<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 JUNE 30, 2000
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:
42,899,656 shares of Common Stock, $.01 par value as of August 4, 2000.
<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
June 30, 2000 and at December 31, 1999............. 4
Condensed Consolidated Statements of Income
for the Three- and Six- Months Ended
June 30, 2000 and 1999............................. 5
Condensed Consolidated Statements of
Stockholders' Equity for the Six Months Ended
June 30, 2000 and 1999............................. 6
Condensed Consolidated Statements of Cash Flows
for the Six Months Ended June 30, 2000 and 1999.... 7
Notes to Condensed Consolidated Financial
Statements at June 30, 2000 ....................... 8
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations................ 11
Part II. Other Information:
Item 1. Legal Proceedings.................................. 19
Item 2. Changes in the Rights of the Company's
Security Holders................................... 19
Item 3. Defaults Upon Senior Securities.................... 19
Item 4. Submission of Matters to a Vote of
Security Holders................................... 19
Item 5. Other Information.................................. 19
Item 6. Exhibits and Reports on Form 8-K .................. 19
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 June 30, 2000, and the related
condensed consolidated statements of income for the three-month and six-month
periods ended June 30, 2000 and 1999 and related condensed consolidated
statements of stockholders' equity and of cash flows for the six-month periods
ended June 30, 2000 and 1999. 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 auditing standards generally accepted in the United States of America, 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 accounting principles generally accepted in the United States of
America.
We have previously audited, in accordance with auditing standards generally
accepted in the United States of America, the consolidated balance sheet of CNA
Surety Corporation and subsidiaries as of December 31, 1999, 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 22,
2000, 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, 1999 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
August 7, 2000
3
<PAGE> 4
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(Unaudited)
June 30, December 31,
2000 1999
---------- ----------
ASSETS Invested assets and cash:
Fixed income securities, at fair value
(amortized cost: $444,187
and $436,690)................................. $ 430,700 $ 417,956
Equity securities, at fair value
(cost: $28,453 and $23,968)................... 28,082 25,897
Short-term investments, at cost
(approximates fair value)..................... 51,205 43,033
Other investments, at fair value................ 4,989 5,277
Cash............................................ 10,538 7,237
---------- ----------
Total invested assets and cash............... 525,514 499,400
Deferred policy acquisition costs................. 93,398 84,924
Insurance receivables:
Premiums........................................ 9,253 9,822
Reinsurance, including $46,650 and $57,129
from affiliates............................... 70,110 76,158
Intangible assets, net of accumulated
amortization of $16,377 and $13,329
at June 30, 2000 and December 31, 1999,
respectively.................................. 152,931 155,980
Property and equipment, at cost (less accumulated
depreciation: $12,378 and $11,094)............ 15,915 14,769
Prepaid reinsurance premiums...................... 4,000 2,302
Other assets...................................... 8,687 8,220
---------- ----------
Total assets............................... $ 879,808 $ 851,575
========== ==========
LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses...... $ 166,169 $ 157,933
Unearned premiums............................... 207,345 199,300
---------- ----------
Total reserves............................... 373,514 357,233
Debt ............................................. 101,900 101,900
Deferred income taxes, net........................ 13,777 10,447
Payable for securities purchased.................. 3,439 7,487
Current income taxes payable...................... 5,921 7,076
Reinsurance and other payables to affiliates...... 4,125 7,229
Other liabilities................................. 28,821 33,899
---------- ----------
Total liabilities............................ $ 531,497 $ 525,271
---------- ----------
Commitments and contingencies (See Note 4)
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; 44,126 shares
issued and 42,899 shares outstanding at
