which is subject to annual adjustments, was $1.7 million as of December 31, 2008. 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 2010, 2011 and 2012, respectively.
The following financial information has been derived from the Consolidated Financial Statements and Notes thereto.
The following information presented for CNA Surety is as of and for the years ended December 31, 2008, 2007, 2006, 2005 and 2004.
Includes the effect of recording revisions of prior year reserves, known as reserve development. The dollar amount and the percentage point effect on the loss and combined ratios of these reserve revisions were a reduction of $45.5 million, or 10.6%, for the year ended December 31, 2008, a reduction of $5.1 million, or 1.2%, for the year ended December 31, 2007, a reduction of $5.3 million, or 1.4%, for the year ended December 31, 2006, a reduction of $23.3 million, or 6.7%, for the year ended December 31, 2005 and a reduction of $0.6 million, or 0.2%, for the year ended December 31, 2004.
Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-based Payment” (“SFAS 123R”) was effective for the Company on January 1, 2006. Prior to 2006, the Company applied the
intrinsic value method under Accounting Principles Board (“APB”) Opinion No. 25 (“APB 25”), and related interpretations, in accounting for its stock-based compensation plan as allowed under the provisions of SFAS No. 123, “Accounting for Stock-based Compensation” (“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. Under SFAS 123R, entities generally are required to measure and record compensation expense using a fair-value based method. Adoption of SFAS 123R increased compensation expense by $1.7 million, $1.9 million and $1.2 million for the years ended December 31, 2008, 2007 and 2006, respectively. Net of deferred tax benefit, adoption of SFAS 123R decreased net income by $1.1 million, $1.2 million and $0.8 million for the years ended December 31, 2008, 2007 and 2006, respectively.
As of December 31, 2006, the Company adopted SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (an amendment of FASB Statements No. 87, 88, 106 and 132(R)), (“SFAS 158”). SFAS 158 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, 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 $1.0 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.
Reported claims are in various stages of the settlement process. Due to the nature of surety, which is the relationship among three parties whereby the surety guarantees the performance of the principal to a third party (the obligee), the investigation of claims and the establishment of case estimates on claim files can be a complex process
that can occur over a period of time depending on the type of bond(s) and the facts and circumstances involving the particular bond(s), the claim(s) and the principal. Case reserves are typically established after a claim is filed and an investigation and analysis has been conducted as to the validity of the claim, the principal’s response to the claim and the principal’s financial viability. To the extent it is determined that there are no bona fide defenses to the claim and the principal is unwilling or financially unable to resolve the claim, a case 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).
While the Company intends to establish initial case reserve estimates that are sufficient to cover the ultimate anticipated loss on a claim file, some estimates need to be adjusted during the life cycle of the claim file as matters continue to develop. Factors that can necessitate case estimate increases or decreases are the complexity of the bond(s) and/or underlying contract(s), if additional and/or unexpected claims are filed, if the financial condition of the principal or obligee changes or as claims develop and more information is discovered that was unknown and/or unexpected at the time the initial case reserve estimate was established. Ultimately, claims are resolved through payment and/or a determination that, based on the information available, a case reserve is no longer required.
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.
This method first projects the expected number of claims for each accident year and then multiplies this estimate by the expected average cost of claims for the applicable accident year. The number of claims can be projected using the historical development technique or other methodology. The average cost of claims for the more recent accident years is estimated by observing the estimated average cost of claims for the older more mature accident years and trending those values to appropriate cost levels for the more recent accident years. The strength of this method is that it is not reliant on loss development factors for less mature accident years which can become highly leveraged and volatile. The weakness is that this method is slow to react to an abrupt change in claim severities.
At December 31, 2008, management’s recorded gross and net reserves were higher than the actuarial point estimate. In response to further deterioration in economic conditions, management recorded reserves that were higher than the actuarial indication for accident years 2006 through 2008. Management continues to believe the current economic environment creates additional uncertainty for loss activity associated with these recent accident years.
