UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2011


o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission file number: 1-13277

CNA SURETY CORPORATION

(Exact name of Registrant as specified in its Charter)


DELAWARE (State or other jurisdiction of incorporation or organization)		36-4144905 (I.R.S. Employer Identification No.)

333 S. WABASH AVE., CHICAGO, ILLINOIS (Address of principal executive offices)		60604 (Zip Code)

(312) 822-5000
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No þ

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o

Accelerated filer þ

Non-accelerated filer o
(Do not check if a smaller reporting company)

Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes þ No

APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY
PROCEEDINGS DURING THE PRECEDING FIVE YEARS:

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. o Yes o No

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

44,973,466 shares of Common Stock, $.01 par value as of April 19, 2011.

CNA SURETY CORPORATION AND SUBSIDIARIES

INDEX


	Page
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements (Unaudited):
Condensed Consolidated Balance Sheets at March 31, 2011 and at December 31, 2010		3
Condensed Consolidated Statements of Income for the Three Months Ended March 31, 2011 and 2010		4
Condensed Consolidated Statements of Stockholders’ Equity for the Three Months Ended March 31, 2011 and 2010		5
Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2011 and 2010		6
Notes to Condensed Consolidated Financial Statements		7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		26
Item 3. Quantitative and Qualitative Disclosures About Market Risk		45
Item 4. Controls and Procedures		47
PART II. OTHER INFORMATION
Item 1. Legal Proceedings		48
Item 1A. Risk Factors		48
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		48
Item 3. Defaults Upon Senior Securities		48
Item 5. Other Information		48
Item 6. Exhibits		48
EX-31.(1)
EX-31.(2)
EX-32.(1)
EX-32.(2)

CNA SURETY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)


	March 31,			December 31,
	2011			2010
	(Amounts in thousands, except
	per share data)
Assets
Invested assets:
Fixed income securities, at fair value (amortized cost: $1,384,865 and $1,353,347)	$	1,429,734		$	1,404,375
Equity securities, at fair value (cost: $1,938 and $1,687)		2,178			1,916
Short-term investments, at amortized cost (approximates fair value)		44,386			53,089

Total invested assets		1,476,298			1,459,380
Cash		5,513			7,313
Deferred policy acquisition costs		101,365			98,572
Insurance receivables:
Premiums, including $8,917 and $10,840 from affiliates, (net of allowance for doubtful accounts: $1,230 and $1,410)		41,472			33,378
Reinsurance		42,945			41,453
Deposit with affiliated ceding company		17,391			23,446
Goodwill and other intangible assets (net of accumulated amortization: $25,523 and $25,523)		138,785			138,785
Property and equipment, at cost (less accumulated depreciation and amortization: $39,245 and $38,931)		14,367			15,645
Prepaid reinsurance premiums		151			164
Accrued investment income		16,803			17,307
Other assets, including $162 and $0 from affiliates		2,545			2,291

Total assets	$	1,857,635		$	1,837,734


Liabilities
Reserves:
Unpaid losses and loss adjustment expenses	$	401,103		$	389,089
Unearned premiums		253,946			245,986

Total reserves		655,049			635,075
Long-term debt		30,930			30,930
Deferred income taxes, net		27,489			29,098
Reinsurance and other payables to affiliates		141			177
Accrued expenses		13,475			21,726
Liability for postretirement benefits		12,577			12,330
Income tax payable		6,820			13,775
Other liabilities		23,079			25,890

Total liabilities		769,560			769,001
Commitments and contingencies (See Notes 3, 5, 6 & 8)

Stockholders’ Equity
Common stock, par value $.01 per share, 100,000 shares authorized; 46,327 shares issued and 44,970 shares outstanding at March 31, 2011 and 46,104 shares issued and 44,748 shares outstanding at December 31, 2010		463			461
Additional paid-in capital		291,050			288,471
Retained earnings		782,682			761,925
Accumulated other comprehensive income		28,440			32,436
Treasury stock, 1,357 and 1,356 shares, at cost		(14,560	)		(14,560	)

Total stockholders’ equity		1,088,075			1,068,733

Total liabilities and stockholders’ equity	$	1,857,635		$	1,837,734

The accompanying notes are an integral part of these condensed consolidated financial statements.

