<PAGE>   1
                                              1998 ANNUAL REPORT------CNA SURETY




                                                                 THE PERFECT FIT

<PAGE>   2


Everyday, people customize the simplest things--coffee, a sandwich, a pair of
pants--in order to achieve the perfect fit. Everyone is different, with a
distinct set of needs and preferences. CNA Surety understands this and has built
itself to be responsive, flexible and focused on satisfying the unique
requirements of each one of its customers. We can provide custom-tailored surety
solutions to virtually all segments of the market, regardless of size or
circumstance. This explains our continued success and validates our potential
for growth. It's why we tell our customers, Challenge us.(SM)


<PAGE>   3

LETTER TO SHAREHOLDERS

Dear Fellow Shareholder On October 1, 1998, we celebrated our first full year as
CNA Surety Corporation, created by the combination of the surety operations of
CNA, Western Surety Company and Universal Surety of America. When we first
brought these three entities together, we knew that building one cohesive
organization would provide us with the flexibility and the resources to respond
to the needs of the changing surety marketplace, giving CNA Surety a leadership
position in the industry.
      We are proud to report that we have successfully integrated CNA Surety
into one unified organization, offering the surety marketplace a full array of
products and services. We would like to share some of the specific actions we
have taken throughout 1998 that will continue to support our strong market
leadership position:

-  In 1998, we began leveraging our broad product line and distribution system
   to meet the full scope of needs of the surety marketplace -- a statement very
   few companies can make. Throughout the year, our entire field sales force
   committed themselves to offering our expanded set of products and services by
   taking advantage of cross-marketing opportunities throughout the
   organization. While the positive results this initiative generated will help
   us sustain new premium growth throughout 1999, we feel we have only just
   begun to realize the full potential of CNA Surety's cross-marketing
   opportunities.

-  We have always spoken of our international expansion strategy as a long-term
   focus, and we made significant strides in the international marketplace in
   1998. Not only have we continued to build on our international relationships
   to service our domestic business on a global basis, we also established a
   number of new international accounts that we expect will generate an
   additional $2 to $3 million in premiums in 1999.

-  While the primary reason for the integration of the three CNA Surety
   businesses was strategic in nature, we realized a number of operational
   efficiencies by consolidating certain functions. For example, an area of
   significant opportunity for cost savings was premium processing, including
   the billing and collection functions. All of our operations are now up and
   running on the same processing system and our agents are receiving combined
   billing statements that reflect bonds written by Western Surety, Universal
   Surety, or any of the CNA-affiliated companies.


<PAGE>   4


-  All of these actions contributed to our impressive financial results for our
   first full year of operation. Net income and operating earnings per share
   were $1.04 and $1.03, respectively. Our combined ratio was 76.1 percent for
   the year. Net written premiums increased five percent in 1998 to $270.6
   million, as compared to pro forma 1997, driven by a six percent increase in
   our core domestic net written premiums. In addition, we paid our first
   quarterly dividend of eight cents per share in December 1998.

-  As the new millennium approaches, we are fully aware of our responsibility to
   review all of our systems to minimize any disruption to our business. In
   1998, we proactively focused on year 2000 remediation, fully testing each of
   our core systems and internally certifying them as year 2000 ready. The
   Competitive Advantage With these initiatives behind us, we are focused on
   taking our businesses to even higher levels of excellence. Even though the
   surety marketplace is still experiencing highly competitive conditions, we
   feel CNA Surety is in a strong position to take advantage of the many
   opportunities this competitive marketplace has to offer.

     As the largest publicly traded surety company, we estimate that CNA Surety
controls approximately nine percent of the surety marketplace based on direct
written premiums. Our superior underwriting performance has resulted in
historical combined ratios well below industry averages.

     In addition to broadening our product portfolio, the exciting opportunities
that we are seeing as a result of the CNA Surety integration have further
unified our organization. In an environment where many surety organizations have
been faced with changes in leadership, the consistency, stability and expertise
of our senior management team sends another powerful message about our company
into the marketplace.

     As CNA Surety, we pride ourselves on having the flexibility to respond to
the needs of the changing surety marketplace and ask our customers to "Challenge
us." We see it as an opportunity to take full advantage of what that flexibility
has to offer and maintain our strong market leadership position in the future.
And it's our commitment to provide the continued value that you, our
shareholders, have come to expect of us. we're ready for the challenge.

  Sincerely,





  R.T. Van Gieson                          Mark C. Vonnahme
  Chairman of the Board of Directors       President and Chief Executive Officer


<PAGE>   5



FINANCIAL HIGHLIGHTS
<TABLE>
<CAPTION>


                                                                                  September 30
                                                                                      (Date of
                                                                                    Inception)    Pro Forma
                                                                      Year ended       through   Year ended
                                                                     December 31   December 31  December 31
In millions, except per share data                                          1998         1997         1997
-------------------------------------------------------------------------------------------------------------------
<S>                                                                       <C>          <C>          <C>     
Net written premium                                                       $  270.6     $   74.0     $  257.1
Underwriting income**                                                         61.8         15.1         87.1
Net investment income*                                                        24.3          5.8         14.5
Pretax income                                                                 73.8         17.7         77.3
Net income*                                                                   45.5         11.0         34.4
Net income per share*                                                         1.04         0.25         0.79
Net operating income per share*                                               1.03         0.25         1.29
</TABLE>
 * Net investment income for the year ended December 31, 1997, excludes
   estimated pro forma investment income on merger-related cash flows of $11.3
   million, $7.3 million net of tax, or $0.17 in pro forma net income and
   operating income per share.

** Includes the effect of recording favorable revisions of prior year reserves
   which were $4.4 million, $0.6 million and $40.9 million ($35.0 million
   related to the former surety business of CNA Financial) for the periods
   presented, respectively.


BALANCE SHEETS
<TABLE>
<CAPTION>

In millions, except per share data                     December 31          1998         1997
-------------------------------------------------------------------------------------------------------------------
<S>                                                                       <C>          <C>     
Invested assets and cash                                                  $  505.4     $  419.7
Intangible assets                                                            156.1        162.0
Total assets                                                                 819.4        725.1
Insurance reserves                                                           333.7        302.2
Long-term debt                                                               113.0        118.0
Total liabilities                                                            509.5        468.4
Stockholders' equity                                                         309.9        256.7
Book value per share                                                          7.03         5.93
Debt to total capitalization                                                    27%          31%
</TABLE>

                                             

CNA Surety Corporation is the largest publicly traded surety company in the U.S.
Through its principal subsidiaries, Western Surety Company and Universal Surety
of America, the Company provides surety and fidelity bonds in all 50 states
through a combined network of approximately 37,000 independent agencies.

<TABLE>


<S>      <C>                    <C>               <C>                      <C>                     <C>
         2                      4                 12                       50                      50
LETTER TO SHAREHOLDERS   COMPANY PROFILE    FINANCIAL REVIEW    DIRECTORS AND OFFICERS     CORPORATE INFORMATION

</TABLE>


<PAGE>   6

Few things in life need to be delivered as quickly and on target as your first
cup of coffee in the morning. This is not the place for waiting ... or
compromise. Ultimately, what's behind the perfect cup is a clear understanding
of needs combined with impassioned responsiveness. It's not just getting what 
you want it's getting it when you want it.

Flexibility and responsiveness are key; they drive everything we do at CNA
Surety. The flexibility that we have as CNA Surety provides us with a "can do"
approach to quickly respond to the changing needs of our customers. From our
experienced senior management team to our dedicated field sales force, we keep
our customers in mind as we work with the resources available throughout our
organization to provide the right solutions for their surety requirements.
      For example, when an agent who does business with Western Surety quickly
needed a bond for a small contractor in Baltimore, he was referred to Universal
Surety. The Universal Surety representative realized the short time frame
necessitated local contact and got the CNA Surety branch office involved to
personally call on the agent the next day. Our quick response resulted in this
new account in addition to other new business with the same agent.
      A referral from another CNA Surety branch office and a custom-tailored
proposal by a Western Surety underwriter resulted in an ongoing relationship to
provide bonds for members of a New Hampshire trade association. By year end, a
total of 340 bonds were written and additional business was generated as the
agent referred CNA Surety to other offices within his agency network.
      Utilizing our unparalleled distribution network of 37,000 agencies,
capitalizing on the experience of our surety professionals, and further building
upon our strong customer, agent and broker relationships, we have generated
significant new account activity.
      At CNA Surety, we are experts at efficiently delivering what the surety
marketplace needs.

                                                                               5

<PAGE>   7

                ["THE PERFECT CUP" GRAPHIC - PHOTO OF COFFEE CUP]

<PAGE>   8



The key to comfort in today's marketplace is selection. If you're shopping for
that perfect pair of jeans, S, M and L will simply not cut it. People come in
all shapes and sizes, and everybody benefits from having options. It is by
offering customers a range of choices that you improve your chances of becoming
their choice.

As CNA Surety, agents and brokers can come to us for all of their customers'
surety needs. We offer an unmatched array of surety products and services --
from small notary bonds for individuals to multi-million dollar contract bond
programs guaranteeing the performance of construction ?rms. No matter how large
or small or what types of bonds are required, we can tailor surety programs to
fit the full range of needs of the marketplace.
      As the needs of our customers change, we are there to continue serving
them. CNA Surety has the resources to grow with them and keep the business
within the CNA Surety organization that previously may have been referred
elsewhere.
      For example, when a client needed a bond which exceeded Universal Surety's
historical underwriting capacity, the Universal Surety office referred the
account to the local CNA Surety branch office. And when a long-term Western
Surety client required a bond larger than Western Surety's previous capacity,
the local surety branch office was able to furnish the client with the
appropriate bond support. Our seamless approach efficiently provided what was
needed and kept the business within CNA Surety.
      By providing a full range of surety choices, CNA Surety is able to retain
more business in addition to generating new accounts. Both are key elements in
achieving our targeted annual premium growth rate of six to nine percent.


                                                                               7


<PAGE>   9


              ["THE PERFECT PAIR" GRAPHIC -- PHOTO OF BLUE JEANS]
<PAGE>   10



The perfect PB&J can be the best thing since sliced bread. But the stickler in
making one lies in having the right ingredients and tools. Stale bread or the
lack of a knife could turn this simple process into a challenge. Never
underestimate the importance of having the proper resources and the expertise in
applying them.

At CNA Surety, we are committed to providing the right tools to the surety
marketplace to help our customers operate more efficiently. For example, in
1998, we began providing a centralized service to national brokers and other
major producers. Our Sioux Falls service center includes a unique infrastructure
and information base for our small commercial surety and fidelity products, as
well as an experienced, well-trained staff which can provide world-class
telephone, underwriting, and processing service. The service center can
centralize handling of bonds needed by organizations with national operations
and complements the marketing efforts of our entire field organization.
      We also expanded the use of bONdLINE,SM an automated commercial surety
bond processing and reporting system. The system includes an extensive forms
library, simplified single-screen data entry and high quality forms output.
Technology will continue to be a major area of focus to help us generate even
more efficient surety-related products.
      Developing and providing the right tools and resources to the surety
marketplace demonstrates our commitment to meet its challenges.



                                                                               9

<PAGE>   11


               ["THE PERFECT COMBO" GRAPHIC - PHOTO OF SANDWICH]

<PAGE>   12



It takes more than momentum to be at the top of your game. It is only by
combining skill, diligence and a determined, competitive spirit that you have a
shot at the winner's spot. Uncompromised standards, aggressive pro-activity and
outstanding, sustainable performance spells leadership in any league.

We started something big back in 1997 when we became CNA Surety. We knew it at
the time, but we just started rolling. As we continued throughout 1998, we felt
the momentum building, picking up power and speed throughout the year as we
integrated all of our resources into one cohesive entity. Individually, our
three organizations were dominant forces in their own segments; together, we are
at the top of our game, a market leader in an extremely competitive industry.
      We have evolved as a full-service surety organization this past year with
outstanding results. As we look to the future, our focus continues to be on
operational execution -- taking full advantage of the resources we have as CNA
Surety and the capacity, stability and consistency our customers recognize us
for in the marketplace.
      Leadership does not just happen. It requires a commitment to do whatever
it takes to stay on top. This commitment is supported by our long-term growth
strategies, which include: leveraging our broad product line; expanding
internationally; identifying and providing new products/markets; and pursuing
strategic acquisitions that will enhance our existing operations. Pursuing these
strategies will allow us to continue meeting the demands of the surety
marketplace and further enhance our leadership position.
      At CNA Surety, we have the winning game plan in place to remain a market
leader and continue building shareholder value.


                                                                              11
<PAGE>   13


              ["THE PERFECT GAME" GRAPHIC - PHOTO OF BOWLING BALL]








<PAGE>   14


                     MANAGEMENTS DISCUSSION AND ANALYSIS    13
                     
                     FINANCIAL STATEMENTS                   29
                     
                     NOTES TO FINANCIAL STATEMENTS          33
FINANCIAL REVIEW                     
                     REPORT OF INDEPENDENT AUDITORS         50
                     
                     DIRECTORS AND OFFICERS                 50
                     
                     CORPORATE INFORMATION                  50 

<PAGE>   15


                     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 insurance subsidiaries' operating results,
liquidity and capital resources and financial condition. This discussion should
be read in conjunction with the Consolidated Financial Statements of CNA Surety
and notes thereto.

FORMATION OF CNA SURETY 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 a newly-formed holding company, CNA
Surety Corporation. CNAF, through its operating subsidiaries, writes multiple
lines of property and casualty insurance, including surety business that is
reinsured by Western Surety. CNAF owns approximately 61% of the outstanding
common stock of CNA Surety. Loews Corporation owns approximately 85% of the
outstanding common stock of CNAF. The principal operating subsidiaries of CNAF
that wrote the surety line of business for their own account prior to the Merger
were Continental Casualty Company and its property and casualty affiliates
(collectively, "CCC") and The Continental Insurance Company and its property and
casualty affiliates (collectively, "CIC"). CIC was acquired by CNAF on May 10,
1995. The combined surety operations of CCC and CIC are referred to herein as
CCC Surety Operations ("Predecessor").
      Pursuant to a reorganization agreement, CCC Surety Operations and Capsure
merged their respective operations at the close of business on September 30,
1997 ("Merger Date"). CNAF, through its property and casualty subsidiaries, CCC
and CIC, contributed $52.25 million of capital to CNA Surety. Through
reinsurance agreements, CCC and CIC ceded to Western Surety all of their net
unearned premiums and loss and loss adjustment expense reserves, as of the
Merger Date, and will cede to Western Surety all surety business written or
renewed by CCC and CIC for a period of five years thereafter. Further, CCC and
CIC have agreed to assume the obligation for any adverse development on recorded
reserves for CCC Surety Operations as of the Merger Date, to limit the loss
ratio on certain defined business written by CNA Surety through December 31,
2000 and to provide certain additional excess of loss reinsurance. CCC also
agreed to provide certain administrative services at specified rates, subject to
inflationary increases, for three years after the Merger, if CNA Surety chooses
to purchase such services.

BUSINESS
CNA Surety's insurance subsidiaries write surety and fidelity bonds in all 50
states through a combined network of approximately 37,000 independent agencies.
CNA Surety's principal insurance subsidiaries are Western Surety and usa.
Western Surety writes, on a direct basis or as business assumed from CCC and
CIC, small fidelity and non-contract surety bonds, referred to as commercial
bonds; small, medium and large contract bonds; international surety and credit
insurance; and errors and omissions ("E&O") liability insurance, as a licensed
insurer in all 50 states and the District of Columbia. Western Surety's
affiliated company, Surety Bonding Company of America ("sbca"), writes
principally small commercial surety business and is licensed in 23 states. usa
specializes in the underwriting of small contract and commercial surety bonds.
usa is licensed in 43 states and the District of Columbia with most of its
business generated in Texas.
      The Company's corporate objective is to be the leading provider of surety
and surety-related products in the United States and in selected international
markets and to be the surety of choice for customers and independent agents and
brokers.
      Western Surety and usa are currently rated a+ (Superior) and a
(Excellent), respectively, by a.m. Best Company, Inc. ("a.m. Best"). Through
intercompany reinsurance and related agreements, CNA Surety's customers will
continue to have access to CCC's broader underwriting capacity. CCC is currently
rated a by a.m. Best.

