CNA Surety leases its executive offices and its shared branch locations with CCC under the Administrative Services Agreement (“ASA”) 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 89,000 square feet and related personal property at 35 branch locations and its home and executive offices (30,360 square feet) in Chicago, Illinois. In 2010, CNA Surety’s annual rent under the ASA was approximately $2.1 million. Annual rent for space leased through the ASA will be approximately $2.0 million beginning January 1, 2011.
CNA Surety leases approximately 83,550 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 $1.8 million as of December 31, 2010. On September 21, 2010, CNA Surety entered into a lease agreement for a new property to be occupied following the expiration of the current lease. The new lease includes various contingencies including completion of construction of the building and office space to be occupied. The lease term shall be ten years from its commencement date as defined in the agreement. Other specific lease terms such as final rental square feet and cost will be finalized upon satisfaction of the required contingencies.
The following financial information for CNA Surety as of and for the years ended December 31, 2010, 2009, 2008, 2007 and 2006 has been derived from the Consolidated Financial Statements and Notes thereto.
Includes the effect of re-estimates of prior year reserves, known as reserve development. The dollar amount of these reserve reductions were $76.3 million, $54.3 million, $45.5 million, $5.1 million and $5.3 million for the years ended December 31, 2010, 2009, 2008, 2007 and 2006, respectively. The percentage point effect of these reserve reductions on the loss and combined ratios for these years were 18.3, 12.8, 10.6, 1.2 and 1.4 percentage points, respectively.
In October 2010, the Company received an unsolicited proposal from CNAF to acquire all of the outstanding shares of common stock that are not currently owned by subsidiaries of CNAF at a purchase price of $22.00 per share in cash (the “CNAF Proposal”). The Company’s Board of Directors appointed a special committee (the “Special Committee”), comprised solely of the Company’s three independent directors, to review and evaluate the CNAF proposal. The Special Committee retained both legal and financial advisors to assist in their consideration of the CNAF Proposal.
On February 4, 201l, the Special Committee announced that it does not support the terms of the proposal and advised CNAF that it is open to alternate proposals.
The Company’s accounting policies related to reserves and disclosures 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 and of themselves, are inherently uncertain and difficult to predict. In addition, management believes the other most critical accounting policies and related disclosures for purposes of understanding the Company’s results of operations and financial condition pertain to investments, goodwill and other intangible assets, recognition of premium revenue and the related unearned premium liability and deferred policy acquisition costs.
Reported claims are in various stages of the settlement process. Due to the nature of surety, which is the relationship among three parties whereby the surety guarantees the performance of the principal to a third party (the obligee), the investigation of claims and the establishment of case estimates on claim files can be a complex process that can occur over a period of time depending on the type of bond(s) and the facts and circumstances involving the particular bond(s), the claim(s) and the principal. Case reserves are typically established after a claim is filed and an investigation and analysis has been conducted as to the validity of the claim, the principal’s response to the claim and the principal’s financial viability. To the extent it is determined that there are no bona fide defenses to the claim and the principal is unwilling or financially unable to resolve the claim, a case reserve is established on the claim file for the amount the Company estimates it will have to pay to honor its obligations under the provisions of the bond(s).
The following table shows the estimated liability as of December 31, 2010 for unpaid claims applicable to reported claims and to IBNR (dollars in thousands) for each sub-line of business:
The incurred Bornhuetter-Ferguson (“B-F”) method is commonly used to provide a more stable estimate of ultimate losses in situations where loss development is volatile, substantial and/or immature. The method calculates IBNR (or unpaid loss when conducting a paid B-F projection) directly as the product of: Expected Ultimate Losses multiplied by IBNR (or Unpaid) Percentage.
The IBNR (or unpaid) percentage is derived from the incurred (or paid) loss development patterns. Various approaches can be used to determine the expected ultimate losses (e.g., prior year estimates, pricing assumptions, etc.). An expected loss ratio (ultimate losses divided by earned premium) based on review of prior accident years’ loss ratio experience is utilized to obtain an estimate of expected ultimate losses. This estimate is then applied to the more recent accident years’ earned premium. The strength of the B-F method is that it is less leveraged than the historical development method and thus does not result in an overreaction to an unusual claim occurrence (or an unusual lack of claims). The weakness of the method is that it is reliant on an initial expectation of ultimate losses.
on the Company’s large (i.e., leveraged) development factors and thus are believed to represent a more stable set of methods from which to select indicated reserves for the more recent years.
At December 31, 2009, management’s recorded gross and net reserves were also higher than the actuarial point estimate primarily due to the factors and analysis described above as related to accident years 2008 and 2009. Recorded reserves for accident years 2007 and prior were materially consistent with the actuarial point estimates.
