<PAGE> 1
FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended SEPTEMBER 30, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission file number: 1-13277
CNA SURETY CORPORATION
(Exact name of Registrant as specified in its Charter)
DELAWARE 36-4144905
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
CNA PLAZA, CHICAGO, ILLINOIS 60685
(Address of principal executive offices) (Zip Code)
(312) 822-5000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
--- ---
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
44,085,838 shares of Common Stock, $.01 par value as of November 5 , 1998.
<PAGE> 2
CNA SURETY CORPORATION AND SUBSIDIARIES
INDEX
<TABLE>
<CAPTION>
Page
Part I. Financial Information (Unaudited):
<S> <C>
Item 1. Condensed Consolidated Financial Statements:
Independent Accountants' Report................................................................ 3
Condensed Consolidated Balance Sheets at September 30, 1998 and
at December 31, 1997........................................................................... 4
Condensed Consolidated Statements of Income for the Periods Ended
September 30, 1998 and Condensed Statements of Certain Revenues and
Direct Operating Expenses of Predecessor for the Periods Ended
September 30, 1997............................................................................. 5
Condensed Consolidated Statement of Stockholders' Equity....................................... 6
Condensed Consolidated Statement of Cash Flows for the Nine Months Ended
September 30, 1998............................................................................. 7
Notes to Condensed Consolidated Financial Statements at September 30, 1998 .................... 8
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations and the Condensed Statement of Certain Revenues and Direct
Operating Expenses of Predecessor ............................................................. 12
Part II. Other Information:
Item 1. Legal Proceedings.............................................................................. 24
Item 2. Changes in the Rights of the Company's Security Holders........................................ 24
Item 3. Defaults Upon Senior Securities................................................................ 24
Item 4. Submission of Matters to a Vote of Security Holders............................................ 24
Item 5. Other Information.............................................................................. 24
Item 6. Exhibits and Reports on Form 8-K .............................................................. 24
</TABLE>
2
<PAGE> 3
INDEPENDENT ACCOUNTANTS' REPORT
To the Board of Directors and Stockholders of
CNA Surety Corporation
Chicago, Illinois
We have reviewed the accompanying condensed consolidated balance sheet of CNA
Surety Corporation and subsidiaries as of September 30, 1998 and the related
condensed consolidated statements of income for the three- and nine-month
periods ended September 30, 1998 and related condensed consolidated statements
of stockholders' equity and cash flows for the nine-month period ended September
30, 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-
and nine-month periods ended September 30, 1997. These financial statements are
the responsibility of the Company'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.
We have previously audited, in accordance with generally accepted auditing
standards, 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 (not presented herein). In our report dated
February 27, 1998, we expressed an unqualified opinion on those consolidated
financial statements. In our opinion, the information set forth in the condensed
consolidated balance sheet as of December 31, 1997 is fairly stated, in all
material respects, in relation to the consolidated balance sheet from which it
has been derived.
Deloitte & Touche LLP
Chicago, Illinois
November 11, 1998
3
<PAGE> 4
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
(Unaudited)
September 30, December 31,
1998 1997
------------- ------------
ASSETS
<S> <C> <C>
Invested assets and cash:
Fixed income securities, at fair value (amortized cost: $422,821
and $265,545).................................................................. $ 432,964 $ 266,301
Short-term investments, at cost (which approximates fair value)..................... 46,807 147,235
Other investments, at fair value.................................................... 5,624 6,001
Cash ............................................................................... 1,569 130
------------- -------------
486,964 419,667
Deferred policy acquisition costs.................................................... 72,446 64,144
Insurance receivables:
Premiums............................................................................ 9,386 9,683
Reinsurance, including receivable from affiliates of $62,642 at
September 30, 1998 and $47,856 at December 31, 1997................................. 70,125 55,151
Intangible assets, net of accumulated amortization................................... 157,537 161,962
Prepaid reinsurance premiums......................................................... 2,363 2,101
Other assets......................................................................... 16,432 12,423
------------- -------------
Total assets................................................................... $ 815,253 $ 725,131
============= =============
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses.......................................... $ 146,581 $ 130,381
Unearned premiums................................................................... 185,061 171,787
------------- -------------
331,642 302,168
Long-term debt....................................................................... 118,000 118,000
Deferred income taxes, net........................................................... 8,134 --
Payable for securities purchased..................................................... 15,325 10,609
Other liabilities.................................................................... 38,631 37,622
------------- -------------
Total liabilities.............................................................. 511,732 468,399
------------- -------------
Commitments and contingencies (Note 5)
STOCKHOLDERS' EQUITY
Preferred stock, par value $.01 per share, 20,000 shares authorized;
none issued and outstanding......................................................... -- --
Common stock, par value $.01 per share, 100,000 shares authorized;
44,086 and 43,320 shares issued and outstanding at September 30, 1998
and at December 31, 1997, respectively.............................................. 253,620 245,262
Retained earnings.................................................................... 43,450 10,996
Accumulated other comprehensive income............................................... 6,451 474
------------- -------------
Total stockholders' equity..................................................... 303,521 256,732
------------- -------------
Total liabilities and stockholders' equity..................................... $ 815,253 $ 725,131
============= =============
</TABLE>
The accompanying notes are an integral part of these financial statements.
