CNA Surety leases its executive offices and its shared branch locations with CCC under the Administrative Services Agreement with CCC discussed in detail in Item 8., Note 14 of the Notes to the Consolidated Financial Statements, Related Party Transactions. CNA Surety currently uses approximately 95,000 square feet and related personal property at 35 branch locations and its home and executive offices (30,360 square feet) in Chicago, Illinois. CNA Surety’s annual rent for this space is approximately $3.1 million. CNA Surety may terminate its use of these locations as set forth in the Administrative Services Agreement, without material penalty, by providing CCC with 30 days written notice.
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. Given the nature of the surety business, the determination of these balances is inherently a highly subjective exercise, which requires management to analyze, weigh, and balance numerous macroeconomic, customer specific, and claim specific factors and trends, most of which, in themselves, are inherently uncertain and difficult to predict.
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 IBNR reserves also include provisions for losses in excess of the current case reserve for previously reported claims and for claims that may be reopened. The IBNR reserves also include offsets for anticipated indemnity recoveries.
Periodic actuarial analyses of the Company’s loss reserves are performed. These analyses typically include a comprehensive review performed in the third quarter based on data as of June 30 and an update of the comprehensive review performed in January based on data as of December 31. In between these analyses, management monitors claim activity against benchmarks of expected claim activity prepared in connection with the comprehensive review. Beginning in 2009, the Company intends to change the timing of the comprehensive review to occur in the fourth quarter using data as of September 30.
This method relies on historical projected ultimate loss ratios for the more mature accident years to estimate the more recent, less mature accident years’ ultimate losses. Applying a selected loss ratio (by reviewing more mature years) to the more recent years’ earned premium results in an indication of the more recent years’ ultimate losses. The strength of this method is that it can be used in connection with a company’s pricing targets and can be
used when the historical data has limited credibility. The weakness of this method is that it is slow to react to the emerging loss experience for a particular accident year.
The actuarial analysis is the primary tool that management utilizes in determining its best estimate of loss reserves. However, the carried reserve may differ from the actuarial point estimate as a result of management’s consideration of the impact of factors such as the following, especially as they relate to the current accident year:
Current economic conditions, especially corporate default rates and the condition of the construction economy.
The range of reasonable reserve estimates is not intended to reflect the maximum and/or minimum possible outcomes; but rather reflects a range of reasonable estimates given the uncertainty in estimating unpaid claim liabilities for surety business. Further, there is no generally accepted method of estimating reserve ranges, but rather many concepts are currently being vetted within actuarial literature.
At December 31, 2008, the range of reasonable loss reserve estimates, net of reinsurance receivables, was from $306 million to $371 million. Ranges of reasonable loss reserve estimates are not calculated for the sub-lines of business. Management believes that the range calculated over total reserves provides the most meaningful information due to the importance of correlation of losses between the sub-lines of business related to the impact of general economic conditions.
Management believes the Company has the ability to hold all fixed income securities to maturity. However, the Company may dispose of securities prior to their scheduled maturity due to changes in interest rates, prepayments, tax and credit considerations, liquidity or regulatory capital requirements, or other similar factors. As a result, the Company considers all of its fixed income securities (bonds) and equity securities as available-for-sale. These securities are reported at fair value, with unrealized gains and losses, net of deferred income taxes, reported in stockholders’ equity as a separate component of accumulated other comprehensive income. Cash flows from purchases, sales and maturities of fixed income and equity securities are reported gross in the investing activities section of the Consolidated Statements of Cash Flows.
Short-term investments that generally include U.S. Treasury bills, corporate notes, money market funds and investment grade commercial paper equivalents, are carried at amortized cost which approximates fair value.
The Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) discusses certain accounting principles generally accepted in the United States of America (“GAAP”) and non-GAAP financial measures in order to provide information used by management to monitor the Company’s operating performance. Management utilizes various financial measures to monitor the Company’s insurance operations and investment portfolio. Underwriting results, which are derived from certain income statement amounts, are considered a non-GAAP financial measure and are used by management to monitor performance of the Company’s insurance operations.
as well as the net commissions, brokerage and other underwriting expense ratio (“expense ratio”) and combined ratio. The loss ratio is the percentage of net incurred losses and loss adjustment expenses to net earned premiums. The expense ratio is the percentage of net commissions, brokerage and other underwriting expenses, including the amortization of deferred acquisition costs, to net earned premiums. The combined ratio is the sum of the loss and expense ratios.
