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, 2009. CNA Surety also leased space for contract and commercial branch offices in Hoover, Alabama; San Juan, Puerto Rico and Rocklin, California. Annual rent for these offices was $0.1 million with leases terminating in 2009, 2011 and 2012, respectively. The Hoover, Alabama lease was not renewed as the branch was relocated to one of the locations shared with CCC.
Includes the effect of re-estimates of prior year reserves, known as reserve development. The dollar amount of these reserve reductions were $54.3 million, $45.5 million, $5.1 million, $5.3 million and $23.3 million for the years ended December 31, 2009, 2008, 2007, 2006 and 2005, respectively. The percentage point effect of these reserve reductions on the loss and combined ratios for these years were 12.8, 10.6, 1.2, 1.4 and 6.7 percentage points, respectively.
guidance. Under the recognition and measurement principles of that guidance, 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. This change in accounting method increased compensation expense by $2.0 million, $1.7 million, $1.9 million and $1.2 million for the years ended December 31, 2009, 2008, 2007 and 2006, respectively. Net of deferred tax benefit, net income was decreased by $1.3 million, $1.1 million, $1.2 million and $0.8 million for the years ended December 31, 2009, 2008, 2007 and 2006, respectively.
As of December 31, 2006, the Company adopted accounting guidance that requires a company who sponsors one or more single-employer defined benefit plans to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through other comprehensive income. The Company’s postretirement benefit plans are unfunded. Recognition of the accumulated postretirement benefit obligation, measured as of December 31, 2009, increased the liability for postretirement benefits by $0.7 million, gross of deferred tax benefit, and decreased accumulated other comprehensive income by $0.6 million. Recognition of the accumulated postretirement benefit obligation, measured as of December 31, 2008, decreased the liability for postretirement benefits by $1.2 million, gross of deferred tax benefit, and increased accumulated other comprehensive income by $0.5 million. Recognition of the accumulated postretirement benefit obligation, measured as of December 31, 2007, decreased the liability for postretirement benefits by $3.4 million, gross of deferred tax benefit, and increased accumulated other comprehensive income by $2.5 million. Recognition of the accumulated postretirement benefit obligation, measured as of December 31, 2006, increased the liability for postretirement benefits by $4.7 million, gross of deferred tax benefit, and decreased accumulated other comprehensive income by $2.7 million.
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).
The following table shows the estimated liability as of December 31, 2009 for unpaid claims applicable to reported claims and to IBNR (dollars in thousands) for each sub-line of business:
Periodic actuarial analyses of the Company’s loss reserves are performed. These analyses have typically included a comprehensive review performed in the third quarter based on data as of June 30 and an update of the comprehensive review performed in January based on data as of December 31. In 2009, the Company changed the timing of the comprehensive review to occur in the fourth quarter using data as of September 30. In between these analyses, management monitors claim activity against benchmarks of expected claim activity prepared in connection with the comprehensive review and records adjustments as necessary.
changes in losses from one evaluation point to another to project the current valuation of losses to ultimate settlement values. Development patterns which have been exhibited by more mature (older) years are used to estimate the expected development of the less mature (more recent) years. The strength of this method is that it is very responsive to emerging loss experience for each accident year. The weakness is that this method can become highly leveraged and volatile for less mature accident years.
The indicated reserve, or actuarial point estimate, was developed by reviewing the Company’s claims experience by accident year for several individual sub-lines of business. Within each sub-line, the selection of the point estimate was made after consideration of the appropriateness of the various projection methodologies in light of the sub-line’s loss characteristics and historical data. In general, for the older, more mature, accident years the historical development method (i.e., link ratio method) was relied upon more heavily. For the more recent years, the indicated reserves were more heavily based on the Bornhuetter-Ferguson and loss ratio methods since these are not as reliant 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 higher than the actuarial point estimate. Management recorded reserves that were materially consistent with the actuarial point estimates for
accident years 2007 and prior. For accident years 2008 and 2009, management recorded reserves that were higher than the actuarial indications due to the belief that the potential impact on losses of the economic recession and associated challenges facing construction firms was not fully reflected in the actuarial analyses. To determine the recorded reserves for accident years 2008 and 2009, management relied on an analysis of past experience for accident years that were impacted by periods of economic difficulties. This analysis was influenced by management’s assessment of key factors like the length and depth of the recession, the particular challenges facing construction firms, the financial strength of bonded contractors, the contractors’ responses to the economic challenges and the Company’s and the industry’s underwriting discipline. This analysis also included adjustments to historical results to reflect differences in premium rates, reinsurance coverage and changes in underwriting appetite, particularly related to large commercial risks.