4
<PAGE> 5
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND CONDENSED STATEMENTS OF
CERTAIN REVENUES AND DIRECT OPERATING EXPENSES OF PREDECESSOR
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
1998 1997 1998 1997
--------- ----------- -------- ---------
(Predecessor) (Predecessor)
<S> <C> <C> <C> <C>
Revenues:
Net earned premiums ........................................................ $ 69,781 $ 38,580 $ 191,804 $ 108,564
Net investment income ...................................................... 5,366 -- 18,232 --
Net realized investment gains .............................................. 178 -- 222 --
--------- --------- --------- ---------
75,325 38,580 210,258 108,564
Expenses:
Net losses and loss adjustment expenses .................................... 12,552 8,222 34,328 (11,516)
Net commissions, brokerage and
other underwriting expenses .......................................... 40,944 20,004 113,712 59,674
Interest expense ........................................................... 1,847 -- 5,505 --
Amortization of intangible assets .......................................... 1,475 -- 4,425 --
--------- --------- --------- ---------
56,818 28,226 157,970 48,158
--------- --------- --------- ---------
Income before income taxes (Excess of net earned premiums over direct operating
expenses, before income taxes, for Predecessor) ............................ 18,507 10,354 52,288 60,406
Income taxes .................................................................. 7,025 3,657 19,834 21,241
--------- --------- --------- ---------
Net income (Excess of net earned premiums
over direct operating expenses, net of
income taxes, for Predecessor) ............................................. $ 11,482 $ 6,697 $ 32,454 $ 39,165
========= ========= ========= =========
Basic net income per share .................................................... $ 0.26 $ 0.74
========= =========
Diluted net income per share .................................................. $ 0.26 $ 0.74
========= =========
Basic weighted average shares outstanding ..................................... 44,033 43,598
========= =========
Diluted weighted average shares outstanding ................................... 44,155 43,764
========= =========
</TABLE>
The accompanying notes are an integral part of these financial statements.
5
<PAGE> 6
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
Accumulated
Other Total
Common Comprehensive Retained Comprehensive Stockholders'
Stock Income Earnings Income Equity
----- ------------- -------- ------------- -------------
<S> <C> <C> <C> <C> <C>
Balance, January 1, 1998 ........ $245,262 $ 10,996 $ 474 $ 256,732
Comprehensive income:
Net income $ 32,454 32,454 32,454
Unrealized gains on securities
(after income taxes), net
of reclassification adjustment
of $121 ...................... 5,977 5,977 5,977
--------
Comprehensive income ............ $ 38,431
========
Issuance of common stock ........ 7,532 7,532
Stock options exercised ......... 826 826
-------- -------- -------- --------
Balance, September 30, 1998 ..... $253,620 $ 43,450 $ 6,451 $303,521
======== ======== ======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
6
<PAGE> 7
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
Nine Months
Ended
September 30,
1998
-------------
<S> <C>
OPERATING ACTIVITIES:
Net income................................................................... $ 32,454
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation and amortization............................................. 5,869
Amortization of bond premium, net......................................... 1,455
Net realized investment gains............................................. (222)
Changes in:
Insurance receivables..................................................... (14,677)
Reserve for unearned premiums............................................. 11,225
Reserve for unpaid losses and loss adjustment expenses.................... 16,200
Deferred policy acquisition costs......................................... (8,302)
Deferred income taxes, net................................................ 4,762
Other assets and liabilities.............................................. 445
--------------
Net cash provided by operating activities....................................... 49,209
--------------
INVESTING ACTIVITIES:
Securities available-for-sale:
Purchases - fixed income securities....................................... (237,149)
Maturities - fixed income securities...................................... 40,464
Sales - fixed income securities........................................... 42,895
Change in short-term investments............................................. 100,428
Other, net................................................................... (2,419)
--------------
Net cash used in investing activities........................................... (55,781)
--------------
FINANCING ACTIVITIES:
Issuance of common stock..................................................... 7,532
Stock options exercised ..................................................... 479
--------------
Net cash provided by financing activities....................................... 8,011
--------------
Increase in cash................................................................ 1,439
Cash at beginning of period..................................................... 130
--------------
Cash at end of period........................................................... $ 1,569
==============
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest.................................................................. $ 5,415
Income taxes.............................................................. $ 12,500
</TABLE>
The accompanying notes are an integral part of these financial statements.
7
<PAGE> 8
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1998
(UNAUDITED)
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. 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. 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.
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 periods ended September 30, 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 such 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.
8
<PAGE> 9
Since the accompanying Predecessor financial statements exclude certain
revenues and expenses, as described in the preceding paragraph, these financial
statements are not intended to be a complete presentation of CCC Surety
Operations. The revenues and costs that are reflected in the accompanying
financial statements 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.
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>
<CAPTION>
<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>
9
<PAGE> 10
Unaudited Pro Forma Results
The following table of unaudited pro forma information includes the surety
business of CNAF subsidiaries, Western Surety and USA as if these businesses,
which were merged on September 30, 1997; had been combined for all of 1997. This
unaudited pro forma financial information gives effect to the following: (i)
consummation of the Merger and the related transactions and the contribution of
capital to and the incurrence of additional debt by CNA Surety; (ii) purchase
accounting adjustments to reflect Capsure's assets and liabilities at fair
value; (iii) estimated indirect and overhead expenses for the CCC Surety
Operations; and (iv) estimated interest expense related to the additional debt
(dollars in thousands, except per share data):
<TABLE>
<CAPTION>
(Unaudited) (Unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
1997 1997
---------- ------------
<S> <C> <C>
Revenues............................................... $ 65,596 $ 187,398
Net income............................................. $ (13,432) $ 23,379
Basic net income per share............................. $ (0.31) $ 0.54
</TABLE>
The foregoing unaudited pro forma operating results for the nine month
period include $35.0 million ($22.8 million net of income taxes or $0.53 per
share) of favorable loss reserve development of Predecessor. Net income per
share for the pro forma periods of 1997 also include 51 cents per share in
non-recurring merger costs.
