------ ------ -----
<S> <C> <C> <C>
Fixed income securities................................. $1,227 $(471) $ 756
Other................................................... -- (27) (27)
------ ----- -----
$1,227 $(498) 729
------ -----
Deferred income taxes................................... (255)
-----
Net unrealized gain on securities....................... $ 474
=====
</TABLE>
F-14
<PAGE> 92
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
4. LONG-TERM DEBT
CNA Surety has a five-year unsecured revolving credit facility that
provides for borrowings of up to $130 million. The interest rate on borrowings
under the credit facility may be fixed, at CNA Surety's option, for a period of
one, two, three or six months and is based on, among other rates, the London
Interbank Offered Rate ("LIBOR") plus applicable margin. The margin, including
the facility fee, varies based on CNA Surety's leverage ratio (debt to total
capitalization) and ranges from 0.25% to 0.40%. The consolidated balance sheet
reflects total long-term debt of $118 million, comprised of borrowings of $54
million to retire pre-existing Capsure debt, $51 million of borrowings of which
$50 million was contributed to Western Surety in connection with the Merger and
$13 million of borrowings to pay the closing dividend and other merger-related
costs. The weighted average interest rate on outstanding borrowings was 6.17% at
December 31, 1997.
The credit facility contains among other conditions, limitations on CNA
Surety with respect to the incurrence of additional indebtedness and requires
the maintenance of certain financial ratios. As of December 31, 1997, the
Company was in compliance with all restrictions or covenants contained in the
credit facility agreement. The credit facility provides for the payment of all
outstanding principal balances after five years with no required principal
payments prior to such time. Principal prepayments, if any, and interest
payments are expected to be funded primarily through dividends from CNA Surety's
insurance subsidiaries.
5. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table summarizes fair value information about financial
instruments, whether or not recognized in the balance sheet, for which it is
practicable to estimate that value. In cases where quoted market prices are not
available, fair values may be based on estimates using present value or other
valuation techniques. These techniques are significantly affected by the
assumptions used, including the discount rates and estimates of future cash
flows. Accordingly, the estimates presented herein are subjective in nature and
are not necessarily indicative of the amounts that the Company could realize in
a current market exchange. This information excludes certain financial
instruments and all nonfinancial instruments such as insurance contracts from
fair value disclosure. Thus, these fair value amounts cannot be aggregated to
determine the underlying economic value of the Company.
The carrying amounts and estimated fair values of financial instruments at
December 31, 1997 were as follows (dollars in thousands):
<TABLE>
<CAPTION>
CARRYING ESTIMATED
AMOUNT FAIR VALUE
-------- ----------
<S> <C> <C>
Fixed income securities..................................... $266,301 $266,301
Short-term investments...................................... 147,235 147,235
Other investments........................................... 6,001 6,001
Cash........................................................ 130 130
Long-term debt.............................................. 118,000 118,000
</TABLE>
The following methods and assumptions were used by the Company in
estimating fair values of financial instruments:
Investments -- The estimated fair values for the fixed income securities
are based upon quoted market prices, where available. For fixed income
securities not actively traded, the estimated fair values are determined using
values obtained from independent pricing services or, in the case of private
placements, by discounting expected future cash flows using a current market
rate applicable to the yield, credit quality and maturity of the investments.
F-15
<PAGE> 93
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Cash, Short-Term Investments and Other Investments -- The carrying value
for these instruments approximates their estimated fair values.
Long-Term Debt -- The estimated fair value of the Company's long-term debt
is based on the quoted market prices for the same or similar issues or on the
current rates offered to the Company for debt of the same remaining maturity.
6. DEFERRED POLICY ACQUISITION COSTS
Policy acquisition costs deferred and the related amortization of deferred
policy acquisition costs was as follows (dollars in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30,
DATE OF PREDECESSOR
INCEPTION, NINE(1) YEARS ENDED
THROUGH MONTHS ENDED DECEMBER 31,
DECEMBER 31, SEPTEMBER 30, --------------------
1997 1997 1996 1995
------------- ------------- -------- --------
<S> <C> <C> <C> <C>
Balance at beginning of period........... $ 69,094 $ 37,689 $ 42,727 $ 24,314
Deferred policy acquisition costs of CIC
at May 10, 1995, date of acquisition... -- -- -- 21,503
Costs deferred........................... 20,931 48,126 61,344 55,153
Amortization............................. (25,881) (48,075) (66,382) (58,243)
Deferred policy acquisition costs of
Capsure
at September 30, 1997, date of
Merger................................. -- 31,354 -- --
-------- -------- -------- --------
Balance at end of period................. $ 64,144 $ 69,094 $ 37,689 $ 42,727
======== ======== ======== ========
</TABLE>
- ---------------
(1) Amounts are for Predecessor except for the deferred policy acquisition costs
of Capsure acquired and the balance at the end of the period which is for
CNA Surety.
7. REINSURANCE
The Company's insurance subsidiaries, in the ordinary course of business,
cede reinsurance to other insurance companies to limit their exposure to loss.
Reinsurance arrangements are used to limit maximum loss, provide greater
diversification of risk and minimize exposure on larger risks. Reinsurance
contracts do not ordinarily relieve the Company of its primary obligations to
claimants. Therefore, a contingent liability exists with respect to reinsurance
ceded to the extent that any reinsurer is unable to meet the obligations assumed
under the reinsurance agreements. The Company evaluates the financial condition
of its reinsurers, establishes allowances for uncollectible amounts and monitors
concentrations of credit risk. At December 31, 1997, CNA Surety's largest
unaffiliated reinsurance receivable, including prepaid reinsurance premiums of
$1.0 million, was approximately $2.7 million with a company rated A+ (Superior)
by A.M. Best Company, Inc.
F-16
<PAGE> 94
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The effect of reinsurance on premiums written and earned was as follows
(dollars in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, PREDECESSOR
DATE OF INCEPTION, ---------------------------------------------------------------
THROUGH YEARS ENDED DECEMBER 31,
DECEMBER 31, NINE MONTHS ENDED -----------------------------------------
1997 SEPTEMBER 30, 1997 1996 1995
------------------- ------------------- ------------------- -------------------
WRITTEN EARNED WRITTEN EARNED WRITTEN EARNED WRITTEN EARNED
-------- -------- -------- -------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Direct.......................... $24,561 $27,159 $114,969 $112,751 $152,517 $158,160 $135,803 $145,176
Assumed from affiliates......... 50,691 40,653 -- -- -- -- -- --
Assumed from non-
affiliates.................... -- -- 1,106 2,034 2,691 2,429 802 885
Ceded........................... (1,263) (2,379) (7,445) (6,221) (11,304) (11,520) (14,593) (15,458)
------- ------- -------- -------- -------- -------- -------- --------
Net premiums.................... $73,989 $65,433 $108,630 $108,564 $143,904 $149,069 $122,012 $130,603
======= ======= ======== ======== ======== ======== ======== ========
</TABLE>
Assumed premiums from affiliates primarily is comprised of all surety
business written or renewed, net of reinsurance, by CCC and CIC after the Merger
Date that is reinsured by Western Surety pursuant to intercompany reinsurance
and related agreements.
The effect of reinsurance on losses and loss adjustment expenses incurred
was as follows (dollars in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, PREDECESSOR
DATE OF ---------------------------------
INCEPTION, NINE YEARS ENDED
THROUGH MONTHS ENDED DECEMBER 31,
DECEMBER 31, SEPTEMBER 30, -----------------
1997 1997 1996 1995
------------- ------------- ------- -------
<S> <C> <C> <C> <C>
Gross losses and loss adjustment expenses...... $12,613 $ (7,265) $29,952 $34,236
Reinsurance recoveries......................... (479) (4,251) 3,054 (1,796)
------- -------- ------- -------
Net losses and loss adjustment expenses........ $12,134 $(11,516) $33,006 $32,440
======= ======== ======= =======
</TABLE>
F-17
<PAGE> 95
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
8. RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
Activity in the reserves for unpaid losses and loss adjustment expenses was
as follows (dollars in thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30,
DATE OF PREDECESSOR
INCEPTION, NINE(1) YEARS ENDED
THROUGH MONTHS ENDED DECEMBER 31,
DECEMBER 31, SEPTEMBER 30, -------------------
1997 1997 1996 1995
------------- ------------- -------- --------
<S> <C> <C> <C> <C>
Reserves at beginning of period:
Gross........................................ $122,281 $119,151 $138,657 $ 48,818
Ceded reinsurance............................ 7,273 15,467 24,531 13,770
-------- -------- -------- --------
Net reserves at beginning of period........ 115,008 103,684 114,126 35,048
Net reserves of CIC at May 10, 1995, date of
acquisition................................ -- -- -- 64,780
-------- -------- -------- --------
Total net reserves...................... 115,008 103,684 114,126 99,828
-------- -------- -------- --------
Net incurred loss and loss adjustment
expenses:
Provision for insured events of current
period.................................. 12,781 23,484 42,748 43,286
Decrease in provision for insured events of
prior periods........................... (647) (35,000) (9,742) (10,846)
-------- -------- -------- --------
Total net incurred...................... 12,134 (11,516) 33,006 32,440
-------- -------- -------- --------
Net payments attributable to:
Current period events...................... 4,256 4,307 7,728 1,648
Prior periods events....................... 161 3,780 35,720 16,494
-------- -------- -------- --------
Total net payments...................... 4,417 8,087 43,448 18,142
-------- -------- -------- --------
Net reserves of Capsure at September 30,
1997, date of Merger....................... -- 30,927 -- --
Net reserves at end of period................ 122,725 115,008 103,684 114,126
Ceded reinsurance at end of period........... 7,656 7,273 15,467 24,531
-------- -------- -------- --------
Gross reserves at end of period......... $130,381 $122,281 $119,151 $138,657
======== ======== ======== ========
</TABLE>
- ---------------
(1) Amounts are for Predecessor except for the net reserves of Capsure and both
ceded reinsurance and gross reserves at the end of the period which are for
CNA Surety.
Based on the CCC Surety Operations' study of reserves, management
determined that it had been overly cautious in interpreting claim data and had
discounted favorable trends. Consistent with the CCC Surety Operations' regular
study of reserve levels, the CCC Surety Operations released $35.0 million of
prior year reserves in 1997. Approximately $33.0 million of this reserve
development related to CIC and principally to accident years prior to 1996.
Asbestos and Environmental Claims
The Company does not bond contractors that specialize in environmental
remediation work. The Company does however bond several accounts that have
incidental environmental exposure with respect to which the Company provides
limited bonding programs. In the commercial surety market, the Company provides
bonds to large corporations that are in the business of mining various minerals
and are obligated to post reclamation bonds that guarantee that property which
was disturbed during mining is returned to an acceptable condition when the
mining is completed. While no environmental responsibility is overtly provided
by commercial or contract bonds, some risk of environmental exposure may exist
if the surety were to assume
F-18
<PAGE> 96
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
certain rights of ownership of the property in the completion of a defaulted
project or through salvage recovery.
To date, the Company has not received any environmental claim notices nor
is management aware of any potential environmental claims.
9. COMMITMENTS AND CONTINGENCIES
At December 31, 1997 the future minimum commitment under operating leases
was as follows: 1998 -- $3.6 million; 1999 -- $2.3 million; 2000 -- $1.9
million; 2001 -- $1.4 million and 2002 and thereafter -- $0.3 million. Total
rental expense for the period from September 31, 1997 (date of inception)
through December 31, 1997 was $0.8 million.
The Company and its subsidiaries are parties to numerous lawsuits arising
in the normal course of business, some seeking material damages. The Company
believes the resolution of these lawsuits will not have a material adverse
effect on its financial condition or its results of operations.
10. INCOME TAXES
The components of deferred income taxes as of December 31, 1997 and 1996
were as follows (dollars in thousands):
<TABLE>
<CAPTION>
PREDECESSOR
1997 1996
------- -----------
<S> <C> <C>
Deferred tax assets:
Net operating losses...................................... $17,516 $ --
Unearned premium reserves................................. 11,737 6,256
Accrued expenses.......................................... 5,205 --
Loss and loss adjustment expense reserves................. 2,444 1,905
Other..................................................... 2,966 490
------- -------
Total gross deferred tax assets........................ 39,868 8,651
Valuation allowance....................................... 7,950 --
------- -------
Deferred tax asset, net of valuation allowance.............. 31,918 8,651
------- -------
Deferred tax liabilities:
Deferred policy acquisition costs......................... 22,450 13,191
Intangible assets......................................... 7,085 --
Unrealized gain on securities............................. 255 --
Other..................................................... 2,043 --
------- -------
Total deferred tax liabilities......................... 31,833 13,191
------- -------
Net deferred tax asset (liability).......................... $ 85 $(4,540)
======= =======
</TABLE>
The net deferred tax asset for the year ended December 31, 1997 is included
in other assets in the consolidated balance sheet.
The Internal Revenue Service ("IRS") has not audited Capsure's tax returns
for the years in which Capsure reported net operating losses ("NOLs"). Under
Section 382 of the Internal Revenue Code of 1986, as amended (the "Code"),
restrictions on the utilization of Capsure's NOLs occurred due to the change in
ownership upon consummation of the Merger on September 30, 1997. The valuation
allowance reflects the restrictions placed upon CNA Surety's ability to utilize
Capsure's available NOLs in the future.
F-19
<PAGE> 97
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
CNA Surety and its subsidiaries will file a consolidated federal income tax
return. As of December 31, 1997, approximately $50.0 million of consolidated
NOLs remained available to offset future taxable income of the Company and its
subsidiaries. Such carryforwards, which have an aggregate gross tax benefit of
$17.5 million, expire by tax year as follows: $39.2 million in 1998 and $7.1
million in 1999, $2.4 million in 2000, $0.9 million in 2001, and $0.4 million in
2002. Although realization is not assured, management believes that it is more
likely than not that CNA Surety will generate sufficient taxable income to
utilize approximately $9.6 million of tax benefits from its available NOLs as of
December 31, 1997. Such estimates consider the restrictions placed on the
Company's ability to utilize Capsure's NOLs, the earnings history of each of its
insurance subsidiaries and projections of future taxable income. The amount of
the deferred tax asset considered realizable, however, could be reduced in the
near term if estimates of future taxable income during the carryforward period
are reduced.
The income tax provisions consisted of the following (dollars in
thousands):
<TABLE>
<CAPTION>
SEPTEMBER 30, PREDECESSOR
DATE OF ----------------------------------
INCEPTION, NINE YEARS ENDED
THROUGH MONTHS ENDED DECEMBER 31,
DECEMBER 31, SEPTEMBER 30, -----------------
1997 1997 1996 1995
------------- ------------- ------- ------
<S> <C> <C> <C> <C>
Federal current............. $2,558 $21,466 $13,294 $7,448
Federal deferred............ 4,038 (225) (1,106) 1,937
State....................... 67 -- -- --
------ ------- ------- ------
Total income tax expense.... $6,663 $21,241 $12,188 $9,385
====== ======= ======= ======
</TABLE>
A reconciliation from the federal statutory tax rate to the effective tax
rate is as follows:
<TABLE>
<CAPTION>
SEPTEMBER 30, PREDECESSOR
DATE OF -------------------------------
INCEPTION, NINE YEARS ENDED
THROUGH MONTHS ENDED DECEMBER 31,
DECEMBER 31, SEPTEMBER 30, --------------
1997 1997 1996 1995
------------- ------------- ----- -----
<S> <C> <C> <C> <C>
Federal statutory rate......... 35.0% 35.0% 35.0% 35.0%
Non-deductible expenses,
principally amortization of
goodwill..................... 2.4 0.2 0.4 0.3
State income tax, net of
federal
income tax benefit........... 0.2 -- -- --
Other.......................... 0.1 -- -- --
----- ----- ----- -----
Total income tax expense....... 37.7% 35.2% 35.4% 35.3%
===== ===== ===== =====
</TABLE>
11. EMPLOYEE BENEFITS
CNA Surety sponsors a tax deferred savings plan ("401(k) plan") covering
substantially all of its employees. Under the 401(k) plan, the Company matches
70% of the participating employee's contribution up to 6% of eligible
compensation (4.2% maximum matching). In addition, the Company may also make an
annual discretionary profit sharing contribution to the 401(k) plan, subject to
the approval of the Company's board of directors. The profit sharing
contribution is based on the Company's underwriting results and may be
restricted by plan and regulatory limitations. The Company contribution,
including accrued profit sharing, to the 401(k) plan was $0.6 million for the
period from September 30, 1997 (date of inception) through December 31, 1997.
F-20
<PAGE> 98
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Western Surety sponsors two post-retirement benefit plans covering certain
employees. One plan provides medical benefits, and the other plan provides sick
leave termination payments. The post-retirement health care plan is contributory
and the sick leave plan is non-contributory. The actuarially determined net
periodic post-retirement costs for these plans was $0.1 million for the period
from September 30, 1997 (date of inception) through December 31, 1997. The
unfunded accumulated post-retirement benefit obligation (for retirees and fully
vested active plan participants) was $4.7 million as of December 31, 1997 and is
included in other liabilities in the consolidated balance sheet.
12. STOCKHOLDERS' EQUITY
The Company has reserved shares of its common stock for issuance to
directors, officers, employees and certain advisors of the Company through
incentive stock options, non-qualified stock options and stock appreciation
rights ("SARs") to be granted under the CNA Surety 1997 Long-Term Equity
Compensation Plan ("CNA Surety Plan"). The Company has also reserved shares of
its common stock for issuance to Capsure option holders under the CNA Surety
Corporation Replacement Stock Option Plan ("Replacement Plan"). The CNA Surety
Plan and Replacement Plan are collectively referred to as the "Plan". The
aggregate number of shares available for which options may be granted under the
Plan is 3,000,000.
Options issued under the Replacement Plan have the same exercise price,
rights, benefits, terms and conditions as the Capsure options replaced. The
number of unexercised and outstanding Capsure options issued to the holders
under the Replacement Plan on September 30, 1997 was 335,235. The exercise
prices of the replacement options range between $0.05 and $8.00 per share.
The Incentive Compensation Committee (the "Committee") of the Board of
Directors, consisting of independent members of the Board of Directors,
administers the Plan. The Committee determines the option prices. Prices may not
be less than the fair market value of the Company's common stock on the date of
grant for incentive stock options and may not be less than the par value of the
Company's common stock for non-qualified stock options.
The Plan provides for the granting of incentive stock options as defined
under the Code. All non-qualified stock options and incentive stock options
granted under the Plan expire ten years after the date of grant and in the case
of the Replacement Plan the options expire ten years from the original Capsure
grant date.
<TABLE>
<CAPTION>
WEIGHTED
SHARES SUBJECT AVERAGE OPTION
TO OPTION PRICE PER SHARE
-------------- ---------------
<S> <C> <C>
Balance at September 30, 1997......................... 335,235 $ 3.46
Options granted..................................... 463,500 $15.82
Options canceled.................................... (23,363) $15.58
Options exercised................................... (26,000) $ 4.86
-------
Balance at December 31. 1997 749,372 $10.68
=======
</TABLE>
As of December 31, 1997, 237,422 shares were exercisable under the Plan.
The number of shares available for granting of options under the Plan were
2,224,628 at December 31, 1997.
The following table summarizes information about stock options outstanding
at December 31, 1997:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
----------------------------------------------------- --------------------------------
WEIGHTED AVERAGE WEIGHTED AVERAGE WEIGHTED AVERAGE
RANGE OF NUMBER REMAINING EXERCISE NUMBER EXERCISE
EXERCISE PRICES OUTSTANDING CONTRACTUAL LIFE PRICE EXERCISABLE PRICE
- ---------------- ----------- ---------------- ---------------- ----------- ----------------
<S> <C> <C> <C> <C> <C>
$0.05 to $15.875 749,372 7.8 years $10.68 237,422 $3.40
======= ========== ====== ======= =====
</TABLE>
F-21
<PAGE> 99
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The weighted average fair market value (at grant date) per option granted
during the period from September 30, 1997 (date of inception) through December
31, 1997 was $6.62. The fair value of these options was estimated at grant date
using a Black-Scholes option pricing model with the following weighted average
assumptions for the period from September 30, 1997 (date of inception) through
December 31, 1997; risk free interest rate of 5.76%; dividend yield of 0%;
expected option life of 6 years; and volatility of 30.6%.
The Company adopted the financial disclosure provisions of SFAS No. 123,
"Accounting for Stock-Based Compensation" with respect to its stock-based
incentive plans. The Company applies APB Opinion No. 25, "Accounting for Stock
Issued to Employees," and related interpretations, in accounting for its plans
as allowed for under the provisions of SFAS No. 123. Accordingly, no
compensation cost has been recognized for its stock-based incentive plans as the
exercise price of the granted options equals the market price at the grant date.
Had compensation cost for these plans been determined on the fair value at the
grant date for options granted, consistent with the provisions of SFAS No. 123,
the Company's pro forma net income for the period from September 30, 1997 (date
of inception) through December 31, 1997 would have been $10.9 million and net
income and diluted net income per share would have been $0.25.
13. STATUTORY FINANCIAL DATA
CNA Surety's insurance subsidiaries file financial statements prepared in
accordance with statutory accounting practices prescribed or permitted by
applicable insurance regulatory authorities. Prescribed statutory accounting
practices include state laws, regulations and general administrative rules, as
well as guidance provided in a variety of publications of the National
Association of Insurance Commissioners ("NAIC"). Permitted statutory accounting
practices encompass all accounting practices that are not prescribed. The
permitted statutory accounting practices of CNA Surety's insurance subsidiaries
did not have a material effect on reported statutory surplus or income. The
principal differences between statutory financial statements and financial
statements prepared in accordance with generally accepted accounting principles
are that statutory financial statements do not reflect deferred policy
acquisition costs and deferred income taxes and fixed income securities are
generally carried at amortized cost in statutory financial statements.
The NAIC has promulgated Risk Based Capital ("RBC") requirements for
property and casualty insurance companies to evaluate the adequacy of statutory
capital and surplus in relation to investment and insurance risks such as asset
quality, loss reserve adequacy, and other business factors. The RBC information
is used by state insurance regulators as an early warning mechanism to identify
insurance companies that potentially are inadequately capitalized. In addition,
the formula defines new minimum capital standards that supplement the current
system of fixed minimum capital and surplus requirements on a state-by-state
basis. Regulatory compliance is determined by a ratio (the "Ratio") of the
enterprise's regulatory total adjusted capital, as defined by the NAIC, to its
authorized control level RBC, as defined by the NAIC. Generally, a Ratio in
excess of 200% of authorized control level RBC requires no corrective actions by
the company or regulators. As of December 31, 1997, each of CNA Surety's
insurance subsidiaries had a Ratio that was in excess of the minimum RBC
requirements.
CNA Surety's insurance subsidiaries are subject to regulation and
supervision by the various state insurance regulatory authorities in which they
conduct business. Such regulation is generally designed to protect policyholders
and includes such matters as maintenance of minimum statutory surplus and
restrictions on the payment of dividends. Generally, statutory surplus of each
insurance subsidiary in excess of a statutorily prescribed minimum is available
for payment of dividends to the parent company. However, such distributions as
dividends may be subject to prior regulatory approval. Without prior regulatory
approval in 1998, CNA Surety's insurance subsidiaries may pay stockholder
dividends of $16.3 million in the aggregate. Combined statutory surplus for the
insurance subsidiaries at December 31, 1997 was $142.4 million.
F-22
<PAGE> 100
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
14. RELATED PARTY TRANSACTIONS
CCC and the insurance subsidiaries of the Company have entered into various
reinsurance agreements designed to protect against adverse loss reserve
development related to the CCC Surety Operations reserves at the Merger Date,
and help preserve, through the year 2000, the profitability of CCC Surety
Operations and certain additional accounts. The reinsurance agreements together
with the Services and Indemnity Agreement, that is described below, also affect
the transfer of the CCC Surety Operations to the insurance subsidiaries. The
reinsurance agreements entered into at the Merger Date are: (i) the Surety Quota
Share Treaty (the "Quota Share Treaty"); (ii) the Aggregate Stop Loss
Reinsurance Contract (the "Stop Loss Contract"); and (iii) the Surety Excess of
Loss Reinsurance Contract (the "Excess of Loss Contract").
The Services and Indemnity Agreement provides the insurance subsidiaries
with the authority to perform various administrative, management, underwriting
and claim functions in order to conduct the business of the CCC Surety
Operations and to be reimbursed by CCC for services rendered. In consideration
for the provision of the foregoing services, CCC has agreed to pay the insurance
subsidiaries a quarterly fee of $50,000. At December 31, 1997, CCC owed the
insurance subsidiaries $50,000 for the period from September 30, 1997 (date of
inception) through December 31, 1997.
Through the Quota Share Treaty, CCC and CIC ceded, as of the Merger Date,
and subsequently paid on October 1, 1997, to Western Surety all of its net
unearned premiums and loss and loss adjustment expense reserves, net of $29.0
million of ceded commissions. The payment totaled $116.9 million.
Through the Quota Share Treaty, CCC and CIC will also transfer to Western
Surety all of the CCC Surety Operations' business written or renewed by CCC and
CIC after the Merger Date. CCC and CIC will transfer the related liabilities of
such business and pay to Western Surety an amount in cash equal to CCC's and
CIC's net written premiums written on all such business, minus a quarterly
ceding commission to be retained by CCC and CIC equal to $50,000 plus 28% of net
written premiums written on such business. CCC and CIC paid Western Surety, net
of commissions and reinsured loss payments, $21.2 million during the period from
September 30, 1997 (date of inception) through December 31, 1997. As of December
31, 1997, CNA Surety had a reinsurance receivable balance from CCC and CIC of
$47.9 million. This balance is primarily comprised of direct premium receivables
of CCC and CIC with respect to the surety business ceded to Western Surety.
CCC has guaranteed the loss and loss adjustment expenses transferred to
Western Surety by agreeing to pay Western Surety, within 30 days following the
end of each calendar quarter, the amount of any adverse development on such
reserves, as reestimated as of the end of such calendar quarter. There was not
any adverse reserve development for the period from September 30, 1997 (date of
inception) through December 31, 1997. The Quota Share Treaty has a term of five
years from the Merger Date.
The Stop Loss Contract protects the insurance subsidiaries from adverse
loss experience on certain business underwritten after the Merger Date. The Stop
Loss Contract between the insurance subsidiaries and CCC limits the insurance
subsidiaries' prospective net loss ratios with respect to certain accounts and
lines of insured business for at least three fiscal years following the Merger
Date. In the event the insurance subsidiaries' accident year net loss ratio
exceeds 24% in each of 1997 through 2000 on certain insured accounts (the "Loss
Ratio Cap"), the Stop Loss Contract requires CCC at the end of each calendar
quarter following the Merger Date, to pay to the insurance subsidiaries a dollar
amount equal to (i) the amount, if any, by which their actual accident year net
loss ratio exceeds the applicable Loss Ratio Cap, multiplied by (ii) the
applicable net earned premiums. In consideration for the coverage provided by
the Stop Loss Contract, the insurance subsidiaries will pay to CCC an annual
premium of $20,000. The insurance subsidiaries paid CCC the annual premium
during the period from September 30, 1997 (date of inception) through December
31, 1997 and no amount was due to the insurance subsidiaries from CCC under the
Stop Loss Contract for the period from September 30, 1997 (date of inception)
through December 31, 1997.
F-23
<PAGE> 101
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Excess of Loss Contract provides the insurance subsidiaries of CNA
Surety with the capacity to underwrite large surety bond exposures by providing
reinsurance support from CCC. The Excess of Loss Contract provides $75 million
of coverage in excess of the $55 million of coverage provided to the insurance
subsidiaries by third party reinsurers for losses discovered on surety bonds in
force at the Merger Date and for losses discovered on new and renewal business
written or assumed during the term of the Excess of Loss Contract. CCC is also
obligated to act as a joint insurer, or "co-surety," for business covered by the
Excess of Loss Contract when requested by the insurance subsidiaries. In
consideration for the reinsurance coverage provided by the Excess of Loss
Contract, the insurance subsidiaries will pay to CCC, on a quarterly basis, a
premium equal to 1% of the net written premiums applicable to the Excess of Loss
Contract, subject to a minimum premium of $20,000 per quarter. The insurance
subsidiaries paid CCC $80,000 for all minimum quarterly premiums due through
September 30, 1998 during the period from September 30, 1997 (date of inception)
through December 31, 1997. The Excess of Loss Contract has a term of five years
from the Merger Date.
CNA Surety also entered into an Administrative Services Agreement with CCC
as of the Merger Date. The agreement allows the Company continued use of certain
real and personal property owned or leased by CCC. The Company may cancel,
without penalty, any lease under the agreement by giving CCC sixty days notice.
The Company can also purchase many of the administrative services provided to
the CCC Surety Operations by CCC. CNA Surety, however, is under no obligation to
purchase any services under the Administrative Services Agreement. The aggregate
maximum annual cost for the use of real and personal property and for services
available under the agreement is approximately $7.9 million. Administrative
services are provided at specified rates, subject to inflationary increases. For
the period from September 30, 1997 to December 31, 1997, the Company was charged
$2.5 million for rents and services provided under the agreement. The Company
paid CCC $1.4 million and $1.1 million was reflected in other liabilities in the
Company's Consolidated Balance Sheet at December 31, 1997.
F-24
<PAGE> 102
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
15. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of the results of operations of CNA Surety for
the period from September 30, 1997 (date of inception) through December 31, 1997
and a summary of unaudited quarterly results of the Predecessor for the nine
months ended September 30, 1997 and year ended December 31, 1996. (dollars in
thousands, except per share amounts.)