RESULTS OF OPERATIONS
CNA Surety Actual Results for the Year Ended December 31, 1998 compared to Pro
forma Results for the Years Ended December 31, 1997 and December 31, 1996
      As set forth in Note 1 to the Consolidated Financial Statements, the
results of operations of the Predecessor do not reflect investment income and
investment gains and losses. Additionally, certain general and administrative
expenses, which were indirect or overhead in nature, were not allocated to the
Predecessor by CNAF or its




                                                                              13
<PAGE>   16

Management's Discussion and Analysis of Financial Condition
and Results of Operations Cont.

subsidiaries. As a result of these factors and because the merger with Capsure
significantly affected the combined organization, it is not useful to compare
CNA Surety operations to Predecessor operations.
      Accordingly, the remainder of this discussion and analysis is formatted to
compare information for CNA Surety to various time periods in 1997 and 1996 as
if the merger had been consummated at the beginning of each respective period.
Periods presented on this basis are therefore marked "pro forma." This pro forma
financial information gives effect to the following: (i) adjustment to the
Capsure statement of operations for the year ended December 31, 1996, as
reported, to reflect the income effects as if the $10 per share special
distribution was made on January 1, 1996; (ii) consummation of the Merger and
the related transactions and the contribution of capital to and the incurrence
of additional debt by CNA Surety; (iii) purchase accounting adjustments to
reflect Capsure's assets and liabilities at fair value; (iv) estimated indirect
and overhead expenses for the CCC Surety Operations; and (v) estimated interest
expense related to the additional debt. The pro forma financial information does
not include the estimated net investment income resulting from investment of
merger-related cash flows, including (i) the $50 million debt proceeds, (ii) the
$52.25 million capital contribution from CCC, and (iii) collection of the
receivable from CCC.
      The components of income for the Company for the years ended December 31,
1998, 1997 and 1996 are summarized as follows:

<TABLE>
<CAPTION>

                                                                                    Pro Forma    Pro Forma
In thousands                                                                1998         1997         1996        
------------------------------------------------------------------------------------------------------------

<S>                                                                     <C>          <C>          <C>     
Total revenues                                                          $283,840     $258,682     $250,194
------------------------------------------------------------------      ---------    --------     ---------

Underwriting income                                                     $ 61,773     $ 87,146     $ 46,682
Net investment income                                                     24,259       14,534       10,796
Net realized investment gains                                                844          723        1,068
Interest expense                                                           7,218        7,232        7,660
Non-recurring charges and merger costs                                        --       12,087        8,565
Amortization of intangible assets                                          5,900        5,788        5,788
------------------------------------------------------------------      ---------    --------     ---------

Income before income taxes                                                73,758       77,296       36,533
Income taxes                                                              28,243       42,921       14,101
------------------------------------------------------------------      ---------    --------     ---------

Net income                                                              $ 45,515     $ 34,375     $ 22,432
------------------------------------------------------------------      ---------    --------     ---------

Net income per share                                                    $   1.04     $   0.79     $   0.52
------------------------------------------------------------------      ---------    --------     ---------
</TABLE>



Insurance Underwriting
Underwriting results for the Company for the years ended December 31, 1998, 1997
and 1996 are summarized in the following table:

<TABLE>
<CAPTION>

                                                                                    Pro Forma    Pro Forma
In thousands                                                                1998         1997         1996         
-----------------------------------------------------------------------------------------------------------

<S>                                                                     <C>          <C>          <C>     
Gross written premiums                                                  $278,224     $266,418     $251,414
------------------------------------------------------------------      --------     --------     --------

Net written premium                                                     $270,602     $257,067     $235,186
------------------------------------------------------------------      --------     --------     --------

Net earned premium                                                      $258,737     $243,425     $238,330
Net losses and loss adjustment expenses                                   44,998        5,648       41,450
Net commissions, brokerage and other                                     151,966      150,631      150,198
------------------------------------------------------------------      --------     --------     --------

Underwriting income                                                     $ 61,773     $ 87,146     $ 46,682
------------------------------------------------------------------      --------     --------     --------

Loss ratio                                                                  17.4%         2.3%        17.4%
Expense ratio                                                               58.7         61.9         63.0
------------------------------------------------------------------      --------     --------     --------

Combined ratio                                                              76.1%        64.2%        80.4%
------------------------------------------------------------------      --------     --------     --------
</TABLE>



Premiums Written
CNA Surety primarily markets contract and commercial surety bonds. Contract
bonds guarantee obligations covered by a written agreement between two parties.
The most common types include bid, performance and payment bonds. The commercial
surety market includes numerous types of bonds categorized as court judicial,
court


14
<PAGE>   17

                                       CNA Surety Corporation 1998 Annual Report


fiduciary, public official, license and permit and many miscellaneous
bonds that include guarantees of financial performance. The Company also writes
fidelity bonds which cover losses arising from employee dishonesty and E&O
liability insurance.
      Gross written premiums for the years ended December 31, 1998, 1997 and
1996 are shown in the table below:

<TABLE>
<CAPTION>

                                                                                    Pro Forma    Pro Forma
In thousands                                                                1998         1997         1996                 
---------------------------------------------------------------------------------------------------------------------------

<S>                                                                     <C>          <C>          <C>     
Contract                                                                $132,242     $123,014     $124,477
Commercial                                                               121,046      119,662      104,412
Fidelity                                                                  17,113       16,760       16,123
E&O and other                                                              7,823        6,982        6,402
------------------------------------------------------------------      --------     --------     --------

                                                                        $278,224     $266,418     $251,414
------------------------------------------------------------------      --------     --------     --------
</TABLE>



Gross written premiums increased 4.4%, or $11.8 million, for the year ended
December 31, 1998 over the comparable period in 1997. Contract surety accounted
for most of this increase with growth of 7.5%, or $9.2 million, in gross written
premiums as compared to 1997. This increase reflects volume growth from new
account activity and generally favorable economic conditions for public
construction nationwide. The highway/bridge sector has shown particular strength
in new account and bid activity since the United States Congressional passage of
the Transportation Equity Act for the 21st Century ("TEA-21"). TEA-21 authorizes
a 40% increase in total Federal funding for highway and transit systems to over
$200 billion in the six-year period from 1998 to 2004. Commercial surety
increased 1.2%, or $1.4 million, for the year ended December 31, 1998 reflecting
increased competition in this segment, particularly on Fortune 1000 and large
accounts. CNA Surety assumed $10.0 million and $10.1 million of international
surety and credit business in 1998 and 1997, respectively, through a quota share
reinsurance treaty with an affiliate of CCC, CNA Reinsurance Company Limited
(London) ("CNA Re"). Commercial surety, exclusive of international surety and
credit business, increased 1.4% in 1998. The fidelity, E&O and other book of
business, primarily written by Western Surety, increased 5.0%, or $1.2 million,
to $24.9 million for the year ended December 31, 1998.
      Gross written premiums increased 6.0%, or $15.0 million, for the year
ended December 31, 1997 over the comparable pro forma period in 1996. This
increase was primarily attributable to a 14.6%, or $15.3 million, increase in
commercial surety. In 1997, the Company entered into the aforementioned
international credit and surety reinsurance treaty with CNA Re which added $10.1
million in gross written premium in 1997. Commercial surety, exclusive of
international surety and credit business, increased 4.9% in 1997. The fidelity,
E&O and other book of business increased 5.4%, or $1.2 million, to $23.7 million
in 1997, primarily due to continued national expansion of the Company's
insurance agents' E&O product. These increases in commercial surety and
fidelity, E&O and other business were offset by a 1.2%, or $1.5 million,
decrease in contract surety.
      Net written premiums for the years ended December 31, 1998, 1997 and 1996
are shown in the table below:

<TABLE>
<CAPTION>

                                                                                    Pro Forma    Pro Forma
In thousands                                                                1998         1997         1996         
------------------------------------------------------------------      --------     --------     --------

<S>                                                                     <C>          <C>          <C>     
Contract                                                                $127,114     $118,138     $118,268
Commercial                                                               120,638      117,162       96,421
Fidelity                                                                  17,096       16,748       16,076
E&O and other                                                              5,754        5,019        4,421
------------------------------------------------------------------      --------     --------     --------

                                                                        $270,602     $257,067     $235,186
==================================================================      ========     ========     ========  
</TABLE>


For the year ended December 31, 1998, net written premiums increased 5.3%, or
$13.5 million, over the comparable period in 1997 consistent with the changes in
gross written premiums described above. Net written premiums increased 7.6%, or
$9.0 million, for the contract surety business. Commercial surety net written
premiums increased 3.0%, or $3.5 million, in 1998 with domestic commercial
surety up 3.4%, reflecting a full year of increased net retentions in 1998.
Effective September 30, 1997, the Company renegotiated its reinsurance
agreements with its reinsurers, increasing the Company's net retention to $5
million per bonded principal on its commercial surety business. The fidelity,
E&O and other book of business increased 5.0%, or $1.1 million, in 1998.




                                                                              15
<PAGE>   18

Management's Discussion and Analysis of Financial Condition
and Results of Operations Cont.


      For the year ended December 31, 1997, net written premiums increased 9.3%,
or $21.9 million, over the comparable period in 1996. Net written premiums were
up primarily due to a 21.5% increase in commercial surety business for the full
year of 1997. The increase in commercial net written premiums includes the
addition of the aforementioned international surety and credit business as well
as relatively strong growth in Western Surety's core small commercial surety
business throughout 1997. Commercial net written premiums, exclusive of the
international business, increased 11.0% for the year ended December 31, 1997. In
the fourth quarter of 1997, the Company received $3.8 million in previously
ceded reinsurance premium from its reinsurers with respect to the aforementioned
changes in its commercial surety reinsurance program. Absent this returned
premium, domestic commercial surety net written premiums were up 9.0%, in 1997.
The rise in commercial net written premiums was offset by a decrease in contract
surety net written premiums as a result of the competitive market conditions
that existed in the contract surety market. Net written premiums for contract
surety were down slightly for the year ended December 31, 1997. The fidelity,
E&O and other book of business increased 6.2%, or $1.3 million, in 1997
reflecting increased net retention of agents' E&O product.

Underwriting Income
Underwriting income decreased 29.1% to $61.8 million for the year ended December
31, 1998 compared to pro forma 1997. Underwriting income for 1997 increased
86.7% over pro forma 1996. The period to period changes in underwriting income
were due to fluctuations in both the loss and expense ratios as more fully
described below.

Loss Ratio
The loss ratios for the years ended December 31, 1998, 1997 and 1996 were 17.4%,
2.3% and 17.4%, respectively. The loss ratios included $4.4 million, $40.9
million and $16.6 million in favorable reserve development for the years ended
December 31, 1998, 1997 and 1996, respectively. Excluding the impact of the
favorable reserve development, the loss ratios would have been 19.1% for both
1998 and 1997, and 24.4% for the year ended December 31, 1996. Approximately
$35.0 million in favorable reserve development in 1997 relates to the
Predecessor as more fully described in Note 8 to the Consolidated Financial
Statements. The decrease in the adjusted loss ratio since 1996 is due to the
ongoing favorable economic trends that continue to benefit the surety business
in addition to consistent underwriting practices applied since the acquisition
of CIC by CNAF in May of 1995.

Expense Ratio
The expense ratio decreased to 58.7% for the year ended December 31, 1998
compared to 61.9% and 63.0% for pro forma 1997 and 1996, respectively. The 1998
decline is primarily due to the increased scale of the Company as net earned
premiums increased 6% and operating expenses increased a modest 1%. In addition,
the Company consolidated certain administrative and back-office processing
functions in 1998. The most significant of these consolidation activities was
the fourth quarter 1998 migration to a common premium processing platform,
including billing and collection functions. These consolidation activities are
expected to result in total future annual expense savings of $1.5 million, with
roughly one-half of that amount reflected in 1998 results. Together with another
$1.7 million in savings resulting from immediate post-merger corporate level
restructuring, this equates to approximately 1.2 percentage points on our
expense ratio at current premium levels.

Investment Income
For the year ended December 31, 1998, net investment income was $24.3 million
compared to pro forma net investment income for the years ended December 31,
1997 and 1996 of $14.5 million and $10.8 million, respectively. Increases in
investment income for the years ended December 31, 1998 and 1997 are primarily
the result of higher actual invested cash balances which reflects increases from
underwriting cash flows and the investment of merger-related cash flows in the
fourth quarter of 1997. However, pro forma investment income for periods prior
to the Merger does not include the pro forma effects of estimated net investment
income resulting from investment of merger-related cash flows as described
below. The average pretax yield was 5.4% for the year ended December 31, 1998.
      The above unaudited pro forma financial information does not include the
estimated net investment income resulting from investment of merger-related cash
flows, including (i) the $50 million debt proceeds, (ii) the


16
<PAGE>   19


                                       CNA Surety Corporation 1998 Annual Report


$52.25 million capital contribution from CCC, and (iii) collection of the
receivable from CCC. Investment earnings are an integral part of an insurance
entity's operations. If proceeds from these sources of funds were assumed to
have been invested in high-quality, taxable fixed income securities with an
average duration of approximately 3 years, yielding 6.4%, net investment income
would increase approximately $11.3 million ($7.3 million net of tax, or $0.17 in
pro forma earnings per share) for the year ended December 31, 1997 and
approximately $14.2 million ($9.2 million net of tax, or $0.21 in pro forma
earnings per share) for the year ended December 31, 1996.

      Net realized investment gains were $0.8 million for the year ended
December 31, 1998 compared to pro forma net realized investment gains of $0.7
million and $1.1 million for the years ended December 31, 1997 and 1996,
respectively.

Analysis of Other Operations
Amortization expense was $5.9 million for the year ended December 31, 1998
compared to $5.8 million for the years ended December 31, 1997 and 1996.
Intangible assets represent goodwill and identified intangibles arising from the
acquisition of Capsure and goodwill arising from the May 1995 acquisition of CIC
by CNAF that was allocated to the surety business of CIC. Intangible assets are
generally amortized over 30 years.
      Interest expense for the year ended December 31, 1998, remained relatively
unchanged from 1997 and decreased 5.8% from 1996. Average debt outstanding was
$117.6 million in 1998 compared to $119.2 million and $124.7 million in 1997 and
1996, respectively. The weighted average interest rate for the year ended
December 31, 1998 was 5.6% compared to 5.8% and 5.7% for pro forma periods ended
December 31, 1997 and 1996, respectively.
      Capsure incurred $22.0 million, after applicable income taxes, or $0.51
per share, in non-recurring merger costs in 1997 compared to $5.7 million, after
applicable income taxes, or $0.13 per share in non-recurring charges and merger
costs in 1996. In the fourth quarter of 1996, Capsure incurred $1.1 million,
after applicable income taxes, or $0.03 per share, in non-recurring merger
costs.

Income Taxes
Income tax expense was $28.2 million, $42.9 million and $14.1 million and the
effective income tax rates were 38.3%, 55.5% and 38.6% for the years ended
December 31, 1998, 1997 and 1996, respectively. The effective rate for the full
year 1997 reflects the effects of limitations placed on the Company's ability to
utilize Capsure's available nols to offset future taxable income.

CNA Surety Results for the Three Months Ended December 31, 1998 compared to
Results for the Three Months Ended December 31, 1997 and Pro forma Results for
the Three Months Ended December 31, 1996
      A discussion of CNA Surety's actual results of operations for the three
months ended December 31, 1998 and 1997 compared to pro forma results of
operations for the comparative period in 1996 follows. Explanations for changes
in quarterly results are consistent with the explanations provided previously
for full year fluctuations unless otherwise provided.