Recorded reserves at December 31, 2007 were slightly higher than the actuarial point estimate. These higher reserves reflected higher provisions in the more recent accident years primarily in consideration of more difficult economic conditions evidenced by events in the sub-prime mortgage industry and residential construction economy. Management believed it was premature to reduce these loss reserves due to the inherent uncertainty associated with the more recent accident years.
Receivables recorded with respect to insurance losses ceded to reinsurers under reinsurance contracts are estimated in a manner similar to liabilities for insurance losses and, therefore, are also subject to uncertainty. In addition to the factors cited above, assumptions are made regarding the impact of reinsurance programs to be in place in future periods. Estimates of reinsurance recoveries may prove uncollectible if the reinsurer is unable to perform under the contract. Reinsurance contracts do not relieve the ceding company of its obligations to indemnify its own policyholders.
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 and the cumulative effect of amortization of premiums and accretion of discounts. Such amortization and accretion are included in investment income. For mortgage-backed and asset-backed securities, the Company recognizes income using the effective-yield method based on estimated cash flows. All securities transactions are recorded on the trade date. Investment gains or losses realized on the sale of securities are determined using the specific identification method. Investments with an other-than-temporary decline in value are written down to fair value, resulting in losses that are included in realized investment gains and losses.
Invested assets are exposed to various risks, such as interest rate risk, market risk and credit risk. Due to the level of risk associated with 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 materially affect the amounts reported in the Consolidated Balance Sheets and Consolidated Statements of Income.
CNA Surety’s Consolidated Balance Sheet as of December 31, 2008 includes intangible assets of $138.8 million. This amount represents goodwill and identified intangibles with indefinite useful lives arising primarily 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 refers to the amount for which the entire reporting unit may be bought or sold. 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.
Underwriting results are computed as net earned premiums less net loss and loss adjustment expenses and net commissions, brokerage and other underwriting expenses. Management uses underwriting results to monitor its insurance operations’ results without the impact of certain factors, including net investment income, net realized investment gains (losses) and interest expense. Management excludes these factors in order to analyze the direct relationship between net earned premiums and the related net loss and loss adjustment expenses along with net commissions, brokerage and other underwriting expenses.
CNA Surety primarily markets contract and commercial surety bonds. Contract surety bonds generally secure a contractor’s performance and/or payment obligation with respect to a construction project. Contract surety bonds are generally required by federal, state and local governments for public works projects. The most common types include bid, performance and payment bonds. Commercial surety bonds include all surety bonds other than contract and cover obligations typically required by law or regulation. The commercial surety market includes numerous types of bonds categorized as court judicial, court fiduciary, public official, license and permit and many miscellaneous bonds that include guarantees of financial performance. The Company also writes fidelity bonds that cover losses arising from employee dishonesty and other insurance products that are generally companion
products to certain surety bonds. For example, the Company writes surety bonds for notaries and also offers related errors and omissions (“E&O”) insurance coverage.
Gross written premium, which is the aggregate of direct written premiums and assumed written premiums, for the years ended December 31, 2008, 2007 and 2006 are shown in the table below (dollars in thousands) for each sub-line of business:
For 2007, gross written premiums increased 4.5 percent to $471.7 million as compared to 2006. Gross written premiums for contract surety increased 7.2 percent 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.
The Company’s insurance subsidiaries purchase reinsurance from other insurance companies and affiliates. Reinsurance arrangements are used to limit maximum loss, provide greater diversification of risk and minimize exposure on larger risks. The cost of this reinsurance is recorded as ceded written premium. For 2008, ceded written premium decreased $7.9 million compared to 2007 due to the cost savings on the Company’s core reinsurance program.
Ceded written premiums for 2007 increased $1.6 million to $43.4 million compared to 2006 due to additional premiums of $4.3 million recorded in the fourth quarter of 2007 on the core reinsurance contract due to loss activity which more than offset cost savings.