CNA SURETY
<TABLE>
<CAPTION>
INCEPTION TO
DECEMBER 31
------------
<S> <C> <C> <C> <C>
1997
Revenues............................. $71,284
=======
Income before income taxes........... $17,659
Income taxes......................... 6,663
-------
Net income........................... $10,996
=======
Basic and diluted earnings per common
share............................. $ 0.25
=======
</TABLE>
PREDECESSOR
<TABLE>
<CAPTION>
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
----------- ------- ------- -------
<S> <C> <C> <C> <C>
1997
Net earned premiums.................. $33,829 $36,155 $38,580 $ --
======= ======= ======= =======
Excess of net earned premiums over
direct operating costs............ $41,878 $ 8,174 $10,354 $
Income taxes......................... 14,690 2,894 3,657 --
------- ------- ------- -------
Excess of net earned premiums over
direct operating costs, net of
income taxes...................... $27,188 $ 5,280 $ 6,697 $ --
======= ======= ======= =======
1996
Net earned premiums.................. $37,029 $37,504 $37,769 $36,767
======= ======= ======= =======
Excess of net earned premiums over
direct operating costs............ $ 6,696 $ 8,527 $13,472 $ 5,753
Income taxes......................... 2,377 3,017 4,748 2,046
------- ------- ------- -------
Excess of net earned premiums over
direct operating costs, net of
income taxes...................... $ 4,319 $ 5,510 $ 8,724 3,707
======= ======= ======= =======
</TABLE>
16. LOOKBACK ADJUSTMENT
The reorganization agreement provides for a mechanism, referred to as the
"Lookback Adjustment", which may adjust the number of shares of CNA Surety
common stock owned by CNAF operating companies in the event that either or both
of Capsure's and the CCC Surety Operations' actual net written premiums for 1997
vary from certain targets. Application and interpretation of the provisions of
the Lookback Adjustment are presently under review, the ultimate outcome of
which is currently not known. Based on the facts currently available, the total
number of shares of CNA Surety common stock will either not change or be reduced
by approximately 2.5%. Such a change in total outstanding shares would have no
effect on net income; however, earnings per share for the period from September
30, 1997 (date of inception) through December 31, 1997 would have increased from
$0.25 to $0.26 and the ownership of the Company by CNAF operating companies
would be reduced from 61.75% to 60.79%.
F-25
<PAGE> 103
SCHEDULE I
CNA SURETY CORPORATION AND SUBSIDIARIES
SUMMARY OF INVESTMENTS
OTHER THAN INVESTMENTS IN RELATED PARTIES
AS OF DECEMBER 31, 1997
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
FAIR CARRYING
COST VALUE VALUE
-------- -------- --------
<S> <C> <C> <C>
FIXED INCOME SECURITIES:
Bonds:
U.S. Government and government agencies and
authorities......................................... $182,238 $182,721 $182,721
States, municipalities and political subdivisions...... 3,556 3,570 3,570
All other corporate bonds.............................. 79,751 80,010 80,010
-------- -------- --------
Total fixed income securities....................... 265,545 266,301 266,301
-------- -------- --------
Short-term investments................................... 147,235 147,235
Other investments........................................ 6,027 6,001
-------- --------
Total investments................................... $418,807 $419,537
======== ========
</TABLE>
F-26
<PAGE> 104
SCHEDULE II
CNA SURETY CORPORATION
CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY)
BALANCE SHEET
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
AS OF
DECEMBER 31,
1997
------------
<S> <C>
ASSETS
Investments in and advances to Capsure Holdings Corp. and
subsidiaries.............................................. $368,843
Short-term investments...................................... 7,021
Cash........................................................ 26
Deferred income taxes....................................... 1,107
Other assets................................................ 314
--------
$377,311
========
LIABILITIES
Long-term debt.............................................. $118,000
Other liabilities........................................... 2,579
--------
120,579
--------
STOCKHOLDERS' EQUITY
Common stock................................................ 433
Additional paid-in capital.................................. 244,829
Retained earnings........................................... 10,996
Unrealized gain on securities, net of deferred income
taxes..................................................... 474
--------
Total stockholders' equity.................................. 256,732
--------
$377,311
========
</TABLE>
See Note to Condensed Financial Information.
F-27
<PAGE> 105
SCHEDULE II
CNA SURETY CORPORATION
CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY) -- (CONTINUED)
STATEMENT OF INCOME
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
SEPTEMBER 30,
DATE OF
INCEPTION,
THROUGH
DECEMBER 31,
1997
-------------
<S> <C>
Revenues:
Net investment income..................................... $ 33
Net realized investment gains (losses).................... --
Other income.............................................. --
-------
33
-------
Expenses:
Interest expense.......................................... 1,831
Corporate expense......................................... 1,364
-------
3,195
-------
Loss from operations before income taxes and equity in net
income of subsidiaries.................................... (3,162)
Income taxes................................................ (1,107)
-------
Loss before equity in net income of subsidiaries -- Parent
only...................................................... (2,055)
Equity in net income of subsidiaries........................ 13,051
-------
Net income.................................................. $10,996
=======
</TABLE>
See Note to Condensed Financial Information.
F-28
<PAGE> 106
SCHEDULE II
CNA SURETY CORPORATION
CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY) -- (CONTINUED)
STATEMENT OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
SEPTEMBER 30,
DATE OF
INCEPTION,
THROUGH
DECEMBER 31,
1997
-------------
<S> <C>
OPERATING ACTIVITIES:
Net loss.................................................. $ (2,055)
Cash dividends from subsidiaries....................... 4,970
Tax payments received from subsidiaries................ 2,449
Federal and state income tax payments.................. --
Adjustments to reconcile net loss to net cash provided
by operating activities:
Deferred income taxes, net........................... (1,107)
Other assets and liabilities......................... (261)
---------
Net cash provided by operating activities................... 3,996
---------
INVESTING ACTIVITIES:
Net advances to subsidiaries.............................. (65,075)
Capital contribution to Western Surety Company............ (50,000)
Change in short-term investments.......................... (7,021)
---------
Net cash used in investing activities....................... (122,096)
---------
FINANCING ACTIVITIES:
Proceeds from long-term debt.............................. 118,000
Other..................................................... 126
---------
Net cash provided by financing activities................... 118,126
---------
Increase in cash............................................ 26
Cash at beginning of period................................. --
---------
Cash at end of period....................................... $ 26
=========
</TABLE>
See Note to Condensed Financial Information
F-29
<PAGE> 107
SCHEDULE II
CNA SURETY CORPORATION
CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY) -- (CONTINUED)
NOTE TO CONDENSED FINANCIAL INFORMATION
1. BASIS OF PRESENTATION
The condensed financial information of the parent company includes the
accounts of CNA Surety Corporation ("CNA Surety"). On September 30, 1997 CNA
Surety was formed as part of the merger of Capsure Holdings Corp. and its
subsidiaries (Western Surety Company and Universal Surety of America) and the
surety business of CNA Financial Corporation. The merger was accounted for as a
purchase of Capsure.
F-30
<PAGE> 108
SCHEDULE III
CNA SURETY CORPORATION AND SUBSIDIARIES AND PREDECESSOR
SUPPLEMENTARY INSURANCE INFORMATION
CNA SURETY CORPORATION AS OF DECEMBER 31, 1997 AND FOR THE
PERIOD SEPTEMBER 30, 1997 (DATE OF INCEPTION) THROUGH DECEMBER 31, 1997 AND
PREDECESSOR AS OF AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND
YEARS ENDED DECEMBER 31, 1996 AND 1995
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
SEPTEMBER 30, PREDECESSOR
DATE OF -------------------------------------
INCEPTION, NINE YEARS ENDED
THROUGH MONTHS ENDED DECEMBER 31,
DECEMBER 31, SEPTEMBER 30, --------------------
1997 1997 1996 1995
------------- ------------- -------- --------
<S> <C> <C> <C> <C>
Deferred policy acquisition costs........ $ 64,144 $ 37,740 $ 37,689 $ 42,727
======== ======== ======== ========
Future policy benefits, losses, claims
and loss expenses...................... $130,381 $ 88,914 $119,151 $138,657
======== ======== ======== ========
Unearned premiums........................ $173,836 $ 94,577 $ 95,677 $101,059
======== ======== ======== ========
Other policy claims and benefits
payable................................ $ -- $ -- $ -- $ --
======== ======== ======== ========
Net premium revenue...................... $ 65,433 $108,564 $149,069 $130,603
======== ======== ======== ========
Net investment income.................... $ 5,766 $ -- $ -- $ --
======== ======== ======== ========
Benefits, claims, losses and settlement
expenses............................... $ 12,134 $(11,516) $ 33,006 $ 32,440
======== ======== ======== ========
Amortization of deferred policy
acquisition costs...................... $ 25,881 $ 48,075 $ 66,382 $ 58,243
======== ======== ======== ========
Other operating expenses................. $ 12,332 $ 11,599 $ 15,233 $ 13,348
======== ======== ======== ========
Net premiums written..................... $ 73,989 $108,630 $143,904 $122,012
======== ======== ======== ========
</TABLE>
F-31
<PAGE> 109
SCHEDULE IV
CNA SURETY CORPORATION AND SUBSIDIARIES AND PREDECESSOR
REINSURANCE
CNA SURETY CORPORATION FOR THE PERIOD SEPTEMBER 30, 1997
(DATE OF INCEPTION) THROUGH DECEMBER 31, 1997 AND
PREDECESSOR FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND
YEARS ENDED DECEMBER 31, 1996 AND 1995
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
PERCENTAGE
CEDED TO ASSUMED OF AMOUNT
GROSS OTHER FROM OTHER NET ASSUMED
AMOUNT COMPANIES COMPANIES AMOUNT TO NET
-------- --------- ---------- -------- ----------
<S> <C> <C> <C> <C> <C>
CNA SURETY CORPORATION
SEPTEMBER 30, 1997
(DATE OF INCEPTION) THROUGH
DECEMBER 31, 1997
Premiums:
Property and casualty
insurance.................... $ 27,159 $ 2,379 $40,653 $ 65,433 62.1%
-------- ------- ------- -------- ----
Total premiums............... $ 27,159 $ 2,379 $40,653 $ 65,433 62.1%
======== ======= ======= ======== ====
PREDECESSOR
NINE MONTHS ENDED
SEPTEMBER 30, 1997
Premiums:
Property and casualty
insurance.................... $112,751 $ 6,221 $ 2,034 $108,564 1.9%
-------- ------- ------- -------- ----
Total premiums............... $112,751 $ 6,221 $ 2,034 $108,564 1.9%
======== ======= ======= ======== ====
YEAR ENDED DECEMBER 31, 1996
Premiums:
Property and casualty
insurance.................... $158,160 $11,520 $ 2,429 $149,069 1.6%
-------- ------- ------- -------- ----
Total premiums............... $158,160 $11,520 $ 2,429 $149,069 1.6%
======== ======= ======= ======== ====
YEAR ENDED DECEMBER 31, 1995
Premiums:
Property and casualty
insurance.................... $145,176 $15,458 $ 885 $130,603 0.7%
-------- ------- ------- -------- ----
Total premiums............... $145,176 $15,458 $ 885 $130,603 0.7%
======== ======= ======= ======== ====
</TABLE>
F-32
<PAGE> 110
SCHEDULE V
CNA SURETY CORPORATION AND SUBSIDIARIES AND PREDECESSOR
VALUATION AND QUALIFYING ACCOUNTS
CNA SURETY CORPORATION FOR THE PERIOD SEPTEMBER 30, 1997
(DATE OF INCEPTION) THROUGH DECEMBER 31, 1997 AND
PREDECESSOR FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND
YEARS ENDED DECEMBER 31, 1996 AND 1995
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
ADDITIONS
------------------------
BALANCE AT CHARGED TO CHARGED TO BALANCE
BEGINNING OF COSTS AND OTHER AT END OF
PERIOD(1) EXPENSES ACCOUNTS DEDUCTIONS(2) PERIOD
------------ ---------- ---------- ------------- ---------
<S> <C> <C> <C> <C> <C>
CNA SURETY CORPORATION
SEPTEMBER 30, 1997 (DATE OF
INCEPTION) THROUGH DECEMBER
31, 1997
Allowance for possible losses
on premiums receivable.... $893 $(46) $ -- $ -- $847
==== ==== ==== ==== ====
Allowance for possible losses
on reinsurance
receivable................ $ -- $ -- $ -- $ -- $ --
==== ==== ==== ==== ====
PREDECESSOR
NINE MONTHS ENDED SEPTEMBER 30,
1997
Allowance for possible losses
on premiums receivable.... $ -- $ -- $ -- $ -- $ --
==== ==== ==== ==== ====
Allowance for possible losses
on reinsurance
receivable................ $ -- $ -- $ -- $ -- $ --
==== ==== ==== ==== ====
YEAR ENDED DECEMBER 31, 1996
Allowance for possible losses
on premiums receivable.... $ -- $ -- $ -- $ -- $ --
==== ==== ==== ==== ====
Allowance for possible losses
on reinsurance
receivable................ $ -- $ -- $ -- $ -- $ --
==== ==== ==== ==== ====
YEAR ENDED DECEMBER 31, 1995
Allowance for possible losses
on premiums receivable.... $ -- $ -- $ -- $ -- $ --
==== ==== ==== ==== ====
Allowance for possible losses
on reinsurance
receivable................ $ -- $ -- $ -- $ -- $ --
==== ==== ==== ==== ====
</TABLE>
- ---------------
(1) Acquired balance of Capsure Holdings Corp. on September 30, 1997.
(2) Accounts charged against allowance.
F-33
<PAGE> 111
SCHEDULE VI
CNA SURETY CORPORATION AND SUBSIDIARIES AND PREDECESSOR
SUPPLEMENTAL INFORMATION CONCERNING PROPERTY-CASUALTY
INSURANCE OPERATIONS
CNA SURETY CORPORATION AS OF DECEMBER 31, 1997 AND FOR THE
PERIOD SEPTEMBER 30, 1997 (DATE OF INCEPTION) THROUGH DECEMBER 31, 1997 AND
PREDECESSOR AS OF AND FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 AND
YEARS ENDED DECEMBER 31, 1996 AND 1995
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
SEPTEMBER 30, PREDECESSOR
DATE OF -------------------------------------
INCEPTION, NINE YEAR ENDED
THROUGH MONTHS ENDED DECEMBER 31,
DECEMBER 31, SEPTEMBER 30, --------------------
1997 1997 1996 1995
------------- ------------- -------- --------
<S> <C> <C> <C> <C>
Deferred policy acquisition costs........ $ 64,144 $ 37,740 $ 37,689 $ 42,727
======== ======== ======== ========
Reserves for unpaid claims and claim
adjustment expenses.................... $130,381 $ 88,914 $119,151 $138,657
======== ======== ======== ========
Discount (if any) deducted............... $ -- $ -- $ -- $ --
======== ======== ======== ========
Unearned premiums........................ $173,836 $ 94,577 $ 95,677 $101,059
======== ======== ======== ========
Net earned premiums...................... $ 65,433 $108,564 $149,069 $130,603
======== ======== ======== ========
Net investment income.................... $ 5,766 $ -- $ -- $ --
======== ======== ======== ========
Net claims and claim adjustment expenses
incurred related to:
Current year........................ $ 12,781 $ 23,484 $ 42,748 $ 43,286
======== ======== ======== ========
Prior years......................... $ (647) $(35,000) $ (9,742) $(10,846)
======== ======== ======== ========
Amortization of deferred policy
acquisition costs...................... $ 25,881 $ 48,075 $ 66,382 $ 58,243
======== ======== ======== ========
Net paid claims and claim adjustment
expenses............................... $ 4,417 $ 8,087 $ 43,448 $ 18,142
======== ======== ======== ========
Net premiums written..................... $ 73,989 $108,630 $143,904 $122,012
======== ======== ======== ========
</TABLE>
F-34
<PAGE> 112
INDEPENDENT ACCOUNTANTS' REVIEW REPORT
To the Board of Directors and Stockholders of
CNA Surety Corporation
Chicago, IL
We have reviewed the accompanying condensed consolidated balance sheet of
CNA Surety Corporation and subsidiaries as of March 31, 1998, and the related
condensed consolidated statements of income, stockholders' equity and cash flows
for the three-month period ended March 31, 1998. We have also reviewed the
accompanying special-purpose statements of certain revenues and direct operating
expenses of CCC Surety Operations ("Predecessor"), a business unit of CNA
Financial Corporation, for the three-month period ended March 31, 1997. These
financial statements are the responsibility of the Corporation's management.
We conducted our review in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures to
financial data and of making inquiries of persons responsible for financial and
accounting matters. It is substantially less in scope than an audit conducted in
accordance with generally accepted auditing standards, the objective of which is
the expression of an opinion regarding the financial statements taken as a
whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that
should be made to such condensed consolidated financial statements for them to
be in conformity with generally accepted accounting principles.
Deloitte & Touche LLP
May 12, 1998
F-35
<PAGE> 113
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
(UNAUDITED)
MARCH 31, DECEMBER 31,
1998 1997
----------- ------------
<S> <C> <C>
ASSETS
Invested assets and cash:
Fixed income securities, at fair value (amortized cost:
$389,050 and $265,545)................................. $389,396 $266,301
Short-term investments, at cost which approximates fair
value.................................................. 28,734 147,235
Other investments, at fair value.......................... 6,045 6,001
Cash...................................................... 3,424 130
-------- --------
427,599 419,667
Deferred policy acquisition costs........................... 67,520 64,144
Insurance receivables:
Premiums.................................................. 10,473 9,683
Reinsurance, including receivable from affiliates of
$46,819 at March 31, 1998 and $47,856 at December 31,
1997................................................... 55,008 55,151
Intangible assets, net of accumulated amortization.......... 160,487 161,962
Prepaid reinsurance premiums................................ 4,742 4,150
Other assets................................................ 15,042 12,423
-------- --------
Total assets...................................... $740,871 $727,180
======== ========
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses................ $132,100 $130,381
Unearned premiums......................................... 177,520 173,836
-------- --------
309,620 304,217
Long-term debt.............................................. 118,000 118,000
Deferred income taxes, net.................................. 1,624 --
Payable for securities purchased............................ 7,527 10,609
Other liabilities........................................... 37,577 37,622
-------- --------
Total liabilities................................. 474,348 470,448
-------- --------
Commitments and contingencies (Note 6)
STOCKHOLDERS' EQUITY
Preferred stock, par value $0.01 per share, 20,000 shares
authorized; none issued and outstanding................... -- --
Common stock, par value $0.01 per share, 100,000 shares
authorized; 43,379 and 43,320 shares issued and
outstanding at March 31, 1998 and at December 31, 1997,
respectively.............................................. 245,567 245,262
Retained earnings........................................... 20,811 10,996
Accumulated other comprehensive income...................... 145 474
-------- --------
Total stockholders' equity........................ 266,523 256,732
-------- --------
Total liabilities and stockholders' equity........ $740,871 $727,180
======== ========
</TABLE>
See Independent Accountants' Review Report and notes to financial statements.
F-36
<PAGE> 114
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF INCOME AND CONDENSED STATEMENT OF
CERTAIN REVENUES AND DIRECT OPERATING EXPENSES OF PREDECESSOR
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
-----------------------
1998 1997
------- -------------
(PREDECESSOR)
<S> <C> <C>
Revenues:
Net earned premiums....................................... $58,745 $33,829
Net investment income..................................... 6,789 --
Net realized investment gains............................. -- --
------- -------
65,534 33,829
------- -------
Expenses:
Net losses and loss adjustment expenses................... 11,218 (27,612)
Net commissions, brokerage and other underwriting
expenses............................................... 35,039 19,563
Interest expense.......................................... 1,821 --
Amortization of intangible assets......................... 1,475 --
------- -------
49,553 (8,049)
------- -------
Income before income taxes (Excess of net earned premiums
over direct operating expenses, before income taxes, for
Predecessor).............................................. 15,981 41,878
Income taxes................................................ 6,166 14,690
------- -------
Net income (Excess of net earned premiums over direct
operating expenses, net of income taxes, for
Predecessor).............................................. $ 9,815 $27,188
======= =======
Basic net income per share.................................. $ 0.23
=======
Diluted net income per share................................ $ 0.23
=======
Basic weighted average shares outstanding................... 43,348
=======
Diluted weighted average shares outstanding................. 43,570
=======
</TABLE>
See Independent Accountants' Review Report and notes to financial statements.
F-37
<PAGE> 115
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
ACCUMULATED
OTHER TOTAL
COMMON COMPREHENSIVE RETAINED COMPREHENSIVE STOCKHOLDERS'
STOCK INCOME (LOSS) EARNINGS INCOME (LOSS) EQUITY
-------- -------------- -------- -------------- -------------
<S> <C> <C> <C> <C> <C>
Balance, January 1, 1998........... $245,262 $10,996 $ 474 $256,732
Comprehensive income:
Net income....................... $9,815 9,815 9,815
Change in unrealized gains on
investments, net of income
taxes......................... (329) (329) (329)
------
Comprehensive income............... $9,486
======
Stock options exercised............ 305 305
-------- ------- ----- --------
Balance, March 31, 1998............ $245,567 $20,811 $ 145 $266,523
======== ======= ===== ========
</TABLE>
See Independent Accountants' Review Report and notes to financial statements.
F-38
<PAGE> 116
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS
ENDED
MARCH 31,
1998
------------
<S> <C>
OPERATING ACTIVITIES:
Net income................................................ $ 9,815
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation and amortization.......................... 1,942
Accretion of bond discount, net........................ 384
Net realized investment gains.......................... --
Changes in:
Insurance receivables.................................. (647)
Reserve for unearned premiums.......................... 3,684
Reserve for unpaid losses and loss adjustment
expenses.............................................. 1,719
Deferred income taxes, net............................. 1,709
Other assets and liabilities........................... (6,141)
---------
Net cash provided by operating activities................... 12,465
---------
INVESTING ACTIVITIES:
Securities available-for-sale:
Purchases -- fixed income securities................... (135,963)
Maturities -- fixed income securities.................. 8,994
Sales -- fixed income securities....................... --
Change in short-term investments.......................... 118,501
Other, net................................................ (880)
---------
Net cash used in investing activities....................... (9,348)
---------
FINANCING ACTIVITIES:
Stock options exercised................................... 177
---------
Net cash provided by financing activities................... 177
---------
Increase (decrease) in cash................................. 3,294
Cash at beginning of period................................. 130
---------
Cash at end of period....................................... $ 3,424
=========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest............................................... $ 1,727
Income taxes........................................... $ 1,500
</TABLE>
See Independent Accountants' Review Report and notes to financial statements.
F-39
<PAGE> 117
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1998
(UNAUDITED -- SEE INDEPENDENT ACCOUNTANTS' REVIEW REPORT)
1. SIGNIFICANT ACCOUNTING POLICIES
Formation of CNA Surety Corporation and Merger
In December 1996, CNA Financial Corporation ("CNAF") and Capsure Holdings
Corp. ("Capsure") agreed to merge (the "Merger") the surety business of CNAF
with Capsure's insurance subsidiaries, Western Surety Company ("Western Surety")
and Universal Surety of America ("USA"), which are owned by a newly-formed
holding company, CNA Surety Corporation ("CNA Surety" or the "Company"). CNAF,
through its operating subsidiaries, writes multiple lines of property and
casualty insurance, including surety business that is reinsured by Western
Surety. Loews Corporation owns approximately 84% of the outstanding common stock
of CNAF. The principal operating subsidiaries of CNAF that wrote the surety line
of business for their own account prior to the Merger were Continental Casualty
Company and its property and casualty affiliates (collectively, "CCC") and The
Continental Insurance Company and its property and casualty affiliates
(collectively, "CIC"). CIC was acquired by CNAF on May 10, 1995. The combined
surety operations of CCC and CIC are referred to herein as CCC Surety Operations
("Predecessor").
Pursuant to a reorganization agreement, CCC Surety Operations and Capsure
merged their respective operations at the close of business on September 30,
1997 ("Merger Date"). CNAF, through its property and casualty subsidiaries, CCC
and CIC, contributed $52.25 million of capital to CNA Surety. Through
reinsurance agreements, CCC and CIC ceded to Western Surety all of their net
unearned premiums and loss and loss adjustment expense reserves, as of the
Merger Date, and will cede to Western Surety all surety business written or
renewed by CCC and CIC for a period of five years thereafter. Further, CCC and
CIC have agreed to assume the obligation for any adverse development on recorded
reserves for CCC Surety Operations as of the Merger Date, to limit the loss
ratio on certain defined business written by CNA Surety through December 31,
2000 and to provide certain additional excess of loss reinsurance. CCC also
agreed to provide certain administrative services at specified rates, subject to
inflationary increases, for three years after the Merger, if CNA Surety chooses
to purchase such services.
Immediately after the Merger, the CNAF operating subsidiaries owned, on a
diluted basis, 61.75% of CNA Surety's common stock and the stockholders and
option holders of Capsure owned 38.25% of CNA Surety's common stock on a diluted
basis. The reorganization agreement provided a mechanism, referred to as the
"Lookback Adjustment", which could adjust the number of shares of CNA Surety
common stock owned by the CNAF operating subsidiaries in the event that either
or both of Capsure's and the CCC Surety Operations' actual net written premiums
for 1997 varied from certain targets. Application and interpretation of the
provisions of the Lookback Adjustment were completed in April 1998 with no
adjustment to the 61.75% ownership percentage of the CNAF operating
subsidiaries.
Principles of Consolidation
The consolidated financial statements include the accounts of CNA Surety
Corporation and all majority-owned subsidiaries. The consolidated financial
statements include the combined consolidated operating results of CCC Surety
Operations and Capsure since the Merger Date.
Predecessor Financial Information
The accompanying Condensed Statement of Certain Revenues and Direct
Operating Expenses of Predecessor for the quarter ended March 31, 1997 reflects
premiums earned, losses incurred, loss adjustment expenses (allocated and
unallocated) and other direct operating expenses of CCC Surety Operations. Such
operating revenues and costs as investment income, realized gains and losses on
investments and certain
F-40
<PAGE> 118
general and administrative expenses, which are indirect or overhead in nature,
are not reflected in operating results since such items were not historically
allocated to CCC Surety Operations by CNAF or its subsidiaries.
Since the accompanying Predecessor financial statement excludes certain
revenues and expenses, as described in the preceding paragraph, this financial
statement is not intended to be a complete presentation of CCC Surety
Operations. The revenues and costs that are reflected in the accompanying
financial statement have been determined in accordance with generally accepted
accounting principles.
Basis of Presentation
These unaudited Condensed Consolidated Financial Statements should be read
in conjunction with the Consolidated Financial Statements and Notes thereto
included in the Company's 1997 Annual Report on Form 10-K. Certain financial
information that is normally included in annual financial statements prepared in
accordance with generally accepted accounting principles has been condensed or
omitted as it is not required for interim reporting. The accompanying unaudited
Condensed Consolidated Financial Statements reflect, in the opinion of
management, all adjustments necessary for a fair presentation of the interim
financial statements. All such adjustments are of a normal and recurring nature.
The financial results for interim periods may not be indicative of financial
results for a full year. Certain reclassifications have been made to the 1997
Predecessor Financial Statements to conform with the presentation in the 1998
Condensed Consolidated Financial Statements.
Accounting Changes
In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting
Comprehensive Income," which establishes accounting standards for reporting and
display of comprehensive income and its components (revenues, expenses, gains,
and losses) in a full set of general-purpose financial statements. This
Statement requires that an enterprise (a) classify items of other comprehensive
income by their nature in a financial statement and (b) display the accumulated
balance of other comprehensive income separately from retained earnings and
additional paid-in capital in the equity section of a statement of financial
position. The Company has adopted this standard in these Condensed Consolidated
Financial Statements for the period ended March 31, 1998.
2. CAPSURE ACQUISITION
The merger of CCC Surety Operations and Capsure has been accounted for by
CNA Surety as an acquisition of Capsure, using purchase accounting. The purchase
price for Capsure has been allocated to Capsure's assets that were acquired and
to Capsure's liabilities that were assumed based on the estimated fair value of
such assets and liabilities at the Merger Date. The purchase price for the
outstanding shares of Capsure common stock was $182.1 million and has been
allocated as follows (dollars in thousands):
<TABLE>
<S> <C>
Capsure net assets at historical cost....................... $100,875
Fair value adjustments:
Purchased intangibles..................................... (73,844)
Intangibles arising from Merger........................... 155,031
--------
Purchase price.............................................. $182,062
========
</TABLE>
Unaudited Pro Forma Results
The following table of unaudited pro forma information has been prepared as
if the acquisition of Capsure had been consummated on January 1, 1996. This
unaudited pro forma financial information gives effect to the following: (i)
adjustment to the Capsure statement of operations, as reported, to reflect the
income effects as if the $10 per share special distribution was made on January
1, 1996; (ii) consummation of the Merger and the related transactions and the
contribution of capital to and the incurrence of additional debt by CNA Surety;
(iii) purchase accounting adjustments to reflect Capsure's assets and
liabilities at fair value; (iv) estimated
F-41
<PAGE> 119
indirect and overhead expenses for the CCC Surety Operations; and (v) estimated
interest expense related to the additional debt (dollars in thousands, except
per share amounts):
<TABLE>
<CAPTION>
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
1997
------------------
<S> <C>
Revenues.................................................... $56,128
Net income.................................................. $29,411
Basic net income per share.................................. $ 0.68
</TABLE>
The foregoing unaudited pro forma operating results include $35.0 million
($22.8 million net of income taxes or $0.53 per share) of favorable loss reserve
development of Predecessor.
This unaudited pro forma financial information is intended for information
purposes only and is not necessarily indicative of the results of operations
which would have been achieved and reported had the Merger and related
transactions been consummated on the dates assumed, nor is it necessarily
indicative of the future consolidated operating results of CNA Surety.
3. INVESTMENTS
The estimated fair value, gross unrealized gains and losses, and amortized
cost of fixed income securities held by CNA Surety at March 31, 1998, by
investment category, were as follows (dollars in thousands):
<TABLE>
<CAPTION>
AMORTIZED GROSS GROSS ESTIMATED
COST UNREALIZED UNREALIZED FAIR
OR COST GAINS LOSSES VALUE
--------- ---------- ---------- ---------
<S> <C> <C> <C> <C>
Fixed income securities:
U.S. Treasury securities and obligations of
government corporations and agencies........... $189,510 $ 772 $ (221) $190,061
Obligations of states and political
subdivisions................................... 79,784 206 (525) 79,465
Corporate bonds................................... 58,706 331 (362) 58,675
Non-agency collateralized mortgage obligations.... 29,391 40 (120) 29,311
Asset-backed securities........................... 31,659 234 (9) 31,884
-------- ------ ------- --------
Total fixed income securities................ $389,050 $1,583 $(1,237) $389,396
======== ====== ======= ========
</TABLE>
4. REINSURANCE
The effect of reinsurance on the Company's and Predecessor's written and
earned premium was as follows (dollars in thousands):
<TABLE>
<CAPTION>
THREE MONTHS ENDED MARCH 31,
-------------------------------------
1998 1997
----------------- -----------------
WRITTEN EARNED WRITTEN EARNED
------- ------- ------- -------
(PREDECESSOR)
<S> <C> <C> <C> <C>
Direct.................................................. $27,994 $24,306 $32,611 $36,148
Assumed from affiliates................................. 35,854 36,040 -- --
Assumed from non-affiliates............................. -- -- 431 545
Ceded................................................... (2,012) (1,601) (2,562) (2,864)
------- ------- ------- -------
$61,836 $58,745 $30,480 $33,829
======= ======= ======= =======
</TABLE>
F-42
<PAGE> 120
The effect of reinsurance on the Company's and Predecessor's provision for
loss and loss adjustment expenses was as follows (dollars in thousands):
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
--------------------------
1998 1997
------- -------------
(PREDECESSOR)
<S> <C> <C>
Gross loss and loss adjustment expense...................... $13,117 $(25,995)
Ceded amounts............................................... (1,899) (1,617)
------- --------
Net loss and loss adjustment expense........................ $11,218 $(27,612)
======= ========
</TABLE>
5. LOOKBACK ADJUSTMENT
The reorganization agreement provided a mechanism, referred to as the
"Lookback Adjustment", which could adjust the number of shares of CNA Surety
common stock owned by CNAF operating companies in the event that either or both
of Capsure's and the CCC Surety Operations' actual net written premiums for 1997
varied from certain targets. Application and interpretation of the provisions of
the Lookback Adjustment were completed in April 1998 with no adjustment to the
61.75% ownership percentage of the CNAF operating companies.
