which is subject to annual adjustments, was $1.7 million as of December 31, 2007. CNA Surety also leased space for contract and commercial branch offices in New York, New York; Roseville, California; San Juan, Puerto Rico; Hoover, Alabama; and Rocklin, California. Annual rent for these offices was $0.3 million with leases terminating in 2007, 2007, 2011, 2010, and 2012, respectively. The New York, New York lease expiring in 2007 was not renewed as this branch is now a shared location with CCC. The Roseville, California lease was not renewed as the branch was relocated to Rocklin, California.
The following information presented for CNA Surety is as of and for the years ended December 31, 2007, 2006, 2005, 2004 and 2003.
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.
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 estimate 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).
As a group of claims mature, their collective value changes. This change in value over time is referred to as loss development. The loss development method is a traditional actuarial approach which relies on the historical
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, was utilized to obtain an estimate of expected ultimate losses. This estimate was 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.
Each of the projection methodologies employed rely to varying degrees on the basic assumption that the Company’s historical claim experience is indicative of the Company’s future claim development. The amount of weight given to any individual projection method is based on an assessment of the volatility of the historical data and development patterns, an understanding of the changes in the overall surety industry over time and the resultant
potential impact of these changes on the Company’s prospective claims development, an understanding of the changes to the Company’s processes and procedures within its underwriting, claims handling and data systems functions, among other things. The decision as to how much weight to give to any particular projection methodology is ultimately a matter of experience and professional judgment.
Surety results, especially for contract and certain commercial products like insurance program bonds, workers compensation insurance bonds and reclamation bonds, tend to be impacted by fewer, but more severe, losses. With this type of loss experience, it is more difficult to estimate the required reserves, particularly for the most current accident years which may have few reported claims. Therefore, assumptions related to the frequency and magnitude of severe loss are key in estimating surety loss reserves.
Recorded reserves at December 31, 2007 are slightly higher than the actuarial point estimate, with the difference concentrated in the more recent accident years. Management believes that it would be premature to
At December 31, 2006, management’s recorded gross and net reserves were slightly lower than the point estimate, with the percentage difference being somewhat larger on a net basis. At December 31, 2006, management believed continued improvement in economic conditions, lower corporate default rates and fewer reported severe claims indicated a lower provision for severe losses was appropriate. Management believed that the actuarial point estimates included provisions in the most recent accident year for severe losses that continue to be influenced by the Company’s experience in accident years 2002 and 2003 and did not fully reflect the favorable economic conditions, changes in the Company’s exposures and favorable claim experience during the most recent accident years. The conclusion of the actuarial analyses performed in the third quarter of 2007 with data as of June 30, 2007 resulted in lower point estimates, confirming the positive loss trends noted by management.
In developing the indicated range of reserve estimates for the Company, the Mack methodology and the point estimate analysis were utilized in order to estimate the requisite reserve distribution parameters. The Mack methodology is premised on the idea that the volatility in a company’s historical paid loss development is representative of the variability in a company’s future payments and thus can be used to estimate the variability within a company’s reserve estimate. Given the dispersion of the reserve indications, the 50th and 75th percentile were selected as representing a reasonable range of reserve estimates.
surrounding individual claims. Again, it is important to note that it is possible that the actual net payments could fall outside of the estimated range.
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
The Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) discusses certain generally accepted accounting principles (“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.
Underwriting components for the Company for the years ended December 31, 2007, 2006 and 2005 are summarized in the following table (dollars in thousands):
Through one of its insurance subsidiaries, Western Surety Company (“Western Surety”), the Company assumes significant amounts of premiums primarily from affiliates. This includes all surety business written or renewed, net of reinsurance, by Continental Casualty Company (“CCC”) and The Continental Insurance Company (“CIC”), and their affiliates, after September 30, 1997 that is reinsured by Western Surety pursuant to reinsurance and related agreements. Because of certain regulatory restrictions that limit the Company’s ability to write business on a direct basis, the Company continues to utilize the underwriting capacity available through these agreements. The Company is in full control of all aspects of the underwriting and claim management of this assumed business.