June 30, 2000 and 44,123 shares issued
and 43,006 shares outstanding at
December 31, 1999............................. 441 441
Additional paid-in capital........................ 253,389 253,366
Retained earnings................................. 116,776 95,419
Accumulated other comprehensive income (loss)..... (9,313) (11,150)
Treasury stock, at cost........................... (12,982) (11,772)
---------- ----------
Total stockholders' equity................... 348,311 326,304
---------- ----------
Total liabilities and stockholders' equity... $ 879,808 $ 851,575
========== ==========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
<PAGE> 5
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
June 30, June 30,
-------------------------------------------------
2000 1999 2000 1999
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Revenues:
Net earned premiums................ $ 75,554 $ 69,688 $ 151,241 $ 137,558
Net investment income.............. 7,267 6,172 14,468 12,513
Net realized investment gains...... 234 24 230 420
---------- ---------- ---------- ----------
83,055 75,884 165,939 150,491
---------- ---------- ---------- ----------
Expenses:
Net losses and loss
adjustment expenses.............. 13,688 11,758 27,260 23,672
Net commissions, brokerage and
other underwriting............... 44,025 41,838 88,833 81,816
Interest expense................... 1,729 1,331 3,350 2,820
Non-recurring charge............... 500 -- 500 --
Amortization of intangible assets.. 1,523 1,475 3,048 2,950
---------- ---------- ---------- ----------
61,465 56,402 122,991 111,258
---------- ---------- ---------- ----------
Income before income taxes........... 21,590 19,482 42,948 39,233
Income taxes......................... 7,483 6,644 14,728 13,352
---------- ---------- ---------- ----------
Net income........................... $ 14,107 $ 12,838 $ 28,220 $ 25,881
========== ========== ========== ==========
Earnings per share................... $ 0.33 $ 0.29 $ 0.66 $ 0.59
========== ========== ========== ==========
Earnings per share, assuming
dilution........................... $ 0.33 $ 0.29 $ 0.66 $ 0.59
========== ========== ========== ==========
Weighted average shares outstanding.. 42,898 44,098 42,930 44,099
========== ========== ========== ==========
Weighted average shares outstanding,
assuming dilution.................. 43,080 44,267 43,080 44,238
========== ========== ========== ==========
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
<PAGE> 6
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
Common Accumulated
Stock Additional Other Total
Shares Common Paid-In Comprehensive Retained Comprehensive Treasury Stockholders'
Outstanding Stock Capital Income Earnings Income Stock Equity
----------- ------- --------- ------------- -------- ------------- -------- -------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance, December 31, 1998...... 44,093 $ 441 $ 253,215 $ 52,984 $ 3,257 $ -- $ 309,897
Comprehensive income:
Net income.................... -- -- -- $ 25,881 25,881 -- -- 25,881
Other comprehensive income:
Change in unrealized gains
(losses) on securities (after
income taxes), net of
reclassification adjustment
of $775..................... -- -- -- (10,200) -- (10,200) -- (10,200)
---------
Total comprehensive
income................... $ 15,681
=========
Issuance of common stock........ -- -- -- -- -- -- --
Purchase of treasury stock...... (13) -- -- -- -- (163) (163)
Stock options exercised......... 22 -- 111 -- -- -- 111
Dividends paid to stockholders.. -- -- -- (7,057) -- -- (7,057)
------ ------- --------- -------- --------- -------- ---------
Balance, June 30, 1999.......... 44,102 $ 441 $ 253,326 $ 71,808 $ (6,943) $ (163) $ 318,469
====== ======= ========= ======== ========= ======== =========
Balance, December 31, 1999...... 43,006 $ 441 $ 253,366 $ 95,419 $ (11,150) $(11,772) $326,304
Comprehensive income:
Net income.................... -- -- -- 28,220 28,220 -- -- 28,220
Other comprehensive income:
Change in unrealized gains
(losses) on securities
(after income taxes), net
of reclassification
adjustment of $375 -- -- -- 1,837 -- 1,837 -- 1,837
---------
Total comprehensive income. $ 30,057
=========
Purchase of treasury stock...... (110) -- -- -- -- (1,210) (1,210)
Stock options exercised
and other..................... 3 -- 23 -- -- -- 23
Dividends paid to stockholders.. -- -- -- (6,863) -- -- (6,863)
------ ------- --------- -------- --------- -------- ---------
Balance, June 30, 2000.......... 42,899 $ 441 $ 253,389 $116,776 $ (9,313) $(12,982) $ 348,311
====== ======= ========= ======== ========== ========= =========
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
6
<PAGE> 7
