CNA Surety also leased space for contract and commercial branch offices in San Juan, Puerto Rico and Rocklin, California. Annual rent for these offices was $0.1 million with leases terminating in 2011 and 2012, respectively. In 2011, CNA Surety will also lease space in San Antonio, Texas, with a lease terminating in 2016. Annual rent under this lease will be less than $0.1 million.
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 reserve increases or decreases are the complexity of the
The actuarial analyses are based upon multiple projection methodologies that involve detailed statistical analysis of past claim reporting, settlement activity, and indemnification activity, as well as claim frequency and severity data when sufficient information exists to lend statistical credibility to the analysis. The analysis may be based upon internal loss experience or industry experience. Methodologies may vary depending on the type of claim being estimated. While methodologies may vary, each employs significant judgments and assumptions.
As a group of claims mature, their collective value changes. This change in value over time is referred to as loss development. The loss development method is a traditional actuarial approach which relies on the historical 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.
Each of the projection methodologies employed rely to varying degrees on the basic assumption that the Company’s historical claim experience is indicative of the Company’s future claim development. The amount of weight given to any individual projection method is based on an assessment of the volatility of the historical data and development patterns, an understanding of the changes in the overall surety industry over time and the resultant potential impact of these changes on the Company’s prospective claims development, an understanding of the changes to the Company’s processes and procedures within its underwriting, claims handling and data systems functions, among other things. The decision as to how much weight to give to any particular projection methodology is ultimately a matter of experience and professional judgment.
The indicated reserve, or actuarial point estimate, was developed by reviewing the Company’s claims experience by accident year for 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
Changes in underwriting standards and business mix such as the Company’s efforts to reduce exposures to large commercial bonds;
The following table shows the point estimate as determined by the actuarial analysis as compared to the actual loss reserve established by management, both gross and net of reinsurance (dollars in thousands):
At December 31, 2010, 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 2008 and prior. For accident years 2009 and 2010, management recorded reserves that deviated from 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 2009 and 2010, management used the same methodology that was used in 2009. This methodology 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.
In developing the indicated range of reserve estimates, a bootstrapping based methodology was utilized in order to estimate the distribution of reserves. The bootstrap method is premised on the idea that the volatility in a company’s historical paid and incurred loss development is representative of the variability in a company’s future payments and thus can be used to estimate the variability within a company’s reserve estimate. Given the dispersion of the reserve indications, the 50th and 75th percentile were selected as representing a reasonable range of reserve estimates.
securities are reported at fair value, with unrealized gains and losses, net of deferred income taxes, reported in stockholders’ equity as a separate component of accumulated other comprehensive income.
The amortized cost of fixed income securities is determined based on cost, adjustments for previously recorded OTTI 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, 2010 and 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.
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.
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, 2010, 2009 and 2008
Through one of its insurance subsidiaries, Western Surety Company (“Western Surety”), the Company assumes significant amounts of premiums primarily from affiliates. This includes surety business written or renewed, net of reinsurance, by Continental Casualty Company (“CCC”) and The Continental Insurance Company (“CIC”), and their affiliates, after September 30, 1997 that is reinsured by Western Surety pursuant to reinsurance and related agreements. Because of certain regulatory restrictions that limit the Company’s ability to write certain 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 assumed business from CCC and CIC.
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. For the years ended December 31, 2010, 2009, and 2008, assumed premiums written under such arrangements were $4.3 million, $2.4 million and $2.1 million, respectively.
Gross written premium, which is the aggregate of direct written premiums and assumed written premiums, for the years ended December 31, 2010, 2009 and 2008 are shown in the table below (dollars in thousands) for each sub-line of business:
For 2010, gross written premiums increased 0.4 percent to $440.2 million as compared to 2009. Gross written premiums for contract surety increased 1.3 percent to $278.4 million despite continued challenges in the construction industry. For 2010, commercial surety gross written premiums decreased 1.7 percent compared to 2009 due to a modest decline in the small commercial market, partially offset by selective growth in the corporate commercial market. Fidelity and other premiums increased 1.9 percent to $30.5 million.