The primary factors that would result in the Company’s actual losses being closer to either end of the reserve range is the emergence of (or lack thereof) a small number of large claims, as well as the recovery of (or lack thereof) a small 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.
The amortized cost of fixed income securities is determined based on cost, adjustments for previously recorded other-than-temporary impairment losses and the cumulative effect of amortization of premiums and accretion of discounts using the interest method. Such amortization and accretion are included in investment income. For mortgage-backed and asset-backed securities, the Company considers estimates of future prepayments in the calculation of the effective yield used to apply the interest method. If a difference arises between the anticipated prepayments and the actual prepayments, the Company recalculates the effective yield based on actual prepayments and the currently anticipated future prepayments. The amortized costs of such securities are adjusted to the amount that would have resulted had the recalculated effective yields been applied since the acquisition of the securities with a corresponding charge or credit to investment income. Prepayment estimates are based on the structural elements of specific securities, interest rates and generally recognized prepayment speed indices.
CNA Surety’s Consolidated Balance Sheets as of December 31, 2009 include goodwill and intangible assets of approximately $138.8 million. This amount primarily represents goodwill and identified intangibles with indefinite useful lives arising from the acquisition of Capsure Holdings Corp. (“Capsure”).
A significant amount of judgment is required in performing intangible assets impairment tests. Such tests include periodically determining or reviewing the estimated fair value of CNA Surety’s reporting units. Under the
relevant standard, fair value of a reporting unit refers to the price that would be received to sell the reporting unit as a whole in an orderly transaction between market participants. There are several methods of estimating fair value, including market quotations, asset and liability fair values and other valuation techniques, such as discounted cash flows and multiples of earnings or revenues. The Company uses a valuation technique based on discounted cash flows. Significant inputs to the Company’s discounted cash flow model include estimated capital requirements to support the business, expected cash flows from underwriting activity, required capital reinvestment to support growth and the selected discount rates. If the carrying amount of a reporting unit, including goodwill, exceeds the estimated fair value, then individual assets, including identifiable intangible assets, and liabilities of the reporting unit are estimated at fair value. The excess of the estimated fair value of the reporting unit over the estimated fair value of net assets would establish the implied value of intangible assets. The excess of the recorded amount of intangible assets over the implied value of intangible assets is recorded as an impairment loss.
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 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.
Operating ratios are calculated using insurance results and are widely used by the insurance industry and regulators such as state departments of insurance and the National Association of Insurance Commissioners for financial regulation and as a basis of comparison among companies. The ratios discussed in the Company’s MD&A are calculated using GAAP financial results and include the net loss and loss adjustment expense ratio (“loss ratio”) as well as the net
commissions, brokerage and other underwriting expense ratio (“expense ratio”) and combined ratio. The loss ratio is the percentage of net incurred losses and loss adjustment expenses to net earned premiums. The expense ratio is the percentage of net commissions, brokerage and other underwriting expenses, including the amortization of deferred policy acquisition costs, to net earned premiums. The combined ratio is the sum of the loss ratio and expense ratio.
Comparison of CNA Surety Actual Results for the Years Ended December 31, 2009, 2008 and 2007
Underwriting components for the Company for the years ended December 31, 2009, 2008 and 2007 are summarized in the following table (dollars in thousands):
Gross written premium, which is the aggregate of direct written premiums and assumed written premiums, for the years ended December 31, 2009, 2008 and 2007 are shown in the table below (dollars in thousands) for each sub-line of business:
Net written premiums, which is gross written premiums less ceded written premiums, for the years ended December 31, 2009, 2008 and 2007 are shown in the table below (dollars in thousands) for each sub-line of business:
For 2009, net earned premiums decreased by $9.8 million to $421.9 million as compared to 2008 reflecting continued adverse economic conditions, offset by the decrease in ceded written premiums discussed above. Ceded earned premiums decreased $8.1 million to $27.5 million for 2009 compared to 2008. Net earned premiums for contract surety business decreased 2.7 percent to $259.3 million for 2009 compared to 2008. Net earned premiums for commercial surety decreased 1.3 percent to $131.9 million for 2009 compared to 2008. Earned premium for fidelity and other premiums decreased 2.6 percent to $30.6 million for the year 2009 compared to 2008.
