<PAGE>

================================================================================

                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                   ----------

                                   FORM 10-K/A

                                   ----------

|X|   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
      ACT OF 1934

                   FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002

| |   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)

                                   ----------

        Securities registered pursuant to Section 12(b) of the Act: NONE

           Securities registered pursuant to Section 12(g) of the Act:
                          COMMON STOCK, $0.01 PAR VALUE
                                (Title of Class)

                                   ----------

      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 | |

      Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. | |

      Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes |X| No | |

      The aggregate market value of voting stock held by nonaffiliates was
$122.7 million based upon the closing price of $7.90 per share on March 3, 2003,
using beneficial ownership of stock rules adopted pursuant to Section 13 of the
Securities Exchange Act of 1934 to exclude voting stock owned by Directors,
Officers and Major Stockholders, some of whom may not be held to be affiliates
upon judicial determination.

      At March 3, 2003, 42,958,207 shares of the Registrant's Common Stock were
outstanding.

                      DOCUMENTS INCORPORATED BY REFERENCE:

      Portions of the CNA Surety Corporation Proxy Statement prepared for the
2003 annual meeting of shareholders, pursuant to Regulation 14A, are
incorporated by reference into Part III of this report.

================================================================================
<PAGE>
                                EXPLANATORY NOTE

This Amendment No. 1 on Form 10-K/A amends the Registrant's Annual Report on
Form 10-K for the period ended December 31, 2002 as filed by the Registrant on
March 26, 2003 and is being filed to amend and restate Item 1 (Business), Item 6
(Selected Financial Data), Item 7 (Management's Discussion and Analysis of
Financial Condition and Results of Operations), Item 8 (Financial Statements and
Supplementary Data), Item 14 (Controls and Procedures) and Item 15 (Exhibits,
Financial Statement Schedules, and Reports on Form 8-K). Subsequent to the
filing of the CNA Surety Corporation ("CNA Surety" or "Company") Report on Form
10-K for the fiscal year ended December 31, 2002, the Company revised its
accounting for ceded premiums under a multiple year excess of loss reinsurance
treaty with its affiliate, Continental Casualty Company ("CCC"), which has been
in place since October 1, 2002. Under the contract CNA Surety pays a quarterly
premium of $3.125 million, of which 70% is added to an experience account that
is reduced by any losses ceded to the treaty. To the extent CNA Surety commutes
the treaty, it is entitled to receive payment from CCC of its experience
account balance. Under Emerging Issues Task Force ("EITF") Issue 93-6
"Accounting for Multiple-Year Retrospectively Rated Contracts by Ceding and
Assuming Enterprises" ("EITF 93-6"), a receivable for return premium based on
experience under the contract should be established at December 31, 2002. CNA
Surety had not previously established such a receivable, and has restated its
2002 consolidated financial statements to comply with EITF 93-6.

This report on Form 10-K/A does not reflect the effect of any events subsequent
to the filing of the original Form 10-K, except the aforementioned restatement.


                                       2
<PAGE>
                     CNA SURETY CORPORATION AND SUBSIDIARIES

                                TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                                                       PAGE
                                                                                       ----
<S>                                                                                    <C>
      PART  I

       Item 1.       Business ......................................................    4
                     General .......................................................    4
                     Formation of CNA Surety and Merger ............................    4
                     Description of Business .......................................    4
                     Financial Strength Ratings ....................................    4
                     Product Information ...........................................    4-5
                     Marketing .....................................................    7
                     Underwriting ..................................................    8
                     Competition ...................................................    8
                     Reinsurance ...................................................    8
                     Reserves for Unpaid Losses and Loss Adjustment Expenses .......    9
                     Claims ........................................................    11
                     Environmental Claims ..........................................    11
                     Regulation ....................................................    11
                     Investments ...................................................    12
                     Employees .....................................................    12
      PART II

       Item 6.       Selected Financial Data .......................................    14
       Item 7.       Management's Discussion and Analysis of Financial Condition
                     and Results of Operations .....................................    15
       Item 8.       Financial Statements and Supplementary Data ...................    35

      PART III

       Item 14.      Controls and Procedures .......................................    61
      PART IV

       Item 15.      Exhibits, Financial Statement Schedules, and Reports on Form
                     8-K ...........................................................    62
</TABLE>


                                       3
<PAGE>
                     CNA SURETY CORPORATION AND SUBSIDIARIES

                                     PART I.

ITEM 1. BUSINESS

GENERAL

      CNA Surety Corporation ("CNA Surety" or the "Company") is an insurance
holding company in the United States formed through the September 30, 1997
combination of the surety business of CNA Financial Corporation with Capsure
Holdings Corp.'s ("Capsure") insurance subsidiaries. CNA Surety is currently one
of the largest surety providers in the United States with approximately an 8.8%
market share (based upon 2001 A.M. Best Company, Inc. written premium data). Its
wide selection of products range from very small commercial bonds to large
contract bonds.

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 CNA Surety. 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 64% of the
outstanding common stock of CNA Surety. Loews Corporation owns approximately 90%
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.

DESCRIPTION OF BUSINESS

      CNA Surety's insurance subsidiaries write surety and fidelity bonds in all
50 states through a combined network of approximately 34,000 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 small, medium and large non-contract surety
bonds, referred to as commercial bonds; small, medium and large contract bonds;
and errors and omissions ("E&O") liability insurance. Western Surety is a
licensed insurer in all 50 states, the District of Columbia and Puerto Rico. 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
28 states and the District of Columbia.

FINANCIAL STRENGTH RATINGS

A.M. BEST COMPANY, INC. ("A.M. BEST")

      Western Surety and USA are both currently rated A+ (Superior), by A.M.
Best. An A+ (Superior) rating is assigned to those companies which A.M. Best
believes have achieved superior overall performance when compared to the norms
of the property and casualty insurance industry. A+ (Superior) rated insurers
have been shown to be among the strongest in ability to meet policyholder and
other contractual obligations. Through intercompany reinsurance and related
agreements, CNA Surety's customers have access to CCC's broader underwriting
capacity. CCC is currently rated A (Excellent) by A.M. Best. A.M. Best's letter
ratings range from A++ (Superior) to F (In Liquidation) with A++ being highest.

STANDARD AND POOR'S ("S&P")

      CCC, Western Surety and USA are all currently rated A- (Strong), by S&P.
S&P's letter ratings range from AAA+ (Extremely Strong) to CC (Extremely Weak)
with AAA+ being highest. Ratings from "AA" to "CCC" may be modified by the
addition of a plus or minus sign to show relative standing within the major
rating categories. An insurer rated "A" has strong financial security
characteristics, but is somewhat more likely to be affected by adverse business
conditions than are insurers with higher ratings.

PRODUCT INFORMATION


                                       4
<PAGE>
      According to the Surety Association of America ("SAA") industry estimates
for 2000, approximately 75% of the United States surety market is represented by
bonds required by federal statutes, state laws, and local ordinances. These
bonding requirements range from federal construction projects, where the
contractor is required to post performance and payment bonds which guarantee
performance of contracts to the government as well as payment of bills to
subcontractors and suppliers, to license and permit bonds which guarantee
compliance with legal requirements for business operations.

PRODUCTS AND POLICIES

      Unlike a standard, two-party insurance policy, surety bonds are
three-party agreements in which the issuer of the bond (the surety) joins with a
second party (the principal) in guaranteeing to a third party (the
owner/obligee) the fulfillment of some obligation on the part of the principal.
The surety is the party who guarantees fulfillment of the principal's obligation
to the obligee. In addition, sureties are generally entitled to recover from the
principal any losses and expenses paid to third parties. The surety's
responsibility is to evaluate the risk and determine if the principal meets the
underwriting requirements for the bond. Accordingly, surety bond premiums
primarily reflect the type and class of risk and related costs associated with
both processing the bond transaction and investigating the applicant including,
if necessary, an analysis of the applicant's creditworthiness and ability to
perform.

      There are two broad types of surety products -- contract surety 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. Commercial surety bonds include all
surety bonds other than contract and cover obligations typically required by law
or regulation.

      Contract bond guarantee obligations include the following:

            Bid bonds: used by contractors submitting proposals on potential
      contracts.

            Performance bonds: guarantee to the owner the performance of the
      contractor's obligations according to the terms and conditions of the
      contract.

            Payment bonds: guarantee payment of the contractor's obligations
      under the contract for labor, subcontractors, and materials supplied to
      the project. Payment bonds are utilized in public projects where liens are
      not permitted.

      Other examples of contract bonds are completion, maintenance and supply
bonds.

      Commercial surety business is comprised of bonds covering obligations
typically required by law or regulation, such as the following:

            License and Permit bonds: required by statutes or ordinances for a
      number of purposes including guaranteeing the payment of certain taxes and
      fees and providing consumer protection as a condition to granting licenses
      related to selling real estate or motor vehicles and contracting services.

            Judicial and Fiduciary bonds: required by statutes, courts or legal
      documents for the protection of those on whose behalf a fiduciary acts.
      Examples of such fiduciaries include executors and administrators of
      estates, and guardians of minors and incompetents.

            Public Official bonds: required by statutes and ordinances to
      guarantee the lawful and faithful performance of the duties of office by
      public officials.

      In 1997, CNA Surety expanded into the international surety and credit
insurance market through a 50% U.S. dollar denominated quota share treaty with
an affiliate of CCC, CNA Reinsurance Company, Limited (London) ("CNA Re"). In
2000, CNA Re made the decision to discontinue writing assumed international
credit and surety business.

      CNA Surety also writes direct contract and commercial surety bonds for
international risks. Such bonds are written to satisfy the international bond
requirements of the Company's domestic customers and for foreign clients.

      In 2000, CNA Surety purchased an equity interest in De Montfort Insurance
Company PLC, a United Kingdom-based insurance


                                       5
<PAGE>
company, which specializes in providing surety bonds and credit insurance. The
investment in De Montfort further supports CNA Surety's international growth
strategy by enhancing the company's international distribution capabilities in
the European surety marketplace.

      In addition, the Company markets surety related products such as fidelity
bonds and E&O insurance. Fidelity bonds cover losses arising from employee
dishonesty. Examples of purchasers of fidelity bonds are law firms, insurance
agencies and janitorial service companies. CNA Surety writes E&O policies for
two classes of insureds: notaries public and tax preparers. The notary public
E&O policy is marketed as a companion product to the notary public bond and the
tax preparer E&O policy is marketed to small tax return preparation firms.

      Although all of its products are sold through the same independent
insurance agent and broker distribution network, the Company's underwriting is
organized by the two broad types of surety products -- contract surety and
commercial surety, which also includes fidelity bonds and other insurance
products for these purposes. These two operating segments have been aggregated
into one reportable business segment for financial reporting purposes because of
their similar economic and operating characteristics.

      The following tables set forth, for each principal class of bonds, gross
written premiums, net written premiums and number of domestic bonds and policies
in force and the respective percentages of the total for the past three years
(amounts in thousands, except average bond amounts):

<TABLE>
<CAPTION>
                                                                         GROSS WRITTEN PREMIUMS
                                               ---------------------------------------------------------------------------
                                                               % OF                       % OF                       % OF
                                                 2002          TOTAL        2001          TOTAL        2000          TOTAL
                                               --------       ------      --------       ------      --------       ------
<S>                                            <C>            <C>         <C>            <C>         <C>            <C>
      Contract ..........................      $197,875        55.0%      $180,588        54.2%      $161,539        51.0%
      Commercial:
        License and permit ..............        85,787        23.9         77,052        23.1         79,114        25.0
        Judicial and fiduciary ..........        25,358         7.0         26,279         7.9         25,669         8.1
        Public official .................        18,861         5.2         18,530         5.6         18,000         5.7
        Other ...........................         4,033         1.1          3,165         1.0          5,773         1.8
                                               --------       -----       --------       -----       --------       -----
           Total commercial .............       134,039        37.2        125,026        37.6        128,556        40.6
      Fidelity and other ................        27,978         7.8         27,389         8.2         26,572         8.4
                                               --------       -----       --------       -----       --------       -----
                                               $359,892       100.0%      $333,003       100.0%      $316,667       100.0%
                                               ========       =====       ========       =====       ========       =====
      Domestic ..........................      $348,010        96.7%      $322,106        96.7%      $300,079        94.8%
      International .....................        11,882         3.3         10,897         3.3         16,588         5.2
                                               --------       -----       --------       -----       --------       -----
                                               $359,892       100.0%      $333,003       100.0%      $316,667       100.0%
                                               ========       =====       ========       =====       ========       =====
</TABLE>

<TABLE>
<CAPTION>
                                                                          NET WRITTEN PREMIUMS
                                               ---------------------------------------------------------------------------
                                                               % OF                       % OF                       % OF
                                                 2002          TOTAL        2001          TOTAL        2000          TOTAL
                                               --------       ------      --------       ------      --------       ------
<S>                                            <C>            <C>         <C>            <C>         <C>            <C>
         Contract .......................      $172,633        56.3%      $165,603        52.4%      $150,504        49.4%
         Commercial .....................       107,290        35.0        122,812        38.9        126,923        41.7
         Fidelity and other .............        26,731         8.7         27,389         8.7         27,041         8.9
                                               --------       -----       --------       -----       --------       -----
                                               $306,654       100.0%      $315,804       100.0%      $304,468       100.0%
                                               ========       =====       ========       =====       ========       =====
         Domestic .......................      $297,385        97.0%      $305,483        96.7%      $289,049        94.9%
         International ..................         9,269         3.0         10,321         3.3         15,419         5.1
                                               --------       -----       --------       -----       --------       -----
                                               $306,654       100.0%      $315,804       100.0%      $304,468       100.0%
                                               ========       =====       ========       =====       ========       =====
</TABLE>

<TABLE>
<CAPTION>
                                                                     DOMESTIC BONDS/POLICIES IN FORCE
                                               ---------------------------------------------------------------------------
                                                               % OF                       % OF                       % OF
                                                 2002          TOTAL        2001          TOTAL        2000          TOTAL
                                               --------       ------      --------       ------      --------       ------
<S>                                            <C>            <C>         <C>            <C>         <C>            <C>
                Contract ................            39         1.8%            37         1.8%            31         1.7%
                Commercial ..............         1,611        74.7          1,541        75.6          1,444        76.5
                Fidelity and other ......           507        23.5            462        22.6            411        21.8
                                               --------       -----       --------       -----       --------       -----
                                                  2,157       100.0%         2,040       100.0%         1,886       100.0%
                                               ========       =====       ========       =====       ========       =====
</TABLE>

<TABLE>
<CAPTION>
                                                 AVERAGE BOND PENALTY/POLICY LIMIT(1)
                                                 ------------------------------------
                                                   2002          2001          2000
                                                 --------      --------      --------
<S>                                              <C>           <C>           <C>
                    Contract ..............      $905,896      $900,768      $972,588
                    Commercial ............      $ 19,493      $ 22,049      $ 22,869
                    Fidelity and other ....      $ 11,152      $ 13,307      $ 14,183
</TABLE>

----------

(1)   The average bond penalty is a measure of the average limit of liability
      associated with bonds in force at each reporting period.


                                       6
<PAGE>
      In 2002, no individual agency generated more than 1.7% of aggregate gross
written premiums. Approximately $72.4 million, or 20.1%, of gross written
premiums were generated from national insurance brokers in 2002 with the single
largest national broker production comprising $28.3 million, or 7.9%, of gross
written premiums.

MARKETING

      The Company principally markets its products in all 50 states, as well as
the District of Columbia and Puerto Rico. Its products are marketed primarily
through independent producers, including multi-line agents and brokers such as
surety specialists, many of whom are members of the National Association of
Surety Bond Producers. CNA Surety enjoys broad national distribution of its
products, which are marketed through approximately 34,000 of the approximately
44,000 independent property and casualty insurance agencies in the United
States. In addition, the Company employs 42 full-time salaried marketing
representatives and 5 telemarketing representatives to continually service its
vast producer network. Relationships with these independent producers are
maintained through the Company's 41 local branch offices.

      The following table sets forth the distribution of the domestic business
of CNA Surety, by state based upon gross written premiums in each of the last
three years:

<TABLE>
<CAPTION>
                                                                        YEARS ENDED
                                                                        DECEMBER 31,
                                                              --------------------------------
                                                               2002         2001         2000
                                                              ------       ------       ------
<S>                                                           <C>          <C>          <C>
                  Gross Written Premiums by State:
                    Texas ..............................        12.6%        12.9%        11.7%
                    California .........................        10.8          9.8          8.1
                    Florida ............................         7.0          6.8          6.0
                    New York ...........................         4.9          4.9          5.1
                    Pennsylvania .......................         4.5          3.3          3.5
                    Georgia ............................         4.3          3.7          3.7
                    North Carolina .....................         3.4          2.9          2.9
                    Michigan ...........................         3.3          3.1          3.0
                    Massachusetts ......................         3.2          3.0          3.0
                    All Other ..........................        46.0         49.6         53.0
                                                              ------       ------       ------
                       Total ...........................       100.0%       100.0%       100.0%
                                                              ======       ======       ======
</TABLE>

Contract Surety

      With respect to standard contract surety, the core focus for the Company
is contractors with less than $50 million in contracted work in progress. This
segment is comprised of small contractors (less than $5 million in work in
progress), medium contractors ($5-$30 million) and the lower end of the large
contractors (greater than $30 million). These small and medium contractors, as a
group, represent a significant portion of the United States construction market.
While the Company's emphasis continues to be on small and medium contractors,
the Company's aggregate exposures to very large accounts has increased in recent
years. The Company has approximately 41 very large accounts with contracted work
programs of at least $150 million, the majority of which have been clients of
the Company for more than ten years. The Company is actively reducing both the
number of these large accounts and the exposure on each account through a
variety of underwriting methods. Some of these accounts are maintained on a
"co-surety" or joint insurer basis with other sureties in order to manage
aggregate exposure.

      In addition to standard contract surety, the Company has underwriters that
focus on serving the bond requirements of small and emerging specialty
contractors. These contractors typically have limited operating history,
financial resources or other special characteristics that require different
underwriting techniques than standard contract surety. For example, CNA Surety
participates in the non-standard contract surety market through the federal
government's Small Business Administration ("SBA") surety bond guarantee
programs. These programs provide that the SBA assumes 70% -- 90% of the coverage
in exchange for 10% -- 30% of the premium.

Commercial Surety

      A large portion of the commercial surety market is comprised of small
obligations such as license and permit bonds that are routine in nature and
require minimal underwriting. Customers are focused principally on prompt and
efficient service. These small transactional bonds represent more than 75% of
the Company's commercial gross written premiums.


                                       7
<PAGE>
      The Company continues to focus its marketing efforts on this small
commercial bond market through its Sioux Falls, South Dakota service center. In
this market segment, CNA Surety emphasizes one-day response service, easy-to-use
forms and an extensive array of commercial bond products. In addition,
independent agents are provided pre-executed bond forms, powers of attorney, and
facsimile authorizations that allow them to issue many standard bonds in their
offices.

      CNA Surety also maintains a specific underwriting staff in Chicago
dedicated to middle market and "Fortune 1000" accounts. CNA Surety's insurance
subsidiaries may also direct their marketing to particular industries or classes
of bonds on a broad basis. For instance, the Company maintains programs directed
at notary bonds, mortgage broker compliance bonds and grain warehouse dealer
bonds (protecting funds associated with grain storage). The Company's large
commercial account business is estimated to represent less than 25% of the
Company's commercial gross written premiums.

UNDERWRITING

      CNA Surety is focused on consistent underwriting profitability. The extent
and sophistication of underwriting activity varies by type of risk. Contractor
accounts and large commercial surety customers undergo credit, financial and
managerial review and analysis on a regular basis. Certain classifications of
bonds, such as fiduciary and court appeal bonds, also require more extensive
underwriting.

      CNA Surety also targets various products in the surety and fidelity bond
market which are characterized by relatively low-risk exposure and small bond
amounts. The underwriting criteria, including the extent of bonding authority
granted to independent agents, varies depending on the class of business and the
type of bond. For example, relatively little underwriting information is
typically required of certain low-exposure risks such as notary bonds.

COMPETITION

      The surety and fidelity market is highly competitive. According to 2001
data from A.M. Best, the U.S. market aggregates approximately $4.4 billion in
direct written premiums, comprised of approximately $3.5 billion in surety
premiums and approximately $0.9 billion in fidelity premiums. The large
diversified insurance companies hold the largest market shares. For example, the
20 largest surety companies account for approximately 80% of the domestic surety
market and 95% of the domestic fidelity market. In 2001, CNA Surety was the
third largest surety provider with an 8.8% market share.

      Primary competitors of CNA Surety are approximately 20 national,
multi-line companies participating in the surety market throughout the country.
Management believes that its principal strengths are diverse product offerings,
service and accessibility and long-term relationships with agents and accounts.
Competition has increased as a result of ten years of profitable underwriting
experience through 1999. This competition has typically manifested itself
through reduced premium rates and greater tolerance for relaxation of
underwriting standards. Beginning in 2000 and through the end of 2002, the
surety industry's underwriting performance began to be impacted by the
significant increases in corporate defaults. Although premium rates began
firming in 2001, particularly on large accounts, management believes such
competition will continue.

REINSURANCE

      The Company's insurance subsidiaries, in the ordinary course of business,
cede reinsurance to other insurance companies and affiliates. Reinsurance
arrangements are used to limit maximum loss, provide greater diversification of
risk and minimize exposure on larger risks. Reinsurance contracts do not
ordinarily relieve the Company of its primary obligations to claimants.
Therefore, a contingent liability exists with respect to reinsurance ceded to
the extent that any reinsurer is unable to meet the obligations assumed under
reinsurance contracts. The Company evaluates the financial condition of its
reinsurers, establishes allowances for uncollectible amounts and monitors
concentrations of credit risk.

      The Company's reinsurance program is predominantly comprised of excess of
loss reinsurance contracts that limit the Company's retention on a per principal
basis. The Company's reinsurance coverage is provided by third party reinsurers
and related parties. Refer to Item 7, Management's Discussion and Analysis of
Financial Condition and Results of Operations and Note 7 to the Consolidated
Financial Statements, Reinsurance, for further discussion.

      At December 31, 2002, CNA Surety's largest reinsurance receivable from an
affiliate, CCC, an A rated company by A.M. Best, was approximately $17.6
million. At December 31, 2002, CNA Surety's largest reinsurance receivable from
a non-affiliated reinsurer


                                       8
<PAGE>
was approximately $25.6 million with a company rated A++ (Superior) by A.M.
Best.

RESERVES FOR UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES

      CNA Surety's insurance subsidiaries employ generally accepted reserving
approaches in establishing the estimated liability for unpaid losses and loss
adjustment expenses that give consideration to the inherent difficulty and
variability in the estimation process. In addition, CNA Surety utilizes an
independent actuarial firm of national standing to conduct periodic reviews of
loss reserving practices and annually obtains actuarial certification as to the
reasonableness of actuarial assumptions used and the sufficiency of year-end
reserves for each of its principal insurance subsidiaries.

      The estimated liability for unpaid losses and loss adjustment expenses
includes, on an undiscounted basis, estimates of (a) the ultimate settlement
value of reported claims, (b) incurred but not reported ("IBNR") claims, (c)
future expenses to be incurred in the settlement of claims and (d) claim
recoveries, exclusive of reinsurance recoveries which are reported as an asset.
These estimates are determined based on the Company's and surety industry loss
experience as well as consideration of current trends and conditions. The
estimated liability for unpaid losses and loss adjustment expenses is an
estimate and there is the potential that actual future loss payments will differ
significantly from initial estimates. The methods of determining such estimates
and the resulting estimated liability are regularly reviewed and updated.
Changes in the estimated liability are reflected in operating income in the
period in which such changes are determined to be needed.

      A table is included in Note 8 to the Consolidated Financial Statements,
Reserves for Losses and Loss Adjustment Expenses, that presents the activity in
the reserves for unpaid losses and loss adjustment expenses for the Company and
is incorporated herein by reference. This table highlights the impact of
revisions to the estimated liability established in prior years.

      The following table sets forth a reconciliation of the consolidated loss
reserves reported in accordance with generally accepted accounting principles
("GAAP"), and the reserves reported to state insurance regulatory authorities in
accordance with statutory accounting principles ("SAP") for the year ended
December 31, 2002 (dollars in thousands):

<TABLE>
<S>                                                                                <C>
                  Net reserves at end of year, GAAP basis ...................      $ 166,132
                  Ceded reinsurance, net of salvage and subrogation .........        137,301
                                                                                   ---------
                  Gross reserves at end of year, GAAP basis .................        303,433
                  Estimated reinsurance recoverable netted against gross
                    reserves for SAP ........................................       (137,301)
                                                                                   ---------
                  Net reserves at end of year, SAP basis ....................      $ 166,132
                                                                                   =========
</TABLE>

      The loss reserve development table below illustrates the change over time
of reserves established for the Company's estimated losses and loss adjustment
expenses at the end of various calendar years. The first section shows the
reserves as originally reported at the end of the stated year. The second
section shows the cumulative amounts paid as of the end of successive years with
respect to that reserve liability. The third section shows re-estimates of the
original recorded reserve as of the end of each successive year which is the
result of management's expanded awareness of additional facts and circumstances
that pertain to the unsettled claims. The last section compares the latest
re-estimated reserve to the reserve originally established, and indicates
whether or not the original reserve was adequate or inadequate to cover the
estimated costs of unsettled claims.

      The loss reserve development table is cumulative as of each December 31,
and, therefore, ending balances should not be added since the amount at the end
of each calendar year includes activity for both the current and prior years.
The loss reserve development table reflects, on a pro forma basis, the reserves
of the CCC Surety Operations and Capsure since 1992 and CIC since its
acquisition in May of 1995. Such historical development is not necessarily
indicative of the financial results that would have occurred under the ownership
and management of CNA Surety or of future operating results.


                                       9
<PAGE>
<TABLE>
<CAPTION>
                                                         AS OF DECEMBER 31,
                                1992         1993         1994         1995          1996          1997
                              -------      -------      -------      --------      --------      --------
                                                       (DOLLARS IN THOUSANDS)
<S>                           <C>          <C>          <C>          <C>           <C>           <C>
Net reserves for
  losses and loss
  adjustment
  expenses ..............     $61,998      $64,627      $70,398      $147,911      $137,064      $122,725
Net Paid
  (Cumulative) as of:
  One year later ........      17,636       12,923       12,018        42,552         9,866        19,595
  Two years later .......      25,854       19,671       18,149        43,179        20,171        30,775
  Three years
    later ...............      29,495       21,990       21,229        46,782        25,206        43,999
  Four years later ......      30,582       23,070       22,313        48,960        32,918        47,144
  Five years later ......      30,817       23,864       24,776        56,891        35,214        51,742
  Six years later .......      32,150       24,706       24,102        54,724        38,371            --
  Seven years
    later ...............      32,811       23,180       22,167        57,275            --            --
  Eight years
    later ...............      31,126       21,279       23,212            --            --            --
  Nine years later ......      29,220       22,271           --            --            --            --
  Ten years later .......      30,198           --           --            --            --            --
Net Reserves
  Re-estimated as of:
  End of initial
    year ................      61,998       64,627       70,398       147,911       137,064       122,725
  One year later ........      58,603       54,568       51,471       132,267        96,178       118,373
  Two years later .......      54,585       44,749       44,135       103,466        90,796       102,304
  Three years
    later ...............      47,911       38,972       38,829       101,745        77,086        87,321
  Four years later ......      42,542       28,094       38,628        89,348        62,217       86, 271
  Five years later ......      33,699       30,335       31,362        77,477        60,882        86,320
  Six years later .......      37,188       27,842       27,327        72,879        61,443            --
  Seven years
    later ...............      34,966       26,010       24,497        73,428            --            --
  Eight years
    later ...............      31,672       23,221       25,024            --            --            --
  Nine years later ......      29,727       22,821           --            --            --            --
  Ten years later .......      30,718           --           --            --            --            --
                              =======      =======      =======      ========      ========      ========
Total net
  (deficiency)
  redundancy ............     $31,280      $41,806      $45,374      $ 74,483      $ 75,621      $ 36,405
                              =======      =======      =======      ========      ========      ========
Cumulative redundancy
  (deficiency) as a
  percentage of
  original
  estimate ..............        50.5%        64.7%        64.5%         50.4%         55.2%         29.7%
                              =======      =======      =======      ========      ========      ========
</TABLE>

<TABLE>
<CAPTION>
                                                     AS OF DECEMBER 31,
                                1998          1999           2000            2001           2002
                              --------      --------      ---------       ---------       --------
                                                   (DOLLARS IN THOUSANDS)
<S>                           <C>           <C>           <C>             <C>             <C>
Net reserves for
  losses and loss
  adjustment
  expenses ..............     $142,034      $137,469      $ 134,298       $ 149,493       $166,132
Net Paid
  (Cumulative) as of:
  One year later ........       32,428        35,825         44,763          64,832             --
  Two years later .......       52,524        47,795         75,825              --             --
  Three years
    later ...............       58,421        73,341             --              --             --
  Four years later ......       67,451            --             --              --             --
  Five years later ......           --            --             --              --             --
  Six years later .......           --            --             --              --             --
  Seven years
    later ...............           --            --             --              --             --
  Eight years
    later ...............           --            --             --              --             --
  Nine years later ......           --            --             --              --             --
  Ten years later .......           --            --             --              --             --
Net Reserves
  Re-estimated as of:
  End of initial
    year ................      142,034       137,469        134,298         149,493        166,132
  One year later ........      128,949       130,376        139,110         155,673             --
  Two years later .......      114,605       128,134        140,094              --             --
  Three years
    later ...............      110,462       130,280             --              --             --
  Four years later ......      113,748            --             --              --             --
  Five years later ......           --            --             --              --             --
  Six years later .......           --            --             --              --             --
  Seven years
    later ...............           --            --             --              --             --
  Eight years
    later ...............           --            --             --              --             --
  Nine years later ......           --            --             --              --             --
  Ten years later .......           --            --             --              --             --
                              ========      ========      =========       =========       ========
Total net
  (deficiency)
  redundancy ............     $ 28,286      $  7,190      $  (5,796)      $  (6,180)            --
                              ========      ========      =========       =========       ========
Cumulative redundancy
  (deficiency) as a
  percentage of
  original
  estimate ..............         19.9%          5.2%          (4.3)%          (4.1)%
                              ========      ========      =========       =========       ========
</TABLE>


                                        10
<PAGE>
CLAIMS

      Proactive claims management is an important factor for the profitable
underwriting of surety and fidelity products. The Company maintains an
experienced and dedicated staff of in-house claim specialists. Claim handling is
performed in Chicago. The disposition of claims and other claim-related activity
is done in accordance with established policies, procedures and expense controls
designed to minimize loss costs and maximize salvage and subrogation recoveries.
Indemnity and subrogation rights exist on a significant portion of the business
written, enabling the Company to pursue loss recovery from the principal.