For 2007, gross written premiums increased 4.5% to $471.7 million as compared to 2006. Gross written premiums for contract surety increased 7.2% to $305.6 million primarily due to the strength of the non-residential construction economy and the success of our small contractor product. For 2007, commercial surety gross written premiums were flat, and fidelity and other premiums decreased slightly due to the lingering effects of the loss of a large notary program in 2006 and continued selective underwriting of large commercial risks.
For 2006, net written premiums increased by $43.7 million to $409.6 million as compared to 2005 reflecting the increase in gross written premiums discussed previously and a decrease of $9.9 million of ceded written premiums to $41.7 million for 2006. The reduction in ceded written premiums was due to the Company’s decision not to renew a high-level excess of loss reinsurance treaty and cost savings on the core reinsurance program. Net written premiums for contract surety business increased 22.3% to $248.0 million for 2006 compared to 2005. Net written premiums for commercial surety increased 1.8% to $130.3 million for 2006 compared to 2005. Fidelity and other products decreased 10.8% to $31.3 million for the year 2006 compared to 2005 reflecting the decline in production of notary E&O policies resulting from the loss of the large notary program discussed previously.
For 2007, net earned premiums increased by $27.9 million to $421.5 million as compared to 2006 reflecting the increase in gross written premiums discussed above. Ceded earned premiums remained at $45.0 million for 2007 compared to 2006. Net earned premiums for contract surety business increased 12.3% to $259.4 million for 2007 compared to 2006. Net earned premiums for commercial surety increased 1.0% to $130.5 million for 2007 compared to 2006. Earned premium for fidelity and other products decreased 5.9% to $31.6 million for the year 2007 compared to 2006.
For 2006, net earned premiums increased by $45.3 million to $393.6 million as compared to 2005 reflecting the increase in gross written premiums discussed above. Ceded earned premiums decreased $9.2 million due to the Company’s decision not to renew a high-level excess of loss reinsurance treaty and cost savings on the core reinsurance program. Net earned premiums for contract surety business increased 19.9% to $230.9 million for 2006 compared to 2005. Net earned premiums for commercial surety increased 5.1% to $129.2 million for 2006 compared to 2005. Earned premium for fidelity and other products increased 1.9% to $33.6 million for the year 2006 compared to 2005.
Effective January 1, 2006, CNA Surety entered into a new excess of loss treaty (“2006 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the 2005 Excess of Loss Treaty. Under the 2006 Excess of Loss Treaty, the Company’s net retention per principal 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 significant differences between the 2006 Excess of Loss Treaty and the Company’s 2005 Excess of Loss Treaty were as follows. The actual cost for the 2006 Excess of Loss Treaty was $39.9 million compared to the actual cost of the 2005 Excess of Loss Treaty of $41.5 million. The contract included a provision for additional premiums based on losses ceded under the contract. The contract also included an optional extended discovery period, which was not exercised, for an additional premium (a percentage of the original premium based on any unexhausted aggregate limit by layer), which would have provided coverage for losses discovered beyond 2006 on bonds that were in force during 2006. Only the large national contractor that was excluded from the 2005 treaty remained excluded from the 2006 Excess of Loss Treaty.
original premium based on any unexhausted aggregate limit by layer), which would have provided coverage for losses discovered beyond 2007 on bonds that were in force during 2007. The contract also includes a provision for additional premiums based on losses ceded under the contract. The primary difference between the 2007 Excess of Loss Treaty and the Company’s 2006 Excess of Loss Treaty is as follows. The actual cost for the 2007 Excess of Loss Treaty is $42.6 million, which includes an initial estimate of additional premiums of $4.3 million resulting from loss activity, compared to the actual cost of the 2006 Excess of Loss Treaty of $39.9 million. Only the large national contractor that was excluded from the 2006 treaty remained excluded from the 2007 Excess of Loss Treaty.
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 will expire on December 31, 2008, was for an additional premium subject to the level of actual premiums written on bonds for the large national contractor. As of December 31, 2007 and 2006, the Company had ceded losses of $50.0 million under the terms of this contract, with unpaid ceded losses of $46.8 million and $50.0 million as of December 31, 2007 and 2006, respectively.