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 amortized cost and fair value of fixed income securities held
by CNA Surety at September 30, 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..................... $ 139,079 $ 3,897 $ (97) $ 142,879
Obligations of states and political subdivisions............ 152,860 3,308 (49) 156,119
Corporate bonds............................................. 77,848 2,487 (70) 80,265
Non-agency collateralized mortgage obligations.............. 21,809 92 (32) 21,869
Asset-backed securities..................................... 31,225 608 (1) 31,832
------------ ----------- ----------- -------------
Total fixed income securities......................... $ 422,821 $ 10,392 $ (249) $ 432,964
============ =========== =========== =============
</TABLE>
10
<PAGE> 11
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>
Nine Months Ended September 30,
-------------------------------
1998 1997
------------------------- --------------------------
Written Earned Written Earned
----------- ----------- ----------- ------------
(Predecessor)
<S> <C> <C> <C> <C>
Direct........................................................ $ 80,495 $ 76,699 $ 114,969 $ 112,751
Assumed from affiliates....................................... 130,381 120,902 -- --
Assumed from non-affiliates................................... -- -- 1,106 2,034
Ceded......................................................... (6,060) (5,797) (7,445) (6,221)
----------- ----------- ----------- -----------
$ 204,816 $ 191,804 $ 108,630 $ 108,564
=========== =========== =========== ===========
</TABLE>
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>
Nine Months Ended
September 30,
-----------------
1998 1997
----------- -----------
(Predecessor)
<S> <C> <C>
Gross loss and loss adjustment expense....................... $ 39,497 $ (7,265)
Ceded amounts................................................ (5,169) (4,251)
----------- -----------
Net loss and loss adjustment expense......................... $ 34,328 $ (11,516)
=========== ===========
</TABLE>
5. 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.
11
<PAGE> 12
CNA SURETY CORPORATION AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS OF CNA SURETY CORPORATION AND CONDENSED STATEMENT OF
CERTAIN REVENUES AND DIRECT OPERATING EXPENSES OF PREDECESSOR
SEPTEMBER 30, 1998
GENERAL
The following is a discussion and analysis of CNA Surety Corporation ("CNA
Surety" or the "Company") and its insurance subsidiaries' operating results,
financial condition, liquidity and capital resources as well as a discussion of
CCC Surety Operations' ("Predecessor") Condensed Statement of Certain Revenues
and Direct Operating Expenses. This discussion should be read in conjunction
with the Condensed Consolidated Financial Statements of CNA Surety and notes
thereto and the Condensed Statement of Certain Revenues and Direct Operating
Expenses and the related notes thereto of CCC Surety Operations.
FORMATION OF CNA SURETY CORPORATION AND MERGER
In December 1996, CNA Financial Corporation ("CNAF") and Capsure Holdings
Corp. ("Capsure") agreed to merge (the "Merger") the surety business of CNAF
with Capsure's insurance subsidiaries, Western Surety Company ("Western Surety")
and Universal Surety of America ("USA"), which are owned by a newly-formed
holding company, CNA Surety Corporation. CNAF, through its operating
subsidiaries, writes multiple lines of property and casualty insurance,
including surety business that is reinsured by Western Surety. 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. 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.
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.
12
<PAGE> 13
BUSINESS
CNA Surety's insurance subsidiaries write surety and fidelity bonds in all
50 states through a combined network of approximately 36,000 independent
agencies. CNA Surety's 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 23 states. USA
specializes in the underwriting of small contract and commercial surety bonds.
USA is licensed in 42 states and the District of Columbia with most of its
business generated in Texas.
"SAFE HARBOR" STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF
1995
The statements which are not historical facts contained in this Form 10-Q
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 CCC Surety Operations with Western Surety and
USA, 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 and no
assurance can be given that the actual results of operations and financial
condition will conform to forward-looking statements herein. Undue reliance
should not be placed upon 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.
RESULTS OF OPERATIONS
CNA SURETY RESULTS FOR THIRD QUARTER 1998 COMPARED TO PREDECESSOR THIRD
QUARTER 1997
As set forth in Note 1 to the Condensed Consolidated Financial Statements,
the results of operations of the Predecessor did not reflect investment income
and investment gains and losses. Additionally, certain general and
administrative expenses, which were indirect or overhead in nature, were not
allocated to the Predecessor by CNAF or its subsidiaries. As a result of these
factors and because the Merger with Capsure significantly affected the combined
organization, it is not useful to compare CNA Surety operations to Predecessor
operations.