ENVIRONMENTAL CLAIMS

      The Company does not typically bond contractors that specialize in
hazardous environmental remediation work. The Company does however bond several
accounts that have incidental environmental exposure with respect to which the
Company provides bonding programs. In the commercial surety market, the Company
provides bonds to large corporations that are in the business of mining various
minerals and are obligated to post reclamation bonds that guarantee that
property which was disturbed during mining is returned to an acceptable
condition when the mining is completed. The Company also provides court and
other surety bonds for large corporations wherein the underlying action involves
environmental related issues. While no environmental responsibility is overtly
provided by commercial or contract bonds, some risk of environmental exposure
may exist if the surety were to assume certain rights in the completion of a
defaulted project or through salvage recovery. The Company estimates its net
case incurred losses on known claims of this nature to be approximately $12
million as of December 31, 2002.

REGULATION

      The Company's insurance subsidiaries are subject to varying degrees of
regulation and supervision in the jurisdictions in which they transact business
under statutes which delegate regulatory, supervisory and administrative powers
to state insurance regulators. In general, an insurer's state of domicile has
principal responsibility for such regulation which is designed generally to
protect policyholders rather than investors and relates to matters such as the
standards of solvency which must be maintained; the licensing of insurers and
their agents; the examination of the affairs of insurance companies, including
periodic financial and market conduct examinations; the filing of annual and
other reports, prepared on a statutory basis, on the financial condition of
insurers or for other purposes; establishment and maintenance of reserves for
unearned premiums and losses; and requirements regarding numerous other matters.
Licensed or admitted insurers generally must file with the insurance regulators
of such states, or have filed on its behalf, the premium rates and bond and
policy forms used within each state. In some states, approval of such rates and
forms must be received from the insurance regulators in advance of their use.

      Western Surety is domiciled in South Dakota and licensed in all 50 states
and the District of Columbia and Puerto Rico. SBCA is domiciled in South Dakota
and licensed in 28 states and the District of Columbia. USA is domiciled in
Texas and licensed in 44 states and the District of Columbia.

      Insurance regulations generally also require registration and periodic
disclosure of certain information concerning ownership, financial condition,
capital structure, general business operations and any material transactions or
agreements by or among affiliates. Such regulation also typically restricts the
ability of any one person to acquire 10% or more, either directly or indirectly,
of a company's stock without prior approval of the applicable insurance
regulatory authority. In addition, dividends and other distributions to
stockholders generally may be paid only out of unreserved and unrestricted
statutory earned surplus. Such distributions may be subject to prior regulatory
approval, including a review of the implications on Risk-Based Capital
requirements. A discussion of Risk-Based Capital requirements for property and
casualty insurance companies is included in both Management's Discussion and
Analysis of Financial Condition and Results of Operations and Note 14 to the
Consolidated Financial Statements, Statutory Financial Data. Without prior
regulatory approval in 2003, CNA Surety's insurance subsidiaries may pay
stockholder dividends of $32.1 million in the aggregate. For the year ended
December 31, 2002, CNA Surety received $31.2 million in dividends from its
insurance subsidiaries.

      In March of 1998, the National Association of Insurance Commissioners
adopted the Codification of Statutory Accounting Principles ("Codification").
Codification, which intended to standardize regulatory accounting and reporting
to state insurance departments, became effective on January 1, 2001. However,
statutory accounting principles will continue to be established by individual
state laws and permitted practices. The states in which CNA Surety's insurance
subsidiaries conduct business required adoption of Codification for the
preparation of statutory financial statements effective January 1, 2001. The
adoption of Codification increased the Company's statutory capital and surplus
as of January 1, 2001 by approximately $27.0 million primarily due to recording
of deferred tax assets and the recognition of anticipated salvage and
subrogation.


                                       11
<PAGE>
      CNA Surety's insurance subsidiaries are subject to periodic financial and
market conduct examinations. These examinations are generally performed by the
domiciliary state insurance regulatory authorities. The South Dakota Department
of Commerce and Regulation -- Division of Insurance (the "South Dakota
Department") conducted its financial and market conduct examination of Western
Surety for the five year period ended December 31, 1996. The South Dakota
Department made a finding of non--compliance with respect to the Company's
practices regarding return of premiums and recommended that Western Surety
change its current procedures regarding the return of premiums. The regulation
in question was subsequently amended to exclude surety products which eliminated
any non-compliance by the Company. The Texas Department of Insurance (the "Texas
Department") conducted its last examination of USA's financial matters as of
December 31, 1996. There were no significant issues noted which required
corrective action by USA. In 2002, the South Dakota Department and the Texas
Department completed fieldwork for their respective financial examinations of
Western Surety and USA, respectively, for the five year period ended December
31, 2001. The Company is currently awaiting the final financial examination
reports from both the South Dakota Department and the Texas Department.

      Certain states in which CNA Surety's insurance subsidiaries conduct their
business require insurers to join a guaranty association. Guaranty associations
provide protection to policyholders of insurers licensed in such states against
the insolvency of those insurers. In order to provide the associations with
funds to pay certain claims under policies issued by insolvent insurers, the
guaranty associations charge members assessments based on the amount of direct
premiums written in that state. Such assessments were not material to CNA
Surety's results of operations in 2002.

      Western Surety, SBCA and USA qualify as acceptable surety companies for
federal and other public works project bonds pursuant to U.S. Department of
Treasury regulations. U.S. Treasury underwriting limitations are based on an
insurer's statutory surplus. Effective July 1, 2002 through June 30, 2003, the
underwriting limitations of Western Surety, SBCA and USA are $20.7 million, $0.5
million and $1.3 million, respectively. Through the Surety Quota Share Treaty
between CCC and Western Surety Company, CNA Surety has access to CCC and its
affiliates' U.S. Department of Treasury underwriting limitations. The Surety
Quota Share Treaty had an original term of five years from the Merger Date and
was renewed on October 1, 2002 on substantially the same terms. Effective July
1, 2002 through June 30, 2003, the underwriting limitations of CCC and its
affiliates total $382.9 million. CNA Surety management believes that the
foregoing U.S. Treasury underwriting limitations are sufficient for the conduct
of its business.

INVESTMENTS

      CNA Surety insurance subsidiaries' investment practices must comply with
insurance laws and regulations and must also comply with certain covenants under
CNA Surety's credit facility. Generally, insurance laws and regulations
prescribe the nature and quality of, and set limits on, the various types of
investments which may be made by CNA Surety's insurance subsidiaries.

      The Company's investment portfolio generally is managed to maximize
after-tax investment return, while minimizing credit risk with investments
concentrated in high quality income securities. CNA Surety's portfolio is
managed to provide diversification by limiting exposures to any one industry,
issue or issuer, and to provide liquidity by investing in the public securities
markets. The portfolio is structured to support CNA Surety's insurance
underwriting operations and to consider the expected duration of liabilities and
short-term cash needs.

      An investment committee of CNA Surety's Board of Directors establishes
investment policy and oversees the management of each portfolio. A professional
independent investment adviser has been engaged to assist in the management of
each insurance subsidiary investment portfolio pursuant to established
investment committee guidelines. The insurance subsidiaries pay an advisory fee
based on the market value of the assets under management.

EMPLOYEES

      As of December 31, 2002, the Company employed 774 persons. CNA Surety has
not experienced any work stoppages. Management of CNA Surety believes its
relations with its employees are good.

AVAILABILITY OF SEC REPORTS

      A copy of this Annual Report on Form 10-K/A, as well as CNA Surety's
subsequent Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any
amendments to such reports are available, free of charge, on the Internet at CNA
Surety's website (www.cnasurety.com) as soon as reasonably practicable after
being filed with or submitted to the Securities and Exchange Commission (the
"SEC"). Prior to the filing of this Form 10-K/A, CNA Surety provided links to
the SEC's website (www.sec.gov)


                                       12
<PAGE>
which contained the equivalent of the reports described above. Any materials the
Company files with the SEC may be read and obtained at the SEC's Public
Reference Room at 450 Fifth Street, NW, Washington, DC 20549. Information
regarding the operation of the Public Reference Room may be obtained by calling
the SEC at 1-800-SEC-0330. This reference to CNA Surety's website or the SEC's
address does not constitute incorporation by reference of the information
contained on the website and should not be considered part of this document.


                                       13
<PAGE>
                                    PART II.

ITEM 6. SELECTED FINANCIAL DATA

      The following financial information has been derived from the Consolidated
Financial Statements and Notes thereto.

      The following information presented for CNA Surety is as of and for the
years ended December 31, 2002, 2001, 2000, 1999 and 1998.

<TABLE>
<CAPTION>
                                                              2002              2001           2000          1999          1998
                                                         ---------------     ----------      --------      --------      --------
                                                         AS RESTATED (3)
                                                                        (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                                      <C>                 <C>             <C>           <C>           <C>
            Total revenues ...........................     $   318,487       $  350,471      $332,273      $309,405      $283,840
                                                           ===========       ==========      ========      ========      ========
            Gross written premiums ...................     $   359,892       $  333,003      $316,667      $306,859      $278,224
                                                           ===========       ==========      ========      ========      ========
            Net written premiums .....................     $   306,654       $  315,804      $304,468      $298,987      $270,602
                                                           ===========       ==========      ========      ========      ========
            Net earned premiums ......................     $   298,319       $  320,910      $301,819      $283,540      $258,737
            Net losses and loss adjustment expenses...          94,198           80,836        55,683        44,672        44,998
            Net commissions, brokerage and other
              underwriting expenses...................         179,827          202,877       181,655       166,974       151,966
            Net investment income ....................          27,754           29,515        29,897        25,850        24,259
            Net realized investment gains
              (losses) ...............................          (7,586)              46           557            15           844
            Interest expense .........................           1,708            3,925         6,956         5,846         7,218
            Non-recurring charges ....................              --               --           500            --            --
            Amortization of intangible
              assets(2) ..............................              --            6,097         6,097         5,982         5,900
                                                           -----------       ----------      --------      --------      --------
            Income before income taxes ...............          42,754           56,736        81,382        85,931        73,758
            Income taxes .............................          12,635           19,828        27,780        29,433        28,243
                                                           -----------       ----------      --------      --------      --------
            Net income ...............................     $    30,119       $   36,908      $ 53,602      $ 56,498      $ 45,515
                                                           ===========       ==========      ========      ========      ========
            Basic and diluted earnings per common
              share ..................................     $      0.70       $     0.86      $   1.25      $   1.28      $   1.04
                                                           ===========       ==========      ========      ========      ========
            Loss ratio(1) ............................            31.6%            25.2%         18.4%         15.7%         17.4%
            Expense ratio ............................            60.3             63.2          60.2          58.9          58.7
                                                           -----------       ----------      --------      --------      --------
            Combined ratio(1) ........................            91.9%            88.4%         78.6%         74.6%         76.1%
                                                           ===========       ==========      ========      ========      ========
            Invested assets and cash .................     $   638,204       $  579,657      $555,975      $499,400      $505,355
            Intangible assets, net of
              amortization ...........................         143,785          143,785       149,882       155,980       156,062
            Total assets .............................       1,096,365        1,061,598       950,568       851,575       819,370
            Insurance reserves .......................         519,646          516,190       406,636       357,233       333,728
            Debt .....................................          60,816           76,195       101,556       101,900       113,000
            Total liabilities ........................         675,804          673,170       576,536       525,271       509,473
            Stockholders' equity .....................         420,561          388,428       374,032       326,304       309,897
            Book value per share .....................     $      9.79       $     9.08      $   8.76      $   7.59      $   7.03
            Dividends paid per share .................     $      0.45       $     0.54      $   0.32      $   0.32      $   0.08
</TABLE>

----------

(1)   These amounts include the effect of recording revisions of prior year
      reserves. The dollar amount and the percentage point effect on the loss
      ratio of these reserve revisions were an addition of $6,180, or 2.1%, for
      the year ended December 31, 2002, an addition of $4,812, or 1.5%, for the
      year ended December 31, 2001, a reduction of $7,093, or 2.4%, for the year
      ended December 31, 2000, a reduction of $13,085, or 4.6%, for the year
      ended December 31, 1999 and a reduction of $4,352, or 1.7%, for the year
      ended December 31, 1998.

(2)   As of January 1, 2002, the Company adopted the Financial Accounting
      Standards Board's Statement of Financial Accounting Standards No. 142
      concerning the accounting for goodwill and other intangible assets. The
      adoption of this standard eliminated the Company's amortization of
      goodwill and intangibles as of December 31, 2001 and therefore, increased
      the Company's reported 2002 net income by $5.7 million, or $0.13 per
      share, respectively, as compared to the same period in 2001. If the
      provisions of this standard were applied to prior periods, net income for
      the years ended December 31, 2001, 2000, 1999 and 1998 would have been
      $42.6 million, or $0.99 per share; $59.3 million, or $1.38 per share;
      $62.1 million, or $1.41 per share; $51.0 million, or $1.16 per share
      respectively.

(3)   See Note 17 to the Consolidated Financial Statements.


                                       14
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

      The following is a discussion and analysis of CNA Surety Corporation ("CNA
Surety" or the "Company") and its 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.

RESTATEMENT

      Subsequent to the filing of CNA Surety's Report on Form 10-K for the
fiscal year ended December 31, 2002, the Company revised its accounting for
ceded premiums under a multiple year excess of loss reinsurance treaty with its
affiliate, Continental Casualty Company, which has been in place since October
1, 2002 (this treaty is discussed in greater detail in Note 7 (Reinsurance)).
Under the contract CNA Surety pays a quarterly premium of $3.125 million, of
which 70% is added to an experience account that is reduced by any losses ceded
to the treaty. On dates specified under the contract, CNA Surety can commute the
treaty and receive payment of the experience account balance. Under Emerging
Issues Task Force ("EITF") Issue 93-6 "Accounting for Multiple-Year
Retrospectively Rated Contracts by Ceding and Assuming Enterprises" ("EITF
93-6"), a receivable for return premium based on experience under the contract
should be established at December 31, 2002. CNA Surety had not previously
established such a receivable, and has restated its 2002 consolidated financial
statements to comply with EITF 93-6. See Note 17 to the Consolidated Financial
Statements. This Management's Discussion and Analysis reflects the effects of
the restatement.

CRITICAL ACCOUNTING POLICIES

      Management believes the most significant accounting policies and related
disclosures for purposes of understanding the Company's results of operations
and financial condition pertain to investments, deferred acquisition costs,
goodwill and other intangible assets, reserves for unpaid losses and loss
adjustment expenses and reinsurance. The Company's accounting policies related
to reserves for unpaid losses and loss adjustment expenses and related estimates
of reinsurance recoverables, are particularly critical to an assessment of the
Company's financial results. These areas are highly subjective and require
management's most complex judgments because of the need to make estimates about
the effects of matters that are inherently uncertain. For these reasons,
disclosure on these topics is contained herein and in Note 1, Significant
Accounting Policies, and Notes 7 and 8, Reinsurance and Reserves for Losses and
Loss Adjustment Expenses of the Consolidated Financial Statements.

Investments

      Management believes the Company has the ability to hold all fixed income
securities to maturity. However, the Company may dispose of securities prior to
their scheduled maturity due to changes in interest rates, prepayments, tax and
credit considerations, liquidity or regulatory capital requirements, or other
similar factors. As a result, the Company considers all of its fixed income
securities (bonds and redeemable preferred stocks) and equity securities as
available-for-sale. These securities are reported at fair value, with unrealized
gains and losses, net of deferred income taxes, reported as a separate component
of stockholders' equity. Cash flows from purchases, sales and maturities are
reported gross in the investing activities section of the Consolidated
Statements of Cash Flows.

      The amortized cost of fixed income securities is determined based on cost
and the cumulative effect of amortization of premiums and accretion of discounts
to maturity. Such amortization and accretion are included in investment income.
For mortgage-backed and certain asset-backed securities, the Company recognizes
income using the effective-yield method based on estimated cash flows. All
securities transactions are recorded on the trade date. Investment gains or
losses realized on the sale of securities are determined using the specific
identification method. Investments with an other-than-temporary decline in value
are written down to fair value, resulting in losses that are included in
realized investment gains and losses.

      Short-term investments which generally include U.S. Treasury bills,
corporate notes, money market funds and investment grade commercial paper
equivalents, are carried at amortized cost which approximates fair value.

Deferred Policy Acquisition Costs


                                       15
<PAGE>
      Policy acquisition costs, consisting of commissions, premium taxes and
other underwriting expenses which vary with, and are primarily related to, the
production of business, net of reinsurance commissions, are deferred and
amortized as a charge to income as the related premiums are earned. Anticipated
investment income is considered in the determination of the recoverability of
deferred acquisition costs.

Goodwill and Other Intangible Assets

      CNA Surety's Consolidated Balance Sheet as of December 31, 2002 includes
goodwill and identified intangibles of approximately $143.8 million. These
amounts represent goodwill and identified intangibles arising from the
acquisition of Capsure Holdings Corp. ("Capsure"). Prior to 2002, goodwill from
this acquisition was generally amortized as a charge to earnings over periods
not exceeding 30 years. Under Statement of Financial Accounting Standards
("SFAS") No. 142 "Goodwill and Other Intangible Assets" ("SFAS No. 142") which
was adopted by CNA Surety as of January 1, 2002, periodic amortization ceased,
in accordance with an impairment-only accounting model.

      A significant amount of judgment is required in performing goodwill
impairment tests. Such tests include periodically determining or reviewing the
estimated fair value of CNA Surety's reporting units. Under SFAS No. 142, fair
value refers to the amount for which the entire reporting unit may be bought or
sold. There are several methods of estimating fair value, including market
quotations, asset and liability fair values and other valuation techniques, such
as discounted cash flows and multiples of earnings or revenues. If the carrying
amount of a reporting unit, including goodwill, exceeds the estimated fair
value, then individual assets, including identifiable intangible assets, and
liabilities of the reporting unit are estimated at fair value. The excess of the
estimated fair value of the reporting unit over the estimated fair value of net
assets would establish the implied value of goodwill. The excess of the recorded
amount of goodwill over the implied value of goodwill is recorded as an
impairment loss.

Reserves for Unpaid Losses and Loss Adjustment Expenses and Reinsurance

      CNA Surety accrues liabilities for unpaid losses and loss adjustment
expenses under its surety and property and casualty insurance contracts based
upon estimates of the ultimate amounts payable under the contracts related to
losses occurring on or before the balance sheet date. As of any balance sheet
date, all claims have not yet been reported and some claims may not be reported
for many years. As a result, the liability for unpaid losses includes
significant estimates for incurred-but-not-reported claims. Additionally,
reported claims are in various stages of the settlement process. Each claim is
settled individually based upon its merits and certain claim liabilities may
take years to settle, especially if legal action is involved.

      The Company uses a variety of techniques to establish the liabilities for
unpaid claims recorded at the balance sheet date. While techniques may vary,
each employs significant judgments and assumptions. Techniques may involve
detailed statistical analysis of past claim reporting, settlement activity,
salvage and subrogation activity, claim frequency and severity data when
sufficient information exists to lend statistical credibility to the analysis.
The analysis may be based upon internal loss experience or industry experience.
Techniques may vary depending on the type of claim being estimated. Liabilities
may also reflect implicit or explicit assumptions regarding the potential
effects of future economic and social inflation, judicial decisions, law
changes, and recent trends in such factors.

      Receivables recorded with respect to insurance losses ceded to reinsurers
under reinsurance contracts are estimated in a manner similar to liabilities for
insurance losses and, therefore, are also subject to uncertainty. In addition to
the factors cited above, estimates of reinsurance recoveries may prove
uncollectible if the reinsurer is unable to perform under the contract.
Reinsurance contracts do not relieve the ceding company of its obligations to
indemnify its own policyholders.

      CNA Surety's Consolidated Balance Sheet includes estimated liabilities for
unpaid losses and loss adjustment expenses of $303.4 million and reinsurance
receivables related to losses of $137.3 million at December 31, 2002. Due to the
inherent uncertainties in the process of establishing these amounts, the actual
ultimate claims amounts will differ from the currently recorded amounts. An
incremental percentage change in estimates of this magnitude could result in a
material effect on reported earnings. For example, a 10% increase in the
December 31, 2002 net estimate for unpaid losses and loss adjustment expenses
would produce approximately a $16.6 million charge to pre-tax earnings. Future
effects from changes in these estimates will be recorded as a component of
losses incurred in the period such changes are determined to be needed.

FORMATION OF CNA SURETY CORPORATION AND MERGER


                                       16
<PAGE>
      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 CNA Surety. 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 64% of the
outstanding common stock of CNA Surety. Loews Corporation owns approximately 90%
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.

BUSINESS

      CNA Surety's insurance subsidiaries write surety and fidelity bonds in all
50 states through a combined network of approximately 34,000 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 small, medium and large non-contract surety
bonds, referred to as commercial bonds; small, medium and large contract bonds;
and errors and omissions ("E&O") liability insurance. Western Surety is a
licensed insurer in all 50 states, the District of Columbia and Puerto Rico. 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
28 states and the District of Columbia.

      The Company's corporate objective is to be the leading provider of surety
and surety-related products in the United States and in select international
markets and to be the surety of choice for its customers and independent agents
and brokers.

      Western Surety and USA are both currently rated A+ (Superior) by A.M. Best
Company, Inc. ("A.M. Best"). Through intercompany reinsurance and related
agreements, CNA Surety's customers have access to CCC's broader underwriting
capacity. CCC is currently rated A (Excellent) by A.M. Best. A.M. Best's letter
ratings range from A++ (Superior) to F (In Liquidation) with A++ being highest.
An A+ (Superior) rating is assigned to those companies which A.M. Best believes
have achieved superior overall performance when compared to the norms of the
property and casualty insurance industry. A+ (Superior) rated insurers have been
shown to be among the strongest in ability to meet policyholder and other
contractual obligations. A rating of A (Excellent) is assigned to those
companies which A.M. Best believes have achieved excellent overall performance
when compared to the norms of the property and casualty insurance industry and
generally have demonstrated a strong ability to meet their respective
policyholder and other contractual obligations.

      CCC, Western Surety and USA are all currently rated A- (Strong), by
Standard and Poor's ("S&P"). S&P's letter ratings range from AAA+ (Extremely
Strong) to CC (Extremely Weak) with AAA+ being highest. Ratings from "AA" to
"CCC" may be modified by the addition of a plus or minus sign to show relative
standing within the major rating categories. An insurer rated `A' has strong
financial security characteristics, but is somewhat more likely to be affected
by adverse business conditions than are insurers with higher ratings.

RESULTS OF OPERATIONS

      Financial Measures

      The Management's Discussion and Analysis of Financial Condition and
Results of Operations ("MD&A") discusses certain generally accepted accounting
principles ("GAAP") and non-GAAP financial measures in order to provide
information used by management to monitor the Company's operating performance.
Management utilizes various financial measures to monitor the Company's
insurance operations and investment portfolio. Underwriting results, which are
derived from certain income statement amounts, are considered a non-GAAP
financial measure and are used by management to monitor performance of the
Company's insurance operations. The Company's investment portfolio is monitored
through analysis of various quantitative and qualitative factors and certain
decisions related to the sale or impairment of investments produce realized
gains and losses, which is also a component used in the calculation of net
income and is a non-GAAP financial measure.

      Underwriting results are computed as net earned premiums less net loss and
loss adjustment expenses and net commissions, brokerage and other underwriting
expenses. Management uses underwriting results to monitor its insurance
operations' results without the impact of certain factors, including net
investment income, net realized investment gains (losses) and interest expense.
Management excludes these factors in order to analyze the direct relationship
between net earned premiums and the related net loss and loss adjustment
expenses along with net commissions, brokerage and other underwriting expenses.


                                       17
<PAGE>
      Operating ratios are calculated using insurance results and are widely
used by the insurance industry and regulators such as state departments of
insurance and the National Association of Insurance Commissioners for financial
regulation and as a basis of comparison among companies. The ratios discussed in
the Company's MD&A are calculated using GAAP financial results and include the
net loss and loss adjustment expense ratio ("loss ratio") as well as the net
commissions, brokerage and other underwriting expense ratio ("expense ratio")
and combined ratio. The loss ratio is the percentage of net incurred claim and
claim adjustment expenses to net earned premiums. The expense ratio is the
percentage of net commissions, brokerage and other underwriting expenses,
including the amortization of deferred acquisition costs, to net earned
premiums. The combined ratio is the sum of the loss and expense ratios.

      The Company's investment portfolio is monitored by management through
analyses of various factors including unrealized gains and losses on securities,
portfolio duration and exposure to interest rate, market and credit risk. Based
on such analyses, the Company may impair an investment security in accordance
with its policy, or sell a security. Such activities will produce net realized
investment gains and losses.

      While management uses various GAAP and non-GAAP financial measures to
monitor various aspects of the Company's performance, net income is the most
directly comparable GAAP measure and represents a more comprehensive measure of
operating performance. Management believes that its process of evaluating
performance through the use of these non-GAAP financial measures provides a
basis for enhanced understanding of the operating performance and the impact to
net income as a whole. Management also believes that investors may find these
widely used financial measures described above useful in interpreting the
underlying trends and performance, as well as to provide visibility into the
significant components of net income.


                                       18
<PAGE>
      Analysis of Net Income

      The Company had net income of $30.1 million for the year ended December
31, 2002, compared with $36.9 million and $53.6 million for the comparable
periods in 2001 and 2000, respectively. The principal drivers of the difference
in net income from December 31, 2002 as compared to December 31, 2001, were a
decrease in net realized investment gains of $7.6 million and an increase in net
losses, commissions and related expenses, partially offset by increased net
earned premiums, a decrease in interest expense of $2.2 million and the
cessation of amortization expense of $6.1 million.

      Net income was $36.9 million for the twelve months ended December 31,
2001, compared with $53.6 million in the same period in 2000. The principal
drivers of the difference in net income were an increase in the Company's net
losses and loss adjustment expenses, which was partially offset by a decrease in
net earned premiums, net commissions, broker and other expenses and interest
expense.

      Analysis of the components of net income are discussed in the following
sections.

Results of Insurance Operations

      Underwriting components for the Company for the years ended December 31,
2002, 2001 and 2000 are summarized in the following table (dollars in
thousands):

<TABLE>
<CAPTION>
                                                                   YEARS ENDED DECEMBER 31,
                                                             ------------------------------------
                                                               2002          2001          2000
                                                             --------      --------      --------
<S>                                                          <C>           <C>           <C>
            Gross written premium ......................     $359,892      $333,003      $316,667
                                                             ========      ========      ========
            Net written premium ........................     $306,654      $315,804      $304,468
                                                             ========      ========      ========
            Net earned premium .........................     $298,319      $320,910      $301,819
                                                             ========      ========      ========
            Net losses and loss adjustment expenses ....     $ 94,198      $ 80,836      $ 55,683
                                                             ========      ========      ========
            Net commissions, brokerage and other .......     $179,827      $202,877      $181,655
                                                             ========      ========      ========
            Loss ratio .................................         31.6%         25.2%         18.4%
            Expense ratio ..............................         60.3          63.2          60.2
                                                             --------      --------      --------
            Combined ratio .............................         91.9%         88.4%         78.6%
                                                             ========      ========      ========
</TABLE>

Premiums Written

      CNA Surety primarily markets contract and commercial surety bonds.
Contract surety bonds generally secure a contractor's performance and/or payment
obligation 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 that cover losses arising from employee dishonesty and other insurance
products.

      Gross written premiums for the years ended December 31, 2002, 2001 and
2000 are shown in the table below (dollars in thousands):

<TABLE>
<CAPTION>
                                                   YEARS ENDED DECEMBER 31,
                                              ----------------------------------
                                                2002         2001         2000
                                              --------     --------     --------
<S>                                           <C>          <C>          <C>
                  Contract ..............     $197,875     $180,588     $161,539
                  Commercial ............      134,039      125,026      128,556
                  Fidelity and other ....       27,978       27,389       26,572
                                              --------     --------     --------
                                              $359,892     $333,003     $316,667
                                              ========     ========     ========
</TABLE>


                                       19
<PAGE>
      Gross written premiums for the year ended December 31, 2002 increased
8.1%, or $26.9 million, over the comparable period in 2001. Gross written
premiums for contract surety increased 9.6%, or $17.3 million, reflecting modest
growth in public construction spending and improving rates. Gross written
premiums for commercial surety increased 7.2%, or $9.0 million, for the year
ended December 31, 2002 reflecting continued volume growth of small commercial
products and improving rates on large commercial bonds partially offset by the
impacts of the Company's ongoing efforts to reduce aggregate exposures on large
commercial accounts. The estimated impact of the Company's exposure reduction
efforts to date represents approximately $10 million in annual premium, assuming
an average rate per $1,000 of bond exposure of $2.68, or 27 basis points and
approximately $3.8 billion of bond exposure. Fidelity and other products
increased 2.2% to $28.0 million for the year ended December 31, 2002 as compared
to the same period in 2001 due primarily to an increase in fidelity business
partially offset by the discontinuance of the Company's agents' E&O business.

      Gross written premiums for the year ended December 31, 2001 increased
5.2%, or $16.3 million, for the year ended December 31, 2001 over the comparable
period in 2000. Effective January 1, 2001, the Company began recording written
premium on the effective date of the bond, rather than recording on the date the
bond is processed ("processed premium"). This change did not impact the
recognition of net earned premium but reduced gross written premiums by $8.0
million. In addition, gross written premiums reflect a $6.0 million reduction
due to the discontinuance of the CNA Reinsurance Company, Limited (London) ("CNA
Re"), an affiliate of CCC, assumed international credit and surety business in
2000. Core direct gross processed premiums (gross processed premiums, excluding
international reinsurance business assumed from CNA Re) increased 9.8% to $341.0
million. Gross written premiums for contract surety increased 11.8%, or $19.1
million, as compared to 2000 due to continued strength in public construction
nationwide particularly highway and road, airport and school-related projects.
Gross written premiums for core direct commercial surety increased 2.0%, or $2.5
million, primarily due to favorable trends in the commercial segment including
increased small transactional business and beneficial pricing actions within the
large commercial segment offset by a $6.3 million reduction due to the recording
change on written premium. Fidelity and other products increased 3.0%, or $0.8
million, to $27.4 million for the year ended December 31, 2001.

