<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, 1999
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 Identification No.)
incorporation or organization)
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:
44,091,088 shares of Common Stock, $.01 par value as of May 7,
1999.
<PAGE> 2
CNA SURETY CORPORATION AND SUBSIDIARIES
INDEX
Page
----
Part I. Financial Information (Unaudited):
Item 1. Condensed Consolidated Financial Statements:
Independent Accountants' Report.................... 3
Condensed Consolidated Balance Sheets at
March 31, 1999 and at December 31, 1998............ 4
Condensed Consolidated Statements of Income for
the Three Months Ended March 31, 1999 and 1998..... 5
Condensed Consolidated Statements of
Stockholders' Equity for the Three Months Ended
March 31, 1999 and 1998............................ 6
Condensed Consolidated Statements of Cash Flows
for the Three Months Ended March 31, 1999
and 1998........................................... 7
Notes to Condensed Consolidated Financial
Statements at March 31, 1999 ...................... 8
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations...... 11
Part II. Other Information:
Item 1. Legal Proceedings.................................. 20
Item 2. Changes in the Rights of the Company's
Security Holders................................... 20
Item 3. Defaults Upon Senior Securities.................... 20
Item 4. Submission of Matters to a Vote of
Security Holders................................... 20
Item 5. Other Information.................................. 20
Item 6. Exhibits and Reports on Form 8-K .................. 20
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 March 31, 1999, and the related
condensed consolidated statements of income, stockholders' equity and cash flows
for the three-month periods ended March 31, 1999 and 1998. 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, 1998, and the related consolidated statements of
income, stockholders' equity, and cash flows for the year then ended (not
presented herein); and in our report dated February 8, 1999, we expressed an
unqualified opinion on those consolidated financial statements. In our opinion,
the information set forth in the accompanying condensed consolidated balance
sheet as of December 31, 1998 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
May 7, 1999
3
<PAGE> 4
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(Unaudited)
March 31, December 31,
1999 1998
---------- ----------
ASSETS
Invested assets and cash:
Fixed income securities, at fair value
(amortized cost: $412,411 and $418,866)....... $ 413,492 $ 423,914
Short-term investments, at cost (approximates
fair value)................................... 52,092 57,865
Other investments, at fair value................ 5,553 5,830
Cash............................................ 29,019 17,746
---------- ----------
Total invested assets and cash............. 500,156 505,355
Deferred policy acquisition costs................. 77,290 74,488
Insurance receivables:
Premiums........................................ 10,042 8,950
Reinsurance, including $53,509 and $47,175
from affiliates............................... 61,110 55,350
Intangible assets (net of accumulated
amortization of $8,823 and $7,347).............. 154,586 156,062
Prepaid reinsurance premiums...................... 2,581 2,157
Other assets...................................... 16,765 17,008
---------- ----------
Total assets............................... $ 822,530 $ 819,370
========== ==========
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses...... $ 158,117 $ 150,020
Unearned premiums............................... 185,623 183,708
---------- ----------
Total reserves............................. 343,740 333,728
Long-term debt.................................... 100,000 113,000
Current income taxes payable...................... 10,666 6,726
Deferred income taxes, net........................ 10,468 10,649
Payable for securities purchased.................. 3,435 8,517
Other liabilities................................. 37,550 36,853
---------- ----------
Total liabilities.......................... $ 505,859 $ 509,473
---------- ----------
Commitments and contingencies (See 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; 44,101 shares issued and
outstanding at March 31, 1999 and 44,093
issued and outstanding at December 31, 1998..... 441 441
Additional paid-in capital........................ 253,255 253,215
Retained earnings................................. 62,499 52,984
Accumulated other comprehensive income............ 476 3,257
---------- ----------
Total stockholders' equity................. 316,671 309,897
---------- ----------
Total liabilities and stockholders' equity. $ 822,530 $ 819,370
========== ==========
The accompanying notes are an integral part of these financial statements.
