The following information presented for CNA Surety is for the period from September 30, 1997 (date of inception) through December 31, 1997 and as of December 31, 1997. Selected financial data of the Predecessor is presented on the following page.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF CNA SURETY CORPORATION AND STATEMENT OF CERTAIN ASSETS AND LIABILITIES AND THE STATEMENTS OF CERTAIN REVENUES AND DIRECT OPERATING EXPENSES OF PREDECESSOR
The following is a discussion and analysis of CNA Surety Corporation ("CNA Surety" or the "Company") and its insurance subsidiaries' operating results, financial condition, liquidity and capital resources as well as a discussion of CCC Surety Operations' ("Predecessor") Statement of Certain Assets and Liabilities and Statements of Certain Revenues and Direct Operating Expenses. This discussion should be read in conjunction with the Consolidated Financial Statements of CNA Surety and notes thereto and the audited Statement of Certain Assets and Liabilities and Statements of Certain Revenues and Direct Operating Expenses and the related notes thereto of CCC Surety Operations.
Immediately after the Merger, CCC and CIC owned, on a diluted basis, 61.75% of CNA Surety's common stock and the stockholders and option holders of Capsure owned 38.25% of CNA Surety's common stock on a diluted basis. The reorganization agreement provides for a mechanism, referred to as the "Lookback Adjustment," which could adjust the number of shares of CNA Surety common stock owned by CCC in the event that either or both of Capsure's and the CCC Surety Operations' actual net written premiums for 1997 varied from certain targets. See Note 16 to the Consolidated Financial Statements for a discussion of the Lookback Adjustment.
Western Surety and USA are currently rated A+ (Superior) and A (Excellent), respectively, by A.M. Best Company, Inc. ("A.M. Best"). Through intercompany reinsurance and related agreements, CNA Surety's customers will continue to have access to CCC's broader underwriting capacity. CCC is currently rated A by A.M. Best.
CNA SURETY RESULTS FROM SEPTEMBER 30, 1997 (DATE OF INCEPTION) THROUGH DECEMBER 31, 1997 AND PREDECESSOR RESULTS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1997 COMPARED TO PREDECESSOR YEAR ENDED DECEMBER 31, 1996
Accordingly, the remainder of this discussion and analysis is formatted to compare information for CNA Surety for various time periods in 1997 and 1996 as if the merger had been consummated on January 1, 1996. Periods presented prior to September 30, 1997 that are shown herein on this basis are therefore marked pro forma. The following table of unaudited pro forma information has been prepared as if the acquisition of Capsure had been consummated on January 1, 1996. This unaudited pro forma financial information gives effect to the following: (i) adjustment to the Capsure statement of operations, as reported, to reflect the income effects as if the $10 per share special distribution was made on January 1, 1996; (ii) consummation of the Merger and the related transactions and the contribution of capital to and the incurrence of additional debt by CNA Surety; (iii) purchase accounting adjustments to reflect Capsure's assets and liabilities at fair value; (iv) estimated indirect and overhead expenses for the CCC Surety Operations; and (v) estimated interest expense related to the additional debt. The unaudited pro forma financial information does not include the estimated net investment income resulting from investment of merger-related cash flows, including (i) the $50 million debt proceeds, (ii) the $52.25 million capital contribution from CCC, and (iii) collection of the receivable from CCC.
ANALYSIS OF CNA SURETY'S RESULTS FOR THE THREE MONTHS ENDED AND YEARS ENDED DECEMBER 31, 1997 AND 1996
The components of income for the Company for the three months and years ended December 31, 1997 and 1996 are summarized as follows (dollars in thousands):
Underwriting results for the Company for the three months and years ended December 31, 1997 and 1996 are summarized in the following table (dollars in thousands):
CNA Surety primarily markets contract and commercial surety bonds. Contract bonds guarantee obligations covered by a written agreement between two parties. The most common types include bid, performance and payment bonds. 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 which cover losses arising from employee dishonesty, and E&O liability insurance.