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. Ceded written premiums decreased from $27.3 million to $23.9 million for 2010 compared to 2009 primarily due to the lower cost of the Company’s 2010 third party excess of loss treaty.
Net written premiums, which is gross written premiums less ceded written premiums, for the years ended December 31, 2010, 2009 and 2008 are shown in the table below (dollars in thousands) for each sub-line of business:
Net earned premiums were $418.0 million in 2010 compared to $421.9 million in 2009. While net written premiums for the current year increased, the impact of adverse economic conditions on prior year net written premium is reflected in this $3.9 million decrease. Net earned premiums for contract surety business decreased 1.0 percent to $256.7 million for 2010 compared to 2009. Net earned premiums for commercial surety decreased 0.7 percent to $131.0 million for 2010 compared to 2009. Net earned premium for fidelity and other premiums decreased 1.0 percent to $30.3 million for 2010 compared to 2009.
For 2009, net earned premiums decreased by $9.8 million to $421.9 million as compared to 2008 reflecting continued adverse economic conditions, partially 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. Net earned premium for fidelity and other premiums decreased 2.6 percent to $30.6 million for 2009 compared to 2008.
The favorable development for 2010 was primarily related to accident years 2008, 2007 and 2006. Loss experience for the 2007 and 2006 accident years continued to be lower than expected, particularly for large losses.
activity until the 2009 accident year. The Company’s estimates of losses for accident years 2010 and 2009 continue to reflect the impact of the difficult economic conditions.
The expense ratio for the year ended December 31, 2010 decreased to 54.5% from 55.3% in 2009. The expense ratio for 2009 included impairments of capitalized software development costs related to in-development projects that the Company decided to terminate. These impairments totaled $4.9 million, which added 1.1 percentage points to the expense ratio for 2009.
In 2009, the expense ratio increased to 55.3% from 54.5% in 2008 due to these impairments.
The Company’s income tax expense was $62.7 million for 2010, $51.3 million for 2009 and $48.8 million for 2008. The effective income tax rates were 31.8%, 30.3% and 30.7% for 2010, 2009 and 2008, 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 $24.9 million, $25.5 million and $23.8 million in 2010, 2009 and 2008, respectively.
With respect to contract surety, the Company’s portfolio is predominantly comprised of contractors with bonded backlog of less than $30.0 million. Bonded backlog is an estimate of the Company’s exposure in the event of default before indemnification. The Company does have accounts with bonded backlogs significantly greater than $30.0 million.
The Company’s ceded reinsurance program is predominantly comprised of excess of loss reinsurance contracts that limit the Company’s retention on a per principal basis. The Company’s reinsurance coverage is provided by third party reinsurers and related parties. Due to the terms of these excess of loss treaties, reinsurers may cover some principals in one year but then exclude these same principals in subsequent years. As a result, the Company may have exposures to these principals that have limited or no reinsurance coverage.
At December 31, 2010, Munich Reinsurance America, Inc., Hannover Rückversicherung AG, Odyssey America Reinsurance Corporation, Endurance Reinsurance Corp. of America and Renaissance Reinsurance Ltd. were the five 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”). There were no amounts past due under reinsurance contracts and no allowances were established for uncollectible reinsurance receivables at December 31, 2010 or 2009.
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 excess of loss treaty effective in 2008. 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.
Effective January 1, 2010, CNA Surety entered into an excess of loss treaty (“2010 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the 2009 Excess of Loss Treaty. Under the 2010 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 $12.3 million based on losses ceded under the contract. The actual ceded premiums for the 2010 Excess of Loss Treaty were $23.7 million.