6. LEGAL PROCEEDINGS
The Company and its subsidiaries are parties to numerous lawsuits arising
in the normal course of business, some seeking material damages. The Company
believes the resolution of these lawsuits will not have a material adverse
effect on its financial condition or its results of operations.
F-43
<PAGE> 121
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors
Capsure Holdings Corp.
We have audited the accompanying consolidated financial statements and
financial statement schedules of Capsure Holdings Corp. and Subsidiaries as of
December 31, 1996 and 1995 and for each of the three years in the period ended
December 31, 1996. These consolidated financial statements and financial
statement schedules are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements and financial statement schedules based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the consolidated financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the consolidated financial
statements. An audit also includes assessing the accounting principles used and
the significant estimates made by management, as well as evaluating the overall
consolidated financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Capsure Holdings Corp. and Subsidiaries as of December 31, 1996 and 1995, and
the consolidated results of their operations and their cash flows for each of
the three years in the period ended December 31, 1996 in conformity with
generally accepted accounting principles. In addition, in our opinion, the
financial statement schedules referred to above, when considered in relation to
the basic consolidated financial statements taken as a whole, present fairly, in
all material respects, the information required to be included therein.
COOPERS & LYBRAND L.L.P.
Chicago, Illinois
February 20, 1997
F-44
<PAGE> 122
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1996 1995
-------- --------
<S> <C> <C>
ASSETS
Invested assets and cash:
Fixed maturities, at fair value (amortized cost: $135,420;
$233,276).............................................. $135,895 $235,718
Equity securities, at fair value (cost: $3,687;
$27,124)............................................... 4,526 27,753
Short-term investments, at cost which approximates fair
value.................................................. 19,416 37,865
Other investments, at fair value.......................... 2,695 3,219
Cash...................................................... 2,736 3,001
-------- --------
165,268 307,556
Deferred policy acquisition costs........................... 28,523 27,057
Reinsurance receivable...................................... 5,642 40,097
Intangible assets, net of amortization...................... 14,024 15,715
Excess cost over net assets acquired, net of amortization... 61,932 68,443
Deferred income taxes, net of valuation allowance........... 16,019 29,293
Other assets................................................ 21,731 26,607
-------- --------
Total assets...................................... $313,139 $514,768
======== ========
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses................ $ 38,874 $126,061
Unearned premiums......................................... 69,570 76,781
-------- --------
108,444 202,842
Long-term debt.............................................. 60,000 25,000
Other liabilities........................................... 22,112 29,622
-------- --------
Total liabilities................................. 190,556 257,464
-------- --------
Commitments and contingencies
STOCKHOLDERS' EQUITY
Preferred stock, par value $.01 per share, 5,000,000 shares
authorized;
none issued and outstanding............................... -- --
Common stock, par value $.05 per share, 25,000,000 shares
authorized; 15,804,749 shares issued at December 31, 1996;
15,408,749 shares issued at December 31, 1995............. 790 770
Additional paid-in capital.................................. 118,413 179,276
Retained earnings from August 1, 1986 (date of
reorganization)........................................... 2,297 75,286
Unrealized gain on securities, net of deferred income
taxes..................................................... 1,083 1,972
-------- --------
Total stockholders' equity........................ 122,583 257,304
-------- --------
$313,139 $514,768
======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-45
<PAGE> 123
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
--------------------------------
1996 1995 1994
-------- -------- --------
<S> <C> <C> <C>
Revenues:
Net earned premiums...................................... $ 92,491 $ 98,692 $ 92,481
Net investment income.................................... 16,444 20,471 19,129
Net investment gains (losses)............................ 1,715 (1,653) 945
-------- -------- --------
110,650 117,510 112,555
-------- -------- --------
Expenses:
Net loss and loss adjustment expenses.................... 10,054 (7,451) 23,344
Net commissions, brokerage and other underwriting........ 63,204 61,312 53,904
Interest expense......................................... 1,717 4,103 4,726
Write-off of unamortized deferred loan fees.............. 700 -- 1,556
Non-recurring compensation and merger costs.............. 7,865 -- --
Amortization and impairment of goodwill and
intangibles........................................... 2,761 16,853 3,365
Other expenses, net...................................... 2,789 2,442 1,881
-------- -------- --------
89,090 77,259 88,776
-------- -------- --------
Income before income taxes................................. 21,560 40,251 23,779
Income taxes............................................... 8,181 19,721 9,401
-------- -------- --------
Net income................................................. $ 13,379 $ 20,530 $ 14,378
======== ======== ========
Weighted average shares outstanding:
Primary.................................................. 16,395 15,404 15,160
======== ======== ========
Fully diluted............................................ 16,510 15,917 15,455
======== ======== ========
Earnings per share:
Primary.................................................. $ .82 $ 1.33 $ .95
======== ======== ========
Fully diluted............................................ $ .81 $ 1.29 $ .93
======== ======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-46
<PAGE> 124
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
--------------------------------
1996 1995 1994
-------- -------- --------
<S> <C> <C> <C>
Common Stock:
Balance, January 1....................................... $ 770 $ 770 $ 753
Common stock issued...................................... -- -- 15
Common stock issued through exercise of warrants and
options............................................... 20 -- 2
-------- -------- --------
Balance, December 31..................................... $ 790 $ 770 $ 770
======== ======== ========
Additional Paid-In Capital:
Balance, January 1....................................... $179,276 $179,250 $165,257
Common stock issued...................................... -- -- 3,985
Common stock issued through exercise of warrants and
options............................................... 2,283 26 8
Return of capital distribution on common stock........... (69,880) -- --
Change in valuation allowance for deferred tax assets.... -- -- 10,000
Stock option repricing................................... 6,734 -- --
-------- -------- --------
Balance, December 31..................................... $118,413 $179,276 $179,250
======== ======== ========
Retained Earnings:
Balance, January 1....................................... $ 75,286 $ 54,756 $ 40,378
Net income............................................... 13,379 20,530 14,378
Dividend on common stock................................. (86,368) -- --
-------- -------- --------
Balance, December 31..................................... $ 2,297 $ 75,286 $ 54,756
======== ======== ========
Unrealized Gain (Loss) on Securities, Net of Deferred
Income Taxes:
Balance, January 1....................................... $ 1,972 $ (9,830) $ 1,318
Impact of adopting SFAS No. 115.......................... -- -- 3,203
Transfer of held-to-maturity securities.................. -- 224 --
Change for the year...................................... (889) 11,578 (14,351)
-------- -------- --------
Balance, December 31..................................... $ 1,083 $ 1,972 $ (9,830)
======== ======== ========
Treasury Stock:
Balance, January 1....................................... $ -- $ (81) $ (81)
Common stock reissued through exercise of options........ -- 81 --
-------- -------- --------
Balance, December 31..................................... $ -- $ -- $ (81)
======== ======== ========
</TABLE>
<TABLE>
<CAPTION>
COMMON STOCK
-------------------------
ISSUED IN TREASURY
---------- -----------
<S> <C> <C>
Shares:
Balance, January 1, 1994.................................. 15,055,231 (13,666)
Common stock issued through exercise of warrants and
options................................................ 45,481 --
Common stock issued in connection with Universal Surety
Holding Corp. acquisition.............................. 307,103 --
---------- -------
Balance, December 31, 1994................................ 15,407,815 (13,666)
Common stock reissued from treasury through exercise of
options................................................ -- 13,666
Common stock issued through exercise of options........... 934 --
---------- -------
Balance, December 31, 1995................................ 15,408,749 --
Common stock issued through exercise of options........... 396,000 --
---------- -------
Balance, December 31, 1996................................ 15,804,749 --
========== =======
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-47
<PAGE> 125
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-----------------------------------
1996 1995 1994
--------- --------- ---------
<S> <C> <C> <C>
OPERATING ACTIVITIES:
Net income............................................ $ 13,379 $ 20,530 $ 14,378
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization...................... 4,822 18,272 4,617
Accretion of bond discount, net.................... (409) (2,471) (3,933)
Net investment (gains) losses...................... (1,715) 1,653 (945)
Non-recurring compensation and merger costs........ 7,865 -- --
Changes in:
Reserves for unpaid losses and loss adjustment
expenses......................................... (2,364) (22,980) 10,477
Reserve for unearned premiums...................... 5,457 151 (1,160)
Deferred income taxes, net......................... 7,291 18,086 8,820
Other assets and liabilities....................... (3,193) (2,502) (2,970)
--------- --------- ---------
Net cash provided by operating activities............... 31,133 30,739 29,284
--------- --------- ---------
INVESTING ACTIVITIES:
Securities available-for-sale:
Purchases -- fixed maturities...................... (73,862) (108,924) (93,452)
Sales -- fixed maturities.......................... 67,380 71,889 43,762
Maturities -- fixed maturities..................... 46,935 63,315 35,020
Purchases -- equity securities..................... (190) (3,165) (28,350)
Sales -- equity securities......................... 22,451 6,225 8,091
Change in short-term investments...................... 855 (15,786) 47,881
Net proceeds from the sale of UCHC.................... 28,024 -- --
Acquisitions, net of cash acquired.................... -- -- (26,175)
Proceeds from sale of other invested assets........... 508 1,821 1,733
Capital expenditures, net............................. (2,948) (1,351) (1,679)
--------- --------- ---------
Net cash provided by (used in) investing activities..... 89,153 14,024 (13,169)
--------- --------- ---------
FINANCING ACTIVITIES:
Proceeds from long-term debt.......................... 62,000 -- 96,000
Principal payments on long-term debt.................. (27,000) (46,000) (110,214)
Dividends paid........................................ (156,248) -- --
Exercise of warrants and options, net of option
repricing payments................................. 1,186 107 10
Debt issuance costs................................... (489) -- (1,060)
--------- --------- ---------
Net cash used in financing activities................... (120,551) (45,893) (15,264)
--------- --------- ---------
Increase (decrease) in cash............................. (265) (1,130) 851
Cash at beginning of year............................... 3,001 4,131 3,280
--------- --------- ---------
Cash at end of year..................................... $ 2,736 $ 3,001 $ 4,131
========= ========= =========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the year for:
Interest........................................... $ 1,426 $ 3,759 $ 4,121
Income taxes, net of refunds....................... $ 1,195 $ 658 $ 642
Supplemental Disclosure of Non-Cash Investing and
Financing Activities:
Common stock issued in connection with
acquisitions..................................... $ -- $ -- $ 4,000
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-48
<PAGE> 126
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of Capsure
Holdings Corp. and all significant majority-owned subsidiaries ("Capsure" or the
"Company"). Capsure provides surety and fidelity bonds in all 50 states through
a combined network of 120,000 independent agents. Capsure's principal
subsidiaries are Western Surety Company ("Western Surety"), acquired in August
1992, and Universal Surety of America ("Universal Surety"), acquired in
September 1994. Western Surety writes small fidelity and noncontract surety
bonds, referred to as "miscellaneous" bonds, and errors and omissions liability
insurance, as a licensed insurer in all 50 states and the District of Columbia.
Western Surety's sister company, Surety Bonding Company of America, writes
similar business and is licensed in 17 states. Universal Surety specializes in
the underwriting of small contract and miscellaneous surety bonds. Universal
Surety is licensed in 37 states and the District of Columbia with most of its
business generated in Texas.
Basis of Presentation
The accompanying consolidated financial statements have been prepared in
accordance with generally accepted accounting principles. The preparation of
financial statements in conformity with generally accepted accounting principles
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from those estimates. Certain balances in the prior years' financial statements
have been reclassified to conform to current presentation.
Investments
The Company has the ability to hold all debt 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 substantially all of its debt (bonds and
redeemable preferred stocks) and equity securities as available-for-sale.
Certain equity securities at the parent company level that are held principally
for the purpose of selling them in the near term are considered trading
securities.
The accounting policies for each investment category are as follows:
Available-for-Sale Securities -- These securities are reported at fair
value, with unrealized gains and losses, net of deferred income taxes,
reported as a separate component of stockholders' equity until realized.
Cash flows from purchases, sales and maturities are reported gross in the
investing activities section of the cash flow statement.
Trading Securities -- These securities are reported on the balance
sheet at fair value, with any unrealized gains and losses included in
earnings. Cash flows from purchases, sales and maturities are included in
the operating activities section of the cash flow statement.
The amortized cost of debt securities is adjusted for amortization of
premiums and accretion of discounts to maturity. Such amortization is included
in investment income. For mortgage-backed and certain asset-backed securities,
Capsure recognizes income using a constant effective yield based on estimated
cash flows including anticipated prepayments. Significant variances in actual
cash flows from expected cash flows are accounted for prospectively. Any related
adjustment is reflected in investment income. Investment gains or losses are
determined using the specific identification method. Investments with an other
than temporary decline in value are written down to fair value, resulting in
losses that are included in investment gains and losses.
F-49
<PAGE> 127
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Short-term investments are carried at amortized cost which approximates
fair value.
Deferred Policy Acquisition Costs
Policy acquisition costs, consisting of commissions and other underwriting
expenses which vary with, and are directly related to, the production of
business, net of reinsurance commission income, are deferred and amortized to
income as the related premiums are earned. Deferred policy acquisition costs are
subject to a limitation representing the excess of anticipated net earned
premiums over anticipated losses, loss adjustment expenses and maintenance
costs. The ultimate recoverability of policy acquisition costs is determined
without regard to investment income.
Excess Cost Over Net Assets Acquired and Intangible Assets
The excess cost over the fair value of the net assets acquired is amortized
substantially over 40 years. Other intangible assets are amortized over periods
ranging from three to 20 years, a substantial portion of which is amortized over
20 years. Other intangible assets primarily relate to the estimated value of the
acquired insurance in force and the producing agency force as of the acquisition
date. Excess cost over net assets acquired is reported net of accumulated
amortization of $6.3 million and $21.1 million (includes $13.2 million
write-down in 1995) at December 31, 1996 and 1995, respectively. Intangible
assets are reported net of accumulated amortization of $27.3 million and $25.7
million at December 31, 1996 and 1995, respectively.
Management assesses the recoverability of goodwill and intangible assets
based upon estimates of undiscounted future operating cash flows whenever
significant events or changes in circumstances suggest that the carrying amount
of an asset may not be recoverable.
Unpaid Losses and Loss Adjustment Expenses
The liability for unpaid losses and loss adjustment expenses is based on
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. These estimates are determined
based on the Company's and industry loss experience as well as consideration of
current trends and conditions. The liability for unpaid losses and loss
adjustment expenses is an accounting estimate and, similar to other accounting
estimates, 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 continually reviewed and updated.
Changes in the estimated liability are reflected in operating income in the year
in which such changes are determined. As described in Note 6, the Company's
incurred losses and loss adjustment expenses in 1995 were reduced by $29.1
million, net of reinsurance, as a result of favorable claim settlements and
certain changes in estimates relating to insured events of prior years.
Insurance Premiums
Insurance premiums are recognized as revenue ratably over the terms of the
related policies. Unearned premiums represent the portion of premiums written
applicable to the unexpired terms of policies in force calculated on a daily pro
rata basis. Premium revenues are reported net of amounts ceded to reinsurers.
Reinsurance
Amounts recoverable from reinsurers are estimated in a manner consistent
with the claim liability associated with the reinsured policy and are reported
as reinsurance receivable rather than netted against the liability for unpaid
losses and loss adjustment expenses. Losses and loss adjustment expenses
incurred are reported net of estimated recoveries under reinsurance contracts.
F-50
<PAGE> 128
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Income Taxes
The Company uses the asset and liability method of accounting for income
taxes required by SFAS No. 109, "Accounting for Income Taxes." Under the asset
and liability method, deferred income taxes are established for the future tax
effects of temporary differences between the tax and financial reporting bases
of assets and liabilities using currently enacted tax rates. Such temporary
differences primarily relate to net operating tax loss carryforwards ("NOLs"),
loss reserve discounting, deferred policy acquisition costs and intangible
assets. Under SFAS No. 109, the effect on deferred taxes of a change in tax
rates is recognized in income in the period of enactment.
In addition, deferred tax assets are valued based upon the expectation of
future realization on a "more likely than not" basis. The initial recognition of
the tax benefits of the NOLs resulted in a credit to additional paid-in capital
for the available NOLs for which future realization was expected. Tax benefits
resulting from the future utilization of such NOLs will reduce the net deferred
tax asset established in accordance with SFAS No. 109.
Reorganization Proceedings
On July 31, 1986, the Company emerged from voluntary bankruptcy proceedings
under Chapter 11 of the United States Bankruptcy Code (the "Bankruptcy Code").
After the requisite acceptances were obtained and the Bankruptcy Court
determined that the Second Amended Joint Plan of Reorganization, as amended (the
"Plan of Reorganization"), satisfied applicable requirements of the Bankruptcy
Code, the Bankruptcy Court confirmed the Plan of Reorganization on December 20,
1985, and the Plan of Reorganization was consummated on July 31, 1986 (the
"Reorganization Date"). The Company emerged from bankruptcy with approximately
$300 million of NOLs resulting from oil and gas operations prior to the
reorganization.
In accordance with accounting principles applicable to reorganizations, the
net assets of the Company were adjusted to fair value, the accumulated deficit
in retained earnings at the date of reorganization was eliminated and the excess
of the fair values of the net assets over the stated value of outstanding
capital stock was assigned to additional paid-in capital.
Earnings Per Share
Earnings per common and common equivalent shares outstanding are computed
using the treasury stock method. Weighted average shares outstanding assuming
full dilution for 1996, 1995 and 1994 were 16.5 million, 15.9 million and 15.5
million, respectively.
Pending Accounting Standards
In February 1997, the FASB issued SFAS No. 128, "Earnings Per Share," which
is effective for both interim and annual periods ending after December 15, 1997.
SFAS No. 128 replaces APB Opinion No. 15, "Earnings Per Share." APB Opinion No.
15 required that entities with simple capital structures present a single
earnings per common share ("EPS") on the face of the income statement, whereas
those with complex capital structures had to present both primary and fully
diluted EPS. SFAS No. 128 simplifies the computation of EPS by replacing the
presentation of primary EPS with a presentation of basic EPS and requires dual
presentation of basic and diluted EPS by entities with complex capital
structures. Basic EPS includes no dilution and is computed by dividing income
available to common stockholders by the weighted average number of common shares
outstanding for the period, whereas primary EPS includes the dilutive effect of
common stock equivalents, such as stock options. Diluted EPS reflects the
potential dilution of securities that could share in the earnings of an entity,
similar to fully diluted EPS. The Company intends to present basic and diluted
EPS in financial statements issued after the effective date.
F-51
<PAGE> 129
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. ACQUISITION AND DISPOSITION OF SUBSIDIARIES
On September 22, 1994, Capsure, through its wholly owned subsidiary,
Capsure Financial Group, Inc. ("CFG"), acquired all of the outstanding common
stock of Universal Surety Holding Corp. ("USHC"). USHC is the holding company of
Universal Surety. Capsure paid $28 million in cash and $4 million in Capsure
common stock for USHC, pursuant to a Stock Purchase Agreement dated as of July
26, 1994. The cash portion of the purchase price was financed with borrowings
under Capsure's revolving credit facility.
The acquisition has been accounted for as a purchase and, accordingly, the
acquired assets and liabilities have been recorded at their estimated fair
values. The operating results of USHC are included in the consolidated
statements of income and cash flows from the September 22, 1994 acquisition
date. The excess of the purchase price over the fair value of net assets
acquired is recorded as excess cost over net assets acquired in the consolidated
balance sheets.
The USHC Stock Purchase Agreement provides for a contingent payment to
certain of the selling shareholders. Such payment shall be in cash or an
equivalent amount of Capsure common stock, at the Company's option, in the year
2000, equal to twenty percent of the excess of the after-tax fair market value
of Universal Surety at December 31, 1999, over an assumed fifteen percent
return, compounded annually, on Capsure's invested capital. The contingent
consideration, if any, shall be reported as compensation expense in the period
the contingency is resolved and the consideration is payable. If the contingent
consideration was determined and payable solely upon results through December
31, 1996, there would be no such payment required.
The following table of unaudited pro forma information has been prepared as
if the acquisition of USHC had been consummated on January 1, 1993, at the same
purchase price, with adjustments to the consolidated results of operations for
the effects of the acquisition in the same manner as subsequent to the
acquisition. Such adjustments include: (i) decreased net investment income and
realized investment gains at USHC; (ii) decreased operating expenses at USHC;
and (iii) increased interest and amortization expense. In management's opinion,
the pro forma financial information is not indicative of consolidated results of
operations that may have occurred had the acquisition taken place on January 1,
1993, or of future results of operations of USHC under the ownership and
operation of Capsure. In the following table, the dollars are in thousands,
except per share amounts:
<TABLE>
<CAPTION>
PRO FORMA (UNAUDITED)
FOR THE YEAR ENDED
DECEMBER 31, 1994
---------------------
<S> <C>
Revenues......................... $122,967
Net income....................... $ 15,086
Net income per common share...... $ .98
</TABLE>
On May 22, 1996, the Company consummated the sale of United Capitol Holding
Company ("UCHC") and its subsidiaries, United Capitol Insurance Company ("United
Capitol"), United Capitol Managers, Inc. and Fischer Underwriting Group,
Incorporated, to a subsidiary of Frontier Insurance Group, Inc. The operating
results of UCHC and its subsidiaries are reflected in Capsure's results through
the closing date. Net proceeds to Capsure of $77 million, which included the
purchase price for the capital stock of UCHC and the release of United Capitol's
excess statutory surplus at closing, approximated Capsure's carrying value. The
goodwill associated with the 1990 acquisition of United Capitol was previously
reduced to estimated net realizable value as of December 31, 1995, resulting in
a $13.2 million impairment of goodwill in 1995.
F-52
<PAGE> 130
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. INVESTMENTS
The cost and estimated fair values of investments in debt and equity
securities as of December 31, 1996 and 1995 were as follows (dollars in
thousands):
<TABLE>
<CAPTION>
AMORTIZED GROSS GROSS ESTIMATED
COST UNREALIZED UNREALIZED FAIR
OR COST GAINS LOSSES VALUE
--------- ---------- ---------- ---------
<S> <C> <C> <C> <C>
AS OF DECEMBER 31, 1996:
Fixed maturities:
U.S. Treasury securities and obligations of U.S.
Government corporations and agencies:
U.S. Treasury notes........................... $ 5,030 $ 66 $ (13) $ 5,083
Collateralized mortgage obligations........... 35,565 373 (49) 35,889
Mortgage pass-through securities.............. 36,221 244 (84) 36,381
Obligations of states and political
subdivisions.................................. 2,696 8 (36) 2,668
Non-agency collateralized mortgage
obligations................................... 21,877 114 (59) 21,932
Asset-backed securities:
Second mortgages/home equity loans............ 26,961 135 (114) 26,982
Other underlying assets....................... 7,070 22 (132) 6,960
-------- ------ ------- --------
Total fixed maturities................ 135,420 962 (487) 135,895
Equity securities............................... 3,687 839 -- 4,526
-------- ------ ------- --------
Total available-for-sale securities... $139,107 $1,801 $ (487) $140,421
======== ====== ======= ========
AS OF DECEMBER 31, 1995:
Fixed maturities:
U.S. Treasury securities and obligations of U.S.
Government corporations and agencies:
U.S. Treasury notes........................... $ 15,047 $ 488 $ (1) $ 15,534
Collateralized mortgage obligations........... 64,610 430 (349) 64,691
Mortgage pass-through securities.............. 40,313 788 (3) 41,098
Debt securities of foreign governments.......... 5 -- -- 5
Obligations of states and political
subdivisions.................................. 5,748 10 (18) 5,740
Corporate bonds................................. 91 -- (16) 75
Non-agency collateralized mortgage
obligations................................... 34,574 392 (66) 34,900
Asset-backed securities:
Second mortgages/home equity loans............ 49,060 947 (102) 49,905
Automobile loans.............................. 8,229 1 (2) 8,228
Other underlying assets....................... 15,599 97 (154) 15,542
-------- ------ ------- --------
Total fixed maturities................ 233,276 3,153 (711) 235,718
Equity securities............................... 24,758 1,303 (1,245) 24,816
-------- ------ ------- --------
Total available-for-sale securities... $258,034 $4,456 $(1,956) $260,534
======== ====== ======= ========
Equity trading securities....................... $ 2,366 $ 593 $ (22) $ 2,937
======== ====== ======= ========
</TABLE>
As of December 31, 1996, virtually 100% of the Company's debt securities
were considered investment grade by The Standard & Poors Corporation or Moody's
Investor Services, Inc., and 93% were rated at least AA by those agencies. In
addition, the Company's investments in debt securities did not contain any
significant geographic or industry concentration of credit risk.
F-53
<PAGE> 131
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The U.S. Treasury notes and mortgage pass-through securities are backed by
the full faith and credit of the U.S. Government. The U.S. Government
collateralized mortgage obligations consist of securities collateralized by
first mortgages issued by the Federal National Mortgage Association and the
Federal Home Loan Mortgage Corporation, or guaranteed by the Government National
Mortgage Association.
The Company has reduced the prepayment variability commonly associated with
collateralized mortgage obligations by generally investing in planned
amortization class tranches which are structured largely to insulate the
investor from prepayment risk.
The Company's insurance subsidiaries, as required by state law, deposit
certain securities with state insurance regulatory authorities. At December 31,
1996, fixed maturities on deposit had an aggregate carrying value of $4.8
million.
Short-term investments are generally comprised of U.S. Treasury notes,
maturing corporate notes, money market funds, and investment grade commercial
paper equivalents.
The amortized cost and estimated fair value of debt securities at December
31, 1996, by contractual maturity, are shown below. Expected maturities will
differ from contractual maturities as borrowers may have the right to call or
prepay obligations with or without call or prepayment penalties (dollars in
thousands):
<TABLE>
<CAPTION>
ESTIMATED
AMORTIZED FAIR
COST VALUE
--------- ---------
<S> <C> <C>
AVAILABLE-FOR-SALE SECURITIES
Due within one year......................................... $ 110 $ 111
Due after one year but within five years.................... 4,911 4,951
Due after five years but within ten years................... 208 224
Due after ten years......................................... 2,496 2,466
-------- --------
7,725 7,752
Mortgage pass-through securities, collateralized mortgage
obligations and asset-backed securities................... 127,695 128,143
-------- --------
$135,420 $135,895
======== ========
</TABLE>
Major categories of net investment income and net investment gains (losses)
were as follows (dollars in thousands):
<TABLE>
<CAPTION>
1996 1995 1994
------- ------- -------
<S> <C> <C> <C>
Investment income:
Fixed maturities.......................................... $12,009 $16,964 $16,405
Equity securities......................................... 720 1,924 915
Short-term investments.................................... 3,593 1,814 1,722
Other..................................................... 519 260 532
------- ------- -------
Total investment income................................... 16,841 20,962 19,574
Investment expenses......................................... 397 491 445
------- ------- -------
Net investment income....................................... $16,444 $20,471 $19,129
======= ======= =======
Gross investment gains:
Fixed maturities.......................................... $ 1,109 $ 722 $ 88
Equity securities......................................... 4,220 2,505 3,762
Gross investment losses:
Fixed maturities.......................................... (973) (3,757) (625)
Equity securities......................................... (2,718) (2,068) (1,802)
Net unrealized gains (losses) on trading securities......... -- 945 (374)
Other....................................................... 77 -- (104)
------- ------- -------
Net investment gains (losses)............................... $ 1,715 $(1,653) $ 945
======= ======= =======
</TABLE>
F-54
<PAGE> 132
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Net unrealized gain (loss) on securities included in stockholders' equity
was as follows (dollars in thousands):
<TABLE>
<CAPTION>
1996 1995
------------------------ --------------------------
GAINS LOSSES NET GAINS LOSSES NET
------ ------ ------ ------ ------- -------
<S> <C> <C> <C> <C> <C> <C>
Fixed maturities..................... $ 962 $(487) $ 475 $3,153 $ (711) $ 2,442
Equity securities.................... 839 -- 839 1,303 (1,245) 58
Other................................ 352 -- 352 534 -- 534
------ ----- ------ ------ ------- -------
$2,153 $(487) 1,666 $4,990 $(1,956) 3,034
====== ===== ====== =======
Deferred income taxes................ (583) (1,062)
------ -------
Net unrealized gain on securities.... $1,083 $ 1,972
====== =======
</TABLE>
The net investment losses in 1995 reflected the $2.7 million write-down of
the carrying value for two asset-backed securities from the same issuer which
experienced an other than temporary decline in fair value.
A majority of the realized investment gains and losses on equity securities
resulted from sales of securities held at the parent company level. For 1996,
1995 and 1994, investment activity for the equity trading portfolio held at the
parent company level included gross realized investment gains of $3.4 million,
$1.9 million and $1.5 million, respectively, and gross realized investment
losses of $2.6 million, $1.8 million and $1.0 million, respectively.
4. DEFERRED POLICY ACQUISITION COSTS
Policy acquisition costs deferred and the related amortization charged to
income were as follows (dollars in thousands):
<TABLE>
<CAPTION>
1996 1995 1994
------- ------- --------
<S> <C> <C> <C>
Balance at January 1............................... $27,057 $25,150 $ 18,421
Balance at date of acquisition (disposition)....... (478) -- 4,369
Costs deferred during year......................... 39,449 37,666 31,750
Amortization during year........................... (37,505) (35,759) (29,390)
------- ------- --------
Balance at December 31............................. $28,523 $27,057 $ 25,150
======= ======= ========
</TABLE>
5. REINSURANCE
The Company's insurance subsidiaries, in the ordinary course of business,
cede reinsurance to other insurance companies to limit their exposure to loss.