Casualty insurance loss reserves are subject to a significant amount of uncertainty. Given the nature of surety losses with its low frequency, high severity characteristics, this is particularly true for surety loss reserves. As a result, the range of reasonable loss reserve estimates may be broader than that associated with traditional property/casualty insurance products. While the loss reserve estimates represent the best professional judgments, arrived at after careful actuarial analysis of the available data, it is important to note that variation from the estimates is not only possible but, in fact, probable. The sources of this inherent variability are numerous - future economic conditions, court decisions, legislative actions and individual large claim impacts, for example.
At December 31, 2010, the range of reasonable loss reserve estimates, net of reinsurance receivables, was from $313 million to $381 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.
The primary factors that would result in the Company’s actual losses being closer to either end of the reserve range are the number of large claims, as well as the number of large indemnification amounts. In other words, the primary factors that, if they were to occur, would result in the Company’s actual payments being at the high end of the indicated range are if the Company experiences an unusually high number of large claims and/or an unusually low number of large indemnification recoveries. Conversely, if the Company were to experience an unusually low number of large claims and/or an unusually high number of large indemnification recoveries, the Company’s actual payments would tend to be at the low end of the range. These variations in outcomes could be driven by broader issues such as the state of the construction economy or the level of corporate defaults, or by the specific facts and circumstances surrounding individual claims. Again, it is important to note that it is possible that the actual payments could fall outside of the estimated range.
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
Insurance premium receivables do not include financing costs or other fees and are presented net of an estimated allowance for doubtful accounts. This allowance is based on a periodic evaluation of the aging and collectibility of premium receivables. Premium receivables and any related allowance are written off after collection efforts have been exhausted.
Policy acquisition costs, consisting of commissions, premium taxes and other underwriting expenses which vary with, and are primarily related to, the production of business, net of reinsurance commissions, are deferred and amortized as a charge to income as the related premiums are earned. The Company periodically tests that deferred policy acquisition costs are recoverable based on the expected profitability embedded in the reserve for unearned premium. If the expected profitability is less than the balance of deferred policy acquisition costs, a charge to net income is taken and the deferred policy 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 policy acquisition costs.
Underwriting results are computed as net earned premiums less net losses and loss adjustment expenses and net commissions, brokerage and other underwriting expenses. Management uses underwriting results to monitor its insurance operations’ results without the impact of certain factors, including net investment income, net realized investment gains (losses) and interest expense. Management excludes these factors in order to analyze the direct relationship between net earned premiums and the related net losses and loss adjustment expenses along with net commissions, brokerage and other underwriting expenses.
The Company had net income of $134.4 million for the year ended December 31, 2010 as compared to $117.9 million for the year ended December 31, 2009 and $110.4 million for the year ended December 31, 2008. The increase in net income in 2010 over 2009 reflects the higher levels of favorable loss development discussed below, lower underwriting expenses and higher investment income, partially offset by lower net earned premium. The increase in net income in 2009 over 2008 reflects the higher levels of favorable loss development discussed below and higher investment income, partially offset by lower net earned premium.
Underwriting components for the Company for the years ended December 31, 2010, 2009 and 2008 are summarized in the following table (dollars in thousands):
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 insurance coverage.
For 2009, gross written premiums decreased 6.2 percent to $438.3 million as compared to 2008. Gross written premiums for contract surety decreased 8.5 percent to $274.8 million primarily due to lower demand resulting from fewer new construction projects. For 2009, commercial surety gross written premiums decreased 1.8 percent compared to 2008 due, in part, to continued adverse economic conditions. Commercial surety gross written premiums for 2008 included a non-recurring premium recognition from a single account of $1.1 million. Fidelity and other premiums decreased 3.2 percent to $29.9 million.
Ceded written premium in 2009 decreased compared to 2008 from $35.5 million to $27.3 million. The Company’s decision to increase the per principal retention from $10.0 million to $15.0 million resulted in lower ceded premiums on the 2009 third party excess of loss treaty. Further, 2008 ceded written premium included $4.2 million recorded as a result of additional losses ceded under the 2007 excess of loss treaty as compared to $0.5 million recorded in 2009 as the result of additional losses ceded under the 2007 third party excess of loss treaty.
The loss ratios for the years ended December 31, 2010, 2009 and 2008 were 10.8%, 16.5% and 18.7%, respectively. These loss ratios include re-estimates of prior accident year reserves, known as reserve development. The dollar amount and percentage point effect of these reserve reductions were $76.3 million, or 18.3 percentage points, $54.3 million, or 12.8 percentage points, and $45.5 million, or 10.6 percentage points, for the years ended December 31, 2010, 2009, and 2008, respectively.