The components of income for the Company for the three months ended
December 31, 1998, 1997 and 1996 are summarized as follows:

<TABLE>
<CAPTION>

                                                                                                  Pro Forma
In thousands                                                                1998         1977          1996
------------------------------------------------------------------      --------     --------     --------

<S>                                                                      <C>          <C>          <C>    
Total revenues                                                           $73,582      $71,284      $62,754
==================================================================      ========     ========     ========  

Underwriting income                                                      $18,009      $15,086      $ 8,989
Net investment income                                                      6,027        5,766        2,866
Net investment gains                                                         622           85           19
Interest expense                                                           1,713        1,831        1,807
Non-recurring charges and merger costs                                        --           --        1,524
Amortization of intangible assets                                          1,475        1,447        1,447
------------------------------------------------------------------      --------     --------     --------

Income before income taxes                                                21,470       17,659        7,096
Income taxes                                                               8,409        6,663        2,751
------------------------------------------------------------------      --------     --------     --------

Net income                                                               $13,061      $10,996      $ 4,345
==================================================================      ========     ========     ========  

Net income per share                                                     $  0.30      $  0.25      $  0.10
==================================================================      ========     ========     ========  
</TABLE>



                                                                              17
<PAGE>   20


Management's Discussion and Analysis of Financial Condition
and Results of Operations Cont.

Insurance Underwriting
Underwriting results for the Company for the three months ended December
31, 1998, 1997 and 1996 are summarized in the following table:

<TABLE>
<CAPTION>

                                                                                                 Pro Forma
In thousands                                                                1998         1997         1996        
------------------------------------------------------------------      --------     --------     --------

<S>                                                                      <C>          <C>          <C>    
Gross written premiums                                                   $67,348      $72,755      $64,126
==================================================================      ========     ========     ========  

Net written premium                                                      $65,786      $73,989      $59,808
==================================================================      ========     ========     ========  

Net earned premium                                                       $66,933      $65,433      $59,869
Net losses and loss adjustment expenses                                   10,670       12,134       11,237
Net commissions, brokerage and other                                      38,254       38,213       39,643
------------------------------------------------------------------      --------     --------     --------

Underwriting income                                                      $18,009      $15,086      $ 8,989
==================================================================      ========     ========     ========  

Loss ratio                                                                  15.9%        18.5%        18.8%
Expense ratio                                                               57.2         58.4         66.2
==================================================================      ========     ========     ========  

Combined ratio                                                              73.1%        76.9%        85.0%
==================================================================      ========     ========     ========  
</TABLE>



Premiums Written
Gross written premiums for the three months ended December 31, 1998, 1997 and
1996 are shown in the table below:

<TABLE>
<CAPTION>

                                                                                                 Pro Forma
In thousands                                                                1998         1997         1996          
------------------------------------------------------------------      --------     --------     --------

<S>                                                                      <C>          <C>          <C>    
Contract                                                                 $32,438      $29,336      $31,639
Commercial                                                                29,053       37,780       27,233
Fidelity                                                                   3,766        3,673        3,661
E&O and other                                                              2,091        1,966        1,593
------------------------------------------------------------------      --------     --------     --------

                                                                         $67,348      $72,755      $64,126
==================================================================      ========     ========     ========  

</TABLE>


Gross written premiums decreased 7.4%, or $5.4 million, for the three months
ended December 31, 1998 over the comparable period in 1997. In the fourth
quarter 1998, contract surety increased 10.6% to $32.4 million, reflective of
favorable economic conditions for public construction as previously discussed.
The fidelity, E&O and other business increased 3.9% to $5.9 million. These
increases were offset by a decrease in the commercial surety business of 23.1%,
or $8.7 million, for the three months ended December 31, 1998. In the fourth
quarter of 1997, the Company assumed $10.1 million of international surety and
credit business from CNA Re compared to $2.5 million in 1998. Commercial surety,
exclusive of international surety and credit business, decreased 4.0% compared
to the same period in 1997.
      Gross written premiums increased 13.5%, or $8.6 million, in the fourth
quarter 1997 compared to the pro forma fourth quarter 1996. These increases were
primarily attributable to $10.1 million international surety and credit business
assumed in the fourth quarter 1997 under the reinsurance treaty with CNA Re.
Commercial surety gross written premiums, exclusive of international surety and
credit business, increased 1.6% for the fourth quarter 1997. The fidelity, E&O
and other business, primarily written by Western Surety, increased 7.3%, or $0.4
million, in the fourth quarter ended December 31, 1997 over the comparable pro
forma period in 1996. The increases in commercial surety and fidelity, E&O and
other business were offset by a decrease in contract surety business of 7.3%, or
$2.3 million, in the fourth quarter 1997. The decrease in contract surety
reflects the competitive pressures primarily in the medium to large contract
segment of the market and to a lesser extent, the timing of the contractor
accounts being awarded new business by their customers.



18
<PAGE>   21

                                       CNA Surety Corporation 1998 Annual Report

      Net written premiums for the three months ended December 31, 1998, 1997
and 1996 are shown in the table below:

<TABLE>
<CAPTION>

                                                                                                 Pro Forma
In thousands                                                                1998         1997         1996       
------------------------------------------------------------------      --------     --------     --------

<S>                                                                      <C>          <C>          <C>    
Contract                                                                 $31,564      $27,850      $30,170
Commercial                                                                28,915       41,078       24,901
Fidelity                                                                   3,789        3,694        3,651
E&O and other                                                              1,518        1,367        1,086
------------------------------------------------------------------      --------     --------     --------

                                                                         $65,786      $73,989      $59,808
==================================================================      ========     ========     ========  
</TABLE>



Net written premiums for the fourth quarter ended December 31, 1998 decreased
11.1%, or $8.2 million, over the comparable period in 1997. In the fourth
quarter 1998, contract surety increased 13.3%, or $3.7 million. The fidelity,
E&O and other business increased 4.9%, or $0.2 million, over the comparable
period in 1997. In the fourth quarter 1998, the commercial surety business
decreased 29.6%, or $12.2 million, over the comparable period in 1997. In 1997,
net written premiums for commercial surety included an additional $7.6 million
in premiums assumed under the reinsurance arrangement mentioned above and $3.8
million in return premiums related to the reinsurance change discussed earlier.
In the fourth quarter 1998, domestic commercial surety net written premiums,
exclusive of international surety and credit business, decreased 14.7%, or $4.5
million, compared to the fourth quarter 1997.
      For the three months ended December 31, 1997, net written premiums
increased 23.7%, or $14.2 million, over the comparable pro forma period 1996.
Net written premiums were up primarily due to a 65.0% increase in commercial
surety in the fourth quarter 1997. Commercial net written premiums, exclusive of
the assumed international business, increased 24.3% for the three months ended
December 31, 1997. Absent the $3.8 million return premium in 1997, domestic
commercial surety net written premiums were up 5.0% for the quarter. Net written
premiums for contract surety decreased 7.7%, or $2.3 million, over the
comparable pro forma period 1996. The fidelity, E&O and other business increased
6.8%, or $0.3 million, for the three months ended December 31, 1997.

Underwriting Results
Underwriting income increased 19.4% to $18.0 million in the fourth quarter of
1998 compared to fourth quarter 1997. Underwriting income increased 67.8% to
$15.1 million in the fourth quarter of 1997 compared to the same pro forma
period in 1996. The period to period changes in underwriting income and combined
ratios were due to fluctuations in both the loss and expense ratios as more
fully described below.
      The loss ratio for the fourth quarter 1998 was 15.9% compared to 18.5% and
18.8% for the fourth quarter 1997 and pro forma period of 1996, respectively.
The loss ratio included favorable reserve development of $2.4 million, $0.6
million and $4.9 million for the three months ended December 31, 1998, 1997 and
1996, respectively. Excluding the impact of the favorable reserve development,
the loss ratios would have been 19.5% for the fourth quarters ended December 31,
1998 and 1997 and 26.9% for the fourth quarter ended December 31, 1996.
      The expense ratio decreased to 57.2% in the fourth quarter of 1998 as
compared to 58.4% and 66.2% for fourth quarter 1997 and pro forma 1996,
respectively. The decline in the Company's expense ratio for the quarter was
largely due to the larger scale of the combined organization as net earned
premiums advanced 2.3% for the quarter while total underwriting expenses
remained virtually unchanged. In the fourth quarter 1998, the Company recognized
additional expense savings as a result of the successful consolidation of
certain administrative and back-office processing functions as previously
discussed.

Investment Income
Net investment income was $6.0 million in the fourth quarter of 1998 compared to
$5.8 million for the fourth quarter of 1997 and $2.9 for the same pro forma
period of 1996. The average pretax yield was 5.0% and 5.7% for the three months
ended December 31, 1998 and 1997, respectively. In 1998, investment income was
adversely affected by a general decline in interest rates and the Company's
aggressive shift to tax exempt securities given attractive after-tax yields. In
fourth quarter 1997, increases in investment income were the direct result of
higher actual invested cash balances which reflects the investment of
merger-related cash flows. However, pro forma


                                                                              19
<PAGE>   22

Management's Discussion and Analysis of Financial Condition
and Results of Operations Cont.

investment income for 1996 does not include the pro forma effects of estimated
net investment income resulting from investment of merger-related cash flows as
described earlier.
      Net realized investment gains were $0.6 million in the fourth quarter of
1998 as compared to $0.1 million in the fourth quarter of 1997.

Analysis of Other Operations
Amortization expense was $1.5 million for the fourth quarter of 1998 compared to
$1.4 million in both the fourth quarter of 1997 and 1996. Intangible assets
represents 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. Intangibles are generally amortized
over 30 years.
      Interest expense for the fourth quarter of 1998 decreased 6.4% and 5.2%
compared to the fourth quarter 1997 and pro forma 1996, respectively.

Income Taxes
Income tax expense was $8.4 million for the quarter ended December 31, 1998. The
effective income tax rate for the three months ended December 31, 1998 was
39.2%. Income taxes were $6.7 million and $2.8 million and the effective income
tax rates were 37.7% and 38.8% for the three months ended December 31, 1997 and
1996, respectively.

LIQUIDITY AND CAPITAL RESOURCES
It is anticipated that the liquidity requirements of CNA Surety will be met
primarily by funds generated from operations. The principal operating cash flow
sources are premiums, investment income, and sales and maturities of
investments. CNA Surety also may generate funds from additional borrowings under
the credit facility described below. The primary cash flow uses are payments for
claims, operating expenses, federal income taxes, debt service on the credit
facility, 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 income tax sharing payments of its insurance
subsidiaries. At December 31, 1998, the carrying value of the Company's
insurance subsidiaries' invested assets was comprised of $423.9 million of fixed
income securities, $43.4 million of short-term investments, $5.8 million of
other investments and $1.8 million of cash. At December 31, 1997, the carrying
value of the Company's insurance subsidiaries' invested assets was comprised of
$266.3 million of fixed income securities, $140.2 million of short-term
investments, $6.0 million of other investments and $0.1 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 and pay operating
expenses and pay dividends to stockholders. At December 31, 1998, the parent
company's invested assets consisted of $14.5 million of short-term investments
and $15.9 million of cash. At December 31, 1997, the parent company's invested
assets consisted of $7.0 million of short-term investments.
      The Company's consolidated net cash flow provided by operating activities
was $88.7 million for the year ended December 31, 1998 and $29.0 million for the
three months ended December 31, 1997.
      The Company received $116.9 cash from CNAF on October 1, 1997. This
payment from CNAF reflected the effects of the reinsurance agreement whereby CCC
and CIC ceded all of their net unearned premiums and loss and loss adjustment
expense reserves for their surety business to Western Surety as of the Merger
Date.
      CNA Surety's bank borrowings are under a five-year unsecured revolving
credit facility (the "Credit Facility") that provides for borrowings up to $130
million. CNA Surety borrowed $105 million as of September 30, 1997 and used the
proceeds to retire the existing Capsure debt of approximately $54 million and to
make a $50 million capital contribution to Western Surety. On October 6, 1997,
CNA Surety borrowed an additional $13 million to pay the $10.6 million closing
dividend to Capsure stockholders and other merger-related costs. On November 30,
1998, CNA Surety repaid $5 million of this debt.


20
<PAGE>   23

                                       CNA Surety Corporation 1998 Annual Report

      The interest rate on borrowings under the Credit Facility may be fixed, at
CNA Surety's option, for a period of one, two, three, or six months and is based
on, among other rates, the London Interbank Offered Rate ("libor"), plus the
applicable margin. The margin, including the facility fee, varies based on CNA
Surety's leverage ratio (debt to total capitalization) and ranges from 0.25% to
0.40%. As of December 31, 1998, the weighted average interest rate was 5.5% on
the $113.0 million of outstanding borrowings. As of December 31, 1997, the
weighted average interest rate was 6.17% on the $118.0 million of outstanding
borrowings.
      The Credit Facility contains, among other conditions, limitations on CNA
Surety with respect to the incurrence of additional indebtedness and requires
the maintenance of certain financial ratios. As of December 31, 1998, the
Company was in compliance with all restrictions and covenants contained in the
Credit Facility agreement. The Credit Facility provides for the payment of all
outstanding principal balances after five years with no required principal
payments prior to such time. Principal prepayments, if any, and interest
payments are expected to be funded primarily through dividends from CNA Surety's
insurance subsidiaries.
      As an insurance holding company, CNA Surety is dependent upon dividends
and other permitted payments from its insurance subsidiaries to pay cash
dividends, if any, as well as to pay operating expenses and meet debt service
requirements. The payment of dividends by the insurance subsidiaries are subject
to varying degrees of supervision by the insurance regulatory authorities in
South Dakota and Texas. In South Dakota, where Western Surety and sbca are
domiciled, insurance companies may only pay dividends from earned surplus
excluding surplus arising from unrealized capital gains or revaluation of
assets. In Texas, where usa is domiciled, an insurance company may only declare
or pay dividends to stockholders from the insurer's earned surplus. The
insurance subsidiaries may pay dividends without obtaining prior regulatory
approval only if such dividend or distribution (together with dividends or
distributions made within the preceding 12-month period) is less than, as of the
end of the immediately preceding year, the greater of (i) 10% of the insurer's
surplus to policyholders or (ii) statutory net income. In South Dakota, net
income includes net realized capital gains in an amount not to exceed 20% of net
unrealized capital gains. All dividends must be reported to the appropriate
insurance department prior to payment.
      The dividends that may be paid without prior regulatory approval are
determined by formulas established by the applicable insurance regulations, as
described above. The formulas that determine dividend capacity in the current
year are dependent on, among other items, the prior year's ending statutory
surplus and statutory net income. Dividend capacity for 1999 will be based on
statutory surplus and income at and for the year ended December 31, 1998.
Without prior regulatory approval in 1999, CNA Surety's insurance subsidiaries
may pay stockholder dividends of $32.7 million in the aggregate. CNA Surety
received $6.6 million in dividends from its insurance subsidiaries in 1998 and
$5.0 million in the fourth quarter of 1997.
      In accordance with the provisions of intercompany tax sharing agreements
between CNA Surety and its subsidiaries, the tax of each subsidiary shall be
determined based upon each subsidiary's separate return liability, as calculated
in accordance with the Internal Revenue Code of 1986, (the "Code") as amended.
Intercompany tax payments are made at such times as estimated tax payments would
be required by the Internal Revenue Service ("irs"). CNA Surety received tax
sharing payments from its subsidiaries of $28.5 million for the year ended
December 31, 1998 and $2.4 million in the period from September 30, 1997 through
December 31, 1997.
      CNA Surety management believes that it will have sufficient available
resources to meet its present capital needs.