Gross written premiums increased 17.4%, or $11.1 million, in the fourth quarter ended December 31, 1997 compared to the fourth quarter of 1996 and gross written premiums increased 6.0%, or $15.0 million, for the year ended December 31, 1997 compared to 1996. These increases were primarily attributable to $10.1 million of international surety and credit business assumed in the fourth quarter of 1997, as a result of the Company's initiative to more aggressively expand its products and services into the international markets. In 1997, CNA Surety expanded into the international surety and credit insurance market through a quota share reinsurance treaty with an affiliate of CCC, CNA Reinsurance Company Limited (London). Commercial surety, exclusive of international surety and credit business, was up 11.0% for the fourth quarter and 4.9% in 1997. The fidelity and other book of business, primarily written by Western Surety, increased 8.6% and 5.6% in the fourth quarter and year ended December 31, 1997, respectively. These increases in commercial surety and fidelity and other business were offset by a decrease in contract surety business of 7.8% in the fourth quarter and 1.2% for the full year ended December 31, 1997. The decreases in contract surety reflect the competitive pressures primarily in the medium to large contract segment of the market and to a lesser extent, the timing of the contractor accounts being awarded new business by their customers.
reinsurance premium from its reinsurers. Absent this returned premium, domestic commercial surety net written premiums were up 8.6% for the quarter and 7.0% for the year.
The loss ratio for the fourth quarter 1997 was 18.5% compared to 18.8% for the pro forma fourth quarter of 1996. The loss ratio included $0.6 million and $4.9 million in favorable reserve development for the three months ended December 31, 1997 and 1996, respectively.
The expense ratio decreased to 58.4% in the fourth quarter of 1997 compared to 66.2% in the pro forma fourth quarter of 1996. The decline in the Company's expense ratio for the quarter was largely due to the larger scale of the combined organization as net earned premiums advanced 9.3% for the quarter while total underwriting expenses decreased 3.6%. The $1.4 million decline in underwriting expenses on a pro forma basis for the quarter is not necessarily indicative of a trend management expects to continue near term.
The expense ratio for the year ended December 31, 1997 decreased to 61.9% from 63.0% for 1996. This decline was also primarily due to the increased scale of the Company as net earned premiums increased 2.1% and underwriting expenses increased only 0.3%.
Net investment income was $5.8 million for the fourth quarter of 1997 compared to $2.9 million for the pro forma fourth quarter of 1996. Pro forma net investment income for the years ended December 31, 1997 and 1996 was $14.5 million and $10.8 million, respectively. Increases in investment income for the quarter and in pro forma investment income for the year ended December 31, 1997 are the direct result of higher actual invested cash balances in the fourth quarter of 1997 which reflects the investment of merger-related cash flows. However, pro forma investment income for periods prior to the Merger do not include the pro forma effects of estimated net investment income resulting from investment of merger-related cash flows as described below. The average pretax yield was 5.7% for the three months ended December 31, 1997.
The above unaudited pro forma financial information does not include the estimated net investment income resulting from investment of merger-related cash flows, including (i) the $50 million debt proceeds, (ii) the $52.25 million capital contribution from CCC, and (iii) collection of the receivable from CCC. Investment earnings are an integral part of an insurance entity's operations. If proceeds from these sources of funds were assumed to be invested in high-quality, taxable fixed income securities with an average duration of approximately 3 years, yielding 6.4%, net investment income would increase approximately $11.3 million ($7.3 million net of tax, or $0.17 in pro forma earnings per share) for the year ended December 31, 1997, and approximately $3.8 million ($2.5 million net of tax, or $0.06 in pro forma earnings per share) and
Net realized investment gains were $0.1 million in the fourth quarter of 1997 and pro forma net realized investment gains were $0.7 million and $1.1 million for the years ended December 31, 1997 and 1996, respectively. Net realized investment gains on securities held at Capsure's parent company were $0.8 million for the year ended December 31, 1996.
Interest expense for the fourth quarter of 1997 increased 1.3% compared to pro forma fourth quarter 1996. While the average outstanding debt was down to $117.3 million in the fourth quarter of 1997, the weighted average interest rate was 5.9% compared to 5.6% in the fourth quarter of 1996. Pro forma interest expense decreased 5.6%, or $0.4 million, for the year ended December 31, 1997 compared to the prior year. This decrease was primarily due to lower average outstanding debt of $119.2 million in 1997 compared to $124.7 million in 1996. The weighted average interest rate for the year ended December 31, 1997 was 5.8% compared to 5.7% for the year ended December 31, 1996.
