CNA Surety leases approximately 81,100 square feet of office space for its primary processing and service center at 101 South Phillips Avenue, Sioux Falls, South Dakota, under a lease expiring in 2012. The annual rent, which is subject to annual adjustments, was $1.4 million as of December 31, 2005. CNA Surety also leased space for contract and commercial branch offices in Tallahassee, Florida, New York, New York; Troy, Michigan; Roseville,
Management believes the most significant accounting policies and related disclosures for purposes of understanding the Company's results of operations and financial condition pertain to reserves for unpaid losses and loss adjustment expenses and reinsurance, investments, goodwill and other intangible assets, recognition of premium revenue and the related unearned premium liability, and deferred policy acquisition costs. The Company's accounting policies related to reserves for unpaid losses and loss adjustment expenses and related estimates of reinsurance recoverables, are particularly critical to an assessment of the Company's financial results. These balances are highly subjective and require management's most complex judgments because of the need to make estimates about the effects of matters that are inherently uncertain.
As of any balance sheet date, not all claims have been reported and some claims may not be reported for many years. As a result, the liability for unpaid losses includes significant estimates for incurred-but-not-reported ("IBNR") claims. The following table shows the estimated liability as of December 31, 2005 for unpaid claims applicable to reported claims and to IBNR (dollars in thousands) for each sub-line of business:
- Changes in underwriting standards and business mix such as the Company's efforts to reduce exposures to large commercial bonds
The Company's Consolidated Balance Sheet includes estimated liabilities for unpaid losses and loss adjustment expenses of $424.4 million and reinsurance receivables related to unpaid losses of $147.4 million at December 31, 2005 compared to estimates of $363.4 million and $116.8 million, respectively, at December 31, 2004.
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
A significant amount of judgment is required in performing goodwill impairment tests. Such tests include periodically determining or reviewing the estimated fair value of CNA Surety's reporting units. Under the relevant standard, fair value refers to the amount for which the entire reporting unit may be bought or sold. There are several methods of estimating fair value, including market quotations, asset and liability fair values and other valuation techniques, such as discounted cash flows and multiples of earnings or revenues. The Company uses a valuation technique based on discounted cash flows. If the carrying amount of a reporting unit, including goodwill, exceeds the estimated fair value, then individual assets, including identifiable intangible assets, and liabilities of the reporting unit are estimated at fair value. The excess of the estimated fair value of the reporting unit over the estimated fair value of net assets would establish the implied value of goodwill. The excess of the recorded amount of intangible assets over the implied value of intangible assets is recorded as an impairment loss.
COMPARISON OF CNA SURETY ACTUAL RESULTS FOR THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003
The Company had net income of $38.4 million for the year ended December 31, 2005 as compared to $39.7 million for the year ended December 31, 2004, and a net loss of $14.2 million for the year ended December 31, 2003. The decrease in 2005 reflects higher losses in large part due to the establishment of a $60.0 million net loss reserve related to the large national contractor (discussed later), partially offset by increased favorable loss development on prior accident years of $22.7 million. The higher losses were also offset by higher net earned premium, higher net investment income, and lower expenses. The increase in 2004 compared to 2003 reflects the absence of adverse loss development of $39.0 million which occurred during the third quarter of 2003, higher net earned premium and higher net investment income, partially offset by higher expenses.
CNA Surety primarily markets contract and commercial surety bonds. Contract surety bonds generally secure a contractor's performance and/or payment obligation with respect to a construction project. Contract surety bonds are generally required by federal, state and local governments for public works projects. The most common types include bid, performance and payment bonds. Commercial surety bonds include all surety bonds other than contract and cover obligations typically required by law or regulation. The commercial surety market includes numerous types of bonds categorized as court judicial, court fiduciary, public official, license and permit and many miscellaneous bonds that include guarantees of financial performance. The Company also writes fidelity bonds that cover losses arising from employee dishonesty and other insurance products that are generally companion products to certain surety bonds. For example, the Company writes surety bonds for notaries and also offers related errors and omissions ("E&O") insurance coverage.
The Company assumes significant amounts of premiums primarily from affiliates. This includes all surety business written or renewed, net of reinsurance, by CCC and CIC, and their affiliates, after the Merger Date that is reinsured by Western Surety pursuant to reinsurance and related agreements. Because of certain regulatory restrictions that limit the Company's ability to write business on a direct basis, the Company continues to utilize the underwriting capacity available through these agreements. The Company is in full control of all aspects of the underwriting and claim management of the assumed business.
Gross written premiums for the years ended December 31, 2005, 2004 and 2003 are shown in the table below (dollars in thousands) for each sub-line of business:
For the year ended December 31, 2004, net written premiums decreased slightly to $318.3 million as compared to 2003, reflecting higher reinsurance costs. Ceded written premiums increased $19.0 million to $71.1 million for the year ended December 31, 2004 compared to 2003 primarily due to the Company's decision to reduce its per principal retention by purchasing additional reinsurance protection. Net written premiums for contract surety business decreased 6.6% to $172.3 million due to a higher allocation of reinsurance costs in 2004. Because of the significant reductions in exposures to large commercial bonds, a greater share of the reinsurance protection is related to contract bonds. Net written premiums for commercial surety increased 8.0% to $115.5 million for the year ended December 31, 2004. Fidelity and other products increased 9.7% to $30.5 million for the year 2004 as compared to 2003.