Effective January 1, 2011, CNA Surety entered into an excess of loss treaty (“2011 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the 2010 Excess of Loss Treaty. Under the 2011 Excess of Loss Treaty, the Company’s net retention per principal remains at $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
Through the Quota Share Treaty, CCC and CIC transfer to Western Surety surety business written or renewed by CCC and CIC after the Merger Date. The Quota Share Treaty was renewed on January 1, 2010 and expired on December 31, 2010. The Quota Share treaty was renewed on substantially the same terms on January 1, 2011 and expires on December 31, 2011 and is annually renewable thereafter. CCC and CIC transfer the related liabilities of such business and pay to Western Surety an amount in cash equal to CCC’s and CIC’s net written premiums written on all such business, minus a quarterly ceding commission to be retained by CCC and CIC equal to $50,000 plus 25% of net written premiums written on all such business. For 2010 and 2009 this resulted in an override commission on their actual direct acquisition costs of 4.7% and 4.8%, respectively, to CCC and CIC.
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, 2010.
As of December 31, 2010 and December 31, 2009, CNA Surety had an insurance receivable balance from CCC and CIC of $10.8 million and $9.8 million, respectively, comprised of premiums receivable. CNA Surety had no reinsurance payables to CCC or CIC as of December 31, 2010.
The Company’s Consolidated Balance Sheets also include a “Deposit with affiliated ceding company” of $23.4 million and $26.9 million at December 31, 2010 and December 31, 2009, 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.
would depend on a number of factors such as the prevailing interest rates and credit spreads, the duration of the assets sold and the marketability of the assets. The need to liquidate fixed income securities would be expected to cause a reduction in future investment income.
The Company’s consolidated net cash flow provided by operating activities was $142.1 million, $158.0 million and $124.2 million for 2010, 2009 and 2008, respectively. The decrease in net cash flow provided by operating activities in 2010 primarily relates to higher income tax payments partially offset by lower claim payments. The increase in net cash flow provided by operating activities in 2009 compared to 2008 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 Company does not have any material off-balance sheet arrangements as defined by Item 303 of Regulation S-K under the Securities Act of 1933 and the Securities Exchange Act of 1934.
A summary of the Company’s contractual obligations as of December 31, 2010 is presented in the following table:
In addition to the operating lease obligations included in the table above, on September 21, 2010, CNA Surety entered into a lease agreement for a new property to be occupied following the 2012 expiration of the lease for its primary processing and service center in Sioux Falls, South Dakota. The new lease includes various contingencies including completion of construction of the building and office space to be occupied. The lease term shall be ten years from its commencement date as defined in the agreement. Other specific lease terms such as final rental square feet and cost will be finalized upon satisfaction of the required contingencies.
As an insurance holding company, CNA Surety is dependent upon dividends and other permitted payments from its insurance subsidiaries to pay operating expenses and meet debt service requirements, as well as to potentially pay cash dividends. The payment of dividends by the insurance subsidiaries is subject to varying degrees of supervision by the insurance regulatory authorities in the insurance subsidiaries’ states of domicile. Western Surety, Surety Bonding Company of America (“Surety Bonding”) and Universal Surety of America (“Universal Surety”) are domiciled in South Dakota. In South Dakota, insurance companies may only pay dividends from earned surplus excluding surplus arising from unrealized capital gains or revaluation of assets. The insurance subsidiaries may pay dividends without obtaining prior regulatory approval only if such dividend or distribution (together with dividends or distributions made within the preceding 12-month period) is less than, as of the end of the immediately preceding year, the greater of (i) 10% of the insurer’s surplus to policyholders or (ii) statutory net income. In South Dakota, net income includes net realized capital gains in an amount not to exceed 20% of net unrealized capital gains. All dividends must be reported to the South Dakota Division of Insurance prior to payment.
In accordance with the provisions of intercompany tax sharing agreements between CNA Surety and its subsidiaries, the income tax of each subsidiary shall be determined based upon each subsidiary’s separate return
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, 2009 through June 30, 2010, the underwriting limitations of Western Surety and Surety Bonding were $54.7 million and $0.7 million, respectively. Effective July 1, 2010 through June 30, 2011, the underwriting limitations of Western Surety and Surety Bonding are $67.1 million and $0.8 million, respectively. Through the Quota Share Treaty previously discussed, CNA Surety has access to CCC and its affiliates’ U.S. Department of Treasury underwriting limitations. Effective July 1, 2010 through June 30, 2011, the underwriting limitations of CCC and its affiliates utilized under the Quota Share Treaty total $892.1 million. CNA Surety management believes that the foregoing U.S. Treasury underwriting limitations are sufficient for the conduct of its business.
