<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 MARCH 31, 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)
<TABLE>
<S> <C>
DELAWARE 36-4144905
(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.)
CNA PLAZA, CHICAGO, ILLINOIS 60685
(Address of principal executive offices) (Zip Code)
</TABLE>
(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:
43,380,119 shares of Common Stock, $.01 par value as of May 8, 1998.
<PAGE> 2
CNA SURETY CORPORATION AND SUBSIDIARIES
INDEX
<TABLE>
<CAPTION>
Page
----
<S> <C>
Part I. Financial Information (Unaudited):
Item 1. Condensed Consolidated Financial Statements:
Independent Accountant's Report ............................................................... 3
Condensed Consolidated Balance Sheets at March 31, 1998 and
at December 31, 1997........................................................................... 4
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................................................................................. 5
Condensed Consolidated Statement of Stockholders' Equity....................................... 6
Condensed Consolidated Statement of Cash Flows for the Three Months Ended
March 31, 1998................................................................................. 7
Notes to Condensed Consolidated Financial Statements at March 31, 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 ............................................................. 13
Part II. Other Information:
Item 1. Legal Proceedings.............................................................................. 21
Item 2. Changes in the Rights of the Company's Security Holders........................................ 21
Item 3. Defaults Upon Senior Securities................................................................ 21
Item 4. Submission of Matters to a Vote of Security Holders............................................ 21
Item 5. Other Information.............................................................................. 21
Item 6. Exhibits and Reports on Form 8-K ................................................................. 21
</TABLE>
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<PAGE> 3
INDEPENDENT ACCOUNTANTS' 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.
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); and 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 accompanying 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
May 12, 1998
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<PAGE> 4
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 $.01 per share, 20,000 shares authorized;
none issued and outstanding ....................................... -- --
Common stock, par value $.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>
The accompanying notes are an integral part of these financial statements.
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<PAGE> 5
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>
The accompanying notes are an integral part of these financial statements.
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<PAGE> 6
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>
The accompanying notes are an integral part of these financial statements.
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<PAGE> 7
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>
The accompanying notes are an integral part of these financial statements.
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<PAGE> 8
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 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. 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.
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<PAGE> 9
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 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 ended March 31, 1998.
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<PAGE> 10
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 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.
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<PAGE> 11
3. INVESTMENTS
The estimated fair value 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>
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>
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<PAGE> 12
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.
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<PAGE> 13
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
MARCH 31, 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. 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.
-13-
<PAGE> 14
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.
BUSINESS
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 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, product and policy demand and market response risks, the
effect of economic conditions, the impact of competitive products, policies and
pricing, product and policy development, regulatory changes and conditions,
rating agency policies and practices, development of claims and the effect on
loss reserves, the performance of reinsurance companies under reinsurance
contracts with the Company, investment portfolio developments and reaction to
market conditions, the results of financing efforts, the actual closing of
contemplated transactions and agreements, the effect of the Company's accounting
policies, and other risks detailed in the Company's Securities and Exchange
Commission filings. No assurance can be given that the actual results of
operations and financial condition will conform to the forward-looking
statements contained herein.
RESULTS OF OPERATIONS
CNA SURETY RESULTS FOR FIRST QUARTER 1998 COMPARED TO PREDECESSOR FIRST
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.
-14-
<PAGE> 15
Accordingly, the remainder of this discussion and analysis is formatted to
compare information for CNA Surety's first quarter ended March 31, 1998 to the
first quarter of 1997 as if the merger had been consummated on January 1, 1996.
The results for the quarter ended March 31, 1997 that were determined on this
basis are therefore marked pro forma. 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.
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 MONTHS ENDED MARCH 31, 1998
AND 1997
The components of income for the Company for the three months ended March
31, 1998 and 1997 are summarized as follows (dollars in thousands):
<TABLE>
<CAPTION>
Three Months Ended
March 31,
----------------------------
1998 1997
------------- ------------
(Pro Forma)
<S> <C> <C>
Total revenues................................................................... $ 65,534 $ 59,338
============= ============
Underwriting income (1).......................................................... $ 12,488 $ 46,181
Net investment income............................................................ 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) Includes $36.9 million of favorable reserve development for the three
months ended March 31, 1997 of which $35.0 million is related to
Predecessor and is principally related to accident years prior to 1996.
-15-
<PAGE> 16
Insurance Underwriting
Underwriting results for the Company for the three months ended March 31,
1998 and 1997 are summarized in the following table (dollars in thousands):
<TABLE>
<CAPTION>
Three Months Ended
March 31,
----------------------------
1998 1997
------------- ------------
(Pro Forma)
<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 loss adjustment expenses (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 $36.9 million of favorable reserve development for the three
months ended March 31, 1997 of which $35.0 million is related to
Predecessor and is principally related to accident years prior to 1996.
