CNA Surety leases its executive offices and its shared branch locations with CCC under the Administrative Services Agreement (“ASA”) with CCC discussed in detail in Item 8., Note 14 of the Notes to the Consolidated Financial Statements, Related Party Transactions. CNA Surety currently uses approximately 91,000 square feet and related personal property at 35 branch locations and its home and executive offices (30,360 square feet) in Chicago, Illinois. In 2009, CNA Surety’s annual rent under the ASA was approximately $3.0 million. Annual rent for space leased through the ASA will be approximately $2.0 million beginning January 1, 2010.
Effective in 2006, the Company adopted accounting guidance that requires stock-based compensation expense to be measured and recorded using a fair-value based method. Prior to 2006, the Company applied the intrinsic value method in accounting for its stock-based compensation plan as allowed under the previous accounting
The following is a discussion and analysis of CNA Surety Corporation and its subsidiaries’ (“CNA Surety” or the “Company”) operating results, liquidity and capital resources and financial condition. The most significant risk and uncertainties impacting the operating performance and financial condition of the Company are discussed in Item 1A, Risk Factors of this Form 10-K. This discussion should be read in conjunction with the Consolidated Financial Statements of CNA Surety and Notes thereto.
The Company’s accounting policies related to reserves for unpaid losses and loss adjustment expenses and related estimates of reinsurance recoverables are particularly critical to an assessment of the Company’s financial results. Given the nature of the surety business, the determination of these balances is inherently a highly subjective exercise, which requires management to analyze, weigh and balance numerous macroeconomic, customer specific and claim specific factors and trends, most of which, in and of themselves, are inherently uncertain and difficult to predict. In addition, management believes the other most significant accounting policies and related disclosures for purposes of understanding the Company’s results of operations and financial condition pertain to investments, goodwill and other intangible assets, recognition of premium revenue and the related unearned premium liability and deferred policy acquisition costs.
CNA Surety accrues liabilities for unpaid losses and loss adjustment expenses (“LAE”) under its surety and property and casualty insurance contracts based upon estimates of the ultimate amounts payable under the contracts related to losses occurring on or before the balance sheet date.
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
This method relies on historical projected ultimate loss ratios for the more mature accident years to estimate the more recent, less mature accident years’ ultimate losses. Applying a selected loss ratio (by reviewing more mature years) to the more recent years’ earned premium results in an indication of the more recent years’ ultimate losses. The strength of this method is that it can be used in connection with a company’s pricing targets and can be used when the historical data has limited credibility. The weakness of this method is that it is slow to react to the emerging loss experience for a particular accident year.
Management believes the Company has the ability to hold all fixed income securities to maturity. However, the Company may dispose of securities prior to their scheduled maturity due to changes in interest rates, prepayments, tax and credit considerations, liquidity or regulatory capital requirements, or other similar factors. As a result, the Company considers all of its fixed income securities (bonds) and equity securities as available-for-sale. These 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.
Fixed income securities in an unrealized loss position that the Company intends to sell, or it more likely than not will be required to sell before recovery of amortized cost, are considered to be other-than-temporarily impaired (“OTTI”). These securities are 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 for which management believes a credit loss exists are also considered to be other-than-temporarily impaired. For those securities, the Company bifurcates the impairment into a credit component and a non-credit component. The credit component, which represents the difference between discounted cash flows and the fixed income security’s amortized cost, is recognized in earnings and the non-credit component is recognized in other comprehensive income. Cash flows from purchases, sales and maturities of fixed income and equity securities are reported gross in the investing activities section of the Consolidated Statements of Cash Flows.
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.
While management uses various GAAP and non-GAAP financial measures to monitor various aspects of the Company’s performance, net income is the most directly comparable GAAP measure and represents a more comprehensive measure of operating performance. Management believes that its process of evaluating performance through the use of these non-GAAP financial measures provides a basis for enhanced understanding of the operating performance and the impact to net income as a whole. Management also believes that investors may find these widely used financial measures described above useful in interpreting the underlying trends and performance, as well as to provide visibility into the significant components of net income.