4
<PAGE> 5
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
Three Months Ended
March 31,
-------------------------
1999 1998
---------- ----------
Revenues:
Net earned premium.............................. $ 67,870 $ 58,745
Net investment income........................... 6,341 6,789
Net realized investment gains................... 396 --
---------- ----------
74,607 65,534
---------- ----------
Expenses:
Net losses and loss adjustment expenses......... 11,914 11,218
Net commissions, brokerage and other
underwriting.................................. 39,978 35,039
Interest expense................................ 1,489 1,821
Amortization of intangible assets............... 1,475 1,475
---------- ----------
54,856 49,553
---------- ----------
Income before income taxes........................ 19,751 15,981
Income taxes...................................... 6,708 6,166
---------- ----------
Net income........................................ $ 13,043 $ 9,815
========== ==========
Earnings per share................................ $ 0.30 $ 0.23
========== ==========
Earnings per share, assuming dilution............. $ 0.30 $ 0.23
========== ==========
Weighted average shares outstanding............... 44,100 43,348
========== ==========
Weighted average shares outstanding,
assuming dilution............................... 44,213 43,570
========== ==========
The accompanying notes are an integral part of these financial statements.
5
<PAGE> 6
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
Common Stock Additional
Shares Common Paid-In Comprehensive
Issued Stock Capital Income
--------------- --------------- --------------- ---------------
<S> <C> <C> <C> <C>
Balance, December 31, 1997................................... 43,320 $ 433 $ 244,829
Comprehensive income:
Net income................................................. -- -- -- 9,815
Other comprehensive income:
Change in unrealized gains on securities (after income
taxes), net of reclassification adjustment of $0........ -- -- -- (329)
---------
Total comprehensive income.............................. $ 9,486
=========
Stock options exercised...................................... 59 -- 305
--------- --------- ---------
Balance, March 31, 1998...................................... 43,379 $ 433 $ 245,134
========= ========= =========
Balance, December 31, 1998................................... 44,093 $ 441 $ 253,215
Comprehensive income:
Net income................................................. -- -- -- $13,043
Other comprehensive income:
Change in unrealized gains on securities (after income
taxes), net of reclassification adjustment of $361...... -- -- -- (2,781)
----------
Total comprehensive income.............................. $ 10,262
=========
Issuance of common stock..................................... -- -- --
Stock options exercised...................................... 8 -- 40
Dividends paid to stockholders............................... -- -- --
--------- --------- ---------
Balance, March 31, 1999...................................... 44,101 $ 441 $ 253,255
========= ========= =========
</TABLE>
<TABLE>
<CAPTION>
Accumulated
Other
Retained Comprehensive Total
Earnings Income Stockholders'Equity
----------------- ----------------- -------------------
<S> <C> <C> <C>
Balance, December 31, 1997................................... $ 10,996 $ 474 $ 256,732
Comprehensive income:
Net income................................................. 9,815 -- 9,815
Other comprehensive income:
Change in unrealized gains on securities (after income
taxes), net of reclassification adjustment of $0........ -- (329) (329)
Total comprehensive income..............................
Stock options exercised...................................... -- -- 305
--------- --------- ---------
Balance, March 31, 1998...................................... $ 20,811 $ 145 $ 266,523
========= ========= =========
Balance, December 31, 1998................................... $ 52,984 $ 3,257 $ 309,897
Comprehensive income:
Net income................................................. 13,043 -- 13,043
Other comprehensive income:
Change in unrealized gains on securities (after income
taxes), net of reclassification adjustment of $361...... -- (2,781) (2,781)
Total comprehensive income..............................
Issuance of common stock..................................... -- -- --
Stock options exercised...................................... -- -- 40
Dividends paid to stockholders............................... (3,528) -- (3,528)
--------- --------- ---------
Balance, March 31, 1999...................................... $ 62,499 $ 476 $ 316,671
========= ========= =========
</TABLE>
The accompanying notes are an integral part of these financial statements.
6
<PAGE> 7
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
Three Months Ended
March 31,
-------------------------
1999 1998
---------- ----------
OPERATING ACTIVITIES:
Net income...................................... $ 13,043 $ 9,815
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization................ 2,045 1,942
Accretion of bond discount, net.............. 566 384
Net realized investment gains................ (396) --
Changes in:
Insurance receivables........................ (6,852) (647)
Reserve for unearned premiums................ 1,915 3,684
Reserve for unpaid losses and loss
adjustment expenses........................ 8,097 1,719
Deferred policy acquisition costs............ (2,802) (3,376)
Deferred income taxes, net................... 1,303 1,709
Other assets and liabilities................. 4,459 (2,765)
---------- ----------
Net cash provided by operating activities.. 21,378 12,465
---------- ----------
INVESTING ACTIVITIES:
Fixed income securities:
Purchases.................................... (60,731) (135,963)
Maturities................................... 25,670 8,994
Sales........................................ 41,346 --
Changes in short-term investments............... 5,773 118,501
Other, net...................................... (5,658) (880)
---------- ----------
Net cash provided by (used in)
investing activities..................... 6,400 (9,348)
---------- ----------
FINANCING ACTIVITIES:
Principal payments on long-term debt............ (13,000) --
Dividends to stockholders....................... (3,528) --
Other........................................... 23 177
---------- ----------
Net cash (used in) provided by financing
activities............................... (16,505) 177
---------- ----------
Increase in cash.................................. 11,273 3,294
Cash at beginning of period....................... 17,746 130
---------- ---------
Cash at end of period............................. $ 29,019 $ 3,424
========== ==========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest..................................... $ 2,013 $ 1,727
Income taxes................................. $ 1,300 $ 1,500
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
MARCH 31, 1999
(UNAUDITED)
1. SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of CNA Surety
Corporation and all majority-owned subsidiaries.
Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
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 1998 Annual Report to Shareholders. 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 1998
Financial Statements to conform with the presentation in the 1999 Condensed
Consolidated Financial Statements.
Accounting Changes
In March 1998, the American Institute of Certified Public Accountants'
Accounting Standards Executive Committee ("AcSEC") 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. The Company has
adopted this standard effective January 1, 1999 and such adoption did not have a
material impact on the Company's financial position and results of operations as
of and for the three months ended March 31, 1999.
In April 1998, AcSEC issued SOP 98-5, "Reporting on the Costs of Start-Up
Activities," which provides guidance on the financial reporting of start-up
costs and organization costs. It requires that costs of start-up activities and
organization costs, as defined, be expensed as incurred. The Company has adopted
this standard effective January 1, 1999 and such adoption did not have a
material impact on the
8
<PAGE> 9
Company's financial position and results of operations as of and for the three
months ended March 31, 1999.
In October 1998, AcSEC issued SOP 98-7, "Deposit Accounting: Accounting for
Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk," which
provides accounting guidance for insurance and reinsurance contracts that do not
transfer insurance risk, excluding long-duration life and health insurance
contracts. The Company has adopted this standard effective January 1, 1999 and
such adoption did not have a material impact on the Company's financial position
and results of operations as of and for the three months ended March 31, 1999.
3. INVESTMENTS
The estimated amortized cost and fair value of fixed income securities held
by CNA Surety at March 31, 1999 and December 31, 1998, by investment category,
were as follows (dollars in thousands):
<TABLE>
<CAPTION>
Gross Gross
Amortized Cost Unrealized Unrealized Estimated Fair
March 31, 1999 or Cost Gains Losses Value
- -------------------------------------------------- ----------------- ---------------- --------------- -----------------
<S> <C> <C> <C> <C>
Fixed income securities:
U.S. Treasury securities and obligations of U.S.
Government and agencies:
U.S. Treasury............................. $ 16,965 $ 277 $ -- $ 17,242
U.S. Agencies............................. 42,936 433 (114) 43,255
Collateralized mortgage obligations....... 5,016 41 (3) 5,054
Mortgage pass-through securities.......... 41,730 265 (84) 41,911
Obligations of states and political subdivisions 229,865 1,782 (1,086) 230,561
Corporate bonds................................ 36,567 175 (692) 36,050
Non-agency collateralized mortgage obligations. 15,446 18 (131) 15,333
Other asset-backed securities:
Second mortgages/home equity loans........... 11,044 212 (3) 11,253
Credit card receivables...................... 3,509 17 -- 3,526
Other........................................ 9,333 21 (47) 9,307
---------- ---------- ----------- ----------
Total fixed income securities............. $ 412,411 $ 3,241 $ (2,160) $ 413,492
========== ========== =========== ==========
Gross Gross
Amortized Cost Unrealized Unrealized Estimated Fair
December 31, 1998 or Cost Gains Losses Value
- -------------------------------------------------- ----------------- ---------------- --------------- -----------------
Fixed income securities:
U.S. Treasury securities and obligations of U.S.
