CNA Surety leases its executive offices and its shared branch locations with CCC under an Administrative Services Agreement. CNA Surety currently uses approximately 72,500 square feet and related personal property at 41 branch locations and its home and executive offices (15,243 square feet), in Chicago, Illinois. CNA Surety's annual rent for this space is approximately $1.6 million. CNA Surety may terminate its use of these locations as set forth in the Administrative Services Agreement, without penalty, by providing CCC with 60 days written notice.
The following financial information has been derived from the Consolidated Financial Statements and notes thereto which appear elsewhere in this Form 10-K.
(1) Includes investment income and investment gains for CNA Surety for the period from September 30, 1997 (date of inception) through December 31, 1997.
(2) Includes the effect of recording releases of prior year loss reserves. The dollar amount and the percentage point effect on the loss ratio of these reserve revisions was $647 and 1.0% for the period from September 30, 1997 (date of inception) through December 31, 1997.
The following information of the Predecessor is presented for the three months ended December 31, 1996, for the nine months ended September 30, 1997 and 1996 and for the years ended December 31, 1996, 1995, 1994 and 1993. The selected financial information of the Predecessor does not include data with respect to assets, liabilities (other than insurance reserves) and equity because CNAF did not customarily allocate the investment portfolio or equity of its operating subsidiaries to its business units like CCC Surety Operations.
(2) Includes the effect of recording releases of prior year loss reserves. The dollar amount and the percentage point effect on the loss ratio of these reserve revisions, all of which were net reductions, were $1,232 or 3.4% for the three months ended December 31, 1996, $35,000 or 32.2% and $8,510 or 7.6% for the nine months ended September 30, 1997 and 1996, respectively, and $9,742 and 6.5%, $10,846 and 8.3%, and $8,454 and 10.8% for the years ended December 31, 1996, 1995, and 1994, respectively.
(4) The insurance reserves include both loss and loss adjustment expense and unearned premium reserves. These reserves are shown before the effects of ceded reinsurance. In accordance with the reorganization and related reinsurance agreements, these reserves, as of the Merger Date, were transferred to Western Surety, net of reinsurance which totaled $9,979 and $23,876 for the nine months ended September 30, 1997 and 1996 and $21,779, $31,060, $21,098, and $28,362 at December 31, 1996, 1995, 1994, and 1993, respectively.
In December 1996, CNA Financial Corporation ("CNAF") and Capsure Holdings Corp. ("Capsure") agreed to merge (the "Merger") the surety business of CNAF with Capsure's insurance subsidiaries, Western Surety Company ("Western Surety") and Universal Surety of America ("USA"), which are owned by a newly-formed holding company, CNA Surety Corporation. CNAF, through its operating subsidiaries, writes multiple lines of property and casualty insurance, including surety business that is reinsured by Western Surety. Loews Corporation owns approximately 84% of the outstanding common stock of CNAF. The principal operating subsidiaries of CNAF that wrote the surety line of business for their own account prior to the Merger were Continental Casualty Company and its property and casualty affiliates (collectively, "CCC") and The Continental Insurance Company and its property and casualty affiliates (collectively, "CIC"). CIC was acquired by CNAF on May 10, 1995. The combined surety operations of CCC and CIC are referred to herein as CCC Surety Operations ("Predecessor").
Pursuant to a reorganization agreement, CCC Surety Operations and Capsure merged their respective operations at the close of business on September 30, 1997 ("Merger Date"). CNAF, through its property and casualty subsidiaries, CCC and CIC contributed $52.25 million of capital to CNA Surety. Through reinsurance agreements, CCC and CIC ceded to Western Surety all of their net unearned premiums and loss and loss adjustment expense reserves, as of the Merger Date, and will cede to Western Surety all surety business written or renewed by CCC and CIC for a period of five years thereafter. Further, CCC and CIC have agreed to assume the obligation for any adverse development on recorded reserves for CCC Surety Operations as of the Merger Date, to limit the loss ratio on certain defined business written by CNA Surety through December 31, 2000 and to provide certain additional excess of loss reinsurance. CCC also agreed to provide certain administrative services at specified rates, subject to inflationary increases, for three years after the Merger, if CNA Surety chooses to purchase such services.
insurance, as a licensed insurer in all 50 states and the District of Columbia. Western Surety's affiliated company, Surety Bonding Company of America ("SBCA"), writes principally small commercial surety business and is licensed in 22 states. USA specializes in the underwriting of small contract and commercial surety bonds. USA is licensed in 41 states and the District of Columbia with most of its business generated in Texas.