The Company had net income of $117.9 million for the year ended December 31, 2009 as compared to $110.4 million for the year ended December 31, 2008 and $92.5 million for the year ended December 31, 2007. The increase in net income in 2009 over 2008 reflects the higher levels of favorable loss development discussed below and higher investment income, offset by lower net earned premium. The increase in net income in 2008 over 2007 reflects higher earned premium, higher favorable loss development and higher net investment income.
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.
For 2009, gross written premiums decreased 6.2 percent to $438.3 million as compared to 2008. Gross written premiums for contract surety decreased 8.5 percent to $274.8 million primarily due to lower demand resulting from fewer new construction projects. For 2009, commercial surety gross written premiums decreased 1.8 percent compared to the year ended December 31, 2008 due, in part, to continued adverse economic conditions. Commercial surety gross written premiums for 2008 included a non-recurring premium recognition from a single account of $1.1 million. Fidelity and other premiums decreased 3.2 percent to $29.9 million.
For 2008, net earned premiums increased by $10.2 million to $431.7 million as compared to 2007 reflecting the decrease in ceded written premiums discussed above. Ceded earned premiums decreased $9.5 million to $35.5 million for 2008 compared to 2007. Net earned premiums for contract surety business increased 2.8 percent to $266.6 million for 2008 compared to 2007. Net earned premiums for commercial surety increased 2.4 percent to $133.7 million for 2008 compared to 2007. Earned premium for fidelity and other premiums decreased 0.5 percent to $31.4 million for the year 2008 compared to 2007.
The favorable development in 2008 primarily resulted from several significant case reserve reductions, favorable indemnity recoveries and a low level of new loss activity for accident years 2006 and prior. These favorable developments were somewhat offset by adverse development related to the 2007 accident year which was recorded in response to economic conditions at December 31, 2008. Also, the initial estimates of losses for accident
year 2008 reflected the Company’s expectations of the impact of continued deterioration of these economic conditions.
The expense ratio increased to 55.3% from 54.5% for the same period in 2008 due to 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.
For 2009, net investment income was $50.4 million compared to net investment income for 2008 and 2007 of $47.3 million and $44.6 million, respectively. The annualized pre-tax yield was 4.2%, 4.4% and 4.6% for 2009, 2008 and 2007, respectively. The annualized after-tax yield was 3.5%, 3.6% and 3.8% for 2009, 2008 and 2007, respectively. The increase in net investment income for 2009 and 2008 is primarily attributable to higher overall invested assets resulting from significant cash flow from operations, partially offset by a decline in yields.
The following summarizes net realized investment gains (losses) activity (dollars in thousands):
The Company manages its exposure to any one contract credit and aggressively looks for co-surety, shared accounts and other means to support or reduce larger exposures. Reinsurance and indemnification rights, including rights to contract proceeds on construction projects in the event of default, exist that substantially reduce CNA Surety’s exposure to loss.
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. Only the large national contractor discussed below was excluded from the third party reinsurance agreements effective for the treaty periods discussed; however, as discussed below, the Company has no further exposure to this principal.
At December 31, 2009, Munich Reinsurance America, Inc., Hannover Rückversicherung-Aktiengesellschaft, Odyssey America Reinsurance Corporation and Renaissance Reinsurance Ltd. 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”).
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, 2009 and expired on December 31, 2009. The Quota Share Treaty was renewed on substantially the same terms on January 1, 2010 and expires on December 31, 2010 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 2009 and 2008, this resulted in an override commission on their actual direct acquisition costs of 4.8% and 5.9%, 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, 2009.
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 surety 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 with the same terms on January 1, 2009. Effective June 30, 2009, this agreement was amended so that the Company’s authority to conduct administrative, management, underwriting and claim functions for bonds written for the large national contractor discussed below shall continue until CCC’s bonds for such contractor have expired and claims have been settled or closed. As of December 31, 2009 and 2008, there were no amounts due to the CNA Surety insurance subsidiaries under this agreement. This agreement was renewed with the same terms on January 1, 2010 and expires on December 31, 2010 and is annually renewable thereafter.