Comparison of CNA Surety Actual Results for the Years Ended December 31, 2008, 2007 and 2006
The Company had net income of $110.4 million for the year ended December 31, 2008 as compared to $92.5 million for the year ended December 31, 2007 and $82.8 million for the year ended December 31, 2006. The increase in net income in 2008 over 2007 reflects higher earned premium, higher favorable loss development and higher net investment income. The increase in net income in 2007 over 2006 reflects higher earned premium, higher net investment income and the impact of a lower expense ratio.
Underwriting components for the Company for the years ended December 31, 2008, 2007 and 2006 are summarized in the following table (dollars in thousands):
For 2008, gross written premiums decreased 1.0 percent to $467.1 million as compared to 2007. Gross written premiums for contract surety decreased 1.8 percent to $300.2 million primarily due to lower demand resulting from fewer new construction projects. For 2008, commercial surety gross written premiums increased 0.9 percent to $136.0 million and fidelity and other premiums decreased 1.0 percent to $30.9 million.
Net written premiums, which is gross written premiums less ceded written premiums, for the years ended December 31, 2008, 2007 and 2006 are shown in the table below (dollars in thousands) for each sub-line of business:
The expense ratio increased to 54.5% from 54.0% for the same period in 2007 due to the impact of an increased accrual for incentive compensation based on strong financial results, partially offset by the impact of higher earned premiums.
For 2008, net investment income was $47.3 million compared to net investment income for 2007 and 2006 of $44.6 million and $39.3 million, respectively. The annualized pre-tax yield was 4.4%, 4.6% and 4.5% for 2008, 2007 and 2006, respectively. The annualized after-tax yield was 3.6%, 3.8% and 3.7% for 2008, 2007 and 2006, respectively. The increase in net investment income for 2008 is primarily attributable to higher overall invested assets resulting from significant cash flow from operations, partially offset by a decline in short-term yields and the effect on the yield from the increase in short-term investments. The increase in net investment income for 2007 is primarily attributable to higher overall invested assets resulting from significant cash flow from operations and, to a lesser extent, higher yields on short-term investments.
The following summarizes net realized investment gains and losses for the years ended December 31, 2008, 2007 and 2006 (in thousands):
Through the Quota Share Treaty, CCC and CIC transfer to Western Surety all surety business written or renewed by CCC and CIC after the Merger Date. The Quota Share Treaty was renewed on January 1, 2008 and expired on December 31, 2008 and is annually renewable thereafter. CCC and CIC transfer the related liabilities of such business and pay to Western Surety an amount in cash equal to CCC’s and CIC’s net written premiums written on all such business, minus a quarterly ceding commission to be retained by CCC and CIC equal to $50,000 plus 25% of net written premiums written on all such business. For 2008, this resulted in an override commission on their actual direct acquisition costs of 5.9% to CCC and CIC.
The Company and CCC previously participated in a $40 million excess of $60 million reinsurance contract effective from January 1, 2005 to December 31, 2005 providing coverage exclusively for the one large national contractor 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 was ceded under this 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
It is anticipated that the liquidity requirements of CNA Surety will be met primarily by funds generated from operations. The principal sources of operating cash flows are premiums, investment income, recoveries under reinsurance contracts and sales and maturities of investments. The primary cash flow uses are payments for claims, operating expenses, federal income taxes and debt service. In general, surety operations generate premium collections from customers in advance of cash outlays for claims. Premiums are invested until such time as funds are required to pay claims and claims adjusting expenses.
The Company believes that total invested assets, including cash and short-term investments, are sufficient in the aggregate and have suitably scheduled maturities to satisfy all policy claims and other operating liabilities, including dividend and income tax sharing payments of its insurance subsidiaries. If cash requirements unexpectedly exceed cash inflows, the Company may raise additional cash by liquidating fixed income securities ahead of their scheduled maturity. Depending on the interest rate environment at that time, the Company could generate realized gains or losses that would increase or decrease net income for the period. The extent of these gains or losses would depend on a number of factors such as the prevailing interest rates and credit spreads, the duration of the assets sold and the marketability of the assets. The need to liquidate fixed income securities would be expected to cause a reduction in future investment income.