Reinsurance contracts do not relieve the Company of its primary obligations to
claimants. A contingent liability exists with respect to reinsurance ceded to
the extent that any reinsurer is unable to meet the obligations assumed under
the reinsurance agreements. The Company evaluates the financial condition of its
reinsurers, establishes allowances for uncollectible amounts and monitors
concentrations of credit risk. At December 31, 1996, Capsure's largest
reinsurance receivable, including prepaid reinsurance premiums of $0.8 million,
was approximately $2.3 million with Transatlantic Reinsurance Company.
Transatlantic Reinsurance Company is rated A+ (Superior) by A.M. Best Company,
Inc.
F-55
<PAGE> 133
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The effect of reinsurance on premiums written and earned was as follows
(dollars in thousands):
<TABLE>
<CAPTION>
1996 1995 1994
------------------- ------------------- -------------------
WRITTEN EARNED WRITTEN EARNED WRITTEN EARNED
-------- -------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C>
Direct............................. $107,197 $105,467 $111,305 $113,538 $102,062 $103,871
Assumed............................ 72 45 93 247 294 143
Ceded.............................. (12,160) (13,021) (13,670) (15,093) (11,778) (11,533)
-------- -------- -------- -------- -------- --------
Net premiums....................... $ 95,109 $ 92,491 $ 97,728 $ 98,692 $ 90,578 $ 92,481
======== ======== ======== ======== ======== ========
</TABLE>
The effect of reinsurance on losses and loss adjustment expenses incurred
was as follows (dollars in thousands):
<TABLE>
<CAPTION>
1996 1995 1994
------- ------- -------
<S> <C> <C> <C>
Gross losses and loss adjustment expenses..... $12,769 $ (815) $31,566
Reinsurance recoveries........................ (2,715) (6,636) (8,222)
------- ------- -------
Net losses and loss adjustment expenses....... $10,054 $(7,451) $23,344
======= ======= =======
</TABLE>
6. LIABILITY FOR LOSSES AND LOSS ADJUSTMENT EXPENSES
Activity in the liability for unpaid losses and loss adjustment expenses
was as follows (dollars in thousands):
<TABLE>
<CAPTION>
1996 1995 1994
-------- -------- --------
<S> <C> <C> <C>
Gross balance at January 1................................. $126,061 $149,041 $135,825
Balance at date of acquisition (disposition)............... (84,823) -- 2,738
Incurred related to:
Current year............................................... 23,685 34,073 46,206
Prior years................................................ (10,579) (34,559) (14,522)
-------- -------- --------
Total incurred............................................. 13,106 (486) 31,684
-------- -------- --------
Paid related to:
Current year............................................... 3,390 4,150 3,003
Prior years................................................ 12,080 18,344 18,203
-------- -------- --------
Total paid................................................. 15,470 22,494 21,206
-------- -------- --------
Gross balance at December 31............................... $ 38,874 $126,061 $149,041
======== ======== ========
Balance net of reinsurance at December 31.................. $ 33,378 $ 87,078 $111,164
======== ======== ========
</TABLE>
As a result of favorable claim settlements and changes in estimates of
insured events in prior years, the provision for losses and loss adjustment
expenses decreased by $10.6 million ($6.9 million, net of reinsurance) in 1996,
$34.6 million ($29.1 million, net of reinsurance) in 1995 and $14.5 million
($8.3 million, net of reinsurance) in 1994.
United Capitol's claims development through December 31, 1995, had been
favorable relative to expectations based on industry experience. Due to the
limited prior operating experience of United Capitol and the long-tail nature of
its business, management previously relied principally upon industry development
patterns and expected loss ratios in estimating IBNR. Given the availability of
nine full years of experience and the growing evidence of favorable loss trends
relative to industry indications, management concluded in the fourth quarter of
1995 that it was appropriate to place greater reliance on United Capitol's own
development patterns and emerging loss ratios in estimating IBNR. United Capitol
reduced loss and loss adjustment expenses by $23.2 million in 1995 for net
favorable development related to prior years,
F-56
<PAGE> 134
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
substantially all of which pertains to this change in estimate. This loss
reserve reduction increased Capsure's consolidated income before taxes by $23.2
million, and net income by $15.1 million, or $0.98 per share.
7. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table summarizes disclosure of fair value information of
financial instruments, whether or not recognized in the balance sheet, for which
it is practicable to estimate that value. In cases where quoted market prices
are not available, fair values may be based on estimates using present value or
other valuation techniques. These techniques are significantly affected by the
assumptions used, including the discount rates and estimates of future cash
flows. Accordingly, the estimates presented herein are subjective in nature and
are not necessarily indicative of the amounts that Capsure could realize in a
current market exchange. This information excludes certain financial instruments
and all nonfinancial instruments such as insurance contracts from fair value
disclosure. Thus, the following fair value amounts cannot be aggregated to
determine the underlying economic value of Capsure.
The carrying amounts and estimated fair values of financial instruments
were as follows (dollars in thousands):
<TABLE>
<CAPTION>
1996 1995
---------------------- ----------------------
CARRYING ESTIMATED CARRYING ESTIMATED
AMOUNT FAIR VALUE AMOUNT FAIR VALUE
-------- ---------- -------- ----------
<S> <C> <C> <C> <C>
Debt securities......................... $135,895 $135,895 $235,718 $235,718
Equity securities....................... 4,526 4,526 27,753 27,753
Short-term investments.................. 19,416 19,416 37,865 37,865
Other investments....................... 2,695 2,695 3,219 3,219
Cash.................................... 2,736 2,736 3,001 3,001
Long-term debt.......................... 60,000 60,000 25,000 25,000
</TABLE>
The following methods and assumptions were used by Capsure in estimating
fair values of financial instruments:
Investment Securities -- The estimated fair values for debt securities
(including redeemable preferred stock) are based upon quoted market prices,
where available. For debt securities not actively traded, the estimated
fair values are determined using values obtained from independent pricing
services or, in the case of private placements, by discounting expected
future cash flows using a current market rate applicable to the yield,
credit quality and maturity of the investments. The estimated fair values
for equity securities are based on quoted market prices.
Cash, Short-Term Investments and Other Investments -- The carrying
amount for these instruments approximates their estimated fair values.
Long-Term Debt -- The estimated fair value of Capsure's long-term debt
is based on the quoted market prices for the same or similar issues or on
the current rates offered to the Company for debt of the same remaining
maturity.
8. LONG-TERM DEBT
On March 29, 1994, the Company formed a direct, wholly owned subsidiary,
CFG, to which Capsure contributed substantially all its assets and liabilities.
Concurrently, CFG entered into a senior reducing revolving credit agreement with
a syndicate of banks for the principal amount of $135 million (the "Credit
Facility"). The common stock of substantially all of Capsure's subsidiaries and
substantially all assets of Capsure's non-insurance operations have been pledged
under the Credit Facility.
F-57
<PAGE> 135
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Concurrent with the sale of UCHC and its subsidiaries, Capsure and its
lenders entered into an agreement to amend and restate the Credit Facility. The
amendment reduced the commitment to $100 million from $135 million and permitted
an initial draw of up to $70 million for a special dividend to stockholders.
Transaction costs totaled approximately $0.5 million. As of December 31, 1996
and 1995, $60 million and $25 million, respectively, were outstanding under the
Credit Facility. The remaining availability under the Credit Facility may be
used for additional dividends, stock repurchases, acquisitions and for general
corporate purposes.
On September 11, 1996, the Company declared a special cash distribution in
the amount of $10 per share of common stock, payable to all holders of record as
of September 25, 1996. The special distribution was funded from $62 million of
borrowings under the Credit Facility and approximately $94 million from
available cash and marketable securities accumulated at the parent company
level.
The interest rate on borrowings under the Credit Facility may be fixed, at
the Company's option, for a period of one to six months and is based on a margin
over either the London Interbank Offered Rate ("LIBOR") or the greatest of the
agent banks' prime rate, certificate of deposit rate plus 1.0% and the Federal
Funds Effective Rate plus 0.5%. The margin varies based on a leverage ratio and
ranges from 0.75% to 1.50% on LIBOR borrowings and 0.0% to 0.50% on non-LIBOR
borrowings. The Credit Facility provides for a commitment fee on the unused
availability which also varies based on leverage. At December 31, 1996, the
interest rate on outstanding borrowings was 6.56% and the applicable commitment
fee was 0.25%.
The Credit Facility limits the Company with respect to the incurrence of
additional indebtedness and the payment of dividends, imposes certain
restrictions on investments and requires the maintenance of certain financial
ratios and levels of Risk-Based Capital ("RBC"). As of December 31, 1996, the
Company was in compliance with all material restrictions or covenants contained
in the Credit Facility agreement. The use of the Credit Facility for acquisition
purposes is subject to certain conditions with respect to the business and
historical financial results of the target company, the maintenance of certain
financial ratios on a prospective and pro forma basis, and the structure of the
acquisition transaction.
Total borrowings available under the Credit Facility reduce semi-annually
commencing March 31, 1997 by the following amounts (dollars in thousands):
<TABLE>
<S> <C>
March 31, 1997.............................................. $ 6,250
September 30, 1997.......................................... 6,250
March 31, 1998.............................................. 7,000
September 30, 1998.......................................... 7,000
March 31, 1999.............................................. 7,500
September 30, 1999.......................................... 7,500
March 31, 2000.............................................. 8,500
September 30, 2000.......................................... 8,500
March 31, 2001.............................................. 8,500
September 30, 2001.......................................... 8,500
March 31, 2002.............................................. 8,500
September 30, 2002.......................................... 8,500
March 31, 2003.............................................. 7,500
--------
$100,000
========
</TABLE>
Principal and interest payments required under the Credit Facility are
funded principally by dividend and intercompany tax sharing payments received
from Capsure's insurance subsidiaries.
F-58
<PAGE> 136
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. STATUTORY FINANCIAL DATA
Capsure's insurance subsidiaries file annual financial statements prepared
in accordance with statutory accounting practices prescribed or permitted by
applicable insurance regulatory authorities. Prescribed statutory accounting
practices include state laws, regulations and general administrative rules, as
well as guidance provided in a variety of publications of the National
Association of Insurance Commissioners ("NAIC"). Permitted statutory accounting
practices encompass all accounting practices that are not prescribed. Such
practices may differ from state to state, may differ from company to company
within a state, and may change in the future. The permitted statutory accounting
practices of Capsure's insurance subsidiaries did not have a material effect on
reported statutory surplus. The principal differences between statutory
financial statements and financial statements prepared in accordance with
generally accepted accounting principles are that statutory financial statements
do not reflect deferred policy acquisition costs and deferred income taxes and
debt securities are generally carried at amortized cost in statutory financial
statements.
The NAIC has promulgated RBC requirements for property/casualty insurance
companies to evaluate the adequacy of statutory capital and surplus in relation
to investment and insurance risks such as asset quality, asset and liability
matching, loss reserve adequacy, and other business factors. The RBC information
will be used by state insurance regulators as an early warning tool to identify,
for the purpose of initiating regulatory action, insurance companies that
potentially are inadequately capitalized. In addition, the formula defines new
minimum capital standards that will supplement the current system of fixed
minimum capital and surplus requirements on a state-by-state basis. Regulatory
compliance is determined by a ratio (the "Ratio") of the enterprise's regulatory
total adjusted capital, as defined by the NAIC, to its authorized control level
RBC, as defined by the NAIC. Generally, a Ratio in excess of 200% of authorized
control level RBC requires no corrective actions by the company or regulators.
As of December 31, 1996, each of Capsure's insurance subsidiaries had a Ratio
that was substantially in excess of the minimum RBC requirements.
Capsure's insurance subsidiaries are subject to regulation and supervision
by the various state insurance regulatory authorities in which they conduct
business. Such regulation is generally designed to protect policyholders and
includes such matters as maintenance of minimum statutory surplus and
restrictions on the payment of dividends. Generally, statutory surplus of each
insurance subsidiary in excess of a statutorily prescribed minimum is available
for payment of dividends to the parent company. However, such distributions as
dividends may be subject to prior regulatory approval, including a review of the
impact on RBC. Without prior regulatory approval in 1997, Capsure's insurance
subsidiaries may pay stockholder dividends of $18.0 million in the aggregate. In
1996, 1995 and 1994, Capsure received $65.7 million (including $50.2 million of
dividends requiring prior approval), $40.9 million (including $21.6 million of
dividends requiring prior approval), and $21.0 million (including $5.0 million
of dividends requiring prior approval), respectively, in dividends from its
insurance subsidiaries. Capsure received $15.6 million, $21.9 million and $9.5
million in dividends from its surety and fidelity subsidiaries in 1996, 1995 and
1994, respectively.
Combined statutory surplus and net income for insurance operations,
including preacquisition results, as reported to regulatory authorities were as
follows (dollars in thousands):
<TABLE>
<CAPTION>
1996 1995 1994
------- -------- --------
<S> <C> <C> <C>
Statutory surplus........................... $48,913 $113,894 $109,750
Statutory net income........................ $22,045 $ 41,717 $ 23,796
</TABLE>
F-59
<PAGE> 137
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. INCOME TAXES
The components of deferred income taxes were as follows (dollars in
thousands):
<TABLE>
<CAPTION>
1996 1995
------- -------
<S> <C> <C>
Deferred tax assets:
Net operating losses................................... $50,122 $62,000
Loss and loss adjustment expense reserves.............. 793 5,534
Unearned premium reserves.............................. 4,673 4,791
Accrued expenses....................................... 3,738 3,768
Other.................................................. 3,626 839
------- -------
Total gross deferred tax assets................ 62,952 76,932
Valuation allowance.................................... 30,800 30,800
------- -------
Deferred tax asset, net of valuation allowance........... 32,152 46,132
------- -------
Deferred tax liabilities:
Intangible assets...................................... 4,894 5,477
Deferred policy acquisition costs...................... 9,983 9,470
Unrealized gain on securities.......................... 583 1,062
Other.................................................. 673 830
------- -------
Total deferred tax liabilities................. 16,133 16,839
------- -------
Net deferred tax asset................................... $16,019 $29,293
======= =======
</TABLE>
The Internal Revenue Service ("IRS") has not examined the Company's tax
returns for the years in which the Company reported net operating losses. Under
Section 382 of the Internal Revenue Code of 1986, as amended (the "Code"),
certain restrictions on the utilization of NOLs will apply if there is an
ownership change of a corporation entitled to use such carryovers. The Company
believes that there is currently no restriction on the ability of the Company to
utilize its NOLs. If the pending business combination as described in Note 16 is
consummated, an ownership change of the Company under Section 382 of the Code
will occur. This will result in significant restrictions of the Company's
ability to utilize NOLs during all taxable periods after the date of the
business combination.
Capsure and its subsidiaries file a consolidated federal income tax return.
As of December 31, 1996, based upon the Company's consolidated federal income
tax returns, approximately $143 million of consolidated NOLs were available to
offset future taxable income of the Company and its subsidiaries. Such
carryforwards expire by tax year as follows: $42.4 million in 1997, $50.7
million in 1998, $39.2 million in 1999, $7.0 million in 2000, $2.4 million in
2001, $0.9 million in 2002 and $0.4 million in 2003. Although realization is not
assured, management believes that it is more likely than not that Capsure will
generate sufficient taxable income to utilize at least $19.3 million of tax
benefits from its available NOLs at December 31, 1996. Such estimate is based
upon the earnings history of each of its insurance subsidiaries and projections
of future taxable income. The amount of the deferred tax asset considered
realizable, however, could be reduced in the near term if estimates of future
taxable income during the carryforward period are reduced, or if an ownership
change under Section 382 of the Code were to occur.
F-60
<PAGE> 138
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The income tax provisions consisted of the following (dollars in
thousands):
<TABLE>
<CAPTION>
1996 1995 1994
------ ------- ------
<S> <C> <C> <C>
Federal deferred................................ $7,291 $18,086 $8,820
Federal current................................. 560 1,500 305
State........................................... 330 135 276
------ ------- ------
Total income tax expense........................ $8,181 $19,721 $9,401
====== ======= ======
</TABLE>
Reconciliations from the federal statutory tax rate to the effective tax
rate are as follows:
<TABLE>
<CAPTION>
1996 1995 1994
---- ---- ----
<S> <C> <C> <C>
Federal statutory rate................................. 35.0% 35.0% 35.0%
Excess of cost over net assets acquired and other
purchase accounting adjustments...................... 2.8 13.7 3.0
State income and environmental tax, net of federal
income tax benefit................................... 1.0 .1 .8
Tax exempt interest.................................... (0.1) (.3) (.3)
Other.................................................. (0.8) .5 1.0
---- ---- ----
Effective tax rate........................... 37.9% 49.0% 39.5%
==== ==== ====
</TABLE>
Intercompany tax sharing agreements between Capsure and its subsidiaries
provide that tax sharing payments shall be determined based upon each
subsidiaries' separate return liability, as calculated in accordance with the
Code. Intercompany tax payments are remitted at such times as estimated tax
payments would be required to be made to the IRS. Capsure received tax sharing
payments from its subsidiaries of $17.3 million, $12.8 million and $12.3 million
in 1996, 1995 and 1994, respectively, of which $10.8 million, $8.3 million and
$7.3 million were from its surety and fidelity subsidiaries.
11. COMMITMENTS AND CONTINGENCIES
At December 31, 1996, the future minimum commitment under operating leases
was as follows: 1997 -- $2.5 million; 1998 -- $2.3 million; 1999 -- $1.7
million; 2000 -- $1.3 million; 2001 -- $1.1 million and 2002 and after -- $0.3
million. Total rental expense for 1996, 1995 and 1994 was $2.8 million, $2.3
million and $2.3 million, respectively.
The Company was engaged in oil and gas production, exploration and
development until mid-1993. In connection with the sale of substantially all of
the Company's oil and gas properties, the buyers assumed all material
environmental liabilities.
The Company and its subsidiaries are parties to numerous lawsuits arising
in the normal course of business, some seeking material damages. The Company
believes the resolution of these lawsuits will not have a material adverse
effect on its financial condition, results of operations and liquidity.
12. EMPLOYEE BENEFITS
The Company sponsors a tax-deferred savings plan (401(k)) covering
substantially all of its employees. The Company matches 50% of the participating
employee's contribution up to 6% of eligible compensation (3% maximum matching).
Western Surety employees may also receive a discretionary profit sharing payment
up to 3% of eligible compensation. Company contributions, including profit
sharing payments, for the years ended December 31, 1996, 1995 and 1994, were
$0.8 million, $0.7 million and $0.7 million, respectively.
The Company sponsors a noncontributory defined contribution retirement plan
covering all eligible employees other than Western Surety personnel. The Company
contributes 4.35% of eligible compensation
F-61
<PAGE> 139
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(8.7% on amounts exceeding the social security wage base). Company contributions
for the years ended December 31, 1996, 1995 and 1994, were $0.2 million, $0.3
million and $0.1 million, respectively.
Western Surety sponsors two postretirement benefit plans covering
substantially all of its employees. One plan provides medical benefits, and the
other plan provides sick leave termination payments. The postretirement health
care plan is contributory; the sick leave plan is noncontributory. The
actuarially determined net periodic postretirement benefit costs for these plans
were $0.4 million, $0.3 million and $0.5 million for the years ended December
31, 1996, 1995 and 1994, respectively. The unfunded accumulated postretirement
benefit obligation (for retirees and fully vested active plan participants) was
$4.4 million and $4.1 million as of December 31, 1996 and 1995, respectively.
13. STOCKHOLDERS' EQUITY
On September 11, 1996, the Company declared a special cash distribution in
the amount of $10 per share of common stock, payable to all holders of record as
of September 25, 1996. Approximately $86.4 million ($5.53 per share) of the
$156.2 million total distribution was paid out of available retained earnings,
with the excess of $69.8 million ($4.47 per share) charged to additional paid-in
capital. The special distribution was paid on October 4, 1996 and was funded
from $62 million of borrowings under Capsure's revolving credit agreement and
approximately $94 million from available cash and marketable securities
accumulated at the parent company level.
On May 24, 1995, the Board of Directors of the Company approved a stock
repurchase plan. The plan authorizes the Company to repurchase up to 500,000
shares of its common stock. These shares may be purchased from time to time in
the public market or through privately negotiated transactions. As of December
31, 1996, no shares have been repurchased under this plan.
The Company has reserved shares of its Common Stock for issuance to
directors, officers, employees and consultants of the Company through incentive
stock options, non-qualified stock options and stock appreciation rights
("SARs") to be granted under the Company's Amended and Restated 1990 Stock
Option Plan (the "Plan"). The most recent Plan amendments approved by
stockholders at the Annual Meeting held on May 23, 1996, among other matters,
increased the aggregate number of shares available for which options and SARs
may be granted under the Plan to 2,250,000 shares.
The Plan is administered by the Compensation Committee (the "Committee"),
consisting of independent members of the Board of Directors. The option prices
are determined by the Committee, but may not be less than the fair market value
of the Common Stock of the Company at the date of grant for incentive stock
options, and may not be less than the par value of the Common Stock of the
Company for non-qualified stock options.
The Plan provides for the granting of incentive stock options as defined
under the Code. All non-qualified stock options and incentive stock options
expire ten years after the date of grant. Since January 1, 1993, all stock
options were granted at an option price equal to fair market value at the date
of grant. In connection with the payment of the special distribution, the Board
of Directors also authorized a corresponding repricing of all outstanding stock
options. This resulted in a new measurement date for the stock options under
applicable accounting pronouncements and required the Company to record in the
third quarter of 1996 a non-recurring compensation charge of $4.1 million, after
applicable income taxes, or 25 cents per share of which $3.6 million, or 22
cents per share, was non-cash. All repriced stock options will be treated as
non-qualified stock options for tax purposes.
F-62
<PAGE> 140
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Stock option activity for the three years ended December 31, 1996 was as
follows:
<TABLE>
<CAPTION>
WEIGHTED
SHARES SUBJECT AVERAGE OPTION
TO OPTION PRICE PER SHARE
-------------- ---------------
<S> <C> <C>
Balance at January 1, 1994...................... 905,775 $ 8.97
Options granted............................... 295,250 $13.38
Options canceled.............................. (1,876) $12.25
Options exercised............................. (1,037) $ 7.74
---------
Balance at December 31, 1994.................... 1,198,112 $10.05
Options granted............................... 190,000 $13.55
Options canceled.............................. (9,063) $13.22
Options exercised............................. (14,600) $ 7.34
---------
Balance at December 31, 1995.................... 1,364,449 $10.55
Options granted............................... 45,000 $18.00
Options canceled.............................. (30,050) $ 9.00
Options exercised............................. (216,000) $10.28
---------
Balance at October 4, 1996 (date of
repricing).................................... 1,163,399 $ 2.04
Options canceled after repricing.............. (1,339) $ 3.26
Options exercised after repricing............. (180,000) $ .46
---------
Balance at December 31, 1996.................... 982,060 $ 2.32
=========
</TABLE>
As of December 31, 1996, 754,662 shares were exercisable under the Plan.
The number of shares available for granting of options under the Plan were
802,528 and 96,189 at December 31, 1996 and 1995, respectively.
The weighted average fair value of options granted in 1996 was $3.22. The
fair value of each option granted during 1996 was estimated on the date of grant
using the Black-Scholes option-pricing model with the following assumptions: (1)
dividend yield of 0%, (2) expected volatility of 25.7%, (3) risk-free interest
rate of 6.47%, and (4) expected life of 6 years.
The following table summarizes information about stock options outstanding
at December 31, 1996:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
-------------------------------------- ------------------------
RANGE OF WGTD. AVG. WGTD. AVG. WGTD. AVG.
EXERCISE NUMBER REMAINING EXERCISE NUMBER EXERCISE
PRICES OUTSTANDING CONTR. LIFE PRICE EXERCISABLE PRICE
-------- ----------- ----------- ---------- ----------- ----------
<S> <C> <C> <C> <C> <C>
$0.05 to $8.00...................... 982,060 6.3 years $2.32 754,662 $2.10
======= ========== ===== ======= =====
</TABLE>
In October 1995, the Financial Accounting Standards Board issued SFAS No.
123, "Accounting for Stock-Based Compensation." SFAS No. 123 is effective for
fiscal years beginning after December 15, 1995. SFAS No. 123 introduces a
preferable fair value-based method of accounting for stock-based compensation.
SFAS No. 123 encourages, but does not require, companies to recognize
compensation expense for grants of stock, stock options, and other equity
instruments to employees based on the new fair value-based method of accounting.
As permitted under SFAS No. 123, the Company has continued to apply the existing
accounting rules contained in Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees,"
F-63
<PAGE> 141
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
and related interpretations. Required pro forma disclosures, as if the Company
had adopted the fair value-based recognition requirements under SFAS No. 123 in
1995, are presented below:
<TABLE>
<CAPTION>
1996 1995
----------------------- -----------------------
AS REPORTED PRO FORMA AS REPORTED PRO FORMA
----------- --------- ----------- ---------
<S> <C> <C> <C> <C>
Net income (in thousands)......................... $13,379 $13,256 $20,530 $20,438
======= ======= ======= =======
Net income per common share....................... $ .82 $ .81 $ 1.33 $ 1.32
======= ======= ======= =======
</TABLE>
The effects of applying SFAS No. 123 in this pro forma disclosure are not
indicative of future amounts. SFAS No. 123 does not apply to awards prior to
1995.
14. RELATED PARTY TRANSACTIONS
Equity Group Investments, Inc. ("EGI"), a company affiliated with certain
directors, officers and stockholders of the Company; other affiliated entities;
and individuals affiliated with certain directors and officers of the Company
perform or provide services to the Company and its subsidiaries. These services
relate to acquisition consulting, financial planning, legal and tax advice, and
investor relations, as well as leasing office space and providing certain
computer equipment, operations and maintenance services to the Company. Related
party agreements are generally for a term of one year and are approved by the
independent members of the Board of Directors. The Company's corporate office
space is leased pursuant to a facilities sharing agreement with EGI.
The Company paid rent, administrative services, and office facility
services to EGI or its affiliates of $0.1 million in 1996, 1995 and 1994. The
Company paid $0.2 million in 1996, 1995 and 1994 for financial planning, tax,
accounting, investor relations and computer support and maintenance to EGI or
its affiliates. The Company paid approximately $0.1 million in 1996 and 1995 and
$0.2 million in 1994 in fees for legal services to a law firm affiliated with
EGI. The Company received reimbursement from affiliates of EGI for financial
management services provided by employees of the Company amounting to
approximately $0.1 million in 1995 and 1994, and a negligible amount in 1996.
F-64
<PAGE> 142
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
15. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of the unaudited results of operations for the
past two years. The Company sold United Capitol on May 22, 1996 and the
consolidated results of operations shown below include the operating results of
United Capitol through the date of disposition, which affects the comparability
of the financial information (dollars in thousands, except per share data):
<TABLE>
<CAPTION>
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
------- ------- ------- -------
<S> <C> <C> <C> <C>
1996
Revenues.......................................... $28,906 $28,828 $26,878 $26,038
======= ======= ======= =======
Income before income taxes........................ $ 8,917 $ 8,062 $ 899 $ 3,682
Income taxes...................................... 3,397 3,057 342 1,385
------- ------- ------- -------
Net income........................................ $ 5,520 $ 5,005 $ 557 $ 2,297
======= ======= ======= =======
Earnings per common and common equivalent share... $ .35 $ .31 $ .02 $ .14
======= ======= ======= =======
1995
Revenues.......................................... $29,535 $29,485 $29,431 $29,059
======= ======= ======= =======
Income before income taxes........................ $ 6,968 $ 7,287 $ 7,235 $18,761
Income taxes...................................... 2,731 2,851 2,816 11,323
------- ------- ------- -------
Net income........................................ $ 4,237 $ 4,436 $ 4,419 $ 7,438
======= ======= ======= =======
Earnings per common and common equivalent share... $ .28 $ .28 $ .29 $ .48
======= ======= ======= =======
</TABLE>
As described in Note 6, the Company's incurred losses and loss adjustment
expenses were reduced by $29.1 million, net of reinsurance, in the fourth
quarter of 1995 as a result of favorable claim settlements and certain changes
in estimates relating to insured events of prior years. As described in Note 2,
the goodwill associated with the 1990 acquisition of United Capitol was reduced
to estimated net realizable value as of December 31, 1995, resulting in a $13.2
million impairment of goodwill in the fourth quarter of 1995.
16. PENDING BUSINESS COMBINATION
On December 19, 1996, Capsure and certain direct and indirect subsidiaries
of CNA Financial Corporation ("CNAF") entered into a definitive Reorganization
Agreement pursuant to which Capsure will merge with a wholly-owned subsidiary of
CNA Surety Corporation ("CNA Surety"). CNAF, through its subsidiaries, will be
the majority stockholder of CNA Surety, owning 61.75 percent of the shares on a
fully diluted basis. The remaining shares will be issued to the existing Capsure
stockholders (a portion of these shares will be reserved for issuance to the
existing holders of Capsure options who will receive CNA Surety options in the
merger) in a tax-free exchange for their Capsure shares on a one-for-one basis.
The CNA Surety shares are expected to be traded on the New York Stock Exchange.
Equity Capsure Limited Partnership ("Equity Capsure"), Capsure's largest
stockholder with a 25.6 percent ownership interest, and certain other directors
of the Company have agreed to vote their shares in favor of the merger. The
agreement and the transactions contemplated thereby are subject to several
conditions, including ratification by the affirmative vote of Capsure
stockholders and approval by governmental and insurance regulatory authorities.
The completion of the merger pursuant to the Reorganization Agreement will
cause an ownership change under Section 382 of the Code and significantly limit
the future utilization of Capsure's NOLs. If the Reorganization Agreement and
transactions contemplated thereby are approved, Capsure shareholders will be
asked to approve an amendment to its Certificate of Incorporation to delete a
provision designed to facilitate the Company's ability to preserve and utilize
its NOLs.