The loss ratios for the years ended December 31, 2009, 2008 and 2007 were 16.5%, 18.7% and 24.5%, 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 $54.3 million, or 12.8 percentage points, $45.5 million, or 10.6 percentage points, and $5.1 million, or 1.2 percentage points, for the years ended December 31, 2009, 2008, and 2007, respectively.
In 2008, the expense ratio increased to 54.5% from 54.0% for the same period in 2007 due to the impact of an increased accrual for incentive compensation based on strong financial results, partially offset by the impact of higher earned premiums.
The Company’s investment portfolio is generally managed to maximize after-tax investment return, while minimizing credit risk with investments concentrated in high quality fixed income securities. CNA Surety’s portfolio is managed to provide diversification by limiting exposures to any one industry, issue or issuer, and to provide liquidity by investing in the public securities markets. The portfolio is structured to support CNA Surety’s insurance underwriting operations and to consider the expected duration of liabilities and short-term cash needs. In achieving these goals, assets may be sold to take advantage of market conditions or other investment opportunities or regulatory, credit and tax considerations. These activities will produce realized gains and losses.
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 $0.8 million, or 35.2 percent, for 2009 compared to 2008. Interest expense also decreased $0.8 million, or 26.4 percent, for 2008 compared to 2007 due to lower interest rates. Weighted average debt outstanding was $30.9 million for each of these periods. The weighted average interest rate for 2009, 2008 and 2007 was 4.3%, 6.4% and 8.7%, respectively.
The Company’s income tax expense was $51.3 million for 2009, $48.8 million for 2008 and $39.7 million for 2007. The effective income tax rates were 30.3%, 30.7% and 30.1% for 2009, 2008 and 2007, respectively. The effective tax rates are lower than the statutory tax rates primarily due to the Company’s ability to exclude interest income from its significant investments in tax-exempt securities. Investment income included income from tax-exempt securities of $25.5 million, $23.8 million and $21.4 million in 2009, 2008 and 2007, respectively.
Effective January 1, 2009, CNA Surety entered into an excess of loss treaty (“2009 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the 2008 Excess of Loss Treaty. Under the 2009 Excess of Loss Treaty, the Company’s net retention per principal was $15 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company’s retention. The contract provided aggregate coverage of $185 million and included an optional extended discovery period, which was not exercised. The contract also included a provision for additional premiums of up to $13.8 million based on losses ceded under the contract. The actual ceded premiums for the 2009 Excess of Loss Treaty were $26.6 million.
It is anticipated that the liquidity requirements of CNA Surety will be met primarily by funds generated from operations. The principal sources of operating cash flows are premiums, investment income and recoveries under reinsurance contracts. The primary cash flow uses are payments for claims, operating expenses, federal income taxes and debt service. In general, surety operations generate premium collections from customers in advance of cash outlays for claims. Premiums are invested until such time as funds are required to pay claims and claims adjusting expenses.
Cash flow at the parent company level is derived principally from dividend and tax sharing payments from its insurance subsidiaries, and to a lesser extent, investment income. The principal obligations at the parent company level are to service debt and pay operating expenses, including income taxes. At December 31, 2009, the parent company’s invested assets consisted of $1.6 million of equity securities, $12.1 million of short-term investments and $1.9 million of cash. At December 31, 2008, the parent company’s invested assets consisted of $1.2 million of equity securities, $8.5 million of short-term investments and $4.6 million of cash. As of December 31, 2009 and
The Company’s consolidated net cash flow provided by operating activities was $158.0 million, $124.2 million and $129.2 million for 2009, 2008 and 2007, respectively. The increase in net cash flow provided by operating activities in 2009 primarily relates to the absence of the payment of $23.6 million, net of reinsurance recoveries, in 2008 in settlement of a large claim that had been fully reserved. This increase also reflects the impact of lower ceded premiums and lower federal income tax payments. The decrease in net cash flow in 2008 compared to 2007 primarily relates to the net payment of $23.6 million discussed above and the absence of a $7.9 million return of collateral to a principal in 2007.
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 LIBOR plus 337.5 basis points with a 30-year term. Beginning in May 2009, these securities may be redeemed, in whole or in part, at par value at any scheduled quarterly interest payment date. As of December 31, 2009, none of these preferred securities have been redeemed. The Company continually assesses its option to redeem these preferred securities based on analysis of the cost of the associated debt, projected capital needs and the Company’s liquidity position.
The junior subordinated debenture bears interest at a rate of LIBOR plus 337.5 basis points and matures in April 2034. As of December 31, 2009 and 2008, the interest rate on the junior subordinated debenture was 3.65% and 5.52%, respectively.