Accordingly, the remainder of this discussion and analysis is formatted to
compare information for CNA Surety's three- and nine-month periods ended
September 30, 1998 to the comparable periods of
13
<PAGE> 14
1997 as if these businesses, which were merged on September 30, 1997, had been
combined for all of 1997. The results for the periods ended September 30, 1997
that were determined on this basis are therefore marked pro forma. This
unaudited pro forma financial information gives effect to the following: (i)
consummation of the Merger and the related transactions and the contribution of
capital to and the incurrence of additional debt by CNA Surety; (ii) purchase
accounting adjustments to reflect Capsure's assets and liabilities at fair
value; (iii) estimated indirect and overhead expenses for the CCC Surety
Operations; and (iv) estimated interest expense related to the additional debt.
The unaudited pro forma financial information does not include the estimated net
investment income resulting from investment of Merger-related cash flows,
including (i) the $50 million debt proceeds, (ii) the $52.25 million capital
contribution from CCC, and (iii) collection of the receivable from CCC.
ANALYSIS OF CNA SURETY'S RESULTS FOR THE THREE- AND NINE-MONTHS ENDED
SEPTEMBER 30, 1998 AND 1997
The components of income for the Company for each period are summarized as
follows (dollars in thousands, except per share data):
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
1998 1997 1998 1997
---- ---- ---- ----
(Pro Forma) (Pro Forma)
<S> <C> <C> <C> <C>
Total revenues ........................................ $ 75,325 $ 65,596 $ 210,258 $ 187,398
========= ========= ========= =========
Underwriting income (1) ............................... $ 16,285 $ 13,935 $ 43,764 $ 72,060
Net investment income ................................. 5,366 2,844 18,232 8,768
Net investment gains .................................. 178 2 222 638
Interest expense ...................................... 1,847 1,836 5,505 5,401
Non-recurring charges and merger costs (2) ............ -- 12,087 -- 12,087
Amortization of intangible assets ..................... 1,475 1,447 4,425 4,341
--------- --------- --------- ---------
Income before income taxes ............................ 18,507 1,411 52,288 59,637
Income taxes (2) ...................................... 7,025 14,843 19,834 36,258
--------- --------- --------- ---------
Net Income ............................................ $ 11,482 $ (13,432) $ 32,454 $ 23,379
========= ========= ========= =========
Basic net income per share ............................ $ 0.26 $ (0.31) $ 0.74 $ 0.54
--------- --------- --------- ---------
</TABLE>
(1) Includes $0.3 million and $1.5 million of favorable reserve development
for the three months ended September 30, 1998 and 1997, respectively.
For the nine months ended September 30, 1998 and 1997, favorable
reserve development was $1.9 million and $40.2 million ($35.0 million
was related to Predecessor and was principally related to accident
years prior to 1996), respectively.
(2) The Company incurred $22.0 million, after applicable income taxes, or
$0.51 per share in non-recurring merger costs. Such costs include
adjustments to the provision for income taxes to reflect the effects of
limitations placed on the Company's ability to utilize Capsure's
available net operating tax loss carry forwards.
14
<PAGE> 15
Insurance Underwriting
Underwriting results for the Company are summarized in the following table
(dollars in thousands):
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------- -----------------------------
1998 1997 1998 1997
-------- -------- --------- --------
(Pro Forma) (Pro Forma)
<S> <C> <C> <C> <C>
Gross written premium ..................... $ 71,883 $ 67,593 $ 210,876 $ 193,663
======== ======== ========== ==========
Net written premiums ...................... $ 69,871 $ 63,947 $ 204,816 $ 183,078
======== ======== ========== ==========
Net earned premiums ....................... $ 69,781 $ 62,750 $ 191,804 $ 177,992
Net losses and loss adjustment
expenses (1)............................. 12,552 10,093 34,328 (6,486)
Net commissions, brokerage and other ...... 40,944 38,722 113,712 112,418
-------- -------- ---------- ----------
Underwriting income........................ $ 16,285 $ 13,935 $ 43,764 $ 72,060
======== ======== ========== ==========
Loss ratio(1) ............................. 18.0% 16.1% 17.9% (3.6)%
Expense ratio ............................. 58.7 61.7 59.3 63.2
-------- -------- ---------- ----------
Combined ratio(1).......................... 76.7% 77.8% 77.2% 59.6%
======== ======== ========== ==========
</TABLE>
(1)Includes $0.3 million and $1.5 million of favorable reserve development
for the three months ended September 30, 1998 and 1997, respectively.
For the nine months ended September 30, 1998 and 1997, favorable
reserve development was $1.9 million and $40.2 million ($35.0 million
was related to Predecessor and was principally related to accident
years prior to 1996), respectively.
Premiums Written
Gross written premiums are shown in the table below (dollars in thousands):
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------- ---------------------
1998 1997 1998 1997
---------- --------- ---------- ----------
(Pro Forma) (Pro Forma)
<S> <C> <C> <C> <C>
Contract................................................ $ 36,718 $ 34,828 $ 99,804 $ 93,678
Commercial.............................................. 29,316 27,076 91,993 81,882
Fidelity................................................ 4,349 4,354 13,347 13,087
E&O and other........................................... 1,500 1,335 5,732 5,016
---------- --------- ---------- ----------
$ 71,883 $ 67,593 $ 210,876 $ 193,663
========== ========= ========== ==========
</TABLE>
Gross written premiums increased 6.3%, or $4.3 million, for the three
months ended September 30, 1998 compared to the pro forma third quarter of 1997.