      Net written premiums for the years ended December 31, 2002, 2001 and 2000
are shown in the table below (dollars in thousands):

<TABLE>
<CAPTION>
                                                   YEARS ENDED DECEMBER 31,
                                              ----------------------------------
                                                2002         2001         2000
                                              --------     --------     --------
<S>                                           <C>          <C>          <C>
                  Contract ..............     $172,633     $165,603     $150,504
                  Commercial ............      107,290      122,812      126,923
                  Fidelity and other ....       26,731       27,389       27,041
                                              --------     --------     --------
                                              $306,654     $315,804     $304,468
                                              ========     ========     ========
</TABLE>

      For the year ended December 31, 2002 net written premiums decreased 2.9%
to $306.7 million as compared to the same period in 2001, reflecting the
aforementioned gross production variances, the effects of higher reinsurance
costs and the Company's efforts to reduce large commercial bond exposures. Ceded
written premiums increased $36.0 million to $53.2 million for the year ended
December 31, 2002. Ceded written premiums for 2002 include $30.0 million for the
Company's $40 million excess of $20 million per principal excess of loss
coverage and $8.5 million for the purchase of extended discovery coverage on the
Company's $55 million excess of $5 million per principal excess of loss
coverage. Net written premiums for contract surety business increased 4.2% to
$172.6 million. Net written premiums for commercial surety decreased 12.6% to
$107.3 million for the year ended December 31, 2002. Fidelity and other products
decreased 2.4% to $26.7 million for the year 2002 as compared to 2001 due to a
new quota share reinsurance arrangement effective January 1, 2002.

      Net written premiums for the year ended December 31, 2001 increased 3.7%
percent, or $11.3 million, reflecting the aforementioned gross production
variances and the effects of higher reinsurance costs. The reinsurance costs
reflected in ceded premiums are based upon reinsurers' loss experience under the
Company's surety excess of loss reinsurance contract. Due primarily to increased
large losses reported to the Company's excess of loss reinsurers, ceded written
premiums increased $5.0 million to $17.2 million in 2001. Net written premiums
increased 10.0%, or $15.1 million, for the contract surety business. Commercial
surety net written premiums, excluding international reinsurance business
assumed, increased 1.6%, or $1.9 million, in 2001. The fidelity and other
products increased 1.3%, or $0.3 million, for the year ended December 31, 2001.

Excess of Loss Reinsurance

      Since the second half of calendar year 1999, the Company has experienced
an increase in claim severity and frequency in the most recent accident years.
The increase in claim severity in more recent accident years has generally
resulted in higher gross accident year loss ratios and greater losses ceded to
reinsurers under the Company's $5 million per principal excess of loss
reinsurance contract in place in 2001, as well as changes in the Company's 2002
reinsurance program. CNA Surety is paying higher costs for reinsurance as a


                                       20
<PAGE>
result of this loss experience.

      The Company's reinsurance program is predominantly comprised of excess of
loss reinsurance contracts that limit the Company's retention on a per principal
basis. The Company's reinsurance coverage is provided by third party reinsurers
and related parties.

2002 Third Party Reinsurance Compared to 2001 Third Party Reinsurance

      The Company's ceded reinsurance program changed significantly in 2002 as
compared to 2001. The material differences between the 2002 excess of loss
reinsurance program ("2002 Excess of Loss Treaty") and the Company's 2001
program are as follows. The annual aggregate coverage decreased from $115
million in 2001 to $100 million in 2002 with a sub-limit of $60 million for
large commercial accounts. The minimum annual premium for the 2002 Excess of
Loss Treaty is $30.0 million compared to $17.2 million of reinsurance premiums
paid in 2001. The 2002 Excess of Loss Treaty provides the Company with coverage
on a per principal basis of 90% of $40 million excess of $20 million retained by
the Company. In addition, CCC is providing reinsurance coverage (the "10% Quota
Share Agreement") to the Company for 10% of any losses between $20 million and
$60 million with respect to single large surety bonds written effective January
1, 2002 through December 31, 2002. CCC receives 10% of the written premium the
Company received in exchange for the coverage provided.

      In addition, the terms of the 2002 Excess of Loss Treaty required a
special acceptance process for certain larger contract accounts in-force at the
inception date of the treaty. The reinsurers conducted an underwriting file
review and approval process for these risks that would otherwise be excluded.
This file review process resulted in one large national contract principal being
excluded from the 2002 Excess of Loss Treaty. In addition, the treaty excludes
certain classes of business relating to two other principals. The Company no
longer writes these classes but has exposures that are in run-off. Should the
Company incur a loss on these excluded principals, the Company would be subject
to a maximum retention of $60 million per principal.

      The higher net retention of $20 million per principal together with other
changes in reinsurance coverage associated with the 2002 Excess of Loss
Reinsurance Treaty and the extended discovery and related provisions of the
excess of loss reinsurance contract in place for 2001 may increase the
variability of the Company's future results of operations and cash flows.
Moreover, as stated above, if CNA Surety suffered any losses arising from bonds
issued to the large national contractor, CNA Surety would retain the first $60
million per principal under its various excess of loss reinsurance contracts.

      In December 2002 and January 2003, CNAF provided loans in an aggregate
amount of approximately $45 million to the large national contractor that
undertakes projects for the construction of government and private facilities.
CNA Surety has provided significant surety bond protection for this contractor's
projects through surety bonds underwritten by CCC or its affiliates. The loans
were provided by CNAF to help the contractor meet its liquidity needs. The loans
are evidenced by demand notes and, until replaced by the credit facility
described below, accrue interest at 10%. The owners of the contractor have
pledged to CNAF substantially all the assets of the contractor as collateral for
these loans.

      In March 2003, CNAF entered into an agreement to provide a credit facility
with the contractor. The closing of this agreement is subject to the execution
of certain agreements and the provision to CNAF of specified security interests
in addition to those already provided. Under this credit facility, CNAF would be
obligated to provide up to $86.4 million of loans to the contractor and certain
of its subsidiaries, including a refinancing of the already advanced $45 million
described above. The credit facility and all loans thereunder would mature in
March 2006. Advances under the credit facility, including the already funded $45
million, would bear interest at the prime rate plus 6%, with 50% of the interest
due monthly and the remainder deferred until the credit facility matures.

      Loews Corporation and CNAF have entered into a participation agreement,
pursuant to which Loews has agreed to purchase a one-third participation share
in the new credit facility, on a dollar-for-dollar basis, up to a maximum of $25
million. Although Loews does not have rights against the contractor directly
under the participation agreement, it shares recoveries and fees under the
facility on a proportional basis with CNAF.

      In March 2003, CNAF also purchased approximately $28 million principal
amount of the contractor's outstanding bank debt for $16.4 million. Under the
new credit facility, CNAF agreed to sell the bank debt to the contractor for
$16.4 million, with $11.4 million of the purchase price being funded under the
new credit facility and $5 million from amounts loaned to the contractor by its
shareholders. Under its purchase agreement with the banks, CNAF is also required
to reimburse the banks for any draws upon approximately $6.5 million in
outstanding letters of credit issued by the banks for the contractor's benefit
that expire between May and August of 2003. Any CNAF reimbursements for draws
upon the banks' letters of credit will become obligations of the contractor to
CNAF as draws upon the credit facility.


                                       21
<PAGE>
      The contractor has initiated a restructuring plan that is intended to
reduce costs and improve cash flow, and a chief restructuring officer has been
appointed to manage execution of the plan. CNA Surety intends to continue to
provide surety bonds on behalf of the contractor during this restructuring
period, subject to the contractor's initial and ongoing compliance with CNA
Surety's underwriting standards. Indemnification and subrogation rights,
including rights to contract proceeds on construction projects in the event of
default, reduce CNA Surety's exposure to loss. If the contractor does not
perform its contractual obligations underlying all of the Company's surety
bonds, the Company estimates that possible losses, net of indemnification and
subrogation recoveries, but before recoveries under reinsurance contracts, could
be up to $200 million. However, the related party reinsurance treaties discussed
below should limit the Company's per principal exposure to approximately $60
million. While CNA Surety believes that the contractor's restructuring efforts
will be successful and provide sufficient cash flow for its operations, the
contractor's failure to achieve its restructuring plan could have a material
adverse effect on CNA Surety's future results of operations, cash flows and
capital resources.

      In connection with the changes in the Company's 2002 reinsurance program,
CNA Surety purchased extended discovery coverage, available under the excess of
loss reinsurance coverage in place in 2001, at a cost of approximately $8.5
million. This covers losses on surety bonds written prior to January 1, 2002 and
discovered in the two years after January 1, 2002. The limit of this extended
discovery coverage is the unused portion of the annual aggregate limit of $115
million under the 2001 excess of loss treaty. This limit has two layers
comprised of a $65 million aggregate limit for per principal losses between $5
million and $25 million and $50 million aggregate for per principal losses
between $25 million and $60 million. Based upon the Company's settlement of its
exposure to Enron and its current claim estimates of other discovered losses,
the Company estimates that as of December 31, 2002 the first layer of the annual
aggregate has been exhausted and approximately $30 million of limit remains
under the second layer to cover adverse development on losses discovered prior
to December 31, 2001 as well as newly discovered losses in the extended
discovery period. It is possible that these remaining annual aggregate limits
could be insufficient to fully cover all adverse development that could occur on
losses discovered prior to December 31, 2001 or any newly discovered losses
under the extended discovery provisions. The unfavorable resolution of these
uncertainties could have a material adverse impact on the Company's future
results of operations and cash flows.

2003 Third Party Reinsurance Compared to 2002 Third Party Reinsurance

      Effective January 1, 2003, CNA Surety entered into a new excess of loss
treaty ("2003 Excess of Loss Treaty") with a group of third party reinsurers
that reduced its net retention per principal on new bonds to $15 million with a
5% co-participation in the $45 million layer of third party reinsurance coverage
above the Company's retention. This new excess of loss treaty replaces the $40
million excess of $20 million per principal coverage. The material differences
between the new excess of loss reinsurance program and the Company's 2002 Excess
of Loss Treaty are as follows. The annual aggregate coverage increases from $100
million in 2002 to $110 million in 2003. The minimum annual premium for the 2003
Excess of Loss Treaty is $38.0 million compared to $30.0 million of reinsurance
premiums paid in 2002. The 2003 Excess of Loss Treaty provides the Company with
coverage on a per principal basis of 95% of $45 million excess of $15 million
retained by the Company. The contract also includes similar special acceptance
provisions for larger contract accounts contained in the 2002 Excess of Loss
Treaty. In addition to the one large contract principal and the two commercial
principals excluded (based upon class of business in 2002), the Company's
reinsurers have initially excluded three other contract principals from the 2003
Excess of Loss Treaty. The three additional contract principals are in the
process of completing asset sales and other reorganization efforts that
management believes will result in the reinsurers' acceptance of the accounts in
the treaty.

Related Party Reinsurance

      Intercompany reinsurance agreements together with the Services and
Indemnity Agreement that are described below provide for the transfer of the
surety business written by CCC and CIC to Western Surety. All these agreements
originally were entered into on September 30, 1997 (the "Merger Date"): (i) the
Surety Quota Share Treaty (the "Quota Share Treaty"); (ii) the Aggregate Stop
Loss Reinsurance Contract (the "Stop Loss Contract"); and (iii) the Surety
Excess of Loss Reinsurance Contract (the "Excess of Loss Contract"). All of
these contracts have expired. Some have been renewed on different terms as
described below.

      The Services and Indemnity Agreement provides the Company's insurance
subsidiaries with the authority to perform various administrative, management,
underwriting and claim functions in order to conduct the business of CCC and CIC
and to be reimbursed by CCC for services rendered. In consideration for
providing the foregoing services, CCC has agreed to pay Western Surety a
quarterly fee of $50,000. This agreement had an original term of five years that
expired on September 30, 2002 and was renewed on October 1, 2002 on
substantially the same terms with an expiration date of December 31, 2003; and
is annually renewable thereafter.


                                       22
<PAGE>
      Through the Quota Share Treaty, CCC and CIC transfer to Western Surety all
surety business written or renewed by CCC and CIC after the Merger Date. CCC and
CIC transfer the related liabilities of such business and pay to Western Surety
an amount in cash equal to CCC's and CIC's net written premiums written on all
such business, minus a quarterly ceding commission to be retained by CCC and CIC
equal to $50,000 plus 28% of net written premiums written on such business.

      The Quota Share Treaty was renewed on October 1, 2002 on substantially the
same terms with an expiration date of December 31, 2003; and is annually
renewable thereafter. The ceding commission paid to CCC and CIC by Western
Surety remained at 28% of net written premiums and contemplates an approximate
4% override commission for fronting fees to CCC and CIC on top of their actual
direct acquisition costs for the year ended December 31, 2002.

      The Stop Loss Contract terminated on December 31, 2000 and was not
renewed. The Stop Loss Contract protected the insurance subsidiaries from
adverse loss experience on certain business underwritten after the Merger Date.
The Stop Loss Contract between the insurance subsidiaries and CCC limited the
insurance subsidiaries' prospective net loss ratios with respect to certain
accounts and lines of insured business for three full accident years following
the Merger Date. In the event the insurance subsidiaries' accident year net loss
ratio exceeds 24% in any of 1997 through 2000 on certain insured accounts (the
"Loss Ratio Cap"), the Stop Loss Contract requires CCC at the end of each
calendar quarter following the Merger Date, to pay to the insurance subsidiaries
a dollar amount equal to (i) the amount, if any, by which their actual accident
year net loss ratio exceeds the applicable Loss Ratio Cap, multiplied by (ii)
the applicable net earned premiums. In consideration for the coverage provided
by the Stop Loss Contract, the insurance subsidiaries paid to CCC an annual
premium of $20,000. The CNA Surety insurance subsidiaries have paid CCC all
required annual premiums. The Company recorded estimated reinsurance recoveries
from CCC of $2.5 million in 2002, $16.6 million in 2001 and $5.8 million in 2000
under this contract. As of December 31, 2002, the Company billed and received
approximately $25 million from CCC under the Stop Loss Contract. This amount
exceeds the Company's current estimate of paid loss recoverable under this
agreement by $20.3 million, which is reflected as reinsurance payable to CCC at
December 31, 2002.

      The Excess of Loss Contracts provided the insurance subsidiaries of CNA
Surety with the capacity to underwrite large surety bond exposures by providing
reinsurance support from CCC. The Excess of Loss Contract provides $75 million
of coverage for losses in excess of the $60 million per principal. Subsequent to
the Merger Date, the Company entered into a second excess of loss contract with
CCC ("Second Excess of Loss Contract"). The Second Excess of Loss Contract
provides additional coverage for principal losses that exceed the foregoing
coverage of $75 million per principal provided by the Excess of Loss Contract,
or aggregate losses per principal in excess of $135 million. In consideration
for the reinsurance coverage provided by the Excess of Loss Contracts, the
insurance subsidiaries paid to CCC, on a quarterly basis, a premium equal to 1%
of the net written premiums applicable to the Excess of Loss Contract, subject
to a minimum premium of $20,000 and $5,000 per quarter under the Excess of Loss
Contract and Second Excess of Loss Contract, respectively. The two Excess of
Loss Contracts collectively provided coverage for losses discovered on surety
bonds in force as of the Merger Date and for losses discovered on new and
renewal business written during the term of the Excess of Loss Contracts. Both
Excess of Loss Contracts commenced following the Merger Date and continued until
September 30, 2002. The discovery period for losses covered by the Excess of
Loss Contracts extends until September 30, 2005.

      Effective October 1, 2002, the Company secured replacement excess of loss
protection from CCC for per principal losses that exceed $60 million in two
parts -- a) $40 million excess of $60 million and b) $50 million excess of $100
million. This excess of loss protection is primarily necessary to support
contract surety accounts with bonded backlogs or work-in-process in excess of
$60 million. The Company's goal is to generally limit support to large
commercial surety accounts to $25 million. In addition to the foregoing
structural changes in its high layer excess of loss reinsurance programs, the
cost for these protections increased significantly as compared to the cost of
the previous two Excess of Loss Contracts. The $40 million excess of $60 million
contract is for a three year term beginning October 1, 2002 and provides annual
aggregate coverage of $80 million and $120 million aggregate coverage for the
entire three year term. The Company will pay CCC annual reinsurance premiums of
$12.5 million in year one and $17.5 million in years two and three, payable
quarterly. The Company may commute the contract at the end of each contract year
under certain circumstances. If the treaty is commuted, the Company may be
entitled to a return premium payment. Based on the experience under the treaty
to December 31, 2002, the Company established a return premium receivable of
$2.2 million in connection with the restatement described in Note 17 to the
accompanying financial statements. The reinsurance premium for the coverage
provided by the $50 million excess of $100 million contract was $4.0 million.
This contract was effective October 1, 2002 and expires on December 31, 2003.

      CCC also provided reinsurance coverage (the "10% Quota Share Agreement")
to the Company for 10% of any losses between $20 million and $60 million with
respect to single large surety bonds written effective January 1, 2002 through
December 31, 2002. CCC received 10% of the written premium in exchange for the
coverage provided.


                                       23
<PAGE>
Net Loss Ratio

      The loss ratios for the years ended December 31, 2002, 2001 and 2000 were
31.6%, 25.2% and 18.4%, respectively. The loss ratios included $6.2 million and
$4.8 million in net unfavorable loss reserve development related to prior years
for the years ended December 31, 2002 and 2001, respectively, and $7.1 million
in net favorable loss reserve development for the year ended December 31, 2000.
The net adverse loss reserve development in 2002 includes $2.4 million
associated with the assumed international credit and surety business from CNA Re
that was discontinued in 2000. The remainder is primarily related to increased
claim frequency in the small and specialty contract business. The increases in
the adjusted loss ratio for 2002 of 5.8 percentage points relates primarily to
estimated net incurred losses of $12.0 million with respect to the bankruptcy
filing of a large national trucking concern.

      For the first half of 2002, the Company used an initial 2002 accident year
net loss ratio of 30.0 percent to reserve for its medium to large commercial and
contract branch business compared to 22.5 percent when the per principal
retention was $5 million. This business represents about 58% of the Company's
gross premiums.

      The occurrence of the $12.0 million bankruptcy related loss in the third
quarter of 2002 significantly increased the estimated branch contract and
commercial net accident year loss ratio for the nine months ended September 30,
2002. Due to the occurrence of this loss and other adverse loss trends, together
with the uncertain outlook for the economy and credit markets, the Company
raised its expected baseline accident year net loss ratio on the branch contract
and commercial business to 36.0 percent for the fourth quarter from the initial
2002 accident year net loss ratio of 30.0 percent.

      The $4.8 million of adverse reserve development in 2001 includes
approximately $1 million of adverse development for the Company's discontinued
insurance agent E&O product. The remainder is primarily related to increased
claim frequency in the small and specialty contract business. In addition to the
$4.8 million of net unfavorable loss reserve development during 2001, the 2001
loss ratio includes approximately $7.8 million pertaining to the Company's
exposure to Enron Corporation. Gross incurred loss and loss adjustment expenses
for the year ended December 31, 2001 reflect $78 million for this exposure.

      On January 2, 2003, CNA Surety settled litigation brought by J.P. Morgan
Chase & Co. ("Chase") in connection with three surety bonds issued on behalf of
Enron Corporation subsidiaries. The penal sums of the three bonds totaled
approximately $78 million. Although the Company believed it had valid defenses
to the litigation, based on the uncertainty and risk of an adverse jury verdict,
pursuant to the settlement agreement, the Company paid Chase approximately $40.7
million and assigned its recovery rights in the Enron bankruptcy to Chase in
exchange for a full release of its obligations under the bonds. The Company has
no other exposure related to the Enron Corporation. CNA Surety's net loss
related to the settlement, after anticipated recoveries under excess of loss
reinsurance treaties, was previously fully reserved. Immediately upon execution
of the settlement documents, the Company sent written notice for reimbursement
to its reinsurers. A number of those reinsurers have requested a variety of
documents and reserved their rights before making a decision concerning coverage
of the settlement under the reinsurance treaties. Management believes that the
reinsurers have no valid defense under the reinsurance treaties to avoid
payment, and that the Company will fully recover all


                                       24
<PAGE>
reinsurance recoverables recorded related to this settlement. As such, the
Company has not recorded a reduction with respect to these reinsurance
recoverables as of December 31, 2002.

      The surety business assumed from CCC and CIC is subject to an aggregate
stop loss reinsurance contract between CCC and the Company that limits the
Company's accident year net loss ratio on this business to 24% for accident
years 1997 (October 1, 1997 to December 31, 1997), 1998, 1999 and 2000. The
Company recorded estimated reinsurance recoveries from CCC of $2.5 million in
2002, $16.6 million in 2001 and $5.8 million in 2000 under this contract.

Expense Ratio

      The expense ratio decreased to 60.3% for the year ended December 31, 2002
as compared to 63.2% for 2001. The decrease in the expense ratio for the year
ended December 31, 2002 primarily reflects reduced acquisition and underwriting
expenses which were partially offset by the effect of higher reinsurance costs
on net earned premiums. Net earned premiums declined 7.0% and operating expenses
decreased at a higher rate of 11.4% for the year ended December 31, 2002. The
Company continues to work to offset higher reinsurance and loss costs with
premium rate actions, acquisition cost reductions and continued productivity
improvements and operating efficiencies.

      The expense ratio increased to 63.2% for the year ended December 31, 2001
as compared to 60.2% for 2000. The increase in the expense ratio for the year
ended December 31, 2001 primarily reflects the impact of higher reinsurance
costs and operating expenses. Operating expenses reflect higher technology
related expenditures and $2.2 million of fourth quarter charges consisting
primarily of asset write-offs. Net earned premiums increased 6.3% in 2001 and
operating expenses increased at a higher rate of 11.7%.

Exposure Management

      As the foregoing results indicate, the Company's business is subject to
certain risks and uncertainties associated with the current economic environment
and corporate credit conditions. In response to these risks and uncertainties,
the Company has enacted various exposure management initiatives, particularly to
reduce its risks on large commercial accounts. As the following table depicts,
the Company has reduced its exposure, before the effects of reinsurance, by 40%
in 2002 on large commercial accounts, which are defined as accounts with
exposures in excess of $10 million:

<TABLE>
<CAPTION>
                                                 NUMBER OF
                                                 ACCOUNTS
                                                   AS OF                      TOTAL EXPOSURE
                                                DECEMBER 31,                AS OF DECEMBER 31,
                                              ---------------        --------------------------------
            COMMERCIAL ACCOUNT EXPOSURE       2002       2001        2002        2001     % REDUCTION
            ---------------------------       ----       ----        ----        ----     -----------
                                                            (DOLLARS IN BILLIONS)
<S>                                           <C>        <C>         <C>         <C>      <C>
            $100 million and larger ...         13         20        $2.5        $5.0        49.3%
            $50 to $100 million .......         19         27         1.2         1.8        32.9
            $25 to $50 million ........         16         35         0.6         1.2        52.2
            $10 to $25 million ........         75         80         1.2         1.3         5.8
                                               ---        ---        ----        ----        ----
            Total .....................        123        162        $5.5        $9.3        40.4
                                               ===        ===        ====        ====        ====
</TABLE>

      With respect to contract surety, the Company's portfolio is predominantly
comprised of contractors with work programs of less than $50 million. "Work
program" is the estimated contract value of uncompleted bonded and unbonded
work. Bonded backlog is a measure of the Company's exposure in the event of
default before indemnification, salvage and subrogation recoveries.

      The following table summarizes the composition of the Company's contractor
portfolio by size of estimated work program at December 31, 2002:

<TABLE>
<CAPTION>
                                                               ESTIMATED
                                               NUMBER OF        BONDED
                                                ACCOUNTS        BACKLOG
                                                 AS OF           AS OF
                                              DECEMBER 31,    DECEMBER 31,
               CONTRACT WORK PROGRAM              2002            2002
            ----------------------------      ------------    ------------
                                                              (DOLLARS IN
                                                                BILLIONS)
<S>                                           <C>             <C>
            $150 million and larger ....             41          $ 7.1
            $100 to $150 million .......             33            1.9
            $50 to $100 million ........            136            4.1
            $30 to $50 million .........            152            2.0
            Less than $30 million ......          3,574            3.2
                                                  -----          -----
            Total ......................          3,936          $18.3
                                                  =====          =====
</TABLE>

      The Company will manage its exposure to any one contract credit and
aggressively looks for co-surety, shared accounts and other means to support or
reduce larger exposures. Reinsurance, indemnification and subrogation rights,
including rights to contract proceeds on construction projects in the event of
default, exist that substantially reduce CNA Surety's exposure to loss.

Investment Income

      For the year ended December 31, 2002, net investment income was $27.8
million compared to net investment income for the years ended December 31, 2001
and 2000 of $29.5 million and $29.9 million, respectively. The annualized pretax
yield was 4.8%, 5.3% and 5.6% for the years ended December 31, 2002, 2001 and
2000, respectively. The annualized after-tax yield was 3.8%, 4.0% and 4.3% for
the years ended December 31, 2002, 2001 and 2000, respectively. The decrease in
investment income for the year ended December 31, 2002 is attributable to the
impact of lower investment yields. The decrease in investment income for the
year ended December 31, 2001 is attributable to the impact of lower investment
yields and reduced invested assets primarily associated with increased dividend
payments to shareholders and the retirement of debt.

      Net realized investment losses were approximately $7.6 million, for the
year ended December 31, 2002 compared to net realized investment gains of
approximately $46,000 and $0.6 million, for the years ended December 31, 2001
and 2000, respectively. The net realized investment losses in 2002 reflect the
Company's insurance subsidiaries decision to liquidate their common equity
portfolios during the fourth quarter of 2002. The volatility of the equity
markets was adversely impacting the Company's reported regulatory capital
requirements.

      The following summarizes net realized investment gains (losses) for the
three years ended December 31, 2002:

<TABLE>
<CAPTION>
                                                              YEARS ENDED DECEMBER 31,
                                                         ----------------------------------
                                                           2002         2001         2000
                                                         --------      -------      -------
<S>                                                      <C>           <C>          <C>
            Gross realized investment gains ........     $ 11,183      $ 1,118      $ 3,251
            Gross realized investment losses .......      (18,769)      (1,072)      (2,694)
                                                         --------      -------      -------
            Net realized investment (loss) gain ....     $ (7,586)     $    46      $   557
                                                         ========      =======      =======
</TABLE>

      The Company's investment portfolio generally is managed to maximize
after-tax investment return, while minimizing credit risk with investments
concentrated in high quality income securities. CNA Surety's portfolio is
managed to provide diversification by limiting exposures to any one industry,
issue or issuer, and to provide liquidity by investing in the public securities
markets. The portfolio is structured to support CNA Surety's insurance
underwriting operations and to consider the expected duration of liabilities and
short-term cash needs. In achieving these goals, assets may be sold to take
advantage of market conditions or other investment opportunities or regulatory,
credit and tax considerations. These activities will produce realized gains and
losses.

      Invested assets are exposed to various risks, such as interest rate,
market and credit. Due to the level of risk associated with certain of these
invested assets and the level of uncertainty related to changes in the value of
these assets, it is possible that changes in risks in the near term may
significantly affect the amounts reported in the Consolidated Balance Sheets and
Consolidated Statements of Income.


                                       25
<PAGE>
Analysis of Other Operations

      As of January 1, 2002, the Company adopted SFAS No. 142 which requires
that goodwill and intangible assets with indefinite useful lives no longer be
amortized, but instead be tested for impairment at least annually. The periodic
amortization of goodwill and intangibles ceased as of December 31, 2001.
Amortization expense was $6.1 million for the years ended December 31, 2001 and
2000. Intangible assets primarily represent goodwill and identified intangibles
arising from the acquisition of Capsure.

      During 2002, the Company completed its initial goodwill impairment testing
and an annual goodwill impairment testing on October 1, 2002 whereby no
impairment was indicated. In the fourth quarter of 2002, the Company again
tested for goodwill impairment. Based upon the Company's analysis supported by
an outside valuation study, the Company concluded that there was no impairment.

      Interest expense decreased $2.2 million, or 56.5%, for the year ended
December 31, 2002 compared to the same period in 2001, primarily due to lower
outstanding debt levels and lower interest rates. The weighted average interest
rate for the year ended December 31, 2002 was 2.2% compared to 4.4% and 6.6% for
the periods ended December 31, 2001 and 2000, respectively. Interest expense
decreased $3.0 million, or 43.6%, for the year ended December 31, 2001 compared
to the same period in 2000, primarily due to lower outstanding debt levels and
lower interest rates. Average debt outstanding was $73.4 million in 2002
compared to $82.8 million and $101.8 million in 2001 and 2000, respectively.

Income Taxes

      Income tax expense was $12.6 million, $19.8 million and $27.8 million and
the effective income tax rates were 29.6%, 35.0% and 34.1% for the years ended
December 31, 2002, 2001 and 2000, respectively. The decrease in the estimated
effective tax rate in 2002 primarily relates to the increased tax exempt income
and the adoption of SFAS No. 142 which ended the periodic amortization the
Company's goodwill and intangibles.

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 sources of
operating cash flows 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, as
well as 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 dividend and income tax sharing payments of its insurance
subsidiaries. At December 31, 2002, the carrying value of the Company's
insurance subsidiaries' invested assets was comprised of $564.8 million of fixed
income securities, $41.9 million of short-term investments, $1.3 million of
other investments and $10.7 million of cash. At December 31, 2001, the carrying
value of the Company's insurance subsidiaries' invested assets was comprised of
$466.6 million of fixed income securities, $35.8 million of equity securities,
$38.9 million of short-term investments, $5.3 million of other investments and
$0.8 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, including income taxes, and pay dividends to stockholders. At December
31, 2002, the parent company's invested assets consisted of $5.7 million of
fixed income securities, $0.8 million of equity securities, $8.8 million of
short-term investments and $4.3 million of cash. At December 31, 2001, the
parent company's invested assets consisted of $5.3 million of fixed income
securities, $14.7 million of short-term investments and $12.4 million of cash.
As of December 31, 2002 and December 31, 2001, parent company short-term
investments and cash included $4.8 million and $13.8 million, respectively, of
restricted cash related to premium receipt collections ultimately due to the
Company's insurance subsidiaries.

      The Company's consolidated net cash flow provided by operating activities
was $85.5 million, $57.0 million and $79.2 million for the years ended December
31, 2002, 2001 and 2000, respectively. The increase in net cash flow provided by
operating activities in 2002 primarily relates to decreases in insurance
receivables, primarily reinsurance recoverables from affiliates.


                                       26
<PAGE>
      CNA Surety's bank borrowings were previously under a five-year unsecured
revolving credit facility effective September 30, 1997 (the "1997 Credit
Facility") that provided for borrowings of up to $130 million. The Company paid
down outstanding borrowings under the 1997 Credit Facility by $10 million to $65
million on July 29, 2002. The 1997 Credit Facility matured September 30, 2002.