The 2005 Credit Facility was entered into on July 27, 2005, when the Company refinanced $30.0 million in outstanding borrowings under its previous credit facility. The 2005 Credit Facility provided an aggregate of up to $50.0 million in borrowings under a revolving credit facility. In September 2006, the Company reduced the available aggregate revolving credit facility to $25.0 million in borrowings. The 2005 Credit Facility also contained certain conditions and limitations on the Company. The Company was in compliance with all covenants as of and for the six months ended June 30, 2008 when the 2005 Credit Facility matured.
The Company does not have any material off-balance sheet arrangements as defined by Item 303 of Regulation S-K under the Exchange Acts of 1933 and 1934.
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 2010 is based on statutory surplus and income at and for the year ended December 31, 2009. Without prior regulatory approval in 2010, Western Surety may pay dividends of $122.9 million to CNA Surety. CNA Surety received dividends of $5.0 million, $3.0 million and $2.0 million from its insurance subsidiaries during 2009, 2008 and 2007, respectively. CNA Surety did not receive any dividends from its non-insurance subsidiaries during 2009, 2008 or 2007.
Western Surety and Surety Bonding each qualify as an acceptable surety for federal and other public works project bonds pursuant to U.S. Department of Treasury regulations. U.S. Treasury underwriting limitations, the maximum net retention on a single federal surety bond, are based on an insurer’s statutory surplus. Effective July 1, 2008 through June 30, 2009, the underwriting limitations of Western Surety and Surety Bonding were $43.5 million
On December 5, 2007, the California Department of Insurance issued the final and adopted examination report for the market conduct examination of Western Surety, Surety Bonding and Universal Surety that commenced in 2007. The examination report reflected findings of a small percentage of errors in the bond files reviewed by the California Department of Insurance pursuant to the examination and such errors have been addressed by management. The matters noted did not have a material impact on the insurance subsidiaries’ statutory surplus, nor did they result in any fines or penalties to CNA Surety or any of its subsidiaries.
The following table summarizes the distribution of the Company’s fixed income and equity portfolios at estimated fair values as of December 31, 2009 and 2008 (dollars in thousands):
The Company’s investment portfolio generally is managed to maximize after-tax investment return, while minimizing credit risk with investments concentrated in high-quality income securities. CNA Surety’s portfolio is managed to provide diversification by limiting exposures to any one industry, issue or issuer, and to provide liquidity by investing in the public securities markets. The portfolio is structured to support CNA Surety’s insurance underwriting operations and to consider the expected duration of liabilities and short-term cash needs. In achieving these goals, assets may be sold to take advantage of market conditions or other investment opportunities or regulatory, credit and tax considerations. These activities will produce realized gains and losses.
We have audited the internal control over financial reporting of CNA Surety Corporation and subsidiaries (the “Company”) as of December 31, 2009, 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 Company’s internal control over financial reporting based on our audit.
In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
CNA Surety management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2009. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control - Integrated Framework. Based on our assessment we believe that, as of December 31, 2009, the Company’s internal control over financial reporting is effective based on those criteria.
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, 2009 and 2008, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2009, 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.
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, 2009, 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, 2010 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 62% of the outstanding common stock of CNA Surety. Loews Corporation (“Loews”) owns approximately 90% of the outstanding common stock of CNAF.
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, and as such, they are carried at fair value.
The amortized cost of fixed income securities is determined based on cost, adjustments for previously recorded other-than-temporary impairment losses and the cumulative effect of amortization of premiums and accretion of discounts using the interest method. Such amortization and accretion are included in net investment income in the Consolidated Statements of Income. For mortgage-backed and asset-backed securities, the Company considers estimates of future prepayments in the calculation of the effective yield used to apply the interest method. If a difference arises between the anticipated prepayments and the actual prepayments, the Company recalculates the effective yield based on actual prepayments and the currently anticipated future prepayments. The amortized costs of such securities are adjusted to the amount that would have resulted had the recalculated effective yields been applied since the acquisition of the securities with a corresponding charge or credit to net investment income in the Consolidated Statements of Income. Prepayment estimates are based on the structural elements of specific securities, interest rates and generally recognized prepayment speed indices.
CNA Surety’s Consolidated Balance Sheet as of December 31, 2009 includes intangible assets of $138.8 million comprised of $122.7 million of goodwill and $16.1 million of 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.