CNA Surety management believes that the Company has sufficient available resources, including capital protection against large losses provided by the Company’s excess of loss reinsurance arrangements, to meet its present capital needs.
The unrealized loss position of this security was $0.3 million at December 31, 2010.
We have audited the internal control over financial reporting of CNA Surety Corporation and subsidiaries (the “Company”) as of December 31, 2010, 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, 2010, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedules as of and for the year ended December 31, 2010 of the Company and our report dated February 18, 2011 expressed an unqualified opinion on those financial statements and financial statement schedules and included an explanatory paragraph relating to a change in method of accounting for the recognition and presentation of other-than-temporary impairments in 2009.
CNA Surety management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2010. 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, 2010, the Company’s internal control over financial reporting is effective based on those criteria.
CNA Surety’s independent registered public accounting firm, Deloitte & Touche LLP, has issued an audit report covering the Company’s internal control over financial reporting. Their report appears immediately prior to this Management’s Report on Internal Control Over Financial Reporting as the first item of Item 8, Financial Statements and Supplementary Data of this Form 10-K.
The amortized cost of fixed income securities is determined based on cost, adjustments for previously recorded other-than-temporary impairment (“OTTI”) 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.
In April 2009, the Financial Accounting Standards Board (“FASB”) issued updated accounting guidance, which amended the OTTI loss model for fixed income securities. A fixed income security is impaired if the fair value of the security is less than its amortized cost basis, which is its cost adjusted for accretion, amortization and previously recorded OTTI losses. The updated accounting guidance requires an OTTI loss equal to the difference between fair value and amortized cost to be recognized in earnings if the Company intends to sell the fixed income security or if it is more likely than not that the Company will be required to sell the fixed income security before recovery of its amortized cost basis.
The remaining fixed income securities in an unrealized loss position are evaluated to determine if a credit loss exists. If the Company does not expect to recover the entire amortized cost basis of a fixed income security, the security is deemed to be other-than-temporarily impaired for credit reasons. For these securities, the bifurcation of OTTI losses into a credit component and a non-credit component is required by the updated accounting guidance. The credit component is recognized in earnings and represents the difference between the present value of the future cash flows that the Company expects to collect and a fixed income security’s amortized cost basis. The non-credit component is recognized in other comprehensive income and represents the difference between fair value and the present value of the future cash flows that the Company expects to collect.
Short-term investments, that generally include U.S. Treasury bills, corporate notes, money market funds and investment grade commercial paper equivalents, are carried at amortized cost which approximates fair value.
CNA Surety’s Consolidated Balance Sheet as of December 31, 2010 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.
collectibility of premium receivables. Premium receivables and any related allowance are written off after collection efforts have been exhausted.
The Company measures and records stock-based compensation expense using a fair-value based method. The Company applies the alternative transition method in calculating its pool of excess tax benefits available to absorb future tax deficiencies and accounts for graded vesting using the accelerated method.
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 2010, 2009 and 2008 was $6.2 million, $6.0 million and $5.7 million, respectively. The cost of maintenance and repairs is charged to income as incurred; major improvements are capitalized.
In October 2010, the FASB issued ASU No. 2010-26, “Financial Services - Insurance (Topic 944) - Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts.” This updated accounting guidance modifies the definition of the types of costs incurred to acquire or renew insurance contracts that may be capitalized. Under the new guidance, these costs include those costs that are incremental direct costs and certain costs that are directly related to successful contract acquisitions. This accounting guidance is effective for fiscal years, and interim periods within those
In December 2010, the FASB issued ASU No. 2010-28, “Intangibles - Goodwill and Other (Topic 350) - When to Perform Step 2 of the Goodwill Impairment Test for Reporting Units with Zero or Negative Carrying Amounts.” This guidance clarifies application of Step 2 of the goodwill impairment tests. When Step 1 of the goodwill impairment test results in a zero or negative amount, some entities had concluded that Step 2 of the test was unnecessary because the fair value of their reporting unit would be greater than zero. The guidance requires an entity to perform Step 2 if it is more likely than not that an impairment exists. This accounting guidance is effective for fiscal years beginning after December 15, 2010. The Company does not expect the adoption of this guidance to have an impact on the Company’s financial condition or results of operations.