CNA SURETY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(UNAUDITED)


	Three Months Ended
	March 31,
	2011		2010
	(Amounts in thousands, except
	per share data)
Revenues:
Net earned premium	$	96,658	$	98,252
Net investment income		14,435		13,377
Net realized investment gains (losses):
Other-than-temporary impairment losses		—		—
Portion of other-than-temporary impairment losses recognized in other comprehensive income (before taxes)		—		(94	)

Net impairment losses recognized in earnings		—		(94	)
Net realized investment gains, excluding impairment losses		313		417

Total net realized investment gains		313		323

Total revenues		111,406		111,952


Expenses:
Net losses and loss adjustment expenses		28,031		28,581
Net commissions, brokerage and other underwriting expenses		52,266		52,788
Interest expense		284		281
Other expense		2,027		—

Total expenses		82,608		81,650

Income before income taxes		28,798		30,302
Income tax expense		8,041		9,497

Net income	$	20,757	$	20,805


Earnings per common share	$	0.46	$	0.47

Earnings per common share, assuming dilution	$	0.46	$	0.47

Weighted average shares outstanding		44,810		44,280

Weighted average shares outstanding, assuming dilution		45,157		44,421

The accompanying notes are an integral part of these condensed consolidated financial statements.

CNA SURETY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(UNAUDITED)


	Common											Accumulated
	Stock				Additional							Other			Treasury			Total
	Shares		Common		Paid-in		Comprehensive			Retained		Comprehensive			Stock			Stockholders’
	Outstanding		Stock		Capital		Income			Earnings		Income (Loss)			At Cost			Equity
	(Amounts in thousands)
Balance, January 1, 2010		44,268	$	456	$	279,388				$	627,505	$	30,406		$	(14,671	)	$	923,084

Comprehensive income:
Net income		—	$	—	$	—	$	20,805		$	20,805	$	—		$	—		$	20,805
Other comprehensive income:
Change in unrealized gains on securities, after income tax expense of $865 (net of reclassification adjustment of $228, after income tax expense of $123)		—		—		—		1,607			—		1,607			—			1,607
Other-than-temporary impairment losses not recognized in the Condensed Consolidated Statements of Income, after income tax expense of $41 (net of reclassification adjustment of ($353), after income tax benefit of $190)		—		—		—		77			—		77			—			77
Net change related to postretirement benefits, after income tax benefit of $9		—		—		—		(18	)		—		(18	)		—			(18	)

Total comprehensive income		—		—		—	$	22,471			—		—			—			—

Stock-based compensation		—		—		441					—		—			—			441
Stock options exercised and other		30		1		297					—		—			65			363

Balance, March 31, 2010		44,298	$	457	$	280,126				$	648,310	$	32,072		$	(14,606	)	$	946,359


Balance, January 1, 2011		44,748	$	461	$	288,471				$	761,925	$	32,436		$	(14,560	)	$	1,068,733

Comprehensive income:
Net income		—	$	—	$	—	$	20,757		$	20,757	$	—		$	—		$	20,757
Other comprehensive income:
Change in unrealized gains on securities, after income tax benefit of $2,154 (net of reclassification adjustment of $140, after income tax expense of $76)		—		—		—		(4,000	)		—		(4,000	)		—			(4,000	)
Other-than-temporary impairment losses not recognized in the Condensed Consolidated Statements of Income, after income tax expense of $2		—		—		—		4			—		4			—			4

Total comprehensive income		—		—		—	$	16,761			—		—			—			—

Stock-based compensation		105		1		567					—		—			—			568
Stock options exercised and other		117		1		2,012					—		—			—			2,013

Balance, March 31, 2011		44,970	$	463	$	291,050				$	782,682	$	28,440		$	(14,560	)	$	1,088,075

The accompanying notes are an integral part of these condensed consolidated financial statements.