The Company's reinsurance program is predominantly comprised of excess of loss reinsurance contracts that limit the Company's retention on a per principal basis. At December 31, 2005, American Re-Insurance Company, Renaissance Reinsurance LTD, XL Reinsurance America, Inc., and Odyssey America Reinsurance Corporation (all rated at least A by A.M. Best) were the four unaffiliated reinsurers from which the Company had its largest reinsurance receivables.
Effective January 1, 2004, CNA Surety entered into a new excess of loss treaty ("2004 Excess of Loss Treaty") with a group of third party reinsurers that reduced its net retention per principal to $10 million with a 5% co- participation in the $90 million layer of third party reinsurance coverage above the Company's retention. This new excess of loss treaty replaced the $45 million excess of $15 million per principal coverage ("2003 Excess of
With respect to the three contract principals other than the large national contractor, two contract principals that have completed asset sales and other reorganization efforts were accepted into the 2004 Excess of Loss Treaty. The Company received claims related to the third contract principal in 2003, making it ineligible for inclusion in the 2004 Excess of Loss Treaty.
Effective January 1, 2005, CNA Surety entered into a new excess of loss treaty ("2005 Excess of Loss Treaty") with a group of third party reinsurers on terms similar to the 2004 Excess of Loss Treaty. Under the 2005 Excess of Loss Treaty, the Company's net retention per principal remained at $10.0 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company's retention. The significant differences between the 2005 Excess of Loss Treaty and the Company's 2004 Excess of Loss Treaty are as follows. The annual aggregate coverage increased from $157 million in 2004 to $185 million in 2005. The actual annual premium for the 2005 Excess of Loss Treaty was $41.3 million compared to the actual cost of the 2004 Excess of Loss Treaty of $50.6 million. The 2005 Excess of Loss Treaty provides coverage for one commercial principal that had been excluded from the 2004 Excess of Loss Treaty. The Company no longer has exposure to a second commercial principal that was excluded from the 2004 Excess of Loss Treaty. Only the large national contractor (described later) that was excluded from the 2004 Excess of Loss Treaty remained excluded from the 2005 Excess of Loss Treaty.
Effective January 1, 2006, CNA Surety entered into a new excess of loss treaty ("2006 Excess of Loss Treaty") with a group of third party reinsurers on terms similar to the 2005 Excess of Loss Treaty. Under the 2006 Excess of Loss Treaty, the Company's net retention per principal remains at $10 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company's retention. The material differences between the 2006 Excess of Loss Treaty and the Company's 2005 Excess of Loss Treaty are as follows. The base annual premium for the 2006 Excess of Loss Treaty is $36.9 million compared to the actual cost of the 2005 Excess of Loss Treaty of $41.3 million. The contract includes an optional extended discovery period, for an additional premium (a percentage of the original premium based on any unexhausted aggregate limit by layer), which will provide coverage for losses discovered beyond 2006 on bonds that were in force during 2006. Only the large national contractor (described later) that was excluded from the 2005 Excess of Loss Treaty remains excluded from the 2006 Excess of Loss Treaty.
The Services and Indemnity Agreement provides the Company's insurance subsidiaries with the authority to perform various administrative, management, underwriting and claim functions in order to conduct the business of CCC and CIC and to be reimbursed by CCC for services rendered. In consideration for providing the foregoing services, CCC has agreed to pay Western Surety a quarterly fee of $50,000. This agreement was renewed on January 1, 2006 and expires on December 31, 2006; and is annually renewable thereafter. There was no amount due to the CNA Surety insurance subsidiaries as of December 31, 2005.
The Quota Share Treaty was renewed on January 1, 2004 on substantially the same terms with an expiration date of December 31, 2004; and is annually renewable thereafter. The ceding commission paid to CCC and CIC by Western Surety remained at 28% of net written premiums and contemplated an approximate 4% override commission for fronting fees to CCC and CIC on their actual direct acquisition costs. Due to lower commissions paid to producers on the business covered by the Quota Share Treaty, the actual override commission paid to CCC and CIC for 2004 was approximately 7%. The Quota Share Treaty was renewed for one year on January 1, 2005 on substantially the same terms except that the ceding commission to CCC and CIC was reduced to 25% in order to provide an approximate 4% override commission to CCC and CIC. The Quota Share Treaty was renewed for one year on January 1, 2006 on substantially the same terms as 2005.
Through the Stop Loss Contract, the Company's insurance subsidiaries were protected from adverse loss experience on certain business underwritten after the Merger Date. The Stop Loss Contract between the insurance subsidiaries and CCC limited the insurance subsidiaries' prospective net loss ratios with respect to certain accounts and lines of insured business for three full accident years following the Merger Date. In the event the insurance subsidiaries' accident year net loss ratio exceeds 24% in any of the accident years 1997 through 2000 on certain insured accounts (the "Loss Ratio Cap"), the Stop Loss Contract requires CCC at the end of each calendar quarter following the Merger Date, to pay to the insurance subsidiaries a dollar amount equal to (i) the amount, if any, by which their actual accident year net loss ratio exceeds the applicable Loss Ratio Cap, multiplied by (ii) the applicable net earned premiums. In consideration for the coverage provided by the Stop Loss Contract, the insurance subsidiaries paid to CCC an annual premium of $20,000. The CNA Surety insurance subsidiaries have paid CCC all required annual premiums. As of December 31, 2005, the net amount billed and received under the Stop Loss Contract was $45.9 million, which included a return of $9.0 million in 2005 due to a reduction of net loss ratios for years covered by the contract.
for an additional minimum premium of $0.8 million, subject to adjustment based on the level of actual premiums written on bonds for the large national contractor.