Under the terms of the agreements effecting this commutation, the Company paid CCC $1.8 million. This settlement reflects the difference between the Company’s $60.0 million retention under the excess of loss contract and the $58.2 million paid by the Company for losses of the large national contractor through June 30, 2009. These transactions had no net impact on the results of operations for the twelve months ended December 31, 2009.
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 expire on December 31, 2010 and are annually renewable thereafter.
At December 31, 2009, the carrying value of the Company’s insurance subsidiaries’ invested assets was comprised of $1,266.2 million of fixed income securities, $36.9 million of short-term investments and $2.9 million of cash. 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.
December 31, 2008, parent company short-term investments and cash included $11.1 million and $11.5 million, respectively, of cash and short-term investments primarily related to premium receipt collections ultimately due to the Company’s insurance subsidiaries.
Combined statutory surplus totaled $679.3 million at December 31, 2009, resulting in a net written premium to statutory surplus ratio of 0.6 to 1. Insurance regulations restrict the insurance subsidiaries’ maximum net retention on a single surety bond to 10 percent of statutory surplus. Under the 2010 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, 2009, this regulation would limit Western Surety’s largest gross risk to $153.4 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 income 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. CNA Surety received tax-sharing payments of $41.3 million from its subsidiaries for 2009, $48.6 million for 2008 and $43.4 million for 2007.
CNA Surety’s insurance subsidiaries are subject to periodic financial and market conduct examinations. These examinations are generally performed by the domiciliary state insurance regulatory authorities, however, they may be performed by any jurisdiction in which the insurer transacts business. During 2008, the South Dakota Division of Insurance began its financial examination of Western Surety, Surety Bonding and Universal Surety as of and for the period January 1, 2004 through December 31, 2008. The final financial examination report was filed with the South Dakota Division of Insurance on December 11, 2009. On January 13, 2010, the Company was notified that the final examination report was adopted by the Director of the South Dakota Division of Insurance as filed. No adverse findings were included in the final examination report.
The amortized cost, gross unrealized gains, gross unrealized losses, estimated fair value and OTTI 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, 2009, by investment category, were as follows (dollars in thousands):
We have audited the accompanying consolidated balance sheets of CNA Surety Corporation and subsidiaries (the “Company”) as of December 31, 2009 and 2008, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2009. Our audits also included the financial statement schedules listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
In April 2009, the Financial Accounting Standards Board (“FASB”) issued guidance which amends the criteria for the recognition and presentation of other-than-temporary impairments (“OTTI”) for debt securities and requires that credit losses be recognized in earnings and losses resulting from factors other than credit of the issuer be recognized in other comprehensive income. The Company records OTTI losses in accordance with this guidance.
The Company used a valuation technique based on discounted cash flows to complete its annual intangible asset impairment test as of October 1, 2009. 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 and (c) future expenses to be incurred in the settlement of claims, 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
The Company assumes and cedes insurance with other insurers and reinsurers 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. Premiums and losses and loss adjustment expenses 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.
Effective in 2006, the Company adopted accounting guidance that requires stock-based compensation expense to be measured and recorded using a fair-value based 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 this guidance. The Company accounts for graded vesting using the accelerated method.
Effective in 2007, the Company adopted guidance which prescribed 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 this guidance as interest expense. Likewise, penalties, if any, recognized in accordance with this guidance will be classified as miscellaneous expense.
In September 2008, the FASB issued guidance which requires disclosures by sellers of credit derivatives and requires additional disclosure about the current status of the risk of a guarantee. This guidance was effective for the Company on January 1, 2009. The adoption had no impact on the Company’s required disclosures as the Company does not sell derivative instruments.
In December 2008, the FASB issued guidance which requires employers to make additional disclosures regarding postretirement benefit plan assets and to provide information regarding the following: how investment allocation decisions are made, including the factors that are pertinent to an understanding of investment policies and procedures; the major categories of plan assets; the inputs and valuation techniques used to measure the fair value of plan assets; the effect of fair value measurements using significant unobservable inputs (Level 3) on changes in plan assets for the period; and significant concentrations of risk within plan assets. The disclosures are required for fiscal years ending after December 15, 2009 and were effective for the Company on January 1, 2009. The adoption had no impact on the Company’s disclosures as the Company’s postretirement benefit plans have no plan assets.