F-65
<PAGE> 143
SCHEDULE I
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
SUMMARY OF INVESTMENTS
OTHER THAN INVESTMENTS IN RELATED PARTIES
AS OF DECEMBER 31, 1996
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
FAIR CARRYING
COST VALUE VALUE
-------- -------- --------
<S> <C> <C> <C>
FIXED MATURITIES:
Bonds:
U.S. Government and government agencies and
authorities........................................... $ 76,816 $ 77,353 $ 77,353
States, municipalities and political subdivisions........ 2,696 2,668 2,668
All other corporate bonds................................ 55,908 55,874 55,874
-------- -------- --------
Total fixed maturities........................... 135,420 135,895 135,895
-------- -------- --------
EQUITY SECURITIES:
Real estate investment trusts.............................. 3,687 4,526 4,526
-------- -------- --------
Total equity securities.......................... 3,687 4,526 4,526
-------- -------- --------
Short-term investments..................................... 19,416 19,416
Other investments.......................................... 2,343 2,695
-------- --------
Total investments................................ $160,866 $162,532
======== ========
</TABLE>
F-66
<PAGE> 144
SCHEDULE II
CAPSURE HOLDINGS CORP.
CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY)
BALANCE SHEETS
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1996 1995
-------- --------
<S> <C> <C>
ASSETS
Investment in and advances to Capsure Financial Group,
Inc....................................................... $ 93,695 $221,552
Deferred income taxes, net of valuation allowance........... 31,647 37,275
-------- --------
$125,342 $258,827
======== ========
LIABILITIES
Other liabilities........................................... $ 2,759 $ 1,523
-------- --------
STOCKHOLDERS' EQUITY
Common stock................................................ 790 770
Additional paid-in capital.................................. 118,413 179,276
Retained earnings from August 1, 1986 (date of
reorganization)........................................... 2,297 75,286
Unrealized gain on securities, net of deferred income
taxes..................................................... 1,083 1,972
-------- --------
Total stockholders' equity.................................. 122,583 257,304
-------- --------
$125,342 $258,827
======== ========
</TABLE>
See Notes to Condensed Financial Information and Notes to Consolidated Financial
Statements
F-67
<PAGE> 145
SCHEDULE II
CAPSURE HOLDINGS CORP.
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
(PARENT COMPANY) -- (CONTINUED)
STATEMENTS OF INCOME
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-----------------------------
1996 1995 1994
------- ------- -------
<S> <C> <C> <C>
Revenues:
Net investment income..................................... $ -- $ -- $ 17
Net investment gains...................................... -- -- 444
Other income.............................................. -- -- --
------- ------- -------
-- -- 461
Expenses:
Non-recurring compensation and merger costs............... 7,865 -- --
Corporate expense......................................... -- -- 355
------- ------- -------
7,865 -- 355
------- ------- -------
Income (loss) from operations before income taxes and equity
in net income of subsidiaries............................. (7,865) -- 106
Income taxes................................................ (2,632) -- 37
------- ------- -------
Income (loss) before equity in net income of subsidiaries... (5,233) -- 69
Equity in net income of subsidiaries, less cash dividends... 18,612 20,530 14,309
------- ------- -------
Net income.................................................. $13,379 $20,530 $14,378
======= ======= =======
</TABLE>
See Notes to Condensed Financial Information and Notes to Consolidated Financial
Statements
F-68
<PAGE> 146
SCHEDULE II
CAPSURE HOLDINGS CORP.
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
(PARENT COMPANY) -- (CONTINUED)
STATEMENTS OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
---------------------------------
1996 1995 1994
--------- -------- --------
<S> <C> <C> <C>
OPERATING ACTIVITIES:
Net income.............................................. $ 13,379 $ 20,530 $ 14,378
Adjustments to reconcile net income to net cash
provided by operating activities:
Equity in net income of subsidiaries, less cash
dividends....................................... (18,612) (20,530) (14,309)
Net investment gains............................... -- -- (444)
Non-recurring compensation and merger costs........ 7,865 -- --
Changes in:
Deferred income taxes, net......................... 5,628 18,341 1,217
Other assets and liabilities....................... (279) -- 2,406
--------- -------- --------
Net cash provided by operating activities................. 7,981 18,341 3,248
--------- -------- --------
INVESTING ACTIVITIES:
Available-for-sale equity securities purchased.......... -- -- (209)
Change in short-term investments........................ -- -- 5,451
Change in investments in and advances to subsidiaries... 147,081 (18,448) (8,981)
--------- -------- --------
Net cash provided by (used in) investing activities....... 147,081 (18,448) (3,739)
--------- -------- --------
FINANCING ACTIVITIES:
Dividends paid.......................................... (156,248) -- --
Exercise of warrants and options, net of repricing
payments............................................. 1,186 107 10
--------- -------- --------
Net cash (used in) provided by financing activities....... (155,062) 107 10
--------- -------- --------
Increase (decrease) in cash............................... -- -- (481)
Cash at beginning of year................................. -- -- 481
--------- -------- --------
Cash at end of year....................................... $ -- $ -- $ --
========= ======== ========
</TABLE>
See Notes to Condensed Financial Information and Notes to Consolidated Financial
Statements
F-69
<PAGE> 147
SCHEDULE II
CAPSURE HOLDINGS CORP.
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
(PARENT COMPANY) -- (CONTINUED)
NOTES TO CONDENSED FINANCIAL INFORMATION
1. BASIS OF PRESENTATION
The condensed financial information of the parent company includes the
accounts of Capsure Holdings Corp. ("Capsure"). On March 29, 1994, Capsure
formed Capsure Financial Group, Inc., a direct wholly owned subsidiary, to which
Capsure contributed substantially all its assets and liabilities, including its
investments in SI Acquisition Corp. (parent company of Western Surety), NI
Acquisition Corp. (former parent company of United Capitol) and Pin Oak
Petroleum, Inc.
F-70
<PAGE> 148
SCHEDULE III
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
SUPPLEMENTARY INSURANCE INFORMATION
AS OF AND FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
PROPERTY AND CASUALTY INSURANCE
--------------------------------
1996 1995 1994
-------- -------- --------
<S> <C> <C> <C>
Deferred policy acquisition costs.......................... $ 28,523 $ 27,057 $ 25,150
======== ======== ========
Future policy benefits, losses, claims and loss expenses... $ 38,874 $126,061 $149,041
======== ======== ========
Unearned premiums.......................................... $ 69,570 $ 76,781 $ 76,630
======== ======== ========
Other policy claims and benefits payable................... $ -- $ -- $ --
======== ======== ========
Net premium revenue........................................ $ 92,491 $ 98,692 $ 92,481
======== ======== ========
Net investment income...................................... $ 14,195 $ 19,773 $ 18,597
======== ======== ========
Benefits, claims, losses and settlement expenses........... $ 10,054 $ (7,451) $ 23,344
======== ======== ========
Amortization of deferred policy acquisition costs.......... $ 37,505 $ 35,759 $ 29,390
======== ======== ========
Other operating expenses................................... $ 25,699 $ 25,553 $ 24,514
======== ======== ========
Net premiums written....................................... $ 95,109 $ 97,728 $ 90,578
======== ======== ========
</TABLE>
F-71
<PAGE> 149
SCHEDULE IV
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
REINSURANCE
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
PERCENTAGE
CEDED TO ASSUMED OF AMOUNT
GROSS OTHER FROM OTHER NET ASSUMED
AMOUNT COMPANIES COMPANIES AMOUNT TO NET
-------- --------- ---------- ------- ----------
<S> <C> <C> <C> <C> <C>
1996
Premiums:
Property and casualty insurance.... $105,467 $13,021 $ 45 $92,491 --
-------- ------- ---- ------- ---
Total premiums.................. $105,467 $13,021 $ 45 $92,491 --
======== ======= ==== ======= ===
1995
Premiums:
Property and casualty insurance.... $113,538 $15,093 $247 $98,692 0.3%
-------- ------- ---- ------- ---
Total premiums.................. $113,538 $15,093 $247 $98,692 0.3%
======== ======= ==== ======= ===
1994
Premiums:
Property and casualty insurance.... $103,871 $11,533 $143 $92,481 0.2%
-------- ------- ---- ------- ---
Total premiums.................. $103,871 $11,533 $143 $92,481 0.2%
======== ======= ==== ======= ===
</TABLE>
F-72
<PAGE> 150
SCHEDULE V
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
ADDITIONS
------------------------
BALANCE AT CHARGED TO CHARGED TO BALANCE AT
BEGINNING OF COSTS AND OTHER END OF
PERIOD EXPENSES ACCOUNTS DEDUCTIONS(1) PERIOD
------------ ---------- ---------- ------------- ----------
<S> <C> <C> <C> <C> <C>
Year ended December 31, 1996
Allowance for possible losses on
premiums receivable........... $ 768 $423 $ -- $329 $862
====== ==== ==== ==== ====
Allowance for possible losses on
reinsurance receivable........ $ 70 $ -- $ -- $ 70 $ --
====== ==== ==== ==== ====
Year ended December 31, 1995
Allowance for possible losses on
premiums receivable........... $ 898 $245 $ -- $375 $768
====== ==== ==== ==== ====
Allowance for possible losses on
reinsurance receivable........ $ 5 $ 65 $ -- $ -- $ 70
====== ==== ==== ==== ====
Year ended December 31, 1994
Allowance for possible losses on
premiums receivable........... $1,276 $190 $ -- $568 $898
====== ==== ==== ==== ====
Allowance for possible losses on
reinsurance receivable........ $ 2 $ 3 $ -- $ -- $ 5
====== ==== ==== ==== ====
</TABLE>
- ---------------
(1) Accounts charged against allowance.
F-73
<PAGE> 151
SCHEDULE VI
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
SUPPLEMENTAL INFORMATION CONCERNING PROPERTY-CASUALTY
INSURANCE OPERATIONS
AS OF AND FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
1996 1995 1994
-------- -------- --------
<S> <C> <C> <C>
Deferred policy acquisition costs.......................... $ 28,523 $ 27,057 $ 25,150
======== ======== ========
Reserves for unpaid claims and claim adjustment expenses... $ 38,874 $126,061 $149,041
======== ======== ========
Discount (if any) deducted................................. $ -- $ -- $ --
======== ======== ========
Unearned premiums.......................................... $ 69,570 $ 76,781 $ 76,630
======== ======== ========
Net earned premiums........................................ $ 92,491 $ 98,692 $ 92,481
======== ======== ========
Net investment income...................................... $ 14,195 $ 19,773 $ 18,597
======== ======== ========
Net claims and claim adjustment expenses incurred related
to:
Current year............................................. $ 16,909 $ 21,631 $ 31,688
======== ======== ========
Prior years.............................................. $ (6,855) $(29,082) $ (8,344)
======== ======== ========
Amortization of deferred policy acquisition costs.......... $ 37,505 $ 35,759 $ 29,390
======== ======== ========
Net paid claims and claim adjustment expenses.............. $ 11,039 $ 16,636 $ 16,719
======== ======== ========
Net premiums written....................................... $ 95,109 $ 97,728 $ 90,578
======== ======== ========
</TABLE>
F-74
<PAGE> 152
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT SHARE DATA)
(UNAUDITED)
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
1997 1996
-------- ------------
<S> <C> <C>
ASSETS
Invested assets and cash:
Fixed maturities, at fair value (amortized cost: $133,794;
$135,420).............................................. $133,968 $135,895
Equity securities, at fair value (cost: $3,687)........... -- 4,526
Short-term investments, at cost which approximates fair
value.................................................. 28,219 19,416
Other investments, at fair value.......................... 2,442 2,695
Cash...................................................... 2,951 2,736
-------- --------
167,580 165,268
Deferred policy acquisition costs........................... 31,201 28,523
Reinsurance receivable...................................... 8,073 5,642
Intangible assets, net of amortization...................... 13,469 14,024
Excess cost over net assets acquired, net of amortization... 61,080 61,932
Deferred income taxes, net of valuation allowance........... 11,832 16,019
Other assets................................................ 24,408 21,731
-------- --------
Total assets...................................... $317,643 $313,139
======== ========
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses................ $ 39,301 $ 38,874
Unearned premiums......................................... 74,931 69,570
-------- --------
114,232 108,444
Long-term debt.............................................. 54,000 60,000
Other liabilities........................................... 19,904 22,112
-------- --------
Total liabilities................................. 188,136 190,556
======== ========
Commitments and contingencies
STOCKHOLDERS' EQUITY
Preferred stock, par value $.01 per share, 5,000,000 shares
authorized; none issued and outstanding................... -- --
Common stock, par value $.05 per share, 25,000,000 shares
authorized; 15,850,245 shares issued at June 30, 1997;
15,804,749 shares issued at December 31, 1996............. 793 790
Additional paid-in capital.................................. 118,580 118,413
Retained earnings........................................... 9,847 2,297
Unrealized gain on securities, net of deferred income
taxes..................................................... 287 1,083
-------- --------
Total stockholders' equity........................ 129,507 122,583
-------- --------
$317,643 $313,139
======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-75
<PAGE> 153
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------ ------------------
1997 1996 1997 1996
------- ------- ------- -------
<S> <C> <C> <C> <C>
Revenues:
Net earned premiums............................... $22,962 $23,184 $45,258 $46,533
Net investment income............................. 2,798 4,512 5,924 9,546
Net investment gains.............................. 549 1,132 636 1,655
------- ------- ------- -------
26,309 28,828 51,818 57,734
------- ------- ------- -------
Expenses:
Net losses and loss adjustment expenses........... 1,931 2,801 3,159 6,197
Net commissions, brokerage and other
underwriting................................... 15,909 15,699 31,286 30,455
Interest expense.................................. 995 127 1,998 633
Write-off of unamortized deferred loan fees....... -- 700 -- 700
Amortization of goodwill and intangibles.......... 698 705 1,396 1,418
Other expenses, net............................... 632 734 1,300 1,352
------- ------- ------- -------
20,165 20,766 39,139 40,755
------- ------- ------- -------
Income before income taxes.......................... 6,144 8,062 12,679 16,979
Income taxes........................................ 2,407 3,057 5,129 6,454
------- ------- ------- -------
Net income.......................................... $ 3,737 $ 5,005 $ 7,550 $10,525
======= ======= ======= =======
Weighted average shares outstanding:
Primary........................................... 16,600 15,955 16,594 15,931
======= ======= ======= =======
Fully diluted..................................... 16,613 15,968 16,613 15,968
======= ======= ======= =======
Earnings per share:
Primary........................................... $ .22 $ .31 $ .45 $ .66
======= ======= ======= =======
Fully diluted..................................... $ .22 $ .31 $ .45 $ .66
======= ======= ======= =======
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-76
<PAGE> 154
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
SIX MONTHS ENDED
JUNE 30,
--------------------
1997 1996
-------- --------
<S> <C> <C>
OPERATING ACTIVITIES:
Net income................................................ $ 7,550 $ 10,525
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation and amortization.......................... 2,207 2,341
Accretion of bond discount, net........................ (75) (317)
Net investment gains................................... (636) (1,655)
Changes in:
Reserve for unpaid losses and loss adjustment
expenses.............................................. 427 707
Reserve for unearned premiums.......................... 5,361 7,091
Deferred income taxes, net............................. 4,519 5,896
Other assets and liabilities........................... (9,126) (8,198)
-------- --------
Net cash provided by operating activities................... 10,227 16,390
-------- --------
INVESTING ACTIVITIES:
Securities available-for-sale:
Purchases -- fixed maturities.......................... (13,317) (51,725)
Sales -- fixed maturities.............................. -- 59,463
Maturities -- fixed maturities......................... 15,029 27,507
Purchases -- equity securities......................... -- (190)
Sales -- equity securities............................. 4,314 19,813
Change in short-term investments.......................... (8,803) (74,702)
Net proceeds from the sale of UCHC........................ -- 28,024
Change in other investments............................... 253 475
Capital expenditures, net................................. (1,606) (1,280)
-------- --------
Net cash (used in) provided by investing activities......... (4,130) 7,385
-------- --------
FINANCING ACTIVITIES:
Principal payments on long-term debt...................... (6,000) (25,000)
Exercise of stock options................................. 118 5
-------- --------
Net cash used in financing activities....................... (5,882) (24,995)
-------- --------
Increase (decrease) in cash................................. 215 (1,220)
Cash at beginning of period................................. 2,736 3,001
-------- --------
Cash at end of period....................................... $ 2,951 $ 1,781
======== ========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest............................................... $ 2,017 $ 646
Income taxes, net of refunds........................... $ 378 $ 765
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-77
<PAGE> 155
CAPSURE HOLDINGS CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1997
(UNAUDITED)
1. SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
These unaudited Consolidated Financial Statements should be read in
conjunction with the Consolidated Financial Statements and Notes thereto
included in Capsure Holdings Corp.'s ("Capsure" or the "Company") 1996 Annual
Report on Form 10-K. The following Notes to the Consolidated Financial
Statements highlight significant changes to the Notes included in the 1996
Annual Report on Form 10-K and such interim disclosures as required by the
Securities and Exchange Commission. Certain financial information that is
normally included in annual financial statements prepared in accordance with
generally accepted accounting principles but is not required for interim
reporting purposes has been condensed or omitted. The accompanying unaudited
Consolidated Financial Statements reflect, in the opinion of management, all
adjustments necessary for a fair presentation of the interim financial
statements. All such adjustments are of a normal and recurring nature. The
financial results for interim periods may not be indicative of financial results
for a full year. Certain reclassifications have been made to the 1996
Consolidated Financial Statements to conform with the presentation in the 1997
Consolidated Financial Statements.
2. INVESTMENTS
The cost and estimated fair value of investments at June 30, 1997 were as
follows (dollars in thousands):
<TABLE>
<CAPTION>
AMORTIZED GROSS GROSS ESTIMATED
COST UNREALIZED UNREALIZED FAIR
OR COST GAINS LOSSES VALUE
--------- ---------- ---------- ---------
<S> <C> <C> <C> <C>
Available-For-Sale Securities
Fixed maturities:
U.S. Treasury securities and obligations of U.S.
Government corporations and agencies:
U.S. Treasury notes........................... $ 7,014 $ 45 $ (17) $ 7,042
Collateralized mortgage obligations........... 34,546 206 (241) 34,511
Mortgage pass-through securities.............. 37,379 383 (66) 37,696
Obligations of states and political
subdivisions.................................. 2,276 4 (17) 2,263
Non-agency collateralized mortgage
obligations................................... 19,733 75 (55) 19,753
Asset-backed securities:
Second mortgages/home equity loans............ 26,136 121 (123) 26,134
Other underlying assets....................... 6,710 23 (164) 6,569
-------- ---- ----- --------
Total available-for-sale securities... $133,794 $857 $(683) $133,968
======== ==== ===== ========
</TABLE>
F-78
<PAGE> 156
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
JUNE 30, 1997
(UNAUDITED)
3. REINSURANCE
The effect of reinsurance on premiums written and earned for the six months
ended June 30, 1997 and 1996 was as follows (dollars in thousands):
<TABLE>
<CAPTION>
1997 1996
------------------ ------------------
WRITTEN EARNED WRITTEN EARNED
------- ------- ------- -------
<S> <C> <C> <C> <C>
Direct.............................. $52,502 $49,203 $60,776 $55,422
Assumed............................. -- -- 82 31
Ceded............................... (2,136) (3,945) (9,863) (8,920)
------- ------- ------- -------
Net premiums........................ $50,366 $45,258 $50,995 $46,533
======= ======= ======= =======
</TABLE>
The effect of reinsurance on losses and loss adjustment expenses incurred
for the six months ended June 30, 1997 and 1996 was as follows (dollars in
thousands):
<TABLE>
<CAPTION>
1997 1996
------- -------
<S> <C> <C>
Gross losses and loss adjustment expenses................ $ 6,128 $ 9,184
Reinsurance recoveries................................... (2,969) (2,987)
------- -------
Net losses and loss adjustment expenses.................. $ 3,159 $ 6,197
======= =======
</TABLE>
F-79
<PAGE> 157
- ------------------------------------------------------
- ------------------------------------------------------
NO DEALER, SALESPERSON OR OTHER PERSON HAS BEEN AUTHORIZED TO GIVE ANY
INFORMATION OR TO MAKE ANY REPRESENTATIONS IN CONNECTION WITH THIS OFFERING
OTHER THAN THOSE CONTAINED IN THE PROSPECTUS, AND, IF GIVEN OR MADE, SUCH
INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED
BY THE COMPANY OR ANY OF THE UNDERWRITERS. THIS PROSPECTUS DOES NOT CONSTITUTE
AN OFFER TO SELL OR A SOLICITATION OF AN OFFER TO BUY ANY OF THE SECURITIES
OFFERED HEREBY BY ANYONE IN ANY JURISDICTION IN WHICH SUCH OFFER OR SOLICITATION
IS NOT AUTHORIZED OR IN WHICH THE PERSON MAKING SUCH OFFER OR SOLICITATION IS
NOT QUALIFIED TO DO SO OR TO ANY PERSON TO WHOM IT IS UNLAWFUL TO MAKE SUCH
OFFER OR SOLICITATION. NEITHER THE DELIVERY OF THIS PROSPECTUS NOR ANY SALE MADE
HEREUNDER SHALL, UNDER ANY CIRCUMSTANCES, CREATE ANY IMPLICATION THAT THE
INFORMATION HEREIN IS CORRECT AS OF ANY TIME SUBSEQUENT TO THE DATE HEREOF OR
THAT THERE HAS BEEN NO CHANGE IN THE AFFAIRS OF THE COMPANY SINCE SUCH DATE.
------------------------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
<S> <C>
Available Information.................. 2
Cautionary Statement Regarding Forward-
Looking Information.................. 2
Prospectus Summary..................... 3
Risk Factors........................... 12
The Company............................ 18
Use of Proceeds........................ 19
Dividend Policy........................ 19
Price Range of Common Stock............ 20
Selected Consolidated Financial Data... 21
Pro Forma Condensed Statement of
Consolidated Operations.............. 26
Management's Discussion and Analysis of
Financial Condition and Results of
Operations of CNA Surety and of the
Statement of Certain Assets and
Liabilities and the Statements of
Certain Revenues and Direct Operating
Expenses of the Predecessor
Operations........................... 30
Business of the Company................ 46
Management of the Company.............. 61
Executive Compensation................. 64
Certain Relationships and Related
Transactions......................... 67
Principal and Selling Stockholders..... 71
Description of Capital Stock........... 73
Underwriting........................... 74
Experts................................ 75
Legal Matters.......................... 75
Glossary of Selected Insurance Terms... 76
Index To Financial Statement
Schedules............................ F-1
</TABLE>
- ------------------------------------------------------
- ------------------------------------------------------
------------------------------------------------------
------------------------------------------------------
4,188,129 SHARES
CNA SURETY CORPORATION
COMMON STOCK
[CNA SURETY LOGO]
-------------------------
PROSPECTUS
-------------------------
DONALDSON, LUFKIN & JENRETTE
SECURITIES CORPORATION
SALOMON SMITH BARNEY
JULY 9, 1998
------------------------------------------------------
------------------------------------------------------
<PAGE> 158
PART II
INFORMATION NOT REQUIRED IN PROSPECTUS
ITEM 13. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION
Expenses in connection with the Offering, other than underwriting discounts
and commissions, to be paid by the Company are as follows:
<TABLE>
<S> <C>
Securities and Exchange Commission Registration Fee......... $ 23,633
NASD Filing Fees............................................ $ 8,500
NYSE Filing Fees............................................ $ 2,304
Registrar and Transfer Agent................................ $ 7,000*
Printing Fees............................................... $350,000*
Legal Fees.................................................. $200,000*
Blue Sky Fees............................................... $ 7,500
Accounting Fees............................................. $ 50,000*
Miscellaneous............................................... $ 51,063*
--------
Total..................................................... $700,000*
</TABLE>
- ---------------
* Estimated.
The Company will bear all of the foregoing expenses. In addition, the
Company intends to pay all expenses of registration, issuance of and
distribution, excluding underwriters' discounts and commissions, with respect to
the shares being sold by the Selling Stockholders.
ITEM 14. INDEMNIFICATION OF OFFICERS AND DIRECTORS.
Delaware law permits a corporation to adopt a provision in its certificate
of incorporation eliminating or limiting the personal liability of a director to
the corporation or its stockholders for monetary damages for breach of fiduciary
duty as a director, except that such provision shall not limit the liability of
a director for: (i) any breach of the director's duty of loyalty to the
corporation or its stockholders; (ii) acts or omissions not in good faith or
which involve intentional misconduct or a knowing violation of the law; (iii)
liability under section 174 of the Delaware General Corporation Law; or (iv) any
transaction from which the directors derived an improper personal benefit. The
CNA Surety certificate of incorporation limits the personal liability of CNA
Surety's directors for monetary damages to the fullest extent permissible under
applicable law.
Under Delaware law, a corporation may indemnify any person made a party or
threatened to be made a party to any type of proceeding (other than an action by
or in the right of the corporation) because he or she is or was an officer,
director, employee or agent of the corporation, or was serving at the request of
the corporation as an officer, director, employee or agent of the corporation,
against expenses, judgements, fines, and amounts paid in settlement actually and
reasonably incurred in connection with such proceeding if: (i) he or she acted
in good faith and in a manner such director reasonably believed to be in or not
opposed to the best interests of the corporation; or (ii) in the case of a
criminal proceeding, he or she had no reasonable cause to believe that his or
her conduct was unlawful. A corporation may indemnify any person made party or
threatened to be made a party to any threatened, pending or completed action or
suit brought by or in the right of the corporation because he or she was an
officer, director, employee or agent of the corporation, or was serving at the
request of the corporation as an officer, director, employee or agent of the
corporation, against expenses actually and reasonably incurred in connection
with such action or suit if he or she acted in good faith and in a manner such
director reasonably believed to be in or not opposed to the best interests of
the corporation, except that there may be no such indemnification if the person
is found liable to the corporation unless, in such case, the court determines
the person is entitled thereto. A corporation must indemnify a director,
officer, employee or agent against expenses actually and reasonably incurred by
him or her who successfully defends himself or herself in a proceeding to which
they were a party because he or she was a director, officer, employee or agent
of the corporation. Expenses incurred by any officer or director (or other
II-1
<PAGE> 159
employees or agents as deemed appropriate by the board of directors) in
defending a civil or criminal proceeding may be paid by the corporation in
advance of the final disposition of such proceeding upon receipt of an
undertaking by or on behalf of such director or officer to repay such amount if
it shall ultimately be determined that he or she is not entitled to be
indemnified by the corporation. The Delaware law indemnification and expense
advancement provisions are not exclusive of any other rights which may be
granted by the bylaws, a vote of stockholders or disinterested directors,
agreement or otherwise.
The CNA Surety bylaws provide for the indemnification, in a non-derivative
suit, of any person who is a party or is threatened to be made a party to any
suit or proceeding, because such person, or a person for whom such person was or
is a representative, was or is an officer, director, employee or agent of the
CNA Surety, or was serving at the request of CNA Surety as an officer, director,
employee or agent of the corporation, against expenses in connection with such
suit, action or proceeding if such person acted in good faith and in a manner
such director reasonably believed to be in or not opposed to the best interests
of CNA Surety, and with respect to any criminal action or proceeding, had no
reasonable cause to believe such conduct was unlawful. The CNA Surety bylaws
provide further for the indemnification in derivative suits if such person acted
in good faith and in a manner such person believed to be in or not opposed to
the best interests of CNA Surety; provided, however, that no indemnification
will be made for any claim, issue or matter as to which such person has been
adjudged liable to CNA Surety, unless the court in which such action was brought
determined, despite the adjudication of liability, that such person is fairly
and reasonably entitled to indemnity for such expenses that such court deems
proper. The bylaws of CNA Surety also permit the advancement of expenses
incurred by a director, officer, employee or agent of CNA Surety in defending a
suit or action, provided that such person executes an undertaking to repay the
advanced expenses if it is ultimately determined that such person is not
entitled to be indemnified by CNA Surety.
ITEM 15. RECENT SALES OF UNREGISTERED SECURITIES.
None.
ITEM 16. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
<TABLE>
<CAPTION>
EXHIBIT NUMBER DESCRIPTION
- -------------- -----------
<S> <C>
1(1)* Form of Underwriting Agreement.
2(1) Reorganization Agreement dated as of December 19, 1996 among
Capsure Holdings Corp., Continental Casualty Company, CNA
Surety Corporation, Surety Acquisition Company and certain
affiliates of Continental Casualty Company (filed on
December 27, 1996 as Exhibit 2 to Capsure Holdings Corp.'s
Form 8-K, and incorporated herein by reference).
2(2) First Amendment to the Reorganization Agreement dated as of
July 14, 1997 among Capsure Holdings Corp., Continental
Casualty Company, CNA Surety Corporation, Surety Acquisition
Company and certain affiliates of Continental Casualty
Company (filed on July 16, 1997 as Exhibit 2 to Capsure
Holdings Corp.'s Form 8-K, and incorporated herein by
reference).
3(1) Certificate of Incorporation of CNA Surety Corporation dated
December 10, 1996 (filed on August 15, 1997 as Exhibit
3(1)to CNA Surety Corporation's Registration Statement on
Form S-4 (Registration No. 333-33753), and incorporated
herein by reference).
3(2) Amendment to Certificate of Incorporation of CNA Surety
Corporation dated May 27, 1997 (filed on August 15, 1997 as
Exhibit 3(2) to CNA Surety Corporation's Registration
Statement on Form S-4 (Registration No. 333-33753), and
incorporated herein by reference).
3(3) Bylaws of CNA Surety Corporation (filed on August 15, 1997
as Exhibit 3(3)to CNA Surety Corporation's Registration
Statement on Form S-4 (Registration No. 333-33753), and
incorporated herein by reference).
3(4) Amendment to Bylaws of CNA Surety Corporation (filed on
March 20, 1998 as Exhibit 3(4) to CNA Surety Corporation's
Annual Report on Form 10-K, and incorporated herein by
reference).
</TABLE>
II-2
<PAGE> 160
<TABLE>
<CAPTION>
EXHIBIT NUMBER DESCRIPTION
- -------------- -----------
<S> <C>
4(1) Specimen certificate of CNA Surety Corporation (filed on
August 15, 1997 as Exhibit 4(1) to CNA Surety Corporation's
Registration Statement on Form S-4 (Registration No.
333-33753), and incorporated herein by reference).
4(2) Registration Rights Agreement, dated as of September 30,
1996 between CNA Surety Corporation and Equity Capsure
Limited Partnership (filed on August 15, 1997 as Exhibit
4(2) to CNA Surety Corporation's Registration Statement on
Form S-4 (Registration No. 333-33753), and incorporated
herein by reference).
5* Opinion of Seyfarth, Shaw, Fairweather & Geraldson.