Net written premiums are recognized as revenue over time as net earned premiums. Net earned premiums for the years ended December 31, 2008, 2007 and 2006 are shown in the table below (dollars in thousands) for each sub-line of business:
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 percent to $259.4 million for 2007 compared to 2006. Net earned premiums for commercial surety increased 1.0 percent to $130.5 million for 2007 compared to 2006. Earned premium for fidelity and other products decreased 5.9 percent to $31.6 million for the year 2007 compared to 2006.
The loss ratios for the years ended December 31, 2008, 2007 and 2006 were 18.7%, 24.5% and 24.3%, respectively. The loss ratios reflect $45.5 million, $5.1 million and $5.3 million of net favorable loss reserve development on prior accident years for the years ended December 31, 2008, 2007 and 2006, respectively.
Net realized investment losses were $1.4 million, $0.4 million and $1.3 million in 2008, 2007, and 2006, respectively. The net realized investment losses in 2008 reflect recognition of impairment losses on a non-investment grade fixed income security issued by the financing subsidiary of a large domestic automaker and impairment losses on equity securities that are related to the Company’s nonqualified deferred compensation plan. The net realized investment losses in both 2007 and 2006 were primarily due to the recognition of impairment losses on, and additional losses on the subsequent sale of, certain fixed income securities which are discussed below in the Financial Condition section.
Interest expense decreased $0.8 million, or 26.4 percent for 2008 compared to 2007 due to lower interest rates. Interest expense decreased $0.8 million, or 20.5% for 2007 compared to 2006 due to a reduction in debt outstanding. The weighted average interest rate for 2008, 2007 and 2006 was 6.4%, 8.7% and 7.3%, respectively. Average debt outstanding was $30.9 million in both 2008 and 2007 compared to $44.2 million in 2006.
The Company’s income tax expense was $48.8 million for 2008, $39.7 million for 2007 and $32.8 million for 2006. The effective income tax rates were 30.7%, 30.1% and 28.4% for 2008, 2007 and 2006, 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. The impact of tax-exempt securities on taxable income was $23.8 million, $21.4 million and $18.1 million for 2008, 2007 and 2006, respectively.
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. At December 31, 2008, Munich Reinsurance America, Inc., Renaissance Reinsurance Ltd., Hannover Rückversicherungs Aktiengesellschaft and Odyssey America Reinsurance Corporation were the four unaffiliated reinsurers from which the Company had its largest reinsurance receivables. Each of these reinsurers was rated at least A by A.M. Best Company, Inc. (“A.M. Best”).
Effective January 1, 2007, CNA Surety entered into a new excess of loss treaty (“2007 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to prior treaties. Under the 2007 Excess of Loss Treaty, the Company’s net retention per principal remained at $10 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company’s retention. The contract provided aggregate coverage of $185 million and included an optional extended discovery period, which was not exercised. The contract also included a provision for additional premiums of up to $28.6 million based on losses ceded under the contract. The actual cost for the 2007 Excess of Loss Treaty was $46.8 million, which includes the Company’s estimate of additional premiums of $8.5 million resulting from loss activity recorded in 2007 and 2008. Only the large national contractor discussed below that was excluded from prior treaties remained excluded from the 2007 Excess of Loss Treaty.
Effective January 1, 2009, CNA Surety entered into a new 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 becomes $15 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company’s retention. The contract provides aggregate coverage of $185 million and includes an optional extended discovery period, for an additional premium (a percentage of the original premium based on any unexhausted aggregate limit by layer), which will provide coverage for losses discovered beyond 2009 on bonds that were in force during 2009. The contract also includes a provision for additional premiums of up to $13.8 million based on losses ceded under the contract. The base annual premium for the 2009 Excess of Loss Treaty is $28.0 million. Only the large national contractor discussed below that was excluded from the 2008 Excess of Loss Treaty remains excluded from the 2009 Excess of Loss Treaty.
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.