                                                                              21
<PAGE>   24

Management's Discussion and Analysis of Financial Condition
and Results of Operations Cont.


FINANCIAL CONDITION
Investment Portfolio
The following table summarizes the distribution of the Company's fixed income
portfolio at estimated fair values as of December 31, 1998 and 1997:

<TABLE>
<CAPTION>

                                                         Estimated                 Estimated
                                                        Fair Value                 Fair Value
                                                       December 31                December 31
In thousands                                                  1998       Percent         1997        Percent
----------------------------------------------------   -----------      --------  -----------        -------
<S>                                                       <C>              <C>      <C>              <C>  
Fixed income securities:
U.S. Treasury securities and obligations of U.S.
   Government and agencies:
     U.S. Treasury                                        $ 19,421         4.5%     $ 59,355         22.3%
     U.S. Agencies                                          71,111        16.8        51,629         19.4
     Collateralized mortgage obligations                    17,743         4.2        37,567         14.1
     Mortgage pass-through securities                       25,005         5.9        34,170         12.8
Obligations of states and political subdivisions           208,238        49.1         3,570          1.3
Corporate bonds                                             36,759         8.7        26,840         10.1
Non-agency collateralized mortgage obligations              18,694         4.4        19,626          7.4
Other asset-backed securities:                                                      
   Second mortgages/home equity loans                       12,387         2.9        21,742          8.2
   Credit card receivables                                   4,898         1.2         6,513          2.4
   Other underlying assets                                   9,658         2.3         5,289          2.0
----------------------------------------------------   -----------      ------     ---------       ------

     Total fixed income securities                        $423,914       100.0%     $266,301        100.0%
====================================================   ===========      ======      ========       ====== 
</TABLE>


The Company's investment portfolio is managed to maximize after-tax investment
return while minimizing credit risk with investments concentrated in high
quality securities to support its insurance underwriting operations. The
Company's investment policies emphasize high credit quality and diversification
by industry, issue and issuer.
      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, 1998 and
1997:
<TABLE>
<CAPTION>

                                                                                         
In thousands                                                                1998                      1997
Credit Rating                                           Fair Value       Percent   Fair Value      Percent
------------------------------------------------------  ----------       -------   ----------      ---------

<S>                                                       <C>               <C>      <C>                <C>  
AAA/AAA                                                   $278,792          65.8%    $232,133           87.2%
AA/AA                                                       89,090          21.0          629            0.2
A/A                                                         34,676           8.2       26,757           10.1
BBB                                                         21,356           5.0        6,782            2.5
------------------------------------------------------  ----------       -------   ----------      ---------

   Total                                                  $423,914         100.0%    $266,301          100.0%
==================================================================       =======   ==========      ==========   
</TABLE>


As of December 31, 1998 and 1997, 100% of the Company's fixed income securities
were considered investment grade by s&p or Moody's, and 87% were rated at least
AA by those agencies. In addition, the Company's investments in fixed income
securities did not contain any signi?cant geographic or industry concentration
of credit risk.




22
<PAGE>   25

                                       CNA Surety Corporation 1998 Annual Report


Market Risk
CNA Surety's investment portfolio is subject to economic losses due to adverse
changes in the fair value of its financial instruments, or market risk. Interest
rate risk represents the largest market risk factor affecting the Company's
consolidated financial condition due to its significant level of investments in
fixed income securities. Increases and decreases in prevailing interest rates
generally translate into decreases and increases in the fair value of the
Company's fixed income portfolio. The fair value of these interest rate
sensitive instruments may also be affected by the creditworthiness of the
issuer, prepayment options, relative value of alternative investments, the
liquidity of the instrument, income tax considerations and general market
conditions. The Company manages its exposure to interest rate risk primarily
through an asset/liability matching strategy. The Company's exposure to interest
rate risk is mitigated by the relative short-term nature of its insurance and
other liabilities. The targeted effective duration of the Company's investment
portfolio is approximately 4.75 years consistent with the expected duration of
its insurance and other liabilities.
      The table below summarizes the estimated effects of certain hypothetical
increases and decreases in interest rates. It is assumed that the changes occur
immediately and uniformly across each investment category. The hypothetical
changes in market interest rates selected reflect the Company's expectations of
the reasonably possible best or worst case scenarios over a one-year period. The
hypothetical fair values are based upon the same prepayment assumptions that
were utilized in computing fair values as of December 31, 1998. Significant
variations in market interest rates could produce changes in the timing of
repayments due to prepayment options available. The fair value of such
instruments could be affected and therefore actual results might differ from
those reflected in the following table.

<TABLE>
<CAPTION>
                                                                                                     Hypothetical
                                                                                  Estimated Fair       Percentage
                                                                   Hypothetical      Value after         Increase
                                                 Fair Value at        Change in     Hypothetical    (Decrease) in
                                                   December 31    Interest Rate        Change in    Stockholders'
                                                          1998    (basis points)   Interest Rate           Equity

--------------------------------------------------------------   --------------- ---------------   --------------

<S>                                                   <C>        <C>                 <C>                <C>   
Fixed Income Securities:
U.S. Government and government
   agencies and authorities                           $133,280   200 bp increase     $126,416           (1.4)%
                                                                 100 bp increase      129,964           (0.7)
                                                                 100 bp decrease      136,484            0.7
                                                                 200 bp decrease      139,790            1.4

States, municipalities and political subdivisions      208,238   200 bp increase      186,658           (4.5)
                                                                 100 bp increase      196,769           (2.4)
                                                                 100 bp decrease      221,119            2.7
                                                                 200 bp decrease      235,014            5.6

Corporate bonds and all other                           82,396   200 bp increase       76,436           (1.3)
--------------------------------------------------------------   

                                                                 100 bp increase       79,453           (0.6)
                                                                 100 bp decrease       86,794            0.9
                                                                 200 bp decrease       93,296            2.3

   Total fixed income securities                      $423,914   200 bp increase      389,510           (7.2)
==============================================================
                                                                 100 bp increase      406,186           (3.7)
                                                                 100 bp decrease      444,397            4.3
                                                                 200 bp decrease      468,100            9.3

</TABLE>



                                                                              23
<PAGE>   26

Management's Discussion and Analysis of Financial Condition
and Results of Operations Cont.


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 loss and loss
adjustment expenses that give consideration to the inherent difficulty and
variability in the estimation process. In addition, CNA Surety utilizes
independent actuarial firms 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
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 year
in which such changes are determined to be needed.
      The Company recorded favorable reserve development which resulted in
reductions in the estimated liability of $4.4 million for the year ended
December 31, 1998 and $0.6 million for the period from inception through
December 31, 1997. On a pro forma basis, favorable development was $40.9 million
($35.0 million related to the Predecessor) and $16.6 million for the years ended
December 31, 1997 and 1996, respectively. 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 and the
Predecessor. 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 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 on behalf of the company or
regulators. As of December 31, 1998, each of CNA Surety's insurance subsidiaries
had a Ratio that was in compliance with the 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 should not exceed 3
to 1 (the terms of the Credit Facility also limit this ratio to 3 to 1 for
Western Surety and usa). On December 31, 1998, the Company had a combined
statutory surplus of $169.9 million. The combined statutory surplus of Western
Surety and sbca was $153.2 million and its net written premiums to surplus ratio
was 1.6 to 1. usa's statutory surplus was $16.7 million and the net written
premiums to surplus ratio was 1.4 to 1. On December 31, 1997, the Company had a
combined statutory surplus of $142.4 million. Western Surety's statutory surplus
was $128.7 million and its net written premiums to surplus ratio was 1.8 to 1.
usa's statutory surplus was $13.7 million and its net written premiums to
surplus ratio was 1.6 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 eleven key financial
ratios that address various aspects of each insurer's financial condition and
stability. In 1998, usa's IRIS ratios were within all of the








24
<PAGE>   27

                                       CNA Surety Corporation 1998 Annual Report

"usual ranges" as defined by the NAIC. Western and its affiliated company
sbca failed one ratio each: Agents Balance to Surplus and Change in Net
Writings, respectively. Due to the Merger that occurred on September 30, 1997
and related reinsurance transaction, Western's agents balances increased
significantly, causing this ratio to be outside the "usual" range. In 1998,
sbca's net written premium included additional premium resulting from the
introduction of a new notary program. Accordingly, this growth in premium caused
this ratio to be outside the "usual" range.

IMPACT OF YEAR 2000 ON THE COMPANY
The widespread use of computer programs, both in the United States and
internationally, that rely on two digit date fields to perform computations and
decision making functions may cause computer systems to malfunction when
processing information involving dates beginning after 1999. Such malfunctions
could lead to business delays and disruptions.
      For several years prior to the Merger, CNAF and Western Surety had each,
as a matter of normal maintenance and system development practices, begun to
address Year 2000 considerations. The Company has continued to participate in
CNAF's Year 2000 activities following the Merger. The Company's internal target
for achieving Year 2000 internal substantial readiness generally coincided with
CNAF's December 1, 1998 target substantial readiness date. Based upon internal
certification achieved as part of the CNAF Year 2000 activities, the Company's
management believes that the Company has accomplished the December 1, 1998
target date for its internal systems requiring renovation.

Independent Assessment of Year 2000 Readiness
In December 1997, the Company engaged an independent information consulting firm
of national standing to perform a limited review and assessment of the Company's
Year 2000 plans. This engagement included collecting and reviewing existing
enterprise-wide and business unit Year 2000 plans and supporting documentation,
reviewing the process for managing critical external agents and business
partners, and determining if timing and coordination efforts appear reasonable
with respect to program testing and enterprise certification. Based upon the
Company's internal examination and the foregoing review and assessment, the
Company has been and is currently in the process of implementing various
resulting recommendations, including the designation of a Year 2000 project
manager with broad authority for the management and coordination of all Year
2000 efforts and the establishment of regular Year 2000 status reporting by the
project manager to senior management and the board of directors of CNA Surety.

Non-IT Systems Remediation Status
The Company considers its non-information technology ("non-it") systems to
consist of essentially two elements: office facilities and communication
systems, including telephone and facsimile systems.
      The Company leases space for home office and branch locations from various
parties, including the Company's Chicago home office and various branch
locations from CNAF pursuant to the Administrative Services Agreement ("asa").
The Company has confirmed with CNAF and building management for each building
location that reasonable efforts are being undertaken to ensure timely Year 2000
readiness for such facilities and continues to monitor the progress of
third-party landlords.
      Communication systems i.e., telephone switching equipment and facsimile
server systems, are essential to the business operations of CNA Surety. CNAF has
informed the Company that all communication systems provided by CNAF pursuant to
the asa are anticipated to be Year 2000 ready, and management believes that usa
and Western's separate communication systems will also be Year 2000 ready on a
timely basis.

IT Systems Remediation Status
The Company has confirmed that information technology ("it") systems provided by
CNAF pursuant to the asa have been certified by CNAF as Year 2000 ready.
      With respect to its internal systems, the Company has created plans to
monitor the Year 2000 renovation or replacement of the Company's it systems.
Several of these systems are deemed to be obsolete and will not be used in a
Year 2000 ready business environment. As a result of a post-Merger Company
initiative to consolidate






                                                                              25
<PAGE>   28

Management's Discussion and Analysis of Financial Condition
and Results of Operations Cont.


and centralize disparate technology systems, Company management decided to
combine any needed Year 2000 renovation effort with Western Surety's
modification efforts.

Year 2000 Readiness
All existing it systems undergoing renovation have been internally certified as
Year 2000 ready during the fourth quarter of 1998. In addition to having
accomplished the December 1, 1998 target date for its internal systems requiring
renovation the Company is currently developing and will be implementing several
new it systems that it anticipates will become operational before January 1,
2000. The development and implementation of these systems will involve design
and testing to confirm their Year 2000 readiness on a timely basis.

Year 2000 and IT Expenditures
The Company's enterprise-wide Year 2000 readiness efforts are currently
estimated to cost approximately $540,000 in excess of the cost of ordinary
software upgrades and replacements and will be funded through working capital.
As of December 31, 1998, approximately $407,000 had been incurred in Year
2000-related expenditures. The estimated amount includes expenses incurred or
anticipated to be incurred for third-party remediation and testing and
additional equipment hardware purchases to facilitate further testing. The Year
2000 estimated readiness costs comprised approximately 5% of the Company's total
1998 it budget, and the Year 2000 estimated readiness costs anticipated to be
expended in 1999 comprise approximately less than one percent of the Company's
total 1999 it budget.

Business Partner Identification and Communication
The Company believes that it has identified and established communication
regarding Year 2000 issues with substantially all of the business partners
management considers to be significant to its operations. Management has not yet
identified any one business partner whose expected failure to achieve timely
Year 2000 readiness will materially and adversely impact the Company's ability
to continue its business operations. However, due to the interdependent nature
of computer systems, the Company may be adversely impacted depending upon
whether it or other entities not af?liated with the Company (vendors and other
business partners) address Year 2000 issues successfully.

Year 2000-related Risks
Management believes that the most reasonably likely worst case Year 2000
scenarios involve either failure of all or part of either or both the nation's
telephonic and/or electrical power distribution systems. Due to the general
uncertainty inherent in the Year 2000 problem, resulting in part from the Year
2000 compliance of third parties, the Company is unable to determine with any
degree of certainty the specific potential consequences of the Year 2000
problem. The failure of a third party to correct a material Year 2000 problem,
which affects the Company's business operations, however, could have a material
adverse effect on the Company's results of operations, financial condition and
liquidity.

Contingency Plan
The Company has been and continues to be in the process of revising its overall
enterprise contingency plan to address the continuation of key business
processes. This planning considers disruptions in addition to Year 2000-related
failures, such as fire, vandalism and other perils.
      Company management has concluded that it is not reasonably possible to
continue the Company's business operations without the use of automation and
information technology, such as computers and telephones. Management, for
contingency planning, is considering using, as a back up for its main frame
computer capability, an existing computer application that can be operated at
stand-alone computer stations. Management believes that this particular
application may provide a short-term solution that will enable the Company to
process, record and invoice for transactions, and to store such transactional
data until main frame processing capability is restored. Through Western Surety,
the Company also subscribes to a third-party disaster recovery site, although
access is subject to certain conditions and potential allocation among other
subscribers. Further, as part of its contingency planning process, the Company
is currently exploring the development of additional restoration alternatives.


26
<PAGE>   29

                                       CNA Surety Corporation 1998 Annual Report

Company Products and Services' Year 2000 Exposures
Although the Company has not received any claims based on alleged losses
resulting from the Year 2000 issues, there can be no assurance that bond
obligees or insureds will not suffer losses of this type and seek compensation
under the Company's bonds or policies. If any claims are made, the Company's
obligations, if any, will depend upon the facts and circumstances of the claims
and provisions of the bond or policy. At this time, the Company is unable to
determine whether the adverse impact, if any, in connection with the foregoing
circumstances would be material to the Company's results of operations,
financial condition and liquidity.