10(1) Agreement dated as of June 30, 1997 by and among John Knox,
Jr., Capsure Holdings Corp. and CNA Surety Corporation
(filed on August 15, 1997 as Exhibit 10(6) to CNA Surety
Corporation's Registration Statement on Form S-4
(Registration No. 333-33753), and incorporated herein by
reference).
10(2) Stock Purchase Agreement among John T. Knox, Jr., Universal
Surety Holding Corp., Capsure Financial Group, Inc. and
Capsure Holdings Corp. dated July 26, 1994 (filed on October
6, 1994 as Exhibit 2 to Capsure Holdings Corp.'s Current
Report on Form 8-K, and incorporated herein by reference).
10(3) Non-Competition and Non-Solicitation Agreement between
Capsure Holdings Corp. and Frontier Insurance Company, dated
as of May 22, 1996 (filed on August 15, 1997 as Exhibit
10(9) to CNA Surety's Registration Statement on Form S-4
(Registration No. 333-33753), and incorporated herein by
reference).
10(4) Contract Surety Bond Reinsurance Agreement dated as of
September 22, 1994 between Western Surety Company, a South
Dakota corporation, and Universal Surety of America, a Texas
corporation (filed on March 30, 1995 as Exhibit 10(23) to
Capsure Holdings Corp.'s Annual Report on Form 10-K, and
incorporated herein by reference).
10(5) Co-Employee Agreement dated as of September 22, 1994 between
Western Surety Company and Universal Surety of America
(filed on March 30, 1995 as Exhibit 10(24) to Capsure
Holdings Corp.'s Annual Report on Form 10-K, and
incorporated herein by reference).
10(6) Form of CNA Surety Corporation Replacement Stock Option Plan
(filed on August 15, 1997 as Exhibit 10(12) to CNA Surety
Corporation's Registration Statement on Form S-4
(Registration No. 333-33753), and incorporated herein by
reference).
10(7) Form of CNA Surety Corporation 1997 Long-Term Equity
Compensation Plan (filed on August 15, 1997 as Exhibit
10(12) to CNA Surety Corporation's Registration Statement on
Form S-4 (Registration No. 333-33753), and incorporated
herein by reference).
10(8) Form of Aggregate Stop Loss Reinsurance Contract by and
between Western Surety Company, Universal Surety of America,
Surety Bonding Company of America and Continental Casualty
Company (filed on December 27, 1996 as Exhibit 2 to Capsure
Holdings Corp.'s Form 8-K, and incorporated herein by
reference).
10(9) Form of Surety Excess of Loss Reinsurance Contract by and
between Western Surety Company, Universal Surety of America,
Surety Bonding Company of America and Continental Casualty
Company (filed on December 27, 1996 as Exhibit 2 to Capsure
Holdings Corp.'s Form 8-K, and incorporated herein by
reference).
10(10) Form of Surety Quota Share Treaty by and between Western
Surety Company and Continental Casualty Company (filed on
December 27, 1996 as Exhibit 2 to Capsure Holdings Corp.'s
Form 8-K, and incorporated herein by reference).
10(11) Employment Agreement dated as of October 1, 1997 by and
between CNA Surety Corporation and Dan L. Kirby (filed on
March 20, 1998 as Exhibit 10(13) to CNA Surety's Annual
Report on Form 10-K, and incorporated herein by reference).
10(12) Employment Agreement dated as of October 3, 1997 by and
between CNA Surety Corporation and Mark C. Vonnahme (filed
on March 20, 1998 as Exhibit 10(14) to CNA Surety's Annual
Report on Form 10-K, and incorporated herein by reference).
10(13) Credit Agreement, dated as of September 30, 1997, among CNA
Surety Corporation, the lenders party thereto, and Chase
Manhattan Bank, as Administrative Agent.
10(14) Surety Second Excess of Loss Reinsurance Contract by and
between Western Surety Company, Universal Surety of America,
Surety Bonding Company of America and Continental Casualty
Company.
10(15) Form of CNA Surety Corporation Non-Employee Directors
Deferred Compensation Plan.
</TABLE>
II-3
<PAGE> 161
<TABLE>
<CAPTION>
EXHIBIT NUMBER DESCRIPTION
- -------------- -----------
<S> <C>
15 Awareness Letter from Deloitte & Touche, dated June 3, 1998.
21 Subsidiaries of the Registrant.
23(1)* Consent of Deloitte & Touche LLP dated July 8, 1998.
23(2)* Consent of Seyfarth, Shaw, Fairweather & Geraldson dated
July 9, 1998 included in opinion filed as Exhibit 5.
23(3)* Consent of PricewaterhouseCoopers LLP, dated July 8, 1998.
24 Powers of Attorney.
27 Financial Data Schedule.
99(1) Consent of William Pate, dated June 3, 1998.
</TABLE>
- ---------------
* Filed herewith.
All other schedules are omitted because they are not applicable, not
required under the instructions or the information required is set forth in the
financial statements or the notes to the financial statements.
ITEM 17. UNDERTAKINGS
(a) Insofar as indemnification for liabilities arising under the Act may be
permitted to directors, officers and controlling persons of the registrant
pursuant to the foregoing provisions, or otherwise, the registrant has been
advised that in the opinion of the Securities and Exchange Commission such
indemnification is against public policy as expressed in the Act and is,
therefore, unenforceable. In the event that a claim for indemnification against
such liabilities (other than the payment by the registrant of expenses incurred
or paid by a director, officer or controlling person of the registrant in the
successful defense of any action, suit or proceeding) is asserted by such
director, officer or controlling person in connection with the securities being
registered, the registrant will, unless in the opinion of its counsel the matter
has been settled by controlling precedent, submit to a court of appropriate
jurisdiction the question whether such indemnification by it is against public
policy as expressed in the Act and will be governed by the final adjudication of
such issue.
(b) The undersigned registrant hereby undertakes that:
(1) For purposes of determining any liability under the Securities Act
of 1933, the information omitted from the form of prospectus filed as part
of this registration statement in reliance upon Rule 430A and contained in
a form of prospectus filed by the registrant pursuant to Rule 424(b)(1) or
(4) or 497(h) under the Securities Act shall be deemed to be part of this
registration statement as of the time it was declared effective.
(2) For the purpose of determining any liability under the Securities
Act of 1933, each post-effective amendment that contains a form of
prospectus shall be deemed to be a new registration statement relating to
the securities offered therein, and the offering of such securities at that
time shall be deemed to be the initial bona fide offering thereof.
II-4
<PAGE> 162
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, the Company has
duly caused this Amendment No. 2 to the Registration Statement to be signed on
its behalf by the undersigned, thereunto duly authorized, in the City of
Chicago, State of Illinois, on this 8th day of July, 1998.
CNA SURETY CORPORATION
/s/ MARK C. VONNAHME
By:
--------------------------------------
Mark C. Vonnahme
President and Chief Executive
Officer
Pursuant to the requirements of the Securities Act of 1933, this
Registration Statement has been signed by the following persons in the
capacities and dates indicated.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<C> <C> <S>
* /s/ GIORGIO BALZER Director July 8, 1998
- ---------------------------------------------
*Giorgio Balzer
* /s/ PHILIP H. BRITT Director July 8, 1998
- ---------------------------------------------
*Philip H. Britt
Director
- ---------------------------------------------
David T. Cumming
* /s/ ROD F. DAMMEYER Director July 8, 1998
- ---------------------------------------------
*Rod F. Dammeyer
* /s/ MELVIN GRAY Director July 8, 1998
- ---------------------------------------------
*Melvin Gray
* /s/ JOE KIRBY Director July 8, 1998
- ---------------------------------------------
*Joe Kirby
* /s/ ROY E. POSNER Director July 8, 1998
- ---------------------------------------------
*Roy E. Posner
* /s/ ADRIAN M. TOCKLIN Director July 8, 1998
- ---------------------------------------------
*Adrian M. Tocklin
* /s/ ROBERT T. VAN GIESON Chairman of the Board of Directors July 8, 1998
- ---------------------------------------------
*Robert T. Van Gieson
/s/ MARK C. VONNAHME President, Chief Executive Officer and July 8, 1998
- --------------------------------------------- Director (Principal Executive Officer)
Mark C. Vonnahme
</TABLE>
II-5
<PAGE> 163
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<C> <C> <S>
/s/ JOHN S. HENEGHAN Vice President and Chief Financial July 8, 1998
- --------------------------------------------- Officer (Principal Financial Officer)
John S. Heneghan
/s/ THOMAS A. POTTLE Vice President, Chief Operations Officer July 8, 1998
- --------------------------------------------- and Assistant Secretary
Thomas A. Pottle (Principal Accounting Officer)
* /s/ SANDRA D. WAGMAN July 8, 1998
- ---------------------------------------------
Sandra D. Wagman
Attorney-In-Fact
</TABLE>
II-6
<PAGE> 1
4,188,129 Shares
CNA Surety Corporation
Common Stock
FORM OF UNDERWRITING AGREEMENT
July 8, 1998
DONALDSON, LUFKIN & JENRETTE
SECURITIES CORPORATION
SMITH BARNEY INC.
As representatives of the
several underwriters
named in Schedule I hereto
c/o Donaldson, Lufkin & Jenrette
Securities Corporation
277 Park Avenue
New York, New York 10172
Dear Sirs:
Certain stockholders named in Schedule II hereto (the "Selling
Shareholders") of CNA Surety Corporation (the "Company"), severally propose to
sell to the several underwriters named in Schedule I hereto (the "Underwriters")
an aggregate of 4,188,129 shares of Common Stock, par value $.01 per share, of
the Company (the "Firm Shares"), each Selling Shareholder selling the amount of
Firm Shares set forth opposite such Selling Shareholder's name set forth on
Schedule II hereto. The Company also proposes to issue and sell to the several
Underwriters not more than 628,219 additional shares of Common Stock, par value
$.01 per share, of the Company (the "Additional Shares"), if requested by the
Underwriters as provided in Section 2 hereof. The Firm Shares and the Additional
Shares are herein collectively called the "Shares". The shares of common stock
of the Company to be outstanding after giving effect to the sales contemplated
hereby are hereinafter referred to as the "Common Stock". The Company and the
Selling Shareholders are hereinafter collectively called the "Sellers".
SECTION 1. Registration Statement and Prospectus. The Company has
prepared and filed with the Securities and Exchange Commission (the
"Commission") in accordance with
<PAGE> 2
the provisions of the Securities Act of 1933, as amended, and the rules and
regulations of the Commission thereunder (collectively, the "Act"), a
registration statement on Form S-1 (No. 333-56063) including a prospectus
relating to the Shares. The registration statement, as amended at the time when
it became effective, including the information (if any) deemed to be part of the
registration statement at the time of effectiveness pursuant to Rule 430A under
the Act, is hereinafter referred to as the "Registration Statement"; and the
prospectus in the form first used to confirm sales of Shares is hereinafter
referred to as the "Prospectus". If the company has filed or is requested
pursuant to the terms hereof to file a registration statement pursuant to Rule
462(b) under the Act registering additional shares of Common Stock (a "Rule
462(b) Registration Statement"), then, unless otherwise specified, any reference
herein to the term "Registration Statement" shall be deemed to include such Rule
462(b) Registration Statement.
SECTION 2. Agreements to Sell and Purchase and Lock-Up Agreements. On
the basis of the representations and warranties contained in this Agreement, and
subject to its terms and conditions, (i) each Selling Shareholder agrees,
severally and not jointly, to sell to the Underwriters the number of Firm Shares
set forth opposite such Selling Shareholder's name in Schedule II hereto and
(ii) each Underwriter agrees, severally and not jointly, to purchase from each
Selling Shareholder at a price per Firm Share of $13.06 (the "Purchase Price")
the number of Firm Shares (subject to such adjustments to eliminate fractional
shares as you may determine) which bears the same proportion to the total number
of Firm Shares to be sold by such Selling Shareholder as the number of Firm
Shares set forth opposite the name of such Underwriter in Schedule I hereto
bears to the total number of Firm Shares.
On the basis of the representations and warranties contained in this
Agreement, and subject to the terms and conditions hereof, (i) the Company
agrees to issue and sell up to 628,219 Additional Shares and (ii) the
Underwriters shall have the right to purchase, severally and not jointly, up to
an aggregate of 628,219 Additional Shares from the Company at the Purchase
Price. Additional Shares may be purchased solely for the purpose of covering
over-allotments made in connection with the offering of the Firm Shares. The
Underwriters may exercise their right to purchase Additional Shares in whole or
in part from time to time by giving written notice thereof to the Company within
30 days after the date of this Agreement. You shall give any such notice on
behalf of the Underwriters and such notice shall specify the aggregate number of
Additional Shares to be purchased pursuant to such exercise and the date for
payment and delivery thereof. The date specified in any such notice shall be a
business day (i) no earlier than the Closing Date (as hereinafter defined), (ii)
no later than ten business days after such notice has been given and (iii) no
earlier than three business days after such notice has been given. If any
Additional Shares are to be purchased, each Underwriter, severally and not
jointly, agrees to purchase from the Company the number of Additional Shares
(subject to such adjustments to eliminate fractional shares as you may
determine) which bears the same proportion to the total number of Additional
Shares to be purchased from the Company as the number of Firm Shares set forth
opposite the name of such Underwriter in Schedule I bears to the total number of
Firm Shares.
Each Seller hereby agrees not to (i) offer, pledge, sell, contract to
sell, sell any option or contract to purchase, purchase any option or contract
to sell, grant any option, right or warrant to purchase, or otherwise transfer
or dispose of, directly or indirectly, any shares of Common Stock or any
securities convertible into or exercisable or exchangeable for Common
<PAGE> 3
Stock or (ii) enter into any swap or other arrangement that transfers all or a
portion of the economic consequences associated with the ownership of any Common
Stock (regardless of whether any of the transactions described in clause (i) or
(ii) is to be settled by the delivery of Common Stock, or such other securities,
in cash or otherwise), except to the Underwriters pursuant to this Agreement,
for a period of 180 days after the date of the Prospectus without the prior
written consent of Donaldson, Lufkin & Jenrette Securities Corporation.
Notwithstanding the foregoing, during such period the Company may (i) grant
stock options pursuant to the Company's existing stock option plans, (ii) issue
shares of Common Stock upon the exercise of any option or warrant or the
conversion of a security outstanding on the date hereof and (iii) issue shares
or options in connection with an acquisition in which the acquiror or acquirors
of such shares agree(s) to the restrictions set forth herein. The Company also
agrees not to file any registration statement with respect to any shares of
Common Stock for a period of 180 days after the date of the Prospectus without
the prior written consent of Donaldson, Lufkin & Jenrette Securities
Corporation. In addition, each Selling Shareholder agrees that, for a period of
180 days after the date of the Prospectus without the prior written consent of
Donaldson, Lufkin & Jenrette Securities Corporation, it will not make any demand
for, or exercise any right with respect to, the registration of any shares of
Common Stock or any securities convertible into or exercisable or exchangeable
for Common Stock. The Company shall, prior to or concurrently with the execution
of this Agreement, deliver an agreement executed by (i) each Selling
Stockholder, (ii) each of the directors and officers of the Company who is not a
Selling Stockholder and (iii) each other stockholder listed on Annex I hereto to
the effect that such person will not, during the period commencing on the date
such person signs such agreement and ending 180 days after the date of the
Prospectus, without the prior written consent of Donaldson, Lufkin & Jenrette
Corporation, (A) engage in any of the transactions described in the first
sentence of this paragraph or (B) make any demand for, or exercise any right
with respect to, the registration of any shares of Common Stock or any
securities convertible into or exercisable or exchangeable for Common Stock.
SECTION 3. Terms of Public Offering. The Sellers are advised by you
that the Underwriters propose (i) to make a public offering of their respective
portions of the Shares as soon after the execution and delivery of this
Agreement as in your judgment is advisable and (ii) initially to offer the
Shares upon the terms set forth in the Prospectus.
SECTION 4. Delivery and Payment. The Shares shall be represented by
definitive certificates and shall be issued in such authorized denominations and
registered in such names as Donaldson, Lufkin & Jenrette Securities Corporation
shall request not later than two business days prior to the Closing Date or the
applicable Option Closing Date (as defined below), as the case may be. The
Shares shall be delivered by or on behalf of the Sellers, with any transfer
taxes thereon duly paid by the respective Sellers, to Donaldson, Lufkin &
Jenrette Securities Corporation through the facilities of The Depository Trust
Company ("DTC"), for the respective accounts of the several Underwriters,
against payment to the Sellers of the Purchase Price therefore by wire transfer
of Federal or other funds immediately available in New York City. The
certificates representing the Shares shall be made available for inspection not
later than 9:30 A.M., New York City time, on the business day prior to the
Closing Date or the applicable Option Closing Date (as defined below), as the
case may be, at the office of DTC or its designated custodian (the "Designated
Office"). The time and date of delivery and payment for the Firm Shares shall be
9:00 A.M., New York City time, on July 14, 1998 or such other time
<PAGE> 4
on the same or such other date as Donaldson, Lufkin & Jenrette Securities
Corporation, the Company and the Selling Shareholders shall agree in writing.
The time and date of delivery and payment for the Firm Shares are hereinafter
referred to as the "Closing Date". The time and date of delivery and payment for
any Additional Shares to be purchased by the Underwriters shall be 9:00 A.M.,
New York City time, on the date specified in the applicable exercise notice
given by you pursuant to Section 2 or such other time on the same or such other
date as Donaldson, Lufkin & Jenrette Securities Corporation and the Company
shall agree in writing. The time and date of delivery and payment for any
Additional Shares are hereinafter referred to as the "Option Closing Date".
The documents to be delivered on the Closing Date or any Option Closing
Date on behalf of the parties hereto pursuant to Section 9 of this Agreement
shall be delivered at the offices of Simpson Thacher & Bartlett, 425 Lexington
Avenue, New York, New York, and the Shares shall be delivered at the Designated
Office, all on the Closing Date or such Option Closing Date, as the case may be.
SECTION 5. Agreements of the Company. The Company agrees with you:
(a) To advise you promptly and, if requested by you, to confirm such
advice in writing, (i) of any request by the Commission for amendments to
the Registration Statement or amendments or supplements to the Prospectus
or for additional information, (ii) of the issuance by the Commission of
any stop order suspending the effectiveness of the Registration Statement
or of the suspension of qualification of the Shares for offering or sale in
any jurisdiction, or the initiation of any proceeding for such purposes,
(iii) when any amendment to the Registration Statement becomes effective,
(iv) if the Company is required to file a Rule 462(b) Registration
Statement after the effectiveness of this Agreement, when the Rule 462(b)
Registration Statement has become effective and (v) of the happening of any
event during the period referred to in Section 5(d) below which makes any
statement of a material fact made in the Registration Statement or the
Prospectus untrue or which requires the making of any additions to or
changes in the Registration Statement or the Prospectus in order to make
the statements therein not misleading. If at any time the Commission shall
issue any stop order suspending the effectiveness of the Registration
Statement, the Company will use its best efforts to obtain the withdrawal
or lifting of such order at the earliest possible time.
(b) To furnish to you, without charge, three signed copies of the
Registration Statement as first filed with the Commission and of each
amendment to it, including all exhibits, and to furnish to you and each
Underwriter designated by you such number of conformed copies of the
Registration Statement as so filed and of each amendment to it, without
exhibits, as you may reasonably request.
(c) To prepare the Prospectus, the form and substance of which shall be
satisfactory to you, and to file the Prospectus in such form with the
Commission within the applicable period specified in Rule 424(b) under the
Act; during the period specified in Section 5(d) below, not to file any
further amendment to the Registration Statement and not to make any
amendment or supplement to the Prospectus of which you shall not previously
have been advised or to which you shall reasonably object after being so
<PAGE> 5
advised; and, during such period, to prepare and file with the Commission,
promptly upon your reasonable request, any amendment to the Registration
Statement or amendment or supplement to the Prospectus which may be
necessary or advisable in connection with the distribution of the Shares by
you, and to use its best efforts to cause any such amendment to the
Registration Statement to become promptly effective.
(d) Prior to 10:00 A.M., New York City time, on the first business day
after the date of this Agreement and from time to time thereafter for such
period as, in the opinion of counsel for the Underwriters, a prospectus is
required by law to be delivered in connection with sales by an Underwriter
or a dealer, to furnish in New York City to each Underwriter and any dealer
as many copies of the Prospectus (and of any amendment or supplement to the
Prospectus) as such Underwriter or dealer may reasonably request.
(e) If during the period specified in Section 5(d) any event shall
occur or condition shall exist as a result of which, in the opinion of
counsel for the Underwriters, it becomes necessary to amend or supplement
the Prospectus in order to make the statements therein, in the light of the
circumstances under which they were made, when the Prospectus is delivered
to a purchaser, not misleading, or if, in the opinion of counsel for the
Underwriters, it is necessary to amend or supplement the Prospectus to
comply with any applicable law, forthwith to prepare and file with the
Commission an appropriate amendment or supplement to the Prospectus so that
the statements in the Prospectus, as so amended or supplemented, will not,
in the light of the circumstances under which they were made, when it is so
delivered, be misleading, or so that the Prospectus will comply with
applicable law, and to furnish to each Underwriter and to any dealer as
many copies thereof as such Underwriter or dealer may reasonably request.
(f) Prior to any public offering of the Shares, to cooperate with you
and counsel for the Underwriters in connection with the registration or
qualification of the Shares for offer and sale by the several Underwriters
and by dealers under the state securities or Blue Sky laws of such
jurisdictions as you may request, to continue such registration or
qualification in effect so long as required for distribution of the Shares
and to file such consents to service of process or other documents as may
be necessary in order to effect such registration or qualification;
provided, however, that the Company shall not be required in connection
therewith to qualify as a foreign corporation in any jurisdiction in which
it is not now so qualified or to take any action that would subject it to
general consent to service of process or taxation other than as to matters
and transactions relating to the Prospectus, the Registration Statement,
any preliminary prospectus or the offering or sale of the Shares, in any
jurisdiction in which it is not now so subject.
(g) To mail and make generally available to its stockholders as soon as
practicable an earnings statement covering the twelve-month period ending
September 30, 1999 that shall satisfy the provisions of Section 11 (a) of
the Act, and to advise you in writing when such statement has been so made
available.
(h) During the period of three years after the date of this Agreement,
to furnish to you as soon as available copies of all reports or other
communications furnished to the record holders of Common Stock or furnished
to or filed with the Commission or any
<PAGE> 6
national securities exchange on which any class of securities of the
Company is listed and such other publicly available information concerning
the Company and its subsidiaries as you may reasonably request.
(i) Whether or not the transactions contemplated in this Agreement are
consummated or this Agreement is terminated, to pay or cause to be paid all
expenses incident to the performance of the Sellers' obligations under this
Agreement, including: (i) the fees, disbursements and expenses of the
Company's counsel and the Company's accountants in connection with the
registration and delivery of the Shares under the Act and all other fees
and expenses in connection with the preparation, printing, filing and
distribution of the Registration Statement (including financial statements
and exhibits), any preliminary prospectus, the Prospectus and all
amendments and supplements to any of the foregoing, including the mailing
and delivering of copies thereof to the Underwriters and dealers in the
quantities specified herein, (ii) all costs and expenses related to the
transfer and delivery of the Shares to the Underwriters, including any
transfer or other taxes payable thereon, (iii) all costs of printing or
producing this Agreement and any other agreements or documents in
connection with the offering, purchase, sale or delivery of the Shares,
(iv) all expenses in connection with the registration or qualification of
the Shares for offer and sale under the securities or Blue Sky laws of the
several states and all costs of printing or producing any Preliminary and
Supplemental Blue Sky Memoranda in connection therewith (including the
filing fees and fees and disbursements of counsel for the Underwriters in
connection with such registration or qualification and memoranda relating
thereto), (v) the filing fees and disbursements of counsel for the
Underwriters in connection with the review and clearance of the offering of
the Shares by the National Association of Securities Dealers, Inc., (vi)
the cost of printing certificates representing the Shares, (vii) the costs
and charges of any transfer agent, registrar and/or depositary, and (viii)
all other costs and expenses incident to the performance of the obligations
of the Company and the Selling Shareholders hereunder for which provision
is not otherwise made in this Section. The provisions of this Section shall
not supersede or otherwise affect any agreement that the Company and the
Selling Shareholders may otherwise have for allocation of such expenses
among themselves.
(j) To use its best efforts to maintain the listing of the Shares on
the New York Stock Exchange ("NYSE") for a period of three years after the
date of this Agreement.
(k) To use its best efforts to do and perform all things required or
necessary to be done and performed under this Agreement by the Company
prior to the Closing Date or any Option Closing Date, as the case may be,
and to satisfy all conditions precedent to the delivery of the Shares.
(l) If the Registration Statement at the time of the effectiveness of
this Agreement does not cover all of the Shares, to file a Rule 462(b)
Registration Statement with the Commission registering the Shares not so
covered in compliance with Rule 462(b) by 10:00 P.M., New York City time,
on the date of this Agreement and to pay to the Commission the filing fee
for such Rule 462(b) Registration Statement at the time of the filing
thereof or to give irrevocable instructions for the payment of such fee
pursuant to
<PAGE> 7
Rule 111 (b) under the Act.
SECTION 6. Representations and Warranties of the Company. The Company
represents and warrants to each Underwriter that:
(a) The Registration Statement has become effective (other than any
Rule 462(b) Registration Statement to be filed by the Company after the
effectiveness of this Agreement); any Rule 462(b) Registration Statement
filed after the effectiveness of this Agreement will become effective no
later than 10:00 P.M., New York City time, on the date of this Agreement;
and no stop order suspending the effectiveness of the Registration
Statement is in effect, and no proceedings for such purpose are pending
before or threatened by the Commission.
(b) (i) The Registration Statement (other than any Rule 462(b)
Registration Statement to be filed by the Company after the effectiveness
of this Agreement), when it became effective, did not contain and, as
amended, if applicable, will not contain any untrue statement of a material
fact or omit to state a material fact required to be stated therein or
necessary to make the statements therein not misleading, (ii) the
Registration Statement (other than any Rule 462(b) Registration Statement
to be filed by the Company after the effectiveness of this Agreement) and
the Prospectus comply and, as amended or supplemented, if applicable, will
comply in all material respects with the Act, (iii) if the Company is
required to file a Rule 462(b) Registration Statement after the
effectiveness of this Agreement, such Rule 462(b) Registration Statement
and any amendments thereto when they become effective (A) will not contain
any untrue statement of a material fact or omit to state a material fact
required to be stated therein or necessary to make the statements therein
not misleading and (B) will comply in all material respects with the Act
and (iv) the Prospectus does not contain, and, as amended or supplemented,
if applicable, will not contain, any untrue statement of a material fact or
omit to state a material fact necessary to make the statements therein, in
the light of the circumstances under which they were made, not misleading,
except that the representations and warranties set forth in this paragraph
do not apply to statements or omissions in the Registration Statement or
the Prospectus based upon information relating to any Underwriter furnished
to the Company in writing by such Underwriter through you expressly for use
therein.
(c) Each preliminary prospectus filed as part of the registration
statement as originally filed or as part of any amendment thereto, or filed
pursuant to Rule 424 under the Act, complied when so filed in all material
respects with the Act, and did not contain an untrue statement of a
material fact or omit to state a material fact required to be stated
therein or necessary to make the statements therein, in the light of the
circumstances under which they were made, not misleading, except that the
representations and warranties set forth in this paragraph do not apply to
statements or omissions in any preliminary prospectus based upon
information relating to any Underwriter furnished to the Company in writing
by such Underwriter through you expressly for use therein.
(d) Each of the Company and its subsidiaries has been duly
incorporated, is validly existing as a corporation in good standing under
the laws of its jurisdiction of
<PAGE> 8
incorporation and has the corporate power and authority to carry on its
business as described in the Prospectus and to own, lease and operate its
properties, and each is duly qualified and is in good standing as a foreign
corporation authorized to do business in each jurisdiction in which the
nature of its business or its ownership or leasing of property requires
such qualification, except where the failure to be so qualified would not
have a material adverse effect on the business, financial condition or
results of operations of the Company and its subsidiaries, taken as a
whole.
(e) Except as disclosed on Schedule III hereto, there are no
outstanding subscriptions, rights, warrants, options, calls, convertible
securities, commitments of sale or liens granted or issued by the Company
or any of its subsidiaries relating to or entitling any person to purchase
or otherwise to acquire any shares of the capital stock of the Company or
any of its subsidiaries, except as otherwise disclosed in the Registration
Statement.
(f) All the Firm Shares have been duly authorized and validly issued
and are fully paid, non-assessable and none of the outstanding shares of
capital stock of the Company (including the Shares to be sold by the
Selling Stockholders) are subject to any preemptive or similar rights; and
the Additional Shares to be issued and sold by the Company have been duly
authorized and, when issued and delivered to the Underwriters against
payment therefor as provided by this Agreement, will be validly issued,
fully paid and non-assessable, and the issuance of such Additional Shares
will not be subject to any preemptive or similar rights.
(g) All of the outstanding shares of capital stock of each of the
Company's subsidiaries have been duly authorized and validly issued and are
fully paid and non-assessable, and are owned by the Company, directly or
indirectly through one or more subsidiaries, free and clear of any security
interest, claim, lien, encumbrance or adverse interest of any nature.
(h) The authorized capital stock of the Company conforms as to legal
matters to the description thereof contained in the Prospectus under
"Description of Capital Stock"; and the only outstanding shares of capital
stock of the Company are shares of Common Stock.
(i) Neither the Company nor any of its subsidiaries is in violation of
its respective charter or by-laws or in default in the performance of any
material obligation, agreement, covenant or condition contained in any
indenture, loan agreement, mortgage, lease or other agreement or instrument
that is material to the Company and its subsidiaries, taken as a whole, to
which the Company or any of its subsidiaries is a party or by which the
Company or any of its subsidiaries or their respective property is bound.
(j) The execution, delivery and performance of this Agreement by the
Company, the compliance by the Company with all the provisions hereof and
the consummation of the transactions contemplated hereby will not (i)
require any consent, approval, authorization or other order of, or
qualification with, any court or governmental body or agency (except such
as may be required under the securities or Blue Sky laws of the
<PAGE> 9
various states), (ii) conflict with or constitute a breach of any of the
terms or provisions of, or a default under, the charter or by-laws of the
Company or any of its subsidiaries, (iii) conflict with or constitute a
material breach of any indenture, loan agreement, mortgage, lease or other
agreement or instrument that is material to the Company and its
subsidiaries, taken as a whole, to which the Company or any of its
subsidiaries is a party or by which the Company or any of its subsidiaries
or their respective property is bound, (iv) violate or conflict with any
applicable law or any rule, regulation, judgment, order or decree of any
court or any governmental body or agency having jurisdiction over the
Company, any of its subsidiaries or their respective property or (v) result
in the suspension, termination or revocation of any Authorization (as
defined below) of the Company or any of its subsidiaries or any other
impairment of the rights of the holder of any such Authorization, except
where such suspension, termination, revocation or impairment would not,
singly or in the aggregate, have a material adverse effect on the business,
prospects, financial condition or results of operations of the Company and
its subsidiaries, taken as a whole.