      The Company refinanced $65 million in outstanding borrowings under the
1997 Credit Facility under a new credit facility (the "2002 Credit Facility").
The 2002 Credit Facility provided an aggregate of up to $65 million in initial
borrowings divided between a 364 day revolving credit facility (the "Revolving
Credit Facility") of $35 million and a three year term loan facility (the "Term
Loan") of $30 million. The Revolving Credit Facility may be extended, with the
consent of lenders, for up to two additional periods of up to 364 days each, but
in no case shall the Revolving Credit Facility be extended to mature on a date
later than three years from the effective date of the Revolving Credit Facility.
The Revolving Credit Facility may be increased from time to time by the amount
of amortization under the Term Loan facility. Such increase is subject to
consent by each Revolving Credit Bank, and will take place upon receipt by the
Banks of the respective installment payments under the Term Loan facility.

      Of the $65 million in initial outstanding borrowings, $15 million was
provided pursuant to a guarantee by CNAF which expired on November 30, 2002. On
November 29, 2002, the Company repaid $11 million of the $15 million of the
Company's revolving credit loan that was due on November 30, 2002. The due date
on the remaining $4 million was extended until another lender joined the credit
facility. On December 30, 2002, a second lender joined the credit facility for
$10 million resulting in net additional funds of $6 million to CNA Surety.
Outstanding borrowings under the credit facility were $60 million as of December
31, 2002, consisting of $30 million under the Revolving Credit Facility and $30
million under the Term Loan Facility. Effective January 28, 2003, the Company
entered into an interest rate swap on the $30 million term loan that fixed the
interest rate at 2.75%.

      Amortization of the Term Loan will take place at $10,000,000 per year, in
equal installments of $5,000,000 on the following dates:

<TABLE>
<CAPTION>
                     DATE                   AMORTIZATION     OUTSTANDING BALANCE
            -----------------------         ------------     -------------------
<S>                                         <C>              <C>
            June 30, 2003 .........          $5,000,000          $25,000,000
            September 30, 2003 ....           5,000,000           20,000,000
            March 31, 2004 ........           5,000,000           15,000,000
            September 30, 2004 ....           5,000,000           10,000,000
            March 31, 2005 ........           5,000,000            5,000,000
            September 30, 2005 ....           5,000,000                    0
</TABLE>

      The interest rate on borrowings under the 2002 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 a facility fee and utilization
fee on the 2002 Credit Facility, was 0.625% at December 31, 2002 and can vary
based on CNA Surety's leverage ratio (debt to total capitalization) from 0.48%
to 0.80%. As of December 31, 2002, the weighted average interest rate was 1.9%
on the $60 million of outstanding borrowings. As of December 31, 2001, the
weighted average interest rate on the 1997 Credit Facility was 2.5% on the $75.0
million of outstanding borrowings.

      The 2002 Credit Facility contains, among other conditions, limitations on
CNA Surety with respect to the incurrence of additional indebtedness and
maintenance of a rating of at least "A" by A.M. Best for each of the Company's
insurance subsidiaries. The 2002 Credit Facility also requires the maintenance
of certain financial ratios as follows: a) maximum funded debt to total
capitalization ratio of 25%, b) minimum net worth of $350.0 million and c)
minimum fixed charge coverage ratio of 2.5 times. As of December 31, 2002, the
Company was in compliance with all restrictions and covenants contained in the
2002 Credit Facility.

      In 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%.
The balance of this promissory note at December 31, 2002 was $0.8 million.

      As an insurance holding company, CNA Surety is dependent upon dividends
and other permitted payments from its insurance subsidiaries to pay operating
expenses, meet debt service requirements, as well as to pay cash dividends. The
payment of dividends by the insurance subsidiaries is 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


                                       27
<PAGE>
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 2003 is based on
statutory surplus and income at and for the year ended December 31, 2002.
Without prior regulatory approval in 2003, CNA Surety's insurance subsidiaries
may pay stockholder dividends of $32.1 million in the aggregate. CNA Surety
received $31.2 million in dividends from its insurance subsidiaries in 2002 and
$56.9 million in 2001.

      Combined statutory surplus totaled $231.4 million at year-end, resulting
in a net written premium to statutory surplus ratio of 1.3 to 1. Approximately
$219 million of the combined surplus relates to Western Surety. Insurance
regulations restrict Western Surety's maximum net retention on a single surety
bond to 10 percent of statutory surplus. Under the 2003 Excess of Loss Treaty,
the Company's net retention on new bonds would generally be $15 million plus a
5% co-participation in the $45 million layer of excess reinsurance above the
Company's retention and this regulation would require minimum statutory surplus
of $172.5 million at Western Surety. This surplus constraint may limit the
amount of future dividends Western Surety could otherwise pay to CNA Surety
Corporation.

      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. 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 $9.9 million for the year ended December 31,
2002 and $18.2 million for the year ended December 31, 2001.

      Western Surety, SBCA and USA qualify as acceptable surety companies for
federal and other public works project bonds pursuant to U.S. Department of
Treasury regulations. U.S. Treasury underwriting limitations are based on an
insurer's statutory surplus. Effective July 1, 2002 through June 30, 2003, the
underwriting limitations of Western Surety, SBCA and USA are $20.7 million, $0.5
million and $1.3 million, respectively. Through the Surety Quota Share Treaty
between CCC and Western Surety Company, CNA Surety has access to CCC and its
affiliates' U.S. Department of Treasury underwriting limitations. The Surety
Quota Share Treaty had an original term of five years from the Merger Date and
was renewed on October 1, 2002 on substantially the same terms. Effective July
1, 2002 through June 30, 2003, the underwriting limitations of CCC and its
affiliates total $382.9 million. CNA Surety management believes that the
foregoing U.S. Treasury underwriting limitations are sufficient for the conduct
of its business.

      Subject to the aforementioned uncertainties concerning the Company's per
principal net retentions, CNA Surety management believes that the Company has
sufficient available resources, including capital protection against large
losses provided by the Company's excess of loss reinsurance arrangements, to
meet its present capital needs.


                                       28
<PAGE>
FINANCIAL CONDITION

Investment Portfolio

      The following table summarizes the distribution of the Company's fixed
income and equity portfolios at estimated fair values as of December 31, 2002
and 2001:

<TABLE>
<CAPTION>
                                                                     DECEMBER 31,
                                                                        2002                       DECEMBER 31,
                                                                      ESTIMATED                       2001
                                                                        FAIR           % OF         ESTIMATED        % OF
                                                                        VALUE          TOTAL        FAIR VALUE       TOTAL
                                                                     ------------      -----       ------------      -----
<S>                                                                  <C>               <C>         <C>               <C>
            Fixed income securities:
            U.S. Treasury securities and obligations of
              U.S. Government and agencies:
                 U.S. Treasury ................................        $ 17,100          3.0%        $ 25,307          5.0%
                 U.S. Agencies ................................          29,930          5.2           68,952         13.6
                 Collateralized mortgage obligations ..........             163          0.0              414          0.1
                 Mortgage pass-through securities .............          22,047          3.9           22,396          4.4
            Obligations of states and political
              subdivisions ....................................         367,934         64.4          220,799         43.5
            Corporate bonds ...................................          82,145         14.4           72,380         14.3
            Non-agency collateralized mortgage obligations ....          10,916          1.9           12,625          2.5
            Other asset-backed securities:
              Second mortgages/home equity loans ..............          12,456          2.2           16,321          3.2
              Credit card receivables .........................           5,087          0.9           10,327          2.0
              Other ...........................................           8,491          1.5            8,763          1.7
            Redeemable preferred stock ........................          14,269          2.5           13,557          2.7
                                                                       --------        -----         --------        -----
                 Total fixed income securities ................         570,538         99.9%         471,841         93.0%
            Equity securities .................................             761          0.1           35,754          7.0
                                                                       --------        -----         --------        -----
                 Total ........................................        $571,299        100.0%        $507,595        100.0%
                                                                       ========        =====         ========        =====
</TABLE>

      The Company's investment portfolio generally is managed to maximize
after-tax investment return, while minimizing credit risk with investments
concentrated in high quality income securities. CNA Surety's portfolio is
managed to provide diversification by limiting exposures to any one industry,
issue or issuer, and to provide liquidity by investing in the public securities
markets. The portfolio is structured to support CNA Surety's insurance
underwriting operations and to consider the expected duration of liabilities and
short-term cash needs.

      CNA Surety classifies its fixed maturity securities and its equity
securities as available-for-sale, and as such, they are carried at fair value.
The amortized cost of fixed maturity securities is adjusted for amortization of
premiums and accretion of discounts to maturity, which is included in net
investment income. Changes in fair value are reported as a component of other
comprehensive income.

      The estimated fair value and amortized cost of fixed income and equity
securities held by CNA Surety by investment category, were as follows (dollars
in thousands):

<TABLE>
<CAPTION>
                                                                                                  GROSS           GROSS
                                                                AMORTIZED COST   UNREALIZED     UNREALIZED   ESTIMATED FAIR
                            DECEMBER 31, 2002                       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 ............................        $ 16,140        $   960        $  --         $ 17,100
                 U.S. Agencies ............................          29,396            537           (3)          29,930
                 Collateralized mortgage
                   obligations ............................             156              7           --              163
                 Mortgage pass-through securities .........          20,981          1,066           --           22,047
            Obligations of states and political
              subdivisions ................................         347,918         20,099          (83)         367,934
            Corporate bonds ...............................          76,181          6,154         (190)          82,145
            Non-agency collateralized mortgage
              obligations .................................          10,497            477          (58)          10,916
            Other asset-backed securities:
              Second mortgages/home equity loans ..........          11,842            614           --           12,456
              Credit card receivables .....................           5,000             87           --            5,087
              Other .......................................           7,838            653           --            8,491
            Redeemable preferred stock ....................          13,415            854           --           14,269
                                                                   --------        -------        -----         --------
                 Total fixed income securities ............         539,364         31,508         (334)         570,538
            Equity securities .............................             852             --          (91)             761
                                                                   --------        -------        -----         --------
                 Total ....................................        $540,216        $31,508        $(425)        $571,299
                                                                   ========        =======        =====         ========
</TABLE>


                                       29
<PAGE>
      Invested assets are exposed to various risks, such as interest rate,
market and credit. Due to the level of risk associated with certain of these
invested assets and the level of uncertainty related to changes in the value of
these assets, it is possible that changes in risks in the near term may
significantly affect the amounts reported in the Consolidated Balance Sheets and
Consolidated Statements of Income. The Company's Quantitative and Qualitative
Discussion about Market Risk is contained in Item 7A of this Form 10-K/A.

      The following table sets forth the ratings assigned by The Standard &
Poor's Corporation ("S&P") or Moody's Investor Services, Inc. ("Moody's") of the
fixed income securities portfolio of the Company as of December 31, 2002 and
2001 (dollars in thousands):

<TABLE>
<CAPTION>
                                                   2002                           2001
                                         -------------------------      -------------------------
                   CREDIT RATING         FAIR VALUE     % OF TOTAL      FAIR VALUE     % OF TOTAL
                   -------------         ----------     ----------      ----------     ----------
<S>                                      <C>            <C>             <C>            <C>
                  AAA/Aaa ........        $358,976          62.9%        $305,178          64.7%
                  AA/Aa ..........         110,593          19.4           75,189          15.9
                  A/A ............          52,447           9.2           56,107          11.9
                  BBB ............          41,612           7.3           28,849           6.1
                  Not Rated ......           6,910           1.2            6,518           1.4
                                          --------        ------         --------        ------
                       Total .....        $570,538        $100.0%        $471,841        $100.0%
                                          ========        ======         ========        ======
</TABLE>

      As of December 31, 2002 and 2001, 99% of the Company's fixed income
securities were considered investment grade by S&P or Moody's and 82% and 81%
were rated at least AA by those agencies for 2002 and 2001, respectively. The
Company's investments in fixed income securities do not contain any industry
concentration of credit risk.

      As of December 31, 2002, municipal securities of the State of Texas, the
State of Michigan and the State of Illinois and each state's related political
subdivisions each represent 6.2%, 4.7% and 4.5%, respectively, of the estimated
fair value of the Company's fixed income portfolio. Municipal securities of each
other state individually represent less than 4% of the Company's fixed income
portfolio.

Reserves for Unpaid Losses and Loss Adjustment Expenses

      CNA Surety's insurance subsidiaries employ generally accepted reserving
approaches in establishing the estimated liability for unpaid losses and loss
adjustment expenses that give consideration to the inherent difficulty and
variability in the estimation process. The estimated liability for unpaid losses
and loss adjustment expenses includes, on an undiscounted basis, estimates of
(a) the ultimate settlement value of reported claims, (b) incurred but not
reported ("IBNR") claims, (c) future expenses to be incurred in the settlement
of claims and (d) claim recoveries, exclusive of reinsurance recoveries which
are reported as an asset. These estimates are determined based on the Company's
and surety industry loss experience as well as consideration of current trends
and conditions. The estimated liability for unpaid losses and loss adjustment
expenses is an estimate and there is the potential that actual future loss
payments will differ significantly from initial estimates. The methods of
determining such estimates and the resulting estimated liability are regularly
reviewed and updated. Changes in the estimated liability are reflected in
operating income in the period in which such changes are determined to be
needed.

      The Company's estimated liability for unpaid loss and loss adjustment
expenses are recorded at management's best estimate which is based on various
statistical reviews and analyses performed by the Company and management's
judgment as to the responsiveness of these reviews and analyses to the factors
affecting the Company's loss and loss adjustment expense reserves. Management
considers factors such as changes in inflation, changes in claim handling and
case reserving, changes in underwriting and pricing, changes in reinsurance
programs, the Company's net retained liability and changes in the legal
environment.

      CNA Surety utilizes an independent actuarial firm of national standing to
conduct periodic reviews of claim procedures and loss reserving practices, and
annually obtains actuarial certification as to the reasonableness of actuarial
assumptions used and the


                                       30
<PAGE>
sufficiency of year-end reserves for each of its principal insurance
subsidiaries. In connection with this actuarial certification, the Company's
independent actuarial firm provides management with additional reports and
analysis and its independent judgments regarding loss and loss adjustment
expense reserve estimates for management's review.

      The Company recorded net unfavorable loss reserve development which
resulted in increases in the estimated liability of $6.2 million and $4.8
million for the years ended December 31, 2002 and 2001, respectively and net
favorable loss reserve development which resulted in reductions in the estimated
liability of $7.1 million for the year ended December 31, 2000. Note 8 to the
accompanying Consolidated Financial Statements presents a table of the activity
in the reserves for unpaid losses and loss adjustment expenses for the Company.
This table highlights the impact of revisions to the estimated liability
established in prior years.

Risk Based Capital ("RBC") and Other Regulatory Ratios

      The National Association of Insurance Commissioners ("NAIC") has
promulgated RBC requirements for property and casualty insurance companies to
evaluate the adequacy of statutory capital and surplus in relation to investment
and insurance risks such as asset quality, loss reserve adequacy, and other
business factors. The RBC information is used by state insurance regulators as
an early warning mechanism to identify insurance companies that potentially are
inadequately capitalized. In addition, the formula defines minimum capital
standards that supplement the current system of fixed minimum capital and
surplus requirements on a state-by-state basis. Regulatory compliance is
determined by a ratio (the "Ratio") of the enterprise's regulatory total
adjusted capital, as defined by the NAIC, to its authorized control level RBC,
as defined by the NAIC. Generally, a Ratio in excess of 200% of authorized
control level RBC requires no corrective actions on behalf of a company or
regulators. As of December 31, 2002, each of CNA Surety's insurance subsidiaries
had a Ratio that was in compliance with minimum RBC requirements.

      CNA Surety's insurance subsidiaries require capital to support premium
writings. In accordance with industry and regulatory guidelines, the net written
premiums to surplus ratio of a property and casualty insurer generally should
not exceed 3 to 1. On December 31, 2002, the Company had a combined statutory
surplus of $231.4 million. The combined statutory surplus of Western Surety and
SBCA was $223.7 million and its net written premiums to surplus ratio was 1.3 to
1. USA's statutory surplus was $7.6 million and the net written premiums to
surplus ratio was 0.8 to 1. On December 31, 2001, the Company had a combined
statutory surplus of $227.5 million. The combined statutory surplus of Western
Surety and SBCA was $212.0 million and its net written premiums to surplus ratio
was 1.5 to 1. USA's statutory surplus was $15.4 million and the net written
premiums to surplus ratio was 0.5 to 1. The Company believes that each insurance
company's statutory surplus is sufficient to support its current and anticipated
premium levels.

      The NAIC has also developed a rating system, the Insurance Regulatory
Information System ("IRIS"), primarily intended to assist state insurance
departments in overseeing the financial condition of all insurance companies
operating within their respective states. IRIS consists of twelve financial
ratios that address various aspects of each insurer's financial condition and
stability. In 2002 and 2001, Western's IRIS ratios were within all the "usual"
ranges as defined by the NAIC, as were most of the ratios for USA and SBCA
except as noted. In 2002 and 2001, USA's Two-Year Overall Operating ratio was
outside of the usual range, primarily due to increases in the loss and expense
ratios. In 2002, USA's Change in Policyholders' Surplus ratio was outside of the
usual range primarily due to USA's declaration and payment of an extraordinary
dividend to CNA Surety. In 2002, SBCA's Change in Net Writings ratio was outside
of the usual range due to increased notary bond volume. SBCA's Investment Yield
for 2002 was outside of the usual range primarily due to generally lower
investment rates along with an increased tax exempt portfolio. In 2001, SBCA's
IRIS ratios were within all the "usual" ranges as defined by the NAIC.

IMPACT OF ADOPTING ACCOUNTING PRONOUNCEMENTS

      In June 2001, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 141 and No. 142 entitled "Business Combinations" ("SFAS No. 141") and
"Goodwill and Other Intangible Assets" ("SFAS No. 142"), respectively. SFAS No.
141 requires that the purchase method of accounting be used for all business
combinations subsequent to June 30, 2001 and specifies criteria for recognizing
intangible assets acquired in a business combination. The Company will adopt
this standard for any future business combinations. SFAS No. 142 requires that
goodwill and intangible assets with indefinite useful lives no longer be
amortized, but instead be tested for impairment at least annually. Any
impairment loss for the excess of the carrying amount of an intangible asset
over its fair value would be recognized as a charge to operations. Intangible
assets with definite useful lives will continue to be amortized over their
respective estimated useful lives. The Company has adopted the provisions of
SFAS No. 142 effective January 1, 2002.

      During 2002, the Company completed its initial goodwill impairment testing
and an annual goodwill impairment testing as of


                                       31
<PAGE>
October 1, 2002 whereby no impairment was indicated. In the fourth quarter of
2002, the Company again tested for goodwill impairment. Based upon the Company's
analysis supported by an outside valuation study, the Company concluded that
there was no impairment.

      In determining whether there is an impairment of goodwill or other
intangible assets, the Company calculated its estimated fair value using the
present value of estimated expected future cash flows. The resulting estimated
fair value was then compared to the net book value, including goodwill. If the
net book value exceeded the estimated fair value, the Company would have
measured the amount of impairment loss by comparing the implied estimated fair
value of goodwill with the carrying amount of that goodwill. To the extent that
the carrying amount of the goodwill exceeds its implied fair value, a goodwill
impairment loss would be recognized. This impairment test will be performed
annually and whenever facts and circumstances indicate that there is a possible
impairment of goodwill. The Company believes the methodology it uses in testing
impairment of goodwill provides a reasonable basis in determining whether an
impairment charge is required.

      The adoption of this standard eliminated the Company's amortization of
goodwill and intangible assets as of December 31, 2001 and therefore, increased
the Company's reported net income in 2002 by $5.7 million, or $0.13 per share as
compared to prior years. If the provisions of this standard were applied to
prior periods, net income for the years ended December 31, 2001 and 2000 would
have been $42.6 million, or $0.99 per share, and $59.3 million, or $1.38 per
share, respectively.

      In October 2001, the FASB issued SFAS No. 144 entitled "Accounting for the
Impairment or Disposal of Long-Lived Assets" ("SFAS No. 144"). SFAS No. 144
addresses accounting and reporting for the impairment or disposal of long-lived
assets. This statement supersedes SFAS No. 121, "Accounting for the Impairment
of Long-Lived Assets and for Long-Lived Assets to be Disposed Of." The
provisions of this statement were effective for CNA Surety beginning January 1,
2002. The initial adoption of this standard had no impact on the Company's
financial position or results of operations.

      In June of 2002, the FASB issued SFAS No. 146 entitled "Accounting for
Costs Associated with Exit or Disposal Activities" ("SFAS No. 146"). SFAS No.
146 addresses financial accounting and reporting for costs associated with exit
or disposal activities and supercedes Emerging Issues Task Force ("EITF") Issue
No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and
Other Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring)" ("EITF 94-3"). The Company adopted the provisions of SFAS No.
146 for all disposal activities initiated after June 30, 2002. The adoption of
SFAS No. 146 did not have a significant impact on the Company's financial
position or results of operations.

      In December 2002, the FASB issued SFAS No. 148 entitled "Accounting for
Stock-Based Compensation, Transition and Disclosure" ("SFAS No. 148"). SFAS No.
148 provides alternative methods of transition for a voluntary change to the
fair value based method of accounting for stock-based employee compensation.
SFAS No. 148 also amends the disclosure requirements of SFAS No. 123,
"Accounting for Stock-Based Compensation", ("SFAS No. 123")to require prominent
disclosures in both annual and interim financial statements about the method of
accounting for stock-based employee compensation and the effect of the method
used on reported results. The Company has adopted this standard beginning with
the 2002 annual financial statements and will meet the disclosure requirements
in all subsequent annual and interim financial statements. The Company has not
determined if it will adopt fair value accounting in 2003.

IMPACT OF ACCOUNTING PRONOUNCEMENTS NOT YET ADOPTED

      In August 2001, the FASB issued SFAS No. 143 entitled "Accounting for
Asset Retirement Obligations" ("SFAS No 143"). SFAS No. 143 addresses accounting
and reporting for obligations associated with the retirement of tangible
long-lived assets and the associated asset retirement costs. The provisions of
this standard are effective for CNA Surety beginning January 1, 2003. The
Company is in the process of quantifying the impact this new standard will have
on the Company's financial position or results of operations.

      In November of 2002, the FASB issued FASB Interpretation No. 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others (an interpretation of FASB
statements Nos. 5, 57, and 107 and rescission of FASB Interpretation No. 34)"
("FIN No. 45"). FIN No. 45 clarifies the requirements of SFAS No. 5, "Accounting
for Contingencies" ("SFAS No. 5") relating to a guarantor's accounting for, and
disclosure of, the issuance of certain types of guarantees. FIN No. 45 provides
for additional disclosure requirements related to guarantees, effective for
financial periods ending after December 15, 2002. Additionally, FIN No. 45
outlines provisions for initial recognition and measurement of the liability
incurred in providing a guarantee. These provisions are to be applied on a
prospective basis to guarantees issued or modified after December 31, 2002. The
Company has adopted the disclosure requirements of FIN No. 45 and will adopt the
provisions for initial recognition and


                                       32
<PAGE>
measurement for all guarantees issued or modified after December 31, 2002. The
adoption of FIN No. 45 is not expected to have a significant impact on the
Company's financial position or results of operations.

      In January of 2003, the FASB issued FASB Interpretation No. 46,
"Consolidation of Variable Interest Entities, an interpretation of Accounting
Research Bulletin No. 51 ("ARB No. 51")" ("FIN No. 46"). As a general rule,
ownership by the parent, either directly or indirectly, of over fifty percent of
the outstanding voting shares of a subsidiary is a condition pointing toward
preparation of consolidated financial statements of the parent and its
subsidiary. FIN No. 46 clarifies the exceptions to this general rule, as
enunciated in paragraph 2 of ARB No. 51. FIN No. 46 requires an entity to
consolidate a variable interest entity ("VIE") even though the entity does not,
either directly or indirectly, own over fifty percent of the outstanding voting
shares.

      FIN No. 46 defines a VIE as one in which a) the equity investment is not
sufficient to permit the entity to finance its activities without additional
subordinated financial support from other parties which is provided through
other interests that will absorb some or all of the expected losses of the
entity or b) the equity investors lack one or more of the following essential
characteristics of a controlling financial interest i) direct or indirect
ability to make decisions about the entity's activities through voting rights or
similar rights or ii) the obligation to absorb the expected losses of the
entity, if they occur or receive residual returns of the entity, if they occur
or iii) the right to receive the expected residual returns of the entity if they
occur. The primary beneficiary of a VIE is required to consolidate the results
of operations of the VIE.

      Financial statements issued after January 31, 2003 are required to
disclose the nature, purpose, activities and size of the VIE and maximum
exposure to loss as a result of its involvement with the VIE. The Company
reviewed FIN No. 46 and is of the opinion that at the present time the Company
is neither a primary beneficiary of a VIE nor does it have a significant
involvement with a VIE.

FORWARD-LOOKING STATEMENTS

      This report includes a number of statements which relate to anticipated
future events (forward-looking statements) rather than actual present conditions
or historical events. You can identify forward-looking statements because
generally they include words such as "believes," "expects," "intends,"
"anticipates," "estimates," and similar expressions. Forward-looking statements
in this report include expected developments in the Company's insurance
business, including losses and loss reserves; the impact of routine ongoing
insurance reserve reviews being conducted by the Company; the ongoing state
regulatory examinations of the Company's primary insurance company subsidiaries,
and the Company's responses to the results of those reviews and examinations;
the Company's expectations concerning its revenues, earnings, expenses and
investment activities; expected cost savings and other results from the
Company's expense reduction and restructuring activities; and the Company's
proposed actions in response to trends in its business.

      Forward-looking statements, by their nature, are subject to a variety of
inherent risks and uncertainties that could cause actual results to differ
materially from the results projected. Many of these risks and uncertainties
cannot be controlled by the Company. Some examples of these risks and
uncertainties are:

      -     general economic and business conditions;

      -     changes in financial markets such as fluctuations in interest rates,
            long-term periods of low interest rates, credit conditions and
            currency, commodity and stock prices;

      -     the effects of corporate bankruptcies, such as Enron and WorldCom,
            on surety bond claims, as well as on capital markets;

      -     changes in foreign or domestic political, social and economic
            conditions;

      -     regulatory initiatives and compliance with governmental regulations,
            judicial decisions, including interpretation of policy provisions,
            decisions regarding coverage, trends in litigation and the outcome
            of any litigation involving the Company, and rulings and changes in
            tax laws and regulations;

      -     regulatory limitations, impositions and restrictions upon the
            Company, including the effects of assessments and other surcharges
            for guaranty funds and other mandatory pooling arrangements;

      -     the impact of competitive products, policies and pricing and the
            competitive environment in which the Company operates, including
            changes in the Company's books of business;

      -     product and policy availability and demand and market responses,
            including the level of ability to obtain rate increases and decline
            or non-renew underpriced accounts, to achieve premium targets and
            profitability and to realize growth and retention estimates;


                                       33
<PAGE>
      -     development of claims and the impact on loss reserves, including
            changes in claim settlement practices;

      -     the performance of reinsurance companies under reinsurance contracts
            with the Company;

      -     results of financing efforts, including the availability of bank
            credit facilities;

      -     changes in the Company's composition of operating segments;

      -     the sufficiency of the Company's loss reserves and the possibility
            of future increases in reserves;

      -     the risks and uncertainties associated with the Company's loss
            reserves as outlined in the Reserves section of this MD&A; and,

      -     the possibility of further changes in the Company's ratings by
            ratings agencies, including the inability to access certain markets
            or distribution channels and the required collateralization of
            future payment obligations as a result of such changes, and changes
            in rating agency policies and practices;

      Any forward-looking statements made in this report are made by the Company
as of the date of this report. The Company does not have any obligation to
update or revise any forward-looking statement contained in this report, even if
the Company's expectations or any related events, conditions or circumstances
change.


                                       34
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                          INDEPENDENT AUDITORS' REPORT

The Board of Directors and Shareholders
CNA Surety Corporation

      We have audited the accompanying consolidated balance sheets of CNA Surety
Corporation and subsidiaries as of December 31, 2002 and 2001, and the related
consolidated statements of operations, stockholders' equity, and cash flows for
each of the three years in the period ended December 31, 2002. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

      We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

      In our opinion, such consolidated financial statements present fairly, in
all material respects, the financial position of CNA Surety Corporation and
subsidiaries as of December 31, 2002 and 2001, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2002, in conformity with accounting principles generally accepted
in the United States of America.

      As discussed in Note 17, the accompanying 2002 consolidated financial
statements have been restated.

      Also, as discussed in Note 1, the Company changed its method of accounting
for goodwill and indefinite-lived intangible assets in 2002.

DELOITTE & TOUCHE LLP

Chicago, Illinois
February 10, 2003
(March 12, 2004 as to the effects of the restatement described in Note 17.)