IMPACT OF ADOPTING STATEMENTS OF FINANCIAL ACCOUNTING STANDARDS ("SFAS")
In June 1997, the fasb issued sfas No. 130, "Reporting Comprehensive Income,"
which established accounting standards for reporting and display of
comprehensive income and its components (revenues, expenses, gains and losses)
in a full set of general-purpose financial statements. This Statement requires
that an enterprise (a) classify items of other comprehensive income by their
nature in a financial statement and (b) display the accumulated balance of other
comprehensive income separately from retained earnings and additional paid-in
capital in the equity section of a statement of financial position. The Company
has adopted sfas No. 130 in the accompanying Consolidated Financial Statements.
      In June 1997, the fasb issued sfas No. 131, "Disclosures about Segments of
an Enterprise and Related Information," which established accounting standards
about the way public enterprises report information about operating segments in
its annual financial statements and requires that those enterprises report
selected information about operating segments in interim financial reports
issued to shareholders. It also established standards for related disclosures
about products and services, geographic areas and major customers. sfas No. 131
replaced sfas No. 14, "Financial Reporting for Segments of a Business
Enterprise." The Company has adopted sfas No. 131 in the accompanying
Consolidated Financial Statements.
      In February 1998, the fasb issued sfas No. 132, "Employers' Disclosures
about Pensions and Other Postretirement Benefits," which revises employers'
disclosures about pensions and other postretirement benefit plans. sfas No. 132
does not change the measurement or recognition requirements of those plans under
the previous accounting standards. The new standardized disclosures require
additional information on changes in the benefit obligations and fair value of
plan assets as well as eliminate certain disclosures from prior accounting
standards that are no longer as useful. The Company has adopted sfas No. 132 in
the accompanying Consolidated Financial Statements.
      In December 1997, the American Institute of Certified Public Accountants'
Accounting Standards Executive Committee ("acsec") issued Statement of Position
("sop") 97-3, "Accounting by Insurance and Other Enterprises for
Insurance-Related Assessments," which provides guidance on accounting by all
entities that are subject to insurance-related assessments. It requires that
entities should recognize liabilities for insurance-related assessments when all
of the following criteria have been met: an assessment has been imposed or a
probable assessment will be imposed; the event obligating an entity to pay an
imposed or probable assessment has occurred on or before the date of the
financial statements; and the amount of the assessment can be reasonably
estimated. The Company has adopted sop 97-3 in the accompanying Consolidated
Financial Statements. The adoption of which did not have a material effect on
the Company's results of operations.




                                                                              27
<PAGE>   30

Management's Discussion and Analysis of Financial Condition
and Results of Operations Cont.


IMPACT OF ACCOUNTING PRONOUNCEMENTS NOT YET ADOPTED
In March 1998, the acsec issued sop 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use," which provides guidance on
accounting for costs of computer software developed or obtained for internal use
and for determining whether computer software is for internal use. For the
purposes of the sop, internal-use software is software acquired, internally
developed or modified solely to meet the entity's internal needs for which no
substantive plan exists or is being developed to market the software externally
during the software's development or modification. Accounting treatment for
costs associated with software developed or obtained for internal use, as
defined by this sop, is based upon a number of factors, including the point in
time during the project that costs are incurred as well as the types of costs
incurred. This sop is effective for financial statements for fiscal years
beginning after December 15, 1998. The Company is currently evaluating the
effects of this sop.
      In June 1998, the fasb issued sfas 133, "Accounting for Derivative
Instruments and Hedging Activities," which establishes standards for the
accounting and reporting for derivative instruments and for hedging activities.
It requires that an entity recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those instruments
at fair value. If certain conditions are met, a derivative may be specifically
designated as (a) a hedge of the exposure to changes in the fair value of a
recognized asset or liability or an unrecognized firm commitment, (b) a hedge of
the exposure to variable cash flows of a forecasted transaction, or (c) a hedge
of the foreign currency exposure of a net investment in a foreign operation, an
unrecognized firm commitment, and available-for-sale security, or a
foreign-currency-denominated forecasted transaction. The accounting for changes
in the fair value of a derivative depends on the intended use of the derivative
and the resulting designation. This Statement is effective for all fiscal
quarters of fiscal years beginning after June 15, 1999. This Statement is not
anticipated to have a material impact on the financial position and results of
operations of the Company.
      In April 1998, acsec issued sop 98-5, "Reporting on the Costs of Start-Up
Activities," which provides guidance on the financial reporting of start-up
costs and organization costs. It requires costs of start-up activities and
organization costs, as defined, to be expensed as incurred. sop 98-5 is
effective for financial statements in 1999. The Company does not expect the
adoption of this sop to have an impact on the operations or equity of the
Company.
      In October 1998, acsec issued sop 98-7, "Deposit Accounting: Accounting
for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk,"
which provides accounting guidance for insurance and reinsurance contracts that
do not transfer insurance risk, excluding long-duration life and health
insurance contracts. CNA Surety is currently evaluating the effects of this sop.
This statement is not anticipated to have a material impact on the financial
position and results of operations of the Company.

"SAFE HARBOR" STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT
OF 1995
The statements which are not historical facts contained in this Form 10-k are
forward-looking statements that involve risks and uncertainties, including, but
not limited to, product and policy demand and market response risks, the effect
of economic conditions, the impact of competitive products, policies and
pricing, product and policy development, regulatory changes and conditions,
rating agency policies and practices, development of claims and the effect on
loss reserves, the performance of reinsurance companies under reinsurance
contracts with the Company, investment portfolio developments and reaction to
market conditions, the results of financing efforts, the actual closing of
contemplated transactions and agreements, the effect of the Company's accounting
policies, and other risks detailed in the Company's Securities and Exchange
Commission filings. No assurance can be given that the actual results of
operations and financial condition will conform to the forward-looking
statements contained herein.


28

<PAGE>   31

                                       CNA Surety Corporation 1998 Annual Report

                                                     CONSOLIDATED BALANCE SHEETS


<TABLE>
<CAPTION>


In thousands, except per share data                                  December 31         1998         1997    
--------------------------------------------------------------------------------     --------     --------
<S>                                                                                  <C>          <C>     
ASSETS
Invested assets and cash:
   Fixed income securities, at fair value

     (amortized cost: $418,866 and $265,545)                                         $423,914     $266,301
   Short-term investments, at cost (approximates fair value)                           57,865      147,235
   Other investments, at fair value                                                     5,830        6,001
   Cash                                                                                17,746          130
--------------------------------------------------------------------------------     --------     --------

     Total invested assets and cash                                                   505,355      419,667
Deferred policy acquisition costs                                                      74,488       64,144
Insurance receivables:
   Premiums                                                                             8,950        9,683
   Reinsurance, including $47,175 and $47,856 from affiliates                          55,350       55,151
Intangible assets, net of accumulated amortization of $7,347 and $1,447
   at December 31, 1998 and 1997, respectively                                        156,062      161,962
Prepaid reinsurance premiums                                                            2,157        2,101
Other assets                                                                           17,008       12,423
--------------------------------------------------------------------------------     --------     --------

     Total assets                                                                    $819,370     $725,131
================================================================================     ========     ========

LIABILITIES
Reserves:
   Unpaid losses and loss adjustment expenses                                        $150,020     $130,381
   Unearned premiums                                                                  183,708      171,787
--------------------------------------------------------------------------------     --------     --------

     Total reserves                                                                   333,728      302,168
Long-term debt                                                                        113,000      118,000
Deferred income taxes, net                                                             10,649           --
Payable for securities purchased                                                        8,517       10,609
Current income taxes payable                                                            6,726        6,547
Other liabilities                                                                      36,853       31,075
--------------------------------------------------------------------------------     --------     --------

     Total liabilities                                                               $509,473     $468,399
================================================================================     ========     ========



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; 44,093 shares
   issued and outstanding at December 31, 1998 and 43,320 issued and outstanding
   at December 31, 1997                                                                   441          433
Additional paid-in capital                                                            253,215      244,829
Retained earnings                                                                      52,984       10,996
Accumulated other comprehensive income                                                  3,257          474
--------------------------------------------------------------------------------     --------     --------

     Total stockholders' equity                                                       309,897      256,732
--------------------------------------------------------------------------------     --------     --------

     Total liabilities and stockholders' equity                                      $819,370     $725,131
================================================================================     ========     ========
</TABLE>

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



                                                                              29

3
<PAGE>   32
---------------------------------
CONSOLIDATED STATEMENTS OF INCOME
---------------------------------

and Statements of Certain Revenues and Direct Operating Expenses of Predecessor

<TABLE>
<CAPTION>
                                                                    September 30
                                                                        (Date of  PREDECESSOR
                                                                      Inception)  Nine Months  PREDECESSOR
                                                        Year Ended       through        Ended   Year Ended
                                                       December 31   December 31 September 30  December 31
In thousands, except per share data                           1998          1997         1997         1996
-----------------------------------------------------  -----------  ------------ ------------  -----------
<S>                                                       <C>            <C>         <C>          <C>
Revenues:
   Net earned premium                                     $258,737       $65,433     $108,564     $149,069
   Net investment income                                    24,259         5,766           --           --
   Net realized investment gains                               844            85           --           --
-----------------------------------------------------  -----------  ------------ ------------  -----------

     Total revenues                                        283,840        71,284      108,564      149,069
-----------------------------------------------------  -----------  ------------ ------------  -----------

Expenses:
   Net losses and loss adjustment expenses                  44,998        12,134      (11,516)      33,006
   Net commissions, brokerage and other underwriting       151,966        38,213       59,674       81,615
   Interest expense                                          7,218         1,831           --           --
   Amortization of intangible assets                         5,900         1,447           --           --
-----------------------------------------------------  -----------  ------------ ------------  -----------

     Total expenses                                        210,082        53,625       48,158      114,621
-----------------------------------------------------  -----------  ------------ ------------  -----------

Income before income taxes (Excess of net earned 
   premium over direct operating expenses, before
   income taxes, for Predecessor)                           73,758        17,659       60,406       34,448
Income taxes                                                28,243         6,663       21,241       12,188
-----------------------------------------------------  -----------  ------------ ------------  -----------

Netincome (Excess of net earned premium over 
   direct operating expenses, before income taxes,
   for Predecessor)                                       $ 45,515       $10,996     $ 39,165     $ 22,260
-----------------------------------------------------  -----------  ------------ ------------  -----------

Earnings per share                                        $   1.04       $  0.25
=====================================================  ===========  ============

Earnings per share, assuming dilution                     $   1.04       $  0.25
=====================================================  ===========  ============

Weighted average shares outstanding                         43,722        43,302
=====================================================  ===========  ============

Weighted average shares outstanding, assuming dilution      43,875        43,552
=====================================================  ===========  ============
</TABLE>

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


30

<PAGE>   33

                                 -----------------------------------------------
                                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                                 -----------------------------------------------

<TABLE>
<CAPTION>
                                                                                                           Accumulated
                                                                    Additional                                   Other        Total
                                         Common Stock                  Paid-In  Comprehensive  Retained  Comprehensive Stockholders'
In thousands                            Shares Issued Common Stock     Capital         Income  Earnings         Income       Equity
--------------------------------------- ------------- ------------  ----------  -------------  --------  ------------- -------------
<S>                                     <C>           <C>           <C>         <C>            <C>       <C>           <C>
Balance, September 30, 1997
   (Date of Inception)                             -- $         --  $       --  $          --  $     --  $          -- $         --
Comprehensive income:
   Net income                                      --           --          --         10,996    10,996             --       10,996
Other comprehensive income:
   Change in unrealized gains on
     securities (after income taxes),
     net of reclassification
     adjustment of $0                              --           --          --            474        --            474          474
--------------------------------------                                          -------------                                     
Total comprehensive income                                                      $      11,470
======================================                                          =============

Increase due to Capsure
   Acquisition (See Note 2)                    43,294          433     181,629                       --             --      182,062
Capital contribution and the
   effects of reinsurance
   agreements (See Note 2)                         --           --      62,859                       --             --       62,859
Stock options exercised                            26           --         341                       --             --          341
--------------------------------------- ------------- ------------  ----------                 --------  ------------- -------------
Balance, December 31, 1997                     43,320 $        433  $  244,829                 $ 10,996  $         474 $    256,732
--------------------------------------- ------------- ------------  ----------                 --------  ------------- -------------

Comprehensive income:
   Net income                                      --           --          --         45,515    45,515             --       45,515
Other comprehensive income:
   Change in unrealized gains on
     securities (after income taxes),
     net of reclassification
     adjustment of $208                            --           --          --          2,783        --          2,783        2,783
--------------------------------------                                          -------------                                     
Total comprehensive income                                                      $      48,298
======================================                                          =============

Issuance of common stock                          628            6       7,525                       --             --        7,531
Stock options exercised                           145            2         861                       --             --          863
Dividends paid to stockholders                     --           --          --                   (3,527)            --       (3,527)
--------------------------------------- ------------- ------------  ----------                 --------  ------------- -------------
Balance, December 31, 1998                     44,093 $        441  $  253,215                 $ 52,984  $       3,257 $    309,897
======================================= ============= ============  ==========                 ========  ============= =============
</TABLE>

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


                                                                              31
<PAGE>   34
-------------------------------------
CONSOLIDATED STATEMENTS OF CASH FLOWS
-------------------------------------

<TABLE>
<CAPTION>
                                                                                              September 30
                                                                                                 (Date of
                                                                                                Inception)
                                                                                  Year Ended      through
                                                                                  December 31  December 31
In thousands                                                                             1998             
--------------------------------------------------------------------------------- ----------- ------------
<S>                                                                               <C>         <C>
OPERATING ACTIVITIES
Net income                                                                        $    45,515 $     10,996
Adjustments to reconcile net income to net cash provided by operating activities:
   Depreciation and amortization                                                        7,720        1,915
   Accretion of bond discount, net                                                      2,065          172
   Net realized investment gains                                                         (844)         (85)
Changes in:
   Insurance receivables                                                                  534      (13,282)
   Reserve for unearned premiums                                                       11,921        7,184
   Reserve for unpaid losses and loss adjustment expenses                              19,639        8,100
   Deferred policy acquisition costs                                                  (10,344)       4,950
   Deferred income taxes, net                                                           7,485        4,038
   Other assets and liabilities                                                         5,002        5.010
--------------------------------------------------------------------------------- ----------- ------------

Net cash provided by operating activities                                              88,693       28,998
--------------------------------------------------------------------------------- ----------- ------------

INVESTING ACTIVITIES Fixed income securities:
   Purchases                                                                         (297,654)    (149,580)
   Maturities                                                                          56,947        8,654
   Sales                                                                               86,170        5,146
Changes in short-term investments                                                      89,370     (117,919)
Other, net                                                                             (5,417)        (586)
--------------------------------------------------------------------------------- ----------- ------------

Net cash used in investing activities                                                 (70,584)    (254,285)
--------------------------------------------------------------------------------- ----------- ------------

FINANCING ACTIVITIES
Proceeds from long-term debt                                                               --      118,000
Collection of receivable from affiliates, net                                              --      116,939
Principal payments on long-term debt                                                   (5,000)     (54,000)
Capital contribution from CCC                                                              --       52,250
Closing dividend to Capsure stockholders                                                   --      (10,591)
Proceeds from issuance of common stock                                                  7,531           --
Dividend to stockholders                                                               (3,527)          --
Other                                                                                     503          126
--------------------------------------------------------------------------------- ----------- ------------

Net cash (used in) provided by financing activities                                      (493)     222,724
--------------------------------------------------------------------------------- ----------- ------------

Increase (decrease) in cash                                                            17,616       (2,563)
Cash at beginning of period                                                               130        2,693
--------------------------------------------------------------------------------- ----------- ------------

   Cash at end of period                                                          $    17,746 $        130
================================================================================= =========== ============

Supplemental Disclosure of Cash Flow Information:
   Cash paid during the period for:
     Interest                                                                     $     6,721 $      1,704
     Income taxes                                                                 $    17,750 $         --
   Non-cash investing activities:
     Common stock and options issued in connection with
       Capsure acquisition (See Note 2)                                           $        -- $    182,062
================================================================================= =========== ============
</TABLE>

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


32


<PAGE>   35
                                      ------------------------------------------
                                      NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                      ------------------------------------------

NOTE 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 61% of the outstanding
common stock of CNA Surety. Loews Corporation owns approximately 85% of the
outstanding common stock of CNAF. The principal operating subsidiaries of CNAF
that wrote the surety line of business for their own account prior to the Merger
were Continental Casualty Company and its property and casualty affiliates
(collectively, "CCC") and The Continental Insurance Company and its property and
casualty affiliates (collectively, "CIC"). CIC was acquired by CNAF on May 10,
1995. The combined surety operations of CCC and CIC are referred to herein as
CCC Surety Operations ("Predecessor").