Under the terms of the Quota Share Treaty, CCC has guaranteed the loss and loss adjustment expense reserves transferred to Western Surety as of the Merger Date by agreeing to pay Western Surety, within 30 days following the end of each calendar quarter, the amount of any adverse development on such reserves, as re-estimated as of the end of such calendar quarter. There was no adverse reserve development for the period from the Merger Date through December 31, 2008. The Quota Share Treaty was renewed for one year on January 1, 2009 on substantially the same terms as 2008.
to $7.0 million and to eliminate the additional premium provision. This treaty provides coverage for the life of bonds either in force or written during the term of the treaty which was from January 1, 2005 to December 31, 2005. In November 2005, the Company and CCC agreed by addendum to extend this contract for twelve months. This extension, which expired on December 31, 2006, was for an additional minimum premium of $0.8 million, subject to adjustment based on the level of actual premiums written on bonds for the large national contractor. In January 2007, the Company and CCC agreed by addendum to extend this contract for another twelve months. This extension, which expired on December 31, 2007, was for an additional premium of $0.5 million, which was based on the level of actual premiums written on bonds for the large national contractor. In December 2007, the Company and CCC agreed by addendum to extend this contract for another twelve months. This extension, which expired on December 31, 2008, was for an additional premium of $0.2 million based on the level of actual premiums written on bonds for the large national contractor. In December 2008, the Company and CCC agreed by addendum to extend this contract for another twelve months. This extension, which will expire on December 31, 2009, is for an additional premium subject to the level of actual premiums written on bonds for the large national contractor. As of both December 31, 2008 and December 31, 2007, the Company had ceded losses of $50.0 million under the terms of this contract, with unpaid ceded losses of $46.8 million.
As of December 31, 2008 and December 31, 2007, CNA Surety had an insurance receivable balance from CCC and CIC of $60.4 million, including $46.1 million of reinsurance recoverables and $14.3 million of premiums receivable, and $62.9 million, including $50.5 million of reinsurance recoverables and $12.4 million of premiums receivable, respectively. CNA Surety had reinsurance payables to CCC and CIC of $1.2 million and $0.1 million as of December 31, 2008 and 2007, respectively.
At December 31, 2008, the carrying value of the Company’s insurance subsidiaries’ invested assets was comprised of $1,034.6 million of fixed income securities, $72.1 million of short-term investments and $4.1 million of cash. At December 31, 2007, the carrying value of the Company’s insurance subsidiaries’ invested assets was comprised of $963.4 million of fixed income securities, $42.2 million of short-term investments and $4.7 million of cash.
Cash flow at the parent company level is derived principally from dividend and tax sharing payments from its insurance subsidiaries, and to a lesser extent, investment income. The principal obligations at the parent company level are to service debt and pay operating expenses, including income taxes. 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
The Company’s consolidated net cash flow provided by operating activities was $124.2 million, $129.2 million and $124.2 million for 2008, 2007 and 2006, respectively. The decrease in net cash flow in 2008 primarily relates to the payment, net of reinsurance recoveries, of $23.6 million in settlement of a large claim that had been fully reserved and the absence of a $7.9 million return of collateral to a principal in 2007.
The increase in net cash flow provided by operating activities in 2007 primarily relates to lower loss payments of $13.3 million, partially offset by higher income tax payments of $3.9 million and $5.3 million returned to CCC under the Stop Loss Contract discussed previously.
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, 2008 and 2007, the interest rate on the junior subordinated debenture was 5.52% and 8.24%, respectively.
A summary of the Company’s contractual obligations as of December 31, 2008 is presented in the following table:
Combined statutory surplus totaled $554.6 million at December 31, 2008, resulting in a net written premium to statutory surplus ratio of 0.8 to 1. Insurance regulations restrict Western Surety’s maximum net retention on a single surety bond to 10 percent of statutory surplus. Under the 2009 Excess of Loss Treaty, the Company’s net retention on new bonds would generally be $15 million plus a 5% co-participation in the $90 million layer of excess reinsurance above the Company’s retention. Based on statutory surplus as of December 31, 2008, this regulation would limit Western Surety’s largest gross risk to $141.0 million. This surplus requirement may limit the amount of future dividends Western Surety could otherwise pay to CNA Surety.