A significant amount of judgment is required in performing intangible assets impairment tests. Such tests include periodically determining or reviewing the estimated fair value of CNA Surety’s reporting units. Under the relevant standard, fair value of a reporting unit refers to the price that would be received to sell the reporting unit as a whole in an orderly transaction between market participants. There are several methods of estimating fair value, including market quotations, asset and liability fair values and other valuation techniques, such as discounted cash flows and multiples of earnings or revenues. The Company uses a valuation technique based on discounted cash flows. Significant inputs to the Company’s discounted cash flow model include estimated capital requirements to support the business, expected cash flows from underwriting activity, required capital reinvestment to support growth and the selected discount rates. If the carrying amount of a reporting unit, including goodwill and other intangible assets, exceeds the estimated fair value, then individual assets, including identifiable intangible assets, and liabilities of the reporting unit are estimated at fair value. The excess of the estimated fair value of the reporting unit over the estimated fair value of net assets would establish the implied value of intangible assets. The excess of the recorded amount of intangible assets over the implied value of intangible assets is recorded as an impairment loss.
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.
Property and equipment are carried at cost less accumulated depreciation. The Company records depreciation using the straight-line method based on the estimated useful lives of the various classes of property and equipment ranging from 3 years to 20 years. Depreciation and amortization expense for 2009, 2008 and 2007 was $6.0 million, $5.7 million and $6.1 million, respectively. The cost of maintenance and repairs is charged to income as incurred; major improvements are capitalized.
The computation of earnings per share is as follows (amounts in thousands, except for per share data):
No adjustments were made to reported net income in the computation of earnings per share. Options to purchase shares of common stock of 0.7 million, 0.6 million and 0.3 million for the years ending December 31, 2009, 2008 and 2007, 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.
The Company has evaluated subsequent events since the date of these consolidated financial statements through the issuance date of February 19, 2010.
In December 2007, the FASB issued guidance related to noncontrolling interests in consolidated financial statements. This guidance establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary and clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. This noncontrolling interest guidance requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the noncontrolling interest and requires disclosure, on the face of the consolidated statement of income, of the amounts of consolidated net income attributable to the parent and to the noncontrolling interest. The guidance also establishes a single method of accounting for changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation and clarifies that all of those transactions are equity transactions if the parent retains its controlling financial interest in the subsidiary. Finally, the guidance requires expanded disclosures in the consolidated financial statements that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners of a subsidiary. The guidance was effective for the Company on January 1, 2009. The adoption had no impact on the Company’s financial condition or results of operations.
In February 2008, the FASB issued guidance which delayed the effective date for disclosures related to nonrecurring fair value measurements of nonfinancial assets and nonfinancial liabilities until fiscal years beginning after November 15, 2008. The Company adopted this fair value disclosure guidance on January 1, 2009. The adoption had no impact on the Company’s disclosures.
In March 2008, the FASB issued guidance which requires enhanced disclosures about how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for and how derivative instruments and related hedge items affect an entity’s financial position, financial performance and cash flows. This derivative guidance also requires the disclosure of the fair values of derivative instruments and their gains and losses in a tabular format and requires cross-referencing within the footnotes of important information about derivative instruments. The Company adopted this guidance on January 1, 2009. The adoption had no impact on the Company’s required disclosures as the Company has no derivative instruments.
has evaluated subsequent events and whether that date represents the date the financial statements were issued or were available to be issued. This guidance does not change previous guidance regarding the recognition or disclosure of subsequent events, other than the additional requirement regarding the date through which subsequent events have been considered. The Company has disclosed the date through which subsequent events are evaluated.
additional other-than-temporary impairment losses on equity securities related to the Company’s nonqualified deferred compensation plan as discussed below. Net realized investment losses were $1.4 million for 2008 due to the recognition of an other-than-temporary impairment loss on a fixed income security and other-than-temporary impairment losses on equity securities related to the Company’s nonqualified deferred compensation plan. Net realized investment losses were $0.4 million for 2007 including the recognition of impairment losses on certain fixed income securities as discussed below.
The unrealized loss position of this security has improved to $0.5 million at December 31, 2009.
A security is in an unrealized loss position, or impaired, if the fair value of the security is less than its amortized cost or cost, which includes adjustments for accretion, amortization and previously recorded other-than-temporary impairment losses. When a security is impaired, the impairment is evaluated to determine whether it is temporary or other-than-temporary.