      Pursuant to a reorganization agreement, CCC Surety Operations and Capsure
merged their respective operations at the close of business on September 30,
1997 ("Merger Date"). CNAF, through its property and casualty subsidiaries, CCC
and CIC, contributed $52.25 million of capital to CNA Surety. Through
reinsurance agreements, CCC and CIC ceded to Western Surety all of their net
unearned premiums and loss and loss adjustment expense reserves, as of the
Merger Date, and will cede to Western Surety all surety business written or
renewed by CCC and CIC for a period of five years thereafter. Further, CCC and
CIC have agreed to assume the obligation for any adverse development on recorded
reserves for CCC Surety Operations as of the Merger Date, to limit the loss
ratio on certain defined business written by CNA Surety through December 31,
2000 and to provide certain additional excess of loss reinsurance. CCC also
agreed to provide certain administrative services at specified rates, subject to
inflationary increases, for three years after the Merger, if CNA Surety chooses
to purchase such services.

Principles of Consolidation
The consolidated financial statements include the accounts of CNA Surety
Corporation and all majority-owned subsidiaries. The consolidated financial
statements include the actual combined consolidated operating results of CCC
Surety Operations and Capsure since the Merger Date.

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.

Predecessor Financial Information
The accompanying Statements of Certain Revenues and Direct Operating Expenses
for the nine months ended September 30, 1997 and for the year ended December 31,
1996, reflect premiums earned, losses incurred, loss adjustment expenses
(allocated and unallocated) and other direct operating expenses of CCC Surety
Operations, the Predecessor. Such operating revenues and costs as investment
income, realized gains and losses on investments and certain general and
administrative expenses, which are indirect or overhead in nature, are not
reflected in operating results since such items were not historically allocated
to CCC Surety Operations by CNAF or its subsidiaries.

      Since the accompanying Predecessor financial statements exclude certain
revenues and expenses, these financial statements are not intended to be a
complete presentation of CCC Surety Operations. Those revenues and costs that
are reflected in the accompanying financial statements have been determined in
accordance with generally accepted accounting principles.

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 




                                                                              33

<PAGE>   36
Notes to Consolidated Financial Statements Cont.

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 cash flow statement.

     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.
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 are carried at amortized cost which approximates
fair value.

Deferred Policy Acquisition Costs
Policy acquisition costs, consisting of commissions and other underwriting
expenses which vary with, and are directly related to, the production of
business, net of reinsurance commission income, are deferred and amortized as a
charge to income as the related premiums are earned.

Intangible Assets
The Merger of CCC Surety Operations and Capsure has been accounted for by CNA
Surety as an acquisition of Capsure, using purchase accounting. Intangible
assets represent goodwill and identified intangibles arising from the
acquisition of Capsure and goodwill arising from the May 1995 acquisition of CIC
by CNAF that was allocated to the surety business of CIC. Intangible assets are
amortized on a straight line basis generally over 30 years.

     Management assesses the recoverability of intangible assets based upon
estimates of undiscounted future operating cash flows whenever significant
events or changes in circumstances suggest that the carrying amount of an asset
may not be recoverable.

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 year 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. 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 calculated on a daily 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 receivable rather than netted against the estimated
liability for unpaid losses and loss adjustment expenses.


34

<PAGE>   37

Stock-Based Compensation
As allowed under Statement of Financial Accounting Standards ("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.

Income Taxes
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.

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.

Accounting Changes
In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No.
130, "Reporting Comprehensive Income," which established accounting standards
for reporting and display of comprehensive income and its components (revenues,
expenses, gains and losses) in a full set of general-purpose financial
statements. This Statement requires that an enterprise (a) classify items of
other comprehensive income by their nature in a financial statement and (b)
display the accumulated balance of other comprehensive income separately from
retained earnings and additional paid-in capital in the equity section of a
statement of financial position. The Company has adopted SFAS No. 130 in the
accompanying Consolidated Financial Statements.
      In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information," which established accounting standards
about the way public enterprises report information about operating segments in
its annual financial statements and requires that those enterprises report
selected information about operating segments in interim financial reports
issued to shareholders. It also established standards for related disclosures
about products and services, geographic areas and major customers. SFAS No. 131
replaced SFAS No. 14, "Financial Reporting for Segments of a Business
Enterprise." The Company has adopted the disclosure requirements of SFAS No. 131
in the accompanying Consolidated Financial Statements.
      In February 1998, the FASB issued SFAS No. 132, "Employers' Disclosures
about Pensions and Other Postretirement Benefits," which revises employers'
disclosures about pensions and other postretirement benefit plans. SFAS No. 132
does not change the measurement or recognition requirements of those plans under
the previous accounting standards. The new standardized disclosures require
additional information on changes in the benefit obligations and fair value of
plan assets as well as eliminate certain disclosures from prior accounting
standards that are no longer as useful. The Company has adopted the disclosure
requirements of SFAS No. 132 in the accompanying Consolidated Financial
Statements.
      In December 1997, the American Institute of Certified Public Accountants'
Accounting Standards Executive Committee issued Statement of Position ("SOP")
97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related
Assessments," which provides guidance on accounting by all entities that are
subject to insurance-related assessments. It requires that entities should
recognize liabilities for insurance-related assessments when all of the
following criteria have been met: an assessment has been imposed or a probable
assessment will be imposed; the event obligating an entity to pay an imposed or
probable assessment has occurred on or before the date of the financial
statements; and the amount of the assessment can be reasonably estimated. The
Company has adopted SOP 97-3 in the accompanying Consolidated Financial
Statements. The adoption of this SOP did not have a material effect on the
Company's results of operations or equity.


                                                                              35

<PAGE>   38
Notes to Consolidated Financial Statements Cont.

Reclassifications
Certain reclassifications have been made to the 1997 and Predecessor financial
statements to conform with the presentation in the 1998 Consolidated Financial
Statements.

NOTE 2. CAPSURE ACQUISITION
The purchase price for Capsure has been allocated to Capsure's assets that were
acquired and to Capsure's liabilities that were assumed based on the estimated
fair value of such assets and liabilities at the Merger Date. The purchase price
for the outstanding shares of Capsure common stock was determined as follows:

<TABLE>
<CAPTION>
     In thousands
     -----------------------------------------------------------------------------------   ---------
     <S>                                                                                    <C>
     Traded value of Capsure shares to be exchanged at $11.00 per share                     $178,177
     Value of Capsure options                                                                  2,527
     CCC Surety Operations merger-related costs                                                1,358
     -----------------------------------------------------------------------------------   ---------

     Total purchase price                                                                   $182,062
     ===================================================================================   =========



     The purchase price was allocated as follows:

     In thousands
     -----------------------------------------------------------------------------------   ---------

     Capsure net assets at historical cost                                                  $100,875
     Fair value adjustments:
        Purchased intangibles                                                                (73,844)
        Intangibles arising from Merger                                                      155,031
     -----------------------------------------------------------------------------------   ---------

     Total purchase price                                                                   $182,062
     ===================================================================================   =========



     CNA Surety's beginning stockholders' equity was comprised of the following:

     In thousands
     -----------------------------------------------------------------------------------   ---------

     Purchase price                                                                         $182,062
     Capital contribution of $52,250 from CCC and the effects of reinsurance agreements       62,859
     -----------------------------------------------------------------------------------   ---------

     Stockholders' equity                                                                   $244,921
     ===================================================================================   =========
</TABLE>

Unaudited Pro Forma Results
The following table of unaudited pro forma information has been prepared as if
the acquisition of Capsure had been consummated at the beginning of each
respective year. This unaudited pro forma financial information gives effect to
the following: (i) adjustment to the Capsure statement of operations for the
year ended December 31, 1996, as reported, to reflect the income effects as if
the $10 per share special distribution was made on January 1, 1996; (ii)
consummation of the Merger and the related transactions and the contribution of
capital to and the incurrence of additional debt by CNA Surety; (iii) purchase
accounting adjustments to reflect Capsure's assets and liabilities at fair
value; (iv) estimated indirect and overhead expenses for the CCC Surety
Operations; and (v) estimated interest expense related to the additional debt:


<TABLE>
     <CAPTION>
                                              Three Months Ended December 31   Years Ended December 31
                                                      (Actual)   (Pro Forma)               (Pro Forma)
                                              ----------------   -----------   -----------------------
                                                     Unaudited     Unaudited    Unaudited    Unaudited
     In thousands, except per share amount                1997          1996         1997         1996
     ---------------------------------------  ----------------   -----------   ----------    ---------
     <S>                                               <C>           <C>         <C>          <C>
     Revenues                                          $71,284       $62,754     $258,682     $250,194
     Net income                                        $10,996       $ 4,345     $ 34,375     $ 22,432
     Earnings per share                                $  0.25       $  0.10     $   0.79     $   0.52
     =======================================  ================   ===========   ==========    =========
</TABLE>

The foregoing unaudited pro forma operating results include non-recurring
charges, primarily merger-related costs of Capsure, of $22.0 million, net of tax
(or $0.51 per share) for the year ended December 31, 1997 and $1.1 million, net
of tax (or $0.03 per share) and $5.7 million, net of tax (or $0.13 per share) of
non-recurring charges and merger-related costs of Capsure for the three and
twelve month periods ended December 31, 1996, respectively.


36

<PAGE>   39

      This unaudited pro forma financial information is intended for information
purposes only and is not necessarily indicative of the results of operations
which would have been achieved and reported had the Merger and related
transactions been consummated on the dates assumed, nor is it necessarily
indicative of the future consolidated operating results of CNA Surety.

NOTE 3. Investments
The estimated fair value and amortized cost of fixed income securities held by
CNA Surety by investment category, were as follows:

<TABLE>
<CAPTION>
                                                                           Gross       Gross
                                                         Amortized    Unrealized   Unrealized    Estimated
December 31, 1998  In thousands                       Cost or 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                                          $ 19,009        $  412          $--     $ 19,421
   U.S. Agencies                                            68,922         2,189           --       71,111
   Collateralized mortgage obligations                      17,741            78          (76)      17,743
   Mortgage pass-through securities                         24,834           172           (1)      25,005
Obligations of states and political subdivisions           206,264         2,329         (355)     208,238
Corporate bonds                                             36,538           686         (465)      36,759
Non-agency collateralized mortgage obligations              18,811            32         (149)      18,694
Other asset-backed securities:
   Second mortgages/home equity loans                       12,169           219           (1)      12,387
   Credit card receivables                                   4,896             5           (3)       4,898
   Other                                                     9,682            24          (48)       9,658
---------------------------------------------------   ------------    ----------   ----------   ----------

     Total fixed income securities                        $418,866        $6,146      $(1,098)    $423,914
===================================================   ============    ==========   ==========   ==========
</TABLE>

<TABLE>
<CAPTION>
                                                                           Gross       Gross
                                                         Amortized    Unrealized   Unrealized    Estimated
December 31, 1997  In thousands                       Cost or 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                                          $ 59,140        $  218         $ (3)    $ 59,355
   U.S. Agencies                                            51,331           298           --       51,629
   Collateralized mortgage obligations                      37,550           151         (134)      37,567
   Mortgage pass-through securities                         34,217            42          (89)      34,170
Obligations of states and political subdivisions             3,556            14           --        3,570
Corporate bonds                                             26,644           350         (154)      26,840
Non-agency collateralized mortgage obligations              19,654            41          (69)      19,626
Other asset-backed securities:
   Second mortgages/home equity loans                       21,678            80          (16)      21,742
   Credit card receivables                                   6,498            15           --        6,513
   Other                                                     5,277            18           (6)       5,289
---------------------------------------------------   ------------    ----------   ----------   ----------

     Total fixed income securities                        $265,545        $1,227        $(471)    $266,301
===================================================   ============    ==========   ==========   ==========
</TABLE>


The Company's insurance subsidiaries, as required by state law, deposit certain
securities with state insurance regulatory authorities. At December 31, 1998,
securities on deposit had an aggregate carrying value of $3.7 million.
      Short-term investments are generally comprised of U.S. Treasury bills,
corporate notes, money market funds and investment grade commercial paper
equivalents.


                                                                              37


<PAGE>   40
Notes to Consolidated Financial Statements Cont.

     The amortized cost and estimated fair value of fixed income securities, by
contractual maturity, at December 31, 1998 and 1997 are shown below. Actual
maturities will differ from contractual maturities as borrowers may have the
right to call or prepay obligations with or without call or prepayment
penalties:

<TABLE>
<CAPTION>
          In thousands                                                                1998                         1997
          --------------------------------------------------- ----------------------------  ---------------------------
                                                                                Estimated                     Estimated
          Fixed Income Securities:                            Amortized Cost    Fair Value  Amortized Cost   Fair Value
          --------------------------------------------------- --------------    ----------  --------------   ----------
          <S>                                                       <C>           <C>             <C>          <C>
          Due within one year                                       $  3,354      $  3,364        $     --     $     --
          Due after one year but within five years                    67,091        68,817         112,097      112,616
          Due after five years but within ten years                  160,158       163,152           1,000        1,015
          Due after ten years                                        100,130       100,196          27,574       27,763
          --------------------------------------------------- --------------    ----------  --------------   ----------
                                                                     330,733       335,529         140,671      141,394
          Mortgage pass-through securities, collateralized
             mortgage obligations and asset-backed securities         88,133        88,385         124,874      124,907
          --------------------------------------------------- --------------    ----------  --------------   ----------
                                                                    $418,866      $423,914        $265,545     $266,301
          =================================================== ==============    ==========  ==============   ==========
     </TABLE>

Major categories of net investment income and net realized investment gains
(losses) were as follows:


     <TABLE>
     <CAPTION>
                                                                                                           September 30
                                                                                                               (Date of
                                                                                                             Inception)
                                                                                                Year Ended      through
                                                                                               December 31  December 31
     In thousands                                                                                     1998         1997
     ----------------------------------------------------------------------------------------- ----------- ------------
     <S>                                                                                           <C>           <C>
     Investment income:
        Fixed income securities                                                                    $22,111       $3,061
        Short-term investments                                                                       2,233        2,707
        Other                                                                                          523          112
     ----------------------------------------------------------------------------------------- ----------- ------------

          Total investment income                                                                   24,867        5,880
     Investment expenses                                                                              (608)        (114)
     ----------------------------------------------------------------------------------------- ----------- ------------

     Net investment income                                                                         $24,259       $5,766
     ----------------------------------------------------------------------------------------- ----------- ------------

     Gross realized investment gains:
        Fixed income securities                                                                    $   867       $   90
        Other                                                                                            2           11
     Gross realized investment losses:
        Fixed income securities                                                                        (19)          --
        Other                                                                                           (6)         (16)
     ----------------------------------------------------------------------------------------- ----------- ------------

     Net realized investment gain                                                                  $   844       $   85
     ========================================================================================= =========== ============
</TABLE>

Net unrealized gain on securities included in stockholders' equity at December
31, 1998 and 1997 was comprised of the following:


<TABLE>
<CAPTION>
                                                                   1998                                    1997
                                  -------------------------------------  --------------------------------------
     In thousands                       Gains       Losses          Net         Gains       Losses          Net
     ---------------------------- -----------  -----------  -----------  ------------  -----------  -----------
     <S>                               <C>         <C>          <C>            <C>           <C>           <C>
     Fixed income securities           $6,146      $(1,098)     $ 5,048        $1,227        $(471)        $756
     Other                                 --          (37)         (37)           --          (27)         (27)
     ---------------------------- -----------  -----------  -----------  ------------  -----------  -----------
     
                                       $6,146      $(1,135)       5,011        $1,227        $(498)         729
     ---------------------------- -----------  -----------               ------------  -----------  -----------
     Deferred income taxes                                       (1,754)                                   (255)
                                                            -----------
     
     Net unrealized gain
        on securities                                           $ 3,257                                    $474
     ============================                           ===========                             ===========
</TABLE>


38

<PAGE>   41

NOTE 4. LONG-TERM DEBT
CNA Surety has a five-year unsecured revolving credit facility that provides for
borrowings of up to $130 million. The interest rate on borrowings under the
credit facility may be fixed, at CNA Surety's option, for a period of one, two,
three or six months and is based on, among other rates, the London Interbank
Offered Rate ("libor") plus applicable margin. The margin, including the
facility fee, varies based on CNA Surety's leverage ratio (debt to total
capitalization) and ranges from 0.25% to 0.40%. The credit facility provides for
the payment of all outstanding principal balances after five years with no
required principal payments prior to such time.
      The credit facility contains among other conditions, limitations on CNA
Surety with respect to the incurrence of additional indebtedness and requires
the maintenance of certain financial ratios. As of December 31, 1998, management
believes that the Company was in compliance with all restrictions or covenants
contained in the credit facility agreement.
      The consolidated balance sheet at December 31, 1998 reflects total
long-term debt of $113 million and $118 million at December 31, 1997. The 1997
balance consisted of borrowings of $54 million to retire pre-existing Capsure
debt, $51 million of borrowings of which $50 million was contributed to Western
Surety in connection with the Merger and $13 million of borrowings to pay a
closing dividend to Capsure stockholders and other merger-related costs. The
weighted average interest rate on outstanding borrowings was 5.53% and 6.17% at
December 31, 1998 and 1997, respectively.