In accordance with the provisions of intercompany tax sharing agreements between CNA Surety and its subsidiaries, the tax of each subsidiary shall be determined based upon each subsidiary’s separate return liability. Intercompany tax payments are made at such times when estimated tax payments would be required by the Internal Revenue Service (“IRS”). CNA Surety received tax-sharing payments of $48.6 million from its subsidiaries for 2008 and $43.4 million for 2007.
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, 2008, 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, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, 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, 2008, 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 17, 2009 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. 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. 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”).
The preparation of financial statements in conformity with generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
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
The Company used a valuation technique based on discounted cash flows to complete its annual intangible asset impairment test as of October 1, 2008. No impairment was indicated. The Company also evaluated the indefinite-lived intangible and determined that no events or circumstances have occurred that warrant a re-categorization of this intangible to a finite-lived intangible.
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) indemnity 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.
that are ceded under reinsurance arrangements reduce the respective revenues and expenses. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy and are reported as reinsurance receivables. The Company evaluates the financial condition of its reinsurers, monitors concentrations of credit risk and establishes allowances for uncollectible amounts when indicated.
Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-based Payment” (“SFAS 123R”) was effective for the Company on January 1, 2006. Prior to 2006, the Company applied the intrinsic value method under Accounting Principles Board (“APB”) Opinion No. 25 (“APB 25”), and related interpretations, in accounting for its stock-based compensation plan as allowed under the provisions of SFAS No. 123, “Accounting for Stock-based Compensation” (“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. Under SFAS 123R, entities generally are required to measure and record compensation expense using a fair-value based method. Public companies are to apply SFAS 123R using either the modified prospective method or the modified retrospective method. The Company applied the modified prospective transition method to record compensation expense. The Company accounts for graded vesting using the accelerated method. The Company applied the alternative transition method in calculating its pool of excess tax benefits available to absorb future tax deficiencies as provided by Financial Accounting Standards Board (“FASB”) Staff Position (“FSP”) FAS 123(R)-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards”.
FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109” (“FIN 48”) was effective for the Company 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 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.
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 2008, 2007 and 2006 was $5.7 million, $6.1 million and $5.2 million, respectively. The cost of maintenance and repairs is expensed as incurred; major improvements are capitalized.
No adjustments were made to reported net income in the computation of earnings per share. Options to purchase shares of common stock of 0.6 million were excluded from the calculation of diluted earnings per share for the year ended December 31, 2008 because the exercise price of the options was greater than the average market price of CNA Surety’s common stock. 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.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with GAAP and expands disclosures about fair value measurements. SFAS 157 retains the exchange price notion in the definition of fair value and clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability. SFAS 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement and the
The Company’s insurance subsidiaries, as required by state law, deposit certain securities with state insurance regulatory authorities. At December 31, 2008, securities on deposit had an aggregate estimated fair value of $5.7 million.
The amortized cost and estimated fair value of fixed income securities, by contractual maturity, at December 31, 2008 and 2007 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):
Gross 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 as discussed below. Gross realized investment losses were $1.0 million for 2007 due to the recognition of impairment losses on certain fixed income securities as discussed below. Gross realized investment losses were $1.4 million for 2006 due to the recognition of impairment losses and additional losses on the subsequent sale of certain fixed income securities as discussed below.
During the fourth quarter of 2008, the Company recorded other-than-temporary impairment losses of $1.0 million on one fixed income security. The security was issued by the financing subsidiary of a large domestic automaker and was rated below investment grade by S&P and Moody’s.
During the third quarter and fourth quarters of 2008, the Company recorded other-than-temporary impairment losses of $0.4 million on the equity securities that are related to the Company’s nonqualified deferred compensation plan.