CNA SURETY CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
(UNAUDITED)
Six Months Ended
June 30,
------------------------
2000 1999
---------- ----------
OPERATING ACTIVITIES:
Net income....................................... $ 28,220 $ 25,881
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization................. 4,602 4,032
Accretion of bond discount, net............... 606 1,117
Net realized investment (gains)............... (230) (420)
Changes in:
Insurance receivables......................... 6,617 (25,649)
Reserve for unearned premiums................. 8,045 8,366
Reserve for unpaid losses and loss
adjustment expenses......................... 8,236 8,457
Deferred policy acquisition costs............. (8,474) (6,343)
Deferred income taxes, net.................... 2,338 1,487
Reinsurance and other payables to affiliates.. (3,104) (5,683)
Other assets and liabilities.................. (8,225) 4,760
---------- ----------
Net cash provided by operating activities... 38,631 16,005
---------- ----------
INVESTING ACTIVITIES:
Fixed income securities:
Purchases..................................... (70,472) (117,535)
Maturities.................................... 53,048 23,207
Sales......................................... 7,197 96,317
Purchases of equity securities................... (7,961) (6,035)
Proceeds from the sale of equity securities...... 5,621 51
Changes in short-term investments................ (7,964) 9,687
Purchases of property and equipment.............. (2,863) (7,064)
Other, net....................................... (3,880) (2,238)
---------- ----------
Net cash used in investing activities....... (27,274) (3,610)
---------- ---------
FINANCING ACTIVITIES:
Principal payments on long-term debt............. -- (13,000)
Dividends to stockholders........................ (6,864) (7,057)
Purchase of treasury stock....................... (1,210) (163)
Other............................................ 18 64
---------- ----------
Net cash used in financing activities....... (8,056) (20,156)
---------- ----------
Increase in cash................................... 3,301 (7,761)
Cash at beginning of period........................ 7,237 17,746
---------- ----------
Cash at end of period.............................. $ 10,538 $ 9,985
========== ==========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest...................................... $ 3,829 $ 3,375
Income taxes.................................. $ 13,050 $ 8,800
The accompanying notes are an integral part of these condensed consolidated
financial statements.
7
<PAGE> 8
CNA SURETY CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2000
(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 1999 Annual Report to Shareholders. Certain financial
information that is normally included in annual financial statements prepared in
accordance with accounting principles generally accepted in the United States of
America 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 1999 Financial Statements to conform
with the presentation in the 2000 Condensed Consolidated Financial Statements.
8
<PAGE> 9
2. INVESTMENTS
The estimated amortized cost and fair value of fixed income securities held
by CNA Surety at June 30, 2000 and December 31, 1999, by investment category,
were as follows (dollars in thousands):
<TABLE>
<CAPTION>
Gross Gross
Amortized Cost Unrealized Unrealized Estimated Fair
June 30, 2000 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............................. $ 19,778 $ 52 $ (123) $ 19,707
U.S. Agencies............................. 51,842 -- (1,252) 50,590
Collateralized mortgage obligations....... 1,563 -- (33) 1,530
Mortgage pass-through securities.......... 43,524 -- (1,656) 41,868
Obligations of states and political subdivisions 232,738 1,469 (7,696) 226,511
Corporate bonds................................ 43,379 112 (3,192) 40,299
Non-agency collateralized mortgage obligations 11,763 -- (270) 11,493
Other asset-backed securities:
Second mortgages/home equity loans........... 15,639 12 (335) 15,316
Credit card receivables...................... 10,561 1 (410) 10,152
Manufactured housing......................... 7,983 64 (270) 7,777
Other........................................ 1,417 14 (4) 1,427
Redeemable preferred stock..................... 4,000 30 -- 4,030
---------- ---------- ---------- ----------
Total fixed income securities............. 444,187 1,754 (15,241) 430,700
Equity securities.............................. 28,453 2,817 (3,188) 28,082
---------- ---------- ---------- ----------
Total..................................... $ 472,640 $ 4,571 $ (18,429) $ 458,782
========== ========== =========== ==========
Gross Gross