$4.6 million of cash. At December 31, 2007, the parent company’s invested assets consisted of $1.8 million of equity securities, $7.3 million of short-term investments and $4.8 million of cash. As of December 31, 2008 and December 31, 2007, parent company short-term investments and cash included $11.5 million and $9.8 million, respectively, of restricted cash and short-term investments primarily related to premium receipt collections ultimately due to the Company’s insurance subsidiaries.
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 the London Interbank Offered Rate (“LIBOR”) plus 337.5 basis points with a 30-year term and are redeemable at par value beginning in May 2009. 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 approximately $74.3 million, consisting of annual dividend payments of $1.7 million over 26 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.
Reflects unfunded postretirement benefit plans and long term incentive plan payments to certain executives.
As an insurance holding company, CNA Surety is dependent upon dividends and other permitted payments from its insurance subsidiaries to pay operating expenses and meet debt service requirements, as well as to potentially pay cash dividends to shareholders. The payment of dividends by the insurance subsidiaries is subject to varying degrees of supervision by the insurance regulatory authorities in the insurance subsidiaries’ states of domicile. Western Surety and Surety Bonding Company of America (“Surety Bonding”) are domiciled in South Dakota. Universal Surety of America (“Universal Surety”) was domiciled in Texas but as of January 1, 2008 was re-domiciled in South Dakota. In South Dakota, insurance companies may only pay dividends from earned surplus excluding surplus arising from unrealized capital gains or revaluation of assets. 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 South Dakota Division of Insurance 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 2009 is based on statutory surplus and income at and for the year ended December 31, 2008. Without prior regulatory approval in 2009, Western Surety may pay dividends of $112.4 million to CNA Surety. CNA Surety received dividends of $3.0 million from its insurance subsidiaries during 2008. CNA Surety received dividends of $2.0 million from its insurance subsidiaries during 2007. CNA Surety did not receive any dividends from its non-insurance subsidiaries during 2008 or 2007.
Western Surety and Surety Bonding each qualify as an acceptable surety for federal and other public works project bonds pursuant to U.S. Department of Treasury regulations. U.S. Treasury underwriting limitations are based on an insurer’s statutory surplus. Effective July 1, 2008 through June 30, 2009, the underwriting limitations of
Western Surety and Surety Bonding are $43.5 million and $0.7 million, respectively. Through the Quota Share Treaty previously discussed, CNA Surety has access to CCC and its affiliates’ U.S. Department of Treasury underwriting limitations. Effective July 1, 2008 through June 30, 2009, the underwriting limitations of CCC and its affiliates utilized under the Quota Share Treaty total $783.7 million. CNA Surety management believes that the foregoing U.S. Treasury underwriting limitations are sufficient for the conduct of its business.
The following table summarizes the distribution of the Company’s fixed income and equity portfolios at estimated fair values as of December 31, 2008 and 2007 (dollars in thousands):
The management of CNA Surety Corporation and subsidiaries (“CNA Surety” or the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting. CNA Surety’s internal control system was designed to provide reasonable assurance to the Company’s management, its Audit Committee and Board of Directors regarding the preparation and fair presentation of published financial statements.
CNA Surety management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2008. 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, 2008, the Company’s internal control over financial reporting is effective based on those criteria.
We have audited the accompanying consolidated balance sheets of CNA Surety Corporation and subsidiaries (the “Company”) as of December 31, 2008 and 2007, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008. Our audits also included the financial statement schedules listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
Management believes the Company has the ability to hold all fixed income securities to maturity. However, the Company may dispose of securities prior to their scheduled maturity due to changes in interest rates, prepayments, tax and credit considerations, liquidity or regulatory capital requirements, or other similar factors. As a result, the Company considers all of its fixed income securities (bonds) and 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.
The amortized cost of fixed income securities is determined based on cost and the cumulative effect of amortization of premiums and accretion of discounts. Such amortization and accretion are included in investment income. For mortgage-backed and asset-backed securities, the Company recognizes income using the effective-yield method based on estimated cash flows. All securities transactions are recorded on the trade date. Investment gains or losses realized on the sale of securities are determined using the specific identification method. Investments with an other-than-temporary decline in value are written down to fair value, resulting in losses that are included in net realized investment gains/losses.