Government and agencies:
U.S. Treasury............................. $ 19,009 $ 412 $ -- $ 19,421
U.S. Agencies............................. 68,922 2,189 -- 71,111
Collateralized mortgage obligations....... 17,741 78 (76) 17,743
Mortgage pass-through securities.......... 24,834 172 (1) 25,005
Obligations of states and political subdivisions 206,264 2,329 (355) 208,238
Corporate bonds................................ 36,538 686 (465) 36,759
Non-agency collateralized mortgage obligations. 18,811 32 (149) 18,694
Other asset-backed securities:
Second mortgages/home equity loans........... 12,169 219 (1) 12,387
Credit card receivables...................... 4,896 5 (3) 4,898
Other........................................ 9,682 24 (48) 9,658
---------- ---------- ----------- ----------
Total fixed income securities............. $ 418,866 $ 6,146 $ (1,098) $ 423,914
========== ========== =========== ==========
</TABLE>
9
<PAGE> 10
4. REINSURANCE
The effect of reinsurance on the Company's written and earned premium was
as follows (dollars in thousands):
<TABLE>
<CAPTION>
Three Months Ended March 31,
-------------------------------------------------------
1999 1998
------------------------- --------------------------
Written Earned Written Earned
<S> <C> <C> <C> <C>
Direct............................. $ 28,757 $ 25,109 $ 27,994 $ 24,306
Assumed from affiliates............ 42,767 44,509 35,854 36,040
Assumed from non-affiliates........ -- -- -- --
Ceded.............................. (2,162) (1,748) (2,012) (1,601)
----------- ----------- ----------- -----------
$ 69,362 $ 67,870 $ 61,836 $ 58,745
=========== =========== =========== ===========
</TABLE>
The effect of reinsurance on the Company's provision for loss and loss
adjustment expenses was as follows (dollars in thousands):
<TABLE>
<CAPTION>
Three Months Ended
March 31,
--------------------------
1999 1998
----------- -----------
<S> <C> <C>
Gross loss and loss adjustment expense......................... $ 13,847 $ 13,117
Ceded amounts.................................................. (1,933) (1,899)
----------- -----------
Net loss and loss adjustment expense........................... $ 11,914 $ 11,218
=========== ===========
</TABLE>
5. LEGAL PROCEEDINGS
The Company and its subsidiaries are parties to various lawsuits arising in
the normal course of business, some seeking material damages. The Company
believes the resolution of these lawsuits will not have a material adverse
effect on its financial condition or its results of operations.
10
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CNA SURETY CORPORATION AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
GENERAL
The following is a discussion and analysis of CNA Surety Corporation ("CNA
Surety" or the "Company") and its insurance subsidiaries' operating results,
liquidity and capital resources, and financial condition. This discussion should
be read in conjunction with the Consolidated Financial Statements of CNA Surety
and notes thereto.
FORMATION OF CNA SURETY AND MERGER
In December 1996, CNA Financial Corporation ("CNAF") and Capsure agreed to
merge (the "Merger") the surety business of CNAF with Capsure's insurance
subsidiaries, Western Surety Company ("Western Surety") and Universal Surety of
America ("USA"), into 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. CNAF owns approximately 61% of the outstanding common stock of CNA
Surety. Loews Corporation owns approximately 85% 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.
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 non-contract 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
11
<PAGE> 12
business and is licensed in 23 states. USA specializes in the underwriting of
small contract and commercial surety bonds. USA is licensed in 43 states and the
District of Columbia with most of its business generated in Texas.
The Company's corporate objective is to be the leading provider of surety
and surety-related products in the United States and in selected international
markets and to be the surety of choice for its customers and independent agents
and brokers.
"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 THREE MONTHS ENDED MARCH 31, 1999 AND 1998
The components of income for the Company for the three months ended March
31, 1999 and 1998 are summarized as follows (dollars in thousands):
Three Months Ended March 31,
1999 1998
---------- ----------
Total revenues............................... $ 74,607 $ 65,534
========== ==========
Underwriting income.......................... $ 15,978 $ 12,488
Net investment income........................ 6,341 6,789
Net investment gains......................... 396 --
Interest expense............................. 1,489 1,821
Amortization of intangible assets............ 1,475 1,475
---------- ----------
Income before income taxes................... 19,751 15,981
Income taxes................................. 6,708 6,166
---------- ----------
Net income................................... $ 13,043 $ 9,815
========== ==========
Net income per share......................... $ 0.30 $ 0.23
========== ==========
12
<PAGE> 13
Insurance Underwriting
Underwriting results for the Company for the three months ended March 31,
1999 and 1998 are summarized in the following table (dollars in thousands):
Three Months Ended March 31,
1999 1998
---------- ----------
Gross written premiums....................... $ 71,524 $ 63,848
========== ==========
Net written premium.......................... $ 69,362 $ 61,836
========== ==========
Net earned premium........................... $ 67,870 $ 58,745
Net losses and loss adjustment expenses...... 11,914 11,218
Net commissions, brokerage and other......... 39,978 35,039
---------- ----------
Underwriting income.......................... $ 15,978 $ 12,488
========== ==========
Loss ratio................................... 17.6% 19.1%
Expense ratio................................ 58.9 59.6
---------- ----------
Combined ratio............................... 76.5% 78.7%
========== ==========
Premiums Written
CNA Surety primarily markets contract and commercial surety bonds. Contract
bonds guarantee obligations covered by a written agreement between two parties.