Beginning in 2008, the Company began recording higher loss provisions for the current accident year in response to the severe deterioration in economic conditions that began in 2008. The results of subsequent actuarial reviews indicated redundancies for accident year 2008, but management believed that the potential impacts of the economic downturn were not fully recognized by the actuarial methodologies and maintained their higher loss estimates. The actuarial review performed in 2010 indicated a larger redundancy for accident year 2008 than at December 31, 2009. At December 31, 2010, management believed that the experience for the 2008 accident year was sufficiently mature to make the actuarial indication credible and adjusted the reserves to the actuarial indication. In retrospect, it appears that this deterioration in economic conditions did not begin to impact loss
The favorable development in 2009 resulted primarily from a level of loss activity substantially below expectations for accident years 2006 and 2007. This level of loss activity was particularly influenced by a lower than expected emergence of large claims. Significant case reserve reductions and better than expected indemnification recoveries for accident years 2005 and prior also contributed to the favorable development in 2009. The Company’s initial estimates of losses for accident year 2009 and the estimate for accident year 2008 continued to reflect the expected impact of less favorable economic conditions.
As previously discussed, in October 2010, the Company received an unsolicited proposal from CNAF to acquire all of the outstanding shares of common stock that are not currently owned by subsidiaries of CNAF. The Special Committee appointed to review and evaluate the CNAF Proposal retained both legal and financial advisors to assist in their consideration of the CNAF Proposal. The Company incurred expenses of $1.5 million in 2010 related to the evaluation of the CNAF Proposal. These expenses are shown as “Other expense” in the Consolidated Statements of Income and are not included in the expense ratio discussed above.
For 2010, net investment income was $53.6 million compared to net investment income for 2009 and 2008 of $50.4 million and $47.3 million, respectively. The annualized pre-tax yield was 4.0%, 4.2% and 4.4% for 2010, 2009 and 2008, respectively. The annualized after-tax yield was 3.2%, 3.5% and 3.6% for 2010, 2009 and 2008, respectively. The increase in net investment income for 2010 and 2009 is primarily attributable to higher overall invested assets resulting from significant cash flow from operations, partially offset by a decline in yields.
The benchmark interest rate for the Company’s variable interest rate debt is the London Interbank Offered Rate (“LIBOR”). Due to lower three-month LIBOR rates, interest expense decreased $0.2 million, or 16.3 percent, for 2010 compared to 2009. Interest expense also decreased $0.8 million, or 35.2 percent for 2009 compared to 2008 due to lower interest rates. Weighted average debt outstanding was $30.9 million for each of these periods. The weighted average interest rate for 2010, 2009 and 2008 was 3.7%, 4.3% and 6.4%, respectively.
The Company manages its exposure on each account and aggressively looks for co-surety, shared accounts and other means to support or reduce larger exposures. Reinsurance and indemnification rights, including rights to contract proceeds on construction projects in the event of default, exist that substantially reduce CNA Surety’s exposure to loss.
coverage for losses discovered beyond 2011 on bonds that were in force during 2011. The contract also includes a provision for additional premiums of up to $10.7 million based on losses ceded under the contract. The base annual premium for the 2011 Excess of Loss Treaty is $21.7 million.
Reinsurance agreements together with the Services and Indemnity Agreement described below provide for the transfer of the surety business written by CCC and CIC to Western Surety. Many of these agreements originally were entered into on September 30, 1997 (the “Merger Date”) and include: (i) the Surety Quota Share Treaty (the “Quota Share Treaty”); (ii) the Aggregate Stop Loss Reinsurance Contract (the “Stop Loss Contract”) and (iii) the Surety Excess of Loss Reinsurance Contract. Although the contracts entered on the Merger Date have expired, some have been renewed on different terms as described below.
Through the Stop Loss Contract, the Company’s insurance subsidiaries were protected from adverse loss development on certain business underwritten after the Merger Date. The Stop Loss Contract between the Company’s 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 the Company’s 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 Company’s insurance subsidiaries paid CCC an annual premium of $20,000. The CNA Surety insurance subsidiaries have paid CCC all required annual premiums. Through December 31, 2010, losses incurred under the Stop Loss Contract were $47.2 million. Through December 31, 2009, losses incurred under the Stop Loss Contract were $49.1 million. The net amount settled in 2010 under this contract was $1.9 million paid to CCC as a result of favorable development on claims subject to the Stop Loss Contract. At December 31, 2010, the amount received under the Stop Loss Contract included $2.7 million held by the Company for losses covered under this contract that were incurred but not paid.
In 2009, the Company and CCC terminated the excess of loss contract discussed in the preceding paragraph. Related to the termination of this contract, the Company and CCC also commuted the Quota Share Treaty as regards the premium and losses for the large national contractor. The impact of this commutation was a decrease of gross loss reserves of $51.8 million. Under the terms of the agreements effecting this commutation, the Company paid CCC $1.8 million. This settlement reflected the difference between the Company’s $60.0 million retention under the excess of loss contract and the $58.2 million paid by the Company for losses of the large national contractor through 2009.