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.
CNA Surety’s Consolidated Balance Sheet as of December 31, 2008 includes intangible assets of $138.8 million. These amounts represent goodwill and identified intangibles with indefinite useful lives arising from the acquisition of Capsure. The Company performs impairment tests of these intangible assets annually, or when certain conditions are present.
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
The Company accounts for income taxes under the asset and liability method. Under this method, deferred income taxes are established for the future tax effects of temporary differences between the tax and financial reporting bases of assets and liabilities using currently enacted tax rates. Such temporary differences primarily relate to unearned premium reserves and deferred policy acquisition costs. The effect on deferred taxes of a change in tax rates is recognized in income in the period of enactment. Future tax benefits are recognized to the extent that realization of such benefits are more likely than not.
fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. SFAS 157 expands disclosures surrounding the use of fair value to measure assets and liabilities and specifically focuses on the sources used to measure fair value. In instances of recurring use of fair value measures using unobservable inputs, SFAS 157 requires separate disclosure of the effect on earnings for the period. For fiscal years beginning after November 15, 2007, companies are required to implement the standard for financial assets and liabilities, as well as for any other assets and liabilities that are carried at fair value on a recurring basis in financial statements. In February 2008, the FASB issued Staff Position SFAS 157-2, “Effective Date of FASB Statement No. 157” (“FSP SFAS 157-2”), which delays the effective date of SFAS 157 for all nonrecurring fair value measurements of nonfinancial assets and nonfinancial liabilities until fiscal years beginning after November 15, 2008. In October 2008, the FASB issued Staff Position SFAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active” (“FSP SFAS 157-3”), which clarifies the application of SFAS 157 in a market that is not active and provides an example to illustrate in determining fair value in that market. FSP SFAS 157-3 was effective and adopted by the Company immediately upon issuance.
The following table provides the composition of fixed income securities with an unrealized loss at December 31, 2008 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, 2008 and 2007, 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):
Investment grade is determined by the higher of the two ratings, Standard & Poor’s (“S&P”) or Moody’s Investor Services (“Moody’s”), when the security has a split rating.
The table also discloses the corresponding count of securities in an unrealized loss position and estimated fair value by category (in thousands of dollars):
Of the 85 securities in an unrealized loss position, eight were in a loss position that exceeded 20% of the security’s amortized cost. 15 other securities were in an unrealized loss position that exceeded 10% of each security’s amortized cost, and 22 additional securities were in an unrealized loss position that exceeded 5% of each security’s amortized cost. The largest unrealized loss percentage was 51.2% ($2.2 million) of that security’s amortized cost. This security was an asset-backed security collateralized by sub-prime home loans. The security with the largest unrealized loss in dollars was issued by a governmental utility authority and was in an unrealized loss position of $3.7 million (34.3% of its amortized cost).
The Company believes that the unrealized losses are primarily due to credit spread widening, and to a lesser extent, market illiquidity and certain asset classes being out of favor with investors. The Company intends and believes it has the ability to hold these investments until the expected recovery in value, which may be at maturity.
On June 30, 2008, the Company’s credit facility matured. There was no outstanding balance under this facility (the “2005 Credit Facility”) during 2008. The 2005 Credit Facility was entered into on July 27, 2005, when the Company refinanced $30.0 million in outstanding borrowings under its previous credit facility. The 2005 Credit Facility provided an aggregate of up to $50.0 million in borrowings under a revolving credit facility. In September 2006, the Company reduced the available aggregate revolving credit facility to $25.0 million in borrowings. The 2005 Credit Facility also contained certain conditions and limitations on the Company. The Company was in compliance with all covenants as of December 31, 2007 and for the six months ended June 30, 2008 when the 2005 Credit Facility matured.