Amortized Cost Unrealized Unrealized Estimated Fair
December 31, 2000 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............................. $ 17,575 $ 6 $ (129) $ 17,452
U.S. Agencies............................. 49,786 58 (1,764) 48,080
Collateralized mortgage obligations....... 2,123 3 (10) 2,116
Mortgage pass-through securities.......... 46,701 -- (1,610) 45,091
Obligations of states and political subdivisions 229,499 56 (11,402) 218,153
Corporate bonds................................ 43,395 3 (2,934) 40,464
Non-agency collateralized mortgage obligations 12,845 -- (278) 12,567
Other asset-backed securities:
Second mortgages/home equity loans........... 19,041 16 (237) 18,820
Credit card receivables...................... 8,101 1 (323) 7,779
Other........................................ 7,624 2 (192) 7,434
---------- ---------- ----------- ----------
Total fixed income securities............. 436,690 145 (18,879) 417,956
Equity securities.............................. 23,968 3,274 (1,345) 25,897
---------- ---------- ---------- ----------
Total..................................... $ 460,658 $ 3,419 $ (20,224) $ 443,853
========== ========== =========== ==========
</TABLE>
9
<PAGE> 10
3. REINSURANCE
The effect of reinsurance on the Company's written and earned premium was
as follows (dollars in thousands):
Six Months Ended June 30,
------------------------------------------
2000 1999
------------------- -------------------
Written Earned Written Earned
-------- -------- -------- --------
Direct............................ $ 58,601 $ 52,686 $ 56,127 $ 50,548
Assumed from affiliates........... 104,431 104,631 93,578 90,103
Ceded............................. (5,443) (6,076) (4,170) (3,093)
-------- -------- -------- --------
$157,589 $151,241 $145,535 $137,558
======== ======== ======== ========
The effect of reinsurance on the Company's provision for loss and loss
adjustment expenses was as follows (dollars in thousands):
Six Months Ended
June 30,
-------------------
2000 1999
-------- --------
Gross loss and loss adjustment expense.................. $ 53,896 $ 27,406
Ceded amounts........................................... (26,636) (3,734)
-------- --------
Net loss and loss adjustment expense.................... $ 27,260 $ 23,672
======== ========
4. 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.
5. PROPOSED TENDER OFFER
On March 20, 2000, Continental Casualty Company ("CCC") proposed a cash
tender offer to purchase the remaining common stock of CNA Surety that it and
its affiliates did not own for $13.00 per share. On May 26, 2000, CCC informed
CNA Surety that CCC did not intend to pursue a proposed tender offer to acquire
the remaining equity interests of the Company not currently owned by CCC. The
Company recorded a non-recurring charge of $0.5 million before income taxes, or
$0.3 million after tax (1 cent per share), for costs incurred with respect to
the proposed tender offer by CCC.
As reported in CNA Financial Corporation ("CNAF") public filings, CCC and
other insurance subsidiaries of CNAF that own shares of CNA Surety may review
their respective positions of CNA Surety shares from time to time and may
acquire additional shares depending upon market conditions or other factors
existing at the time of such review, resulting in increases or decreases in
their respective positions.
The Company postponed its Annual Meeting of Shareholders which was
originally scheduled for May 16, 2000. The Annual Meeting of Shareholders was
postponed pending the outcome of CCC's proposed tender offer. The Annual Meeting
of Shareholders has been rescheduled for August 15, 2000.
10
<PAGE> 11
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 63% of the outstanding common stock of CNA
Surety. Loews Corporation owns approximately 87% 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
("CCC Surety Operations" or "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. Management anticipates that the Administrative
Services Agreement that expires on September 30, 2000 will be renewed on similar
terms and conditions as the current arrangement.
PROPOSED TENDER OFFER
On March 20, 2000, CCC proposed a cash tender offer to purchase the
remaining common stock of CNA Surety that it and its affiliates did not own for
$13.00 per share. On May 26, 2000, CCC informed CNA Surety that CCC did not
intend to pursue a proposed tender offer to acquire the remaining equity
interests of the Company not currently owned by CCC. The Company recorded a
non-recurring charge of $0.5 million before income taxes, or $0.3 million after
tax (1 cent per share), for costs incurred with respect to the proposed tender
offer by CCC.