The most common types include bid, performance and payment bonds. The commercial
surety market includes numerous types of bonds categorized as court judicial,
court fiduciary, public official, license and permit and many miscellaneous
bonds that include guarantees of financial performance. The Company also writes
fidelity bonds which cover losses arising from employee dishonesty and E&O
liability insurance.
Gross written premiums are shown in the table below (dollars in
thousands):
Three Months Ended March 31,
1999 1998
---------- ----------
Contract..................................... $ 30,713 $ 26,200
Commercial................................... 33,365 30,404
Fidelity..................................... 4,914 4,719
E&O and other................................ 2,532 2,525
---------- ----------
$ 71,524 $ 63,848
========== ==========
Gross written premiums increased 12.0%, or $7.7 million, for the three
months ended March 31, 1999 over the comparable period in 1998. Contract surety
accounted for most of this increase with growth of 17.2%, or $4.5 million, in
gross written premiums as compared to 1998. This increase reflects increased
volume from new accounts added during 1998 and generally healthy economic
conditions for public construction nationwide. The highway/bridge sector has
shown particular strength since the United States Congressional passage of The
Transportation Equity Act for the 21st Century (TEA-21). TEA-21 authorizes a 40%
increase in total Federal funding for highway and transit systems to over $200
billion in the six year period from 1998 to 2004. Commercial surety increased
9.7%, or $3.0 million, for the three months ended March 31, 1999 reflecting
increased business with key national and regional distribution partners. CNA
Surety assumed $2.3 million and $2.5 million of international surety and credit
business for the three months ended March 31, 1999 and 1998, respectively,
through a quota share reinsurance treaty with an affiliate of CCC, CNA
Reinsurance Company Limited (London) ("CNA Re"). Commercial surety, exclusive of
international surety and credit business, increased 11.5% for the first three
months in 1999 as
13
<PAGE> 14
compared to the same period in 1998. The fidelity, E&O and
other book of business increased 2.8%, or $0.2 million, to $7.4 million for the
three months ended March 31, 1999 as compared to the same period in 1998.
Net written premiums are shown in the table below (dollars in
thousands):
Three Months Ended March 31,
1999 1998
---------- ----------
Contract..................................... $ 29,659 $ 25,240
Commercial................................... 32,884 29,972
Fidelity..................................... 4,914 4,696
E&O and other................................ 1,905 1,928
---------- ----------
$ 69,362 $ 61,836
========== ==========
For the three months ended March 31, 1999, net written premiums increased
12.2%, or $7.5 million, over the comparable period in 1998, consistent with the
changes in gross written premiums described above. Net written premiums
increased 17.5%, or $4.4, million for the contract surety business. Commercial
surety net written premiums increased 9.7%, or $2.9, million for the first three
months in 1999 with domestic commercial surety up 11.5%. The fidelity, E&O and
other book of business increased 2.9%, or $0.2 million, for the first three
months in 1999 as compared to the same period in 1998.
Underwriting Income
Underwriting income increased 28.0% to $16.0 million for the three months
ended March 31, 1999 compared to the same period in 1998. The period to period
changes in underwriting income primarily reflect the 15.5% increase in earned
premiums along with improved loss experience.
Loss Ratio
The loss ratios for the three months ended March 31, 1999 and 1998 were
17.6% and 19.1%, respectively. The loss ratios included $1.7 million and $0.6
million of favorable reserve development for the three months ended March 31,
1999 and 1998, respectively. Excluding the impact of the favorable reserve
development, the loss ratios would have been 20.1% for both the period ended
March 31, 1999 and March 31,1998.
Expense Ratio
The expense ratio decreased to 58.9% for the three months ended March 31,
1999 compared to 59.6% for the same period in 1998. The 1999 decline is
primarily due to the increased scale of the Company as net earned premiums
increased 15.5% and operating expenses increased at a lower rate of 14.1%.