On January 1, 2010, the Company and CCC entered into separate agreements that provide for the transfer of the Canadian surety business of CCC to Western Surety. These agreements, which include a quota share treaty (the “Canadian Quota Share Treaty”) and a services and indemnity agreement (the “Canadian Services and Indemnity Agreement”), are substantially similar to the Quota Share Treaty and the Services and Indemnity Agreement discussed above. The Canadian Services and Indemnity Agreement provides Western Surety with the authority to supervise various administrative, underwriting and claim functions associated with the surety business written by CCC, through its Canadian branch, on behalf of the Company. Through the Canadian Quota Share Treaty, this Canadian surety business is transferred to Western Surety. Pursuant to these agreements, CCC will transfer the subject premium and related liabilities of such business and pay to Western Surety an amount equal to CCC’s net written premiums on all such business, minus a ceding commission of 33.5% of net written premiums. Further, Western Surety will pay an additional ceding commission to CCC in the amount of actual direct expense in producing such premium. These agreements expired on December 31, 2010. These agreements renewed with the same terms on January 1, 2011 and expire on December 31, 2011 and are annually renewable thereafter.
At December 31, 2010, the carrying value of the Company’s insurance subsidiaries’ invested assets was comprised of $1,404.4 million of fixed income securities, $39.7 million of short-term investments and $3.4 million of cash. At December 31, 2009, the carrying value of the Company’s insurance subsidiaries’ invested assets was comprised of $1,266.2 million of fixed income securities, $36.9 million of short-term investments and $2.9 million of cash.
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. In 2010, parent company cash flows included significant cash flows from the exercise of stock options under the Company’s stock-based compensation plan. The principal obligations at the parent company level are to service debt and pay operating expenses, including income taxes. At December 31, 2010, the parent company’s invested assets consisted of $1.9 million of equity securities and $16.7 million of short-term investments and cash. At December 31, 2009, the parent company’s invested assets consisted of $1.6 million of equity securities and $14.0 million of short-term investments and cash. At December 31, 2010 and December 31, 2009, parent company short-term investments and cash included $11.5 million and $11.1 million, respectively, of cash and short-term investments primarily related to premium receipt collections ultimately due to the Company’s insurance subsidiaries.
Combined statutory surplus totaled $825.6 million at December 31, 2010, resulting in a net written premium to statutory surplus ratio of 0.5 to 1. Insurance regulations restrict the insurance subsidiaries’ maximum net retention on a single surety bond to 10 percent of statutory surplus. Under the 2011 Excess of Loss Treaty, the Company’s net retention on new bonds would generally be $15 million plus a 5% co-participation in the $90 million layer of excess reinsurance above the Company’s retention. Based on statutory surplus as of December 31, 2010, this regulation would limit Western Surety’s largest gross risk to $168.1 million. This surplus requirement may limit the amount of future dividends Western Surety could otherwise pay to CNA Surety.
The following table summarizes the distribution of the Company’s fixed income and equity portfolios at estimated fair values as of December 31, 2010 and 2009 (dollars in thousands):
The unrealized loss position of this security was $0.5 million at December 31, 2009.
Invested assets are exposed to various risks, such as interest rate, market and credit. Due to the level of risk associated with certain of these invested assets and the level of uncertainty related to changes in the value of these assets, it is possible that changes in risks in the near term may significantly affect the amounts reported in the Consolidated Balance Sheets and Consolidated Statements of Income. The Company’s Quantitative and Qualitative Disclosures about Market Risk is contained in
We have audited the accompanying consolidated balance sheets of CNA Surety Corporation and subsidiaries (the “Company”) as of December 31, 2010 and December 31, 2009, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2010. 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.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of CNA Surety Corporation and subsidiaries as of December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2010, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for the recognition and presentation of other-than-temporary impairments in 2009.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2010, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 18, 2011 expressed an unqualified opinion on the Company’s internal control over financial reporting.
In December 1996, CNA Financial Corporation (“CNAF”) and Capsure Holdings Corp. (“Capsure”) agreed to merge (the “Merger”) the surety business of CNAF with Capsure’s insurance subsidiaries, Western Surety Company (“Western Surety”), Surety Bonding Company of America (“Surety Bonding”) and Universal Surety of America (“Universal Surety”), into CNA Surety Corporation (“CNA Surety” or the “Company”). CNAF, through its operating subsidiaries, writes multiple lines of property and casualty insurance, including surety business that is reinsured by Western Surety. The principal operating subsidiaries of CNAF that wrote the surety line of business for their own account prior to the Merger were Continental Casualty Company and its property and casualty affiliates (collectively, “CCC”) and The Continental Insurance Company and its property and casualty affiliates (collectively, “CIC”). Through its insurance subsidiaries, CNAF owns approximately 61% of the outstanding common stock of CNA Surety. Loews Corporation owns approximately 90% of the outstanding common stock of CNAF.
In October 2010, the Company received an unsolicited proposal from CNAF to acquire all of the outstanding shares of common stock that are not currently owned by subsidiaries of CNAF at a purchase price of $22.00 per share in cash (the “CNAF Proposal”). The Company’s Board of Directors appointed a special committee (the “Special Committee”), comprised solely of the Company’s three independent directors, to review and evaluate the CNAF Proposal. The Special Committee retained both legal and financial advisors to assist in their consideration of the CNAF Proposal. During 2010, the Company incurred expenses of $1.5 million directly related to the consideration of the proposal. These expenses are shown as “Other expense” in the Consolidated Statements of Income.