                                       35
<PAGE>
                     CNA SURETY CORPORATION AND SUBSIDIARIES

                           CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                                                             DECEMBER 31,
                                                                                                  ---------------------------------
                                                                                                        2002                2001
                                                                                                  ---------------       -----------
                                                                                                  AS RESTATED (a)
                                                                                                          (AMOUNTS IN THOUSANDS,
                                                                                                          EXCEPT PER SHARE DATA)
<S>                                                                                               <C>                   <C>
                                      ASSETS
Invested assets and cash:
  Fixed income securities, at fair value (amortized cost:
    $539,364 and $464,102) ...................................................................      $   570,538         $   471,841
  Equity securities, at fair value (cost: $852 and $42,614) ..................................              761              35,754
  Short-term investments, at cost (approximates fair value) ..................................           50,669              53,600
  Other investments, at fair value ...........................................................            1,257               5,303
  Cash .......................................................................................           14,979              13,159
                                                                                                    -----------         -----------
    Total invested assets and cash ...........................................................          638,204             579,657
Deferred policy acquisition costs ............................................................           96,386              89,788
Insurance receivables:
  Premiums, including $34,097 and $29,829 from affiliates (net of allowance for doubtful
    accounts: $1,365 and $2,614) .............................................................           45,423              39,911
  Reinsurance, including $17,589 and $58,027 from affiliates .................................          132,949             176,235
Intangible assets (net of accumulated amortization: $25,523 and $25,523) .....................          143,785             143,785
Property and equipment, at cost (less accumulated depreciation: $16,047 and $14,138) .........           17,260              17,645
Prepaid reinsurance premiums .................................................................           13,337               5,838
Receivable for securities sold ...............................................................                3                  --
Other assets .................................................................................            9,018               8,739
                                                                                                    -----------         -----------
      Total assets ...........................................................................      $ 1,096,365         $ 1,061,598
                                                                                                    ===========         ===========
                              LIABILITIES
Reserves:
  Unpaid losses and loss adjustment expenses .................................................      $   303,433         $   315,811
  Unearned premiums ..........................................................................          216,213             200,379
                                                                                                    -----------         -----------
    Total reserves ...........................................................................          519,646             516,190
Debt .........................................................................................           60,816              76,195
Deferred income taxes, net ...................................................................           30,727              19,969
Payable for securities purchased .............................................................               --              11,406
Current income taxes payable .................................................................            5,889               1,822
Reinsurance and other payables to affiliates .................................................           25,988              10,374
Other liabilities ............................................................................           32,738              37,214
                                                                                                    -----------         -----------
    Total liabilities ........................................................................      $   675,804         $   673,170
                                                                                                    -----------         -----------
Commitments and contingencies (See Note 9)
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; 44,386 shares issued and
  42,947 shares outstanding at December 31, 2002 and 44,229 shares issued and 42,780 shares
  outstanding at December 31, 2001 ...........................................................              444                 442
Additional paid-in capital ...................................................................          255,765             254,133
Retained earnings ............................................................................          159,937             149,128
Accumulated other comprehensive income .......................................................           19,861                 278
Treasury stock, at cost ......................................................................          (15,446)            (15,553)
                                                                                                    -----------         -----------
    Total stockholders' equity ...............................................................          420,561             388,428
                                                                                                    -----------         -----------
    Total liabilities and stockholders' equity ...............................................      $ 1,096,365         $ 1,061,598
                                                                                                    ===========         ===========
</TABLE>

        The accompanying notes are an integral part of these consolidated
                              financial statements.

(a) See Note 17.


                                       36
<PAGE>
                     CNA SURETY CORPORATION AND SUBSIDIARIES

                        CONSOLIDATED STATEMENTS OF INCOME

<TABLE>
<CAPTION>
                                                                                  YEARS ENDED DECEMBER 31,
                                                                       ---------------------------------------------
                                                                             2002             2001            2000
                                                                       ---------------      --------        --------
                                                                       AS RESTATED (a)
                                                                                     (AMOUNTS IN THOUSANDS,
                                                                                     EXCEPT PER SHARE DATA)
<S>                                                                    <C>                  <C>             <C>
      Revenues:
        Net earned premium .......................................        $ 298,319         $320,910        $301,819
        Net investment income ....................................           27,754           29,515          29,897
        Net realized investment (losses) gains ...................           (7,586)              46             557
                                                                          ---------         --------        --------
           Total revenues ........................................          318,487          350,471         332,273
                                                                          ---------         --------        --------
      Expenses:
        Net losses and loss adjustment expenses ..................           94,198           80,836          55,683
        Net commissions, brokerage and other underwriting
           expenses ..............................................          179,827          202,877         181,655
        Interest expense .........................................            1,708            3,925           6,956
        Non-recurring charge .....................................               --               --             500
        Amortization of intangible assets ........................               --            6,097           6,097
                                                                          ---------         --------        --------
           Total expenses ........................................          275,733          293,735         250,891
                                                                          ---------         --------        --------
      Income before income taxes .................................           42,754           56,736          81,382
      Income taxes ...............................................           12,635           19,828          27,780
                                                                          ---------         --------        --------
      Net income .................................................        $  30,119         $ 36,908        $ 53,602
                                                                          =========         ========        ========
      Earnings per share .........................................        $    0.70         $   0.86        $   1.25
                                                                          =========         ========        ========
      Earnings per share, assuming dilution ......................        $    0.70         $   0.86        $   1.25
                                                                          =========         ========        ========
      Weighted average shares outstanding ........................           42,910           42,744          42,898
                                                                          =========         ========        ========
      Weighted average shares outstanding, assuming dilution .....           43,028           42,938          43,028
                                                                          =========         ========        ========
</TABLE>

        The accompanying notes are an integral part of these consolidated
                              financial statements.

(a) See Note 17.


                                       37
<PAGE>
                     CNA SURETY CORPORATION AND SUBSIDIARIES

                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>
                                                COMMON
                                                 STOCK
                                                 SHARES          COMMON          ADDITIONAL       COMPREHENSIVE
                                              OUTSTANDING         STOCK        PAID-IN CAPITAL        INCOME
                                              -----------       ----------     ---------------    -------------
                                                                   (AMOUNTS IN THOUSANDS)
<S>                                           <C>               <C>            <C>                <C>
Balance, December 31, 1999 .............         43,006         $      441        $253,366
                                                 ======         ==========        ========
Comprehensive income:
Net income .............................             --                 --              --              53,602
Other comprehensive income:
  Change in unrealized
    (losses) on securities
    (after income taxes), net
    of reclassification
    adjustment of $(1,263) .............             --                 --              --              11,417
                                                                                                    ----------
         Total comprehensive
           income ......................                                                            $   65,019
                                                                                                    ==========
Purchase of treasury stock .............           (327)                --              --
Stock options exercised and
  other ................................             23                 --             131
Dividends paid to
  stockholders .........................             --                 --              --
                                                 ------         ----------        --------
Balance, December 31, 2000 .............         42,702         $      441        $253,497
                                                 ======         ==========        ========
Comprehensive income:
Net income .............................             --                 --              --              36,908
Other comprehensive income:
  Change in unrealized gains
    on securities (after
    income taxes), net of
    reclassification
    adjustment of $(823) ...............             --                 --              --                  11
                                                                                                    ----------
         Total comprehensive
           income ......................                                                            $   36,919
                                                                                                    ==========
Purchase of treasury stock .............             --                 --              --
Employee Stock Purchase
  Program issuance from
  treasury stock .......................             --                 --               5
Stock options exercised and
  other ................................             78                  1             631
Dividends paid to
  stockholders .........................             --                 --              --
                                                 ------         ----------        --------
Balance, December 31, 2001 .............         42,780         $      442        $254,133
                                                 ======         ==========        ========
Comprehensive income:
Net income (As restated (a)) ...........             --                 --              --              30,119
Other comprehensive income:
  Change in unrealized gains
    on securities (after
    income taxes), net of
    reclassification
    adjustment of
    $(16,627) ..........................             --                 --              --              19,583
                                                                                                    ----------
         Total comprehensive
           Income (As restated (a)) ....                                                            $   49,702
                                                                                                    ==========
Purchase of treasury stock .............             --                 --              --
Employee Stock Purchase
  Program issuance from
  treasury stock .......................             10                 --              15
Stock options exercised and
  other ................................            157                  2           1,617
Dividends paid to
  stockholders .........................             --                 --              --
                                                 ------         ----------        --------
Balance, December 31, 2002
(As restated (a)) ......................         42,947         $      444        $255,765
                                                 ======         ==========        ========
</TABLE>

<TABLE>
<CAPTION>
                                                              ACCUMULATED
                                                                 OTHER          TREASURY           TOTAL
                                             RETAINED        COMPREHENSIVE        STOCK         STOCKHOLDERS'
                                             EARNINGS        INCOME (LOSS)      (AT COST)          EQUITY
                                             ---------       -------------      ---------       -------------
                                                                  (AMOUNTS IN THOUSANDS)
<S>                                          <C>             <C>                <C>             <C>
Balance, December 31, 1999 .............     $  95,419         $(11,150)        $(11,772)        $ 326,304
                                             =========         ========         ========         =========
Comprehensive income:
Net income .............................        53,602               --               --            53,602
Other comprehensive income:
  Change in unrealized
    (losses) on securities
    (after income taxes), net
    of reclassification
    adjustment of $(1,263) .............            --           11,417               --            11,417

         Total comprehensive
           income ......................

Purchase of treasury stock .............            --               --           (3,709)           (3,709)
Stock options exercised and
  other ................................            --               --               --               131
Dividends paid to
  stockholders .........................       (13,713)              --               --           (13,713)
                                             ---------         --------         --------         ---------
Balance, December 31, 2000 .............     $ 135,308         $    267         $(15,481)        $ 374,032
                                             =========         ========         ========         =========
Comprehensive income:
Net income .............................        36,908               --               --            36,908
Other comprehensive income:
  Change in unrealized gains
    on securities (after
    income taxes), net of
    reclassification
    adjustment of $(823) ...............            --               11               --                11

         Total comprehensive
           income ......................

Purchase of treasury stock .............            --               --             (124)             (124)
Employee Stock Purchase
  Program issuance from
  treasury stock .......................            --               --               52                57
Stock options exercised and
  other ................................            --               --               --               632
Dividends paid to
  stockholders .........................       (23,088)              --               --           (23,088)
                                             ---------         --------         --------         ---------
Balance, December 31, 2001 .............     $ 149,128         $    278         $(15,553)        $ 388,428
                                             =========         ========         ========         =========
Comprehensive income:
Net income (As restated (a)) ...........        30,119               --               --            30,119
Other comprehensive income:
  Change in unrealized gains
    on securities (after
    income taxes), net of
    reclassification
    adjustment of
    $(16,627) ..........................            --           19,583               --            19,583

         Total comprehensive
           Income (As restated (a)) ....

Purchase of treasury stock .............            --               --               --                --
Employee Stock Purchase
  Program issuance from
  treasury stock .......................            --               --              107               122
Stock options exercised and
  other ................................            --               --               --             1,619
Dividends paid to
  stockholders .........................       (19,310)              --               --           (19,310)
                                             ---------         --------         --------         ---------
Balance, December 31, 2002
(As restated (a)) ......................     $ 159,937         $ 19,861         $(15,446)        $ 420,561
                                             =========         ========         ========         =========
</TABLE>

        The accompanying notes are an integral part of these consolidated
                              financial statements.

(a) See Note 17.


                                       38
<PAGE>
                     CNA SURETY CORPORATION AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                                        YEARS ENDED DECEMBER 31,
                                                                           -----------------------------------------------
                                                                                2002              2001              2000
                                                                           ---------------     ---------         ---------
                                                                           AS RESTATED (a)
                                                                                        (AMOUNTS IN THOUSANDS)
<S>                                                                        <C>                 <C>               <C>
      OPERATING ACTIVITIES:
        Net income ..................................................        $  30,119         $  36,908         $  53,602
        Adjustments to reconcile net income to net cash provided
           by operating activities:
           Depreciation and amortization ............................            3,866             9,614             9,291
           Accretion of bond discount, net ..........................            1,028               728             1,043
           Net realized investment losses (gains) ...................            7,586               (46)             (557)
        Changes in:
           Insurance receivables ....................................           37,774           (99,609)          (30,557)
           Reserve for unearned premiums ............................           15,834            (1,800)            2,879
           Reserve for unpaid losses and loss adjustment
             expenses ...............................................          (12,378)          111,354            46,524
           Deferred policy acquisition costs ........................           (6,598)            1,615            (6,479)
           Deferred income taxes, net ...............................              171               181             3,078
           Reinsurance and other payables to affiliates .............           15,614               806               888
           Prepaid reinsurance premiums .............................           (7,499)           (3,306)             (230)
           Other assets and liabilities .............................               21               593              (238)
                                                                             ---------         ---------         ---------
                Net cash provided by operating activities ...........           85,538            57,038            79,244
                                                                             ---------         ---------         ---------
      INVESTING ACTIVITIES:
        Fixed income securities:
           Purchases ................................................         (239,019)         (140,857)         (133,679)
           Maturities ...............................................           29,303            62,507            35,394
           Sales ....................................................          142,322            67,370            77,788
        Purchases of equity securities ..............................          (22,870)           (6,706)          (19,587)
        Proceeds from the sale of equity securities .................           48,900             1,617             8,525
        Changes in short-term investments ...........................            2,942              (938)           (9,228)
        Changes in other investments ................................            3,209              (131)                3
        Purchases of property and equipment .........................           (3,881)           (6,396)           (4,166)
        Changes in receivables/payables for securities
           sold/purchased ...........................................          (11,409)           21,812           (17,894)
        Other, net ..................................................              (62)              (53)              (24)
                                                                             ---------         ---------         ---------
                Net cash used in investing activities ...............          (50,565)           (1,775)          (62,868)
                                                                             ---------         ---------         ---------
      FINANCING ACTIVITIES:
        Proceeds from debt ..........................................           71,000                --                --
        Principal payments on debt ..................................          (86,379)          (25,361)             (344)
        Dividends to stockholders ...................................          (19,310)          (23,088)          (13,713)
        Issuance of treasury stock to employee stock purchase
           plan .....................................................              122                57                --
        Purchase of treasury stock ..................................               --              (124)           (3,709)
        Employee stock option exercises .............................            1,414               462               103
                                                                             ---------         ---------         ---------
                Net cash used in financing activities ...............          (33,153)          (48,054)          (17,663)
                                                                             ---------         ---------         ---------
      Increase (decrease) in cash ...................................            1,820             7,209            (1,287)
      Cash at beginning of period ...................................           13,159             5,950             7,237
                                                                             ---------         ---------         ---------
      Cash at end of period .........................................        $  14,979         $  13,159         $   5,950
                                                                             =========         =========         =========
      Supplemental Disclosure of Cash Flow Information:
        Cash paid during the period for:
           Interest .................................................        $   2,136         $   3,563         $   7,363
           Income taxes .............................................        $   8,000         $  23,750         $  24,050
</TABLE>

        The accompanying notes are an integral part of these consolidated
                              financial statements.

(a) See Note 17


                                       39
<PAGE>
                     CNA SURETY CORPORATION AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. SIGNIFICANT ACCOUNTING POLICIES

Formation of CNA Surety Corporation and Merger

      In December 1996, CNA Financial Corporation ("CNAF") and Capsure Holdings
Corp. ("Capsure") agreed to merge (the "Merger") the surety business of CNAF
with Capsure's insurance subsidiaries, Western Surety Company ("Western Surety")
and Universal Surety of America ("USA"), into CNA Surety Corporation ("CNA
Surety" or the "Company"). CNAF, through its operating subsidiaries, writes
multiple lines of property and casualty insurance, including surety business
that is reinsured by Western Surety. CNAF owns approximately 64% of the
outstanding common stock of CNA Surety. Loews Corporation owns approximately 90%
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.

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.

Investments

      Management believes the Company has the ability to hold all fixed income
securities to maturity. However, the Company may dispose of securities prior to
their scheduled maturity due to changes in interest rates, prepayments, tax and
credit considerations, liquidity or regulatory capital requirements, or other
similar factors. As a result, the Company considers all of its fixed income
securities (bonds and redeemable preferred stocks) and equity securities as
available-for-sale. These securities are reported at fair value, with unrealized
gains and losses, net of deferred income taxes, reported as a separate component
of stockholders' equity. Cash flows from purchases, sales and maturities are
reported gross in the investing activities section of the Consolidated
Statements of Cash Flows.

      The amortized cost of fixed income securities is determined based on cost
and the cumulative effect of amortization of premiums and accretion of discounts
to maturity. Such amortization and accretion are included in investment income.
For mortgage-backed and certain asset-backed securities, the Company recognizes
income using the effective-yield method based on estimated cash flows. All
securities transactions are recorded on the trade date. Investment gains or
losses realized on the sale of securities are determined using the specific
identification method. Investments with an other-than-temporary decline in value
are written down to fair value, resulting in losses that are included in
realized investment gains and losses.

      Short-term investments which generally include U.S. Treasury bills,
corporate notes, money market funds and investment grade commercial paper
equivalents, are carried at amortized cost which approximates fair value.

Deferred Policy Acquisition Costs

      Policy acquisition costs, consisting of commissions, premium taxes and
other underwriting expenses which vary with, and are primarily related to, the
production of business, net of reinsurance commissions, are deferred and
amortized as a charge to income as the related premiums are earned. Anticipated
investment income is considered in the determination of the recoverability of
deferred acquisition costs.


                                       40
<PAGE>
Intangible Assets

      The acquisition of CCC Surety Operations and Capsure was accounted for
under purchase accounting by CNA Surety. 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 arising from the Merger were $20.5
million related to the agency force and $134.5 million for goodwill.

      In 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. Goodwill arising from this acquisition was $5.9 million.

      Prior to 2002, goodwill from each acquisition was generally amortized as a
charge to earnings over periods not exceeding 30 years. Under Statement of
Financial Accounting Standards ("SFAS") No. 142 entitled "Goodwill and Other
Intangible Assets" ("SFAS 142"), which was adopted by CNA Surety as of January
1, 2002, periodic amortization ceased, in accordance with an impairment-only
accounting model.

      A significant amount of judgment is required in performing goodwill
impairment tests. Such tests include periodically determining or reviewing the
estimated fair value of CNA Surety's reporting units. Under SFAS No. 142, fair
value refers to the amount for which the entire reporting unit may be bought or
sold. There are several methods of estimating fair value, including market
quotations, asset and liability fair values and other valuation techniques, such
as discounted cash flows and multiples of earnings or revenues. If the carrying
amount of a reporting unit, including goodwill, exceeds the estimated fair
value, then individual assets, including identifiable intangible assets, and
liabilities of the reporting unit are estimated at fair value. The excess of the
estimated fair value of the reporting unit over the estimated fair value of net
assets would establish the implied value of goodwill. The excess of the recorded
amount of goodwill over the implied value of goodwill is charged-off as an
impairment loss.

Reserves for Unpaid Losses and Loss Adjustment Expenses

      The estimated liability for unpaid losses and loss adjustment expenses
includes, on an undiscounted basis, estimates of (a) the ultimate settlement
value of reported claims, (b) incurred but not reported ("IBNR") claims, (c)
future expenses to be incurred in the settlement of claims and (d) claim
recoveries, before reinsurance recoveries which are reported as an asset. These
estimates are determined based on the Company's loss experience as well as
consideration of industry experience, current trends and conditions. The
estimated liability for unpaid losses and loss adjustment expenses is an
estimate and there is the potential that actual future loss payments will differ
significantly from initial estimates. The methods of determining such estimates
and the resulting estimated liability are regularly reviewed and updated.
Changes in the estimated liability are reflected in operating income in the
period in which such changes are determined to be needed.

Insurance Premiums

      Insurance premiums are recognized as revenue ratably over the terms of the
related policies in proportion to the insurance protection provided. Premium
revenues are net of amounts ceded to reinsurers. Unearned premiums represent the
portion of premiums written, before ceded reinsurance which is shown as an
asset, applicable to the unexpired terms of policies in force determined on a
pro rata basis.

Reinsurance

      The Company assumes and cedes insurance with other insurers and reinsurers
to limit maximum loss, provide greater diversification of risk and minimize
exposure on larger risks. Premiums and loss and loss adjustment expenses that
are ceded under reinsurance arrangements reduce the respective revenues and
expenses. Amounts recoverable from reinsurers are estimated in a manner
consistent with the claim liability associated with the reinsured policy and are
reported as reinsurance receivables.

Stock-Based Compensation

      As allowed under SFAS No. 123, "Accounting for Stock-Based Compensation,"
the Company accounts for its stock option plans in accordance with Accounting
Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to
Employees." The Company has not issued stock options where the exercise price is
less than the fair market value of the Company's common stock on the date of
grant and, accordingly, no compensation expense has been recognized.


                                       41
<PAGE>
      The following table illustrates the effect on net income and earnings per
share data if the Company had applied the fair value recognition provisions of
SFAS No. 123 to stock based compensation under the Company's stock-based
compensation plan.

<TABLE>
<CAPTION>
                                                                                           Years ended December 31
                                                                                    ------------------------------------
      (in thousands, except per share data)                                           2002          2001          2000
                                                                                    --------      --------      --------
<S>                                                                                 <C>           <C>           <C>
      Net income                                                                    $ 30,119      $ 36,908      $ 53,602
      Less: Total stock based compensation cost determined under the fair value
      method, net of tax                                                                 (12)         (530)         (640)
                                                                                    --------      --------      --------
      Pro forma net income                                                          $ 30,107      $ 36,378      $ 52,962
                                                                                    ========      ========      ========

      Basic and diluted earnings per share, as reported                             $   0.70      $   0.86      $   1.25
                                                                                    ========      ========      ========
      Basic and diluted earnings per share, pro forma                               $   0.70      $   0.85      $   1.23
                                                                                    ========      ========      ========
</TABLE>

Income Taxes

      The Company accounts for income taxes under the liability method. Under
the liability method, deferred income taxes are established for the future tax
effects of temporary differences between the tax and financial reporting bases
of assets and liabilities using currently enacted tax rates. Such temporary
differences primarily relate to insurance reserves, deferred policy acquisition
costs and intangible assets. The effect on deferred taxes of a change in tax
rates is recognized in income in the period of enactment.

Property and Equipment

      Property and equipment are carried at cost less accumulated depreciation.
Depreciation is based on the estimated useful lives of the various classes of
property and equipment and determined principally on a straight-line basis. The
cost of maintenance and repairs is charged to income as incurred; major
improvements are capitalized.

Earnings Per Share

      Basic earnings per common share is computed by dividing income available
to common stockholders by the weighted average number of common shares
outstanding for the period. Diluted earnings per common share is computed based
on the weighted average number of shares outstanding plus the dilutive effect of
common stock equivalents which is computed using the treasury stock method.

      The computation of earnings per share is as follows (amounts in thousands,
except for per share data):

<TABLE>
<CAPTION>
                                                                               Years Ended December 31,
                                                                           -------------------------------
                                                                             2002        2001        2000
                                                                           -------     -------     -------
<S>                                                                        <C>         <C>         <C>
      Net income .....................................................     $30,119     $36,908     $53,602
                                                                           =======     =======     =======
      Shares:
      Weighted average shares outstanding ............................      42,780      42,702      43,006
           Weighted average shares of options
           exercised/shares repurchased ..............................         130          42        (108)
                                                                           -------     -------     -------
      Total weighted average shares outstanding ......................      42,910      42,744      42,898
           Effect of dilutive options ................................         118         194         130
                                                                           -------     -------     -------
      Total weighted average shares outstanding, assuming dilution ...      43,028      42,938      43,028
                                                                           =======     =======     =======

      Earnings per share .............................................     $  0.70     $  0.86     $  1.25
                                                                           =======     =======     =======

      Earnings per share, assuming dilution ..........................     $  0.70     $  0.86     $  1.25
                                                                           =======     =======     =======
</TABLE>

      No adjustments were made to reported net income in the computation of
earnings per share.


                                       42
<PAGE>
Accounting Changes

      In June 2001, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 141 entitled "Business Combinations" ("SFAS No. 141") and SFAS No. 142.
SFAS No. 141 requires that the purchase method of accounting be used for all
business combinations subsequent to June 30, 2001 and specifies criteria for
recognizing intangible assets acquired in a business combination. The Company
will adopt this standard for any future business combinations. SFAS No. 142
requires that goodwill and intangible assets with indefinite useful lives no
longer be amortized, but instead be tested for impairment at least annually. Any
impairment loss for the excess of the carrying amount of an intangible asset
over its fair value would be recognized as a charge to operations. Intangible
assets with definite useful lives will continue to be amortized over their
respective estimated useful lives. The Company has adopted the provisions of
SFAS No. 142 effective January 1, 2002.

      During 2002, the Company completed its initial goodwill impairment testing
and an annual goodwill impairment testing as of October 1, 2002 whereby no
impairment was indicated. In the fourth quarter of 2002, the Company again
tested for goodwill impairment. Based upon the Company's analysis supported by
an outside valuation study, the Company concluded that there was no impairment.

      In determining whether there is an impairment of goodwill or other
intangible assets, the Company calculated its estimated fair value using the
present value of estimated expected future cash flows. The resulting estimated
fair value was then compared to the net book value, including goodwill. If the
net book value exceeded the estimated fair value, the Company would have
measured the amount of impairment loss by comparing the implied estimated fair
value of goodwill with the carrying amount of that goodwill. To the extent that
the carrying amount of the goodwill exceeds its implied fair value, a goodwill
impairment loss would be recognized. This impairment test will be performed
annually and whenever facts and circumstances indicate that there is a possible
impairment of goodwill. The Company believes the methodology it uses in testing
impairment of goodwill provides a reasonable basis in determining whether an
impairment charge is required.

      The adoption of this standard eliminated the Company's amortization of
goodwill and intangibles as of December 31, 2001 and therefore, increased the
Company's reported net income in 2002 by $5.7 million, or $0.13 per share as
compared to prior years. If the provisions of this standard were applied to
prior periods, net income for the year ended December 31, 2001 and 2000 would
have been $42.6 million, or $0.99 per share and $59.3 million, or $1.38 per
share, respectively, and is illustrated in the following table:

<TABLE>
<CAPTION>
                                                                                                 Year ended December 31,
                                                                                             --------------------------------
            (in thousands except per share data)                                               2002        2001        2000
                                                                                             --------     -------     -------
<S>                                                                                          <C>          <C>         <C>
            Net income                                                                       $ 30,119     $36,908     $53,602
            Add: Goodwill and indefinite-lived intangible assets amortization, after tax           --       5,738       5,738
                                                                                             --------     -------     -------
            Pro forma net income                                                             $ 30,119     $42,646     $59,340
                                                                                             ========     =======     =======

            Basic and diluted earnings per share, as reported                                $   0.70     $  0.86     $  1.25
                                                                                             ========     =======     =======
            Basic and diluted earnings per share, pro forma                                  $   0.70     $  0.99     $  1.38
                                                                                             ========     =======     =======
</TABLE>

      In October 2001, the FASB issued SFAS No. 144 entitled "Accounting for the
Impairment or Disposal of Long-Lived Assets" ("SFAS No. 144"). SFAS No. 144
addresses accounting and reporting for the impairment or disposal of long-lived
assets. This statement supersedes SFAS No. 121, "Accounting for the Impairment
of Long-Lived Assets and for Long-Lived Assets to be Disposed Of." The
provisions of this statement were effective for CNA Surety beginning January 1,
2002. The initial adoption of this standard had no impact on the Company's
financial position or results of operations.

      In June of 2002, the FASB issued SFAS No. 146 entitled "Accounting for
Costs Associated with Exit or Disposal Activities" ("SFAS No. 146"). SFAS No.
146 addresses financial accounting and reporting for costs associated with exit
or disposal activities and supercedes Emerging Issues Task Force ("EITF") Issue
No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and
Other Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring)" ("EITF 94-3"). The Company adopted the provisions of SFAS No.
146 for all disposal activities initiated after June 30, 2002. The adoption of
SFAS No. 146 did not have a significant impact on the Company's financial
position or results of operations.


                                       43
<PAGE>
      In December 2002, the FASB issued SFAS No. 148 entitled "Accounting for
Stock-Based Compensation, Transition and Disclosure" ("SFAS No. 148"). SFAS No.
148 provides alternative methods of transition for a voluntary change to the
fair value based method of accounting for stock-based employee compensation.
SFAS No. 148 also amends the disclosure requirements of SFAS No. 123,
"Accounting for Stock-Based Compensation", to require prominent disclosures in
both annual and interim financial statements about the method of accounting for
stock-based employee compensation and the effect of the method used on reported
results. The Company has adopted this standard beginning with the 2002 annual
financial statements and will meet the disclosure requirements in all subsequent
annual and interim financial statements. The Company has not determined if it
will adopt fair value accounting in 2003.

      In August 2001, the FASB issued SFAS No. 143 entitled "Accounting for
Asset Retirement Obligations" ("SFAS No 143"). SFAS No. 143 addresses accounting
and reporting for obligations associated with the retirement of tangible
long-lived assets and the associated asset retirement costs. The provisions of
this standard are effective for CNA Surety beginning January 1, 2003. The
Company is in the process of quantifying the impact this new standard will have
on the Company's financial position or results of operations.

      In November of 2002, the FASB issued FASB Interpretation No. 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others (an interpretation of FASB
statements Nos. 5, 57, and 107 and rescission of FASB Interpretation No. 34)"
("FIN No. 45"). FIN No. 45 clarifies the requirements of SFAS No. 5, "Accounting
for Contingencies" ("SFAS No. 5") relating to a guarantor's accounting for, and
disclosure of, the issuance of certain types of guarantees. FIN No. 45 provides
for additional disclosure requirements related to guarantees effective for
financial periods ending after December 15, 2002. Additionally, FIN No. 45
outlines provisions for initial recognition and measurement of the liability
incurred in providing a guarantee. These provisions are to be applied on a
prospective basis to guarantees issued or modified after December 31, 2002. The
Company has adopted the disclosure requirements of FIN No. 45 and will adopt the
provisions for initial recognition and measurement for all guarantees issued or
modified after December 31, 2002. The adoption of FIN No. 45 is not expected to
have a significant impact on the Company's financial position or results of
operations.

      In January of 2003, the FASB issued FASB Interpretation No. 46,
"Consolidation of Variable Interest Entities, an interpretation of Accounting
Research Bulletin No. 51 ("ARB No. 51") ("FIN No. 46"). As a general rule,
ownership by the parent, either directly or indirectly, of over fifty percent of
the outstanding voting shares of a subsidiary is a condition pointing toward
preparation of consolidated financial statements of the parent and its
subsidiary. FIN No. 46 clarifies the exceptions to this general rule, as
enunciated in paragraph 2 of ARB No. 51. FIN No. 46 requires an entity to
consolidate a variable interest entity ("VIE") even though the entity does not,
either directly or indirectly, own over fifty percent of the outstanding voting
shares.

      FIN No. 46 defines a VIE as one in which a) the equity investment is not
sufficient to permit the entity to finance its activities without additional
subordinated financial support from other parties which is provided through
other interests that will absorb some or all of the expected losses of the
entity or b) the equity investors lack one or more of the following essential
characteristics of a controlling financial interest i) direct or indirect
ability to make decisions about the entity's activities through voting rights or
similar rights or ii) the obligation to absorb the expected losses of the
entity, if they occur or receive residual returns of the entity, if they occur
or iii) the right to receive the expected residual returns of the entity if they
occur. The primary beneficiary of a VIE is required to consolidate the results
of operations of the VIE.

      Financial statements issued after January 31, 2003 are required to
disclose the nature, purpose, activities and size of the VIE and maximum
exposure to loss as a result of its involvement with the VIE. The Company
reviewed FIN No. 46 and is of the opinion that at the present time the Company
is neither a primary beneficiary of a VIE nor does it have a significant
involvement with a VIE.

Reclassifications

      Certain reclassifications have been made to the 2001 and 2000 financial
statements and notes to conform with the presentation in the 2002 Consolidated
Financial Statements.

2. 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 the 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, for costs incurred with respect to the proposed


                                       44
<PAGE>
tender offer by CCC.

      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 or dispose
of shares depending upon market conditions or other factors existing at the time
of such review, resulting in increases or decreases in their respective
ownership positions.