(k) There are no legal or governmental proceedings pending or, to the
knowledge of the Company, threatened to which the Company or any of its
subsidiaries is a party or to which any of their respective property is
subject that are required to be described in the Registration Statement or
the Prospectus and are not so described; nor are there any statutes,
regulations, contracts or other documents that are required to be described
in the Registration Statement or the Prospectus or to be filed as exhibits
to the Registration Statement that are not so described or filed as
required.
(l) Each of the Company and its subsidiaries has such permits,
licenses, consents, exemptions, franchises, authorizations and other
approvals (each, an "Authorization") of, and has made all filings with and
notices to, all governmental or regulatory authorities and self-regulatory
organizations and all courts and other tribunals, including, without
limitation, under any applicable Environmental Laws, as are necessary to
own, lease, license and operate its respective properties and to conduct
its business, except where the failure to have any such Authorization or to
make any such filing or notice would not, singly or in the aggregate, have
a material adverse effect on the business, financial condition or results
of operations of the Company and its subsidiaries, taken as a whole. Each
such Authorization is valid and in full force and effect and each of the
Company and its subsidiaries is in material compliance with all the terms
and conditions thereof and with the rules and regulations of the
authorities and governing bodies having jurisdiction with respect thereto;
and no event has occurred (including, without limitation, the receipt of
any notice from any authority or governing body) which allows or, after
notice or lapse of time or both, would allow, revocation, suspension or
termination of any such Authorization or results or, after notice or lapse
of time or both, would result in any other impairment of the rights of the
holder of any such Authorization; except where such failure to be valid and
in full force and effect or to be in compliance, the occurrence of any such
event or the presence of any such restriction would not, singly or in the
aggregate, have a material adverse effect on the business, financial
condition or results of operations of the Company and its subsidiaries,
taken as a whole.
(m) This Agreement has been duly authorized, executed and delivered by
the
<PAGE> 10
Company.
(n) Deloitte & Touche LLP are independent public accountants with
respect to the Company and its subsidiaries as required by the Act.
(o) Coopers & Lybrand L.L.P. were independent public accountants with
respect to Capsure Holdings Corp., a Delaware corporation ("Capsure"), as
required by the Act.
(p) The financial statements, together with related schedules and notes
forming part of the Registration Statement and the Prospectus (and any
amendment or supplement thereto), present fairly in all material respects
the consolidated financial position, results of operations and cash flows
of the Company and its subsidiaries on the basis stated in the Registration
Statement at the respective dates or for the respective periods to which
they apply; such statements and related schedules and notes have been
prepared in accordance with generally accepted accounting principles
consistently applied throughout the periods involved, except as disclosed
therein; and the other financial and statistical information and data set
forth in the Registration Statement and the Prospectus (and any amendment
or supplement thereto) is, in all material respects, accurately presented
and prepared on a basis consistent with such financial statements and the
books and records of the Company.
(q) The financial statements, together with related schedules and notes
forming part of the Registration Statement and the Prospectus (and any
amendment or supplement thereto), presented fairly in all material respects
the consolidated financial position, results of operations and changes in
financial position of Capsure and its subsidiaries on the basis stated in
the Registration Statement at the respective dates or for the respective
periods to which they apply; such statements and related schedules and
notes were prepared in accordance with generally accepted accounting
principles consistently applied throughout the periods involved, except as
disclosed therein; and the other financial and statistical information and
data set forth in the Registration Statement and the Prospectus (and any
amendment or supplement thereto) is, in all material respects, accurately
presented and prepared on a basis consistent with such financial statements
and the books and records of Capsure.
(r) The pro forma financial statements of the Company and its
subsidiaries and the related notes thereto set forth in the Registration
Statement and the Prospectus (and any supplement or amendment thereto) have
been prepared on a basis consistent with the historical financial
statements of the Company and its subsidiaries, give effect to the
assumptions used in the preparation thereof on a reasonable basis and in
good faith. Such pro forma financial statements have been prepared in
accordance with the applicable requirements of Rule 11-02 of Regulation S-X
promulgated by the Commission. The other pro forma financial and
statistical information and data set forth in the Registration Statement
and the Prospectus (and any supplement or amendment thereto) are, in all
material respects, accurately presented and prepared on a basis consistent
with the pro forma financial statements.
(s) The Company is not and, after giving effect to the offering and
sale of the
<PAGE> 11
Shares and the application of the proceeds thereof as described in the
Prospectus, will not be, an "investment company" as such term is defined in
the Investment Company Act of 1940, as amended.
(t) Except as disclosed on Schedule IV hereto, there are no contracts,
agreements or understandings between the Company and any person granting
such person the right to require the Company to file a registration
statement under the Act with respect to any securities of the Company or to
require the Company to include such securities with the Shares registered
pursuant to the Registration Statement.
(u) Since the respective dates as of which information is given in the
Prospectus other than as set forth in the Prospectus (exclusive of any
amendments or supplements thereto subsequent to the date of this
Agreement), (i) there has not occurred any material adverse change or, to
the knowledge of the Company, any development which could reasonably be
expected to cause a prospective material adverse change in the condition,
financial or otherwise, or the earnings, business, management or operations
of the Company and its subsidiaries, taken as a whole, (ii) there has not
been any material adverse change or, to the knowledge of the Company, any
development which could reasonably be expected to cause a prospective
material adverse change in the capital stock or in the long-term debt of
the Company or any of its subsidiaries and (iii) neither the Company nor
any of its subsidiaries has incurred any material liability or obligation,
direct or contingent, other than liabilities under surety bonds in the
ordinary course of business.
(v) The Common Stock is listed on the NYSE.
(w) Except as disclosed in the Prospectus, there are no business
relationships or related party transactions required to be disclosed
therein by Item 404 of Regulation S-K of the Commission.
(x) There is (i) no significant unfair labor practice complaint pending
against the Company or any of its subsidiaries or, to the best knowledge of
the Company, threatened against any of them, before the National Labor
Relations Board or any state or local labor relations board, and no
significant grievance or more significant arbitration proceeding arising
out of or under any collective bargaining agreement is so pending against
the Company or any of its subsidiaries or, to the best knowledge of the
Company, threatened against any of them, and (ii) no significant strike,
labor dispute, slowdown or stoppage pending against the Company or any of
its subsidiaries or, to the best knowledge of the Company, threatened
against it or any of its subsidiaries except for such actions specified in
clause (i) or (ii) above, which, singly or in the aggregate could not
reasonably be expected to have a material adverse effect on the Company and
its subsidiaries, taken as a whole.
(y) The Company and each of its subsidiaries maintains a system of
internal accounting controls sufficient to provide reasonable assurance
that (i) transactions are executed in accordance with management's general
or specific authorizations; (ii) transactions are recorded as necessary to
permit preparation of financial statements in
<PAGE> 12
conformity with generally accepted accounting principles and to maintain
asset accountability; (iii) access to assets is permitted only in
accordance with management's general or specific authorization; and (iv)
the recorded accountability for assets is compared with the existing assets
at reasonable intervals and appropriate action is taken with respect to any
differences.
(z) All material tax returns required to be filed by the Company and
each of its subsidiaries in any jurisdiction have been filed, other than
those filings being contested in good faith, and all material taxes,
including withholding taxes, penalties and interest, assessments, fees and
other charges due pursuant to and as set forth in such returns or pursuant
to any assessment received by the Company or any of its subsidiaries have
been paid, other than those being contested in good faith or for which
adequate reserves have been provided.
(aa) The Company and each of its subsidiaries (i) own or possess
adequate rights to use all material trademarks, copyrights and licenses
necessary for the conduct of their respective businesses and (ii) have no
reason to believe that the conduct of their respective businesses will
conflict with, and have not received any notice of any claim of conflict
with, any such rights of others which would render any rights of the
Company or any of its subsidiaries invalid or inadequate to protect the
interest of the Company or such subsidiary therein and which infringement
or conflict (if the subject of any unfavorable decision, ruling or
finding), invalidity or inadequacy, individually or in the aggregate, would
have a material adverse affect on the Company and its subsidiaries, taken
as a whole.
(bb) To the best of the Company's knowledge, except as disclosed in the
Registration Statement, no change in any insurance laws, rules or
regulations has been introduced which would reasonably be expected to be
adopted and, if adopted, would reasonably be expected to have, individually
or in the aggregate with all such changes, a material adverse effect upon
the financial condition, business affairs or results of operations of the
Company and its Insurance Subsidiaries (as defined below) considered as one
enterprise. As used in this Agreement, "Insurance Subsidiaries" shall be
the collective reference to Western Surety Company ("Western Surety") and
Universal Surety of America ("USA").
(cc) The Company and the Insurance Subsidiaries have filed all reports,
information statements and other documents with the insurance regulatory
authorities of their respective jurisdictions of incorporation as are
required to be filed pursuant to the insurance statutes of such
jurisdictions and the rules and regulations of the insurance regulator
authorities thereunder (the "Applicable Insurance Laws"), except where the
failure to file such statements or reports would not, individually or in
the aggregate, have a material adverse effect on the financial condition,
business affairs or results of operations of the Company and its
subsidiaries taken as a whole.
(dd) The Company and the Insurance Subsidiaries have made no material
changes in their reserving practices or accounting policies since December
31, 1997.
<PAGE> 13
(ee) All reinsurance treaties, agreements and arrangements to which the
Company or any Insurance Subsidiary is a party are in full force and effect
and neither the Company nor any Insurance Subsidiary is in violation of or
in default in the performance, observance or fulfillment of, any
obligation, agreement, covenant or condition contained therein which
violation or default would reasonably be expected to have a material
adverse effect on the financial condition, business affairs or results of
operations of the Company and its subsidiaries taken as a whole; neither
the Company nor any Insurance Subsidiary has received any notice from any
of the other parties to such treaties, contracts or agreements that such
other party intends not to perform such treaty and, to the best knowledge
of the Company, the Company has no reason to believe that any of the other
parties to such treaties or arrangements will be unable to perform such
treaty or arrangement.
(ff) The 1997 statutory financial statements of the Company and the
Insurance Subsidiaries have been prepared in conformity with statutory
accounting principles or practices required or permitted by the National
Association of Insurance Commissioners, by the South Dakota Department of
Commerce and Regulation -- Division of Insurance (in the case of Western
Surety) and the Texas Department of Insurance (in the case of USA) and such
statutory accounting principles and practices have been applied on a
consistent basis throughout the periods involved, except as may otherwise
be indicated therein or in the notes thereto, and present fairly in all
material respects the combined statutory financial position of the Company
or the Insurance Subsidiaries, as the case may be, as of the dates thereof,
and the statutory basis results of operations of the Company or the
Insurance Subsidiaries, as the case may be, for the periods covered thereby
is in conformity with such statutory accounting principles and practices.
(gg) Western Surety is rated "A+" (Superior) and USA is rated "A"
(Excellent) by A.M. Best & Company.
(hh) Each certificate signed by any officer of the Company and
delivered to the Underwriters or counsel for the Underwriters shall be
deemed to be a representation and warranty by the Company to the
Underwriters as to the matters covered thereby.
SECTION 7. Representations and Warranties of the Selling Shareholders.
Each Selling Shareholder represents and warrants to each Underwriter that:
(a) Such Selling Shareholder is the lawful owner of the Firm Shares to
be sold by such Selling Shareholder pursuant to this Agreement and has, and
on the Closing Date will have, good and clear title to such Firm Shares,
free of all restrictions on transfer, liens, encumbrances, security
interests, equities and claims whatsoever (subject to any lien created
hereby and restrictions arising under applicable securities law, which do
not survive the Closing).
(b) Such Selling Shareholder has, and on the Closing Date will have,
full legal right, power and authority, and all authorization and approval
required by law, to enter into this Agreement and the Power of Attorney
(the "Power of Attorney") of such Selling Shareholder, if applicable,
appointing certain individuals as such Selling Shareholder's
<PAGE> 14
attorneys-in-fact (the "Attorneys") to the extent set forth therein,
relating to the transactions contemplated hereby and by the Registration
Statement and to sell, assign, transfer and deliver the Shares to be sold
by such Selling Shareholder in the manner provided herein and therein.
(c) This Agreement has been duly authorized, executed and delivered by
or on behalf of such Selling Shareholder.
(d) The Power of Attorney of such Selling Shareholder has been duly
authorized, executed and delivered by such Selling Shareholder and is a
valid and binding instrument of such Selling Shareholder, enforceable in
accordance with its terms, and, pursuant to such Power of Attorney, such
Selling Shareholder has, among other things, authorized the Attorneys, or
any one of them, to execute and deliver on such Selling Shareholder's
behalf this Agreement and any other document that they, or any one of them,
may deem necessary or desirable in connection with the transactions
contemplated hereby and thereby and to deliver the Firm Shares to be sold
by such Selling Shareholder pursuant to this Agreement.
(e) Upon delivery of and payment for the Firm Shares to be sold by such
Selling Shareholder pursuant to this Agreement, the Underwriters will
acquire all of the rights of such Selling Shareholder and will also acquire
their interest in such Firm Shares free of any adverse claim.
(f) The execution, delivery and performance of this Agreement and Power
of Attorney, if applicable, of such Selling Shareholder by or on behalf of
such Selling Shareholder, the compliance by such Selling Shareholder with
all the provisions hereof and thereof and the consummation of the
transactions contemplated hereby and thereby will not (i) require any
consent, approval, authorization or other order of, or qualification with,
any court or governmental body or agency (except such as may be required
under the securities or Blue Sky laws of the various states), (ii) conflict
with or constitute a breach of any of the terms or provisions of, or a
default under, the organizational documents of such Selling Shareholder, if
such Selling Shareholder is not an individual, or any indenture, loan
agreement, mortgage, lease or other agreement or instrument to which such
Selling Shareholder is a party or by which such Selling Shareholder or any
property of such Selling Shareholder is bound or (iii) violate or conflict
with any applicable law or any rule, regulation, judgment, order or decree
of any court or any governmental body or agency having jurisdiction over
such Selling Shareholder or any property of such Selling Shareholder, other
than, in the case of clauses (ii) and (iii), any conflict or violation
that, would not affect the validity of, or adversely affect the Selling
Shareholder's ability to consummate the transactions contemplated
hereunder.
(g) The information in the Registration Statement under the caption
"Principal and Selling Stockholders" which specifically relates to such
Selling Shareholder does not, and will not on the Closing Date, contain any
untrue statement of a material fact or omit to state any material fact
required to be stated therein or necessary to make the statements therein,
in the light of the circumstances under which they were made, not
misleading.
<PAGE> 15
(h) At any time during the period described in Section 5(d), if there
is any change in the information referred to in Section 7(g), such Selling
Shareholder will immediately notify you of such change.
(i) Such Selling Stockholder has not taken, and will not take, directly
or indirectly, any action designed to, or which might reasonably be
expected to, cause or result in stabilization or manipulation of the price
of any security of the Company to facilitate the sale or resale of the
Shares pursuant to the distribution contemplated by this Agreement, and
other than as permitted by the Act, such Selling Stockholder has not
distributed and will not distribute any prospectus or other offering
material in connection with the offering and sale of the Shares.
(j) Each certificate signed by or on behalf of such Selling Shareholder
and delivered to the Underwriters or counsel for the Underwriters shall be
deemed to be a representation and warranty by such Selling Shareholder to
the Underwriters as to the matters covered thereby.
SECTION 8. Indemnification. (a) The Company agrees to indemnify and
hold harmless each Underwriter, its directors, its officers and each person, if
any, who controls any Underwriter within the meaning of Section 15 of the Act or
Section 20 of the Securities Exchange Act of 1934, as amended (the "Exchange
Act"), from and against any and all losses, claims, damages, liabilities and
judgments (including, without limitation, any legal or other expenses incurred
in connection with investigating or defending any matter, including any action,
that could give rise to any such losses, claims, damages, liabilities or
judgments) caused by any untrue statement or alleged untrue statement of a
material fact contained in the Registration Statement (or any amendment
thereto), the Prospectus (or any amendment or supplement thereto) or any
preliminary prospectus, or caused by any omission or alleged omission to state
therein a material fact required to be stated therein or necessary to make the
statements therein not misleading, except insofar as such losses, claims,
damages, liabilities or judgments are caused by any such untrue statement or
omission or alleged untrue statement or omission based upon information relating
to any Underwriter furnished in writing to the Company by such Underwriter
through you expressly for use therein; provided, however, that the foregoing
indemnity agreement with respect to any preliminary prospectus shall not inure
to the benefit of any Underwriter who failed to deliver a Prospectus (as then
amended or supplemented, provided by the Company to the several Underwriters in
the requisite quantity and on a timely basis to permit proper delivery on or
prior to the Closing Date) to the person asserting any losses, claims, damages
and liabilities and judgments caused by any untrue statement or alleged untrue
statement of a material fact contained in any preliminary prospectus, or caused
by any omission or alleged omission to state therein a material fact required to
be stated therein or necessary to make the statements therein not misleading, if
such material misstatement or omission or alleged material misstatement or
omission was cured in such Prospectus and such Prospectus was required by law to
be delivered at or prior to the written confirmation of sale to such person.
(b) Each of the Selling Shareholders agrees, severally and not jointly,
to indemnify and hold harmless each Underwriter, its directors, its officers and
each person, if any, who controls any Underwriter within the meaning of Section
15 of the Act or Section 20 of the Exchange Act to the same extent as the
foregoing indemnity from the Company to each
<PAGE> 16
Underwriter, but only with reference to information relating to such Selling
Shareholder furnished in writing by or on behalf such Selling Shareholder
expressly for use in the Registration Statement, the Prospectus or any
preliminary prospectus. Notwithstanding the foregoing, the aggregate liability
of any Selling Shareholder pursuant to this Section 8(b) shall be limited to an
amount equal to the total proceeds (before deducting underwriting discounts and
commissions and expenses) received by such Selling Shareholder from the
Underwriters for the sale of the Firm Shares sold by such Selling Shareholder
hereunder; provided, however, that the foregoing indemnity agreement with
respect to any preliminary prospectus shall not inure to the benefit of any
Underwriter from whom the person asserting any such losses, claims, damages and
liabilities and judgments purchased Shares, or any person controlling such
Underwriter, if a copy of the Prospectus (as then amended or supplemented if the
Company shall have furnished any amendments or supplements thereto) was not sent
or given by or on behalf of such Underwriter to such person, if required by law
so to have been delivered, at or prior to the written confirmation of the sale
of the Shares to such person, and if the Prospectus (as so amended and
supplemented) would have cured the defect giving rise to such loss, claim,
damage, liability or judgment. The Company and the Selling Shareholders may
enter into other agreements amongst themselves with respect to the
indemnification obligations hereunder, provided that such agreements shall not
affect the indemnification obligations of the Company and the Selling
Shareholders to the several Underwriters under this Agreement.
(c) Each Underwriter agrees, severally and not jointly, to indemnify
and hold harmless the Company, its directors, its officers who sign the
Registration Statement, each person, if any, who controls the Company within the
meaning of Section 15 of the Act or Section 20 of the Exchange Act, each Selling
Shareholder and each person, if any, who controls such Selling Shareholder
within the meaning of Section 15 of the Act or Section 20 of the Exchange Act to
the same extent as the foregoing indemnity from the Company and the Selling
Shareholders to such Underwriter but only with reference to information relating
to such Underwriter furnished in writing to the Company by such Underwriter
through you expressly for use in the Registration Statement (or any amendment
thereto), the Prospectus (or any amendment or supplement thereto) or any
preliminary prospectus.
(d) In case any action shall be commenced involving any person in
respect of which indemnity may be sought pursuant to Section 8(a), 8(b) or 8(c)
(the "indemnified party"), the indemnified party shall promptly notify the
person against whom such indemnity may be sought (the "indemnifying party") in
writing and the indemnifying party shall assume the defense of such action,
including the employment of counsel reasonably satisfactory to the indemnified
party and the payment of all fees and expenses of such counsel, as incurred
(except that in the case of any action in respect of which indemnity may be
sought pursuant to both Sections 8(a) or 8(b) and 8(c), the Underwriter shall
not be required to assume the defense of such action pursuant to this Section
8(d), but may employ separate counsel and participate in the defense thereof,
but the fees and expenses of such counsel, except as provided below, shall be at
the expense of such Underwriter). Any indemnified party shall have the right to
employ separate counsel in any such action and participate in the defense
thereof, but the fees and expenses of such counsel shall be at the expense of
the indemnified party unless (i) the employment of such counsel shall have been
specifically authorized in writing by the indemnifying party, (ii) the
indemnifying party shall have failed to assume the defense of such action or
employ counsel reasonably satisfactory to the indemnified party or (iii) the
named parties to any such action (including any impleaded parties)
<PAGE> 17
include both the indemnified party and the indemnifying party, and the
indemnified party shall have been advised by such counsel that there may be one
or more legal defenses available to it which are different from or additional to
those available to the indemnifying party (in which case the indemnifying party
shall not have the right to assume the defense of such action on behalf of the
indemnified party). In any such case, the indemnifying party shall not, in
connection with any one action or separate but substantially similar or related
actions in the same jurisdiction arising out of the same general allegations or
circumstances, be liable for (i) the fees and expenses of more than one separate
firm of attorneys (in addition to any local counsel) for all Underwriters, their
officers and directors and all persons, if any, who control any Underwriter
within the meaning of either Section 15 of the Act or Section 20 of the Exchange
Act, (ii) the fees and expenses of more than one separate firm of attorneys (in
addition to any local counsel) for the Company, its directors, its officers who
sign the Registration Statement and all persons, if any, who control the Company
within the meaning of either such Section and (iii) the fees and expenses of
more than one separate firm of attorneys (in addition to any local counsel) for
all Selling Shareholders and all persons, if any, who control any Selling
Shareholder within the meaning of either such Section, and all such fees and
expenses shall be reimbursed as they are incurred. In the case of any such
separate firm for the Underwriters, their officers and directors and such
control persons of any Underwriters, such firm shall be designated in writing by
Donaldson, Lufkin & Jenrette Securities Corporation. In the case of any such
separate firm for the Company and such directors, officers and control persons
of the Company, such firm shall be designated in writing by the Company. In the
case of any such separate firm for the Selling Shareholders and such control
persons of any Selling Shareholders, such firm shall be designated in writing by
the Attorneys. The indemnifying party shall indemnify and hold harmless the
indemnified party from and against any and all losses, claims, damages,
liabilities and judgments by reason of any settlement of any action (i) effected
with its written consent or (ii) effected without its written consent if the
settlement is entered into more than twenty business days after the indemnifying
party shall have received a request from the indemnified party for reimbursement
for the fees and expenses of counsel (in any case where such fees and expenses
are at the expense of the indemnifying party) and, prior to the date of such
settlement, the indemnifying party shall have failed to comply with such
reimbursement request. No indemnifying party shall, without the prior written
consent of the indemnified party, effect any settlement or compromise of, or
consent to the entry of judgment with respect to, any pending or threatened
action in respect of which the indemnified party is or could have been a party
and indemnity or contribution may be or could have been sought hereunder by the
indemnified party, unless such settlement, compromise or judgment (i) includes
an unconditional release of the indemnified party from all liability on claims
that are or could have been the subject matter of such action and (ii) does not
include a statement as to or an admission of fault, culpability or a failure to
act, by or on behalf of the indemnified party.
(e) To the extent the indemnification provided for in this Section 8 is
unavailable to an indemnified party or insufficient in respect of any losses,
claims, damages, liabilities or judgments referred to therein, then each
indemnifying party, in lieu of indemnifying such indemnified party, shall
contribute to the amount paid or payable by such indemnified party as a result
of such losses, claims, damages, liabilities and judgments (i) in the case of
the Company (x) in such proportion as is appropriate to reflect the relative
benefits received by the Company and the Selling Shareholders on the one hand
and the Underwriters on the other hand from the offering of the Shares or (y) if
the allocation provided by clause 8(e)(i)(x) above is not permitted
<PAGE> 18
by applicable law, in such proportion as is appropriate to reflect not only the
relative benefits referred to in clause 8(e)(i)(x) above but also the relative
fault of the Company and the Selling Shareholders on the one hand and the
Underwriters on the other hand in connection with the statements or omissions
which resulted in such losses, claims, damages, liabilities or judgments, as
well as any other relevant equitable considerations and (ii) in the case of any
Selling Shareholder (x) in such proportion as is appropriate to reflect the
relative benefits received by such Selling Shareholder on the
one hand and the Underwriters on the other hand from the offering of the Firm
Shares sold by such Selling Shareholder or (y) if the allocation provided by
clause 8(e)(ii)(x) above is not permitted by applicable law, in such proportion
as is appropriate to reflect not only the relative benefits referred to in
clause 8(e)(ii)(x) above but also the relative fault of such Selling
Shareholders on the one hand and the Underwriters on the other hand in
connection with the statements or omissions which resulted in such losses,
claims, damages, liabilities or judgments, as well as any other relevant
equitable considerations. The relative benefits received (A) as between the
Company and the Selling Shareholders on the one hand and the Underwriters on the
other hand shall be deemed to be in the same proportion as the total net
proceeds from the offering (after deducting underwriting discounts and
commissions, but before deducting expenses) received by the Selling
Shareholders, and the total underwriting discounts and commissions received by
the Underwriters, bear to the total price to the public of the Shares and (B) as
between each Selling Shareholder on the one hand and the Underwriters on the
other hand shall be deemed to be in the same proportion as the total net
proceeds from the offering (after deducting underwriting discounts and
commissions, but before deducting expenses) received by such Selling Shareholder
bear to the underwriting discounts and commissions received by the Underwriters
in respect of the Firm Shares sold by such Selling Shareholder, in each case as
set forth in the table on the cover page of the Prospectus. The relative fault
(A) as between the Company and the Selling Shareholders on the one hand and the
Underwriters on the other hand shall be determined by reference to, among other
things, whether the untrue or alleged untrue statement of a material fact or the
omission or alleged omission to state a material fact relates to information
supplied by the Company or the Selling Shareholders on the one hand or the
Underwriters on the other hand and the parties' relative intent, knowledge,
access to information and opportunity to correct or prevent such statement or
omission and (B) as between each Selling Shareholder on the one hand and the
Underwriters on the other hand shall be determined by reference to, among other
things, whether the untrue or alleged untrue statement of a material fact or the
omission or alleged omission to state a material fact relates to information
supplied by such Selling Shareholder on the one hand or the Underwriters on the
other hand and the parties' relative intent, knowledge, access to information
and opportunity to correct or prevent such statement or omission.
The Sellers and the Underwriters agree that it would not be just and
equitable if contribution pursuant to this Section 8(e) were determined by pro
rata allocation (even if the Underwriters were treated as one entity for such
purpose) or by any other method of allocation which does not take account of the
equitable considerations referred to in the immediately preceding paragraph. The
amount paid or payable by an indemnified party as a result of the losses,
claims, damages, liabilities or judgments referred to in the immediately
preceding paragraph shall be deemed to include, subject to the limitations set
forth above, any legal or other expenses incurred by such indemnified party in
connection with investigating or defending any matter, including any action,
that could have given rise to such losses, claims, damages, liabilities or
judgments. Notwithstanding the provisions of this Section 8, no Underwriter
shall
<PAGE> 19
be required to contribute any amount in excess of the amount by which the total
price at which the Shares underwritten by it and distributed to the public were
offered to the public exceeds the amount of any damages which such Underwriter
has otherwise been required to pay by reason of such untrue or alleged untrue
statement or omission or alleged omission and no Selling Shareholder shall be
required to contribute any amount in excess of the amount by which the total
price at which the Firm Shares of such Selling Shareholders were offered to the
public exceeds the amount of any damages which such Selling Shareholder has
otherwise been required to pay by reason of such untrue or alleged untrue
statement or omission or alleged omission and no Selling Shareholder shall be
required to contribute in respect of any losses, claims, damages, liabilities or
judgments (or expenses incurred in connection therewith) unless the same arise
with respect to information relating to such Selling Shareholder furnished in
writing by or on behalf of the Selling Shareholder for use in the Registration
Statement (or any amendment thereto), the Prospectus (or any amendment or
supplement thereto) or any preliminary prospectus. No person guilty of
fraudulent misrepresentation (within the meaning of Section 11(f) of the Act)
shall be entitled to contribution from any person who was not guilty of such
fraudulent misrepresentation. The Underwriters' obligations to contribute
pursuant to this Section 8(e) are several in proportion to the respective number
of Shares purchased by each of the Underwriters hereunder and not joint.
(f) The remedies provided for in this Section 8 are not exclusive and
shall not limit any rights or remedies which may otherwise be available to any
indemnified party at law or in equity.
(g) Each Selling Shareholder hereby designates CNA Surety Corporation,
CNA Plaza, Chicago, Illinois 60685, as its authorized agent, upon which process
may be served in any action which may be instituted in any state or federal
court in the State of New York by any Underwriter, any director or officer of
any Underwriter or any person controlling any Underwriter asserting a claim for
indemnification or contribution under or pursuant to this Section 8, and each
Selling Shareholder will accept the jurisdiction of such court in such action,
and waives, to the fullest extent permitted by applicable law, any defense based
upon lack of personal jurisdiction or venue. A copy of any such process shall be
sent or given to such Selling Shareholder, at the address for notices specified
in Section 12 hereof.
SECTION 9. Conditions of Underwriters' Obligations. The several
obligations of the Underwriters to purchase the Firm Shares under this Agreement
are subject to the satisfaction of each of the following conditions:
(a) All the representations and warranties of the Company contained in
this Agreement shall be true and correct on the Closing Date with the same
force and effect as if made on and as of the Closing Date.
(b) If the Company is required to file a Rule 462(b) Registration
Statement after the effectiveness of this Agreement, such Rule 462(b)
Registration Statement shall have become effective by 10:00 P.M., New York
City time, on the date of this Agreement; and no stop order suspending the
effectiveness of the Registration Statement shall have been issued and no
proceedings for that purpose shall have been commenced or shall be pending
before or, to the knowledge of the Company or the Underwriters,
contemplated
<PAGE> 20
by the Commission.