Capsure incurred $22.0 million, after applicable income taxes, or $0.51 per share, in merger costs in 1997 compared to $5.7 million, after applicable income taxes, or $0.13 per share in non-recurring charges and merger costs in 1996. In the fourth quarter of 1996, Capsure incurred $1.1 million, after applicable income taxes, or $0.03 per share, in non-recurring merger costs.
Income tax expense was $6.7 million for the quarter ended December 31, 1997. The effective income tax rate for the three months ended December 31, 1997 was 37.7%. Income taxes were $42.9 million and $14.1 million and the effective income tax rates were 55.5% and 38.6% for the years ended December 31, 1997 and 1996, respectively. The effective rate for the full year 1997 reflects the effects of limitations placed on the Company's ability to utilize Capsure's available NOLs to offset future taxable income.
The reorganization agreement provides for a mechanism, referred to as the "Lookback Adjustment", which may adjust the number of shares of CNA Surety common stock owned by CNAF operating companies in the event that either or both of Capsure's and the CCC Surety Operations' actual net written premiums for 1997 varied from certain targets. Application and interpretation of the provisions of the Lookback Adjustment are presently under review, the ultimate outcome of which is currently not known. Based on the facts currently available, the total number of shares of CNA Surety common stock will either not change or be reduced by approximately 2.5%. Such a change in total outstanding shares would have no effect on net income; however, earnings per share for the period from September 30, 1997 (date of inception) through December 31, 1997 would have increased from $0.25 to $0.26 and the ownership of the Company by CNAF operating companies would be reduced from 61.75% to 60.79%.
Combined gross written premiums in 1996 declined from the combined 1995 level by $8.6 million. This decrease was attributable in part to the continued program that commenced in 1995 to re-underwrite the CIC book of business on an account-by-account basis and remove business with unsatisfactory profit potential and risk. To a lesser extent, a portion of the decrease is believed to be due to considerable management attention focused on effecting and completing the integration of CIC and CCC. The decrease in gross written premiums in 1996 was 5.3%; this percentage decline was less than half of the 1995 percentage decrease.
(1) Does not include the effects of certain general and administrative expenses, which are indirect or overhead in nature, since such costs were not historically allocated to the CCC Surety Operations by CNAF or its subsidiaries. Accordingly, the comparability of this data to other data that include such costs is affected.
The loss ratio was 22.1% in 1996, compared to 24.8% in 1995. Prior to the CIC acquisition, the average loss ratio was approximately 17% for the past ten years and 19% for the past 15 years. This decrease in the loss ratio in 1996 compared to 1995 was attributable in part to the continued program that commenced in 1995 to re-underwrite the CIC book of business on an account-by-account basis and remove business with unsatisfactory profit potential and risk in addition to more disciplined underwriting practices the Company has adopted since the acquisition of CIC by CNAF in May of 1995. Also in 1996, large losses (individual claims which are in excess of $2.5 million, net of reinsurance) were $14.9 million in aggregate compared to $13.9 million in 1995. These large losses had the effect of increasing loss ratios for 1996 and 1995 by 10.0% and 10.6%, respectively.
It is anticipated that the liquidity requirements of CNA Surety will be met primarily by funds generated from operations. The principal operating cash flow sources are premiums, investment income, and sales and maturities of investments. CNA Surety also may generate funds from additional borrowings under the credit facility described below. The primary cash flow uses are payments for claims, operating expenses, debt service on the credit facility, as well as dividends, if any, to CNA Surety stockholders. In general, surety operations generate premium collections from customers in advance of cash outlays for claims. Premiums are invested until such time as funds are required to pay claims and claims adjusting expenses.
The Company's consolidated net cash flow provided by operating activities was $29.0 million for the three months ended December 31, 1997. Consolidated operating cash flow (pretax income excluding net investment gains and amortization of intangibles assets) for the three months ended December 31, 1997 was $19.0 million.
CNA Surety's bank borrowings are under a five-year unsecured revolving credit facility (the "Credit Facility") that provides for borrowings of $130 million. CNA Surety borrowed $105 million as of September 30, 1997 and used the proceeds to retire the existing Capsure debt of approximately $54 million and to make a $50 million capital contribution to Western Surety. On October 6, 1997, CNA Surety borrowed an additional $13 million to pay the $10.6 million closing dividend to Capsure stockholders and other merger-related costs.