Investment Income
For the three months ended March 31, 1999, net investment income was $6.3
million compared to net investment income for the three months ended March 31,
1998 of $6.8 million. The decrease in investment income is a result of a higher
proportion of the portfolio being invested in tax exempt securities during the
latter half of 1998 and continuing into 1999 and a general decline in interest
rates since January 1, 1997. The average pretax yields were 5.4% and 6.5% for
the three months ended March 31, 1999 and 1998, respectively.
14
<PAGE> 15
Net realized investment gains were $0.4 million for the three months ended
March 31, 1999 compared to $0 net realized investment gains for the same period
in 1998.
Analysis of Other Operations
Amortization expense was $1.5 million for the three months ended March 31,
1999 compared to $1.5 million for the three months ended March 31, 1998.
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 three months ended March 31, 1999 decreased 18.2%
for the first quarter of 1999 as compared to the first quarter in 1998,
primarily due to lower debt levels. Average debt outstanding was $111.7 million
for the first quarter in 1999 compared to $118.0 million in the first quarter of
1998. The weighted average interest rate for the three months ended March 31,
1999 was 5.3% compared to 5.9% for the same period in 1998.
Income Taxes
Income tax expense was $6.7 million and $6.2 million and the effective
income tax rates were 34.0% and 38.6% for the three months ended March 31, 1999
and 1998, respectively. The decline in the effective income tax rate primarily
relates to the aforementioned increased investments in tax exempt securities.
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 operating 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, federal income taxes, debt service on the credit
facility and dividends to CNA Surety stockholders. In general, surety operations
generate premium collections from customers in advance of cash outlays for
claims. Premiums are invested until such time as funds are required to pay
claims and claims adjusting expenses.
The Company believes that total invested assets, including cash and
short-term investments, are sufficient in the aggregate and have suitably
scheduled maturities to satisfy all policy claims and other operating
liabilities, including income tax sharing payments of its insurance
subsidiaries. At March 31, 1999, the carrying value of the Company's insurance
subsidiaries' invested assets was comprised of $413.5 million of fixed income
securities, $43.3 million of short-term investments, $5.6 million of other
investments and $1.2 million of cash. At December 31, 1998, the carrying value
of the Company's insurance subsidiaries' invested assets was comprised of $423.9
million of fixed income securities, $43.4 million of short-term investments,
$5.8 million of other investments and $1.8 million of cash.
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, pay operating
expenses and pay dividends to stockholders. At March 31, 1999, the parent
company's invested assets consisted of $8.8 million of short-term investments
and $27.8 million of cash. At December 31, 1998, the parent company's invested
assets consisted of $14.5 million of short-term investments and $15.9 million of
cash.
15
<PAGE> 16
The Company's consolidated net cash flow provided by operating activities
was $21.4 million for the three months ended March 31, 1999 and $12.5 million
for the comparable period in 1998.
CNA Surety's bank borrowings are under a five-year unsecured revolving
credit facility (the "Credit Facility") that provides for borrowings of up to
$130 million. CNA Surety borrowed $105 million as of September 30, 1997 and used
the proceeds to retire the existing Capsure debt of approximately $54 million
and to make a $50 million capital contribution to Western Surety. On October 6,
1997, CNA Surety borrowed an additional $13 million to pay the $10.6 million
closing dividend to Capsure stockholders and other merger-related costs. As of
March 31, 1999, CNA Surety has repaid $18 million of this debt.
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%. As of March 31, 1999, the weighted average interest rate was 5.1% on the
$100.0 million of outstanding borrowings. As of December 31, 1998, the weighted
average interest rate was 5.9% on the $113.0 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, 1999, 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 and SBCA are domiciled,
insurance companies may only pay dividends from earned surplus excluding surplus
arising from unrealized capital gains or revaluation of assets. In Texas, where
USA is domiciled, an insurance company may only declare or pay dividends to
stockholders from the insurer's earned surplus. The insurance subsidiaries may
pay dividends without obtaining prior regulatory approval only if such dividend
or distribution (together with dividends or distributions made within the
preceding 12-month period) is less than, as of the end of the immediately
preceding year, the greater of (i) 10% of the insurer's surplus to policyholders
or (ii) statutory net income. In South Dakota, net income includes net realized
capital gains in an amount not to exceed 20% of net unrealized capital gains.