In determining whether an equity security is other-than-temporarily impaired, the Company considers a number of factors including, but not limited to: (a) the length of time and the extent to which the market value has been less than book value, (b) the financial condition and near-term prospects of the issuer, (c) the intent and ability of the Company to retain its investment for a period of time sufficient to allow for any anticipated recovery in value and (d) general market conditions and industry or sector specific factors. Currently, the Company’s equity portfolio is comprised solely of mutual funds related to the Company’s deferred compensation plan, which is an unfunded, nonqualified deferred compensation plan for a select group of management or highly compensated employees. Due to the nature of the plan, the Company does not assert the ability to hold these securities until their recovery in value. As such, if any of these securities are in an unrealized loss position, they are considered to be other-than-temporarily impaired.
Fixed income securities in an unrealized loss position that the Company intends to sell, or it more likely than not will be required to sell before recovery of amortized cost, are considered to be other-than-temporarily impaired. These securities are written down to fair value and the resulting losses are recognized in realized gains/losses in the Consolidated Statements of Income.
Based on the Company’s evaluation of this quantitative criteria and qualitative information during 2009, the Company recorded OTTI losses of $1.8 million on one asset-backed fixed income security which included a credit loss component. This security was rated below investment grade by S&P and collateralized by sub-prime home loans. The credit component of the loss, $0.1 million, was recognized in earnings with $1.7 million (49.3% of the security’s amortized cost at that time) of the loss recognized in other comprehensive income.
In addition to this OTTI loss on fixed income securities, during 2009 the Company recorded other-than-temporary impairment losses of less than $0.1 million on the equity securities that are related to the Company’s nonqualified deferred compensation plan.
The following table provides the composition of fixed income securities with an unrealized loss at December 31, 2009 in relation to the total of all fixed income securities by contractual maturities:
The following table summarizes for fixed income securities in an unrealized loss position at December 31, 2009 and 2008, the aggregate fair value and gross unrealized loss by length of time those securities have been continuously in an unrealized loss position (dollars in thousands):
Investment grade is determined by using the S&P rating. If a security is not rated by S&P, the Moody’s rating is used. As of December 31, 2009 and December 31, 2008, all of the Company’s fixed income securities were rated by S&P or Moody’s.
At December 31, 2009, the Company holds 254 fixed income securities with a total estimated fair value of $1,042.7 million in an unrealized gain position of $53.6 million in the aggregate.
The following table summarizes securities in a gross unrealized loss position by investment category and by credit rating. The table also discloses the corresponding count of securities in an unrealized loss position and estimated fair value by category (in thousands of dollars):
As of December 31, 2009, the Company’s fixed income securities included three U.S. Government agency mortgage pass-through securities backed by residential mortgages in an unrealized loss position, none of which exceeded 2% of the 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 these unrealized losses are indicative of a credit loss and, as such, has not recorded an OTTI loss on these securities at December 31, 2009.
During 2009, the Company’s investments in two other obligations of states and political subdivisions, issued by governmental utility authorities, were downgraded below investment grade due to the downgrade of the mono-line bond insurer guaranteeing a portion of these securities. Despite the downgrades, improving market conditions during the year resulted in a $4.1 million improvement in the unrealized loss on these securities compared to December 31, 2008. At December 31, 2009, one of these securities had an unrealized loss of $0.3 million, or 4.8% of its amortized cost, and the other had an unrealized loss of $0.9 million, or 8.4% of its amortized cost. Based on the underlying fundamentals of these securities, 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 to recovery of amortized cost. As such, the Company has not recorded an OTTI loss on these securities at December 31, 2009.
At December 31, 2009 the Company’s exposure to sub-prime home loans is limited to two asset-backed securities collateralized by sub-prime home loans originated prior to 2005. Both of these securities are in an unrealized loss position. One of these securities has an estimated fair value of $2.4 million and is in an unrealized loss position of $0.2 million, or 7.5% of its amortized cost, at December 31, 2009. The other security, which is rated below investment grade, was determined to be other-than-temporarily impaired during the second quarter of 2009. The Company recorded OTTI losses of $0.1 million in earnings in addition to recording an unrealized loss of $1.7 million in other comprehensive income. The Company did not record any additional credit-related loss on this security during the last six months of 2009 and the unrealized loss position has improved to $0.5 million, or 19.0% of its adjusted amortized cost. The Company believes the unrealized losses on these securities are primarily attributable to broader economic conditions and liquidity concerns and are not indicative of the quality of the underlying collateral. During 2009, the Company received repayments on these securities of $2.4 million, or about 30% of the par value outstanding at December 31, 2008. 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 and, as such, has not recorded any additional OTTI losses at December 31, 2009.