The interest rate on borrowings under the Credit Facility may be fixed, at CNA Surety's option, for a period of one, two, three, or six months and is based on, among other rates, the London Interbank Offered Rate ("LIBOR"), plus the applicable margin. The margin, including the facility fee, varies based on CNA Surety's leverage ratio (debt to total capitalization) and ranges from 0.25% to 0.40%. As of December 31, 1997, the weighted average interest rate was 6.17% on the $118.0 million of outstanding borrowings.
The Credit Facility contains, among other conditions, limitations on CNA Surety with respect to the incurrence of additional indebtedness and requires the maintenance of certain financial ratios. As of December 31, 1997, the Company was in compliance with all restrictions and covenants contained in the Credit Facility agreement. The Credit Facility provides for the payment of all outstanding principal balances after five years with no required principal payments prior to such time. Principal prepayments, if any, and interest payments are expected to be funded primarily through dividends from CNA Surety's insurance subsidiaries.
As an insurance holding company, CNA Surety is dependent upon dividends and other permitted payments from its insurance subsidiaries to pay cash dividends, if any, as well as to pay operating expenses and meet debt service requirements. The payment of dividends by the insurance subsidiaries are subject to varying degrees of supervision by the insurance regulatory authorities in South Dakota and Texas. In South Dakota, where Western Surety and SBCA are domiciled, insurance companies may only pay dividends from earned surplus excluding surplus arising from unrealized capital gains or revaluation of assets. In Texas, where USA is domiciled, an insurance company may only declare or pay dividends to stockholders from the insurer's earned surplus. 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 and (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 and approved by the appropriate insurance department prior to payment.
The dividends that may be paid without prior regulatory approval are determined by formulas established by the applicable insurance regulations, as described above. The formulas that determine dividend capacity in the current year are dependent on, among other items, the prior year's ending statutory surplus and statutory net income. Accordingly, dividend capacity for 1998 does not fully reflect the effects of the Merger. Dividend capacity for 1998 is based on statutory surplus and income at and for the year ended December 31, 1997 which will only include the results of the CCC Surety Operations for the period from September 30, 1997 (date of inception) through December 31, 1997. Dividend capacity for 1999 will be based on statutory surplus and income at and for the year ended December 31, 1998 which will include the effects of the CCC Surety Operations for all of 1998. Without prior regulatory approval in 1998, CNA Surety's insurance subsidiaries may pay stockholder dividends of $16.3 million in the aggregate. In the fourth quarter of 1997, CNA Surety received $5.0 million in dividends from its insurance subsidiaries.
In accordance with the provisions of intercompany tax sharing agreements between CNA Surety and its subsidiaries, the tax of each subsidiary shall be determined based upon each subsidiary's separate return liability, as calculated in accordance with the Internal Revenue Code of 1986, as amended (the "Code"). Intercompany tax payments are made at such times as estimated tax payments would be required by the Internal Revenue Service ("IRS"). CNA Surety received tax sharing payments from its subsidiaries of $2.4 million in the period from September 30, 1997 through December 31, 1997.
The Company's policy is to primarily invest in fixed income securities with high quality credit ratings. As of December 31, 1997, approximately 47% of the investment portfolio was held in high-quality, short-duration mortgage pass-through instruments, collateralized mortgage obligations ("CMOs") and other asset-backed securities. CMOs differ from traditional fixed income securities in that they may expose the investor to yield variability and even principal risk due to such factors as high mortgage prepayment rates and defaults and delinquencies in the underlying asset pool. Management believes it has reduced prepayment variability by investing only in short tranches and by owning a substantial amount of planned amortization class ("PAC") tranches which have been structured largely to insulate the investor from prepayment risk. A PAC tranche is structured to amortize in a predictable manner and, therefore, the risk of prepayment of the underlying collateral is shifted to other tranches, whose owners are willing to accept such risk. Further, management believes it has minimized credit risk primarily by generally purchasing securities rated A or better on the date of acquisition and which are collateralized or guaranteed by U.S. Government agencies or have substantial credit enhancement in the form of financial guarantees, mortgage insurance, letters of credit, over- collateralization, subordinated structures and excess servicing spreads. Management monitors the investment portfolio of the insurance subsidiaries and the current rating of each security owned on a monthly basis.