CNA SURETY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)


	Three Months Ended
	March 31,
	2011			2010
	(Amounts in thousands)
Cash Flows from Operating Activities:
Net income	$	20,757		$	20,805
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for doubtful accounts		(21	)		95
Depreciation and amortization		1,551			1,476
Amortization of bond premium, net		1,709			1,492
Loss on disposal or impairment of property and equipment		(12	)		(49	)
Net realized investment gains		(313	)		(323	)
Stock-based compensation		567			441
Deferred income tax expense		242			661
Changes in:
Insurance receivables		(9,565	)		(10,291	)
Reserve for unearned premiums		7,960			8,395
Reserve for unpaid losses and loss adjustment expenses		12,014			20,335
Deposit with affiliated ceding company		6,055			(26	)
Deferred policy acquisition costs		(2,793	)		(2,824	)
Reinsurance and other payables to affiliates		(36	)		128
Prepaid reinsurance premiums		13			13
Accrued expenses		(8,251	)		(6,417	)
Other assets and liabilities		(8,966	)		(7,599	)

Net cash provided by operating activities		20,911			26,312


Cash Flows from Investing Activities:
Fixed income securities:
Purchases		(65,168	)		(63,950	)
Maturities		26,749			14,834
Sales		5,471			8,422
Purchases of equity securities		(719	)		(274	)
Proceeds from the sale of equity securities		490			65
Changes in short-term investments		8,714			9,036
Purchases of property and equipment, net		(262	)		(682	)
Changes in payables for securities purchased		—			2,070

Net cash (used in) investing activities		(24,725	)		(30,479	)


Cash Flows from Financing Activities:
Employee stock option exercises and other		2,014			363

Net cash provided by financing activities		2,014			363


(Decrease) in cash		(1,800	)		(3,804	)
Cash at beginning of period		7,313			5,822

Cash at end of period	$	5,513		$	2,018


Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest	$	289		$	288
Income taxes	$	14,437		$	14,404

The accompanying notes are an integral part of these condensed consolidated financial statements.

CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2011
(UNAUDITED)

1. General

Formation of CNA Surety Corporation

In December 1996, CNA Financial Corporation (“CNAF”) and Capsure Holdings Corp. (“Capsure”) agreed to merge (the “Merger”) the surety business of CNAF with Capsure’s insurance subsidiaries, Western Surety Company (“Western Surety”), Surety Bonding Company of America (“Surety Bonding”) and Universal Surety of America (“Universal Surety”), into CNA Surety Corporation (“CNA Surety” or the “Company”). CNAF, through its operating subsidiaries, writes multiple lines of property and casualty insurance, including surety business that is reinsured by Western Surety. The principal operating subsidiaries of CNAF that wrote the surety line of business for their own account prior to the Merger were Continental Casualty Company and its property and casualty affiliates (collectively, “CCC”) and The Continental Insurance Company and its property and casualty affiliates (collectively, “CIC”). Through its insurance subsidiaries, CNAF owns approximately 61% of the outstanding common stock of CNA Surety. Loews Corporation owns approximately 90% of the outstanding common stock of CNAF.

CNAF Proposal

In October 2010, the Company received an unsolicited proposal from CNAF to acquire all of the outstanding shares of common stock that are not currently owned by subsidiaries of CNAF at a purchase price of $22.00 per share in cash (the “CNAF Proposal”). The Company’s Board of Directors appointed a special committee (the “Special Committee”), comprised solely of the Company’s three independent directors, to review and evaluate the CNAF Proposal. The Special Committee retained both legal and financial advisors to assist in their consideration of the CNAF Proposal. The Company incurred expenses of $2.0 million in the first quarter of 2011 and $1.5 million in the fourth quarter of 2010 directly related to the consideration of the proposal. These expenses are shown as “Other expense” in the Condensed Consolidated Statements of Income.