Net realized investment gains were $1.1 million for 2010. Realized gains on sales of fixed income securities were partially offset by the recognition of additional other-than-temporary impairment losses on a fixed income security for which OTTI losses were first recognized in 2009. The OTTI losses on this security and OTTI losses on equity securities related to the Company’s nonqualified deferred compensation plan partially offset realized gains on sales of fixed income securities resulting in net realized investment gains of $1.2 million for 2009. Net realized investment losses were $1.4 million for 2008 due to the recognition of an OTTI loss on a fixed income security and OTTI losses on equity securities related to the Company’s nonqualified deferred compensation plan.
The amortized cost, gross unrealized gains, gross unrealized losses, estimated fair value and unrealized OTTI losses of fixed income securities and the cost, gross unrealized gains, gross unrealized losses and estimated fair value of equity securities held by CNA Surety at December 31, 2010, by investment category, were as follows (dollars in thousands):
The Company did not hold any non-income producing fixed income securities as of December 31, 2010 or 2009. As of December 31, 2010 and December 31, 2009, no investments in any single issuer exceeded 10% of stockholders’ equity.
A security is in an unrealized loss position, or impaired, if the fair value of the security is less than its amortized 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 an anticipated 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.
For equity securities for which an other-than-temporary impairment loss has been identified, the security is written down to fair value and the resulting losses are recognized in realized gains/losses in the Consolidated Statements of Income.
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 any anticipated 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.
In addition to these factors, the Company considers the results of discounted cash flow modeling using assumptions representative of current market conditions as well as those specific to the Company’s particular security holdings. For asset-backed and mortgage-backed securities, the focus of this analysis is on assessing the sufficiency and quality of underlying collateral and timing of cash flows. Significant assumptions considered by the Company in its cash flow projections include delinquency rates, probable risk of default, over collateralization and credit support from lower level tranches. If the discounted expected cash flows for a security equal or exceed the amortized cost of that security, no credit loss exists and the security is deemed to be temporarily impaired.
Based on the Company’s evaluation of this quantitative criteria and qualitative information, the Company recorded credit-related OTTI losses of $0.1 million on fixed income securities during 2010. These credit-related
The amortized cost and estimated fair value of fixed income securities, by contractual maturity, at December 31, 2010 and 2009 are shown below. Actual maturities may differ from contractual maturities as borrowers may have the right to call or prepay obligations with or without call or prepayment penalties (dollars in thousands):
The following table summarizes for fixed income securities in an unrealized loss position at December 31, 2010 and 2009, 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, 2010 and December 31, 2009, all of the Company’s fixed income securities were rated by S&P or Moody’s.
to recovery of amortized cost. The Company does not believe the unrealized losses on these securities are indicative of credit losses and, as such, has not recorded an OTTI loss on these securities at December 31, 2010.
Of the Company’s thirteen investment grade corporate bond investments with an unrealized loss at December 31, 2010, none was in an unrealized loss position that exceeded 5% of the security’s amortized cost. Although interest rate increases in the fourth quarter of 2010 increased the unrealized loss position of these investments, the overall unrealized loss position on the Company’s corporate bond holdings improved $0.3 million at December 31, 2010 compared to December 31, 2009. The Company has no current intent to sell these securities, nor is it more likely than not that it will be required to sell prior to recovery of amortized cost. The Company does not believe the unrealized losses on these securities are indicative of credit losses and, as such, has not recorded any OTTI losses on these securities at December 31, 2010.