The Company and CCC entered into a $50 million excess of $100 million contract for the period of January 1, 2004 to December 31, 2004. The premium for this contract was $6.0 million plus an additional premium if a loss was ceded under this contract. Effective January 1, 2005, the Company and CCC entered into a new $50 million excess of $100 million contract in force through December 31, 2005. The premium for this contract was $4.8 million plus an additional premium of $14.0 million if a loss is ceded under this contract. In the second quarter of 2005, this contract was amended to exclude coverage for the large national contractor, to reduce the premium to $3.0 million, and to reduce the additional premium to $7.0 million. As of December 31, 2005, no losses have been ceded under this contract, which has not been renewed for 2006.
The Company has provided significant surety bond protection guaranteeing projects undertaken by the large national contract principal that is excluded from the Company's third party reinsurance. As previously described, during the second quarter of 2005, the Company and CCC executed amendments to the reinsurance treaties that provide reinsurance protection for losses associated with the large national contractor. Coverage for all losses in excess of an aggregate $60.0 million is now provided under one treaty. Credit extended to the principal by affiliates of the Company is described below.
Loans under the credit facility are secured by a pledge of substantially all of the assets of the contractor and certain of its affiliates. In connection with the credit facility, CNAF has also guaranteed or provided collateral for letters of credit which are charged against the maximum available line and, if drawn upon, would be treated as loans under the credit facility. As of December 31, 2005 and December 31, 2004, these guarantees and collateral obligations aggregated $13.0 million.
The contractor implemented a restructuring plan intended to reduce costs and improve cash flow, and appointed a chief restructuring officer to manage execution of the plan. In the course of addressing various expense, operational and strategic issues, however, the contractor has decided to substantially reduce the scope of its original business and to concentrate on those segments determined to be potentially profitable. As a consequence, operating cash flow, and in turn the capacity to service debt, has been reduced below previous levels. Restructuring plans have also been extended to accommodate these circumstances. In light of these developments, CNAF recorded an impairment charge of $56.0 million pre-tax ($36.0 million after-tax) for the fourth quarter of 2004, net of the participation by Loews, with respect to amounts loaned under the credit facility and future impairment charges with respect to amounts loaned under the credit facility, and an additional pre-tax impairment charge of $13.0 million ($9.0 million after-tax) during the first quarter of 2005.
The Company intends to continue to provide limited surety bonds on behalf of the contractor to support the continuing restructuring efforts. However, existing reinsurance agreements limit the Company's net loss exposure to the $60.0 million that has already been recorded. The Company estimates that possible additional losses, net of indemnification and subrogation recoveries but before recoveries under reinsurance contracts to be approximately $90.0 million pre-tax.
The Company has had discussions with its insurance regulatory authorities regarding the level of bonds provided for this principal and will continue to keep the insurance regulators informed of its ongoing gross exposure to this account.
The loss ratios for the years ended December 31, 2005, 2004 and 2003 were 36.7%, 27.5% and 56.7%, respectively. The loss ratios reflect $23.3 million and $0.6 million of net favorable loss reserve development for the years ended December 31, 2005 and 2004, respectively, and $39.3 million in net unfavorable loss reserve development for the year ended December 31, 2003.
The higher loss ratio in 2005 compared to 2004 reflects the net reserve increase of $60.0 million related to the large national contractor discussed earlier, which added approximately 17 percentage points to this ratio. This was partially offset by increased favorable development from prior accident years and an increase in net earned premium that resulted from the reduction in the cost of the Company's 2005 reinsurance program.
The improvement in the loss ratio from 2003 to 2004 is primarily due to the absence of both the adverse development on prior accident years that was recorded in 2003 and other large losses related to accident year 2003. Past changes in the Company's business mix and reinsurance program along with increased corporate default rates were the primary drivers of the need to substantially increase reserve levels in 2003. Beginning in the late 1990's, the Company began writing more bonds for large corporate clients. Shortly thereafter, corporate default rates increased dramatically. These exposures proved to be more volatile than the Company's more traditional contract and small commercial surety products, and began resulting in a higher frequency of severe losses. As a result, the Company's reinsurers significantly increased rates, reduced the amount of coverage available to the Company and excluded certain accounts from the reinsurance program. For 2002, the Company's per principal retention increased from $5.0 million to $20.0 million. Although the Company reduced its per principal retention to $15.0 million for 2003, these higher retentions, at a time of continuing higher frequency of severe losses, further increased the volatility of results.