The Company’s insurance subsidiaries, as required by state law, deposit certain securities with state insurance regulatory authorities. At December 31, 2009, securities on deposit had an aggregate estimated fair value of $5.2 million.
Invested assets are exposed to various risks, such as interest rate, market and credit risks. 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.
Level 3 - Valuations derived from valuation techniques in which one or more significant inputs are unobservable.
The Company utilizes a pricing service for the valuation of the majority of securities held. This pricing service is an independent, third party vendor recognized to be an industry leader with access to market information who obtains or computes fair market values from quoted market prices, pricing for similar securities, recently executed transactions, cash flow models with yield curves and other pricing models. For valuations obtained from the pricing service, the Company performs due diligence to understand how the valuation was calculated or derived, focusing on the valuation technique used and the nature of the inputs.
Securities valued using Level 1 inputs include highly liquid government bonds for which quoted market prices are available. Securities using Level 2 inputs are valued using pricing for similar securities, recently executed transactions, cash flow models with yield curves and other pricing models utilizing observable inputs. Most fixed income securities are valued using Level 2 inputs. Level 2 includes corporate bonds, municipal bonds, asset-backed securities and mortgage pass-through securities.
Includes commercial paper, U.S. Government agency discount notes and money market funds.
Assumed premium also includes surety business written by another affiliate, First Insurance Company of Hawaii, Ltd. and its subsidiaries First Indemnity Insurance of Hawaii, Inc., First Fire and Casualty Insurance of Hawaii, Inc. and First Security Insurance of Hawaii, Inc. (collectively, “FICOH”). Through its insurance subsidiaries, CNAF owns approximately 50% of the outstanding common stock of First Insurance Company of Hawaii, Ltd. Under the terms of this excess of loss agreement that covers certain contract surety business, FICOH retains losses of $2 million per principal and Western Surety 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, $0.2 million and $0.1 million in 2009, 2008 and 2007, respectively.
CNA Surety also assumes premium on contract and commercial surety bonds for international risks. Such premiums are assumed pursuant to the terms of reinsurance treaties or as a result of specific international bond requirements of domestic customers.
Reinsurance agreements together with the Services and Indemnity Agreement that are described below provide for the transfer of the surety business written by CCC and CIC to Western Surety. All of these agreements originally were entered into on September 30, 1997 (the “Merger Date”): (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 (the “Excess of Loss Contract”). All of these contracts 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, 2009, losses incurred under the Stop Loss Contract were $49.1 million. Through December 31, 2008, losses incurred under the Stop Loss Contract were $48.9 million. The net amount settled in 2009 under this contract was $0.5 million paid to CCC. At December 31, 2009, the amount received under the Stop Loss Contract included $2.1 million held by the Company for losses covered by this contract that were incurred but not paid.
Since January 1, 2005, the Company and CCC have been parties to an excess of loss contract that provided reinsurance coverage exclusively for the one large national contractor excluded from the Company’s third party reinsurance. This contract provided unlimited coverage in excess of $60 million retention for the life of bonds either in force or written during the period from January 1, 2005 to December 31, 2005. This contract was extended for twelve months beginning on January 1, 2006, 2007, 2008 and 2009. In addition to the initial premium of $7.0 million, premiums for these subsequent periods were $0.8 million, $0.5 million, $0.2 million and less than $0.1 million, respectively, and were based on the level of premiums written on bonds for the large national contractor.
The Company’s Consolidated Balance Sheets also include a “Deposit with affiliated ceding company” of $26.9 million and $29.7 million at December 31, 2009 and December 31, 2008, respectively. In 2005, pursuant to an agreement with the claimant on a bond regarding certain aspects of the claim resolution, the Company deposited $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 $54.3 million, $45.5 million and $5.1 million in 2009, 2008 and 2007, respectively.
At December 31, 2009 the future minimum commitments under operating leases are as follows: 2010 - $2.0 million; 2011 - $1.9 million; 2012 - $0.9. Total rental expense for 2009 was $5.3 million and $5.2 million for both 2008 and 2007, respectively.
The Company has not recognized any liabilities for uncertain income taxes as of December 31, 2009 or December 31, 2008. Also, the Company does not anticipate any material change in the total amount of unrecognized tax benefits to occur within the next twelve months.
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 $4.8 million, $4.6 million and $4.7 million for the years ended December 31, 2009, 2008 and 2007, respectively.