In April 2009, the FASB issued guidance which requires entities to assess whether certain factors exist that indicate that the volume and level of market activity for an asset or liability have decreased or that transactions are not orderly. If, after evaluating those factors, the evidence indicates there has been a significant decrease in the volume and level of activity in relation to normal market activity, observed transactional values or quoted prices may not be determinative of fair value and adjustment to the observed transactional values or quoted prices may be necessary to estimate fair value. This guidance was effective for interim and annual periods ending after June 15, 2009. The adoption had no impact on the Company’s financial condition or results of operations.
In April 2009, the FASB issued guidance which amends the criteria for the presentation and recognition of OTTI losses for debt securities and requires that credit losses be recognized in earnings and losses resulting from factors other than credit of the issuer be recognized in other comprehensive income. Prior to adoption, all OTTI losses were recorded in earnings in the period of recognition. This guidance also expands and increases the frequency of existing disclosures. This guidance was effective for interim and annual periods ending after June 15, 2009, and required a cumulative effect adjustment of initial application as an adjustment to the opening balance of retained earnings with a corresponding adjustment to accumulated other comprehensive income. The adoption had no cumulative effect adjustment to the opening balance of retained earnings or accumulated other comprehensive income as the Company determined that previously recorded OTTI on fixed income securities were credit-related and would have been recognized through earnings as required.
In April 2009, the FASB issued guidance requiring disclosures about fair value of financial instruments in interim as well as annual financial statements. This guidance was effective for interim and fiscal periods ending after June 15, 2009. The Company has included the disclosures required by this guidance.
In August 2009, the FASB issued the following clarifying guidance for determining the fair value of a liability. If a quoted price in an active market for the identical liability is available, it represents a Level 1 measurement. If a quoted price in an active market for the identical liability is not available, an entity may utilize the following approaches: (a) the quoted price of the identical liability when traded as an asset in an active market; (b) the quoted price of the identical liability when traded as an asset in markets that are not active; (c) the quoted price for similar liabilities or similar liabilities traded as assets in markets that are not active; (d) another valuation technique that is consistent with the generally accepted fair value principles (income approach or market approach). This guidance is effective for financial statements issued for reporting periods beginning after August 2009. The Company does not report any of its financial liabilities at fair value. As such, the adoption did not have an impact on the Company’s financial condition or results of operations.
In June 2009, the FASB issued Accounting Standards Update (“ASU”) No. 2009-16, “Transfers and Servicing (Topic 860) - Accounting for Transfers of Financial Assets”. This guidance removes the concept of a qualifying special-purpose entity and eliminates it from exceptions under the guidance for consolidation of variable interest entities. It also modifies the de-recognition conditions related to legal isolation and effective control and adds additional disclosure requirements for transfers of financial assets. This guidance is effective for annual reporting periods beginning after November 15, 2009. The adoption of this guidance will not have a material impact on the Company’s financial condition or results of operations.
In June 2009, the FASB issued ASU No. 2009-17, “Consolidations (Topic 810) - Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities”. This guidance amends existing consolidation guidance applicable for variable interest entities as well as requirements for determination of the primary beneficiary of a variable interest entity, requires an ongoing assessment of whether an entity is the primary beneficiary and requires enhanced disclosures that will provide users of financial statements information regarding an enterprise’s involvement in a variable interest entity. This guidance is effective for annual reporting periods beginning after November 15, 2009. The adoption of this guidance will not have a material impact on the Company’s financial condition or results of operations.