During the second quarter of 2007, the Company recorded other-than-temporary impairment losses of $0.9 million on 13 fixed income securities of various categories of investments that were in an unrealized loss position. These impairment losses were recognized as significant interest rate changes and a revised outlook on the interest rates resulted in the Company’s intention not to hold these securities to their anticipated recovery. These securities were sold during the third quarter of 2007.
The following table summarizes securities in a gross unrealized loss position by investment category and by credit rating(a).
Credit rating is determined by the higher of the two ratings, S&P or Moody’s, when a security has a split rating.
In May 2004, the Company, through a wholly-owned trust, privately issued $30.0 million of preferred securities through two pooled transactions. These securities bear interest at the London Interbank Offered Rate (“LIBOR”) plus 337.5 basis points with a 30-year term and are redeemable at par value beginning in May 2009. The securities were issued by CNA Surety Capital Trust I (the “Issuer Trust”). The Company’s investment of $0.9 million in the Issuer Trust is carried at cost in “Other assets” in the Company’s Consolidated Balance Sheet. The sole asset of the Issuer Trust consists of a $30.9 million junior subordinated debenture issued by the Company to the Issuer Trust. Due to the underlying characteristics of this debt, the carrying value of the debenture approximates its estimated fair value.
The Company has also guaranteed the dividend payments and redemption of the preferred securities issued by the Issuer Trust. The maximum amount of undiscounted future payments the Company could make under the guarantee is approximately $74.3 million, consisting of annual dividend payments of $1.7 million over 26 years and the redemption value of $30.0 million. Because payment under the guarantee would only be required if the Company does not fulfill its obligations under the debentures held by the Issuer Trust, the Company has not recorded any additional liabilities related to this guarantee.
The Company had no assets or liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) at either the adoption of SFAS 157 on January 1, 2008 or at December 31, 2008.
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 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, 2008 and expired on December 31, 2008. There was no amount due to the CNA Surety insurance subsidiaries as of December 31, 2008. This agreement was renewed with the same terms on January 1, 2009 and expires on December 31, 2009 and is annually renewable thereafter.
receivable, respectively. CNA Surety had reinsurance payables to CCC and CIC of $1.2 million and $0.1 million as of December 31, 2008 and 2007, respectively.
The Company’s Consolidated Balance Sheets also include a “Deposit with affiliated ceding company” of $29.7 million and $34.6 million at December 31, 2008 and 2007, 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 is subject to taxation in the United States and various state jurisdictions. The Company’s tax years for 2005 through 2008 are subject to examination by the Internal Revenue Service. The Internal Revenue Service is currently examining the Company’s tax return for the year 2006. Management believes the ultimate resolution of this examination will not result in a material adverse effect to the Company’s financial position or results of operations.
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 $4.6 million, $4.7 million and $4.0 million for the years ended December 31, 2008, 2007 and 2006, respectively.
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 only 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 postretirement benefit plan that provides medical benefits has been determined to be actuarially equivalent to Medicare Part D on an estimated basis under the rules provided in final regulations issued January 21, 2005. As such, the federal subsidy to plan sponsors under the Medicare Modernization Act (“MMA”) has been recognized in the accounting for that plan.
The Company’s postretirement sick leave plan’s accumulated postretirement benefit obligation as of December 31, 2008 is $0.7 million.
The net actuarial gain in 2007 resulted primarily from a change in expected cost of claims under the medical benefit plan. In the fourth quarter of 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 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 obligation as of December 31, 2008 by $1.8 million and increase the aggregate of service cost and interest cost for the year then ended by $0.1 million. Decreasing the assumed health care cost trend rates by 1 percentage point in
each year would decrease the benefit obligation as of December 31, 2008 by $1.4 million and decrease the aggregate of service cost and interest cost for the year then ended by $0.1 million.
The Company expects to contribute $0.2 million to the postretirement benefit plans to pay benefits in 2009. 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 2008, 2007 and 2006 was $1.7 million, $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 in both 2008 and 2007 and $0.4 million in 2006. The amount of cash received from the exercise of stock options was $0.5 million, $3.6 million and $7.8 million in 2008, 2007 and 2006, respectively.