As of December 31, 2007 and December 31, 2006, CNA Surety had an insurance receivable balance from CCC and CIC of $62.9 million, including $50.5 million of reinsurance recoverables and $12.4 million of premiums receivable, and $61.9 million, including $55.0 million of reinsurance recoverables and $6.9 million of premiums receivable, respectively. CNA Surety had reinsurance payables to CCC and CIC as of December 31, 2007 of $0.1 million. CNA Surety had no reinsurance payables to CCC and CIC as of December 31, 2006.
The loss ratios for the years ended December 31, 2007, 2006 and 2005 were 24.5%, 24.3% and 36.7%, respectively. The loss ratios reflect $5.1 million, $5.3 million and $23.3 million of net favorable loss reserve development for the years ended December 31, 2007, 2006 and 2005, respectively.
The Company’s business is subject to certain risks and uncertainties associated with the current economic environment and corporate credit conditions. In response to these risks and uncertainties, the Company has enacted various exposure management initiatives. With respect to risks on large commercial accounts, the Company generally limits its exposure to $25.0 million per account, but will selectively accept higher exposures.
For 2007, net investment income was $44.6 million compared to net investment income for 2006 and 2005 of $39.3 million and $33.7 million, respectively. The annualized pre-tax yield was 4.6%, 4.5% and 4.4% for 2007, 2006 and 2005, respectively. The annualized after-tax yield was 3.8% for 2007. The annualized after-tax yield for 2006 and 2005 was 3.7%. The increase in investment income for both 2007 and 2006 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 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.
The Company might also access available or new credit facilities to meet cash needs. This would increase interest expense by increasing the amount of debt outstanding and potentially increasing the interest rate on previously outstanding debt. The Company currently has $25.0 million of borrowing capacity on existing facilities. The Company’s ability to enter into new facilities is limited by covenants in the existing facility.
The term of borrowings under the 2005 Credit Facility may be fixed, at the Company’s option, for a period of one, two, three, or six months. The interest rate is based on, among other rates, the London Interbank Offered Rate (“LIBOR”) plus the applicable margin. The margin, including a utilization fee, can vary based on the Company’s leverage ratio (debt to total capitalization) from 0.80% to 1.00%. There was no outstanding balance under the 2005
Credit Facility at December 31, 2007 or December 31, 2006. As such, the Company incurred only the facility fee of 0.325% for the years ended December 31, 2007 and 2006.
In May 2004, the Company, through a wholly-owned trust, privately issued $30.0 million of preferred securities through two pooled transactions. These securities bear interest at a rate of LIBOR plus 337.5 basis points with a 30-year term and are redeemable at par value after five years. The securities were issued by CNA Surety Capital Trust I (the “Issuer Trust”). The Company’s investment of $0.9 million in the Issuer Trust is carried at cost in “Other assets” in the Company’s Consolidated Balance Sheet. The sole asset of the Issuer Trust consists of a $30.9 million junior subordinated debenture issued by the Company to the Issuer Trust. The Company has also guaranteed the dividend payments and redemption of the preferred securities issued by the Issuer Trust. The maximum amount of undiscounted future payments the Company could make under the guarantee is $75.0 million, consisting of annual dividend payments of $1.5 million over 30 years and the redemption value of $30.0 million. Because payment under the guarantee would only be required if the Company does not fulfill its obligations under the debentures held by the Issuer Trust, the Company has not recorded any additional liabilities related to this guarantee.
A summary of the Company’s contractual obligations as of December 31, 2007 is presented in the following table:
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 pay cash dividends. 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 (“SBCA”) are domiciled in South Dakota. Universal Surety of America (“Universal Surety”) is domiciled in Texas. As of January 1, 2008, however, Universal Surety has been re-domiciled in South Dakota and the dividend limitations will be subject to the South Dakota regulations. 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 2008 is based on statutory surplus and income at and for the year ended December 31, 2007. Without prior regulatory approval in 2008, Western Surety may pay dividends of $96.7 million to CNA Surety. 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 2007. CNA Surety received dividends of $10.5 million from its insurance subsidiaries during 2006. CNA Surety received $0.9 million in dividends from its non-insurance subsidiaries during 2006.