Net realized investment gains were $1.2 million for 2009. Realized gains on sales of fixed income securities were partially offset by the recognition of an other-than-temporary impairment loss on a fixed income security and
The amortized cost, gross unrealized gains, gross unrealized losses, other-than temporary impairments and estimated fair value 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, 2009, by investment category, were as follows (dollars in thousands):
The amortized cost, gross unrealized gains, gross unrealized losses and estimated fair value 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, 2008, by investment category, were as follows (dollars in thousands):
A significant judgment in the valuation of investments is the determination of when an other-than-temporary decline in value has occurred. The Company follows a consistent and systematic process for identifying securities that sustain other-than-temporary declines in value. The Company has established a watch list that is reviewed by the Chief Financial Officer and one other executive officer on at least a quarterly basis. The watch list includes individual securities that fall below certain thresholds or that exhibit evidence of impairment indicators including, but not limited to, a significant adverse change in the financial condition and near-term prospects of the investment or a significant adverse change in legal factors, the business climate or credit ratings.
The remaining fixed income securities in an unrealized loss position are evaluated to determine if a credit loss exists. To determine if a credit loss exists, the Company considers a number of factors including, but not limited to: (a) the financial condition and near-term prospects of the issuer, (b) credit ratings of the securities, (c) whether the debtor is current on interest and principal payments, (d) the length of time and the extent to which the market value has been less than book value and (e) general market conditions and industry or sector specific factors.
Fixed income securities in an unrealized loss position for which management believes a credit loss exists are considered to be other-than-temporarily impaired. For these fixed income securities, the Company bifurcates OTTI losses into a credit component and a non-credit component. The credit component, which represents the difference between the discounted expected cash flows and the fixed income security’s amortized cost, is recognized in earnings. The non-credit component is recognized in other comprehensive income and represents the difference between fair value and the discounted cash flows that the Company expects to collect.
The following table presents a roll-forward of the Company’s cumulative credit losses recognized in net realized gains (losses) on the Consolidated Statements of Income on fixed income securities held as of December 31, 2009 (in thousands of dollars):
Also, in 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.
In 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 2007.
The amortized cost and estimated fair value of fixed income securities, by contractual maturity, at December 31, 2009 and 2008 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):
Securities are categorized using the S&P rating. If a security is not rated by S&P, the Moody’s rating is used. At December 31, 2009, all of the Company’s fixed income securities were rated by S&P or Moody’s.
The unrealized losses on the Company’s investments in obligations of states and political subdivisions are due to changes in credit spreads and rising interest rates. Of the seventeen investment grade securities of obligations of states and political subdivisions that were in an unrealized loss position at December 31, 2009, only two were in an unrealized loss position exceeding 5% of the security’s amortized cost. One of these securities, issued by a governmental utility authority, had an unrealized loss of $0.6 million, which was 11.3% of the security’s amortized cost. The unrealized loss position of this security has improved from $1.9 million, or 34.4% of amortized cost at December 31, 2008. The other security, a municipal revenue bond supporting an airport project, had an unrealized loss of $0.5 million, which was 5.1% of the security’s amortized cost. Improving market conditions resulted in an $18.3 million improvement in the unrealized losses on the Company’s investment grade securities of obligations of states and political subdivisions compared to December 31, 2008. The Company has no current intent to sell these
securities, nor is it more likely than not that it will be required to sell prior to recovery of amortized cost. 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, 2009.
At December 31, 2009, only one of the Company’s corporate bond investments was in an unrealized loss position that exceeded 5% of its amortized cost. This unrealized loss, 8.5% ($0.3 million) of the security’s amortized cost, was on a security issued by a large student loan provider. The unrealized loss position of this security was 29.0% ($0.9 million) of amortized cost at December 31, 2008. Further, the overall unrealized loss position on the Company’s corporate bond holdings improved $2.8 million compared to December 31, 2008. The unrealized losses on the Company’s corporate bond investments are primarily attributable to increases in interest rates in the fourth quarter of 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, 2009.
Based on the current facts and circumstances discussed above for the Company’s securities in an unrealized loss position, the Company has determined that no additional OTTI losses related to the securities in an unrealized loss position are required to be recorded at December 31, 2009.