(c) You shall have received on the Closing Date a certificate dated the
Closing Date, signed by Mark C. Vonnahme, in his capacity as President and
Chief Executive Officer of the Company, and John S. Heneghan, in his
capacity as Vice President and Chief Financial Officer of the Company,
confirming the matters set forth in Sections 6(w), 9(a) and 9(b) and that
the Company has complied with all of the agreements and satisfied all of
the conditions herein contained and required to be complied with or
satisfied by the Company on or prior to the Closing Date.
(d) Since the respective dates as of which information is given in the
Prospectus other than as set forth in the Prospectus (exclusive of any
amendments or supplements thereto subsequent to the date of this
Agreement), (i) there shall not have occurred any change or any development
involving a prospective change in the condition, financial or otherwise, or
the earnings, business, management or operations of the Company and its
subsidiaries, taken as a whole, (ii) there shall not have been any change
or any development involving a prospective change in the capital stock or
in the long-term debt of the Company or any of its subsidiaries and (iii)
neither the Company nor any of its subsidiaries shall have incurred any
liability or obligation, direct or contingent, the effect of which, in any
such case described in clause 9(d)(i), 9(d)(ii) or 9(d)(iii), in your
judgment, is material and adverse and, in your judgment, makes it
impracticable to market the Shares on the terms and in the manner
contemplated in the Prospectus.
(e) All the representations and warranties of each Selling Shareholder
contained in this Agreement shall be true and correct on the Closing Date
with the same force and effect as if made on and as of the Closing Date and
you shall have received on the Closing Date a certificate dated the Closing
Date from each Selling Shareholder to such effect and to the effect that
such Selling Shareholder has complied with all of the agreements and
satisfied all of the conditions herein contained and required to be
complied with or satisfied by such Selling Shareholder on or prior to the
Closing Date.
(f) You shall have received on the Closing Date an opinion
(satisfactory to you and counsel for the Underwriters), dated the Closing
Date, of Seyfarth, Shaw, Fairweather & Geraldson ("Seyfarth, Shaw"),
counsel for the Company, to the effect that:
(i) each of the Company and its subsidiaries has been
incorporated, is validly existing as a corporation in good standing
under the laws of its jurisdiction of incorporation and has the
corporate power and authority to carry on its business as described in
the Prospectus and to own, lease and operate its properties;
(ii) the Firm Shares have been duly authorized and validly
issued and are fully paid, non-assessable and not subject to any
preemptive or similar rights;
(iii) the Additional Shares to be issued and sold by the
Company hereunder have been duly authorized and, if and when issued
and delivered to the
<PAGE> 21
Underwriters against payment therefor as provided by this Agreement,
will be validly issued, fully paid and non-assessable, and the
issuance of such Additional Shares will not be subject to any
preemptive or similar rights;
(iv) all of the outstanding shares of capital stock of each
of the Company's Insurance Subsidiaries have been duly authorized and
validly issued and are fully paid and non-assessable, and are owned by
the Company, directly or indirectly through one or more subsidiaries,
free and clear of any security interest, claim, lien, encumbrance or
adverse interest of any nature;
(v) this Agreement has been duly authorized, executed and
delivered by the Company;
(vi) the authorized capital stock of the Company conforms as
to legal matters to the description thereof contained in the
Prospectus under the heading "Description of Capital Stock";
(vii) the Registration Statement has become effective under
the Act, no stop order suspending its effectiveness has been issued
and no proceedings for that purpose are, to the best of such counsel's
knowledge, pending before or contemplated by the Commission;
(viii) the statements under the captions "Description of
Capital Stock" in the Prospectus and Items 14 and 15 of Part II of the
Registration Statement, insofar as such statements constitute a
summary of the legal matters, documents or proceedings referred to
therein, fairly present the information required with respect to such
legal matters, documents and proceedings;
(ix) the execution, delivery and performance of this
Agreement by the Company, the compliance by the Company with all the
provisions hereof and the consummation of the transactions
contemplated hereby will not (A) require any consent, approval,
authorization or other order of, or qualification with, any court or
governmental body or agency (except such as may be required under the
securities or Blue Sky laws of the various states or under applicable
state insurance laws if any person acquires an aggregate of more than
10% of the outstanding Common Stock pursuant to the offering), (B)
conflict with or constitute a breach of any of the terms or provisions
of, or a default under, the charter or by-laws of the Company or any
of its subsidiaries or conflict with or constitute a material breach
of any of the terms or provisions of, or a default under, any
indenture, loan agreement, mortgage, lease or other agreement or
instrument that has been identified as material to the business of the
Company and its subsidiaries by an officer of the Company to such
counsel to which the Company or any of its subsidiaries is a party or
by which the Company or any of its subsidiaries or their respective
property is bound (other than as to whether any such action would
constitute a breach or default with respect to any financial ratios or
representation or warranty relating to the financial condition of the
Company or any of its subsidiaries as to which such counsel need not
express any
<PAGE> 22
opinion) or (C) violate or conflict with, in any material respect, any
applicable U.S. Federal, Illinois or Delaware General Corporation law,
rule, regulation (other than with respect to any state securities or
"blue sky" laws or any insurance regulatory or administrative matters
or tax matters as to which such counsel need not express any opinion),
or any judgment, order or decree of any Illinois court, governmental
body or agency having jurisdiction over the Company, any of its
subsidiaries or their respective property;
(x) such counsel does not know of any legal or governmental
proceedings pending or threatened (other than insurance regulatory or
administrative proceedings, as to which such counsel need not express
any opinion) to which the Company or any of its subsidiaries is a
party or to which any of their respective property is subject that are
required to be described in the Registration Statement or the
Prospectus and are not so described, or of any statutes, regulations,
contracts or other documents that are required to be described in the
Registration Statement or the Prospectus or to be filed as exhibits to
the Registration Statement that are not so described or filed as
required;
(xi) the Company is not and, after giving effect to the
offering and sale of the Additional Shares and the application of the
proceeds thereof as described in the Prospectus, will not be, an
"investment company" as such term is defined in the Investment Company
Act of 1940, as amended;
(xii) except as set forth on Schedule IV hereto, to the best
of such counsel's knowledge, there are no contracts, agreements or
understandings between the Company and any person granting such person
the right to require the Company to file a registration statement
under the Act with respect to any securities of the Company or to
require the Company to include such securities with the Shares
registered pursuant to the Registration Statement;
(xiii) (A) the Registration Statement and the Prospectus and
any supplement or amendment thereto (except for the financial
statements, schedules and other financial and statistical data
included therein as to which no opinion need be expressed) comply as
to form, in all material respects, with the Act, (B) nothing has come
to the attention of such counsel that has caused such counsel to
believe that at the time the Registration Statement became effective,
the Registration Statement (except for the financial statements,
schedules and other financial and statistical data as to which such
counsel need not express any belief) contained any untrue statement of
a material fact or omitted to state a material fact required to be
stated therein or necessary to make the statements therein not
misleading and (C) nothing has come to the attention of such counsel
that has caused such counsel to believe that the Prospectus, as
amended or supplemented, if applicable (except for the financial
statements and other financial and statistical data, as aforesaid)
contains any untrue statement of a material fact or omits to state a
material fact necessary in order to make the statements therein, in
the light of the circumstances under which they were made, not
misleading;
<PAGE> 23
The opinion of Seyfarth, Shaw described in Section 9(f) above shall be
rendered to you at the request of the Company and the Selling Shareholders and
shall so state therein.
(g) You shall have received on the Closing Date an opinion
(satisfactory to you and counsel for the Underwriters), dated the Closing Date,
of Rosenberg & Liebentritt, P.C., counsel for the Selling Shareholders, with
respect to each of the Selling Shareholders other than Bruce A. Esselborn and
Lorraine Esselborn to the effect that:
(i) such Selling Stockholder is the record owner of the
Shares to be sold by such Selling Stockholder pursuant to this
Agreement;
(ii) such Selling Shareholder has full legal right, power
and authority, and all authorization and approval required by law, to
enter into this Agreement and the Power of Attorney of such Selling
Shareholder, as applicable, and to sell, assign, transfer and deliver
the Shares to be sold by such Selling Shareholder in the manner
provided herein and therein;
(iii) this Agreement has been duly authorized, executed and
delivered by or on behalf of each Selling Shareholder;
(iv) the Power of Attorney of each such Selling Shareholder,
as applicable, has been duly authorized, executed and delivered by
such Selling Shareholder and is a valid and binding instrument of such
Selling Shareholder, enforceable in accordance with its terms, and,
pursuant to such Power of Attorney such Selling Shareholder has, among
other things, authorized the Attorneys, or any one of them, to execute
and deliver on such Selling Shareholder's behalf this Agreement and
any other document they, or any one of them, may deem necessary or
desirable in connection with the transactions contemplated hereby and
thereby and to deliver the Shares to be sold by such Selling
Shareholder pursuant to this Agreement;
(v) assuming that the Underwriters purchase the Shares to be
delivered by or on behalf of each of such Selling Shareholders at the
Closing without notice of any adverse claim, as such term is used in
Section 8-303 of the Uniform Commercial Code, upon the delivery of
certificates representing such Shares and payment by the Underwriters
of the purchase price therefor pursuant to the Underwriting Agreement,
the Underwriters will acquire their interest in such Shares, free and
clear of all adverse claims.
(vi) the execution, delivery and performance of this
Agreement and Power of Attorney of each such Selling Shareholder by
such Selling Shareholder, the compliance by such Selling Shareholder
with all the provisions hereof and thereof and the consummation of the
transactions contemplated hereby and thereby will not (A) require any
consent, approval, authorization or other order of, or qualification
with, any court or governmental body or agency (except such as may be
required under the securities or Blue Sky laws of the various
<PAGE> 24
states), (B) conflict with or constitute a breach of any of the terms
or provisions of, or a default under, the organizational documents of
such Selling Shareholder, if such Selling Shareholder is not an
individual, or, to our knowledge, any indenture, loan agreement,
mortgage, lease or other agreement or instrument to which such Selling
Shareholder is a party or by which any property of such Selling
Shareholder is bound or (C) violate or conflict with any applicable
law or any rule, regulation, judgment, order or decree of any court or
any governmental body or agency having jurisdiction over such Selling
Shareholder or any property of such Selling Shareholder, except in the
case of clauses (B) or (C), for such conflicts, breaches, defaults or
violations that, singly or in the aggregate, could not reasonably be
expected to have a material adverse effect on the consummation of the
transactions contemplated hereby or thereby;
and with respect to Bruce A. Esselborn and Lorraine Esselborn, an
opinion to the effect that:
(vii) assuming that the Underwriters purchase the Shares to
be delivered by or on behalf of such Selling Shareholder at the
Closing without notice of any adverse claim, as such term is used in
Section 8-303 of the Uniform Commercial Code, upon the delivery of
certificates representing such Shares and payment by the Underwriters
of the purchase price therefor pursuant to the Underwriting Agreement,
the Underwriters will acquire their interest in such Shares, free and
clear of all adverse claims.
The opinion of Rosenberg & Liebentritt, P.C. described in Section 9(g)
above shall be rendered to you at the request of the Selling Shareholders
and shall so state therein.
(h) You shall have received on the Closing Date an opinion, dated the
Closing Date, of Simpson Thacher & Bartlett, counsel for the Underwriters,
in form and substance satisfactory to you.
In giving such opinions with respect to the matters covered by Section
9(f)(xiv), counsel for the Company and counsel for the Underwriters may
state that their opinion and belief are based upon their participation in
the preparation of the Registration Statement and Prospectus and any
amendments or supplements thereto and review and discussion of the contents
thereof, but are without independent check or verification except as
specified.
(i) You shall have received, on each of the date hereof and the Closing
Date, a letter dated the date hereof or the Closing Date, as the case may
be, in form and substance satisfactory to you, from Deloitte & Touche LLP,
independent public accountants, containing the information and statements
of the type ordinarily included in accountants' "comfort letters" to
Underwriters with respect to the financial statements and certain financial
information contained in the Registration Statement and the Prospectus.
(j) You shall have received, on each of the date hereof and the Closing
Date, a
<PAGE> 25
letter dated the date hereof or the Closing Date, as the case may be, in
form and substance satisfactory to you, from Coopers & Lybrand L.L.P.,
independent public accountants, containing the information and statements
of the type ordinarily included in accountants' "comfort letters" to
Underwriters with respect to the financial statements and certain financial
information contained in the Registration Statement and the Prospectus.
(k) The Company shall have delivered to you the agreements specified in
Section 2 hereof which agreements shall be in full force and effect on the
Closing Date.
(l) The Company and the Selling Shareholders shall not have failed on
or prior to the Closing Date to perform or comply with any of the
agreements herein contained and required to be performed or complied with
by the Company or the Selling Shareholders, as the case may be, on or prior
to the Closing Date.
(m) You shall have received on the Closing Date, a certificate of each
Selling Shareholder who is not a U.S. Person (as defined under applicable
U.S. federal tax legislation) to the effect that such Selling Shareholder
is not a U.S. Person, which certificate may be in the form of a properly
completed and executed United States Treasury Department Form W-8 (or other
applicable form or statement specified by Treasury Department regulations
in lieu thereof).
The several obligations of the Underwriters to purchase any Additional
Shares hereunder are subject to the delivery to you on the applicable Option
Closing Date of such documents as you may reasonably request with respect to the
good standing of the Company, the due authorization and issuance of such
Additional Shares and other matters related to the issuance of such Additional
Shares.
SECTION 10. Effectiveness of Agreement and Termination. This Agreement
shall become effective upon the execution and delivery of this Agreement by the
parties hereto.
This Agreement may be terminated at any time on or prior to the Closing
Date by you by written notice to the Sellers if any of the following has
occurred: (i) any outbreak or escalation of hostilities or other national or
international calamity or crisis or change in economic conditions or in the
financial markets of the United States or elsewhere that, in your judgment, is
material and adverse and, in your judgment, makes it impracticable to market the
Shares on the terms and in the manner contemplated in the Prospectus, (ii) the
suspension or material limitation of trading in securities or other instruments
on the New York Stock Exchange, the American Stock Exchange, the Chicago Board
of Options Exchange, the Chicago Mercantile Exchange, the Chicago Board of Trade
or the Nasdaq National Market or limitation on prices for securities or other
instruments on any such exchange or the Nasdaq National Market, (iii) the
suspension of trading of any securities of the Company on any exchange or in the
over-the-counter market, (iv) the enactment, publication, decree or other
promulgation of any federal or state statute, regulation, rule or order of any
court or other governmental authority which in your opinion materially and
adversely affects, or will materially and adversely affect, the business,
prospects, financial condition or results of operations of the Company and its
subsidiaries, taken as a whole, (v) the declaration of a banking moratorium by
either federal or New York State authorities, (vi) the taking of any action by
any federal, state or local government or agency in respect of its
<PAGE> 26
monetary or fiscal affairs which in your opinion has a material adverse effect
on the financial markets in the United States or (vii) A.M. Best shall have
publicly announced that it has under review, with possible negative
implications, its rating of the claims-paying ability of any Insurance
Subsidiary.
If on the Closing Date or on an Option Closing Date, as the case may
be, any one or more of the Underwriters shall fail or refuse to purchase the
Firm Shares or Additional Shares, as the case may be, which it has or they have
agreed to purchase hereunder on such date and the aggregate number of Firm
Shares or Additional Shares, as the case may be, which such defaulting
Underwriter or Underwriters agreed but failed or refused to purchase is not more
than one-tenth of the total number of Firm Shares or Additional Shares, as the
case may be, to be purchased on such date by all Underwriters, each
non-defaulting Underwriter shall be obligated severally, in the proportion which
the number of Firm Shares set forth opposite its name in Schedule I bears to the
total number of Firm Shares which all the non-defaulting Underwriters have
agreed to purchase, or in such other proportion as you may specify, to purchase
the Firm Shares or Additional Shares, as the case may be, which such defaulting
Underwriter or Underwriters agreed but failed or refused to purchase on such
date; provided that in no event shall the number of Firm Shares or Additional
Shares, as the case may be, which any Underwriter has agreed to purchase
pursuant to Section 2 hereof be increased pursuant to this Section 10 by an
amount in excess of one-ninth of such number of Firm Shares or Additional
Shares, as the case may be, without the written consent of such Underwriter. If
on the Closing Date any Underwriter or Underwriters shall fail or refuse to
purchase Firm Shares and the aggregate number of Firm Shares with respect to
which such default occurs is more than one-tenth of the aggregate number of Firm
Shares to be purchased by all Underwriters and arrangements satisfactory to you,
the Company and the Selling Shareholders for purchase of such Firm Shares are
not made within 48 hours after such default, this Agreement will terminate
without liability on the part of any non-defaulting Underwriter, the Company or
the Selling Shareholders. In any such case which does not result
in termination of this Agreement, either you or the Sellers shall have the right
to postpone the Closing Date, but in no event for longer than seven days, in
order that the required changes, if any, in the Registration Statement and the
Prospectus or any other documents or arrangements may be effected. If, on an
Option Closing Date, any Underwriter or Underwriters shall fail or refuse to
purchase Additional Shares and the aggregate number of Additional Shares with
respect to which such default occurs is more than one-tenth of the aggregate
number of Additional Shares to be purchased on such date, the non-defaulting
Underwriters shall have the option to (i) terminate their obligation hereunder
to purchase such Additional Shares or (ii) purchase not less than the number of
Additional Shares that such non-defaulting Underwriters would have been
obligated to purchase on such date in the absence of such default. Any action
taken under this paragraph shall not relieve any defaulting Underwriter from
liability in respect of any default of any such Underwriter under this
Agreement.
SECTION 11. Agreements of the Selling Shareholders. Each Selling
Shareholder agrees with you and the Company:
(a) To pay or to cause to be paid all transfer taxes payable in
connection with the transfer of the Firm Shares to be sold by such Selling
Shareholder to the Underwriters.
<PAGE> 27
(b) To do and perform all things to be done and performed by such
Selling Shareholder under this Agreement prior to the Closing Date and to
satisfy all conditions precedent to the delivery of the Firm Shares to be sold
by such Selling Shareholder pursuant to this Agreement.
SECTION 12. Miscellaneous. Notices given pursuant to any provision of
this Agreement shall be addressed as follows: (i) if to the Company, to CNA
Surety Corporation, CNA Plaza, Chicago, Illinois 60685, (ii) if to the Selling
Shareholders, to Rod Dammeyer, 2 North Riverside Plaza, Suite 600, Chicago,
Illinois, 60606, and (iii) if to any Underwriter or to you, to you c/o
Donaldson, Lufkin & Jenrette Securities Corporation, 277 Park Avenue, New York,
New York 10172, Attention: Syndicate Department, or in any case to such other
address as the person to be notified may have requested in writing.
The respective indemnities, contribution agreements, representations,
warranties and other statements of the Company, the Selling Shareholders and the
several Underwriters set forth in or made pursuant to this Agreement shall
remain operative and in full force and effect, and will survive delivery of and
payment for the Shares, regardless of (i) any investigation, or statement as to
the results thereof, made by or on behalf of any Underwriter, the officers or
directors of any Underwriter, any person controlling any Underwriter, the
Company, the officers or directors of the Company, any person controlling the
Company, any Selling Shareholder or any person controlling such Selling
Shareholder, (ii) acceptance of the Shares and payment for them hereunder and
(iii) termination of this Agreement.
If the sale of the Shares provided for herein is not consummated
because of the refusal, inability or failure of any Selling Shareholder to
perform its agreements herein, comply with any provision hereof or satisfy any
condition to the obligations of the Underwriters set forth in Section 9 hereof
(in each case, other than by reason of a default by any of the Underwriters),
such defaulting Selling Shareholder agrees, severally and not jointly, to
reimburse the several Underwriters for all out of pocket expenses (including
reasonable fees and disbursements of counsel) incurred by them as a result of
such refusal, inability or failure. If the sale of the Shares provided for
herein is not consummated because of the refusal, inability or failure of the
Company to perform its agreements herein, comply with any provision hereof or
satisfy any condition to the obligations of the Underwriters set forth in
Section 9 hereof (in each case, other than by reason of a default by any of the
Underwriters), the Company agrees, severally and not jointly, to reimburse the
several Underwriters for all out of pocket expenses (including reasonable fees
and disbursements of counsel) incurred by them as a result of such refusal,
inability or failure. Notwithstanding any termination of this Agreement, the
Company shall be liable for all expenses which it has agreed to pay pursuant to
Section 5(i) hereof. Each Selling Shareholder also agrees, severally and not
jointly, to reimburse the several Underwriters, their directors and officers and
any persons controlling any of the Underwriters for all out of pocket expenses
(including reasonable fees and disbursements of counsel) incurred by them in
connection with enforcing their rights hereunder against such Selling
Shareholder (including, without limitation, pursuant to Section 8 hereof). The
Company also agrees to reimburse the several Underwriters, their directors and
officers and any persons controlling any of the Underwriters for all out of
pocket expenses (including reasonable fees and disbursements of counsel)
incurred by them in connection with enforcing their rights hereunder against the
Company (including, without limitation, pursuant to Section 8 hereof).
<PAGE> 28
Except as otherwise provided, this Agreement has been and is made
solely for the benefit of and shall be binding upon the Company, the Selling
Shareholders, the Underwriters, the Underwriters' directors and officers, any
controlling persons referred to herein, the Company's directors and the
Company's officers who sign the Registration Statement and their respective
successors and assigns, all as and to the extent provided in this Agreement, and
no other person shall acquire or have any right under or by virtue of this
Agreement. The term "successors and assigns" shall not include a purchaser of
any of the Shares from any of the several Underwriters merely because of such
purchase.
This Agreement shall be governed and construed in accordance with the
laws of the State of New York.
This Agreement may be signed in various counterparts which together
shall constitute one and the same instrument.
<PAGE> 29
Please confirm that the foregoing correctly sets forth the agreement
among the Company, the Selling Shareholders and the several Underwriters.
Very truly yours,
CNA SURETY CORPORATION
By:_____________________________
Title:
THE SELLING SHAREHOLDERS
NAMED IN SCHEDULE II
HERETO (OTHER THAN ANDA
PARTNERSHIP, LFT
PARTNERSHIP AND THE ANN
AND ROBERT H. LURIE
FAMILY FOUNDATION),
ACTING SEVERALLY
By:_____________________________
Attorney-in-fact
LFT PARTNERSHIP
By:_____________________________
Attorney-in-fact
ANDA PARTNERSHIP
By The Ann Only Trust, a general partner
By The Ann and Descendants Trust, a
general partner
By:_____________________________
Attorney-in-fact
<PAGE> 30
THE ANN AND ROBERT H. LURIE
FAMILY FOUNDATION
By:_____________________________
Attorney-in-fact
DONALDSON, LUFKIN & JENRETTE
SECURITIES CORPORATION
SMITH BARNEY INC.
Acting severally on behalf
of themselves and the
several Underwriters named
in Schedule I hereto
By: DONALDSON, LUFKIN & JENRETTE
SECURITIES CORPORATION
By: ______________________________
<PAGE> 31
SCHEDULE I
<TABLE>
<CAPTION>
Number of Firm Shares
Underwriters Being Sold
<S> <C>
Donaldson, Lufkin & Jenrette Securities Corporation 1,664,576
Smith Barney Inc. 1,664,575
ABN AMRO Chicago Corporation 95,442
Chatsworth Securities, LLC 95,442
Cochran, Caronia & Co., Inc. 95,442
Conning & Company 95,442
Dowling & Partners Securities LLC 95,442
Fox-Pitt, Kelton Incorporated 95,442
Janney Montgomery Scott Inc. 95,442
Keefe, Bruyette & Woods, Inc. 95,442
Kelton International 95,442
-----------
Total 4,188,129
</TABLE>
<PAGE> 32
SCHEDULE II
Selling Shareholders
<TABLE>
<CAPTION>
Number of Firm Shares
Name Being Sold
<S> <C>
Samstock, L.L.C. 1,988,769
Alpha/ZFT General Partnership 578,649
Anda Partnership 498,684
LFT Partnership 486,760
Samuel Zell 65,000
Ann and Robert H. Lurie
Family Foundation 486,760
Bruce and Lorraine Esselborn 83,507
-----------
Total 4,188,129
</TABLE>
<PAGE> 33
SCHEDULE III
Securities issued or issuable pursuant to:
(i) CNA Surety Corporation Non Employee Directors Deferred Compensation
Plan;
(ii) CNA Surety Corporation Replacement Stock Option Plan; and
(iii) CNA Surety Corporation 1997 Long-Term Equity Compensation Plan.
<PAGE> 34
SCHEDULE IV
- - Registration Rights Agreement, dated as of September 30, 1996, between CNA
Surety Corporation and Equity Capsure Limited Partnership
- - Restricted Stock and Registration Rights Agreement, dated as of September
22, 1994, by and between Capsure Financial Group, Inc., Capsure Holdings
Corp. and John Knox, Jr.
<PAGE> 35
Annex I
Continental Casualty Company
National Fire Insurance Company of Hartford
American Casualty Company of Reading, Pennsylvania
Fireman's Insurance Company of Newark, New Jersey
Continental Insurance Company
CNA Surety Corporation
Samstock, L.L.C.
Alpha/ZFT General Partnership
Anda Partnership
LFT Partnership
Samuel Zell
The Ann and Robert H. Lurie
Family Foundation
Bruce A. Esselborn
David T. Cumming
Melvin Gray
Joe P. Kirby
Roy Posner
Adrian M. Tocklin
Mark C. Vonnahme
Robert E. Ayo
Dan L. Kirby
Stephen T. Pate
John S. Heneghan
Giorgio Balzer
Philip H. Britt
Rod F. Dammeyer
Robert T. Van Gieson
William Pate
Michael Dougherty
Melita Geoghegan
Thomas P. Greasel
Paul T. Lively
John L. McReynolds
Thomas A. Pottle
Sharon A. Sartori
<PAGE> 1
346-8000
July 9, 1998
CNA Surety Corporation
CNA Plaza
13th Floor
Chicago, Illinois 60685
Re: CNA Surety Corporation
Registration Statement on Form S-1
Registration No. 333-56063
(the "Registration Statement"
Ladies and Gentlemen:
We have acted as special counsel to CNA Surety Corporation, a Delaware
corporation (the "Company"), in connection with the preparation of the
above-referenced Registration Statement. The Registration Statement relates to
the registration under the Securities Act of 1933, as amended (the "Act"), of
4,188,129 shares of the Company's common stock, par value $.01 per share (the
"Shares") offered for sale by certain stockholders of the Company (the "Selling
Stockholders"), and the 628,219 shares of the Company's common stock, par value
$.01 per share, to be issued upon execution of the Underwriters' over-allotment
option (the "Option Shares"), to be issued and sold pursuant to the
Underwriting Agreement to be entered into by and among the Company, the Selling
Stockholders and Donaldson, Lufkin & Jenrette Securities Corporation.
Capitalized terms used herein and not otherwise defined have the meanings given
to them in the Registration Statement.
In connection with this opinion, we have examined originals or copies,
certified or otherwise identified to our satisfaction, of (i) the Company's
Amended and Restated Certificate of Incorporation, and By-laws, (ii) certain
resolutions of the Company's Board of Directors relating to the Offering, (iii)
the Registration Statement, and (iv) such other documents as we have deemed
necessary or appropriate in connection with the opinion set forth below. In such
examination, we have assumed the genuineness of all signatures, the legal
capacity of natural persons, the authenticity of all documents submitted to us
as originals, the conformity to
<PAGE> 2
CNA Surety Corporation
July 9, 1998
Page 2
original documents of all documents submitted to us as certified or photostatic
copies and the authenticity of the originals of such latter documents. As to any
facts material to this opinion which we did not independently establish or
verify, we have relied upon statements and representations of officers and other
representatives of the Company and others.
We do not express herein any opinion concerning any law other than the
corporate law of the State of Delaware and applicable federal law.
Based upon and subject to the foregoing, we are of the opinion that (1)
the Shares have been duly and validly issued and are fully paid and
nonassessable; and (2) the Option Shares have been duly and validly authorized
and, when issued and sold pursuant to the Underwriting Agreement, will be duly
and validly issued, fully paid and nonassessable.
This opinion is furnished to you solely for your benefit in connection
with the filing of the Registration Statement and is not to be used, circulated,
quoted or otherwise referred to for any other purpose without our prior written
consent. Notwithstanding the foregoing, we hereby consent to the filing of this
opinion with the Securities and Exchange Commission as Exhibit 5 to the
Registration Statement. We also consent to the reference to our firm under the
caption "Legal Matters" in the Registration Statement. In giving this consent,
we do not thereby admit that we are included in the category of persons whose
consent is required under Section 7 of the Act or the rules and regulations of
the Securities and Exchange Commission.
Very truly yours,
/s/ SEYFARTH, SHAW, FAIRWEATHER
& GERALDSON
DSS/MEB
<PAGE> 1
EXHIBIT 23 (1)
INDEPENDENT AUDITORS' CONSENT
We consent to the use in this Registration Statement of CNA Surety
Corporation on Form S-1 of our report dated February 27, 1998, appearing in the
Prospectus, which is part of this Registration Statement, on our audit of the
consolidated balance sheet of CNA Surety Corporation and subsidiaries as of
December 31, 1997 and the related consolidated statements of income,
stockholders' equity, and cash flows from September 30, 1997 (date of
inception) through December 31, 1997, and the related financial statement
schedules, as well as the special-purpose statement of certain assets and
liabilities of CCC Surety Operations, a business unit of CNA Financial
Corporation, as of December 31, 1996 and the special-purpose statements of
certain revenues and direct operating expenses for each of the two years in the
period ended December 31, 1996 and for the nine month period ended September
30, 1997. Our report on the foregoing special-purpose financial statements
expresses an unqualified opinion and includes an explanatory paragraph relating
to the basis of presentation.
We also consent to the reference to us under the heading "Experts" in such
Prospectus.
DELOITTE & TOUCHE LLP
Chicago, Illinois
July 9, 1998
<PAGE> 1
Exhibit 23(3)
CONSENT OF INDEPENDENT ACCOUNTANTS
We consent to the inclusion in this registration statement of CNA Surety
Corporation on Form S-1 (File No. 333-56063) of our report dated February 20,
1997, on our audits of the consolidated financial statements and financial
statement schedules of Capsure Holdings Corp. and Subsidiaries as of December
31, 1996 and 1995, and for the years ended December 31, 1996, 1995, and 1994.
We also consent to the reference to our firm under the caption "Experts."
PricewaterhouseCoopers LLP
Chicago, Illinois
July 8, 1998