Reported claim activity improved dramatically in 2004 and continued at lower levels through 2005. Management believes that this is a result of ongoing efforts to reduce its exposures to large corporate clients, continued underwriting discipline in its traditional contract and small commercial products and a reduction in corporate default rates. In 2005, the Company was able to achieve favorable settlements on several large claims that resulted in claim payments that were substantially less than had been previously expected. Two of these favorable settlements were on cases that were part of the adverse loss development recorded in 2003 that is discussed below. In one of these cases, the Company's negotiating position turned out to be stronger than expected. In the other case, the Company was able to negotiate a settlement that included significant recoveries that were not previously expected. In addition, the Company was able to reduce reserves on several large open claims based on new information that emerged in 2005. The independent actuarial review conducted in 2005 confirmed that the favorable claim settlements, the lower reserves on open claims and the reduced level of new claim activity had resulted in a reserve redundancy. Accordingly, the Company recorded favorable loss development of $23.3 million in 2005, primarily for accident years 2002 and 2003.
the settlement, after anticipated recoveries under excess of loss reinsurance treaties, was previously fully reserved. Immediately upon execution of the settlement documents, the Company sent written notice for reimbursement to its reinsurers. As of December 31, 2005, the Company billed a total of $37.1 million to its reinsurers. All nine reinsurers responsible for payment of the treaty proceeds either have paid their portions of the claim or paid the Company to commute the entire reinsurance treaty under which the Enron claim was made.
The Company manages its exposure to any one contract credit and aggressively looks for co-surety, shared accounts and other means to support or reduce larger exposures. Reinsurance, indemnification and subrogation rights, including rights to contract proceeds on construction projects in the event of default, exist that substantially reduce CNA Surety's exposure to loss.
The expense ratio decreased to 58.1% for 2005 as compared to 65.2% for 2004. The decrease in the expense ratio for 2005 primarily reflects higher net earned premium resulting from lower reinsurance costs, the impacts of cost reduction initiatives that began in the first quarter of 2004, and the absence of expenses associated with the increased accrual for policyholder dividends discussed below. These changes decreased the expense ratio by 2.7, 2.9, and 1.5 percentage points, respectively. Ceded earned premium decreased by $15.5 million in 2005 as compared to 2004. Operating expenses decreased 2.2% for 2005 primarily due to the impacts of cost reduction initiatives that began in the first quarter of 2004 and the absence of expenses associated with the increased accrual for policyholder dividends.
2004 expense ratio. The Company streamlined its field office structure during 2004 in order to add consistency to operations and to reduce expenses. No significant expense impact occurred in 2004 due to severance costs associated with this effort.
For 2005, net investment income was $33.7 million compared to net investment income for 2004 and 2003 of $30.2 million and $26.3 million, respectively. The annualized pre-tax yield was 4.4%, 4.5% and 4.4% for 2005, 2004 and 2003, respectively. The annualized after-tax yield was 3.7%, 3.7% and 3.6% for 2005, 2004 and 2003, respectively. The increase in investment income for 2005 is attributable to higher overall invested assets resulting primarily from significant cash flow from operations.
The following summarizes net realized investment gains for the years ended December 31, 2005, 2004, and 2003:
At December 31, 2005, the carrying value of the Company's insurance subsidiaries' invested assets was comprised of $721.3 million of fixed income securities, $48.4 million of short-term investments, $1.0 million of other investments and $4.3 million of cash. At December 31, 2004, the carrying value of the Company's insurance subsidiaries' invested assets was comprised of $722.0 million of fixed income securities, $22.7 million of short-term investments, $1.1 million of other investments and $5.6 million of cash.
During the fourth quarter of 2004, the Company reached agreement with the claimant on a bond regarding certain aspects of the claim resolution. The bond was originally written by an affiliate and assumed by one of the Company's insurance subsidiaries pursuant to the Quota Share Treaty. As part of this agreement, the Company deposited $32.7 million with the affiliate in 2005 to enable the affiliate to establish a trust to fund future payments under the bond. This deposit is included on the Company's Consolidated Balance Sheets as "Deposit with affiliated ceding company". This claim was previously fully reserved. The Company is entitled to the interest income earned by the trust.
Cash flow at the parent company level is derived principally from dividend and tax sharing payments from its insurance subsidiaries, and to a lesser extent, investment income. The principal obligations at the parent company level are to service debt and pay operating expenses, including income taxes. At December 31, 2005, the parent company's invested assets consisted of $1.0 million of fixed income securities, $1.3 million of equity securities, $16.6 million of short-term investments and $2.6 million of cash. At December 31, 2004, the parent company's invested assets consisted of $6.4 million of fixed income securities, $1.2 million of equity securities, $5.8 million of short-term investments and $1.8 million of cash. As of December 31, 2005 and December 31, 2004, parent company short-term investments and cash included $6.6 million and $5.1 million, respectively, of restricted cash primarily related to premium receipt collections ultimately due to the Company's insurance subsidiaries.
The Company's consolidated net cash flow provided by operating activities was $70.0 million, $108.0 million and $25.2 million for 2005, 2004 and 2003, respectively. The decrease in net cash flow provided by operating activities in 2005 primarily relates to the deposit with the affiliated ceding company discussed earlier and higher loss payments. The increase in net cash flow provided by operating activities in 2004 primarily relates to higher premiums received, lower loss payments, receipts from reinsurers and an income tax refund related to the operating loss of 2003.
On July 27, 2005, the Company refinanced $30.0 million in outstanding borrowings under its previous credit facility with a new credit facility (the "2005 Credit Facility"). The 2005 Credit Facility provides an aggregate of up to $50.0 million in borrowings under a revolving credit facility. The 2005 Credit Facility matures on June 30, 2008. In November of 2005, the Company reduced outstanding borrowings by $10.0 million to $20.0 million. No other debt matures in the next five years.