3. INVESTMENTS

      The estimated fair value and amortized cost of fixed income and equity
securities held by CNA Surety by investment category, were as follows (dollars
in thousands):

<TABLE>
<CAPTION>
                                                                         AMORTIZED        GROSS          GROSS
                                                                          COST OR       UNREALIZED     UNREALIZED       ESTIMATED
                                   DECEMBER 31, 2002                       COST           GAINS          LOSSES         FAIR VALUE
                 ------------------------------------------------        ---------      ----------     ----------       ----------
<S>                                                                      <C>            <C>             <C>             <C>
                 Fixed income securities:
                 U.S. Treasury securities and obligations of
                   U.S. Government and agencies:
                      U.S. Treasury .............................        $ 16,140        $   960        $     --         $ 17,100
                      U.S. Agencies .............................          29,396            537              (3)          29,930
                      Collateralized mortgage obligations .......             156              7              --              163
                      Mortgage pass-through securities ..........          20,981          1,066              --           22,047
                 Obligations of states and political
                   subdivisions .................................         347,918         20,099             (83)         367,934
                 Corporate bonds ................................          76,181          6,154            (190)          82,145
                 Non-agency collateralized mortgage
                   obligations ..................................          10,497            477             (58)          10,916
                 Other asset-backed securities:
                   Second mortgages/home equity loans ...........          11,842            614              --           12,456
                   Credit card receivables ......................           5,000             87              --            5,087
                   Other ........................................           7,838            653              --            8,491
                 Redeemable preferred stock .....................          13,415            854              --           14,269
                                                                         --------        -------        --------         --------
                      Total fixed income securities .............         539,364         31,508            (334)         570,538
                 Equity securities ..............................             852             --             (91)             761
                                                                         --------        -------        --------         --------
                      Total .....................................        $540,216        $31,508        $   (425)        $571,299
                                                                         ========        =======        ========         ========
</TABLE>

<TABLE>
<CAPTION>
                                                                         AMORTIZED        GROSS          GROSS
                                                                          COST OR       UNREALIZED     UNREALIZED       ESTIMATED
                                DECEMBER 31, 2001                          COST           GAINS          LOSSES         FAIR VALUE
            -----------------------------------------------------        ---------      ----------     ----------       ----------
<S>                                                                      <C>            <C>             <C>             <C>
            Fixed income securities:
            U.S. Treasury securities and obligations of U.S.
              Government and agencies:
                 U.S. Treasury ..................................        $ 24,751        $   561        $     (5)        $ 25,307
                 U.S. Agencies ..................................          67,539          2,119            (706)          68,952
                 Collateralized mortgage obligations ............             411              4              (1)             414
                 Mortgage pass-through securities ...............          22,165            231              --           22,396
            Obligations of states and political subdivisions ....         217,757          5,029          (1,987)         220,799
            Corporate bonds .....................................          71,029          2,007            (656)          72,380
            Non-agency collateralized mortgage obligations ......          12,898            132            (405)          12,625
            Other asset-backed securities:
              Second mortgages/home equity loans ................          15,784            537              --           16,321
              Credit card receivables ...........................          10,000            327              --           10,327
              Other .............................................           8,333            450             (20)           8,763
            Redeemable preferred stock ..........................          13,435            122              --           13,557
                                                                         --------        -------        --------         --------
                 Total fixed income securities ..................         464,102         11,519          (3,780)         471,841
            Equity securities ...................................          42,614          2,620          (9,480)          35,754
                                                                         --------        -------        --------         --------
                 Total ..........................................        $506,716        $14,139        $(13,260)        $507,595
                                                                         ========        =======        ========         ========
</TABLE>

      The Company's insurance subsidiaries, as required by state law, deposit
certain securities with state insurance regulatory authorities. At December 31,
2002, securities on deposit had an aggregate carrying value of $3.6 million.


                                       45
<PAGE>
      Short-term investments are generally comprised of U.S. Treasury bills,
corporate notes, money market funds and investment grade commercial paper
equivalents.

      The amortized cost and estimated fair value of fixed income securities, by
contractual maturity, at December 31, 2002 and 2001 are shown below. Actual
maturities may differ from contractual maturities as borrowers may have the
right to call or prepay obligations with or without call or prepayment penalties
(dollars in thousands):

<TABLE>
<CAPTION>
                                                                        2002                             2001
                                                              -------------------------       -------------------------
                                                              AMORTIZED       ESTIMATED       AMORTIZED       ESTIMATED
                                                                COST         FAIR VALUE         COST         FAIR VALUE
                                                              ---------      ----------       ---------      ----------
<S>                                                           <C>            <C>              <C>            <C>
            FIXED INCOME SECURITIES:
            Due within one year ......................        $  1,327        $  1,329        $    705        $    724
            Due after one year but within five
              years ..................................          55,040          57,632          70,379          70,935
            Due after five years but within ten
              years ..................................         215,008         227,425         141,011         145,212
            Due after ten years ......................         211,675         224,992         182,417         184,124
                                                              --------        --------        --------        --------
                                                               483,050         511,378         394,512         400,995
            Mortgage pass-through securities,
              collateralized mortgage obligations
              and asset-backed securities ............          56,314          59,160          69,590          70,846
                                                              --------        --------        --------        --------
                                                              $539,364        $570,538        $464,102        $471,841
                                                              ========        ========        ========        ========
</TABLE>

      Major categories of net investment income and gross realized investment
gains and (losses) from sales of available-for-sale securities were as follows
(dollars in thousands):

<TABLE>
<CAPTION>
                                                                YEARS ENDED DECEMBER 31,
                                                           ----------------------------------
                                                             2002         2001         2000
                                                           --------     --------     --------
<S>                                                        <C>          <C>          <C>
            Investment income:
              Fixed income securities .................    $ 25,764     $ 26,819     $ 25,623
              Equity securities .......................       1,213          393          372
              Short-term investments ..................       1,359        2,536        3,998
              Other ...................................         135          402          563
                                                           --------     --------     --------
              Total investment income .................      28,471       30,150       30,556
            Investment expenses .......................        (717)        (635)        (659)
                                                           --------     --------     --------
            Net investment income .....................    $ 27,754     $ 29,515     $ 29,897
                                                           ========     ========     ========
            Gross realized investment gains ...........    $ 11,183     $  1,118     $  3,251
            Gross realized investment losses ..........     (18,769)      (1,072)      (2,694)
                                                           --------     --------     --------
            Net realized investment gain (losses) .....    $ (7,586)    $     46     $    557
                                                           ========     ========     ========
</TABLE>

      Net unrealized gain and loss on securities included in stockholders'
equity at December 31, 2002 and 2001 was comprised of the following (dollars in
thousands):

<TABLE>
<CAPTION>
                                                           2002                                         2001
                                            ------------------------------------       -------------------------------------
                                             GAINS        LOSSES           NET           GAINS         LOSSES          NET
                                            -------      --------       --------       --------       --------       -------
<S>                                         <C>          <C>            <C>            <C>            <C>            <C>
            Fixed income
              securities .............      $31,508      $   (334)      $ 31,174       $ 11,519       $ (3,780)      $ 7,739
            Equity securities ........           --           (91)           (91)         2,620         (9,480)       (6,860)
            Other ....................           --          (527)          (527)            --           (451)         (451)
                                            -------      --------       --------       --------       --------       -------
                                            $31,508      $   (952)        30,556       $ 14,139       $(13,711)          428
                                                                        ========       ========       ========       =======
            Deferred income
              taxes ..................                                   (10,695)                                       (150)
                                                                        --------                                     -------
            Net unrealized gain on
              securities .............                                  $ 19,861                                     $   278
                                                                        ========                                     =======
</TABLE>

4. DEBT

      CNA Surety's bank borrowings were previously under a five-year unsecured
revolving credit facility effective September 30, 1997 (the "1997 Credit
Facility") that provided for borrowings of up to $130 million. The Company paid
down outstanding borrowings under the 1997 Credit Facility by $10 million to $65
million on July 29, 2002. The 1997 Credit Facility matured September 30, 2002.


                                       46
<PAGE>
      The Company refinanced $65 million in outstanding borrowings under the
1997 Credit Facility under a new credit facility (the "2002 Credit Facility").
The 2002 Credit Facility provided an aggregate of up to $65 million in initial
borrowings divided between a 364 day revolving credit facility (the "Revolving
Credit Facility") of $35 million and a three year term loan facility (the "Term
Loan") of $30 million. The Revolving Credit Facility may be extended, with the
consent of lenders, for up to two additional periods of up to 364 days each, but
in no case shall the Revolving Credit Facility be extended to mature on a date
later than three years from the effective date of the Revolving Credit Facility.
The Revolving Credit Facility may be increased from time to time by the amount
of amortization under the Term Loan facility. Such increase is subject to
consent by each Revolving Credit Bank, and will take place upon receipt by the
Banks of the respective installment payments under the Term Loan facility.

      Of the $65 million in initial outstanding borrowings, $15 million was
provided pursuant to a guarantee by CNAF which expired on November 30, 2002. On
November 29, 2002, the Company repaid $11 million of the $15 million of the
Company's revolving credit loan that was due on November 30, 2002. The due date
on the remaining $4 million was extended until another lender joined the credit
facility. On December 30, 2002, a second lender joined the credit facility for
$10 million resulting in net additional funds of $6 million to CNA Surety.
Outstanding borrowings under the credit facility were $60 million as of December
31, 2002, consisting of $30 million under the Revolving Credit Facility and $30
million under the Term Loan Facility. Effective January 30, 2003, the Company
entered into an interest rate swap on the $30 million term loan that fixed the
interest rate at 2.75%.

      Amortization of the Term Loan will take place at $10,000,000 per year, in
equal installments of $5,000,000 on the following dates:

<TABLE>
<CAPTION>
                      DATE                  AMORTIZATION     OUTSTANDING BALANCE
            -----------------------         ------------     -------------------
<S>                                         <C>              <C>
            June 30, 2003 .........          $5,000,000          $25,000,000
            September 30, 2003 ....           5,000,000           20,000,000
            March 31, 2004 ........           5,000,000           15,000,000
            September 30, 2004 ....           5,000,000           10,000,000
            March 31, 2005 ........           5,000,000            5,000,000
            September 30, 2005 ....           5,000,000                    0
</TABLE>

      The interest rate on borrowings under the 2002 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 a facility fee and utilization
fee on the 2002 Credit Facility, was 0.625% at December 31, 2002 and can vary
based on CNA Surety's leverage ratio (debt to total capitalization) from 0.48%
to 0.80%. As of December 31, 2002, the weighted average interest rate was 1.9%
on the $60 million of outstanding borrowings. As of December 31, 2001, the
weighted average interest rate on the 1997 Credit Facility was 2.5% on the $75.0
million of outstanding borrowings.

      The 2002 Credit Facility contains, among other conditions, limitations on
CNA Surety with respect to the incurrence of additional indebtedness and
maintenance of a rating of at least "A" by A.M. Best Company Inc. ("A.M. Best")
for each of the Company's insurance subsidiaries. The 2002 Credit Facility also
requires the maintenance of certain financial ratios as follows: a) maximum
funded debt to total capitalization ratio of 25%, b) minimum net worth of $350.0
million and c) minimum fixed charge coverage ratio of 2.5 times. As of December
31, 2002, the Company was in compliance with all restrictions and covenants
contained in the 2002 Credit Facility.

      In 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%.
The balance of this promissory note at December 31, 2002 was $0.8 million.

      The consolidated balance sheet reflects total debt of $60.8 and $76.2
million at December 31, 2002 and December 31, 2001, respectively. The weighted
average interest rate on outstanding borrowings was 2.0% and 2.6% at December
31, 2002 and December 31, 2001 respectively.

5. FAIR VALUE OF FINANCIAL INSTRUMENTS

      The following table summarizes fair value information about financial
instruments, whether or not recognized in the balance sheet, for which it is
practicable to estimate that value. In cases where quoted market prices are not
available, fair values may be based on estimates using present value or other
valuation techniques. These techniques are significantly affected by the
assumptions used,


                                       47
<PAGE>
including the discount rates and estimates of future cash flows. Potential taxes
and other transaction costs have not been considered in estimating fair value.
Accordingly, the estimates presented herein are subjective in nature and are not
necessarily indicative of the amounts that the Company could realize in a
current market exchange. This information excludes certain financial instruments
such as insurance contracts and all non-financial instruments from fair value
disclosure. Therefore, these fair value amounts cannot be aggregated to
determine the underlying economic value of the Company.

      The carrying amounts and estimated fair values of financial instruments at
December 31, 2002 and 2001 were as follows (dollars in thousands):

<TABLE>
<CAPTION>
                                                          2002                             2001
                                                -------------------------       -------------------------
                                                CARRYING        ESTIMATED       CARRYING        ESTIMATED
                                                 AMOUNT        FAIR VALUE        AMOUNT        FAIR VALUE
                                                --------       ----------       --------       ----------
<S>                                             <C>            <C>              <C>            <C>
            Fixed income securities ....        $570,538        $570,538        $471,841        $471,841
            Equity securities ..........             761             761          35,754          35,754
            Short-term investments .....          50,669          50,669          53,600          53,600
            Other investments ..........           1,257           1,257           5,303           5,303
            Cash .......................          14,979          14,979          13,159          13,159
            Debt .......................          60,816          60,816          76,195          76,195
</TABLE>

      The following methods and assumptions were used by the Company in
estimating fair values of financial instruments:

            Investments -- The estimated fair values for the fixed income
      securities and equity securities are based upon quoted market prices,
      where available. For fixed income securities not actively traded, the
      estimated fair values are determined using values obtained from
      independent pricing services or, in the case of private placements, by
      discounting expected future cash flows using a current market rate
      applicable to the yield, credit quality and maturity of the investments.

            Cash, Short-Term Investments and Other Investments -- The carrying
      value for these instruments approximates their estimated fair values.

            Debt -- The estimated fair value of the Company's debt is based on
      the quoted market prices for the same or similar issues or on the current
      rates offered to the Company for debt of the same remaining maturity.

6. DEFERRED POLICY ACQUISITION COSTS AND OTHER OPERATING EXPENSES

      Policy acquisition costs deferred and the related amortization of deferred
policy acquisition costs were as follows (dollars in thousands):

<TABLE>
<CAPTION>
                                                            YEARS ENDED DECEMBER 31,
                                                    ---------------------------------------
                                                      2002           2001           2000
                                                    ---------      ---------      ---------
<S>                                                 <C>            <C>            <C>
            Balance at beginning of period ....     $  89,788      $  91,403      $  84,924
              Costs deferred ..................       145,589        145,885        140,114
              Amortization ....................      (138,991)      (147,500)      (133,635)
                                                    ---------      ---------      ---------
            Balance at end of period ..........     $  96,386      $  89,788      $  91,403
                                                    =========      =========      =========
</TABLE>

      Net commissions, brokerage and other underwriting expenses were comprised
as follows (dollars in thousands):

<TABLE>
<CAPTION>
                                                                      YEARS ENDED DECEMBER 31,
                                                                 ----------------------------------
                                                                   2002         2001         2000
                                                                 --------     --------     --------
<S>                                                              <C>          <C>          <C>
            Amortization of deferred policy acquisition
              costs ........................................     $138,991     $147,500     $133,635
            Other operating expenses .......................       40,836       55,377       48,020
                                                                 --------     --------     --------
              Net commissions, brokerage and other
                 underwriting expenses .....................     $179,827     $202,877     $181,655
                                                                 ========     ========     ========
</TABLE>

7. REINSURANCE

      The Company's insurance subsidiaries, in the ordinary course of business,
cede reinsurance to other insurance companies and affiliates. Reinsurance
arrangements are used to limit maximum loss, provide greater diversification of
risk and minimize exposure on larger risks. Reinsurance contracts do not
ordinarily relieve the Company of its primary obligations to claimants.
Therefore, a


                                       48
<PAGE>
contingent liability exists with respect to reinsurance ceded to the extent that
any reinsurer is unable to meet the obligations assumed under the reinsurance
contracts. The Company evaluates the financial condition of its reinsurers,
establishes allowances for uncollectible amounts and monitors concentrations of
credit risk. At December 31, 2002, CNA Surety's largest reinsurance receivable
from an affiliate, CCC, an A (Excellent) rated company by A.M. Best, was
approximately $17.6 million. At December 31, 2002, CNA Surety's largest
reinsurance receivable from a non-affiliate reinsurer was approximately $25.6
million with a company rated A++ (Superior) by A.M. Best.

      The effect of reinsurance on premiums written and earned was as follows
(dollars in thousands):

<TABLE>
<CAPTION>
                                                                       YEARS ENDED DECEMBER 31,
                                    ----------------------------------------------------------------------------------------------
                                               2002                              2001                              2000
                                    --------------------------        --------------------------        --------------------------

                                     WRITTEN           EARNED          WRITTEN           EARNED          WRITTEN           EARNED
                                    ---------        ---------        ---------        ---------        ---------        ---------
<S>                                 <C>              <C>              <C>              <C>              <C>              <C>
            Direct ..........       $ 148,186        $ 137,957        $ 127,494        $ 120,687        $ 115,100        $ 109,472
            Assumed .........         211,706          206,146          205,509          214,206          201,567          207,178
            Ceded ...........         (53,238)         (45,784)         (17,199)         (13,983)         (12,199)         (14,831)
                                    ---------        ---------        ---------        ---------        ---------        ---------
            Net premiums ....       $ 306,654        $ 298,319        $ 315,804        $ 320,910        $ 304,468        $ 301,819
                                    =========        =========        =========        =========        =========        =========
</TABLE>

      Assumed premiums primarily includes all surety business written or
renewed, net of reinsurance, by CCC and CIC, and their affiliates, after the
Merger Date that is reinsured by Western Surety pursuant to intercompany
reinsurance and related agreements.

      The effect of reinsurance on the Company's provision for loss and loss
adjustment expenses and the corresponding ratio to earned premium was as follows
(dollars in thousands):

<TABLE>
<CAPTION>
                                                                         YEARS ENDED DECEMBER 31,
                                              ---------------------------------------------------------------------------------
                                                      2002                        2001                            2000
                                              --------------------       -----------------------        -----------------------
                                                 $          RATIO            $            RATIO             $            RATIO
                                              -------       ------       ---------       -------        ---------       -------
<S>                                           <C>           <C>          <C>             <C>            <C>             <C>
            Gross losses and loss
              adjustment expenses .....       $76,199        22.1%       $ 206,980         61.8%        $ 136,004         43.0%
            Reinsurance recoveries ....        17,999        39.3%        (126,144)      (902.1)%        (80,321)       (541.6)%
                                              -------       -----        ---------       ------         ---------       ------
            Net losses and loss
              adjustment expenses .....       $94,198        31.6%       $  80,836         25.2%        $  55,683         18.4%
                                              =======       =====        =========       ======         =========       ======
</TABLE>

      The Company's reinsurance program is predominantly comprised of excess of
loss reinsurance contracts that limit the Company's retention on a per principal
basis. The Company's reinsurance coverage is provided by third party reinsurers
and related parties.

2002 Third Party Reinsurance Compared to 2001 Third Party Reinsurance

      The Company's ceded reinsurance program changed significantly in 2002 as
compared to 2001. The material differences between the 2002 excess of loss
reinsurance program ("2002 Excess of Loss Treaty") and the Company's 2001
program are as follows. The annual aggregate coverage decreased from $115
million in 2001 to $100 million in 2002 with a sub-limit of $60 million for
large commercial accounts. The minimum annual premium for the 2002 Excess of
Loss Treaty is $30.0 million compared to $17.2 million of reinsurance premiums
paid in 2001. The 2002 Excess of Loss Treaty provides the Company with coverage
on a per principal basis of 90% of $40 million excess of $20 million retained by
the Company.

      In addition, the terms of the 2002 Excess of Loss Treaty required a
special acceptance process for certain larger contract accounts in-force at the
inception date of the treaty. The reinsurers conducted an underwriting file
review and approval process for these risks that would otherwise be excluded.
This file review process resulted in one large national contract principal being
excluded from the 2002 Excess of Loss Treaty. In addition, the treaty excludes
certain classes of business relating to two other principals. The Company no
longer writes these classes but has exposures that are in run-off. Should the
Company incur a loss on these excluded principals, the Company would be subject
to a maximum retention of $60 million per principal.

      The higher net retention of $20 million per principal together with other
changes in reinsurance coverage associated with the 2002 Excess of Loss Treaty
and the extended discovery and related provisions of the excess of loss
reinsurance contract in place for 2001 may increase the variability of the
Company's future results of operations and cash flows. Moreover, as stated
above, if CNA Surety suffered any losses arising from bonds issued to the large
national contractor, CNA Surety would retain the first $60 million per principal
under its various excess of loss reinsurance contracts.

      In December 2002 and January 2003, CNAF provided loans in an aggregate
amount of approximately $45 million to the large


                                       49
<PAGE>
national contractor that undertakes projects for the construction of government
and private facilities. CNA Surety has provided significant surety bond
protection for this contractor's projects through surety bonds underwritten by
CCC or its affiliates. The loans were provided by CNAF to help the contractor
meet its liquidity needs. The loans were evidenced by demand notes and, until
replaced by the credit facility described below, accrue interest at 10%. The
owners of the contractor have pledged to CNAF substantially all the assets of
the contractor as collateral for these loans.

      In March 2003, CNAF entered into an agreement to provide a credit facility
with the contractor. The closing of this agreement is subject to the execution
of certain agreements and the provision to CNAF of specified security interests
in addition to those already provided. Under this credit facility, CNAF would be
obligated to provide up to $86.4 million of loans to the contractor and certain
of its subsidiaries, including a refinancing of the already advanced $45 million
described above. The credit facility and all loans thereunder would mature in
March 2006. Advances under the credit facility, including the already funded $45
million, would bear interest at the prime rate plus 6%, with 50% of the interest
due monthly and the remainder deferred until the credit facility matures.

      Loews Corporation and CNAF have entered into a participation agreement,
pursuant to which Loews has agreed to purchase a one-third participation share
in the new credit facility, on a dollar-for-dollar basis, up to a maximum of $25
million. Although Loews does not have rights against the contractor directly
under the participation agreement, it shares recoveries and fees under the
facility on a proportional basis with CNAF.

      In March 2003, CNAF also purchased approximately $28 million principal
amount of the contractor's outstanding bank debt for $16.4 million. Under the
new credit facility, CNAF agreed to sell the bank debt to the contractor for
$16.4 million, with $11.4 million of the purchase price being funded under the
new credit facility and $5 million from amounts loaned to the contractor by its
shareholders. Under its purchase agreement with the banks, CNAF is also required
to reimburse the banks for any draws upon approximately $6.5 million in
outstanding letters of credit issued by the banks for the contractor's benefit
that expire between May and August of 2003. Any CNAF reimbursements for draws
upon the banks' letters of credit will become obligations of the contractor to
CNAF as draws upon the credit facility.

      The contractor has initiated a restructuring plan that is intended to
reduce costs and improve cash flow, and a chief restructuring officer has been
appointed to manage execution of the plan. CNA Surety intends to continue to
provide surety bonds on behalf of the contractor during this restructuring
period, subject to the contractor's initial and ongoing compliance with CNA
Surety's underwriting standards. Indemnification and subrogation rights,
including rights to contract proceeds on construction projects in the event of
default, reduce CNA Surety's exposure to loss. If the contractor does not
perform its contractual obligations underlying all of the Company's surety
bonds, the Company estimates that possible losses, net of indemnification and
subrogation recoveries, but before recoveries under reinsurance contracts, could
be up to $200 million. However, the related party reinsurance treaties discussed
below should limit the Company's per principal exposure to approximately $60
million. While CNA Surety believes that the contractor's restructuring efforts
will be successful and provide sufficient cash flow for its operations, the
contractor's failure to achieve its restructuring plan could have a material
adverse effect on CNA Surety's future results of operations, cash flows and
capital resources.

      In connection with the changes in the Company's 2002 reinsurance program,
CNA Surety purchased extended discovery coverage, available under the excess of
loss reinsurance coverage in place in 2001, at a cost of approximately $8.5
million. This covers losses on surety bonds written prior to January 1, 2002 and
discovered in the two years after January 1, 2002. The limit of this extended
discovery coverage is the unused portion of the annual aggregate limit of $115
million under the 2001 excess of loss treaty. This limit has two layers
comprised of a $65 million aggregate limit for per principal losses between $5
million and $25 million and $50 million aggregate for per principal losses
between $25 million and $60 million. Based upon the Company's settlement of its
exposure to Enron and its current claim estimates of other discovered losses,
the Company estimates that as of December 31, 2002 the first layer of the annual
aggregate has been exhausted and approximately $30 million of limit remains
under the second layer to cover adverse development on losses discovered prior
to December 31, 2001 as well as newly discovered losses in the extended
discovery period. It is possible that these remaining annual aggregate limits
could be insufficient to fully cover all adverse development that could occur on
losses discovered prior to December 31, 2001 or any newly discovered losses
under the extended discovery provisions. The unfavorable resolution of these
uncertainties could have a material adverse impact on the Company's future
results of operations and cash flows.

2003 Third Party Reinsurance Compared to 2002 Third Party Reinsurance

      Effective January 1, 2003, CNA Surety entered into a new excess of loss
treaty ("2003 Excess of Loss Treaty") with a group of third party reinsurers
that reduced its net retention per principal on new bonds to $15 million with a
5% co-participation in the $45 million layer of third party reinsurance coverage
above the Company's retention. This new excess of loss treaty replaces the $40


                                       50
<PAGE>
million excess of $20 million per principal coverage. The material differences
between the new excess of loss reinsurance program and the Company's 2002 Excess
of Loss Treaty are as follows. The annual aggregate coverage increases from $100
million in 2002 to $110 million in 2003. The minimum annual premium for the 2003
Excess of Loss Treaty is $38.0 million compared to $30.0 million of reinsurance
premiums paid in 2002. The 2003 Excess of Loss Treaty provides the Company with
coverage on a per principal basis of 95% of $45 million excess of $15 million
retained by the Company. The contract also includes similar special acceptance
provisions for larger contract accounts contained in the 2002 Excess of Loss
Treaty. In addition to the one large contract principal and the two commercial
principals excluded (based upon class of business in 2002), the Company's
reinsurers have initially excluded three other contract principals from the 2003
Excess of Loss Treaty. The three additional contract principals are in the
process of completing asset sales and other reorganization efforts that
management believes will result in the reinsurers' acceptance of the accounts in
the treaty.

Related Party Reinsurance

      Intercompany reinsurance agreements together with the Services and
Indemnity Agreement that are described below provide for the transfer of the
surety business written by CCC and CIC to Western Surety. All these agreements
originally were entered into on September 30, 1997 (the "Merger Date"): (i) the
Surety Quota Share Treaty (the "Quota Share Treaty"); (ii) the Aggregate Stop
Loss Reinsurance Contract (the "Stop Loss Contract"); and (iii) the Surety
Excess of Loss Reinsurance Contract (the "Excess of Loss Contract"). All of
these contracts have expired. Some have been renewed on different terms as
described below.

      The Services and Indemnity Agreement provides the Company's insurance
subsidiaries with the authority to perform various administrative, management,
underwriting and claim functions in order to conduct the business of CCC and CIC
and to be reimbursed by CCC for services rendered. In consideration for
providing the foregoing services, CCC has agreed to pay Western Surety a
quarterly fee of $50,000. This agreement had an original term of five years that
expired on September 30, 2002 and was renewed on October 1, 2002 on
substantially the same terms with an expiration date of December 31, 2003; and
is annually renewable thereafter. There was no amount due to the CNA Surety
insurance subsidiaries as of December 31, 2002.

      Through the Quota Share Treaty, CCC and CIC transfer to Western Surety all
surety business written or renewed by CCC and CIC after the Merger Date. CCC and
CIC transfer the related liabilities of such business and pay to Western Surety
an amount in cash equal to CCC's and CIC's net written premiums written on all
such business, minus a quarterly ceding commission to be retained by CCC and CIC
equal to $50,000 plus 28% of net written premiums written on such business.

      CCC and CIC paid Western Surety, net of commissions and reinsured loss
payments, $94.4 million, $77.2 million and $88.6 million for the years ended
December 31, 2002, 2001 and 2000. As of December 31, 2002 and 2001, CNA Surety
had an insurance receivable balance from CCC and CIC of $51.7 million and $87.9
million, respectively. The December 31, 2002 balance is comprised of $34.1
million of direct premium receivables from CCC and CIC with respect to the
surety business ceded to Western Surety and $17.6 million of reinsurance
recoverables under the Stop Loss Contract and the Excess of Loss Contracts
written by CCC. CNA Surety had reinsurance payables to CCC and CIC of $24.3
million and $6.2 million as of December 31, 2002 and 2001, respectively,
primarily related to reinsured losses.

      Under the terms of the Quota Share Treaty, CCC has guaranteed the loss and
loss adjustment expenses transferred to Western Surety by agreeing to pay
Western Surety, within 30 days following the end of each calendar quarter, the
amount of any adverse development on such reserves, as reestimated as of the end
of such calendar quarter. There was not any adverse reserve development for the
period from September 30, 1997 (date of inception) through December 31, 2002.

      The Quota Share Treaty had an original term of five years from the Merger
Date and was renewed on October 1, 2002 on substantially the same terms with an
expiration date of December 31, 2003; and is annually renewable thereafter. The
ceding commission paid to CCC and CIC by Western Surety remained at 28% of net
written premiums and contemplates an approximate 4% override commission for
fronting fees to CCC and CIC on their actual direct acquisition costs for the
year ended December 31, 2002.

      The Stop Loss Contract terminated on December 31, 2000 and was not
renewed. The Stop Loss Contract protected the insurance subsidiaries from
adverse loss experience on certain business underwritten after the Merger Date.
The Stop Loss Contract between the insurance subsidiaries and CCC limited the
insurance subsidiaries' prospective net loss ratios with respect to certain
accounts and lines of insured business for three full accident years following
the Merger Date. In the event the insurance subsidiaries' accident year net loss
ratio exceeds 24% in any of 1997 through 2000 on certain insured accounts (the
"Loss Ratio Cap"), the Stop Loss Contract requires CCC at the end of each
calendar quarter following the Merger Date, to pay to the insurance subsidiaries
a dollar amount equal to (i) the amount, if any, by which their actual accident
year net loss ratio exceeds the applicable Loss Ratio Cap, multiplied by (ii)
the


                                       51
<PAGE>
applicable net earned premiums. In consideration for the coverage provided by
the Stop Loss Contract, the insurance subsidiaries paid to CCC an annual premium
of $20,000. The CNA Surety insurance subsidiaries have paid CCC all required
annual premiums. As of December 31, 2002, the Company billed and received
approximately $25 million from CCC under the Stop Loss Contract. This amount
exceeds the Company's paid loss recoverable under this agreement by $20.3
million, which is reflected as reinsurance payable to CCC at December 31, 2002.