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Company uses the following fair value hierarchy in selecting inputs, with the highest priority given to Level 1, as these are the most transparent or reliable:
Assets measured at fair value on a recurring basis are summarized below (amounts in thousands):
The Company’s insurance subsidiaries, in the ordinary course of business, cede insurance to other insurance companies and affiliates. Reinsurance arrangements are used to limit maximum loss, provide greater diversification of risk and minimize exposure on larger risks. Reinsurance contracts do not relieve the Company of its primary obligations to claimants. Therefore, a contingent liability exists with respect to insurance ceded to the extent that any reinsurer is unable to meet the obligations assumed under the reinsurance contracts. The Company evaluates the financial condition of its reinsurers, assesses the need for allowances for uncollectible amounts and monitors concentrations of credit risk. CNA Surety’s largest reinsurance receivable from an affiliate, CCC, an A (Excellent) rated company by A.M. Best was approximately $46.1 million and $50.5 million at December 31, 2008 and 2007, respectively. CNA Surety’s largest reinsurance receivable from a non-affiliate reinsurer, rated A+ (Superior) by A.M. Best, was approximately $7.9 million at December 31, 2008. The largest reinsurance receivable from a non-affiliate reinsurer, rated A (Excellent) by A.M. Best, was approximately $16.8 million at December 31, 2007.
Assumed premium also includes surety business written by another affiliate, First Insurance Company of Hawaii, Ltd. and its subsidiaries First Indemnity Insurance of Hawaii, Inc., First Fire and Casualty Insurance of Hawaii, Inc., and First Security Insurance of Hawaii, Inc. (collectively, “FICOH”). CNAF owns approximately 50% of the outstanding common stock of First Insurance Company of Hawaii, Ltd. Under the terms of this excess of loss agreement that covers certain contract business, FICOH retains losses of $2 million per principal and Western Surety assumes 80% of $5 million per principal subject to an aggregate annual limit of $8 million. Premiums assumed by Western Surety under this agreement were $0.2 million in 2008 and $0.1 million in 2007 and 2006. As of December 31, 2008 and December 31, 2007, CNA Surety had unpaid losses and loss adjustment expense reserves assumed from FICOH of $0.2 million and $0.1 million, respectively.
During 2006, 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. These actions resulted in the unusual fluctuations in the gross and ceded amounts shown above.
Effective January 1, 2008, CNA Surety entered into a new excess of loss treaty (“2008 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the 2007 Excess of Loss Treaty. Under the 2008 Excess of Loss Treaty, the Company’s net retention per principal remained at $10 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company’s retention. The contract provided aggregate coverage of $185 million and included an optional extended discovery period, which was not exercised. The contract also included a provision for additional premiums of up to $26.1 million based on losses ceded under the contract. The actual cost for the 2008 Excess of Loss Treaty was $30.4 million. Only the large national contractor discussed below that was excluded from the 2007 Excess of Loss Treaty remained excluded from the 2008 Excess of Loss Treaty. There will be no additional premiums or recoveries under the 2008 Excess of Loss Treaty as no losses were discovered to this treaty in 2008.
The Company and CCC previously participated in a $40 million excess of $60 million reinsurance contract effective from January 1, 2005 to December 31, 2005 providing coverage exclusively for the one large national contractor 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 was ceded under this 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 was from January 1, 2005 to December 31, 2005. In November 2005, the Company and CCC agreed by addendum to extend this contract for twelve months. This extension, which expired on December 31, 2006, was 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. In January 2007, the Company and CCC agreed by addendum to extend this contract for another twelve months. This extension, which expired on December 31, 2007, was for an additional premium of $0.5 million, which was based on the level of actual premiums written on bonds for the large national contractor. In December 2007, the Company and CCC agreed by addendum to extend this contract for another twelve months. This extension, which expired on December 31, 2008, was for an additional premium of $0.2 million based on the level of actual premiums written on bonds for the large national contractor. In December 2008, the Company and CCC agreed by addendum to extend this contract for another twelve months. This extension, which will expire on December 31, 2009, is for an additional premium subject to the level of actual premiums written on bonds for the large national contractor. As of both December 31, 2008 and December 31, 2007, the Company had ceded losses of $50.0 million under the terms of this contract, with unpaid ceded losses of $46.8 million.
As of December 31, 2008 and December 31, 2007, CNA Surety had an insurance receivable balance from CCC and CIC of $60.4 million, including $46.1 million of reinsurance recoverables and $14.3 million of premiums receivable, and $62.9 million, including $50.5 million of reinsurance recoverables and $12.4 million of premiums
The Company recorded net loss reserve development for prior accident years which resulted in a decrease of the estimated liability of $45.5 million, $5.1 million and $5.3 million in 2008, 2007 and 2006, respectively.