A summary of the Company's commitments as of December 31, 2005 is presented in the following table:
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 2006 is based on statutory surplus and income at and for the year ended December 31, 2005. Without prior regulatory approval in 2006, CNA Surety's insurance subsidiaries may pay to CNA Surety dividends of $39.1 million in the aggregate. CNA Surety received dividends of $20.0 million from its insurance subsidiaries during 2005 and no dividends from its insurance subsidiaries during 2004. CNA Surety received $1.5 million in dividends from its non-insurance subsidiaries during 2005, including $0.5 million in cash. CNA Surety received no dividends from its non-insurance subsidiaries during 2004.
Combined statutory surplus totaled $275.2 million at December 31, 2005, resulting in a net written premium to statutory surplus ratio of 1.3 to 1.0. Insurance regulations restrict Western Surety's maximum net retention on a single surety bond to 10 percent of statutory surplus. Under the 2006 Excess of Loss Treaty, the Company's net retention on new bonds would generally be $10 million plus a 5% co-participation in the $90 million layer of excess reinsurance above the Company's retention and this regulation would require minimum statutory surplus of $145.0 million at Western Surety. At December 31, 2005, Western Surety's statutory surplus was $275.2 million. This surplus requirement may limit the amount of future dividends Western Surety could otherwise pay to CNA Surety.
We have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that CNA Surety Corporation and subsidiaries (the "Company") maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.
In our opinion, management's assessment that the Company maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
CNAS management assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2005. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control -- Integrated Framework. Based on our assessment we believe that, as of December 31, 2005, the Company's internal control over financial reporting is effective based on those criteria.
recoverable based on the expected profitability embedded in the reserve for unearned premium. If the expected profitability is less than the balance of deferred acquisition costs, a charge to net income is taken and the deferred acquisition cost balance is reduced to the amount determined to be recoverable. Anticipated investment income is considered in the determination of the recoverability of deferred acquisition costs.
A significant amount of judgment is required in performing intangible asset impairment tests. Such tests include periodically determining or reviewing the estimated fair value of CNA Surety's reporting units. Under the relevant standard, fair value refers to the amount for which the entire reporting unit may be bought or sold. There are several methods of estimating fair value, including market quotations, asset and liability fair values and other valuation techniques, such as discounted cash flows and multiples of earnings or revenues. If the carrying amount of a reporting unit, including goodwill, exceeds the estimated fair value, then individual assets, including identifiable intangible assets, and liabilities of the reporting unit are estimated at fair value. The excess of the estimated fair value of the reporting unit over the estimated fair value of net assets would establish the implied value of intangible assets. The excess of the recorded amount of intangible assets over the implied value of intangible assets is charged-off as an impairment loss.
As allowed under Statement of Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), the Company accounts for its stock option plans in accordance with Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). 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.
Property and equipment are carried at cost less accumulated depreciation. The Company records depreciation using the straight-line method based on the estimated useful lives of the various classes of property and equipment ranging from 3 years to 20 years. Depreciation and amortization expense for 2005, 2004 and 2003 was $4.4 million, $4.5 million and $4.2 million, respectively. The cost of maintenance and repairs is charged to income as incurred; major improvements are capitalized.
The Company's insurance subsidiaries, as required by state law, deposit certain securities with state insurance regulatory authorities. At December 31, 2005, securities on deposit had an aggregate carrying value of $3.3 million.
The amortized cost and estimated fair value of fixed income securities, by contractual maturity, at December 31, 2005 and 2004 are shown below. Actual maturities may differ from contractual maturities as borrowers may have the right to call or prepay obligations with or without call or prepayment penalties (dollars in thousands):
Net unrealized investment gains and losses and the net change in unrealized gains and losses of available-for-sale securities were as follows (dollars in thousands):
The net realized investment gains in 2005 resulted primarily from the Company's sale of its interest in De Montfort Group, Ltd in the first quarter of 2005. This transaction, which settled on January 5, 2005, was discussed as a subsequent event in the Company's 2004 Form 10-K. The net realized investment gains realized in 2004 and 2003 resulted from opportunities to sell securities that the Company believed would maximize the total return on its portfolio.
The following table provides the composition of fixed income securities with an unrealized loss at December 31, 2005 in relation to the total of all fixed income securities by contractual maturities:
The following table summarizes for fixed income securities in an unrealized loss position at December 31, 2005 and 2004, the aggregate fair value and gross unrealized loss by length of time those securities have been continuously in an unrealized loss position (dollars in thousands):
As of December 31, 2005, 93 separate securities held by the Company were in an unrealized loss position. The Company believes that 92 of these securities are in this position because of changes in interest rates. Of these 92 securities, 67 were rated "AAA" by Standard and Poor's ("S&P") and "Aaa" by Moody's Investor Services ("Moody's"). Only one of these 92 securities was in a loss position that exceeded 5% of its book value.
Based on the foregoing information, the Company believes there are no other-than-temporary impairments at December 31, 2005. No other-than-temporary impairments were recorded for 2004 or 2003.
On July 27, 2005, the Company refinanced $30.0 million in outstanding borrowings under its previous credit facility with a new credit facility (the "2005 Credit Facility"). The 2005 Credit Facility provides an aggregate of up to $50.0 million in borrowings under a revolving credit facility. The 2005 Credit Facility matures on June 30, 2008. No other debt matures in the next five years. In November 2005, the Company reduced the outstanding borrowings by $10.0 million to $20.0 million.