      The Excess of Loss Contracts provided the insurance subsidiaries of CNA
Surety with the capacity to underwrite large surety bond exposures by providing
reinsurance support from CCC. The Excess of Loss Contract provides $75 million
of coverage for losses in excess of the $60 million per principal. Subsequent to
the Merger Date, the Company entered into a second excess of loss contract with
CCC ("Second Excess of Loss Contract"). The Second Excess of Loss Contract
provides additional coverage for principal losses that exceed the foregoing
coverage of $75 million per principal provided by the Excess of Loss Contract,
or aggregate losses per principal in excess of $135 million. In consideration
for the reinsurance coverage provided by the Excess of Loss Contracts, the
insurance subsidiaries paid to CCC, on a quarterly basis, a premium equal to 1%
of the net written premiums applicable to the Excess of Loss Contract, subject
to a minimum premium of $20,000 and $5,000 per quarter under the Excess of Loss
Contract and Second Excess of Loss Contract, respectively. The two Excess of
Loss Contracts collectively provided coverage for losses discovered on surety
bonds in force as of the Merger Date and for losses discovered on new and
renewal business written during the term of the Excess of Loss Contracts. Both
Excess of Loss Contracts commenced following the Merger Date and continued until
September 30, 2002. The discovery period for losses covered by the Excess of
Loss Contracts extends until September 30, 2005.

      Effective October 1, 2002, the Company secured replacement excess of loss
protection from CCC for per principal losses that exceed $60 million in two
parts -- a) $40 million excess of $60 million and b) $50 million excess of $100
million. This excess of loss protection is primarily necessary to support
contract surety accounts with bonded backlogs or work-in-process in excess of
$60 million. The Company's goal is to generally limit support to large
commercial surety accounts to $25 million. In addition to the foregoing
structural changes in its high layer excess of loss reinsurance programs, the
cost for these protections increased significantly as compared to the cost of
the previous two Excess of Loss Contracts. The $40 million excess of $60 million
contract is for a three year term beginning October 1, 2002 and provides annual
aggregate coverage of $80 million and $120 million aggregate coverage for the
entire three year term. The Company will pay CCC annual reinsurance premiums of
$12.5 million in year one and $17.5 million in years two and three, payable
quarterly. The Company may commute the contract at the end of each contract year
under certain circumstances. If the treaty is commuted, the Company may be
entitled to a return premium payment. Based on the experience under the treaty
to December 31, 2002, the Company established a return premium receivable of
$2.2 million in connection with the restatement described in Note 17 to the
accompanying financial statements. The reinsurance premium for the coverage
provided by the $50 million excess of $100 million contract was $4.0 million.
This contract was effective October 1, 2002 and expires on December 31, 2003.

      CCC also provided reinsurance coverage (the "10% Quota Share Agreement")
to the Company for 10% of any losses between $20 million and $60 million with
respect to single large surety bonds written effective January 1, 2002 through
December 31, 2002. CCC received 10% of the written premium in exchange for the
coverage provided.

8. RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES

      Activity in the reserves for unpaid losses and loss adjustment expenses
was as follows (dollars in thousands):

<TABLE>
<CAPTION>
                                                                                    YEARS ENDED DECEMBER 31,
                                                                              -----------------------------------
                                                                                2002         2001          2000
                                                                              --------     --------     ---------
<S>                                                                           <C>          <C>          <C>
            Reserves at beginning of period:
            Gross .......................................................     $315,811     $204,457     $ 157,933
            Ceded reinsurance ...........................................      166,318       70,159        20,464
                                                                              --------     --------     ---------
              Net reserves at beginning of period .......................      149,493      134,298       137,469
                                                                              --------     --------     ---------
            Net incurred loss and loss adjustment expenses:
              Provision for insured events of current period ............       88,018       76,024        62,776
              Increase (decrease) in provision for insured events of
                 prior periods ..........................................        6,180        4,812        (7,093)
                                                                              --------     --------     ---------
                 Total net incurred .....................................       94,198       80,836        55,683
                                                                              --------     --------     ---------
            Net payments attributable to:
              Current period events .....................................       12,727       20,878        23,029
              Prior period events .......................................       64,832       44,763        35,825
                                                                              --------     --------     ---------
                 Total net payments .....................................       77,559       65,641        58,854
                                                                              --------     --------     ---------
            Net reserves at end of period ...............................      166,132      149,493       134,298
            Ceded reinsurance at end of period ..........................      137,301      166,318        70,159
                                                                              --------     --------     ---------
                 Gross reserves at end of period ........................     $303,433     $315,811     $ 204,457
                                                                              ========     ========     =========
</TABLE>


                                       52
<PAGE>
      The Company recorded net unfavorable loss reserve development which
resulted in increases in the estimated liability of $6.2 million and $4.8
million for the years ended December 31, 2002 and 2001, respectively, and net
favorable loss reserve development which resulted in reductions in the estimated
liability of $7.1 million for the year ended December 31, 2000. Adverse claim
trends in more recent accident years, particularly increased claim severity on
large commercial accounts, have resulted in increased gross and net incurred
loss and loss adjustment expenses for the two years ended December 31, 2002.

      Incurred loss and loss adjustment expenses for the year ended December 31,
2002 include $17 million on a gross basis and $12 million on a net basis (after
reinsurance) related to the September 2002 bankruptcy of a large national
trucking concern. Incurred loss and loss adjustment expenses for the year ended
December 31, 2001 reflect $78 million on a gross basis and approximately $7.8
million on a net basis (after reinsurance) for the Company's exposure to Enron
Corporation.

      On January 2, 2003, CNA Surety settled litigation brought by J.P. Morgan
Chase & Co. ("Chase") in connection with three surety bonds issued on behalf of
Enron Corporation subsidiaries. The penal sums of the three bonds totaled
approximately $78 million. Although the Company believed it had valid defenses
to the litigation, based on the uncertainty and risk of an adverse jury verdict,
pursuant to the settlement agreement, the Company paid Chase approximately $40.7
million and assigned its recovery rights in the Enron bankruptcy to Chase in
exchange for a full release of its obligations under the bonds. The Company has
no other exposure related to the Enron Corporation. CNA Surety's net loss
related to the settlement, after anticipated recoveries under excess of loss
reinsurance treaties, was previously fully reserved. Immediately upon execution
of the settlement documents, the Company sent written notice for reimbursement
to its reinsurers. A number of those reinsurers have requested a variety of
documents and reserved their rights before making a decision concerning coverage
of the settlement under the reinsurance treaties. Management believes that the
reinsurers have no valid defense under the reinsurance treaties to avoid
payment, and that the Company will fully recover all reinsurance recoverables
recorded related to this settlement. As such, the Company has not recorded a
reduction with respect to these reinsurance recoverables as of December 31,
2002.

9. COMMITMENTS AND CONTINGENCIES

      At December 31, 2002 the future minimum commitment under operating leases
was as follows: 2003 -- $2.2 million; 2004 -- $1.9 million; 2005 -- $1.7
million, 2006 -- $1.5 million and 2007 and thereafter -- $5.8 million. Total
rental expense for the years ended December 31, 2002, 2001 and 2000 was $4.0
million, $4.4 million and $3.5 million, respectively.

      The Company is party 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 position
or its results of operations.

10. INCOME TAXES

      The components of deferred income taxes as of December 31, 2002 and 2001
were as follows (dollars in thousands):

<TABLE>
<CAPTION>
                                                                       2002        2001
                                                                     -------     -------
<S>                                                                  <C>         <C>
                  Deferred tax assets related to:
                    Unearned premium reserve ...................     $13,621     $13,177
                    Loss and loss adjustment expense reserve ...       3,675       3,096
                    Accrued expenses ...........................       1,320       1,382
                    Capital loss carryforward ..................       1,952          --
                    Other ......................................       1,376       3,340
                                                                     -------     -------
                       Total deferred tax assets ...............      21,944      20,995
                                                                     -------     -------
                  Deferred tax liabilities related to:
                    Deferred policy acquisition costs ..........      33,735      31,426
                    Intangible assets ..........................       5,650       5,650
                    Unrealized gains on securities .............      10,695         150
                    Other ......................................       2,591       3,738
                                                                     -------     -------
                       Total deferred tax liabilities ..........      52,671      40,964
                                                                     -------     -------
                  Net deferred tax liability ...................     $30,727     $19,969
                                                                     =======     =======
</TABLE>


                                       53
<PAGE>
      CNA Surety and its subsidiaries file a consolidated federal income tax
return.

      The income tax provisions consisted of the following (dollars in
thousands):

<TABLE>
<CAPTION>
                                                        YEARS ENDED DECEMBER 31,
                                                    -------------------------------
                                                      2002        2001        2000
                                                    -------     -------     -------
<S>                                                 <C>         <C>         <C>
                  Federal current .............     $12,210     $19,053     $23,753
                  Federal deferred ............         171         181       3,078
                  State .......................         254         594         949
                                                    -------     -------     -------
                  Total income tax expense ....     $12,635     $19,828     $27,780
                                                    =======     =======     =======
</TABLE>

      A reconciliation from the federal statutory tax rate to the effective tax
rate is as follows:

<TABLE>
<CAPTION>
                                                                                   YEARS ENDED
                                                                                   DECEMBER 31,
                                                                        --------------------------------
                                                                         2002         2001         2000
                                                                        ------       ------       ------
<S>                                                                     <C>          <C>          <C>
            Federal statutory rate ................................       35.0%        35.0%        35.0%
            Tax exempt income deduction ...........................       (9.4)        (5.0)        (4.0)
            Non-deductible expenses ...............................        0.5          3.4          2.4
            State income tax, net of federal income tax benefit ...        0.4          0.7          0.8
            Other .................................................        3.1          0.9         (0.1)
                                                                        ------       ------       ------
            Total income tax expense ..............................       29.6%        35.0%        34.1%
                                                                        ======       ======       ======
</TABLE>

11. EMPLOYEE BENEFITS

      CNA Surety sponsors a tax deferred savings plan ("401(k) plan") covering
substantially all of its employees. Prior to December 31, 1999, the Company
matched 70% of the participating employee's contribution up to 6% of eligible
compensation (4.2% maximum matching). Effective January 1, 2000, the Company
match was increased to 100% of the participating employees contribution up to 3%
of eligible compensation and 50% of the participating employees contribution
between 3% and 6% of eligible compensation (4.5% maximum matching). In addition,
the Company may also make an annual discretionary profit sharing contribution to
the 401(k) plan, subject to the approval of the Company's Board of Directors.
The profit sharing contribution may be restricted by plan and regulatory
limitations. The Company contribution, including profit sharing, to the 401(k)
plan was $2.9 million, $2.8 million and $3.3 million for the years ended
December 31, 2002, 2001 and 2000, respectively.

      CNA Surety established the CNA Surety Corporation Deferred Compensation
Plan (the "Plan"), effective April 1, 2000. The Company established and
maintains the Plan as an unfunded, nonqualified deferred compensation plan for a
select group of management or highly compensated employees. The purpose of the
Plan is to permit designated employees of the Company and participating
affiliates to accumulate additional retirement income through a nonqualified
deferred compensation plan that enables them to defer compensation to which they
will become entitled in the future. The Company holds equity securities with a
fair value of $0.8 million as of December 31, 2002 in respect of this deferred
compensation plan.

      Western Surety sponsors two post-retirement benefit plans covering certain
employees. One plan provides medical benefits, and the other plan provides sick
leave termination payments. The post-retirement health care plan is contributory
and the sick leave plan is non-contributory.

      The following table sets forth the plans combined accumulated
postretirement benefit obligation at the beginning and end of the last two
fiscal years (dollars in thousands):

<TABLE>
<CAPTION>
                                                                    2002         2001
                                                                  -------      -------
<S>                                                               <C>          <C>
            Reconciliation of benefit obligation
              Benefit obligation at beginning of the year ...     $ 6,412      $ 6,152
              Service cost ..................................         137          196
              Interest cost .................................         302          372
              Plan amendment ................................          --         (480)
              Curtailment ...................................        (187)          --
              Actuarial (gain)/loss .........................      (1,082)         346
              Benefits and expenses paid ....................        (184)        (174)
                                                                  -------      -------
              Benefit obligation at end of year .............     $ 5,398      $ 6,412
                                                                  =======      =======
</TABLE>


                                       54
<PAGE>
      The following table sets forth the plans combined funded status reconciled
with the amount shown in the Company's statement of financial position at
December 31, 2002 and December 31, 2001 (dollars in thousands).

<TABLE>
<CAPTION>
                                                              2002         2001
                                                            -------      -------
<S>                                                         <C>          <C>
                  Reconciliation of funded status
                    Funded status .....................     $(5,398)     $(6,412)
                    Unrecognized prior service cost ...      (1,060)        (714)
                    Unrecognized net loss .............         199          938
                                                            -------      -------
                    Accrued benefit cost ..............     $(6,259)     $(6,188)
                                                            =======      =======
</TABLE>

      The plans combined net periodic post-retirement benefit cost for the last
three fiscal years included the following components (dollars in thousands):

<TABLE>
<CAPTION>
                                                                       2002        2001        2000
                                                                      -----       -----       -----
<S>                                                                   <C>         <C>         <C>
                 Net periodic benefit cost
                   Service cost at end of year ..................     $ 137       $ 196       $ 215
                   Interest cost ................................       302         372         368
                   Expected return on assets ....................        --          --          --
                   Prior service cost ...........................      (131)        (72)        (30)
                   Curtailment ..................................       (44)         --          --
                   Recognized net actuarial loss/(gain) .........       (10)         24          12
                                                                      -----       -----       -----
                   Net periodic benefit cost ....................     $ 254       $ 520       $ 565
                                                                      =====       =====       =====
</TABLE>

<TABLE>
<CAPTION>
                                                                       2002        2001        2000
                                                                      -----       -----       -----
<S>                                                                   <C>         <C>         <C>
            Key Assumptions
              Discount rate .....................................       6.5%        6.5%        6.5%
              Initial health care cost trend, pre-Medicare ......       7.0%        7.0%        8.0%
              Initial health care cost trend, post-Medicare .....       9.0%        9.0%       10.0%
              Ultimate health care cost trend ...................       5.0%        5.0%        5.0%
              Year in which ultimate trend is reached ...........      2006        2005        2005
</TABLE>

12. STOCKHOLDERS' EQUITY

      The Company has reserved shares of its common stock for issuance to
directors, officers, employees and certain advisors of the Company through
incentive stock options, non-qualified stock options and stock appreciation
rights ("SARs") to be granted under the CNA Surety 1997 Long-Term Equity
Compensation Plan ("CNA Surety Plan"). The Company has also reserved shares of
its common stock for issuance to Capsure option holders under the CNA Surety
Corporation Replacement Stock Option Plan ("Replacement Plan"). The CNA Surety
Plan and Replacement Plan are collectively referred to as the "Plan". The
aggregate number of shares initially available for which options may be granted
under the Plan is 3,000,000.

      Options issued under the Replacement Plan have the same exercise price,
rights, benefits, terms and conditions as the Capsure options replaced. The
number of unexercised and outstanding Capsure options issued to the holders
under the Replacement Plan on September 30, 1997 was 335,235. The exercise
prices of the replacement options ranged between $0.05 and $8.00 per share on
September 30, 1997.

      The Compensation Committee (the "Committee") of the Board of Directors,
consisting of independent members of the Board of Directors, administers the
Plan. The Committee determines the option prices. Prices may not be less than
the fair market value of the Company's common stock on the date of grant for
incentive stock options and may not be less than the par value of the Company's
common stock for non-qualified stock options.

      The Plan provides for the granting of incentive stock options as defined
under Section 382 of the Internal Revenue Code of 1986, as amended. All
non-qualified stock options and incentive stock options granted under the Plan
expire ten years after the date of grant and in the case of the Replacement Plan
the options expire ten years from the original Capsure grant date.

      The following table summarizes stock option activity for the three years
ending December 31, 2002.


                                       55
<PAGE>
<TABLE>
<CAPTION>
                                                                                 WEIGHTED
                                                                              AVERAGE OPTION
                                                            SHARES SUBJECT       PRICE PER
                                                              TO OPTION            SHARE
                                                            --------------    --------------
<S>                                                         <C>               <C>
                  Balance at December 31, 1999 ....           1,221,529           $12.50
                                                              =========
                    Options granted ...............             323,200           $11.50
                    Options cancelled .............             (68,342)          $13.24
                    Options exercised .............             (22,897)          $ 4.51
                                                              ---------
                  Balance at December 31, 2000 ....           1,453,490           $12.37
                                                              =========
                    Options granted ...............             407,886           $14.42
                    Options cancelled .............            (120,250)          $12.32
                    Options exercised .............             (77,839)          $ 5.93
                                                              ---------
                  Balance at December 31, 2001 ....           1,663,287           $13.18
                                                              =========
                    Options granted ...............             325,800           $ 9.35
                    Options cancelled .............            (172,419)          $13.03
                    Options exercised .............            (146,725)          $ 9.63
                                                              ---------
                  Balance at December 31, 2002 ....           1,669,943           $12.76
                                                              =========
</TABLE>

      As of December 31, 2002, the number of shares available for granting of
options under the Plan were 882,128.

      The following table summarizes information about stock options outstanding
at December 31, 2002:

<TABLE>
<CAPTION>

                                                      OPTIONS OUTSTANDING                          OPTIONS EXERCISABLE
                                       ---------------------------------------------------    ------------------------------
                                                      WEIGHTED AVERAGE
                    RANGE OF             NUMBER           REMAINING       WEIGHTED AVERAGE       NUMBER     WEIGHTED AVERAGE
                EXERCISE PRICES        OUTSTANDING    CONTRACTUAL LIFE     EXERCISE PRICE     EXERCISABLE    EXERCISE PRICE
            -----------------------    -----------    ----------------    ----------------    -----------   ----------------
<S>                                    <C>            <C>                 <C>                 <C>           <C>
            $2.25 to $3.50 ........        9,268          1.6 years           $    2.96           9,268         $    2.96
            $9.35 to $11.50 .......      838,089          8.2 years           $   10.53         355,014         $   11.19
            $13.05 to $15.875 .....      822,586          6.6 years           $   15.14         553,271         $   15.49
</TABLE>

      The weighted average fair market value (at grant date) per option granted
was $3.69, $3.72 and $4.33 respectively, for options granted during 2002, 2001
and 2000. The fair value of these options was estimated at grant date using a
Black-Scholes option pricing model with the following weighted average
assumptions for the year ended December 31, 2002: risk free interest rate of
1.1%; dividend yield of 0.0%; expected option life of six years; and volatility
of 39.8%. Similar assumptions for the years ended December 31, 2001 and 2000
were: risk free interest rate of 1.50% and 5.50%; dividend yield of 4.0% and
3.0%; expected option life of 6 years; and volatility of 38.7% and 42.3%,
respectively.

      The Company adopted the financial disclosure provisions of SFAS No. 123,
"Accounting for Stock-Based Compensation" with respect to its stock-based
incentive plans. The Company applies APB Opinion No. 25, "Accounting for Stock
Issued to Employees," and related interpretations, in accounting for its plans
as allowed for under the provisions of SFAS No. 123. Accordingly, no
compensation cost has been recognized for its stock-based incentive plans as the
exercise price of the granted options equals the market price at the grant date.
Had compensation cost for these plans been determined on the fair value at the
grant date for options granted, the Company's pro forma net income for the years
ended December 31, 2002, 2001 and 2000 would have been $30.1 million, $36.4
million and $53.0 million, respectively. Diluted net income per share would have
been $0.70, $0.85 and $1.23 for the years ended December 31, 2002, 2001 and
2000, respectively.

      Effective January 1, 1998, the Company established the CNA Surety
Corporation Non-Employee Directors Deferred Compensation Plan. Under this plan,
each director who is not a full-time employee of the Company or any of its
affiliates may defer all or a portion of the annual retainer fee that would
otherwise be paid to such director. The deferral amount, which must be in
multiples of 10% of the retainer fee, will be credited to a deferred
compensation account and will be deemed invested in Common Stock Units equal to
the deferred fees divided by the fair market value of CNA Surety common stock as
of each quarterly meeting date. Each director will be fully vested in his or her
deferred compensation amount. Aggregate common stock units outstanding as of
December 31, 2002 were 23,089. Common Stock Units are convertible into CNA
Surety common stock at the election of the director.

13. SEGMENT INFORMATION

      The Company is a leading provider of surety and fidelity bonds in the
United States. According to A.M. Best, the surety and fidelity segment of the
domestic property and casualty insurance industry aggregates approximately $4.4
billion in direct written


                                       56
<PAGE>
premiums, comprised of approximately $3.5 billion in surety premiums and $0.9
billion in fidelity premiums.

      Surety bonds are three-party agreements in which the issuer of the bond
(the surety) joins with a second party (the principal) in guaranteeing to a
third party (the owner/obligee) the fulfillment of some obligation on the part
of the principal. The surety is the party who guarantees fulfillment of the
principal's obligation to the obligee. There are two broad types of surety
products -- contract surety 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. Commercial surety bonds include all surety bonds other than
contract and cover obligations typically required by law or regulation. Fidelity
bonds cover losses arising from employee dishonesty.

      Although all of its products are sold through the same independent
insurance agent and broker distribution network, the Company's underwriting is
organized by the two broad types of surety products -- contract surety and
commercial surety, which also includes fidelity bonds and other insurance
products for these purposes. These two operating segments have been aggregated
into one reportable business segment for financial reporting purposes because of
their similar economic and operating characteristics.

      The following tables set forth gross and net written premiums, dollars in
thousands, by product and between domestic and international risks and the
respective percentage of the total for the past three years.

Gross Written Premium

<TABLE>
<CAPTION>
                                                          FOR THE YEAR ENDED DECEMBER 31,
                                         ------------------------------------------------------------------
                                           2002                    2001                    2000
                                         --------                --------                --------
<S>                                      <C>          <C>        <C>          <C>        <C>          <C>
            Contract ...............     $197,875      55.0%     $180,588      54.2%     $161,539      51.0%
            Commercial .............      134,039      37.2       125,026      37.5       128,556      40.6
            Fidelity and other .....       27,978       7.8        27,389       8.3        26,572       8.4
                                         --------     -----      --------     -----      --------     -----
              Total ................     $359,892     100.0      $333,003     100.0      $316,667     100.0
                                         ========     =====      ========     =====      ========     =====
            Domestic ...............     $348,010      96.7%     $322,106      96.7%     $300,079      94.8%
            International ..........       11,882       3.3        10,897       3.3        16,588       5.2
                                         --------     -----      --------     -----      --------     -----
              Total ................     $359,892     100.0      $333,003     100.0      $316,667     100.0
                                         ========     =====      ========     =====      ========     =====
</TABLE>

Net Written Premium

<TABLE>
<CAPTION>
                                                          FOR THE YEAR ENDED DECEMBER 31,
                                         ------------------------------------------------------------------
                                           2002                    2001                    2000
                                         --------                --------                --------
<S>                                      <C>          <C>        <C>          <C>        <C>          <C>
            Contract ...............     $172,633      56.3%     $165,603      52.4%     $150,504      49.4%
            Commercial .............      107,290      35.0       122,812      38.9       126,923      41.7
            Fidelity and other .....       26,731       8.7        27,389       8.7        27,041       8.9
                                         --------     -----      --------     -----      --------     -----
              Total ................     $306,654     100.0      $315,804     100.0      $304,468     100.0
                                         ========     =====      ========     =====      ========     =====
            Domestic ...............     $297,385      97.0%     $305,483      96.7%     $289,049      94.9%
            International ..........        9,269       3.0        10,321       3.3        15,419       5.1
                                         --------     -----      --------     -----      --------     -----
              Total ................     $306,654     100.0      $315,804     100.0      $304,468     100.0
                                         ========     =====      ========     =====      ========     =====
</TABLE>

      Approximately $72.4 million, or 20.1%, of gross written premiums were
generated from national insurance brokers in 2002 with the single largest
national broker production comprising $28.3 million, or 7.9%, of gross written
premiums.

14. STATUTORY FINANCIAL DATA

      CNA Surety's insurance subsidiaries file financial statements prepared in
accordance with statutory accounting practices prescribed or permitted by
applicable insurance regulatory authorities. Prescribed statutory accounting
practices include state laws, regulations and general administrative rules, as
well as guidance provided in a variety of publications of the National
Association of Insurance Commissioners ("NAIC"). Permitted statutory accounting
practices encompass all accounting practices that are not prescribed. The
Company's insurance subsidiaries follow two permitted accounting practices which
did not have a material effect on reported statutory surplus or income. The
Company was given permission to report activity in the Small Business
Administration's Surety Bond Guarantee program as a reinsurance program and to
report all salvage and subrogation recoveries as recoveries of loss rather than
allocating recoveries between loss and loss adjustment expenses. Historically,
the principal differences between statutory financial statements and financial
statements prepared in accordance with generally accepted accounting principles
are that statutory financial statements do not reflect deferred policy
acquisition costs and deferred income taxes and fixed income securities are
generally carried at amortized cost in statutory financial statements.


                                       57
<PAGE>
      In March of 1998, the NAIC adopted the Codification of Statutory
Accounting Principles ("Codification"). Codification, which intended to
standardize regulatory accounting and reporting to state insurance departments,
became effective on January 1, 2001. However, statutory accounting principles
will continue to be established by individual state laws and permitted
practices. The states in which CNA Surety's insurance subsidiaries conduct
business required adoption of Codification for the preparation of statutory
financial statements effective January 1, 2001. The adoption of Codification
increased the Company's statutory capital and surplus as of January 1, 2001 by
approximately $27.0 million primarily due to recording of deferred tax assets
and the recognition of anticipated salvage and subrogation.

      The following table reconciles consolidated stockholders' equity at
December 31, 2002 and 2001 as reported herein in conformity with GAAP with total
statutory capital and surplus of CNA Surety's insurance subsidiaries, determined
in accordance with statutory accounting practices prescribed or permitted by
insurance regulatory authorities (dollars in thousands):

<TABLE>
<CAPTION>
                                                                               2002           2001
                                                                            ---------      ---------
<S>                                                                         <C>            <C>
            Balance per GAAP ..........................................     $ 420,561      $ 388,428
            Parent company and undistributed net income of certain
              subsidiaries ............................................        54,179         65,341
            Intangible assets .........................................      (143,785)      (143,785)
            Net unrealized gain/loss on fixed income securities .......       (30,734)        (7,739)
            Deferred policy acquisition costs .........................       (96,386)       (89,788)
            Deferred income taxes, net ................................        43,869         30,957
            Non-admitted assets and statutory reserves ................       (14,861)       (12,465)
            Prior period accounting restatement (see Note 17) .........        (1,422)            --
                                                                            ---------      ---------
            Other assets and liabilities ..............................           (50)        (3,492)
                                                                            ---------      ---------
            Balance per statutory accounting practices ................       231,371        227,457
                                                                            =========      =========
</TABLE>

      The NAIC has promulgated Risk Based Capital ("RBC") requirements for
property and casualty insurance companies to evaluate the adequacy of statutory
capital and surplus in relation to investment and insurance risks such as asset
quality, loss reserve adequacy, and other business factors. The RBC information
is used by state insurance regulators as an early warning mechanism to identify
insurance companies that potentially are inadequately capitalized. In addition,
the formula defines new minimum capital standards that supplement the current
system of fixed minimum capital and surplus requirements on a state-by-state
basis. Regulatory compliance is determined by a ratio (the "Ratio") of the
enterprise's regulatory total adjusted capital, as defined by the NAIC, to its
authorized control level RBC, as defined by the NAIC. Generally, a Ratio in
excess of 200% of authorized control level RBC requires no corrective actions by
a company or regulators. As of December 31, 2002, each of CNA Surety's insurance
subsidiaries had a Ratio that was in compliance with the minimum RBC
requirements.

      CNA Surety's insurance subsidiaries are subject to regulation and
supervision by the various state insurance regulatory authorities in which they
conduct business. Such regulation is generally designed to protect policyholders
and includes such matters as maintenance of minimum statutory surplus and
restrictions on the payment of dividends. Generally, statutory surplus of each
insurance subsidiary in excess of a statutorily prescribed minimum is available
for payment of dividends to the parent company. However, such distributions as
dividends may be subject to prior regulatory approval. Without prior regulatory
approval in 2002, CNA Surety's insurance subsidiaries may pay dividends of $32.1
million in the aggregate. Combined statutory surplus for the insurance
subsidiaries at December 31, 2002 was $231.4 million.

15. RELATED PARTY TRANSACTIONS

      The Company has the following related party transactions not previously
described in Note 7. Reinsurance.

      Effective January 1, 2001, CNA Surety renewed an Administrative Services
Agreement with CCC. The agreement allows the Company to purchase and/or have
access to certain services provided by CNAF. The Company will also pay CNAF a
management fee for its proportionate share of administrative and overhead costs
incurred in supporting the services provided pursuant to this agreement. The
management fee for the year 2003 is $1.7 million which shall be paid by CNA
Surety to CNAF in equal monthly installments by the last day of each month. The
management fee shall be increased as of January 1, the "adjustment date", of
each year this Administrative Services Agreement is in force by the greater of
5% or the amount of the increase in the Consumer Price Index for All Urban
Consumers for the Chicago, Illinois area as reported by the Bureau of Labor
Statistics for the 12 month period immediately preceding the adjustment date.
This agreement shall be effective so long as CNAF or their affiliates or
shareholders shall continue to


                                       58
<PAGE>
own a majority interest in CNA Surety. This agreement may be terminated by
either party upon the provision of 30 days prior notice of such termination to
the other party.

      The Company was charged $5.2 million, $5.7 million, and $5.9 million for
the years ended December 31, 2002, 2001 and 2000, respectively, for rents and
services provided under a previous Administrative Services Agreement. In
addition, the Company was charged $1.0 million, $2.1 million and $1.9 million
for direct costs incurred by CCC on the Company's behalf during 2002, 2001 and
2000, respectively. The Company owed $0.5 million which was reflected in other
liabilities in the Company's Consolidated Balance Sheet at December 31, 2002.