Two investment grade asset-backed securities, including one with exposure to sub-prime home loans, held by the Company were in an unrealized loss position at December 31, 2010. Neither of these securities was in an unrealized loss position that exceeded 5% 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 the unrealized losses on these securities are indicative of credit losses and, as such, has not recorded any OTTI losses on these securities at December 31, 2010.
At December 31, 2010 the Company’s exposure to sub-prime home loans was limited to two asset-backed securities collateralized by sub-prime home loans which originated prior to 2005. The estimated fair value of these securities was $3.5 million at December 31, 2010. Both of these securities are in an unrealized loss position at December 31, 2010. One of these securities was rated below investment grade at December 31, 2010. The investment grade security was discussed previously. The non-investment grade security is in an unrealized loss position of $0.3 million, or 13.4% of its amortized cost. During 2010, the Company received repayments on this security of $0.7 million, or approximately 25% of the par value outstanding at December 31, 2009. As discussed previously, this security was determined to have credit losses totaling $0.1 million during 2010. The non-credit component of this security’s OTTI recognized in accumulated other
The Company’s insurance subsidiaries, as required by state law, deposit certain securities with state insurance regulatory authorities. At December 31, 2010, securities on deposit had an aggregate estimated fair value of $5.2 million.
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, 2010 and 2009, the interest rate on the junior subordinated debenture was 3.66% and 3.65%, respectively.
Assets measured at fair value on a recurring basis as of December 31, 2010 and December 31, 2009 are summarized below (dollars in thousands):
The Company’s insurance subsidiaries, in the ordinary course of business, cede insurance to other insurance companies and affiliates. Reinsurance arrangements are used to limit maximum loss, provide greater diversification of risk, minimize exposure on larger risks and to meet certain regulatory restrictions that would otherwise limit the size of bonds the Company can write. Reinsurance contracts do not relieve the Company of its primary obligations to claimants. Therefore, a contingent liability exists with respect to insurance ceded to the extent that any reinsurer is unable to meet the obligations assumed under the reinsurance contracts. The Company evaluates the financial condition of its reinsurers, assesses the need for allowances for uncollectible amounts and monitors concentrations of credit risk.
Assumed premiums primarily include surety business written or renewed, net of reinsurance, by CCC and CIC after September 30, 1997 that is reinsured by Western Surety pursuant to reinsurance and related agreements. Because of certain regulatory restrictions that limit Western Surety’s ability to write certain business on a direct basis, the Company utilizes the underwriting capacity available through these agreements while retaining control of the underwriting and claim management of the assumed business.
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 effective January 1, 2010 through December 31, 2010 that covers certain contract surety business, FICOH retains losses of $2 million per principal and Western Surety
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. For the years ended December 31, 2010, 2009 and 2008, assumed premiums written under such arrangements were $4.3 million, $2.4 million and $2.1 million, respectively.
The effect of reinsurance on the Company’s provision for losses and loss adjustment expenses and the corresponding ratio to earned premium was as follows (dollars in thousands):
The unusual relationship in the gross and ceded amounts shown above for the year ended December 31, 2010 resulted from adjustments to the estimated loss and loss adjustment expense reserves during the year ended December 31, 2010. The Company reduced gross reserves related to prior accident years by $92.5 million reflecting changes in estimates of incurred-but-not-reported reserves. The corresponding change in ceded reserves was such that net reserves related to prior accident years were reduced by $76.3 million for the year ended December 31, 2010.
Effective January 1, 2010, CNA Surety entered into an excess of loss treaty (“2010 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the 2009 Excess of Loss Treaty. Under the 2010 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 $12.3 million based on losses ceded under the contract. The actual ceded premiums for the 2010 Excess of Loss Treaty were $23.7 million.
Effective January 1, 2011, CNA Surety entered into an excess of loss treaty (“2011 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the 2010 Excess of Loss Treaty. Under the 2011 Excess of Loss Treaty, the Company’s net retention per principal remains at $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 2011 on bonds that were in force during 2011. The contract also includes a provision for additional premiums of up to $10.7 million based on losses ceded under the contract. The base annual premium for the 2011 Excess of Loss Treaty is $21.7 million.