The term of borrowings under the 2005 Credit Facility may be fixed, at the Company's option, for a period of one, two, three, or six months. The interest rate is based on, among other rates, the London Interbank Offered Rate ("LIBOR") plus the applicable margin. The margin, including a facility fee and utilization fee, can vary based on the Company's leverage ratio (debt to total capitalization) from 1.15% to 1.45%. The margin was 1.25% at December 31, 2005. As of December 31, 2005, the weighted average interest rate on the 2005 Credit Facility was 5.69% on the $20.0 million of outstanding borrowings.
The Company's previous credit facility (the "2002 Credit Facility"), as amended September 30, 2003, provided an aggregate of up to $50.0 million in borrowings divided between a revolving credit facility of $30.0 million and a term loan facility (the "Term Loan Facility") of $20.0 million. As of December 31, 2004, the weighted average interest rate on the 2002 Credit Facility was 3.28% on the $35.0 million of outstanding borrowings.
Due to the net loss reported in the quarter ended June 30, 2005, the Company did not meet the minimum fixed charge coverage ratio of 2.5 times as of June 30, 2005 as required by the 2002 Credit Facility. This issue was resolved as a result of the replacement of the 2002 Credit Facility with the 2005 Credit Facility.
In May 2004, the Company, through a wholly-owned trust, privately issued $30.0 million of preferred securities through two pooled transactions. These securities bear interest at a rate of LIBOR plus 337.5 basis points with a 30- year term and are redeemable after five years. The securities were issued by CNA Surety Capital Trust I (the "Issuer Trust"). The Company's investment of $0.9 million in the Issuer Trust is carried at cost in "Other assets" in the Company's Consolidated Balance Sheet. The sole asset of the Issuer Trust consists of a $30.9 million junior subordinated debenture issued by the Company to the Issuer Trust. The Company has also guaranteed the dividend payments and redemption of the preferred securities issued by the Issuer Trust. The maximum amount of undiscounted future payments the Company could make under the guarantee is $75.0 million, consisting of annual dividend payments of $1.5 million over 30 years and the redemption value of $30.0 million. Because payment under the guarantee would only be required if the Company does not fulfill its obligations under the debentures held by the Issuer Trust, the Company has not recorded any additional liabilities related to this guarantee.
During 2004, the Company reduced certain gross reserves, with corresponding reductions in ceded reserves, reflecting changes in estimates of incurred-but- not-reported reserves for large losses and the associated estimates of reinsurance recoverables. Although there is no impact to net losses and loss adjustment expenses, these actions did result in unusual fluctuations in the gross and ceded amounts shown above.
$157 million in 2004. The premium for the 2004 Excess of Loss Treaty was $50.6 million compared to a total of $42.0 million of reinsurance premiums paid in 2003 for the 2003 Excess of Loss Treaty, the $40 million excess of $60 million treaty and the $3 million excess of $12 million treaty. The 2004 Excess of Loss Treaty also provided for somewhat less restrictive special acceptance provisions for larger contract accounts than those contained in the 2003 Excess of Loss Treaty. In addition to the large national contractor (described later) and two commercial principals (excluded based upon class of business), the Company's reinsurers had excluded three other contract principals from the 2003 Excess of Loss Treaty, for a total of six excluded principals. The large national contractor and the two commercial principals remained excluded from the 2004 Excess of Loss Treaty.
The Company and CCC previously participated in a $40 million excess of $60 million reinsurance contract effective from January 1, 2004 to December 31, 2004 providing coverage exclusively for the one large national contractor that is excluded from the Company's third party reinsurance. The premium for this contract was $3.0 million plus an additional premium of $6.0 million if a loss is ceded under this contract. The Company and CCC entered into a new contract covering the large national contractor effective January 1, 2005 to December 31, 2005 on the same terms as the 2004 contract. In the second quarter of 2005, this contract was amended to provide unlimited coverage in excess of the $60 million retention, to increase the premium to $7.0 million, and to eliminate the additional premium provision. This treaty provides coverage for the life of bonds either in force or written during the term of the treaty which is from January 1, 2005 to December 31, 2005. As of December 31, 2005, the Company has ceded $50.0 million under the terms of this contract. In November 2005, the Company and CCC agreed by addendum to extend this contract for twelve months. This extension, expiring December 31, 2006, was for an additional premium of $0.8 million, subject to adjustment based on the level of actual premiums written on bonds for the large national contractor.
As of December 31, 2005 and December 31, 2004, CNA Surety had an insurance receivable balance from CCC and CIC of $61.0 million and $16.4 million, respectively. CNA Surety had no reinsurance payables to CCC and CIC as of December 31, 2005 and December 31, 2004.
The contractor implemented a restructuring plan intended to reduce costs and improve cash flow, and appointed a chief restructuring officer to manage execution of the plan. In the course of addressing various expense, operational and strategic issues, however, the contractor has decided to substantially reduce the scope of its original business and to concentrate on those segments determined to be potentially profitable. As a consequence, operating cash flow, and in turn the capacity to service debt, has been reduced below previous levels. Restructuring plans have also been extended to accommodate these circumstances. In light of these developments, CNAF recorded an impairment charge of $56.0 million pre-tax for the fourth quarter of 2004, net of the participation by Loews, with respect to amounts loaned under the credit facility and an additional pre-tax impairment charge of $13.0 million.