Premiums Written
Gross written premiums are shown in the table below (dollars in thousands):
<TABLE>
<CAPTION>
Three Months Ended
March 31,
---------------------------
1998 1997
------------- ------------
(Pro Forma)
<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 premium in the first quarter of 1998 under a quota share reinsurance
treaty with an affiliate of CCC, CNA Reinsurance Company Ltd. (London).
Exclusive of the international surety and credit business, commercial surety
gross written premiums were comparable to first quarter 1997. The 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 are primarily due to growth in the small
contract surety and other businesses marketed through the Western Surety agency
force.
-16-
<PAGE> 17
Net written premiums are shown in the table below (dollars in thousands):
<TABLE>
<CAPTION>
Three Months Ended
March 31,
---------------------------
1998 1997
------------- ------------
(Pro Forma)
<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 includes
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 quarter 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 include 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 is primarily associated
with the addition of the international surety and credit business. Approximately
$35.0 million in favorable reserve development in the first quarter of 1997
relates to the Predecessor. Based on 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 the first quarter of 1997. Approximately
$33 million of this reserve development related to CIC and principally to
accident years prior to 1996.
-17-
<PAGE> 18
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 advanced 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.
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 is the direct result of
higher invested cash balances in the first quarter of 1998 which reflects the
investment of merger-related cash flows. However, 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 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.
-18-
<PAGE> 19
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. 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. In general, surety operations generate
premium collections from customers in advance of cash outlays for claims.
Premiums are invested until such time as funds are required to pay claims and
claims adjusting expenses.
The Company believes that total invested assets, including cash and
short-term investments, are sufficient in the aggregate and have suitably
scheduled maturities to satisfy all policy claims and other operating
liabilities, including 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.
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 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.
CNA Surety's bank borrowings are under a five-year unsecured revolving
credit facility (the "Credit Facility") that provides for borrowings of $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
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. All dividends must be reported to and approved by 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. The formulas that determine dividend
-19-
<PAGE> 20
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 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 merger) 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 to the Company in 1998
dividends of $16.3 million in the aggregate.
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").
At March 31, 1998, the insurance subsidiaries had combined policyholders'
surplus of approximately $144.9 million, determined on the statutory basis of
accounting, which generated a net written premium to surplus ratio of
approximately 1.9 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.
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 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 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.
Although the Company has not received any claims for coverage from its customers
based on losses resulting from year 2000 issues, there can be no assurance that
customers will not suffer losses of this type and seek compensation under the
Company's bonds or policies. If any claims are made, coverage, if any will
depend on the facts and circumstances of the claim and the 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.
-20-
<PAGE> 21
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:
February 23, 1998; CNA Surety Corporation Press Release
issued on February 18, 1998.
-21-
<PAGE> 22
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: May 14, 1998
-22-
<TABLE> <S> <C>
<ARTICLE> 7
<LEGEND>
THE 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> 3-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> MAR-31-1998
<DEBT-HELD-FOR-SALE> 389,396
<DEBT-CARRYING-VALUE> 0
<DEBT-MARKET-VALUE> 0
<EQUITIES> 0
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 424,175
<CASH> 3,424
<RECOVER-REINSURE> 55,008
<DEFERRED-ACQUISITION> 67,520
<TOTAL-ASSETS> 740,871
<POLICY-LOSSES> 132,100
<UNEARNED-PREMIUMS> 177,520
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 118,000
434
0
<COMMON> 0
<OTHER-SE> 266,089
<TOTAL-LIABILITY-AND-EQUITY> 740,871
58,745
<INVESTMENT-INCOME> 6,789
<INVESTMENT-GAINS> 0
<OTHER-INCOME> 0
<BENEFITS> 11,218
<UNDERWRITING-AMORTIZATION> 24,464
<UNDERWRITING-OTHER> 10,575
<INCOME-PRETAX> 15,981
<INCOME-TAX> 6,166
<INCOME-CONTINUING> 9,815
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 9,815
<EPS-PRIMARY> 0.23
<EPS-DILUTED> 0.23
<RESERVE-OPEN> 0
<PROVISION-CURRENT> 0
<PROVISION-PRIOR> 0
<PAYMENTS-CURRENT> 0
<PAYMENTS-PRIOR> 0
<RESERVE-CLOSE> 0
<CUMULATIVE-DEFICIENCY> 0
</TABLE>