Commercial surety gross written premiums were up 8.3%, or $2.2 million, in the
third quarter of 1998 compared to the pro forma third quarter of 1997. The
increase in commercial surety premium was largely due to the Company's
international expansion which began in 1997. The Company assumed an additional
$2.5 million of international surety and credit premium
15
<PAGE> 16
in the third quarter of 1998 under a quota share reinsurance treaty with CNA
Reinsurance Company Limited (London), an affiliate of CCC. Excluding the
international surety and credit business, commercial surety gross written
premiums decreased by 1.0% compared to the pro forma third quarter of 1997. The
contract business increased by 5.4%, or $1.9 million, over third quarter 1997
results. The increase in the contract surety segment was driven primarily by
premium growth from the larger contractor segment. The fidelity and other
business increased 2.8% in the third quarter of 1998 to $5.8 million.
Gross written premiums for the first nine months of 1998 increased 8.9%, or
$17.2 million, compared to the pro forma period in 1997. Commercial surety and
contract surety gross written premiums increased 12.3% and 6.5%, respectively,
for the first nine months of 1998. The increase in commercial surety includes
the addition of $7.5 million of assumed international surety and credit
business.
Net written premiums are shown in the table below (dollars in thousands):
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
------------------ -----------------
1998 1997 1998 1997
---- ---- ---- ----
(Pro Forma) (Pro Forma)
<S> <C> <C> <C> <C>
Contract................................................ $ 35,218 $ 33,794 $ 95,550 $ 90,288
Commercial.............................................. 29,262 24,885 91,723 76,084
Fidelity................................................ 4,339 4,349 13,307 13,054
E&O and other ......................................... 1,052 919 4,236 3,652
-------- -------- --------- ---------
$ 69,871 $ 63,947 $ 204,816 $ 183,078
======== ======== ========= =========
</TABLE>
For the three months ended September 30, 1998, net written premiums
increased 9.3%, or $5.9 million, over the comparable period in 1997. The
increase in net written premiums was attributable to the aforementioned changes
in gross written premiums, as well as the effects of increased net retentions of
commercial surety risks effective October 1, 1997. Excluding $2.5 million in
international surety and credit business, net written premiums increased 5.4%
for the three months ended September 30, 1998. Net written premiums of the
commercial surety segment, including international surety and credit business,
were up 17.6% in the third quarter of 1998. Net written premiums for contract
surety increased 4.2%, or $1.4 million, for the third quarter of 1998. Net
written premiums for fidelity and other lines increased 2.3% for the quarter to
$5.4 million.
For the first nine months of 1998, net written premiums increased 11.9%, or
$21.7 million, over the comparable pro forma period with commercial surety and
contract surety up 20.6% and 5.8%, respectively. The increase in commercial
surety includes $7.5 million of assumed international surety and credit
business.
Underwriting Income
Underwriting income was $16.3 million for the three months ended September
30, 1998 up $2.4 million, or 16.9%, over the comparable pro forma period of
1997. Underwriting income was $43.8 million for the nine months ended September
30, 1998 compared to $72.1 million for the pro forma nine months ended September
30, 1997. The pro forma 1997 nine months results include a significant amount of
favorable loss reserve development as more fully described below.
16
<PAGE> 17
Loss Ratio
The loss ratio for the third quarter 1998 was 18.0% compared to 16.1% for
the pro forma third quarter of 1997. Excluding the impact of the favorable
reserve development of $0.3 million and $1.5 million in the third quarter of
1998 and 1997, respectively, the loss ratios would have been 18.4% and 18.5%,
respectively For the nine months ended September 30, 1998, the loss ratio was
17.9% compared to (3.6%) on a pro forma basis for the same period in 1997. The
pro forma nine months results include $35.0 million favorable reserve
development related to the Predecessor. Excluding the impact of all favorable
reserve development of $1.9 million and $40.2 million ($35.0 million was related
to Predecessor and was principally related to accident years prior to 1996) for
the nine months periods ended September 30, 1998 and 1997, respectively, the
loss ratio would have been 18.9% for both periods.
Expense Ratio
The expense ratio decreased to 58.7% in the third quarter of 1998 compared
to 61.7% in the pro forma third quarter of 1997. For the nine months ended
September 30, 1998 the expense ratio decreased to 59.3% from 63.2% for the pro
forma in 1997 due to a 7.8% increase in net earned premiums along with a modest
1.2% increase in operating expenses.
Investment Income
Net investment income for the three months ended September 30, 1998 and the
comparable pro forma period ended September 30, 1997 was $5.4 million and $2.8
million, respectively. The average pretax yields of the portfolio for the three
months ended September 30, 1998 and 1997 were 4.7% and 7.1% respectively. Net
investment income for the nine months ended September 30, 1998 and 1997 was
$18.2 million and $8.8 million, respectively. The average pretax yield was 5.5%
for the nine months ended September 30, 1998 compared to 7.1% for the pro forma
period in 1997.