The June 2005 discussions with the large national contractor revealed significant deterioration of the contractor's operations and cash flow. This deterioration was concentrated in an operating division of the contractor that had previously been placed into run off. As a result of these developments, the Company determined that the large national contractor will likely be unable to meet its obligations that are covered under the surety bonds. Accordingly, in the second quarter of 2005, the Company established a $40.0 million loss reserve based on an initial estimate of loss. In the third quarter of 2005, the Company began a re-evaluation of the contractor's current restructuring efforts. Through this re-evaluation that was completed in the fourth quarter, the Company determined that there had been further deterioration of the contractor's actual and projected cash flows. As a result, the Company increased its gross loss reserves for this account by $70.0 million in the fourth quarter of 2005. After applying expected reinsurance recoveries from CCC, the Company's net incurred loss is $60.0 million, which is the Company's maximum exposure, net of reinsurance, on this account. As of December 31, 2005, the Company has paid approximately $26.0 million of losses to settle outstanding bonded obligations of the contractor.
resulted in a decrease of the estimated liability of $23.3 million and $0.6 million for 2005 and 2004 respectively and an increase in the estimated liability of $39.3 million for 2003. The favorable development in 2005 resulted from favorable outcomes on several specific large claims and lower than expected emergence of additional large claims primarily in the 2003 and 2002 accident years. The decrease in the estimated liability recorded in 2004 for prior accident years resulted from loss adjustment expense payments related to prior accident years that were lower than previously expected. Adverse claim trends in the 2002 and 2003 accident years, particularly increased claim severity on large commercial accounts, had resulted in increased gross and net incurred loss and loss adjustment expenses for 2003.
Incurred loss and loss adjustment expenses for 2003 included net adverse development on prior accident years of $39.3 million that primarily relates to accident years 2001 and 2002 and changes in estimates of large losses resulting from the material adverse claim activity in the third quarter of 2003. The $39.3 million of net adverse development recorded in 2003 was a result of previously unexpected claim activity reported during the third quarter of 2003. First, additional contract bond claims were received during the third quarter of 2003 on a contractor that had filed for bankruptcy in February, 2003. Upon review and verification of these new claims, the existing case reserve was increased by $7.2 million, net of applicable reinsurance. Second, a demand was made during the third quarter of 2003 against a $45 million insurance program bond issued on behalf of a national trucking concern that was now in bankruptcy. This demand was in contradiction of previous information provided by the obligee on the bond. Based on this new information, management reserved the full remaining limits on this bond which resulted in $15.0 million of net adverse development after the application of available reinsurance. Third, claims were also received in the third quarter of 2003 on worker's compensation self insurance bonds written between 1975 and 1986 on behalf of two principals. After verifying coverage and obtaining supporting actuarial information on the underlying workers' compensation claims, the Company increased the case reserves on these bonds by $8.4 million, net of applicable reinsurance. Fourth, after receiving a demand on another insurance program bond in the third quarter of 2003, management identified an outstanding insurance program bond written on behalf of a contractor now in bankruptcy. Based on recent experience with this type of bond, which typically has few defenses available to the surety, and in particular with the obligees on this bond, management recorded a loss provision on this bond of $6.0 million. Finally, management determined that the case reserve on a particular claim was insufficient due to the amount of legal fees that the Company was incurring on the case. Based on their estimate of future legal expenses, management increased the reserve on this bond by $3.0 million.
CNA Surety sponsors a tax deferred savings plan ("401(k) plan") covering substantially all of its employees. Prior to December 31, 1999, the Company matched 70% of the participating employee's contribution up to 6% of eligible compensation (4.2% maximum matching). Effective January 1, 2000, the Company match was increased to 100% of the participating employee's contribution up to 3% of eligible compensation and 50% of the participating employee's contribution between 3% and 6% of eligible compensation (4.5% maximum matching). Effective January 1, 2004, the Company implemented an additional basic contribution for eligible 401(k) plan participants of 3% (if under age 45) or 5% (if 45 or older) of eligible compensation. 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 $4.1 million, $3.5 million and $2.3 million for the years ended December 31, 2005, 2004 and 2003, respectively.
Western Surety sponsors two postretirement benefit plans covering certain employees. One plan provides medical benefits, and the other plan provides sick leave termination payments. The postretirement health care plan is contributory and the sick leave plan is non-contributory. There were no plan assets for either of the postretirement benefit plans.
The postretirement benefit plan that provides medical benefits has been determined to be actuarially equivalent to Medicare Part D on an estimated basis under the rules provided in final regulations issued January 21, 2005. As such, the federal subsidiary to plan sponsors under the Medicare Modernization Act ("MMA") has been recognized in the accounting for that plan.
The following table sets forth the plans' combined funded status reconciled with the amount shown in the Company's statement of financial position at December 31, 2005 and December 31, 2004 (dollars in thousands):
The Company's postretirement sick leave plan is unfunded; the accumulated postretirement benefit obligation and plan assets for that plan as of December 31, 2005 are $0.7 million and $0, respectively.
The 2006 benefit cost is expected to be reduced by approximately $0.2 million as a result of the MMA.