The Company's strategy is to continue the underwriting focus of each of its operating units and to achieve growth from cross-marketing opportunities and building upon the established traditions of high-quality service and long-term relationships.
As set forth in Note 1 to the Consolidated Financial Statements, the results of operations of the Predecessor did not reflect investment income and investment gains and losses. Additionally, certain general and administrative expenses, which were indirect or overhead in nature, were not allocated to the Predecessor by CNAF or its subsidiaries. As a result of these factors and because the merger with Capsure significantly affected the combined organization, it is not useful to compare CNA Surety operations to Predecessor operations. Also, a comparison of the Predecessor results of operations for the nine months ended September 30, 1997 to the year ended December 31, 1996 would not be useful due to the different reporting periods of nine and twelve months.
Net written premiums are shown in the table below (dollars in thousands):
Underwriting income increased 67.8% to $15.1 million in the fourth quarter of 1997 and increased 86.7% to $87.1 million for the year ended December 31, 1997 as compared to the similar periods in 1996. The period to period changes in underwriting income and combined ratios were due to fluctuations in both the loss and expense ratios as more fully described below.
The loss ratios for the years ended December 31, 1997 and 1996 were 2.3% and 17.4%, respectively. Excluding the impact of the favorable reserve development impact of $40.9 million and $16.6 million in 1997 and 1996, respectively, the loss ratios would have been 19.1% and 24.4%, respectively. Approximately $35.0 million in favorable reserve development in 1997 relates to the Predecessor as more fully described in Note 8 to the Consolidated Financial Statements. The decrease in the loss ratio is due to the ongoing favorable economic trends that continue to benefit the surety business in addition to more disciplined underwriting practices the Company has adopted since the acquisition of CIC by CNAF in May of 1995.
Amortization expense was $1.4 million for the fourth quarter of 1997 and 1996 and $5.8 million for the years ended December 31, 1997 and 1996. Intangible assets represent goodwill and identified intangibles arising from the acquisition of Capsure and goodwill arising from the May 1995 acquisition of CIC by CNAF that was allocated to the surety business of CIC. Intangible assets are generally amortized over 30 years.
Net written premiums for the years ended December 31, 1996 and 1995 of CCC Surety Operations throughout the period and of CIC subsequent to May 10, 1995, the date of acquisition, are shown in the table below (dollars in thousands):
Changes in net written premiums during this period were primarily due to the acquisition of CIC in May of 1995 and, in 1996, also due to changes in the reinsurance programs. CIC net written premiums have been included for approximately seven and one-half months in the 1995 results and have been included for the full year in the 1996 results. The more significant changes in the reinsurance programs were that contract surety retentions increased from $3 million to $5 million per principal effective January 1, 1996. Similarly, commercial bond retentions increased from $750,000 to $3 million effective January 1, 1996. These changes in the reinsurance arrangements were made as a result of the larger capital base of the combined operations, and allowed the CCC Surety Operations to lower reinsurance costs and retain additional amounts of surety premiums. The increase in retentions in 1996 accounted for approximately 25% of the total 1996 increase in net written premiums. Correspondingly, the increased retention by the CCC Surety Operations in part contributed to the reduction of ceded loss reserves which decreased from $24.5 million at December 31, 1995 to $15.5 million at December 31, 1996. Although the CCC Surety Operations' potential exposure increased as a result of the increased retentions, CCC Surety Operations' management believed that, based upon the favorable loss experience with respect to such business, the retention of potentially profitable business offset such increased exposure.
Due to the significant effect of the CIC acquisition on the foregoing balances and changes in the reinsurance programs, it is more meaningful to review gross written premiums (premiums written before ceded premiums) during the periods ended December 31, 1996 and 1995, for CCC and CIC, as if they had been combined throughout this period (dollars in thousands):
The following table is a summary of the pretax operating results of the CCC Surety Operations and certain operating ratios for the years ended December 31, 1996 and 1995 (dollars in thousands). As described in Note 1 to the accompanying financial statements, these pretax operating results do not include investment income, realized capital gains and losses, and certain indirect or overhead type expenses.
The year-over-year changes in the combined ratio was due to fluctuations in the loss ratio as more fully discussed in the following paragraph.