Combined statutory surplus totaled $442.2 million at December 31, 2007, resulting in a net written premium to statutory surplus ratio of 1 to 1. Insurance regulations restrict Western Surety’s maximum net retention on a single surety bond to 10 percent of statutory surplus. Under the 2008 Excess of Loss Treaty, the Company’s net retention on new bonds would generally be $10 million plus a 5% co-participation in the $90 million layer of excess reinsurance above the Company’s retention. Based on statutory surplus as of December 31, 2007, this regulation would limit Western Surety’s largest gross risk to $129.7 million. This surplus requirement may limit the amount of future dividends Western Surety could otherwise pay to CNA Surety.
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, 2007 through June 30, 2008, the underwriting limitations of Western Surety and Surety Bonding are $34.2 million and $0.7 million, respectively. Through the Surety Quota Share Treaty previously discussed, CNA Surety has access to CCC and its affiliates’ U.S. Department of Treasury underwriting limitations. Effective July 1, 2007 through June 30, 2008, the underwriting limitations of CCC and its affiliates total $739.9 million. CNA Surety management believes that the foregoing U.S. Treasury underwriting limitations are sufficient for the conduct of its business.
Subject to the aforementioned uncertainties concerning the Company’s per principal net retentions, CNA Surety management believes that the Company has sufficient available resources, including capital protection against large losses provided by the Company’s excess of loss reinsurance arrangements, to meet its present capital needs.
The following table summarizes the distribution of the Company’s fixed income and equity portfolios at estimated fair values as of December 31, 2007 and 2006 (dollars in thousands):
We have audited the internal control over financial reporting of CNA Surety Corporation and subsidiaries (the “Company”) as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying management’s report on internal control over financial reporting. Our responsibility is to express an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We have audited the accompanying consolidated balance sheets of CNA Surety Corporation and subsidiaries (the “Company”) as of December 31, 2007 and 2006, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007. 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.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2007, 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 19, 2008, expressed an unqualified opinion of 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. CNAF owns approximately 62% of the outstanding common stock of CNA Surety. Loews Corporation (“Loews”) owns approximately 89% 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”).
Policy acquisition costs, consisting of commissions, premium taxes and other underwriting expenses that vary with, and are primarily related to, the production of business, net of reinsurance commissions, are deferred and amortized as the related premiums are earned. The Company periodically tests that deferred 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 acquisition costs, a charge to net income is taken and the deferred acquisition cost balance is reduced to the amount determined to be recoverable. Anticipated investment income is considered in the determination of the recoverability of deferred acquisition costs.
CNA Surety’s Consolidated Balance Sheet as of December 31, 2007 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 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, (c) future expenses to be incurred in the settlement of claims, and (d) claim recoveries, before reinsurance recoveries, which are reported as an asset. These estimates are determined based on the 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 terms 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.
The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109” (“FIN 48”), effective on January 1, 2007. FIN 48 prescribes 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 adoption of FIN 48 did not result in the recognition of a liability for uncertain income tax liability benefits at adoption or during 2007. The Company has elected to classify interest, if any, recognized in accordance with FIN 48 as interest expense. Likewise, penalties, if any, recognized in accordance with FIN 48 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 0.3 million were excluded from the calculation of diluted earnings per share for the year ended December 31, 2007 because the exercise price of these options was greater than the average market price of CNA Surety’s common stock. There were no options excluded from the calculation of diluted earnings per share for the year ended December 31, 2006. At December 31, 2005, options to purchase shares of 0.4 million were excluded from the calculation of diluted earnings per share.
In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts” (“SOP 05-1”). SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments”. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occur by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. SOP 05-1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006 and was adopted by the Company as of January 1, 2007. Adoption and subsequent application of this standard did not have an impact on the Company’s results of operations and financial condition.