The Company selected a discount rate of 5.50% to measure the accumulated postretirement benefit obligation. This rate generates approximately the same liability as discounting projected cash flows using the Citigroup Pension Discount Curve. The health care cost trend rate assumption has an effect on the amounts reported. To illustrate, increasing the assumed health care cost trend rates by 1 percentage point in each year would increase the benefit obligation as of December 31, 2005 by $2.0 million and increase the aggregate of service cost and interest cost for the year then ended by $0.2 million. Decreasing the assumed health care cost trend rates by 1 percentage point in each year would decrease the benefit obligation as of December 31, 2005 by $1.6 million and decrease the aggregate of service cost and interest cost for the year then ended by $0.1 million.
The following table summarizes stock option activity for 2005, 2004 and 2003.
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, 2005 and 2004 were 14,709 and 15,079, respectively. Common Stock Units are convertible into CNA Surety common stock at the election of the director.
The Company is a leading provider of surety and fidelity bonds in the United States. According to the Surety Association of America ("SAA"), the surety and fidelity segment of the domestic property and casualty insurance
industry aggregates approximately $5.7 billion in direct written premiums, comprised of approximately $4.3 billion in surety premiums and $1.4 billion in fidelity premiums.
Although all of its products are sold through the same independent insurance agent and broker distribution network, the Company's underwriting is organized by the two broad types of surety products -- contract surety and commercial surety, which also includes fidelity bonds and other insurance products for these purposes. These two operating segments have been aggregated into one reportable business segment for financial reporting purposes because of their similar economic and operating characteristics. The following tables set forth gross and net written premiums, dollars in thousands, by product and between domestic and international risks and the respective percentage of the total for the past three years.
Approximately $61.4 million, or 14.7%, of gross written premiums were generated from national insurance brokers in 2005 with the single largest national broker production comprising $13.3 million, or 3.2%, of gross written premiums. In 2004, approximately $68.1 million, or 17.5%, of gross written premiums were generated from national insurance brokers with the single largest national broker production comprising $18.5 million, or 4.7%, of gross written premiums. In 2003, approximately $61.2 million, or 16.5%, of gross written premiums were generated from national insurance brokers with the single largest national broker production comprising $19.2 million, or 5.2%, of gross written premiums.
The following table reconciles consolidated stockholders' equity at December 31, 2005 and 2004 as reported herein in conformity with GAAP with total statutory capital and surplus of CNA Surety's insurance subsidiaries,
Effective July 1, 2004, CNA Surety entered into an Administrative Services Agreement with CCC. This agreement, that replaced an agreement originally effective January 1, 2001, allows the Company to purchase and/or have access to certain services provided by CNAF. The Company will also pay CNAF a management fee for its proportionate share of administrative and overhead costs incurred in supporting the services provided pursuant to this agreement. The management fee for the year 2006 is $2.0 million that shall be paid by CNA Surety to CNAF in equal monthly installments by the last day of each month. The amounts paid were $1.9 million, $1.8 million and $1.7 million for 2005, 2004 and 2003, respectively. The management fee shall be increased as of January 1, the "adjustment date", of each year this Administrative Services Agreement is in force by the greater of 5% or the amount of the increase in the Consumer Price Index for All Urban Consumers for the Chicago, Illinois area as reported by the Bureau of Labor Statistics for the 12 month period immediately preceding the adjustment date. The
agreement also allows CCC to purchase services from the Company. In 2005, 2004 and 2003, CCC paid the Company $0.8 million, $0.5 million and $0.5 million, respectively, for services in connection with licensing and appointing CCC's insurance producers as required by state insurance laws. This agreement shall be effective so long as CNAF or their affiliates or shareholders shall continue to own a majority interest in CNA Surety. This agreement may be terminated by either party upon the provision of 30 days prior notice of such termination to the other party.
In addition, from time to time Western Surety provided surety bonds guaranteeing insurance payments of certain companies to CCC and its affiliates under retrospectively rated insurance policies underwritten by CCC and its affiliates. Under the terms of these bonds, referred to as insurance program bonds, if the principal, the insured company, failed to make required a required premium payment, CCC and its affiliates would have a claim against the Company under the bond. The Company now has a policy not to issue such bonds to companies insured by CCC and its affiliates. The last such bond was written in 2001 and currently bonds with $2.6 million of total penal sums remain as of December 31, 2005.
Western Surety from time to time provides license and permit bonds and appeal bonds to CCC and its affiliates and to clients of CCC and its affiliates. Under procedures established by the Audit Committee, the Company may issue appeal bonds for CCC and its affiliates and their clients with penal sums of $10.0 million or less without prior Audit Committee approval as long as those bonds meet the Company's normal underwriting standards, the rates charged are market rates and that the Company has received the indemnity of CCC. Bonds greater than $10.0 million require the prior approval of the Audit Committee. As of December 31, 2005, the total amount of the outstanding appeal and license and permit bonds written on behalf of CCC and its affiliates was approximately $99.7 million, which was comprised of 49 bonds. Western Surety has entered into indemnity agreements with CCC and its
affiliates indemnifying Western Surety for any loss arising from the issuance of appeal bonds for CCC and its affiliates. The premium for these bonds was approximately $0.6 million in 2005, $0.5 million in 2004 and $0.4 million in 2003.