NOTE 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, including the discount rates and estimates of future cash
flows. Potential taxes and other transactions 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 and all non-financial instruments such as
insurance contracts 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, 1998 and 1997 were as follows:

<TABLE>
<CAPTION>
                                                       1998                          1997  
                              -----------------------------  ----------------------------
                                                 Estimated                      Estimated
In thousands                  Carrying Amount    Fair Value  Carrying Amount   Fair Value
----------------------------  ---------------    ----------  ----------------  ----------
<S>                                  <C>           <C>               <C>         <C>
Fixed income securities              $423,914      $423,914          $266,301    $266,301
Short-term investments                 57,865        57,865           147,235     147,235
Other investments                       5,830         5,830             6,001       6,001
Cash                                   17,746        17,746               130         130
Long-term debt                        113,000       113,000           118,000     118,000
============================  ===============    ==========  ================  ==========
</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 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.
Long-Term Debt--The estimated fair value of the Company's long-term 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.


                                                                              39

<PAGE>   42

Notes to Consolidated Financial Statements Cont.

NOTE 6. DEFERRED POLICY ACQUISITION COSTS
Policy acquisition costs deferred and the related amortization of deferred
policy acquisition costs were as follows:


<TABLE>
<CAPTION>
                                                                         September 30
                                                                             (Date of      Predecessor
                                                                            Inception)  Nine(1) Months   Predecessor
                                                             Year Ended       through            Ended    Year Ended
                                                            December 31   December 31     September 30   December 31
     In thousands                                                  1998          1997             1997
     -----------------------------------------------------  -----------  -------------  --------------   -----------
     <S>                                                      <C>            <C>              <C>           <C>
     Balance at beginning of period                           $  64,144      $ 69,094         $ 37,689      $ 42,727
        Costs deferred                                          115,764        20,931           48,126        61,344
        Amortization                                           (105,420)      (25,881)         (48,075)      (66,382)
        Deferred policy acquisition costs of Capsure
          at September 30, 1997, date of Merger                      --            --           31,354            --
     -----------------------------------------------------  -----------  -------------  --------------   -----------

     Balance at end of period                                 $  74,488      $ 64,144         $ 69,094      $ 37,689
     =====================================================  ===========  =============  ==============   ===========
</TABLE>

     (1)  Amounts are for Predecessor except for the deferred policy acquisition
          costs of Capsure acquired and the balance at the end of the period 
          which is for CNA Surety.

NOTE 7. REINSURANCE
The Company's insurance subsidiaries, in the ordinary course of business, cede
reinsurance to other insurance companies to limit their exposure to loss.
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 the reinsurance agreements. The Company evaluates the financial condition
of its reinsurers, establishes allowances for uncollectible amounts and monitors
concentrations of credit risk. At December 31, 1998, CNA Surety's largest
reinsurance receivable, including prepaid reinsurance premiums of $1.0 million,
was approximately $3.4 million with a company rated a++ (Superior) by a.m. Best
Company, Inc. The effect of reinsurance on premiums written and earned was as
follows:


<TABLE>
<CAPTION>
                                                 September 30           Predecessor
                                           (Date of Inception)          Nine Months            Predecessor
                             Year Ended               through                 Ended             Year Ended
                            December 31           December 31          September 30            December 31
                                   1998                  1997                  1997                   1996
                  ---------------------   -------------------    ------------------    -------------------
In thousands        Written      Earned    Written     Earned    Written     Earned     Written     Earned
----------------  ---------    --------   ---------  --------    --------  --------    --------   --------
<S>                <C>         <C>         <C>        <C>        <C>       <C>         <C>        <C>
Direct             $105,288    $103,298    $24,561    $27,159    $114,969  $112,751    $152,517   $158,160
Assumed from
   affiliates       172,935     163,003     50,691     40,653          --        --          --         --
Assumed from
   non-affiliates        --          --         --         --       1,106     2,034       2,691      2,429
Ceded                (7,621)     (7,564)    (1,263)    (2,379)     (7,445)   (6,221)    (11,304)   (11,520)
----------------  ---------    --------   ---------  --------    --------  --------    --------   --------

Net premiums       $270,602    $258,737    $73,989    $65,433    $108,630  $108,564    $143,904   $149,069
================  =========    ========   =========  ========    ========  ========    ========   ========
</TABLE>

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


40

<PAGE>   43

The effect of reinsurance on losses and loss adjustment expenses incurred was as
follows:

<TABLE>
<CAPTION>
                                                                    September 30
                                                                        (Date of    PREDECESSOR
                                                                       Inception)   Nine Months    PREDECESSOR
                                                        Year Ended       through          Ended     Year Ended
                                                       December 31   December 31   September 30    December 31
In thousands                                                  1998          1997           1997           1996
-----------------------------------------------------  -----------  ------------   ------------    -----------
<S>                                                        <C>           <C>          <C>              <C>
Gross losses and loss adjustment expenses                  $53,828       $12,613      $ (7,265)        $29,952
Reinsurance recoveries                                      (8,830)         (479)       (4,251)          3,054
-----------------------------------------------------  -----------  ------------   ------------    -----------

Net losses and loss adjustment expenses                    $44,998       $12,134      $(11,516)        $33,006
=====================================================  ===========  ============   ============    ===========
</TABLE>

Note 8. Reserves for Losses and Loss Adjustment Expenses
Activity in the reserves for unpaid losses and loss adjustment expenses was as
follows:


<TABLE>
<CAPTION>
                                                                    September 30
                                                                        (Date of       Predecessor
                                                                       Inception)   Nine(1) Months    Predecessor
                                                        Year Ended       through             Ended     Year Ended
                                                       December 31   December 31      September 30    December 31
In thousands                                                  1998          1997              1997           1996
-----------------------------------------------------  -----------  ------------    --------------    -----------
<S>                                                       <C>           <C>               <C>            <C>
Reserves at beginning of period:
Gross                                                     $130,381      $122,281          $119,151       $138,657
Ceded reinsurance                                            7,656         7,273            15,467         24,531
-----------------------------------------------------  -----------  ------------    --------------    -----------
   Net reserves at beginning of period                     122,725       115,008           103,684        114,126
-----------------------------------------------------  -----------  ------------    --------------    -----------
Net incurred loss and loss adjustment expenses:
   Provision for insured events of current period           49,350        12,781            23,484         42,748
   Decrease in provision for insured events of
     prior periods                                          (4,352)         (647)          (35,000)        (9,742)
-----------------------------------------------------  -----------  ------------    --------------    -----------
     Total net incurred                                     44,998        12,134           (11,516)        33,006
-----------------------------------------------------  -----------  ------------    --------------    -----------
Net payments attributable to:
   Current period events                                     6,094         4,256             4,307          7,728
   Prior period events                                      19,595           161             3,780         35,720
-----------------------------------------------------  -----------  ------------    --------------    -----------
     Total net payments                                     25,689         4,417             8,087         43,448
-----------------------------------------------------  -----------  ------------    --------------    -----------
Net reserves of Capsure at September 30, 1997,
   date of Merger                                               --            --            30,927             --
Net reserves at end of period                              142,034       122,725           115,008        103,684
Ceded reinsurance at end of period                           7,986         7,656             7,273         15,467
-----------------------------------------------------  -----------  ------------    --------------    -----------
     Gross reserves at end of period                      $150,020      $130,381          $122,281       $119,151
=====================================================  ===========  ============    ==============    ===========
</TABLE>

(1) Amounts are for Predecessor except for the net reserves of Capsure and both
    ceded reinsurance and gross reserves at the end of the period which are for 
    CNA Surety.

Based on the CCC Surety Operations' study of reserves, management determined
that it had been overly cautious in interpreting claim data and had discounted
favorable trends. Consistent with the CCC Surety Operations' regular study of
reserve levels, the CCC Surety Operations released $35.0 million of prior year
reserves in 1997. Approximately $33 million of this reserve development related
to CIC and principally to accident years prior to 1996.

NOTE 9. COMMITMENTS AND CONTINGENCIES
At December 31, 1998, the future minimum commitment under operating leases was
as follows: 1999-$3.5 million; 2000-$2.4 million; 2001-$2.0 million; 2002-$0.4
million and 2003 and thereafter-$0.1 million. Total rental expense for the year
ended December 31, 1998 was $3.3 million and $0.8 million for the period from
September 30, 1997 (date of inception) through December 31, 1997.

                                                                              41
<PAGE>   44

Notes to Consolidated Financial Statements Cont.

     The Company and its subsidiaries are parties to various lawsuits arising in
the normal course of business, some seeking material damages. The Company
believes the resolution of these lawsuits will not have a material adverse
effect on its financial condition or its results of operations.

NOTE 10. INCOME TAXES
The components of deferred income taxes as of December 31, 1998 and 1997 were as
follows:

<TABLE>
<CAPTION>
     In thousands                                                 1998         1997
     -------------------------------------------------------  --------      -------
     <S>                                                      <C>           <C>
     Deferred tax assets related to:
        Net operating losses                                  $  3,767      $17,516
        Unearned premium reserve                                12,709       11,737
        Accrued expenses                                         3,768        5,205
        Loss and loss adjustment expense reserve                 3,059        2,444
        Other                                                    2,644        2,966
     -------------------------------------------------------  --------      -------

          Total gross deferred tax assets                       25,947       39,868
     -------------------------------------------------------  --------      -------

        Valuation allowance                                         --        7,950
     -------------------------------------------------------  --------      -------

     Deferred tax asset, net of valuation allowance             25,947       31,918
     Deferred tax liabilities related to:
        Deferred policy acquisition costs                       26,071       22,450
        Intangible assets                                        6,727        7,085
        Unrealized gain on securities                            1,754          255
        Other                                                    2,044        2,043
     -------------------------------------------------------  --------      -------

          Total deferred tax liabilities                        36,596       31,833
     -------------------------------------------------------  --------      -------

     Net deferred tax asset (liability)                       $(10,649)       $  85
     =======================================================  ========      =======
</TABLE>

CNA Surety and its subsidiaries file a consolidated federal income tax return.
As of December 31, 1998, approximately $10.8 million of consolidated nols
remained available to offset future taxable income of the Company and its
subsidiaries. Such carryforwards, which have an aggregate gross tax benefit of
$3.8 million, expire by tax year as follows: $7.1 million in 1999 and $2.4
million in 2000, $0.9 million in 2001 and $0.4 million in 2002. Although
realization is not assured, management believes that it is more likely than not
that CNA Surety will generate sufficient taxable income to utilize approximately
$3.8 million of tax benefits from its available nols as of December 31, 1998. As
of December 31, 1997, the Company established a valuation allowance of
approximately $8.0 million due to limitations placed on the Company's ability to
utilize Capsure's available nol that expired at the end of the 1997 tax year.
Such estimates consider the restrictions placed on the Company's ability to
utilize Capsure's nols, the earnings history of each of its insurance
subsidiaries and projections of future taxable income. The amount of the
deferred tax asset considered realizable, however, could be reduced in the near
term if estimates of future taxable income during the carryforward period are
substantially reduced. The income tax provisions consisted of the following:


<TABLE>
<CAPTION>
                                                September 30
                                                    (Date of  Predecessor
                                                   Inception) Nine Months  Predecessor
                                    Year Ended       through        Ended   Year Ended
                                   December 31   December 31 September 30  December 31
In thousands                              1998          1997         1997         1996  
---------------------------------  -----------  ------------ ------------  -----------
<S>                                    <C>            <C>         <C>          <C>
Federal current                        $20,087        $2,558      $21,466      $13,294
Federal deferred                         7,485         4,038         (225)      (1,106)
State                                      671            67           --           --
---------------------------------  -----------  ------------ ------------  -----------

Total income tax expense               $28,243        $6,663      $21,241      $12,188
=================================  ===========  ============ ============  ===========
</TABLE>


42

<PAGE>   45

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

<TABLE>
<CAPTION>
                                                                    September 30
                                                                        (Date of    PREDECESSOR
                                                                       Inception)   Nine Months    PREDECESSOR
                                                        Year Ended       through          Ended     Year Ended
                                                       December 31   December 31   September 30    December 31
                                                              1998          1997           1997           1996
-----------------------------------------------------  -----------  ------------   ------------    -----------
<S>                                                        <C>           <C>             <C>            <C>   
Federal statutory rate                                       35.0%         35.0%           35.0%          35.0%
Tax exempt income deduction                                  (1.7)           --              --             --
Non-deductible expenses, principally amortization
   of goodwill                                                2.6           2.4             0.2            0.4
State income tax, net of federal income tax benefit           1.0           0.2              --             --
Other                                                         1.4           0.1              --             --
-----------------------------------------------------  -----------  ------------   ------------    -----------

Total income tax expense                                     38.3%         37.7%           35.2%          35.4%
=====================================================  ===========  ============   ============    ===========
</TABLE>

NOTE 11. EMPLOYEE BENEFITS
CNA Surety sponsors a tax deferred savings plan ("401(k) plan") covering
substantially all of its employees. Under the 401(k) plan, the Company matches
70% of the participating employee's contribution up to 6% of eligible
compensation (4.2% 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 $3.2 million for
the year ended December 31, 1998 and $0.6 million for the period from September
30, 1997 (date of inception) through December 31, 1997.
      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 actuarially determined net
periodic post-retirement costs for these plans was $0.4 million for the year
ended December 31, 1998 and $0.1 million for the period from September 30, 1997
(date of inception) through December 31, 1997. The unfunded accumulated
post-retirement benefit obligation (for retirees and fully vested active plan
participants) was $4.9 million as of December 31, 1998 and is included in other
liabilities in the consolidated balance sheet.

NOTE 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
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.

                                                                              43

<PAGE>   46
Notes to Consolidated Financial Statements Cont.

     The Plan provides for the granting of incentive stock options as defined
under the Code. All non-qualified stock options and incentive stock options
granted under the Plan expire 10 years after the date of grant and in the case
of the Replacement Plan the options expire 10 years from the original Capsure
grant date.