The favorable development in 2006 resulted from lower than expected emergence of additional large claims primarily in the 2005 and 2004 accident years, offset by adverse development primarily in the 2003 and 2002
accident years. The adverse development in the 2003 accident year was due to an increase in loss adjustment expense reserves resulting from payments in 2006 that exceeded previous expectations. The adverse development in the 2002 accident year was primarily due to unfavorable development of a large contract claim. Establishment of the case reserve on this claim had been particularly difficult due to on-going litigation that severely hampered the Company’s ability to assess the amount of work required to complete the bonded project and the availability of remaining contract funds.
At December 31, 2008 the future minimum commitments under operating leases are as follows: 2009 - $2.0 million; 2010 - $2.0 million; 2011 - $1.8 million; 2012 - $1.0 million. Total rental expense for 2008, 2007 and 2006 was $5.2 million, $5.2 million and $5.1 million, respectively.
The Company has not recognized any liabilities for uncertain income taxes as of December 31, 2008 or 2007, respectively. Also, the Company does not anticipate any material change in the total amount of unrecognized tax benefits to occur within the next twelve months.
On April 25, 2005, the Board of Directors of CNA Surety Corporation approved the CNA Surety Corporation 2005 Deferred Compensation Plan (the “2005 Plan”) and the CNA Surety Corporation 2005 Deferred Compensation Plan Trust (the “2005 Trust”). The 2005 Plan and 2005 Trust were adopted in connection with the enactment
The Company’s postretirement medical benefit plan’s accumulated postretirement benefit obligation as of December 31, 2008 is $8.6 million.
The following tables set forth the combined plans’ pre-tax adjustment to accumulated other comprehensive income (“AOCI”) (dollars in thousands):
The amounts recognized in the Consolidated Balance Sheets for postretirement benefit obligations at December 31, 2008 and 2007 were as follows (dollars in thousands):
The liability for postretirement benefits at December 31, 2008 and 2007 are as follows (dollars in thousands):
The Company selected a discount rate of 5.87% to measure the accumulated postretirement benefit obligation at December 31, 2008. This rate was selected by developing a weighted average yield on cash flows for the postretirement benefit plans. These cash flows were discounted using published spot rates corresponding to the time period that the cash flow is due. This average yield was compared to the Citibank Pension Liability Index and the resulting weighted average was nearly identical to this index and, as such, the index was used as the discount rate for development of the accumulated postretirement pension benefit obligation. At December 31, 2007, the models used by the Company to evaluate the rate included the Citgroup Pension Discount Curve and the Hewitt Bond Universe. Due to a downward divergence of these models in 2007, the Company relied more heavily on the Hewitt Bond Universe in selecting a discount rate of 5.875%.
Estimated benefit expected to be recognized from AOCI into net periodic benefit cost in 2009:
The 2006 Plan provides for the granting of incentive stock options as defined under Section 409A of the Internal Revenue Code of 1986, as amended. All nonqualified stock options and incentive stock options granted under the 2006 Plan expire ten years after the date of grant and vest ratably over the four-year period following the date of grant.
On February 8, 2008, 259,380 options were granted under the 2006 Plan. The fair market value (at grant date) per option granted was $6.32 for these options. The fair value of these options was estimated at grant date using a Black-Scholes option pricing model with the following weighted average assumptions: risk free interest rate of 2.7%; dividend yield of 0.0%; expected option life of 5.3 years; and volatility of 38.3%. The Company estimated the expected option life of the 2008 grant based on its analysis of past exercise patterns for similar options and did not use the simplified method used for estimating the expected option life of the 2007 grant described below. As of December 31, 2008, the number of shares available for granting of options under the 2006 Plan was 2,451,995.
A summary of the status of the Company’s non-vested options as of December 31, 2008 and changes during the year then ended is presented below:
The total intrinsic value of options exercised was $0.2 million, $1.9 million and $2.6 million for 2008, 2007 and 2006, respectively. The tax benefits recognized by the Company for these exercises were less than $0.1 million for 2008 and $0.6 million and $0.9 million for 2007 and 2006, respectively.
As of December 31, 2008, there was $1.2 million of total unrecognized compensation cost related to non-vested stock-based compensation arrangements granted under the Company’s equity compensation plans. That cost is expected to be recognized as follows: 2009 - $0.8 million; 2010 - $0.3 million; 2011 - $0.1 million.