The amortized cost and estimated fair value of fixed income securities, by contractual maturity, at December 31, 2007 and 2006 are shown below. Actual maturities may differ from contractual maturities as borrowers may have the right to call or prepay obligations with or without call or prepayment penalties (dollars in thousands):
The following table summarizes for fixed income securities in an unrealized loss position at December 31, 2007 and 2006, 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):
During the second quarter of 2007, the Company recognized impairment losses on 13 fixed income securities of various categories of investments that were in an unrealized loss position. In response to the significant change in interest rates in the second quarter, as well as a revised outlook on future interest rates, the Company did not have the intention of holding these securities to their anticipated recovery. These securities were sold during the third quarter. The other-than-temporary impairment losses on these securities were $1.0 million.
In response to the significant change in interest rates during the third quarter of 2006, the Company recognized impairment losses on 21 municipal fixed income securities that were in an unrealized loss position at September 30, 2006. The Company did not have the intention of holding these securities to their anticipated recovery and recorded $0.9 million other-than-temporary impairment losses on these securities. These securities were sold during the fourth quarter of 2006 resulting in an additional loss of $0.5 million.
On July 27, 2005, the Company refinanced $30.0 million in outstanding borrowings under its previous credit facility with a new credit facility (the “2005 Credit Facility”). The 2005 Credit Facility 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 matures on June 30, 2008. No other debt matures in the next five years.
The term of borrowings under the 2005 Credit Facility may be fixed, at the Company’s option, for a period of one, two, three, or six months. The interest rate is based on, among other rates, the London Interbank Offered Rate (“LIBOR”) plus the applicable margin. The margin, including a utilization fee, can vary based on the Company’s leverage ratio (debt to total capitalization) from 0.80% to 1.00%. There was no outstanding balance under the 2005 Credit Facility at December 31, 2007 and December 31, 2006. As such, the Company incurred only the facility fee of 0.325% for the years ended December 31, 2007 and 2006.
The 2005 Credit Facility contains, among other conditions, limitations on the Company with respect to the incurrence of additional indebtedness and maintenance of a rating of at least A- by A.M. Best Company, Inc. (“A.M. Best”) for each of the Company’s insurance subsidiaries. The 2005 Credit Facility also requires the maintenance of certain financial ratios as follows: a) maximum funded debt to total capitalization ratio of 25%, b) minimum net worth of $375.0 million and c) minimum fixed charge coverage ratio of 2.5 times. The Company was in compliance with all covenants as of and for the years ended December 31, 2007 and 2006.
The subordinated debenture bears interest at a rate of LIBOR plus 337.5 basis points and matures in April 2034. As of December 31, 2007 and 2006, the interest rate on the junior subordinated debenture was 8.24% and 8.75%, respectively.
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 $50.5 million and $55.0 million at December 31, 2007 and 2006, respectively. CNA Surety’s largest reinsurance receivable from an unaffiliated reinsurer, rated A (Excellent) by A.M. Best, was approximately $16.8 million and $13.4 million at December 31, 2007 and 2006, respectively.
Assumed premiums primarily includes all surety business written or renewed, net of reinsurance, by CCC and CIC, and their affiliates, after September 30, 1997 that is reinsured by Western Surety pursuant to reinsurance and related agreements. Because of certain regulatory restrictions that limit the Company’s ability to write business on a direct basis, the Company continues to utilize the underwriting capacity available through these agreements. The Company is in full control of all aspects of the underwriting and claim management of the business assumed from these affiliates.
The Company’s reinsurance program is predominantly comprised of excess of loss reinsurance contracts that limit the Company’s retention on a per principal basis. The Company’s reinsurance coverage is provided by third party reinsurers and related parties. Due to the terms of conditions of these excess of loss treaties, reinsurers may cover some principals in one year but then exclude these same principals in subsequent years. As a result, the Company may have exposures to these principals that have limited or no reinsurance coverage.