All securities transactions are recorded on the trade date. Investment gains or losses realized on the sale of securities are determined using the first-in, first-out method. 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.
Policy acquisition costs, consisting of commissions, premium taxes and other underwriting expenses which vary with, and are primarily related to, the production of business, net of reinsurance commissions, are deferred and amortized as a charge to income as the related premiums are earned. The Company tests that deferred policy acquisition costs are recoverable based on the expected profitability embedded in the reserve for unearned premium. If the expected profitability is less than the balance of deferred policy acquisition costs, a charge to income is taken and the deferred policy 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 policy acquisition costs.
The estimated liability for unpaid losses and loss adjustment expenses includes, on an undiscounted basis, estimates of (a) the ultimate settlement value of reported claims, (b) incurred-but-not-reported (“IBNR”) claims, including provisions for losses in excess of the current case reserve for previously reported claims and for claims that may be reopened, as well as offsets for anticipated indemnification recoveries and (c) future expenses to be incurred in the settlement of claims, before reinsurance recoveries, which are reported as an asset. These estimates are determined based on the facts and circumstances of each claim and the Company’s loss experience as well as consideration of industry experience, current trends and conditions. The estimated liability for unpaid losses and loss adjustment expenses is an estimate and there is the potential that actual future loss payments will differ significantly from recorded amounts. The methods of determining such estimates and the resulting estimated liability are regularly reviewed and updated. Changes in the estimated liability are reflected in income in the period in which such changes are determined to be needed.
Insurance premiums are recognized as revenue ratably over the term of the related policies in proportion to the insurance protection provided. Contract bonds provide coverage for the length of the bonded project and not a fixed time period. As such, the Company uses estimates of the contract length as the basis for recognizing premium revenue on these bonds. Premium revenues are net of amounts ceded to reinsurers. Unearned premiums represent the portion of premiums written, before ceded reinsurance which is shown as an asset, applicable to the unexpired terms of policies in force determined on a pro rata basis.
Insurance premium receivables do not include financing costs or other fees and are presented net of an estimated allowance for doubtful accounts. This allowance is based on a periodic evaluation of the aging and
The Company assumes and cedes insurance with other insurers and reinsurers to limit maximum loss, provide greater diversification of risk, minimize exposure on larger risks and to meet certain regulatory restrictions that would otherwise limit the size of bonds the Company can write. Premiums and losses and loss adjustment expenses that are ceded under reinsurance arrangements reduce the respective revenues and expenses. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy and are reported as reinsurance receivables. Reinsurance receivables include unpaid amounts related to paid losses and loss adjustment expenses. These amounts are considered past due based on the reinsurance contract terms. The Company evaluates the financial condition of its reinsurers, monitors concentrations of credit risk and establishes allowances for uncollectible amounts when indicated.
The Company accounts for income taxes under the liability method. Under the liability method, deferred income taxes are established for the future tax effects of temporary differences between the tax and financial reporting bases of assets and liabilities using currently enacted tax rates. Such temporary differences primarily relate to unearned premium reserves, deferred policy acquisition costs and net unrealized gains/losses on securities. 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.
Effective in 2007, the Company adopted guidance which prescribed a comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return. The Company has elected to classify interest, if any, recognized in accordance with this guidance as interest expense. Likewise, penalties, if any, recognized in accordance with this guidance will be classified as miscellaneous expense.
No adjustments were made to reported net income in the computation of earnings per share. Options to purchase shares of common stock of 0.4 million, 0.7 million and 0.6 million for the years ending December 31, 2010, 2009 and 2008, respectively, were excluded from the calculation of diluted earnings per share because the exercise price of the options was greater than the average market price of CNA Surety’s common stock.
In June 2009, the FASB issued Accounting Standards Update (“ASU”) No. 2009-16, “Transfers and Servicing (Topic 860) - Accounting for Transfers of Financial Assets.” This guidance removed the concept of a qualifying special-purpose entity and eliminated it from exceptions under the guidance for consolidation of variable interest entities. It also modified the de-recognition conditions related to legal isolation and effective control and added additional disclosure requirements for transfers of financial assets. This guidance was effective for annual reporting periods beginning after November 15, 2009. The adoption of this guidance did not have an impact on the Company’s financial condition or results of operations.
In June 2009, the FASB issued ASU No. 2009-17, “Consolidations (Topic 810) - Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities.” This guidance amended existing consolidation guidance applicable for variable interest entities as well as requirements for determination of the primary beneficiary of a variable interest entity, required an ongoing assessment of whether an entity is the primary beneficiary and required enhanced disclosures that will provide users of financial statements information regarding an enterprise’s involvement in a variable interest entity. This guidance was effective for annual reporting periods beginning after November 15, 2009. The Company evaluated its trust preferred security arrangement discussed further in Note 3., Debt, to these Consolidated Financial Statements and determined the issuer trust should remain unconsolidated under this guidance. As such, the adoption of this guidance did not have an impact on the Company’s financial condition or results of operations.
fiscal years, beginning after December 15, 2011 with prospective or retrospective application allowed. The Company is currently assessing the available application methods as well as the impact this accounting guidance will have on its financial condition and results of operations.