All dividends must be reported to the appropriate insurance department prior to
payment.
The dividends that may be paid without prior regulatory approval are
determined by formulas established by the applicable insurance regulations, as
described above. The formulas that determine dividend capacity in the current
year are dependent on, among other items, the prior year's ending statutory
surplus and statutory net income. Dividend capacity for 1999 is based on
statutory surplus and income at and for the year ended December 31, 1998.
Without prior regulatory approval in 1999, CNA Surety's insurance subsidiaries
may pay stockholder dividends of $32.7 million in the aggregate. CNA Surety
received $15.0 million in dividends from its insurance subsidiaries during the
first three months of 1999 and $4.4 million in the first three months of 1998.
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
16
<PAGE> 17
liability, as calculated in accordance with the Internal Revenue Code of 1986
(the "Code") as amended. 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 $0.5
million for the three months ended March 31, 1999 and $1.6 million for the same
period in 1998.
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 after 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 coincided with
CNAF's December 1, 1998 target substantial readiness date. Based upon internal
certification achieved as part of the CNAF Year 2000 activities, the Company's
management believes that the Company has accomplished the December 1, 1998
target date for its internal systems requiring renovation.
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.
Non-IT Systems Remediation Status
The Company considers its non-information technology ("non-IT") systems to
consist of essentially two elements: office facilities and communication
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.
Communication systems, i.e., telephone switching equipment and facsimile
server systems, are essential to the business operations of CNA Surety. CNAF has
informed the Company that all communications
17
<PAGE> 18
systems provided by CNAF pursuant to the ASA are anticipated to be Year 2000
ready, and management believes that USA and Western Surety's separate
communication 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 plans to
monitor the Year 2000 renovation or replacement of the Company's IT systems.
Several of these systems are deemed to be obsolete and will not be used in a
Year 2000 ready business environment. 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
All existing IT systems undergoing renovation have been internally
certified as Year 2000 ready during the fourth quarter of 1998. In addition to
having accomplished the December 1, 1998 target date for its internal systems
requiring renovation, the Company is currently developing and will be
implementing several new IT systems that it anticipates will become operational
before January 1, 2000. The development and implementation of these systems will
involve design and testing to confirm their Year 2000 readiness on a timely
basis. In the event that ongoing development of a new enterprise-wide claims
system is not completed and tested for readiness within the time required for
such confirmation, the Company intends to renovate its non-compliant claim
system for timely readiness.
Year 2000 and IT Expenditures
The Company's enterprise-wide Year 2000 readiness efforts are currently
estimated to cost approximately $650,000 in excess of the cost of ordinary
software upgrades and replacements and will be funded through working capital.
As of March 31, 1999, approximately $407,000 had been incurred in Year
2000-related expenditures. The estimated 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 comprised approximately 5% of the Company's total
1998 IT budget, and the remaining Year 2000 estimated readiness costs
anticipated to be expended in 1999 comprise approximately $110,000, or
approximately one percent of the Company's total 1999 IT budget.
Business Partner Identification and Communication
The Company believes that it has identified and established communication
regarding Year 2000 issues 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.
18
<PAGE> 19
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. The Company is taking steps to assure itself of a greater
likelihood of efficient access to the site in the event of a Year 2000-related
disruption of its main frame computer capability.
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.
19
<PAGE> 20
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:
March 10, 1999; CNA Surety Corporation Press Release
issued on March 3, 1999.
20
<PAGE> 21
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 12, 1999
21
<TABLE> <S> <C>
<ARTICLE> 7
<LEGEND>
THE SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION OF CNA SURETY CORPORATION
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-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> MAR-31-1999
<DEBT-HELD-FOR-SALE> 413,493
<DEBT-CARRYING-VALUE> 0
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<MORTGAGE> 0
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<TOTAL-INVEST> 471,137
<CASH> 29,019
<RECOVER-REINSURE> 61,110
<DEFERRED-ACQUISITION> 77,290
<TOTAL-ASSETS> 822,530
<POLICY-LOSSES> 158,117
<UNEARNED-PREMIUMS> 185,623
<POLICY-OTHER> 0
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<NOTES-PAYABLE> 100,000
0
0
<COMMON> 441
<OTHER-SE> 316,230
<TOTAL-LIABILITY-AND-EQUITY> 822,530
67,870
<INVESTMENT-INCOME> 6,341
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