Surety bonds are three-party agreements in which the issuer of the bond (the surety) joins with a second party (the principal) in guaranteeing to a third party (the owner/obligee) the fulfillment of some obligation on the part of the principal. The surety is the party who guarantees fulfillment of the principal’s obligation to the obligee. There are two broad types of surety products - contract surety and commercial surety bonds.
Contract surety bonds secure a contractor’s performance and/or payment obligation generally with respect to a construction project. Contract surety bonds are generally required by federal, state, and local governments for
CNA Surety’s insurance subsidiaries file financial statements prepared in accordance with statutory accounting practices prescribed or permitted by applicable insurance regulatory authorities. Prescribed statutory accounting practices include state laws, regulations and general administrative rules, as well as guidance provided in a variety of publications of the National Association of Insurance Commissioners (“NAIC”). Permitted statutory accounting practices encompass all accounting practices that are not prescribed. The Company’s insurance subsidiaries follow three permitted accounting practices which did not have a material effect on reported statutory surplus or income. The Company’s insurance subsidiaries were given permission to report activity in the Small Business Administration’s Surety Bond Guarantee program as a reinsurance program and to report all indemnification recoveries as recoveries of loss rather than allocating recoveries between loss and loss adjustment expenses. Also, Surety Bonding has been given permission to report ceding commissions received from Western Surety that exceed the acquisition costs related to the business ceded as a reduction to commission expense. Historically, the principal differences between statutory financial statements and financial statements prepared in accordance with GAAP are that statutory financial statements do not reflect deferred policy acquisition costs or intangible assets, deferred income taxes are recorded but there are limitations as to the amount of deferred tax assets that may be reported as “admitted” assets 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 minimum capital standards that supplement the system of fixed minimum capital and surplus requirements on a state-by-state basis. Regulatory compliance is determined by a ratio (the “Ratio”) of the enterprise’s regulatory total adjusted capital, as defined by the NAIC, to its authorized control level RBC, as defined by the NAIC. Generally, a Ratio in excess of 200% of authorized control level RBC requires no corrective actions by a company or regulators. As of December 31, 2008 each of CNA Surety’s insurance subsidiaries had a Ratio that was in compliance with the minimum RBC requirements.
Effective July 1, 2004, CNA Surety entered into an Administrative Services Agreement (“ASA”) 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. CNA Surety leases its executive offices and 35 shared branch locations with CCC under this agreement. 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 that shall be paid by CNA Surety to CNAF for the year 2009 is $2.1 million. The amounts paid were $2.1 million, $2.1 million and $2.0 million for 2008, 2007 and 2006, respectively. The agreement also allows CCC to purchase services from the Company. In 2008, 2007 and 2006, CCC paid the Company $1.3 million, $1.3 million and $1.1 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.
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 of the Board of Directors (“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, 2008, the total amount of the outstanding appeal and license and permit bonds written on behalf of CCC and its affiliates was approximately $82.4 million. Of that amount, the majority consisted of 37 appeal bonds with a penal sum of about $78.8 million. Western Surety has entered into indemnity agreements with CCC and its affiliates indemnifying Western Surety for any loss arising from the issuance of bonds for CCC and its affiliates. The premium for all bonds written on behalf of CCC and its affiliates was approximately $0.6 million in 2008, $0.6 million in 2007 and $0.6 million in 2006.
In 2006, the Company, through the Quota Share Treaty, assumed three bonds issued by an affiliate for Mexdrill Offshore, S. DE R.L. DE C. V. (“Mexdrill Offshore”), a subsidiary of Diamond Offshore Drilling, Inc. (“Diamond Offshore”). Loews owns 50.4% of Diamond Offshore’s shares. Prior to the Company’s issuance of these bonds with penal sums of $24.9 million, $32.0 million and $16.1 million, respectively, the Company’s Audit Committee approved issuance of the bonds on behalf of Diamond Offshore for up to $150.0 million in total bond exposure provided that the bonds meet the Company’s normal underwriting standards, the rates charged are market rates and the Company receives the indemnity of Diamond Offshore. The premium for these bonds was $0.9 million.
The following is a summary of the quarterly results of operations for the years ended December 31, 2008, 2007 and 2006 (dollars in thousands, except per share amounts):