The decline in investment yields in 1998 compared to 1997 primarily relates
to a higher proportion of the portfolio being invested in tax exempt securities
during 1998 and a general decline in interest rates since January 1, 1997. The
increases in investment income in 1998 are the direct result of higher invested
cash balances in 1998 which reflects the investment of Merger-related cash
flows. However, pro forma investment income for the pro forma periods of 1997
does not include any estimate of net investment income resulting from investment
of Merger-related cash flows, including (i) the $50 million debt proceeds, (ii)
the $52.25 million capital contribution from CCC, and (iii) collection of the
receivable from CCC. Investment earnings are an integral part of an insurance
entity's operations. If proceeds from these sources of funds were assumed to be
invested in high-quality, taxable fixed income securities with an average
duration of approximately 3 years, yielding 6.4%, net investment income would
increase approximately $3.9 million ($2.5 million net of income taxes, or $0.06
in pro forma earnings per share) for the three months ended September 30, 1997.
For the nine months ended September 30, 1997, investment income would increase
$11.3 million ($7.3 million net of income taxes or $0.17 in pro forma earnings
per share).
Analysis of Other Operations
Amortization of intangible assets for the third quarter of 1998 and the pro
forma third quarter ended September 30, 1997 was $1.5 million and $1.4 million,
respectively. For the nine months ended September 30, 1998 and 1997,
amortization of intangibles was $4.4 million and $4.3 million, respectively.
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.
17
<PAGE> 18
Intangible assets are generally amortized over 30 years.
Interest expense for the third quarter of 1998 increased 0.6% compared to
the pro forma third quarter of 1997. The weighted average interest rate was 5.9%
in both periods. Interest expense for the nine months ended September 30, 1998
increased 1.9% compared to the pro forma nine months ended September 30, 1997.
The weighted average interest rate was 5.9% for the nine months ended September
30, 1998 and 1997.
Capsure incurred $22.0 million, after applicable income taxes, or $0.51 per
share, in non-recurring merger costs in 1997. Such costs include adjustments to
the provision for income taxes to reflect the effects of limitations placed on
the Company's ability to utilize Capsure's available net operating tax loss
carry forwards ("NOLs").
Income Taxes
Income tax expense was $7.0 million for the third quarter ended September
30, 1998 compared to $14.8 million for the pro forma third quarter of 1997
Income tax expense was $19.8 million and $36.3 million for the nine months ended
September 30, 1998 and the proforma nine months ended September 30, 1997,
respectively. The effective income tax rates for the nine months ended September
30, 1998 and 1997 were 37.9% and 60.8%, respectively. The effective rate for the
nine months ended September 30, 1997 reflects the effects of limitations placed
on the Company's ability to utilize Capsure's available NOLs to offset future
taxable income.
LIQUIDITY AND CAPITAL RESOURCES
It is anticipated that the liquidity requirements of CNA Surety will be met
primarily by funds generated from operations. The principal cash flow sources
are premiums, investment income, and sales and maturities of investments. In
general, surety operations generate premium collections from customers in
advance of cash outlays for claims. Premiums are invested until such time as
funds are required to pay claims and claims adjusting expenses. CNA Surety also
may generate funds from additional borrowings under the credit facility
described below. The primary cash flow uses are payments for claims, operating
expenses, debt service on the credit facility, as well as dividends, if any, to
CNA Surety stockholders. On May 19, 1998, the CNA Surety Board of Directors
adopted a dividend policy under which the Company intends to pay a quarterly
dividend beginning in the fourth quarter of 1998. Although not yet declared, the
Company currently expects that the initial quarterly dividend will be 8 cents
per share.
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 September 30, 1998, the carrying value of the Company's
insurance subsidiaries invested assets and cash was $467.8 million.
Cash flow at the parent company level is derived principally from dividend
and tax sharing payments from its insurance subsidiaries. The principal
obligations at the parent company level are to service debt and pay operating
expenses. At September 30, 1998, the parent company's invested assets and cash
were $19.2 million.
The Company's consolidated net cash flow provided by operating activities
was $49.2 million for the nine months ended September 30, 1998.
18
<PAGE> 19
CNA Surety's bank borrowings are under a five-year unsecured revolving
credit facility (the "Credit Facility") that provides for borrowings 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 nine 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 September 30, 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 September 30, 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
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 only includes the results of the CCC Surety Operations for the period from
September 30, 1997 (date of inception) through December 31, 1997. Dividend
capacity for 1999 will be based on statutory surplus and income at and for the
year ended December 31, 1998 which will include the effects of the CCC Surety
Operations for all of 1998. Without prior regulatory approval in 1998, CNA
Surety's insurance subsidiaries may pay dividends to the Company of $16.3
million in the aggregate. CNA Surety received $4.4 million in dividends from its
insurance subsidiaries for the nine month period ended September 30, 1998.
Because the CCC Surety 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 CCC Surety Operations cannot be determined for years prior to the Merger.
19
<PAGE> 20
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 $19.8 million for the nine month
period ended September 30, 1998.
At September 30, 1998, the insurance subsidiaries had combined
policyholders' surplus of approximately $158.1 million, determined on the
statutory basis of accounting, which generated a net written premium to surplus
ratio of approximately 1.8 to 1. Regulatory guidelines suggest that this net
written premium to surplus ratio for property and casualty insurers, in general,
should not exceed 3 to 1.
In July 1998, the Company issued an additional 628,219 shares of common
stock to cover the over-allotment option granted to the underwriters in
connection with a secondary offering of 4.2 million shares of its common stock
owned by certain stockholders formerly associated with Capsure. The Company
received the net proceeds (after deducting underwriting commissions and offering
related expenses) from this issuance of approximately $7.5 million.
CNA Surety management believes that it will have sufficient available
resources to meet its present capital needs.