The Company believes that total invested assets, including cash and short-term investments, are sufficient in the aggregate and have suitably scheduled maturities to satisfy all policy claims and other operating liabilities, including income tax sharing payments of its insurance subsidiaries. At December 31, 1997, the carrying value of the Company's insurance subsidiaries invested assets was comprised of $266.3 million of fixed income securities, $140.2 million of short-term investments, $6.0 million of other investments and $0.1 million of cash.
CNA Surety management believes that it will have sufficient available resources to meet its present capital needs.
CNA Surety's insurance subsidiaries employs accepted reserving approaches in establishing the estimated liability for unpaid loss and loss adjustment expenses that give consideration to the inherent difficulty and variability in the estimation process. In addition, CNA Surety utilizes independent actuarial firms of national standing to conduct periodic reviews of claim procedures and loss reserving practices, and annually obtains actuarial certification as to the reasonableness of actuarial assumptions used and the sufficiency of year-end reserves for each of its principal insurance subsidiaries.
The estimated liability for unpaid losses and loss adjustment expenses includes, on an undiscounted basis, estimates of (a) the ultimate settlement value of reported claims, (b) incurred but not reported ("IBNR") claims, (c) future expenses to be incurred in the settlement of claims and (d) claim recoveries, exclusive of reinsurance recoveries which are reported as an asset. These estimates are determined based on the Company's and surety industry loss experience as well as consideration of current trends and conditions. The estimated liability for unpaid losses and loss adjustment expenses is an estimate and there is the potential that actual future loss payments will differ significantly from initial estimates. The methods of determining such estimates and the resulting estimated liability are regularly reviewed and updated. Changes in the estimated liability are reflected in operating income in the year in which such changes are determined to be needed.
(1) Amounts are for Predecessor except for the net reserves of Capsure and both ceded reinsurance and gross reserves at the end of the period which are for CNA Surety.
The National Association of Insurance Commissioners ("NAIC") has promulgated RBC requirements for property and casualty insurance companies to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks such as asset quality, loss reserve adequacy, and other business factors. The RBC information is used by state insurance regulators as an early warning mechanism to identify insurance companies that potentially are inadequately capitalized. In addition, the formula defines new minimum capital standards that supplement the current system of fixed minimum capital and surplus
The NAIC has also developed a rating system, the Insurance Regulatory Information System ("IRIS"), primarily intended to assist state insurance departments in overseeing the financial condition of all insurance companies operating within their respective states. IRIS consists of eleven key financial ratios that address various aspects of each insurer's financial condition and stability. In 1997, USA's IRIS ratios fell within all of the "usual ranges." Due to the Merger and related reinsurance transactions that occurred on September 30, 1997, Western Surety's net writings, surplus and agents balances increased significantly causing the applicable IRIS ratios to be outside the "usual ranges." All of the remaining IRIS ratios for Western Surety were normal.
The widespread use of computer programs, both in the United States and internationally, that rely on two digit fields to perform computations and decision making functions may cause computer systems to malfunction when processing information involving dates after 1999. Such malfunction could lead to business delays and disruptions. The Company is in the process of replacing or upgrading its systems to accommodate business for the year 2000, and anticipates that by December 31, 1998 it will have substantially completed its program of replacements and the necessary upgrades to accommodate year 2000 processing of its business. However, due to the interdependent nature of computer systems, the Company may be adversely impacted depending upon whether it or other entities not affiliated with the Company (vendors and business partners) address this issue successfully. The cost of achieving year 2000 compliance is estimated to be less than $1.0 million in excess of the cost of normal software upgrades and replacements and will primarily be incurred in 1998.
In February 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No. 128, "Earnings Per Share." SFAS No. 128 is effective for both interim and annual periods ending after December 15, 1997. SFAS No. 128 replaces Accounting Principles Board ("APB") Opinion No. 15, "Earnings Per Share." APB Opinion No. 15 required that entities with simple capital structures present a single earnings per common share ("EPS") on the face of the income statement, whereas those with complex capital structures had to present both primary and fully diluted EPS. SFAS No. 128 simplifies the computation of EPS by replacing the presentation of primary EPS with a presentation of basic EPS and requires dual presentation of basic and diluted EPS by entities with complex capital structures. Basic EPS
includes no dilution and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period, whereas primary EPS includes the dilutive effect of common stock equivalents, such as stock options. Diluted EPS reflects the potential dilution of securities that could share in the earnings of an entity, similar to fully diluted EPS. The Company has adopted SFAS No. 128 in the accompanying Consolidated Financial Statements.