11
<PAGE> 12
As reported in CNAF public filings, CCC and other insurance subsidiaries of
CNAF that own shares of CNA Surety may review their respective positions of CNA
Surety shares from time to time and may acquire additional shares depending upon
market conditions or other factors existing at the time of such review,
resulting in increases or decreases in their respective positions.
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. The insurance subsidiaries write, on a direct basis or as business assumed
from CCC and CIC, small fidelity and non-contract surety bonds, referred to as
commercial bonds; small, medium and large contract bonds; international surety
and credit insurance; and errors and omissions ("E&O") liability insurance.
Western Surety is a licensed insurer in all 50 states and the District of
Columbia. USA is licensed in 44 states and the District of Columbia. Western
Surety's affiliated company, Surety Bonding Company of America ("SBCA"), is
licensed in 24 states.
"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.
12
<PAGE> 13
RESULTS OF OPERATIONS
CNA SURETY RESULTS FOR THREE- AND SIX- MONTHS ENDED JUNE 30, 2000 AND 1999
The components of net income for the Company for the three and six months
ended June 30, 2000 and 1999 are summarized as follows (dollars in thousands,
except per share amounts):
Three Months Ended Six Months Ended
June 30, June 30,
------------------- -------------------
2000 1999 2000 1999
-------- -------- -------- --------
Total revenues................ $ 83,055 $ 75,884 $165,939 $150,491
======== ======== ======== ========
Underwriting income........... $ 17,841 $ 16,092 $ 35,148 $ 32,070
Net investment income......... 7,267 6,172 14,468 12,513
Net investment gains.......... 234 24 230 420
Interest expense.............. 1,729 1,331 3,350 2,820
Non-recurring charge.......... 500 -- 500 --
Amortization of intangible
assets...................... 1,523 1,475 3,048 2,950
-------- -------- -------- --------
Income before income taxes.... 21,590 19,482 42,948 39,233
Income taxes.................. 7,483 6,644 14,728 13,352
-------- -------- -------- --------
Net income.................... $ 14,107 $ 12,838 $ 28,220 $ 25,881
======== ======== ======== ========
Net income per share.......... $ 0.33 $ 0.29 $ 0.66 $ 0.59
======== ======== ======== ========
Insurance Underwriting
Underwriting results for the Company for the three and six months ended
June 30, 2000 and 1999 are summarized in the following table (dollars in
thousands):
Three Months Ended Six Months Ended
June 30, June 30,
------------------- -------------------
2000 1999 2000 1999
-------- -------- -------- --------
Gross written premiums....... $ 82,376 $ 78,181 $163,031 $149,705
======== ======== ======== ========
Net written premiums......... $ 78,410 $ 76,173 $157,589 $145,535
======== ======== ======== ========
Net earned premiums.......... $ 75,554 $ 69,688 $151,241 $137,558
Net losses and loss
adjustment expenses......... 13,688 11,758 27,260 23,672
Net commissions, brokerage
and other................... 44,025 41,838 88,833 81,816
-------- -------- -------- --------
Underwriting income........... $ 17,841 $ 16,092 $ 35,148 $ 32,070
======== ======== ======== ========
Loss ratio.................... 18.1% 16.9% 18.0% 17.2%
Expense ratio................. 58.3 60.0 58.8 59.5
-------- -------- -------- --------
Combined ratio................ 76.4% 76.9% 76.8% 76.7%
======== ======== ======== ========
Premiums Written
CNA Surety primarily markets contract and commercial surety bonds. Contract
surety bonds secure a contractor's performance and/or payment obligation
generally with respect to a construction project. Contract surety bonds are
generally required by federal, state and local governments for public works
projects. The most common types include bid, performance and payment bonds.