The Services and Indemnity Agreement provides the Company’s insurance subsidiaries with the authority to perform various administrative, management, underwriting and claim functions in order to conduct the business of CCC and CIC and to be reimbursed by CCC for services rendered. In consideration for providing the foregoing services, CCC has agreed to pay Western Surety a quarterly fee of $50,000. This agreement was renewed on January 1, 2007 and expired on December 31, 2007. There was no amount due to the CNA Surety insurance subsidiaries as of December 31, 2007. This agreement was renewed on January 1, 2008 and expires on December 31, 2008 and is annually renewable thereafter.
Through the Stop Loss Contract, the Company’s insurance subsidiaries were protected from adverse loss experience on certain business underwritten after the Merger Date. The Stop Loss Contract between the insurance subsidiaries and CCC limited the insurance subsidiaries’ prospective net loss ratios with respect to certain accounts and lines of insured business for three full accident years following the Merger Date. In the event the insurance subsidiaries’ accident year net loss ratio exceeds 24% in any of the accident years 1997 through 2000 on certain insured accounts (the “Loss Ratio Cap”), the Stop Loss Contract requires CCC at the end of each calendar quarter following the Merger Date, to pay to the insurance subsidiaries a dollar amount equal to (i) the amount, if any, by which 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 insurance subsidiaries paid to CCC an annual premium of $20,000. The CNA Surety insurance subsidiaries have paid CCC all required annual premiums. As of December 31, 2006, the Company had billed $47.9 million and had received $45.9 million under the Stop Loss Contract. The amount received under the Stop Loss Contract included $28.2 million held by the Company for losses covered by this contract that were incurred but not paid as of December 31, 2006. Due to favorable development of losses subject to the Stop Loss Contract during 2007, the Company returned $5.6 million to CCC during 2007. As of December 31, 2007, the net amount billed and received by the Company under the Stop Loss Contract was $42.3 million. The amount received under the Stop Loss Contract included $24.0 million held by the Company for losses covered by this contract that were incurred but not paid as of December 31, 2007.
The favorable development in 2007 primarily resulted from better than expected indemnification recoveries related to a large commercial claim in the 2001 accident year.
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, 2007 the future minimum commitments under operating leases are as follows: 2008 - $2.0 million; 2009 - $2.0 million; 2010 - $2.0 million; 2011 - $1.8 million; 2012 - $0.9 million. Total rental expense for 2007, 2006 and 2005 was $5.2 million, $5.1 million and $5.0 million, respectively.
The components of deferred income taxes as of December 31, 2007 and 2006 were as follows (dollars in thousands):
CNA Surety sponsors a tax deferred savings plan (“401(k) plan”) covering substantially all of its employees. The Company matches 100% of the participating employee’s contribution up to 3% of eligible compensation and 50% of the participating employee’s contribution between 3% and 6% of eligible compensation (4.5% maximum matching). The Company also makes an additional basic contribution to eligible 401(k) plan participants of 3% (if under age 45) or 5% (if 45 or older) of eligible compensation. In addition, the Company may also make an annual discretionary profit sharing contribution to the 401(k) plan, subject to the approval of the Company’s Board of Directors. The profit sharing contribution may be restricted by plan and regulatory limitations. The Company contribution, including profit sharing, to the 401(k) plan was $4.7 million, $4.0 million and $4.1 million for the years ended December 31, 2007, 2006 and 2005, respectively.
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 of Section 409A of the Internal Revenue Code of 1986, as amended (the “Code”), 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.
Western Surety sponsors two postretirement benefit plans covering certain employees. One plan provides medical benefits, and the other plan provides sick leave termination payments. The medical benefit plan provides coverage for employees, and their eligible dependents, hired by Western Surety before November 1, 1991 and who retire at age 55 or later with at least 15 years of service. Only employees hired by Western Surety prior to 1988 are eligible for the sick leave plan. Further, benefits for the sick leave plan are based on unused accrued sick leave as of December 31, 2003, the date the accruals were frozen. The postretirement medical benefit plan is contributory and the sick leave plan is non-contributory. Western Surety uses a December 31 measurement date for both of its postretirement benefit plans. There were no plan assets for either of the postretirement benefit plans.