The following table sets forth the ratings assigned by The Standard & Poors Corporation ("S&P") or Moody's Investor Services, Inc. ("Moody's") of the fixed income securities portfolio of the Company as of December 31, 1997 (dollars in thousands):
As of December 31, 1997, 100% of the Company's fixed income securities were considered investment grade by The Standard & Poors Corporation or Moody's Investor Services, Inc., and 87% were rated at least AA by those agencies. In addition, the Company's investments in fixed income securities did not contain any significant geographic or industry concentration of credit risk.
Based on the CCC Surety Operations' study of reserves, the CCC Surety Operations' management determined that it had been overly cautious in interpreting claim data and had discounted favorable trends. Consistent with the CCC Surety Operations' regular study of reserve levels, the CCC Surety Operations released $35.0 million of prior year reserves in 1997. Approximately $33 million of this reserve development related to CIC and principally to accident years prior to 1996.
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 on behalf of the company or regulators. As of December 31, 1997, each of CNA Surety's insurance subsidiaries had a Ratio that was in excess of the minimum RBC requirements.
CNA Surety's insurance subsidiaries require capital to support premium writings. In accordance with industry and regulatory guidelines, the net written premiums to surplus ratio of a property and casualty insurer should not exceed 3 to 1 (the terms of the Credit Facility also limit this ratio to 3 to 1 for Western Surety and USA). On December 31, 1997, the Company had a combined statutory surplus of $142.4 million. Western Surety's statutory surplus was $128.7 million and its net written premiums to surplus ratio was 1.8 to 1. USA's statutory surplus was $13.7 million and its net written premiums to surplus ratio was 1.6 to 1. The Company believes that each insurance company's statutory surplus is sufficient to support its current and anticipated premium levels.
Although the Company has not received any claims for coverage from its customers based on losses resulting from year 2000 issues, there can be no assurance that customers will not suffer losses of this type and seek compensation under the Company's bonds or policies. If any claims are made, coverage, if any will depend on the facts and circumstances of the claim and the provisions of the bond or policy. At this time, the Company is unable to determine whether the adverse impact, if any, in connection with the foregoing circumstances would be material to the Company.
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income," which establishes accounting standards for reporting and display of comprehensive income and its components (revenues, expenses, gains, and losses) in a full set of general-purpose financial statements. This Statement requires that an enterprise (a) classify items of other comprehensive income by their nature in a financial statement and (b) display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position. This Statement is effective for fiscal years beginning after December 15, 1997. This Statement is not expected to result in a significant change in CNA Surety's disclosures.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," which establishes accounting standards about the way public enterprises report information about operating segments in its annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas and major customers. SFAS No. 131 replaces SFAS No. 14, "Financial Reporting for Segments of a Business Enterprise." This statement is effective for fiscal years beginning after December 15, 1997. This statement is not expected to have a significant impact on CNA Surety's disclosures.
In December 1997, the American Institute of Certified Public Accountants' Accounting Executives Standards Committee issued Statement of Position ("SOP") 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments," which provides guidance on accounting by all entities that are subject to insurance-related assessments. It requires that entities should recognize liabilities for insurance-related assessments when all of the following criteria have been met: an assessment has been imposed or a probable assessment will be imposed; the event obligating an entity to pay an imposed or probable assessment has occurred on or before the date of the financial statements; and the amount of the assessment can be reasonably estimated. This SOP is effective for financial statements for fiscal years beginning after December 15, 1998. The Company does not expect the adoption of this SOP to have a material effect on the Company's results of operations.
"SAFE HARBOR" STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995: The statements which are not historical facts contained in this Form 10-K are forward-looking statements that involve risks and uncertainties, including, but not limited to, product and policy demand and market response risks, the effect of economic conditions, the impact of competitive products, policies and pricing, product and policy development, regulatory changes and conditions, rating agency policies and practices, development of claims and the effect on loss reserves, the performance of reinsurance companies under reinsurance contracts with the Company, investment portfolio developments and reaction to market conditions, the results of financing efforts, the actual closing of contemplated transactions and agreements, the effect of the Company's accounting policies, and other risks detailed in the Company's Securities and Exchange Commission filings. No assurance can be given that the actual results of operations and financial condition will conform to the forward-looking statements contained herein.