The amortized cost, gross unrealized gains, gross unrealized losses, estimated fair value and unrealized OTTI losses of fixed income securities and the cost, gross unrealized gains, gross unrealized losses and estimated fair value of equity securities held by CNA Surety at December 31, 2009, by investment category, were as follows (dollars in thousands):
The following table presents a roll-forward of the Company’s cumulative credit losses recognized in net realized gains/losses on the Consolidated Statements of Income on fixed income securities held as of December 31, 2010 (in thousands of dollars):
The following table presents a roll-forward of the Company’s cumulative credit losses recognized in net realized gains/losses on the Consolidated Statements of Income on fixed income securities held as of December 31, 2009 (in thousands of dollars):
The following table provides the composition of fixed income securities with an unrealized loss at December 31, 2010 in relation to the total of all fixed income securities by contractual maturities:
Securities are categorized using the S&P rating. If a security is not rated by S&P, the Moody’s rating is used. At December 31, 2010, all of the Company’s fixed income securities were rated by S&P or Moody’s.
The unrealized loss on this AAA-rated U.S. Government agency security is negligible and does not result in an amount when rounded to thousands of dollars.
The unrealized losses on the Company’s investments in obligations of states and political subdivisions are due to changes in credit spreads and rising interest rates. Of the thirty-two investment grade obligations of states and political subdivisions in an unrealized loss position at December 31, 2010, only seven were in an unrealized loss position exceeding 5% of the security’s amortized cost. The largest unrealized loss, $0.7 million, or 11.9% of the security’s amortized cost, was on a security issued by a governmental utility authority. The unrealized loss position of this security has deteriorated slightly compared to December 31, 2009 when it was $0.6 million, or 11.3% of the security’s amortized cost. While the overall unrealized loss position of obligations of states and political subdivisions grew from $2.6 million, or 2.9% of their amortized cost, at December 31, 2009 to $5.8 million, or 3.4% of their amortized cost, at December 31, 2010 the Company continues to believe that all interest and principal will be paid according to their contractual terms. The Company has no current intent to sell these securities, nor is it more likely than not that it will be required to sell prior
During 2010, the Company purchased fifteen non-investment grade corporate bonds. These bonds had an estimated fair value of $22.5 million at December 31, 2010. Eight of these securities were in an unrealized loss position at December 31, 2010. In the aggregate, these eight securities had an unrealized loss of $0.1 million as of December 31, 2010. Each of these securities was in an unrealized loss position representing less than 1.2% of that security’s amortized cost. The Company has no current intent to sell these securities, nor is it more likely than not that it will be required to sell prior to recovery of amortized cost. The Company does not believe the unrealized losses on these securities are indicative of credit losses and, as such, has not recorded any OTTI losses on these securities at December 31, 2010.
comprehensive income at December 31, 2010 was $0.2 million. The Company believes the non-credit component of the unrealized loss on this security is primarily attributable to this asset class being out of favor with investors and is not indicative of the quality of the underlying collateral. The Company has no current intent to sell this security, nor is it more likely than not that it will be required to sell prior to recovery of the adjusted amortized cost.
Based on the current facts and circumstances discussed above for the Company’s securities in an unrealized loss position, the Company has determined that no additional OTTI losses related to the securities in an unrealized loss position are required to be recorded at December 31, 2010.
In May 2004, the Company, through a wholly-owned trust, privately issued $30.0 million of preferred securities through two pooled transactions. These securities, issued by CNA Surety Capital Trust I (the “Issuer Trust”), bear interest at the London Interbank Offered Rate (“LIBOR”) plus 337.5 basis points with a 30-year term. As of May 2009, the Company may redeem these securities, in whole or in part, at par value at any scheduled quarterly interest payment date. As of December 31, 2010, none of these preferred securities have been redeemed.
The valuation of securities that are actively traded and have quoted prices are classified as Level 1. These securities include money market funds and U.S. Treasury bills. Level 2 includes commercial paper, for which all significant inputs are observable.
There were no amounts past due under reinsurance contracts and no allowances were established for uncollectible reinsurance receivables at December 31, 2010 or 2009. At both December 31, 2010 and 2009, receivables from five reinsurers individually comprised 10% or more of the Company’s reinsurance receivable balance. At December 31, 2010, these receivables, $7.8 million, $5.6 million, $5.5 million, $4.6 million and $4.2 million, respectively, were from non-affiliated reinsurers rated at least A (Excellent) by A.M. Best. At December 31, 2009, these receivables, $9.0 million, $7.6 million, $6.8 million, $6.1 million and $5.8 million, respectively, were also due from non-affiliated reinsurers rated at least A by A.M. Best. At December 31, 2010 and 2009, CNA Surety had no reinsurance receivable from affiliates.
assumes 80% of $5 million per principal in excess of $2 million subject to an aggregate annual limit of $8 million. Premiums assumed by Western Surety under this agreement were $0.1 million for 2010 and 2009. In 2008, premiums assumed by Western Surety under this agreement were $0.2 million. This treaty was renewed with the same terms on January 1, 2011 and expires on December 31, 2011.