On January 1, 2010, the Company and CCC entered into separate agreements that provide for the transfer of the Canadian surety business of CCC to Western Surety. These agreements, which include a quota share treaty (the “Canadian Quota Share Treaty”) and a services and indemnity agreement (the “Canadian Services and Indemnity Agreement”), are substantially similar to the Quota Share Treaty and the Services and Indemnity Agreement discussed above. The Canadian Services and Indemnity Agreement provides Western Surety with the authority to supervise various administrative, underwriting and claim functions associated with the surety business written by CCC, through its Canadian branch, on behalf of the Company. Through the Canadian Quota Share Treaty, this Canadian surety business is transferred to Western Surety. Pursuant to these agreements, CCC will transfer the subject premium and related liabilities of such business and pay to Western Surety an amount equal to CCC’s net written premiums on all such business, minus a ceding commission of 33.5% of net written premiums. Further, Western Surety will pay an additional ceding commission to CCC in the amount of actual direct expense in producing such premium. These agreements expired on December 31, 2010. These agreements were renewed with the same terms on January 1, 2011 and expire on December 31, 2011 and are annually renewable thereafter.
Beginning in 2008, the Company began recording higher loss provisions for the current accident year in response to the severe deterioration in economic conditions that began in 2008. The results of subsequent actuarial reviews indicated redundancies for accident year 2008, but management believed that the potential impacts of the economic downturn were not fully recognized by the actuarial methodologies and maintained their higher loss estimates. The actuarial review performed in 2010 indicated a larger redundancy for accident year 2008 than at December 31, 2009. At December 31, 2010, management believed that the experience for the 2008 accident year was sufficiently mature to make the actuarial indication credible and adjusted the reserves to the actuarial indication. In retrospect, it appears that this deterioration in economic conditions did not begin to impact loss activity until the 2009 accident year. The Company’s estimates of losses for accident years 2010 and 2009 continue to reflect the impact of the difficult economic conditions.
expected emergence of large claims. Significant case reserve reductions and better than expected indemnification recoveries for accident years 2005 and prior also contributed to the favorable development in 2009. At December 31, 2009, the Company’s initial estimates of losses for accident year 2009 and the estimate for accident year 2008 reflected the impact of less favorable economic conditions.
The favorable development in 2008 primarily resulted from several significant case reserve reductions, favorable indemnity recoveries and a low level of loss activity for accident years 2006 and prior. These favorable developments were somewhat offset by adverse development related to the 2007 accident year, which, along with the initial estimates of the 2008 accident year, reflected the impact of deterioration of economic conditions.
At December 31, 2010 the future minimum commitments under operating leases were as follows: 2011 - $2.0 million; 2012 - $1.1 million; 2013 - $0.2 million; 2014 - $0.2 million; 2015 - $0.2 million. Total rental expense was $4.3 million, $5.3 million and $5.2 million for 2010, 2009, and 2008, respectively.
The Company is party to various lawsuits arising in the normal course of business. The Company believes the resolution of these lawsuits will not have a material adverse effect on its financial condition or its results of operations.
The components of deferred income taxes as of December 31, 2010 and 2009 were as follows (dollars in thousands):
CNA Surety and its subsidiaries file a consolidated federal income tax return. The income tax allocation between the Company and its subsidiaries is subject to written agreement, approved by the Audit Committee of the
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, $4.8 million and $4.6 million for the years ended December 31, 2010, 2009 and 2008, respectively.
Western Surety sponsors two postretirement benefit plans covering certain employees. One plan provides medical benefits and the other plan provides sick leave termination payments. The medical benefit plan provides coverage for employees, and their eligible dependents, hired by Western Surety before November 1, 1992 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 at December 31, 2010 or December 31, 2009.
The Company’s postretirement medical benefit plan’s accumulated postretirement benefit obligation as of December 31, 2010 is $11.6 million.