The Company reserved shares of its common stock for issuance to directors, officers, employees and certain advisors of the Company through incentive stock options, nonqualified stock options, restricted stock, bonus shares or stock appreciation rights (“SARs”) to be granted under the CNA Surety 2006 Long-Term Equity Compensation Plan (the “2006 Plan”), approved by shareholders on April 25, 2006. The aggregate number of shares initially available for which options may be granted under the 2006 Plan was 3,000,000. Option exercises under the 2006 Plan are settled in newly issued common shares.
A summary of option activity for the year ended December 31, 2008 is presented below:
The total fair value of stock options vested was $1.4 million, $0.9 million and $1.2 million in 2008, 2007 and 2006, respectively.
The following table summarizes information about stock options outstanding at December 31, 2008:
A summary of the options vested or expected to vest and options exercisable as of December 31, 2008 is presented below:
Effective January 1, 1998, the Company established the CNA Surety Corporation Non-Employee Directors Deferred Compensation Plan. Under this plan, which was terminated on December 31, 2004, each director who was not a full-time employee of the Company or any of its affiliates could defer all or a portion of the annual retainer fee that would otherwise be paid to such director. The deferral amount was credited to a deferred compensation account and deemed invested in common stock units. Each director was fully vested in his or her deferred compensation amount. Common stock units are convertible into CNA Surety common stock at the election of the director. Aggregate common stock units outstanding as of December 31, 2008 and 2007 were 12,141 and 12,511, respectively.
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 $6.8 billion in direct written premiums, comprised of approximately $5.5 billion in surety premiums and $1.3 billion in fidelity premiums.
public works projects. Commercial surety bonds include all surety bonds other than contract and cover obligations typically required by law or regulation. Fidelity bonds cover losses arising from employee dishonesty.
In 2008, approximately $85.3 million, or 18.3% of gross written premiums were generated from national insurance brokers, with the single largest national broker production comprising $14.3 million, or 3.1%, of gross written premiums. 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.
The following table reconciles consolidated stockholders’ equity at December 31, 2008 and 2007 as reported herein in conformity with GAAP with total statutory capital and surplus of CNA Surety’s insurance subsidiaries, determined in accordance with statutory accounting practices prescribed or permitted by insurance regulatory authorities (dollars in thousands):
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 2009, Western Surety may pay dividends of $112.4 million to CNA Surety. Combined statutory surplus for the insurance subsidiaries at December 31, 2008 was $554.6 million.
The Company was charged $6.9 million, $7.3 million and $7.4 million for the years ended December 31, 2008, 2007 and 2006, respectively, for leased space and services, including the management fee, provided under the ASA. The Company was charged $0.2 million, $0.4 million and $0.5 million for the years ended December 31, 2008, 2007 and 2006, respectively for direct costs incurred by CCC on the Company’s behalf. The Company had a $0.3 million net payable balance to CCC related to the ASA as of December 31, 2008 and 2007, respectively.
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 one bond with less than $0.1 million of total penal sum remains as of December 31, 2008.
In 2007, the Company, through the Quota Share Treaty, assumed one bond issued by an affiliate for Mexdrill Offshore and one bond issued by an affiliate for Diamond Offshore. The penal sums of these bonds were $0.7 million and $7.3 million, respectively. The premium for these two bonds was less than $0.1 million.
Also, in 2007, the Company, through the Quota Share Treaty, assumed two bonds issued by an affiliate for Gulf South Pipeline Company, LP, a subsidiary of Boardwalk Pipeline Partners, LP (“Boardwalk Pipeline”). Loews owns 74% 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 2008, with approval of the Audit Committee, Western Surety wrote two bonds for Diamond Offshore and two bonds for Boardwalk Pipeline. The penal sums for these bonds were $3.4 million, $7.3 million, $1.2 million and $0.4 million, respectively. The premium for these bonds was less than $0.1 million.