Through the Stop Loss Contract, the Company’s insurance subsidiaries were protected from adverse loss development on certain business underwritten after the Merger Date. The Stop Loss Contract between the Company’s 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 the Company’s 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 Company’s insurance subsidiaries paid CCC an annual premium of $20,000. The CNA Surety insurance subsidiaries have paid CCC all required annual premiums. Through December 31, 2010, losses incurred under the Stop Loss Contract were $47.2 million. Through December 31, 2009, losses incurred under the Stop Loss
Contract were $49.1 million. The net amount settled in 2010 under this contract was $1.9 million paid to CCC as a result of favorable development on claims subject to the Stop Loss Contract. At December 31, 2010, the amount received under the Stop Loss Contract included $2.7 million held by the Company for losses covered under this contract that were incurred but not paid.
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 surety 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. In 2009, this agreement was amended so that the Company’s authority to conduct administrative, management, underwriting and claim functions for bonds written for the large national contractor discussed below shall continue until CCC’s bonds for such contractor have expired and claims have been settled or closed. This agreement was renewed on January 1, 2010 and expired on December 31, 2010. As of December 31, 2010 and 2009, there were no amounts due to the CNA Surety insurance subsidiaries under this agreement. This agreement was renewed with the same terms on January 1, 2011 and expires on December 31, 2011 and is annually renewable thereafter.
As of December 31, 2010 and December 31, 2009, CNA Surety had an insurance receivable balance from CCC and CIC of $10.8 million and $9.8 million, respectively, comprised of premiums receivable. CNA Surety had no reinsurance payables to CCC or CIC as of December 31, 2010 or 2009.
$32.7 million with an affiliate to enable the affiliate to establish a trust to fund future payments under the bond. The bond was written by the affiliate and assumed by one of the Company’s insurance subsidiaries pursuant to the Quota Share Treaty. The Company is entitled to the interest income earned by the trust. Prior to the establishment of the trust, the Company had fully reserved its obligation under the bond and the claim remains fully reserved.
The Company recorded net loss reserve development for prior accident years which resulted in a decrease of the estimated liability of $76.3 million, $54.3 million and $45.5 million in 2010, 2009 and 2008, respectively.
The favorable development in 2009 resulted primarily from a level of loss activity substantially below expectations for accident years 2006 and 2007. This level of loss activity was particularly influenced by a lower than
In addition to these operating lease commitments, in September 2010, CNA Surety entered into a lease agreement for a new property to be occupied following the 2012 expiration of the lease for its primary processing and service center in Sioux Falls, South Dakota. The new lease includes various contingencies including completion of construction of the building and office space to be occupied. The lease term shall be ten years from its commencement date as defined in the agreement. Other specific lease terms such as final rental square feet and cost will be finalized upon satisfaction of the required contingencies.
The Company is subject to taxation in the United States, Puerto Rico and various state jurisdictions. The Company’s tax years 2007 through 2010 remain open as to the applicable statute of limitations and are subject to examination by the Internal Revenue Service.
Compensation Plan Trust (the “2005 Trust”). The 2005 Plan and 2005 Trust were adopted in connection with the enactment of Section 409A of the Internal Revenue Code of 1986, as amended, which was implemented under the American Jobs Creation Act of 2004. The 2005 Plan and 2005 Trust will be used in lieu of the 2000 Plan and the CNA Surety Corporation Deferred Compensation Plan Trust (the “2000 Trust”) for all amounts deferred on or after January 1, 2005. Amounts deferred under the 2000 Plan prior to January 1, 2005 will continue to be covered by and paid out in accordance with the terms of the 2000 Plan, the 2000 Trust and the elections made by participants under the 2000 Plan.
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 in 2005. As such, the federal subsidy to plan sponsors under the Medicare Modernization Act (“MMA”) has been recognized in the accounting for that plan. In 2010, enactment of the Patient Protection and Affordable Care Act (the “Act”) and the Healthcare and Education Affordability Reconciliation Act (the “Reconciliation Measure”), which modifies certain provisions of the Act, repeal the current rule permitting deduction, for tax purposes, of the entire cost of providing prescription drug benefits even though a portion is offset by the federal subsidy. The impact of these provisions has been recognized in the accounting for this postretirement benefit plan. The impact included recognition of additional tax expense of $0.5 million in 2010.
The Company’s postretirement sick leave plan’s accumulated postretirement benefit obligation as of December 31, 2010 is $0.7 million.