In May 2004, the Company, through a wholly-owned trust, privately issued $30.0 million of preferred securities through two pooled transactions. These securities, issued by CNA Surety Capital Trust I (the “Issuer Trust”), bear interest at the London Interbank Offered Rate (“LIBOR”) plus 337.5 basis points with a 30-year term. Beginning in May 2009, these securities may be redeemed, in whole or in part, at par value at any scheduled quarterly interest payment date. As of December 31, 2009, none of these preferred securities have been redeemed.
The Company 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 $56.7 million, consisting of annual dividend payments of approximately $1.1 million until maturity and the redemption value of the preferred securities 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.
On June 30, 2008, the Company’s credit facility matured. The term of borrowings under this facility (“the 2005 Credit Facility”) was fixed, at the Company’s option, for a period of one, two, three or six months. The interest rate was based on, among other rates, LIBOR plus the applicable margin. The margin, including a utilization fee, varied based on the Company’s leverage ratio (debt to total capitalization) from 0.80% to 1.00%. There was no outstanding balance under the 2005 Credit Facility during the six months ended June 30, 2008. As such, the Company incurred only the facility fee of 0.30% through the first six months of 2008.
Assets measured at fair value on a recurring basis as of December 31, 2009 and December 31, 2008 are summarized below (amounts 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. At December 31, 2009, CNA Surety had no reinsurance receivable from affiliates. CNA Surety’s largest reinsurance receivable from an affiliate, CCC, an A (Excellent) rated company by A.M. Best was $46.1 million at December 31, 2008. CNA Surety’s largest net receivable from a non-affiliated reinsurer, rated A+ (Superior) by A.M. Best, was approximately $8.3 million and $7.9 million at December 31, 2009 and 2008, respectively.
The effect of reinsurance on the Company’s provision for loss and loss adjustment expenses and the corresponding ratio to earned premium was as follows (dollars in thousands):
Effective January 1, 2008, CNA Surety entered into an excess of loss treaty (“2008 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the excess of loss treaty effective in 2007. Under the 2008 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 $26.1 million based on losses ceded under the contract. The actual ceded premiums for the 2008 Excess of Loss Treaty were $30.4 million. There were no additional premiums or loss recoveries under the 2008 Excess of Loss Treaty as no losses were discovered to this treaty in 2008.
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 expire on December 31, 2010 and are annually renewable thereafter.
Activity in the reserves for unpaid losses and loss adjustment expenses was as follows (dollars in thousands):
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 continued deterioration of economic conditions.
The components of deferred income taxes as of December 31, 2009 and 2008 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 Board of Directors. Allocation is based upon separate return calculations in accordance with the Internal Revenue Code of 1986 with current credit being given to separate company net losses.
The Company is subject to taxation in the United States and various state jurisdictions. On July 22, 2009, the Internal Revenue Service notified the Company that the ongoing examination of the Company’s tax return for the year 2006 had been completed and no changes were made to the Company’s reported income taxes. However, the Company’s tax year 2006, as well as tax years 2007 through 2009, remain open as to the applicable statute of limitations and are subject to examination by the Internal Revenue Service.
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.
The Company’s postretirement medical benefit plan’s accumulated postretirement benefit obligation as of December 31, 2009 is $10.1 million.
The Company’s postretirement sick leave plan’s accumulated postretirement benefit obligation as of December 31, 2009 is $0.6 million.
The amounts recognized in the Consolidated Balance Sheets for postretirement benefit obligations at December 31, 2009 and 2008 were as follows (dollars in thousands):
At December 31, 2009 and 2008, respectively, the Company selected a discount rate of 5.96% and 5.87% based on the Citibank Pension Liability Index to measure the accumulated postretirement benefit obligation. This index was selected by developing a weighted average yield on cash flows for the postretirement benefit plans. These cash flows were discounted using published spot rates corresponding to the time period that the cash flow is due. This average yield was compared to the Citibank Pension Liability Index and the resulting weighted average was nearly identical to this index and, as such, the index was used as the discount rate for development of the accumulated postretirement pension benefit obligation. The Company periodically updates the analysis of the weighted average yield on the cash flows for the postretirement benefit plans to select an appropriate discount rate for measurement of the postretirement benefit obligation.
obligation as of December 31, 2009 by $2.1 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, 2009 by $1.6 million and decrease the aggregate of service cost and interest cost for the year then ended by $0.1 million.