CNA Surety established the CNA Surety Corporation Deferred Compensation Plan (the “2000 Plan”), effective April 1, 2000. The Company established and maintains the 2000 Plan as an unfunded, nonqualified deferred compensation plan for a select group of management or highly compensated employees. The purpose of the CNA Surety Corporation Deferred Compensation Plan is to permit designated employees of the Company and participating affiliates to accumulate additional retirement income through a nonqualified deferred compensation plan that enables them to defer compensation to which they will become entitled in the future.
The net actuarial gain in 2007 resulted primarily from a change in expected cost of claims under the medical benefit plan. In 2007, the Company made a decision to change its service provider effective January 1, 2008. This was expected to cause a significant reduction in the future cost of claims. 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 net actuarial loss in 2009 was driven by higher claim costs for the medical benefit plan.
The liability for postretirement benefits at December 31, 2009 and 2008 are as follows (dollars in thousands):
Estimated benefit expected to be recognized from AOCI into net periodic benefit cost in 2010:
The Company expects to contribute $0.2 million to the postretirement benefit plans to pay benefits in 2010. 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):
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 6, 2009, 217,960 options were granted under the 2006 Plan. The fair market value (at grant date) per option granted was $8.95 for these options. The fair value of these options was estimated at the grant date using a 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, 2009 is presented below:
The total fair value of stock options vested was $1.4 million in both 2009 and 2008 and $0.9 million in 2007.
The following table summarizes information about stock options outstanding at December 31, 2009:
As of December 31, 2009, there was $1.3 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: 2010 - $0.9 million; 2011 - $0.3 million; 2012 - $0.1 million.
The Company is a leading provider of surety and fidelity bonds in the United States. According to the Surety Association of America (“SAA”), the surety and fidelity segment of the domestic property and casualty insurance industry aggregates approximately $6.7 billion in direct written premiums, comprised of approximately $5.5 billion in surety premiums and $1.2 billion in fidelity premiums.
from national insurance brokers, with the single largest national broker production comprising $14.5 million, or 3.1%, of gross written premiums.
In addition to those described in Note 6. Reinsurance, the Company has the following related party transactions.
CNA Surety and CCC are parties to an Administrative Services Agreement (“ASA”), which has been in effect since July 1, 2004, that allows the Company to purchase and/or have access to certain services provided by CCC and its affiliates, including the leasing of executive and branch offices. Pursuant to the ASA, the Company paid CCC an annual management fee of $2.1 million for 2009, 2008 and 2007 in addition to charges of $6.9 million for the years ended December 31, 2009 and 2008 and $7.3 million for the year ended December 31, 2007 for leased office space and services. The Company was also charged $0.2 million for the years ended December 31, 2009 and 2008 and $0.4 million for the year ended December 31, 2007 for direct costs incurred by CCC on the Company’s behalf. The Company had a $0.4 million and $0.3 million payable balance to CCC related to the ASA as of December 31, 2009 and 2008, respectively. As provided by the ASA, CCC paid the Company $1.4 million for the year ended December 31, 2009 and $1.3 million for the years ended December 31, 2008 and 2007 for insurance agent licensing services provided by the Company. This agreement shall remain in effect until CNAF or its affiliates or shareholders cease being a majority shareholder of CNA Surety unless otherwise terminated by either party. This agreement is approved annually by the Audit Committee of the Company’s Board of Directors (“Audit Committee”).
Pursuant to procedures approved by the Audit Committee, Western Surety 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, 2009, the aggregate outstanding liability of these bonds was $42.5 million. The premium for all such bonds written was approximately $0.3 million in 2009 and $0.6 million in 2008 and 2007.
Western Surety also has liability, either directly or through assumed reinsurance, under bonds written for Loews and certain of its subsidiaries which include Diamond Offshore Drilling, Inc. (“Diamond Offshore”), Boardwalk Pipeline Partners, LP (“Boardwalk Pipeline”), Mexdrill Offshore, S. DE R.L. DE C. V. (“Mexdrill Offshore”), which is a subsidiary of Diamond Offshore, and Gulf South Pipeline Company, LP (“Gulf South Pipeline”), which is a subsidiary of Boardwalk Pipeline. As of December 31, 2009, Loews owns 50.4% of Diamond Offshore and 72% of Boardwalk Pipeline. As of December 31, 2009, the aggregate liability under all such bonds was approximately $108.5 million and the premium was approximately $0.2 million in 2009 and less than $0.1 million in 2008 and 2007. All bonds were written with the approval of the Audit Committee.