Commercial surety bonds include all surety bonds other than contract and cover
obligations typically required by law or regulation. The commercial surety
market includes numerous types of bonds categorized as court judicial, court
fiduciary, public official, license and permit and many miscellaneous bonds that
include guarantees of financial performance. The Company also writes fidelity
bonds which cover losses arising from employee
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dishonesty and other insurance products.
Gross written premiums are shown in the table below (dollars in thousands):
Three Months Ended Six Months Ended
June 30, June 30,
------------------- -------------------
2000 1999 2000 1999
-------- -------- -------- --------
Contract...................... $ 42,152 $ 39,004 $ 79,567 $ 69,717
Commercial.................... 33,739 32,902 69,486 66,267
Fidelity and other............ 6,485 6,275 13,978 13,721
-------- -------- -------- --------
$ 82,376 $ 78,181 $163,031 $149,705
======== ======== ======== ========
Gross written premiums increased 5.4%, or $4.2 million, for the three
months ended June 30, 2000 over the comparable period in 1999. Contract surety
accounted for the majority of this increase with growth of 8.1%, or $3.1
million, in gross written premiums as compared to 1999. This increase reflects
generally favorable economic conditions for public construction nationwide. The
highway/bridge sector has shown particular strength in new account and bid
activity 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, excluding
international reinsurance business assumed from CNA Reinsurance Company, Limited
(London) ("CNA Re"), increased 2.8%, or $0.8 million, for the three months ended
June 30, 2000, primarily due to competitive market conditions in the large
commercial products. CNA Surety assumed $3.0 million of international surety and
credit business for the three months ended June 30, 2000 and 1999, respectively,
through a quota share reinsurance treaty with CNA Re, an affiliate of CCC.
Fidelity and other products increased 3.3% to $6.5 million for the three months
ended June 30, 2000 as compared to the same period in 1999.
Gross written premiums for the first half of 2000 increased 8.9%, or $13.3
million, compared to the same period in 1999. Contract surety and commercial
surety gross written premiums increased 14.1% and 4.9%, respectively, for the
first half of 2000. CNA Surety assumed $6.0 million and $5.3 million of
international surety and credit business for the six months ended June 30, 2000
and 1999, respectively, through a quota share reinsurance treaty with an
affiliate of CCC, CNA Re. Fidelity and other products increased 1.9% to $14.0
million for the six months ended June 30, 2000 as compared to the same period in
1999.
Net written premiums are shown in the table below (dollars in thousands):
Three Months Ended Six Months Ended
June 30, June 30,
------------------- -------------------
2000 1999 2000 1999
-------- -------- -------- --------
Contract...................... $ 38,546 $ 37,838 $ 74,476 $ 67,497
Commercial.................... 33,354 32,511 68,669 65,395
Fidelity and other............ 6,510 5,824 14,444 12,643
-------- -------- -------- --------
$ 78,410 $ 76,173 $157,589 $145,535
======== ======== ======== ========
For the three months ended June 30, 2000, net written premiums increased
2.9%, or $2.2 million, over the comparable period in 1999. Net written premium
growth for the second quarter 2000 was reduced by increased reinsurance costs.
Ceded premiums increased $2.0 million to $4.0 million in the second quarter. Net
written premiums increased 1.9%, or $0.7 million, for the contract surety
business. Commercial surety net written premiums increased 2.6%, or $0.8 million
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<PAGE> 15
for the three months ended June 30, 2000. The fidelity and other products
increased 11.8%, or $0.7 million, for the second quarter in 2000 as compared to
the same period in 1999. This increase is primarily due to the cancellation of
reinsurance for other products as of September 30, 1999 that increased our
retention rate on this business from 20% to 100%.
For the first half of 2000, net written premiums increased 8.3%, or $12.1
million, over the comparable period in 1999 with contract surety and commercial
surety up 10.3% and 5.0%, respectively. The fidelity and other book of business
increased 14.2%, or $1.8 million, for the six months ended June 30, 2000 as
compared to the same period in 1999.