The Company’s postretirement medical benefit plan’s accumulated postretirement benefit obligation as of December 31, 2007 is $9.3 million.
The Company’s postretirement sick leave plan’s accumulated postretirement benefit obligation as of December 31, 2007 is $0.7 million.
The amounts recognized in the consolidated balance sheets for postretirement benefit obligations at December 31, 2007 and 2006 were as follows (dollars in thousands):
Liability for postretirement benefits after application of SFAS 158 at December 31, 2007
The Company selected a discount rate of 5.875% to measure the accumulated postretirement benefit obligation. Reasonableness of this rate was verified by determining the single constant discount rate that determines approximately the same liability as does discounting the expected cash flow associated with the liability using a yield curve model for yields on high grade corporate bonds. Models used to evaluate this rate included the Citigroup Pension Discount Curve and the Hewitt Bond Universe. At December 31, 2006, the rates determined by these models were very similar. In selecting the rate of 5.625% at that date, the Company relied more heavily on the Citigroup Pension Discount Curve. As a result of downward divergence of the Hewitt Bond Universe in 2007, the Company relied more heavily on this model to select the December 31, 2007 discount rate.
The health care cost trend rate assumption has a significant effect on the amounts reported. To illustrate, increasing the assumed health care cost trend rates by 1 percentage point in each year would increase the benefit
The estimated benefit expected to be recognized from AOCI into net periodic benefit cost in 2008 is as follows (dollars in thousands):
The Company expects to contribute $0.3 million to the postretirement benefit plans to pay benefits in 2008. 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 compensation expense recorded for the Company’s stock-based compensation plan in 2007 and 2006 was $1.9 million and $1.2 million, respectively. The total income tax benefit recognized in the income statement for stock-based compensation arrangements was $0.6 million and $0.4 million in 2007 and 2006, respectively. The amount of cash received from the exercise of stock options was $3.6 million, $7.8 million and $3.7 million in 2007, 2006 and 2005, respectively.
The Company previously reserved shares of its common stock for issuance to directors, officers, employees and certain advisors of the Company through incentive stock options, non-qualified stock options and stock appreciation rights (“SARs”) to be granted under the CNA Surety 1997 Long-Term Equity Compensation Plan (the “1997 Plan”). Option exercises under the 1997 Plan were settled in newly issued common shares. No options were granted under the 1997 Plan during 2006.
The 2006 Plan provides for the granting of incentive stock options as defined under Section 382 of the Internal Revenue Code of 1986, as amended. All non-qualified 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 13, 2007, 334,100 options were granted under the 2006 Plan. The fair market value (at grant date) per option granted was $9.04 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 4.8%; dividend yield of 0.0%; volatility of 34.7%; and expected option life of 6.3 years. The Company has estimated the expected option life using the simplified method allowed under the Securities and Exchange Commission’s Staff Accounting Bulletin (“SAB”) No. 107 (“SAB 107”). The Company’s stock options qualify for this method based on the criteria defined in SAB 107. As of December 31, 2007, the number of shares available for granting of options under the 2006 Plan was 2,678,700.
No options were granted during 2006. During 2005, 354,775 options were granted. The weighted average fair market value (at grant date) for these options was $5.17 per option. The fair value of these options was estimated at grant date using a Black-Scholes option pricing model with the following weighted average assumptions for the year ended December 31, 2005: risk free interest rate of 4.4%; dividend yield of 0.0%; expected option life of 6 years; and volatility of 30.2%.
The total fair value of stock options vested was $0.9 million, $1.2 million and $0.9 million in 2007, 2006 and 2005, respectively.
The following table summarizes information about stock options outstanding at December 31, 2007:
As previously discussed, the Company adopted SFAS 123R on January 1, 2006. Prior to 2006, the Company applied the intrinsic value method under APB 25, and related interpretations, in accounting for its stock-based compensation plan as allowed under the provisions of SFAS 123. Under the recognition and measurement principles of APB 25, no stock-based compensation cost was recognized, as the exercise price of the granted options equaled the market price of the underlying stock at the grant date. The following table illustrates the effect on net income and earnings per share data if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based compensation under the Company’s stock-based compensation plan (amounts in thousands, except for per share data):
As of December 31, 2007, there was $1.6 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: 2008 - $1.0 million; 2009 - $0.4 million; 2010 - $0.2 million.