At December 31, 2010 and 2009, respectively, the Company selected a discount rate of 5.56% and 5.96% to measure the accumulated postretirement benefit obligation. The Company’s analysis is based on projecting cash outflows for the postretirement benefit plans and discounting those cash outflows using published spot rates corresponding to the time period that the cash outflow is expected. As a result of this analysis, the Company selected 5.56% as the discount rate at December 31, 2010. This rate remains consistent with the Citigroup Pension Liability Index (“CPLI”) which was 5.54% at December 31, 2010. In 2009, the weighted average resulting from the analysis was nearly identical to the CPLI, which was used as the discount rate in 2009 for measurement of the postretirement benefit obligation.
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, 2010 by $2.4 million and increase the aggregate of service cost and interest cost for the year then ended by $0.2 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, 2010 by $1.9 million and decrease the aggregate of service cost and interest cost for the year then ended by $0.1 million.
Estimated cost expected to be recognized from AOCI into net periodic benefit cost in 2011 (dollars in thousands):
The compensation expense recorded for the Company’s stock-based compensation plan in 2010, 2009 and 2008 was $1.8 million, $2.0 million and $1.7 million, respectively. The total income tax benefit recognized in the income statement for stock-based compensation arrangements was $0.6 million, $0.7 million and $0.6 million in 2010, 2009 and 2008, respectively. The amount of cash received from the exercise of stock options was $8.1 million, $1.2 million and $0.5 million in 2010, 2009 and 2008, 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 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.
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
A summary of the status of the Company’s non-vested options as of December 31, 2010 and changes during the year then ended is presented below:
The total fair value of stock options vested was $1.5 million in 2010 and $1.4 million in both 2009 and 2008.
A summary of the options vested or expected to vest and options exercisable as of December 31, 2010 is presented below:
The total intrinsic value of options exercised was $3.3 million, $0.6 million and $0.2 million for 2010, 2009 and 2008, respectively. The tax benefits recognized by the Company for these exercises were $1.2 million for 2010, $0.2 million for 2009 and less than $0.1 million for 2008.
As of December 31, 2010, there was $1.4 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: 2011 - $0.9 million; 2012 - $0.4 million; 2013 - $0.1 million.
The Company is a leading provider of surety and fidelity bonds in the United States. According to the Surety and Fidelity Association of America (“SFAA”), the surety and fidelity segment of the domestic property and casualty insurance industry aggregates approximately $6.3 billion in direct written premiums, comprised of approximately $5.2 billion in surety premiums and $1.1 billion in fidelity premiums.
CNA Surety’s insurance subsidiaries file financial statements prepared in accordance with statutory accounting practices prescribed or permitted by applicable insurance regulatory authorities. Prescribed statutory accounting practices include state laws, regulations and general administrative rules, as well as guidance provided in a variety of publications of the National Association of Insurance Commissioners (“NAIC”). Permitted statutory accounting practices encompass all accounting practices that are not prescribed.
The Company’s insurance subsidiaries follow three permitted accounting practices which did not have a material effect on reported statutory surplus or income at and for the years ended December 31, 2010 and 2009. The Company’s insurance subsidiaries were given permission to report activity in the Small Business Administration’s Surety Bond Guarantee program as a reinsurance program and to report all indemnification recoveries as recoveries of loss rather than allocating recoveries between loss and loss adjustment expenses. Also, Surety Bonding has been given permission to report ceding commissions received from Western Surety that exceed the acquisition costs related to the business ceded as a reduction to commission expense.
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 $4.6 million for leased office space and services for 2010. For both 2009 and 2008, the Company paid CCC $6.9 million for leased office space and services in addition to an annual management fee of $2.1 million. The Company was also charged $0.2 million for the years ended December 31, 2010, 2009 and 2008 for direct costs incurred by CCC on the Company’s behalf. As provided by the ASA, CCC paid the Company $1.3 million, $1.4 million and $1.3 million for the years ended December 31, 2010, 2009 and 2008, respectively, 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”). The Company had a payable balance to CCC related to the ASA of less than $0.1 million at December 31, 2010. At December 31, 2009, the Company had a $0.4 million payable balance to CCC related to the ASA.