      Western Surety has entered into two series of business transactions with
entities in which either or both CCC or affiliates of CCC have an interest. The
first series involves five separate real estate residual value insurance
policies issued by R.V.I. America Insurance Company ("RVI America") reinsured by
Western Surety through the Quota Share Treaty. RVI America is a wholly owned
subsidiary of R.V.I. America Corporation which is a wholly owned subsidiary of
R.V.I. Guaranty Company Ltd. of Bermuda ("RVI Bermuda"). RVI Bermuda is an
unconsolidated affiliate of CCC. The transactions involve policies with limits
totaling approximately $11.5 million. CCC is reinsuring the full extent of RVI
America's exposure on the policies. Pursuant to the Quota Share Treaty, Western
Surety is, in turn, reinsuring all of CCC's exposures on the policies. Western
Surety is reinsuring all of its exposure on the policies with RVI Bermuda, a
non-admitted reinsurer. The policy limits range from approximately $1.7 million
to $3.0 million, with an average policy limit of approximately $2.3 million and
total limits of all policies of $11.5 million. Net premium amounts to be
retained in 2000 relative to these reinsurance transactions total $519,278 as
follows: RVI America, $51,928; CCC, $130,858; Western Surety, $67,298; and RVI
Bermuda, $269,194.

      The second series of transactions is that Western Surety is participating
in various transactions involving the issuance of bonds for certain subsidiaries
of CNA UniSource of America, Inc. (collectively referred to as "CNA UniSource").
CNAF owns 100% of CNA UniSource. Western Surety, with the approval of the Board
of Directors and the Audit Committee, wrote insurance program bonds guaranteeing
CNA UniSource payment obligations under the April 1, 2000, Paid Loss Retro and
WC Deductible Finance Agreement with CCC insurance affiliates, American Casualty
Company of Reading, PA and Transportation Insurance Company. These CCC
affiliates provided certain general liability and worker's compensation
insurance to CNA UniSource. Effective December 31, 2002, the Paid Loss Retro and
WC Deductible Finance Agreement between CNA UniSource and CCC was settled for
approximately $31.0 million cash. CNA UniSource is waiting for a written release
before the bond is canceled. In addition, CCC has issued eight professional
license, mortgage broker, employer leasing, nonresident license and financial
guarantee bonds for CNA UniSource to various state government obligees. Western
Surety reinsures these bonds through the Quota Share Treaty. The combined penal
amount of the bonds at December 31, 2002 was approximately $15 million.
Effective December 31, 2002, CNA UniSource is no longer operating and management
expects the bonds to be cancelled in 2003. CNAF has entered into an agreement
with Western Surety indemnifying Western Surety from any loss arising from the
issuance of bonds for CNA UniSource.

16. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)

      The following is a summary of the results of operations of CNA Surety for
the years ended December 31, 2002, 2001 and 2000. (Dollars in thousands, except
per share amounts.)

<TABLE>
<CAPTION>
                                                                FIRST     SECOND      THIRD         FOURTH           FOURTH
                                                               QUARTER    QUARTER    QUARTER       QUARTER          QUARTER
                                                               -------    -------    -------    -------------   ---------------
                                                                                                AS PREVIOUSLY   AS RESTATED (1)
                                                                                                   REPORTED
<S>                                                            <C>        <C>        <C>        <C>             <C>
            2002
            Revenues ......................................    $74,049    $84,464    $85,529       $72,257          $74,445
                                                               =======    =======    =======       =======          =======
            Income before income taxes ....................    $15,392    $18,819    $ 3,715       $ 2,640          $ 4,828
            Income taxes ..................................      4,835      5,917      1,098            19              785
                                                               -------    -------    -------       -------          -------
            Net income ....................................    $10,557    $12,902    $ 2,617       $ 2,621          $ 4,043
                                                               =======    =======    =======       =======          =======
            Basic and diluted earnings per common share ...    $  0.25    $  0.30    $  0.06       $  0.06          $  0.09
                                                               =======    =======    =======       =======          =======
            2001
            Revenues ......................................    $84,455    $86,522    $89,386       $90,108          $90,108
                                                               =======    =======    =======       =======          =======
            Income before income taxes ....................    $18,420    $19,044    $18,242       $ 1,030          $ 1,030
            Income taxes ..................................      6,476      6,701      6,228           423              423
                                                               -------    -------    -------       -------          -------
            Net income ....................................    $11,944    $12,343    $12,014       $   607          $   607
                                                               =======    =======    =======       =======          =======
            Basic and diluted earnings per common share ...    $  0.28    $  0.29    $  0.28       $  0.01          $  0.01
                                                               =======    =======    =======       =======          =======
            2000
            Revenues ......................................    $82,884    $83,055    $80,930       $85,404          $85,404
                                                               =======    =======    =======       =======          =======
            Income before income taxes ....................    $21,358    $21,590    $19,588       $18,846          $18,846
            Income taxes ..................................      7,245      7,483      6,250         6,802            6,802
                                                               -------    -------    -------       -------          -------
            Net income ....................................    $14,113    $14,107    $13,338       $12,044          $12,044
                                                               =======    =======    =======       =======          =======
            Basic and diluted earnings per common share ...    $  0.33    $  0.33    $  0.31       $  0.28          $  0.28
                                                               =======    =======    =======       =======          =======
</TABLE>

(1) See Note 17.


                                       59
<PAGE>
17. RESTATEMENT

      Subsequent to the filing of CNA Surety's Report on Form 10-K for the
fiscal year ended December 31, 2002, the Company revised its accounting for
ceded premiums under a multiple year excess of loss reinsurance treaty with its
affiliate, Continental Casualty Company, which has been in place since October
1, 2002 (this treaty is discussed in greater detail in Note 7 (Reinsurance)).
Under the contract CNA Surety pays a quarterly premium of $3.125 million, of
which 70% is added to an experience account that is reduced by any losses ceded
to the treaty. On dates specified under the contract, CNA Surety can commute the
treaty and receive payment of the experience account balance. Under Emerging
Issues Task Force ("EITF") Issue 93-6 "Accounting for Multiple-Year
Retrospectively Rated Contracts by Ceding and Assuming Enterprises" ("EITF
93-6"), a receivable for return premium based on experience under the contract
should be established at December 31, 2002. CNA Surety had not previously
established such a receivable, and has restated its 2002 consolidated financial
statements to comply with EITF 93-6. A summary of the significant effects of the
restatement is as follows:

<TABLE>
<CAPTION>
                                                         AS PREVIOUSLY       AS
                                                           REPORTED       RESTATED
                                                             2002           2002
                                                         -------------    --------
            AS OF AND FOR THE YEAR ENDED DECEMBER 31
            (in thousands, except per share data)
<S>                                                      <C>              <C>
            Consolidated balance sheet:
               Insurance receivables: Reinsurance          $130,761       $132,949
               Current income taxes payable                   5,123          5,889
               Retained earnings                            158,515        159,937

            Consolidated statement of income:
               Net earned premium                          $296,131       $298,319
               Total revenue                                316,299        318,487
               Income before income taxes                    40,566         42,754
               Income taxes                                  11,869         12,635
               Net income                                    28,697         30,119

            Basic and Diluted earnings per share           $   0.67       $   0.70
</TABLE>

<TABLE>
<CAPTION>
                                                                                            PAGE
                                                                                            ----
<S>                                                                                         <C>
                  FINANCIAL STATEMENT SCHEDULES:
                  Schedule I -- Summary of Investments................................
                  Schedule II -- Condensed Financial Information of
                    Registrant........................................................
                  Schedule III -- Supplementary Insurance Information.................
                  Schedule IV -- Reinsurance..........................................
                  Schedule V -- Valuation and Qualifying Accounts.....................
                  Schedule VI -- Supplemental Information Concerning
                    Property -- Casualty Insurance Operations.........................
</TABLE>


                                       60
<PAGE>
ITEM 14. CONTROLS AND PROCEDURES

      The Company maintains a system of disclosure controls and procedures which
are designed to ensure that information required to be disclosed by the Company
in reports that it files or submits to the Securities and Exchange Commission
under the Securities and Exchange Act of 1934, including this report, is
recorded, processed, summarized and reported on a timely basis. These disclosure
controls and procedures include controls and procedures designed to ensure that
information required to be disclosed under the Exchange Act is accumulated and
communicated to the Company's management on a timely basis to allow decisions
regarding required disclosure.

      The Company's principal executive officer and its principal financial
officer undertook an evaluation of the Company's disclosure controls and
procedures (as defined in Exchange Act Rules 13a - 15(e) and 15d -15(e)) as of
the end of the period covered by this report and concluded that the Company's
controls and procedures were effective.

      There were no changes in the Company's internal control over financial
reporting that occurred during the Company's last fiscal quarter that have
materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.

      The Company's management has reviewed the circumstances that led to the
restatement of results reflected in this report and concluded that this was an
isolated incident and not indicative of a systemic failure of the controls over
financial reporting.


                                       61
<PAGE>
PART IV.

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

<TABLE>
<CAPTION>
                                                                                                PAGE
                                                                                                ----
<S>                                                                                             <C>
                       (a)(1) Financial Statements:
                              A separate index to the Consolidated Financial
                              Statements is presented in Part II, Item 8................
                       (a)(2) Financial Statement Schedules:
                              Independent Auditors' Report..............................
                              Schedule I -- Summary of Investments......................
                              Schedule II -- Condensed Financial
                              Information of Registrant.................................
                              Schedule III -- Supplementary Insurance
                              Information...............................................
                              Schedule IV -- Reinsurance................................
                              Schedule V -- Valuation and Qualifying
                              Accounts..................................................
                              Schedule VI -- Supplemental Information
                              Concerning Property -- Casualty
                              Insurance Operations......................................
</TABLE>


                                       62
<PAGE>
                                                                      SCHEDULE I

                     CNA SURETY CORPORATION AND SUBSIDIARIES

                             SUMMARY OF INVESTMENTS
                    OTHER THAN INVESTMENTS IN RELATED PARTIES
                        AS OF DECEMBER 31, 2002 AND 2001

<TABLE>
<CAPTION>
                                                                              AS OF DECEMBER 31, 2002
                                                                      --------------------------------------
                                                                       COST OR      ESTIMATED
                                                                      AMORTIZED        FAIR         CARRYING
                                                                        COST           VALUE          VALUE
                                                                      --------      ---------       --------
                                                                               (AMOUNTS IN THOUSANDS)
<S>                                                                   <C>           <C>             <C>
Fixed Income Securities:
  U.S. Government and government agencies and authorities .....       $ 66,673       $ 69,240       $ 69,240
  States, municipalities and political subdivisions ...........        347,918        367,934        367,934
  All other corporate bonds ...................................        124,773        133,364        133,364
                                                                      --------       --------       --------
       Total fixed income securities ..........................        539,364       $570,538        570,538
                                                                      --------       ========       --------
Equity securities .............................................            852       $    761            761
Short-term investments ........................................         50,669                        50,669
Other investments .............................................          1,784                         1,257
                                                                      --------                      --------
       Total investments ......................................       $592,669                      $623,225
                                                                      ========                      ========
</TABLE>

<TABLE>
<CAPTION>
                                                                              AS OF DECEMBER 31, 2001
                                                                      --------------------------------------
                                                                       COST OR      ESTIMATED
                                                                      AMORTIZED        FAIR         CARRYING
                                                                        COST           VALUE          VALUE
                                                                      --------      ---------       --------
                                                                               (AMOUNTS IN THOUSANDS)
<S>                                                                   <C>           <C>             <C>
Fixed Income Securities:
  U.S. Government and government agencies and authorities .....       $114,866       $117,069       $117,069
  States, municipalities and political subdivisions ...........        217,757        220,799        220,799
  All other corporate bonds ...................................        131,479        133,973        133,973
                                                                      --------       --------       --------
       Total fixed income securities ..........................        464,102       $471,841        471,841
                                                                      --------       ========       --------
Equity securities .............................................         42,614       $ 35,754         35,754
Short-term investments ........................................         53,600                        53,600
Other investments .............................................          5,754                         5,303
                                                                      --------                      --------
       Total investments ......................................       $566,070                      $566,498
                                                                      ========                      ========
</TABLE>


                                       63
<PAGE>
                                                                     SCHEDULE II

                             CNA SURETY CORPORATION

                  CONDENSED FINANCIAL INFORMATION OF REGISTRANT
                                (PARENT COMPANY)
                                 BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                      DECEMBER 31,
                                                             -----------------------------
                                                                  2002             2001
                                                             ---------------     ---------
                                                             AS RESTATED (b)
                                                                  (AMOUNTS IN THOUSANDS)
<S>                                                          <C>                 <C>
                        ASSETS
Investments in and advances to subsidiaries .............       $ 480,638        $ 449,457
Fixed income securities .................................           5,682            5,261
Equity investments ......................................             761               --
Short-term investments (restricted: $601 and $1,345) ....           8,761           14,661
Cash (restricted: $4,226 and $12,436) ...................           4,228           12,438
Other assets ............................................              --              154
                                                                ---------        ---------
     Total assets .......................................       $ 500,070        $ 481,971
                                                                =========        =========
                     LIABILITIES
Debt ....................................................       $  60,000        $  75,000
Other liabilities .......................................          19,509           18,543
                                                                ---------        ---------
     Total liabilities ..................................          79,509           93,543
                                                                ---------        ---------
                 STOCKHOLDERS' EQUITY
Common stock ............................................             444              442
Additional paid-in capital ..............................         255,765          254,133
Retained earnings .......................................         159,937          149,128
Accumulated other comprehensive income ..................          19,861              278
Treasury stock, at cost .................................         (15,446)         (15,553)
                                                                ---------        ---------
     Total stockholders' equity .........................         420,561          388,428
                                                                ---------        ---------
          Total liabilities and stockholders' equity ....       $ 500,070        $ 481,971
                                                                =========        =========
</TABLE>

(b) See Note 2.


                                       64
<PAGE>
                                                                     SCHEDULE II

                             CNA SURETY CORPORATION

                  CONDENSED FINANCIAL INFORMATION OF REGISTRANT
                         (PARENT COMPANY) -- (CONTINUED)
                              STATEMENTS OF INCOME

<TABLE>
<CAPTION>
                                                                               YEARS ENDED DECEMBER 31,
                                                                    -------------------------------------------
                                                                         2002            2001            2000
                                                                    ---------------    --------        --------
                                                                    AS RESTATED (b)
                                                                                (AMOUNTS IN THOUSANDS)
<S>                                                                 <C>                <C>             <C>
Revenues:
  Net investment income ........................................       $    713        $  1,891        $  2,046
  Net realized investment losses ...............................             (4)             --              --
                                                                       --------        --------        --------
     Total revenues ............................................            709           1,891           2,046
                                                                       --------        --------        --------
Expenses:
  Interest expense .............................................          1,656           3,855           6,869
  Corporate expense ............................................          3,706           5,243           3,489
                                                                       --------        --------        --------
     Total expenses ............................................          5,362           9,098          10,358
                                                                       --------        --------        --------
Loss from operations before income taxes and equity in net
  income of subsidiaries .......................................         (4,653)         (7,207)         (8,312)
Income taxes ...................................................         (1,629)         (2,523)         (3,359)
                                                                       --------        --------        --------
Net loss before equity in net income of
  subsidiaries-- Parent Company only ...........................         (3,024)         (4,684)         (4,953)
Equity in net income of subsidiaries ...........................         33,143          41,592          58,555
                                                                       --------        --------        --------
Net income .....................................................       $ 30,119        $ 36,908        $ 53,602
                                                                       ========        ========        ========
</TABLE>

(b) See Note 2.


                                       65
<PAGE>
                                                                     SCHEDULE II

                             CNA SURETY CORPORATION

                  CONDENSED FINANCIAL INFORMATION OF REGISTRANT
                         (PARENT COMPANY) -- (CONTINUED)
                            STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                          YEARS ENDED DECEMBER 31,
                                                                -------------------------------------------
                                                                     2002            2001            2000
                                                                ---------------    --------        --------
                                                                AS RESTATED (b)
                                                                            (AMOUNTS IN THOUSANDS)
<S>                                                             <C>                <C>             <C>
OPERATING ACTIVITIES:
  Net income ...............................................       $ 30,119        $ 36,908        $ 53,602
     Cash dividends from subsidiaries ......................         31,162          56,900          56,450
     Tax payments received from subsidiaries ...............          9,894          26,314          29,062
     Federal and state income tax payments .................         (8,000)        (23,750)        (24,050)
     Adjustments to reconcile net income to net cash
       Provided by operating activities:
       Equity in net income of subsidiaries ................        (33,143)        (41,592)        (58,555)
       Change in other assets and liabilities ..............           (759)           (736)         (3,367)
                                                                   --------        --------        --------
Net cash provided by operating activities ..................         29,273          54,044          53,142
                                                                   --------        --------        --------
INVESTING ACTIVITIES:
  Net advances from (to) subsidiaries ......................         (9,713)          1,222           2,145
  Capital contributions to subsidiaries ....................             --         (26,158)             --
  Net sales of fixed income securities .....................             19            (210)         (5,051)
  Net purchases of equity securities .......................           (853)             --              --
  Changes in short-term investments ........................          5,900          29,323         (32,366)
  Other ....................................................            (62)            (54)            (24)
                                                                   --------        --------        --------
Net cash provided by (used in) investing activities ........         (4,709)          4,123         (35,296)
                                                                   --------        --------        --------
FINANCING ACTIVITIES:
  Proceeds from debt .......................................         71,000              --              --
  Principal payments on debt ...............................        (86,000)        (25,000)             --
  Dividends to stockholders ................................        (19,310)        (23,088)        (13,713)
  Purchase of treasury stock ...............................             --            (124)         (3,709)
  Issuance of treasury stock to employee stock purchase
     Plan ..................................................            122              --              --
  Employee stock option exercises ..........................          1,414             518             104
                                                                   --------        --------        --------
Net cash used in financing activities ......................        (32,774)        (47,694)        (17,318)
                                                                   --------        --------        --------
Decrease (increase) in cash ................................         (8,210)         10,473             528
Cash at beginning of period ................................         12,438           1,965           1,437
                                                                   --------        --------        --------
Cash at end of period ......................................       $  4,228        $ 12,438        $  1,965
                                                                   ========        ========        ========
</TABLE>

(b) See Note 2.


                                       66
<PAGE>
                                                                     SCHEDULE II

                    NOTES TO CONDENSED FINANCIAL INFORMATION

1. RESTRICTED CASH AND SHORT TERM INVESTMENTS

      As of December 31, 2002 and December 31, 2001, parent company short-term
investments and cash included $4.8 million and $13.8 million, respectively, of
restricted cash related to premium receipt collections ultimately due to the
Company's insurance subsidiaries.

2. BASIS OF PRESENTATION

      The condensed financial information of CNA Surety Corporation ("CNA
Surety" or "Company") should be read in conjunction with the Consolidated
Financial Statements and Notes hereto included in Part II, Item 8 of this Form
10-K/A. CNA Surety's subsidiaries are accounted for using the equity method of
accounting. Equity in net income of these affiliates is reported as equity in
net income of subsidiaries.

      The Company has revised its accounting for ceded premiums under a multiple
year excess of loss reinsurance treaty with its affiliate, Continental Casualty
Company, which has been in place since October 1, 2002 (this treaty is discussed
in greater detail in Note 7 (Reinsurance) to the Consolidated Financial
Statements). As a result, the Company has restated its previously reported
financial statements as of and for the year ended December 31, 2002. See Note 17
to the Consolidated Financial Statements included under Item 8.

      The preparation of Condensed Financial Statements in conformity with
accounting principles generally accepted in the United States of America
("GAAP") requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and the disclosure of contingent
assets and liabilities at the date of the financial statements and the reported
amounts of revenues and expenses during the reported period. Actual results may
differ from those estimates.


                                       67
<PAGE>
                                                                    SCHEDULE III

                     CNA SURETY CORPORATION AND SUBSIDIARIES

                       SUPPLEMENTARY INSURANCE INFORMATION
              CNA SURETY CORPORATION AS OF AND FOR THE YEARS ENDED
                        DECEMBER 31, 2002, 2001 AND 2000

<TABLE>
<CAPTION>
                                                                           YEARS ENDED DECEMBER 31,
                                                                  -----------------------------------------
                                                                       2002           2001           2000
                                                                  ---------------   --------       --------
                                                                  AS RESTATED (a)
                                                                             (AMOUNTS IN THOUSANDS)
<S>                                                               <C>               <C>            <C>
Deferred policy acquisition costs ............................       $ 96,386       $ 89,788       $ 91,403
                                                                     ========       ========       ========
Reserves for unpaid claims and claim adjustment expenses .....       $303,433       $315,811       $204,457
                                                                     ========       ========       ========
Unearned premiums ............................................       $216,213       $200,379       $202,179
                                                                     ========       ========       ========
Other policy claims and benefits payable .....................       $     --       $     --       $     --
                                                                     ========       ========       ========
Net premium revenue ..........................................       $298,319       $320,910       $301,819
                                                                     ========       ========       ========
Net investment income ........................................       $ 27,754       $ 29,515       $ 29,897
                                                                     ========       ========       ========
Benefits, claims, losses and settlement expenses .............       $ 94,198       $ 80,836       $ 55,683
                                                                     ========       ========       ========
Amortization of deferred policy acquisition costs ............       $138,991       $147,500       $133,635
                                                                     ========       ========       ========
Other operating expenses .....................................       $ 40,836       $ 55,377       $ 48,020
                                                                     ========       ========       ========
Net premiums written .........................................       $306,654       $315,804       $304,468
                                                                     ========       ========       ========
</TABLE>

(a) See Note 17 to the Consolidated Financial Statements.


                                       68
<PAGE>
                                                                     SCHEDULE IV

                     CNA SURETY CORPORATION AND SUBSIDIARIES

                                   REINSURANCE
 CNA SURETY CORPORATION FOR THE YEARS ENDED DECEMBER 31, 2002 (AS RESTATED (a)),
                                 2001 AND 2000

<TABLE>
<CAPTION>
                                                                                                            PERCENTAGE
                                                                  CEDED TO       ASSUMED                     OF AMOUNT
                                                     GROSS          OTHER       FROM OTHER        NET         ASSUMED
                                                     AMOUNT       COMPANIES     COMPANIES        AMOUNT       TO NET
                                                    --------      ---------     ----------      --------    ----------
                                                                           (AMOUNTS IN THOUSANDS)
<S>                                                 <C>           <C>           <C>             <C>         <C>
      YEAR ENDED DECEMBER 31, 2002
      Premiums written:
        Property and casualty insurance .....       $148,186       $53,238       $211,706       $306,654       69.0%
                                                    --------       -------       --------       --------       ----
           Total premiums written ...........       $148,186       $53,238       $211,706       $306,654       69.0%
                                                    ========       =======       ========       ========       ====
      Premiums earned:
        Property and casualty insurance .....       $137,957       $45,784       $206,146       $298,319       69.1%
                                                    --------       -------       --------       --------       ----
           Total premiums earned ............       $137,957       $45,784       $206,146       $298,319       69.1%
                                                    ========       =======       ========       ========       ====
      YEAR ENDED DECEMBER 31, 2001
      Premiums written:
        Property and casualty insurance .....       $127,494       $17,199       $205,509       $315,804       65.1%
                                                    --------       -------       --------       --------       ----
           Total premiums written ...........       $127,494       $17,199       $205,509       $315,804       65.1%
                                                    ========       =======       ========       ========       ====
      Premiums earned:
        Property and casualty insurance .....       $120,687       $13,983       $214,206       $320,910       66.8%
                                                    --------       -------       --------       --------       ----
           Total premiums earned ............       $120,687       $13,983       $214,206       $320,910       66.8%
                                                    ========       =======       ========       ========       ====
      YEAR ENDED DECEMBER 31, 2000
      Premiums written:
        Property and casualty insurance .....       $115,100       $12,199       $201,567       $304,468       66.2%
                                                    --------       -------       --------       --------       ----
           Total premiums written ...........       $115,100       $12,199       $201,567       $304,468       66.2%
                                                    ========       =======       ========       ========       ====
      Premiums earned:
        Property and casualty insurance .....       $109,472       $14,831       $207,178       $301,819       68.6%
                                                    --------       -------       --------       --------       ----
           Total premiums earned ............       $109,472       $14,831       $207,178       $301,819       68.6%
                                                    ========       =======       ========       ========       ====
</TABLE>

      (a) See Note 17 to the Consolidated Financial Statements.


                                       69
<PAGE>
                                                                      SCHEDULE V

                     CNA SURETY CORPORATION AND SUBSIDIARIES

                        VALUATION AND QUALIFYING ACCOUNTS
        CNA SURETY CORPORATION AS OF AND FOR THE YEARS ENDED DECEMBER 31,
                              2002, 2001 AND 2000

<TABLE>
<CAPTION>
                                                                            ADDITIONS
                                                                     -----------------------
                                                        BALANCE AT   CHARGED TO   CHARGED TO                    BALANCE
                                                       BEGINNING OF  COSTS AND      OTHER                       AT END OF
                                                          PERIOD      EXPENSES     ACCOUNTS     DEDUCTIONS(1)    PERIOD
                                                       ------------  ---------    ----------    -------------   ---------
<S>                                                    <C>           <C>          <C>           <C>             <C>
                                                                             (AMOUNTS IN THOUSANDS)
            YEAR ENDED DECEMBER 31, 2002
              Allowance for possible losses on
                 premiums receivable ..............       $2,614       $(363)      $    --         $  (886)      $1,365
                                                          ======       =====       =======         =======       ======
              Allowance for possible losses on
                 reinsurance receivable ...........       $   --       $  --       $    --         $    --       $   --
                                                          ======       =====       =======         =======       ======
            YEAR ENDED DECEMBER 31, 2001
              Allowance for possible losses on
                 premiums receivable ..............       $2,650       $ 866       $    --         $  (902)      $2,614
                                                          ======       =====       =======         =======       ======
              Allowance for possible losses on
                 reinsurance receivable ...........       $   --       $  --       $    --         $    --       $   --
                                                          ======       =====       =======         =======       ======
            YEAR ENDED DECEMBER 31, 2000
              Allowance for possible losses on
                 premiums receivable ..............       $2,826       $ 837       $    --         $(1,013)      $2,650
                                                          ======       =====       =======         =======       ======
              Allowance for possible losses on
                 reinsurance receivable ...........       $   --       $  --       $    --         $    --       $   --
                                                          ======       =====       =======         =======       ======
</TABLE>

----------

(1) Accounts charged against allowance.


                                       70
<PAGE>
                                                                     SCHEDULE VI

                     CNA SURETY CORPORATION AND SUBSIDIARIES

              SUPPLEMENTAL INFORMATION CONCERNING PROPERTY-CASUALTY
                              INSURANCE OPERATIONS
        CNA SURETY CORPORATION AS OF AND FOR THE YEARS ENDED DECEMBER 31,
                              2002, 2001 AND 2000

<TABLE>
<CAPTION>
                                                                          YEARS ENDED DECEMBER 31,
                                                                 ------------------------------------------
                                                                       2002           2001           2000
                                                                 ---------------    --------       --------
                                                                 AS RESTATED (a)
                                                                             (AMOUNTS IN THOUSANDS)
<S>                                                              <C>                <C>            <C>
Deferred policy acquisition costs ............................       $ 96,386       $ 89,788       $ 91,403
                                                                     ========       ========       ========
Reserves for unpaid claims and claim adjustment expenses .....       $303,433       $315,811       $204,457
                                                                     ========       ========       ========
Discount (if any) deducted ...................................       $     --       $     --       $     --
                                                                     ========       ========       ========
Unearned premiums ............................................       $216,213       $200,379       $202,179
                                                                     ========       ========       ========
Net premium revenue ..........................................       $298,319       $320,910       $301,819
                                                                     ========       ========       ========
Net investment income ........................................       $ 27,754       $ 29,515       $ 29,897
                                                                     ========       ========       ========
Net claims and claim expenses incurred related to:
     Current year ............................................       $ 88,018       $ 76,025       $ 62,776
                                                                     ========       ========       ========
     Prior years .............................................       $  6,180       $  4,812       $ (7,093)
                                                                     ========       ========       ========
Amortization of deferred policy acquisition costs ............       $138,991       $147,500       $133,635
                                                                     ========       ========       ========
Net paid claims and claim adjustment expenses ................       $ 77,559       $ 65,642       $ 58,854
                                                                     ========       ========       ========
Net premiums written .........................................       $306,654       $315,804       $304,468
                                                                     ========       ========       ========
</TABLE>

(a) See Note 17 to the Consolidated Financial Statements.


                                       71
<PAGE>
(A)(3) EXHIBITS

<TABLE>
<CAPTION>
            EXHIBIT
            NUMBER                          DESCRIPTION
            -------     -----------------------------------------------------
<S>                     <C>
              11        Earnings Per Share Computation.

              23        Consent of Deloitte & Touche LLP dated March 12, 2004.

              31(1)     Certification pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934,
                        as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002-Chief Executive Officer.

              31(2)     Certification pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934,
                        as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002-Chief Financial Officer.

              32(1)     Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
                        Sarbanes-Oxley Act of 2002-Chief Executive Officer.

              32(2)     Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
                        Sarbanes-Oxley Act of 2002-Chief Financial Officer.

                (b)     Reports on Form 8-K.

                        None



</TABLE>


                                       72
<PAGE>
                                   SIGNATURES

      Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the Registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized.

CNA SURETY CORPORATION


                                /s/ JOHN F. WELCH
           -----------------------------------------------------------
                                  John F. Welch
                      President and Chief Executive Officer
                          (Principal Executive Officer)


                              /s/ JOHN F. CORCORAN
           -----------------------------------------------------------
                                John F. Corcoran
                Senior Vice President and Chief Financial Officer
                  (Principal Financial and Accounting Officer)

Dated: March 12, 2004

      Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, this report has been signed below by the following persons on behalf of
the Registrant and in the capacities and on the dates indicated.

<TABLE>
<CAPTION>
DATE                               TITLE                             SIGNATURE
----                               -----                       ---------------------
<S>                        <C>                                 <C>
March 12, 2004             Chairman of the Board                /s/ JAMES R. LEWIS
                                and Director                    ------------------
                                                                  James R. Lewis


March 12, 2004                    Director                      /s/ PHILIP H. BRITT
                                                                -------------------
                                                                  Philip H. Britt


March 12, 2004                    Director                        /s/ KEN MILLER
                                                                  --------------
                                                                    Ken Miller


March 12, 2004                    Director                     /s/ THOMAS PONTARELLI
                                                               ---------------------
                                                                 Thomas Pontarelli


March 12, 2004                    Director                       /s/ ROY E. POSNER
                                                                 -----------------
                                                                   Roy E. Posner


March 12, 2004                    Director                     /s/ ADRIAN M. TOCKLIN
                                                               ---------------------
                                                                 Adrian M. Tocklin


March 12, 2004                    Director                       /s/ JOHN F. WELCH
                                                                 -----------------
                                                                   John F. Welch
</TABLE>


                                       73