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, 2007 and 2006 were 12,511 and 14,339, respectively.
In 2007, approximately $63.4 million, or 13.4% of gross written premiums were generated from national insurance brokers, with the single largest national broker production comprising $14.5 million, or 3.1%, of gross written premiums. Approximately $61.9 million, or 13.7%, of gross written premiums were generated from national insurance brokers in 2006 with the single largest national broker production comprising $14.5 million, or 3.2%, of gross written premiums. In 2005, approximately $61.4 million, or 14.7%, of gross written premiums were generated from national insurance brokers, with the single largest national broker production comprising $13.3 million, or 3.2%, of gross written premiums.
CNA Surety’s insurance subsidiaries are subject to regulation and supervision by the various state insurance regulatory authorities in which they conduct business. Such regulation is generally designed to protect policyholders and includes such matters as maintenance of minimum statutory surplus and restrictions on the payment of dividends. Generally, statutory surplus of each insurance subsidiary in excess of a statutorily prescribed minimum is available for payment of dividends to the parent company. However, such distributions as dividends may be subject to prior regulatory approval. Without prior regulatory approval in 2008, Western Surety may pay dividends of $96.7 million to CNA Surety. Combined statutory surplus for the insurance subsidiaries at December 31, 2007 was $442.2 million.
Company $1.3 million, $1.1 million and $0.8 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.
From time to time, Western Surety provided surety bonds guaranteeing insurance payments of certain companies to CCC and its affiliates under retrospectively rated insurance policies underwritten by CCC and its affiliates. Under the terms of these bonds, referred to as insurance program bonds, if the principal, the insured company, failed to make a required premium payment, CCC and its affiliates would have a claim against the Company under the bond. The Company now has a policy not to issue such bonds to companies insured by CCC and its affiliates. The last such bond was written in 2001 and currently bonds with less than $0.1 million of total penal sums remain as of December 31, 2007.
Western Surety from time to time provides license and permit bonds and appeal bonds to CCC and its affiliates and to clients of CCC and its affiliates. Under procedures established by the Audit Committee, the Company may issue appeal bonds for CCC and its affiliates and their clients with penal sums of $10.0 million or less without prior Audit Committee approval as long as those bonds meet the Company’s normal underwriting standards, the rates charged are market rates and that the Company has received the indemnity of CCC. Bonds greater than $10.0 million require the prior approval of the Audit Committee. As of December 31, 2007, the total amount of the outstanding appeal and license and permit bonds written on behalf of CCC and its affiliates was approximately $95.2 million. Of that amount, the majority consisted of 36 appeal bonds with a penal sum of $91.6 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 2007, $0.6 million in 2006 and $0.6 million in 2005.
In 2006, the Company, through the Quota Share Treaty, assumed three bonds for Mexdrill Offshore, S. DE R.L. DE C. V. (“Mexdrill Offshore”), a subsidiary of Diamond Offshore Drilling, Inc. (“Diamond Offshore”). Loews owns 51% of Diamond Offshore’s shares. As stated in Note 6. Reinsurance, the Company is in full control of all aspects of the underwriting and claim management of the business assumed under the Quota Share Treaty. 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.
Also, in 2007, the Company, through the Quota Share Treaty, assumed two bonds for Gulf South Pipeline Company, LP, a subsidiary of Boardwalk Pipeline Partners, LP (“Boardwalk Pipeline”). Loews owns 70% of Boardwalk Pipeline shares. Prior to the Company’s issuance of these bonds with penal sums of $1.2 million and $0.4 million, respectively, the Company’s Audit Committee approved issuance of the bonds on behalf of Boardwalk Pipeline. The premium for these two bonds was less than $0.1 million in 2007.
The following is a summary of the quarterly results of operations for the years ended December 31, 2007, 2006 and 2005 (dollars in thousands, except per share amounts):