<TABLE>
     <CAPTION>
                                                                         Weighted
                                                  Shares Subject   Average Option
                                                       to Option  Price Per Share
     -------------------------------------------  --------------  ---------------
     <S>                                                 <C>               <C>
     Balance at September 30, 1997                       335,235           $ 3.46
        Options granted                                  463,500           $15.82
        Options cancelled                                (23,363)          $15.58
        Options exercised                                (26,000)          $ 4.86
     -------------------------------------------  --------------

     Balance at December 31, 1997                        749,372           $10.68
     ===========================================  ==============

        Options granted                                  153,200           $15.50
        Options cancelled                                (15,475)          $15.87
        Options exercised                               (145,031)          $ 3.47
     -------------------------------------------  --------------

     Balance at December 31, 1998                        742,066           $13.34
     ===========================================  ==============
</TABLE>

As of December 31, 1998, the number of shares available for granting of options
under the Plan were 2,086,903. 
     The following table summarizes information about stock options outstanding
at December 31, 1998:

<TABLE>
<CAPTION>
                                                                          Options Outstanding               Options Exercisable
                                            -------------------------------------------------   -------------------------------
                                                          Weighted Average   Weighted Average                  Weighted Average
                                 Range of        Number          Remaining           Exercise         Number           Exercise
                          Exercise Prices   Outstanding   Contractual Life              Price    Exercisable              Price
-----------------------------------------   -----------   ----------------   ----------------    -----------   ----------------
                         <S>                    <C>              <C>                   <C>           <C>                  <C>
                         $2.25 to $15.875       742,066          8.3 years             $13.34        127,944              $3.26
=========================================   ===========   ================   ================    ===========   ================
</TABLE>

The weighted average fair market value (at grant date) per option granted was
$5.04 and $6.62 respectively, for options granted during 1998 and the period
from September 30, 1997 (date of inception) through December 31, 1997. 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, 1998: risk free interest rate of 4.45%; dividend yield of 2.0%;
expected option life of six years; and volatility of 33.4%. Similar assumptions
for the period from September 30, 1997 (date of inception) through December 31,
1997 were: risk free interest rate of 5.76%; dividend yield of 0%; expected
option life of six years; and volatility of 30.6%.
      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 year
ended December 31, 1998 would have been $44.8 million and net income and diluted
net income per share would have been $1.02 and for the period from September 30,
1997 (date of inception) through December 31, 1997 would have been $10.9 million
and net income and diluted net income per share would have been $0.25.





44

<PAGE>   47

      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, 1998 were 6,563. Common Stock Units are convertible into CNA Surety
common stock at the election of the director.

NOTE 13. Segment Information
The Company principally operates in the surety and fidelity segment of the
domestic property and casualty insurance industry. The domestic market
aggregates approximately $3.6 billion in direct written premiums, comprised of
approximately $2.7 billion in surety premiums and approximately $0.9 billion in
?delity premiums. Approximately 80% of the domestic surety market is represented
by bonds required by federal statutes, state laws and local ordinances. Premiums
related to foreign exposures represented less than five percent of the Company's
1998 gross written premiums.

NOTE 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
permitted statutory accounting practices of CNA Surety's insurance subsidiaries
did not have a material effect on reported statutory surplus or income. 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.
      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
the company or regulators. As of December 31, 1998, 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 1999, CNA Surety's insurance subsidiaries may pay stockholder
dividends of $32.7 million in the aggregate. Combined statutory surplus for the
insurance subsidiaries at December 31, 1998 was $169.9 million.


                                                                              45


<PAGE>   48
Notes to Consolidated Financial Statements Cont.

NOTE 15. RELATED PARTY TRANSACTIONS

     CCC and the insurance subsidiaries of the Company have entered into various
reinsurance agreements designed to protect against adverse loss reserve
development related to the CCC Surety Operations reserves at the Merger Date,
and help preserve, through the year 2000, the profitability of CCC Surety
Operations and certain additional accounts. The reinsurance agreements together
with the Services and Indemnity Agreement, that is described below, provided for
the initial transfer of the CCC Surety Operations to the insurance subsidiaries.
The reinsurance agreements entered into at the Merger Date are: (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").
     The Services and Indemnity Agreement provides the insurance subsidiaries
with the authority to perform various administrative, management, underwriting
and claim functions in order to conduct the business of the CCC Surety
Operations and to be reimbursed by CCC for services rendered. In consideration
for providing the foregoing services, CCC has agreed to pay the insurance
subsidiaries a quarterly fee of $50,000. There was no amount due to the CNA
Surety insurance subsidiaries as of December 31, 1998.
     Through the Quota Share Treaty, CCC and CIC ceded, as of the Merger Date,
and subsequently paid on October 1, 1997, to Western Surety all of its net
unearned premiums and loss and loss adjustment expense reserves, net of $29.0
million of ceded commissions. The payment totaled $116.9 million.
     Through the Quota Share Treaty, CCC and CIC will also transfer to Western
Surety all of the CCC Surety Operations' business written or renewed by CCC and
CIC after the Merger Date. CCC and CIC will 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, $100.8 million for the year ended
December 31, 1998 and $21.2 million during the period from September 30, 1997
(date of inception) through December 31, 1997. As of December 31, 1998 and 1997,
CNA Surety had a reinsurance receivable balance from CCC and CIC of $47.2
million and $47.9 million, respectively. This balance is primarily comprised of
direct premium receivables of CCC and CIC with respect to the surety business
ceded to Western Surety.
     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, 1998. The Quota Share Treaty has a term of five
years from the Merger Date.

     The Stop Loss Contract protects 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 limits the insurance
subsidiaries' prospective net loss ratios with respect to certain accounts and
lines of insured business for at least three fiscal years following the Merger
Date. In the event the insurance subsidiaries' accident year net loss ratio
exceeds 24% in each 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 will pay to CCC an annual
premium of $20,000. The CNA Surety insurance subsidiaries have paid CCC all
required annual premiums. There was no amount due to the CNA Surety insurance
subsidiaries from CCC under the Stop Loss Contract as of December 31, 1998.



46
<PAGE>   49

      The Excess of Loss Contract provides 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 in excess of the $55 million of coverage provided to the insurance
subsidiaries by third-party reinsurers, which is in turn in excess of the $5
million of coverage per principal to be retained by the CNA Surety insurance
subsidiaries. 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. The Excess of Loss Contracts collectively provide coverage for losses
discovered on surety bonds in force as of the Merger Date and for losses
discovered on new and renewal business written, renewed or assumed during the
term of the Excess of Loss Contracts. CCC is also obligated to act as a joint
insurer, or "co-surety," for business covered by the Excess of Loss Contract
when requested by the CNA Surety insurance subsidiaries. In consideration for
the reinsurance coverage provided by the Excess of Loss Contracts, the insurance
subsidiaries pay 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 CNA Surety insurance
subsidiaries paid $80,000 for all minimum quarterly premiums due through
September 30, 1998 during the period from September 30, 1997 (date of inception)
through December 31, 1997. CNA Surety insurance subsidiaries paid the remaining
$20,000 in premium for 1998 for Excess of Loss Contract and the $20,000 in
minimum quarterly premiums for the Second Excess of Loss Contract during the
year ended December 31, 1998. There were no amounts due to CCC under the Excess
of Loss Contract and Second Excess of Loss Contract as of December 31, 1998.
Both Excess of Loss Contracts commenced immediately following the Merger Date
and continue for a period of five years from the Merger Date.
      CNA Surety also entered into an Administrative Services Agreement with CCC
as of the Merger Date. The agreement allows the Company continued use of certain
real and personal property owned or leased by CCC. The Company may cancel,
without penalty, any lease under the agreement by giving CCC sixty days notice.
The Company can also purchase many of the administrative services provided to
the CCC Surety Operations by CCC. CNA Surety, however, is under no obligation to
purchase any services under the Administrative Services Agreement. The aggregate
maximum annual cost for the use of real and personal property and for services
available under the agreement is approximately $7.9 million. Administrative
services are provided at specified rates, subject to inflationary increases. The
Company was charged $7.5 million and $2.5 million for the year ended December
31, 1998 and the period from September 30, 1997 to December 31, 1997,
respectively, for rents and services provided under the agreement. In addition,
the Company was charged $2.2 million for direct costs incurred by CCC on the
Company's behalf during 1998. The Company paid CCC $9.5 million and $0.8 million
which was reflected in other liabilities in the Company's Consolidated Balance
Sheet at December 31, 1998.



                                                                              47

<PAGE>   50
Notes to Consolidated Financial Statements Cont.

NOTE 16. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of the results of operations of CNA Surety for the
year ended December 31, 1998 and for the period from September 30, 1997 (date of
inception) through December 31, 1997 and a summary of unaudited quarterly
results of the Predecessor for the nine months ended September 30, 1997 and year
ended December 31, 1996.

<TABLE>
<CAPTION>
CNA Surety
In thousands, except per share amounts               First Quarter Second Quarter Third Quarter Fourth Quarter
---------------------------------------------------  ------------- -------------- ------------- --------------
<S>                                                        <C>            <C>           <C>            <C> 
1998
Revenues                                                   $65,534        $69,399       $75,325        $73,582
===================================================  ============= ============== ============= ==============
Income before income taxes                                 $15,981        $17,800       $18,507        $21,470
Income taxes                                                 6,166          6,643         7,025          8,409
---------------------------------------------------  ------------- -------------- ------------- --------------
Net income                                                 $ 9,815        $11,157       $11,482        $13,061
===================================================  ============= ============== ============= ==============
Basic and diluted earnings per common share                $  0.23        $  0.25       $  0.26        $  0.30
===================================================  ============= ============== ============= ==============

                                                                                                  Inception to
1997                                                                                               December 31
                                                                                                ==============
Revenues                                                                                               $71,284
===================================================                                             ==============
Income before income taxes                                                                             $17,659
Income taxes                                                                                             6,663
---------------------------------------------------                                             --------------
Net income                                                                                             $10,996
===================================================                                             ==============
Basic and diluted earnings per common share                                                            $  0.25
===================================================                                             ==============
</TABLE>

<TABLE>
<CAPTION>
Predecessor
                                                     First Quarter Second Quarter Third Quarter Fourth Quarter
---------------------------------------------------  ------------- -------------- ------------- --------------
<S>                                                        <C>            <C>           <C>            <C>
1997
Net earned premiums                                        $33,829        $36,155       $38,580        $    --
===================================================  ============= ============== ============= ==============

Excess of net earned premiums over direct
   operating costs                                         $41,878        $ 8,174       $10,354        $    --
Income taxes                                                14,690          2,894         3,657             --
---------------------------------------------------  ------------- -------------- ------------- --------------

Excess of net earned premiums over direct
   operating costs, net of income taxes                    $27,188        $ 5,280       $ 6,697        $    --
===================================================  ============= ============== ============= ==============

1996
Net earned premiums                                        $37,029        $37,504       $37,769        $36,767
===================================================  ============= ============== ============= ==============

Excess of net earned premiums over direct
   operating costs                                         $ 6,696        $ 8,527       $13,472        $ 5,753
Income taxes                                                 2,377          3,017         4,748          2,046
---------------------------------------------------  ------------- -------------- ------------- --------------

Excess of net earned premiums over direct
   operating costs, net of income taxes                    $ 4,319        $ 5,510       $ 8,724        $ 3,707
===================================================  ============= ============== ============= ==============
</TABLE>


48


<PAGE>   51

                                                    ----------------------------
                                                    INDEPENDENT AUDITORS' REPORT
                                                    ----------------------------
THE BOARD OF DIRECTORS AND STOCKHOLDERS OF CNA SURETY CORPORATION
We have audited the consolidated balance sheets of CNA Surety Corporation and
subsidiaries as of December 31, 1998 and 1997, and the related consolidated
statements of income, stockholders' equity, and cash flows for the year ended
December 31, 1998 and for the period from September 30, 1997 (date of inception)
through December 31, 1997. We have also audited the accompanying special-purpose
statements of certain revenues and direct operating expenses of CCC Surety
Operations, a business unit of CNA Financial Corporation for the year ended
December 31, 1996 and for the nine-month period ended September 30, 1997. 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 generally accepted auditing
standards. 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 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.
      The accompanying special-purpose financial statements were prepared to
present certain revenues and direct operating expenses of CCC Surety Operations
and are not intended to be a complete presentation of CCC Surety Operations.
Note 1 to the consolidated financial statements describes the basis of
presentation of these special-purpose financial statements.
      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, 1998 and 1997, and the results of their
operations and their cash flows for the year ended December 31, 1998 and for the
period from September 30, 1997 (date of inception) through December 31, 1997, in
conformity with generally accepted accounting principles. Furthermore, in our
opinion, such special-purpose financial statements present fairly, in all
material respects, certain revenues and direct operating expenses of CCC Surety
Operations for the year ended December 31, 1996 and for the nine-month period
ended September 30, 1997, in conformity with generally accepted accounting
principles.

/s/ Deloitte & Touche LLP 

Chicago, Illinois
February 8, 1999



                                                                              49

<PAGE>   52

----------------------
DIRECTORS AND OFFICERS
----------------------

<TABLE>
     <S>                                <C>                                <C>
     BOARD OF DIRECTORS                 Melvin Gray                        Adrian M. Tocklin
     Giorgio Balzer                     Graycor, Inc.                      CNA
     Businessmen's Assurance                                               Retired
     Company of America
                                        Joe P. Kirby                                             
     Philip H. Britt                    Western Surety Company             R. T. Van Gieson
     First Chicago nbd                  Retired                            CNA

     Rod F. Dammeyer                    William C. Pate                    Mark C. Vonnahme
     Equity Group Investments, Inc.     Equity Group Investments, Inc.     CNA Surety Corporation

     Edward Dunlop                      Roy E. Posner
     Chubb Corp.                        Loews Corporation
     Retired                            Retired

                      

     OFFICERS                           John S. Heneghan                   Stephen T. Pate
     Robert E. Ayo                      Vice President,                    Senior Vice President
     Senior Vice President and          Chief Financial Officer            CNA Surety Corporation
     Chief Underwriting Officer,        and Treasurer                      President and
     Contract Surety                    CNA Surety Corporation             Chief Operating Officer
     CNA Surety Corporation                                                Western Surety Company
                                        Dan L. Kirby
     Michael A. Dougherty               Executive Vice President,          Thomas A. Pottle
     Vice President                     Legislative Affairs                Senior Vice President
     and Chief Marketing Officer        CNA Surety Corporation             and Chief Operations Officer
     CNA Surety Corporation                                                CNA Surety Corporation
                                        Paul T. Lively
     Melita H. Geoghegan                Vice President,                    Sharon A. Sartori
     Vice President and                 General Counsel and Secretary      Senior Vice President and
     Chief Human Resources Officer      CNA Surety Corporation             Chief Underwriting Officer,
     CNA Surety Corporation                                                Commercial Surety
                                        Jack L. McReynolds                 CNA Surety Corporation
     Thomas P. Greasel                  Vice President
     Vice President and                 CNA Surety Corporation             Mark C. Vonnahme
     Chief Claims Officer               President and                      President and
     CNA Surety Corporation             Chief Operating Officer            Chief Executive Officer
                                        Universal Surety of America        CNA Surety Corporation




     CORPORATE OFFICES                  INVESTOR SERVICES                  TRANSFER AGENT
     CNA Plaza                          Questions regarding                To keep securities information
     Chicago, Illinois 60685            security ownership                 up to date, please advise the
                                        should be directed                 transfer agent of your new address
     NYSE: SUR                          to the Company's                   or change of name. Write or
                                        Finance Department.                call them directly at:
     INDEPENDENT ACCOUNTANTS            Write to the corporate
     AND AUDITORS                       office address or                  BankBoston, N.A.
     Deloitte & Touche LLP              call (312)822-1908.                c/o EquiServe Limited Partnership
                                                                           P.O. Box 8040
     ANNUAL MEETING Tuesday,            To request printed                 Boston, Massachusetts 02266-8040
     May 11, 1999, 9:00 am CDT          information, please                (800) 736-3001
     CNA Plaza 333 South Wabash         call the Company's                 www.equiserve.com
     44th Floor South                   information request
     Conference Center                  line at (800) 262-9740.
     Chicago, Illinois 60685
                                        Please send change of address
                                        notices directly to the
                                        transfer agent.
</TABLE>                                        
                                                                  
50

<PAGE>   53









CNA SURETY
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