In the second half of calendar year 1999, the Company experienced an
increase in claim severity in the most recent accident years, primarily with
respect to large commercial risks. As a result of this increase in large loss
activity where the Company cedes loss amounts in excess of $5 million per
principal under its excess of loss reinsurance program, CNA Surety anticipates
paying higher costs for reinsurance. The increase in reinsurance costs will
begin to impact net earned premiums in the third quarter of 2000. Assuming a
return to more normal loss experience going forward, the Company's reinsurance
costs could begin to decline as early as the fourth quarter of 2000. The
expected increase in reinsurance costs will have an adverse impact on the
Company's future results of operations.
Underwriting Income
Underwriting income increased 10.9% to $17.8 million for the three months
ended June 30, 2000 compared to the same period in 1999 primarily reflecting an
8.4% period to period increase in net earned premiums. Underwriting income
increased 9.6% to $35.1 million for the six months ended June 30, 2000 compared
to the same period in 1999. The six month period to period change in
underwriting income reflects a 10.0% increase in earned premiums.
Loss Ratio
The loss ratios for the three months ended June 30, 2000 and 1999 were
18.1% and 16.9%, respectively. The loss ratios included $1.8 million and $2.4
million of net favorable reserve development for the three months ended June 30,
2000 and 1999, respectively. Excluding the impact of the favorable reserve
development, the loss ratios would have been 20.5% and 20.4% for the three month
periods ended June 30, 2000 and 1999, respectively. For the six months ended
June 30, 2000 and 1999, the loss ratios were 18.0% and 17.2%, respectively. The
loss ratios included $3.9 million and $4.1 million of net favorable reserve
development for the six months ended June 30, 2000 and 1999, respectively.
Excluding the impact of the favorable reserve development, the loss ratios would
have been 20.6% and 20.2% for the six month periods ended June 30, 2000 and June
30, 1999, respectively.
The net favorable development taken in 2000 reflects on-going positive loss
trends primarily with respect to accident years prior to 1997 partially offset
by adverse development in more recent years with respect to small contract
surety and agent E&O products. The increase in the adjusted loss ratio in 2000
relates primarily to changes in business mix to a higher proportion of contract
surety business which carries a higher accident year loss ratio and increased
retentions on agent E&O business.
Expense Ratio
The expense ratio decreased to 58.3% for the three months ended June 30,
2000 compared to 60.0% for the same period in 1999. For the six months ended
June 30, 2000, the expense ratio decreased to 58.8% from 59.5% for the same
period in 1999. The 1999 expense ratio reflected certain information
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<PAGE> 16
technology related expenditures and other costs related to back office
consolidation efforts. Given the prospective impact of higher reinsurance costs
on net earned premiums, management expects the expense ratio to increase from
58.8% experienced for the first half of 2000 if all other variables remain
constant. The Company is working to offset higher reinsurance costs and softness
in certain markets with continued productivity improvements and operating
efficiencies.
Investment Income
For the three months ended June 30, 2000, net investment income was $7.3
million compared to $6.2 million for the same period in 1999. The increase in
investment income for the three months ended June 30, 2000 reflects higher
average invested assets. The average pretax yield was 5.4% for the three months
ended June 30, 2000 and 1999. Net investment income for the six months ended
June 30, 2000 and 1999 was $14.5 million and $12.5 million, respectively. The
average pretax yields were 5.6% and 5.3% for the six months ended June 30, 2000
and 1999, respectively.
Net realized investment gains were $0.2 million for the three months ended
June 30, 2000 compared to minimal net realized investment gains for the same
period in 1999. For the six months ended June 30, 2000, net realized investment
gains were $0.2 million compared to $0.4 million net realized investment gains
for the same period in 1999.
Analysis of Other Operations
Amortization expense was $1.5 million for the three months ended June 30,
2000 and 1999. For the six months ended June 30, 2000 and 1999, amortization of
intangibles was $3.0 million. 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 increased 29.9% for the second quarter of 2000 as compared
to the same period in 1999, primarily due to higher interest rates. Average debt
outstanding was $101.9 million for the second quarter in 2000 compared to $100.0
million in the second quarter of 1999. The weighted average interest rate for
the three months ended June 30, 2000 was 6.5% compared to 5.1% for the same
period in 1999. Interest expense increased 18.8% for the first six months of
2000 as compared to the same period in 1999. Average debt outstanding was $101.9
million for the first six months in 2000 compared to $105.8 million in the first
six months of 1999. The weighted average interest rate for the six months ended
June 30, 2000 was 6.4% compared to 5.2% for the same period in 1999.