The following tables set forth the combined plans’ pre-tax adjustment to accumulated other comprehensive income/loss (“AOCI”) (dollars in thousands):
The net actuarial loss in 2010 was driven primarily by the lower discount rate used to measure the accumulated postretirement benefit obligation. The net actuarial loss in 2009 was driven by higher claim costs for the medical benefit plan. The net actuarial gain in 2008 resulted primarily from lower per capita claim costs as a result of the change in the plan provider.
The Company expects to contribute $0.2 million to the postretirement benefit plans to pay benefits in 2011. The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid. These amounts are shown both gross and net of the federal subsidy to plan sponsors under the MMA in the following table (dollars in thousands):
The 2006 Plan is administered by the Compensation Committee of the Board of Directors (the “Committee”), consisting of two or more directors of the Company. Subject to the provisions set forth in the 2006 Plan, all of the members of the Committee shall be independent members of the Board of Directors. The Committee determines the option exercise prices. Exercise prices may not be less than the fair market value of the Company’s common stock on the date of grant for incentive stock options and may not be less than the par value of the Company’s common stock for nonqualified stock options.
Black-Scholes option pricing model with the following weighted average assumptions: risk free interest rate of 1.95%; dividend yield of 0.0%; expected option life of 5.3 years and volatility of 51.8%, which was based on historical volatility. The Company estimated the expected option life of the 2009 grant based on its analysis of past exercise patterns for similar options. As of December 31, 2009, the number of shares available for granting of options under the 2006 Plan was 2,252,920.
A summary of option activity for the year ended December 31, 2010 is presented below:
The following table summarizes information about stock options outstanding at December 31, 2010:
Effective January 1, 1998, the Company established the CNA Surety Corporation Non-Employee Directors Deferred Compensation Plan. Under this plan, which was terminated on December 31, 2004, each director who was not a full-time employee of the Company or any of its affiliates could defer all or a portion of the annual retainer fee that would otherwise be paid to such director. The deferral amount was credited to a deferred compensation account and deemed invested in common stock units. Each director was fully vested in his or her deferred compensation amount. Common stock units are convertible into CNA Surety common stock at the election of the director. Aggregate common stock units outstanding as of December 31, 2010 and 2009 were 11,401 and 11,771, respectively.
In 2010, approximately $93.3 million, or 21.2%, of gross written premiums were generated from national insurance brokers, with the single largest national broker production comprising $22.9 million, or 5.2%, of gross written premiums. In 2009, approximately $86.1 million, or 19.7%, of gross written premiums were generated from national insurance brokers, with the single largest national broker production comprising $20.6 million, or 4.7%, of gross written premiums. In 2008, approximately $85.3 million, or 18.3%, of gross written premiums were generated from national insurance brokers, with the single largest national broker production comprising $14.3 million, or 3.1%, of gross written premiums.
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 following table reconciles consolidated stockholders’ equity at December 31, 2010 and 2009 as reported herein in conformity with GAAP with total statutory capital and surplus of CNA Surety’s insurance subsidiaries, determined in accordance with statutory accounting practices prescribed or permitted by insurance regulatory authorities (dollars in thousands):
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, 2010 each of CNA Surety’s insurance subsidiaries had a Ratio that was in compliance with the minimum RBC requirements.
CNA Surety’s insurance subsidiaries are subject to regulation and supervision by the various state insurance regulatory authorities in which they conduct business. Such regulation is generally designed to protect policyholders and includes such matters as maintenance of minimum statutory surplus and restrictions on the payment of dividends. Generally, statutory surplus of each insurance subsidiary in excess of a statutorily prescribed minimum is available for payment of dividends to the parent company. However, such distributions as dividends may be subject to prior regulatory approval. Without prior regulatory approval, Western Surety may pay dividends of $140.2 million to CNA Surety in 2011. Combined statutory surplus for the insurance subsidiaries at December 31, 2010 was $825.6 million.
Pursuant to procedures approved by the Audit Committee, the Company from time to time provides license and permit bonds and appeal bonds for CCC and its affiliates as well as for clients of CCC and its affiliates. As of December 31, 2010, the aggregate outstanding liability of these bonds was approximately $27.8 million. The premium for all such bonds written was $0.3 million in 2010 and 2009. The premium for all such bonds written was $0.6 million in 2008.
From time to time, Western Surety also has liability, either directly or through assumed reinsurance, under bonds written for Loews and certain of its subsidiaries. As of December 31, 2010, the aggregate liability under all such bonds was approximately $79.9 million. This is comprised of the liability for bonds written for Mexdrill Offshore, S. DE R.L. DE C. V., which is a subsidiary of Diamond Offshore Drilling, Inc. (“Diamond Offshore”). As of December 31, 2010, Loews owns 50.4% of Diamond Offshore. Premiums for bonds written for Loews and its subsidiaries were less than $0.1 million in 2010, $0.2 million in 2009 and less than $0.1 million in 2008. All bonds were written with the approval of the Audit Committee.