The compensation expense recorded for the Company’s stock-based compensation plan in 2009, 2008 and 2007 was $2.0 million, $1.7 million and $1.9 million, respectively. The total income tax benefit recognized in the income statement for stock-based compensation arrangements was $0.7 million in 2009 and $0.6 million in both 2008 and 2007. The amount of cash received from the exercise of stock options was $1.2 million, $0.5 million and $3.6 million in 2009, 2008 and 2007, respectively.
The 2006 Plan provides for the granting of incentive stock options as defined under Section 409A of the Internal Revenue Code of 1986, as amended. All nonqualified stock options and incentive stock options granted
On February 8, 2008, 259,380 options were granted under the 2006 Plan. The fair market value (at grant date) per option granted was $6.32 for these options. The fair value of these options was estimated at the grant date using a Black-Scholes option pricing model with the following weighted average assumptions: risk free interest rate of 2.7%; dividend yield of 0.0%; expected option life of 5.3 years and volatility of 38.3%, which was based on historical volatility. The Company estimated the expected option life of the 2008 grant based on its analysis of past exercise patterns for similar options.
On February 13, 2007, 334,100 options were granted under the 2006 Plan. The fair market value (at grant date) per option granted was $9.04 for these options. The fair value of these options was estimated at grant date using a Black-Scholes option pricing model with the following weighted average assumptions: risk free interest rate of 4.8%; dividend yield of 0.0%; expected option life of 6.3 years; and volatility of 34.7%, which was based on historical volatility. The Company estimated the expected option life using the simplified method allowed under the Securities and Exchange Commission’s Staff Accounting Bulletin (“SAB”) No. 107 (“SAB 107”). The Company’s stock options qualified for this method based on the criteria defined in SAB 107.
A summary of the status of the Company’s non-vested options as of December 31, 2009 and changes during the year then ended is presented below:
A summary of the options vested or expected to vest and options exercisable as of December 31, 2009 is presented below:
The total intrinsic value of options exercised was $0.6 million, $0.2 million and $1.9 million for 2009, 2008 and 2007, respectively. The tax benefits recognized by the Company for these exercises were $0.2 million for 2009, less than $0.1 million for 2008 and $0.6 million for 2007.
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, 2009 and 2008 were 11,771 and 12,141, respectively.
Although all of its products are sold through the same independent insurance agent and broker distribution network, the Company’s underwriting is organized by the two broad types of surety products - contract surety and commercial surety, which also includes fidelity bonds and other insurance products for these purposes. These two operating segments have been aggregated into one reportable business segment for financial reporting purposes because of their similar economic and operating characteristics. The following tables set forth gross and net written premiums, dollars in thousands, by product and between domestic and international risks and the respective percentage of the total for the past three years.
The following table reconciles consolidated stockholders’ equity at December 31, 2009 and 2008 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):
The NAIC has promulgated Risk-Based Capital (“RBC”) requirements for property and casualty insurance companies to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks such as asset quality, loss reserve adequacy and other business factors. The RBC information is used by state insurance regulators as an early warning mechanism to identify insurance companies that potentially are inadequately capitalized. In addition, the formula defines minimum capital standards that supplement the system of fixed minimum capital and surplus requirements on a state-by-state basis. Regulatory compliance is determined by a ratio (the “Ratio”) of the enterprise’s regulatory total adjusted capital, as defined by the NAIC, to its authorized control level RBC, as defined by the NAIC. Generally, a Ratio in excess of 200% of authorized control level RBC requires no corrective actions by a company or regulators. As of December 31, 2009 each of CNA Surety’s insurance subsidiaries had a Ratio that was in compliance with the minimum RBC requirements.
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, Western Surety may pay dividends of $122.9 million to CNA Surety in 2010. Combined statutory surplus for the insurance subsidiaries at December 31, 2009 was $679.3 million.
The following is a summary of the quarterly results of operations for the years ended December 31, 2009, 2008 and 2007 (dollars in thousands, except per share amounts):