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 date fields to perform computations and
decision making functions may cause computer systems to malfunction when
processing information involving dates beginning in 1999. Such malfunctions
could lead to business delays and disruptions.
For several years prior to the Merger, CNAF and Western Surety had each, as
a matter of normal maintenance and system development practices, begun to
address Year 2000 considerations. The Company has continued to participate in
CNAF's Year 2000 activities following the Merger. The Company's internal target
for achieving Year 2000 internal substantial readiness generally coincides with
CNAF's December 1, 1998 target substantial readiness date. Company management is
not aware currently of any material impediments to the completion of its Year
2000 readiness plan during the fourth quarter of 1998.
Independent Assessment of Year 2000 Readiness
In December 1997, the Company engaged an independent information consulting
firm of national standing to perform a limited review and assessment of the
Company's Year 2000 plans. This engagement included collecting and reviewing
existing enterprise-wide and business unit Year 2000 plans and supporting
documentation, reviewing the process for managing critical external agents and
business partners, and determining if timing and coordination efforts appear
reasonable with respect to program testing and enterprise certification. Based
upon the Company's internal examination and the foregoing review and assessment,
the Company has been and is currently in the process of implementing various
resulting recommendations, including the designation of a Year 2000 project
manager with broad authority for the management and coordination of all Year
2000 efforts and the establishment of regular Year 2000 status reporting by the
project manager to senior management and the board of directors of CNA Surety.
20
<PAGE> 21
Non-IT Systems Remediation Status
The Company considers its non-information technology ("non-IT") systems to
consist of essentially two elements: office facilities and communications
systems, including telephone and facsimile systems.
The Company leases space for home office and branch locations from various
parties, including the Company's Chicago home office and various branch
locations from CNAF pursuant to the Administrative Services Agreement ("ASA").
The Company has confirmed with CNAF and building management for each building
location that reasonable efforts are being undertaken to ensure timely Year 2000
readiness for such facilities and continues to monitor the progress of third
party landlords.
Telephone switching equipment and facsimile server systems are essential to
the business operations of CNA Surety. CNAF has informed the Company that all
communications systems provided by CNAF pursuant to the ASA are anticipated to
be Year 2000 ready, and management believes that USA and Western's separate
communications systems will also be Year 2000 ready on a timely basis.
IT Systems Remediation Status
The Company has confirmed that information technology ("IT") systems
provided by CNAF pursuant to the ASA have been certified by CNAF as Year 2000
ready.
With respect to its internal systems, the Company has created separate
plans to monitor the Year 2000 renovation or replacement of the Company's IT
systems. Of these plans, several systems are deemed to be obsolete and will not
be used in a Year 2000 ready business environment. The remaining plans are in
various stages of renovation, many of which either have undergone or currently
are undergoing Year 2000 certification testing. As a result of a post-Merger
Company initiative to consolidate and centralize disparate technology systems,
Company management decided to combine any needed Year 2000 renovation effort
with Western Surety's modification efforts.
Year 2000 Readiness
Management believes that all existing IT systems undergoing renovation will
have been internally certified as Year 2000 ready during the fourth quarter of
1998.
Year 2000 and IT Expenditures
The Company's enterprise-wide Year 2000 readiness efforts are currently
estimated to cost approximately $540,000 in excess of the cost of ordinary
software upgrades and replacements and will primarily be incurred in 1998 and
funded through working capital. As of September 30, 1998, approximately $380,000
had been incurred in Year 2000-related expenditures. The former amount includes
expenses incurred or anticipated to be incurred for third party remediation and
testing and additional equipment hardware purchases to facilitate further
testing. The Year 2000 estimated readiness costs comprise approximately 5% of
the Company's total 1998 IT budget.
Business Partner Identification and Communication
The Company believes that it has identified and established communication
regarding Year 2000 issues
21
<PAGE> 22
with substantially all of the business partners management considers to be
significant to its operations. Management has not yet identified any one
business partner whose expected failure to achieve timely Year 2000 readiness
will materially and adversely impact the Company's ability to continue its
business operations. 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 other business
partners) address Year 2000 issues successfully.
Year 2000-related Risks
Management believes that the most reasonably likely worst case Year 2000
scenarios involve either failure of all or part of either or both the nation's
telephonic and/or electrical power distribution systems. Due to the general
uncertainty inherent in the Year 2000 problem, resulting in part from the Year
2000 compliance of third parties, the Company is unable to determine with any
degree of certainty the specific potential consequences of the Year 2000
problem. The failure of a third party to correct a material Year 2000 problem,
which affects the Company's business operations, however, could have a material
adverse effect on the Company's results of operations, financial condition and
liquidity.
Contingency Plan
The Company has been and continues to be in the process of revising its
overall enterprise contingency plan to address the continuation of key business
processes. This planning considers disruptions in addition to Year 2000-related
failures, such as fire, vandalism, and other perils.
Company management has concluded that it is not reasonably possible to
continue the Company's business operations without the use of automation and
information technology, such as computers and telephones. Management, for
contingency planning, is considering using, as a back up for its main frame
computer capability, an existing computer application that can be operated at
stand-alone computer stations. Management believes that this particular
application may provide a short-term solution that will enable the Company to
process, record, and invoice for transactions, and to store such transactional
data until main frame processing capability is restored. Through Western Surety,
the Company also subscribes to a third party disaster recovery site, although
access is subject to certain conditions and potential allocation among other
subscribers. Further, as part of its contingency planning process, the Company
is currently exploring the development of additional restoration alternatives.