During the second quarter of 2000, CNA Surety incurred a $0.3 million,
after applicable income taxes, or $0.01 per share, non-recurring charge for
costs incurred with respect to the proposed tender offer by CNAF.
Income Taxes
Income tax expense was $7.5 million and $6.6 million and the effective
income tax rates were 34.7% and 34.1% for the three months ended June 30, 2000
and 1999, respectively. For the six months ended June 30, 2000 and 1999, income
tax expense was $14.7 million and $13.4 million and the effective income tax
rates were 34.3% and 34.0%, respectively.
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<PAGE> 17
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 June 30, 2000, the carrying value of the Company's insurance
subsidiaries' invested assets was comprised of $430.7 million of fixed income
securities, $28.1 million of equity securities, $25.5 million of short-term
investments, $5.0 million of other investments and $9.2 million of cash. At
December 31, 1999, the carrying value of the Company's insurance subsidiaries'
invested assets was comprised of $418.0 million of fixed income securities,
$25.9 million of equity securities, $31.4 million of short-term investments,
$5.3 million of other investments and $5.8 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 June 30, 2000, the parent
company's invested assets consisted of $25.7 million of short-term investments
and $1.3 million of cash. At December 31, 1999, the parent company's invested
assets consisted of $11.6 million of short-term investments and $1.4 million of
cash.
The Company's consolidated net cash flow provided by operating activities
was $38.6 million for the six months ended June 30, 2000 and $16.0 million for
the comparable period in 1999. The increase in net cash flow provided by
operating activities primarily relates to a decrease in insurance receivables.
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
June 30, 2000, CNA Surety has repaid $18 million of this debt and has unused
capacity under the revolver of approximately $30 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%. As of June 30, 2000, the weighted average interest rate was 6.9% on the
$100.0 million of outstanding borrowings. As of December 31, 1999, the weighted
average interest rate was 6.3% on the $100.0 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 June 30, 2000, the Company
was in compliance with all restrictions and covenants contained in the Credit
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<PAGE> 18
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.
During 1999, CNA Surety acquired certain assets of Clark Bonding Company,
Inc., a Charlotte, North Carolina, insurance agency and brokerage doing business
as The Bond Exchange for $5.9 million. As part of this acquisition, the Company
incurred an additional $1.9 million of debt in the form of a promissory note.
The promissory note matures on July 27, 2004 and has an interest rate of 5.0%.
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 2000 is based on
statutory surplus and income at and for the year ended December 31, 1999.
Without prior regulatory approval in 2000, CNA Surety's insurance subsidiaries
may pay stockholder dividends of $60.5 million in the aggregate. CNA Surety
received $20.0 million in dividends from its insurance subsidiaries during the
first six months of 2000 and $15.0 million in the first six months of 1999.
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 (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 $15.2 million for the six months ended
June 30, 2000 and $12.9 million for the same period in 1999.
CNA Surety management believes that it will have sufficient available
resources to meet its present capital needs.
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CNA SURETY CORPORATION AND SUBSIDIARIES
PART II - OTHER INFORMATION
ITEM 1. Legal Proceedings:
The Company, its directors and majority stockholders had been named as
defendants in several lawsuits seeking class action status in connection with
the proposed cash tender offer by Continental Casualty Company, a subsidiary of
CNA Financial Corporation, to purchase the shares of CNA Surety common stock
that it or its affiliates do not currently own. These lawsuits were filed within
the Delaware Chancery Court and requested unspecified damages. On July 6, 2000,
notices of voluntary dismissal were filed in all cases connected with this
proposed tender offer which named CNA Surety as a defendant.
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:
May 15, 2000; CNA Surety Corporation Press Release issued
on May 8, 2000.
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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: August 11, 2000
20