Company Products and Services' Year 2000 Exposures
Although the Company has not received any claims based on alleged 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 upon the facts and circumstances of the claims
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's results of operations,
financial condition and liquidity.
22
<PAGE> 23
ACCOUNTING STANDARDS:
In June 1997, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) 131, "Disclosures about
Segments of an Enterprise and Related Information," which establishes standards
for the way that public business enterprises report information about operating
segments in interim and annual financial statements. It requires that those
enterprises report a measure of segment profit or loss, certain specific revenue
and expense items, and segment assets, and that the enterprises reconcile the
total of those amounts to the general -purpose financial statements. It also
establishes standards for the related disclosures about products and services,
geographic areas and major customers. This Statement is effective for financial
statements for periods beginning after December 15, 1997. This Statement need
not be applied to interim financial statements in the initial year of its
application. The Company's segment disclosures are not anticipated to change in
connection with the adoption of this standard.
In March 1998, the American Institute of Certified Public Accountants'
Accounting Standards Executive Committee issued Statement of Position (SOP)
98-1, "Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use," which provides guidance on accounting for costs of computer
software developed or obtained for internal use and for determining whether
computer software is for internal use. For the purposes of the SOP, internal-use
software is software acquired, internally developed or modified solely to meet
the entity's internal needs for which no substantive plan exists or is being
developed to market the software externally during the software's development or
modification. Accounting treatment for costs associated with software developed
or obtained for internal use, as defined by this SOP, is based upon a number of
factors, including the point in time during the project that costs are incurred
as well as the types of costs incurred. This SOP is effective for financial
statements for fiscal years beginning after December 15, 1998. The Company is
currently evaluating the effects of this SOP.
In June 1998, the FASB issued SFAS 133, "Accounting for Derivative
Instruments and Hedging Activities," which establishes standards for the
accounting and reporting for derivative instruments and for hedging activities.
It requires that an entity recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those instruments
at fair value. If certain conditions are met, a derivative may be specifically
designated as (a) a hedge of the exposure to changes in the fair value of a
recognized asset or liability or an unrecognized firm commitment, (b) a hedge of
the exposure to variable cash flows of a forecasted transaction, or (c) a hedge
of the foreign currency exposure of a net investment in a foreign operation, an
unrecognized firm commitment, and available-for-sale security, or a
foreign-currency-denominated forecasted transaction. The accounting for changes
in the fair value of a derivative depends on the intended use of the derivative
and the resulting designation. This Statement is effective for all fiscal
quarters of fiscal years beginning after June 15, 1999. This Statement is not
anticipated to have a material impact on the financial position and results of
operations of the Company.
23
<PAGE> 24
CNA SURETY CORPORATION AND SUBSIDIARIES
PART II - OTHER INFORMATION
ITEM 1. Legal Proceedings - None.
ITEM 2. Changes in the Rights of the Company's Security Holders - None.
ITEM 3. Defaults Upon Senior Securities - None.
ITEM 4. Submission of Matters to a Vote of Security Holders - None.
ITEM 5. Other Information - None.
ITEM 6. Exhibits and Reports on Form 8-K:
(a) Exhibits:
27. Financial Data Schedule.
(b) Reports on Form 8-K:
August 13, 1998; CNA Surety Corporation Press Release issued
on August 3, 1998.
24
<PAGE> 25
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934,
the Registrant has duly caused this Report to be signed on its behalf by the
undersigned thereunto duly authorized.
CNA SURETY CORPORATION
(Registrant)
/s/ John S. Heneghan
--------------------
John S. Heneghan
Vice President and Chief Financial Officer
Date: November 13, 1998
25
<TABLE> <S> <C>
<ARTICLE> 7
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION OF CNA SURETY CORPORATION
AND CCC SURETY OPERATIONS EXTRACTED FROM FINANCIAL STATEMENTS AND RELATED NOTES
AND SCHEDULES THERETO INCLUDED IN THIS QUARTERLY REPORT ON FORM 10-Q AND IS
QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<DEBT-HELD-FOR-SALE> 432,964
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 0
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 485,257
<CASH> 1,569
<RECOVER-REINSURE> 70,125
<DEFERRED-ACQUISITION> 72,446
<TOTAL-ASSETS> 815,253
<POLICY-LOSSES> 146,581
<UNEARNED-PREMIUMS> 185,061
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 118,000
0
0
<COMMON> 441
<OTHER-SE> 303,080
<TOTAL-LIABILITY-AND-EQUITY> 815,253
191,804
<INVESTMENT-INCOME> 18,232
<INVESTMENT-GAINS> 222
<OTHER-INCOME> 0
<BENEFITS> 34,328
<UNDERWRITING-AMORTIZATION> 79,379
<UNDERWRITING-OTHER> 34,333
<INCOME-PRETAX> 52,288
<INCOME-TAX> 19,834
<INCOME-CONTINUING> 32,454
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 32,454
<EPS-PRIMARY> 0.74
<EPS-DILUTED> 0.74
<RESERVE-OPEN> 0
<PROVISION-CURRENT> 0
<PROVISION-PRIOR> 0
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</TABLE>