Subsequent Event — Merger Agreement and Tender Offer

On April 21, 2011, the Company and CNAF announced that they had signed a definitive merger agreement pursuant to which CNAF will commence a tender offer to acquire all of the outstanding shares of common stock of CNA Surety not currently owned by subsidiaries of CNAF for $26.55 per share in cash.

The transaction has been approved by the Board of Directors of CNA Surety, following the recommendation and approval of the Special Committee. The tender offer will be conditioned upon, among other things, acceptance by the holders of a majority of the publicly held shares of CNA Surety. Subject to the satisfaction of the foregoing, it is currently anticipated that the transaction will be completed by the end of the second quarter.

Principles of Consolidation

The Condensed Consolidated Financial Statements include the accounts of CNA Surety and all majority-owned subsidiaries.

Estimates

The preparation of financial statements in conformity with generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Basis of Presentation

These unaudited Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in the Company’s 2010 Form 10-K. Certain financial information that is included in annual financial statements prepared in accordance with GAAP is not required for interim reporting and has been condensed or omitted. The accompanying unaudited Condensed Consolidated Financial Statements reflect, in the opinion of management, all adjustments necessary for a fair presentation of the interim financial statements. All such adjustments are of a normal and recurring nature. The financial results for interim periods may not be indicative of financial results for a full year.

Earnings Per Share

Basic earnings per common share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. For the purpose of calculating basic earnings per share, restricted stock shares granted under the Company’s stock-based compensation plan that have not yet vested are excluded from common shares outstanding. Diluted earnings per common share is computed based on the weighted average number of shares outstanding plus the dilutive effect of common stock equivalents, which includes restricted stock shares, computed using the treasury stock method.

The computation of earnings per common share is as follows (amounts in thousands, except for per share data):


	Three Months Ended
	March 31,
	2011		2010
Net income	$	20,757	$	20,805

Shares:
Weighted average shares outstanding		44,748		44,268
Weighted average shares of options exercised and additional stock issuance		62		12

Total weighted average shares outstanding		44,810		44,280
Effect of dilutive securities:
Common stock options		271		128
Restricted common stock awards		65		—
Other		11		13

Total effect of dilutive securities		347		141

Total weighted average shares outstanding, assuming dilution		45,157		44,421

Earnings per share	$	0.46	$	0.47

Earnings per share, assuming dilution	$	0.46	$	0.47

No adjustments were made to reported net income in the computation of earnings per share. No options to purchase shares of common stock were excluded from the calculation of diluted earnings per share for the three months ended March 31, 2011. At March 31, 2010, 0.7 million options to purchase shares of common stock were excluded from the calculation of diluted earnings per share because the exercise price of the options was greater than the average market price of CNA Surety’s common stock.

Adopted Accounting Pronouncements

In December 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“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 clarified 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 was effective for fiscal years beginning after December 15, 2010. The adoption of this guidance did not have an impact on the Company’s financial condition or results of operations.

Pending Accounting Pronouncements

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 fiscal years, beginning after December 15, 2011 with prospective or retrospective application allowed. The Company is currently assessing the available application methods as well as the impact this accounting guidance will have on its financial condition and results of operations.

2. Investments

Major categories of net investment income were as follows (dollars in thousands):


	Three Months Ended
	March 31,
	2011		2010
Investment income:
Fixed income securities	$	14,750	$	13,666
Equity securities		9		8
Short-term investments		18		15
Other		10		13

Total investment income on available-for-sale securities		14,787		13,702
Investment income on deposit with affiliated ceding company		23		26
Investment expenses		375		351

Net investment income	$	14,435	$	13,377

The Company did not hold any non-income producing fixed income securities as of March 31, 2011 or December 31, 2010.

Net realized investment gains and losses and the net change in unrealized gains and losses of available-for-sale securities were as follows (dollars in thousands):


	Three Months Ended
	March 31,
	2011			2010
Net realized investment gains (losses):
Fixed income securities:
Gross realized investment gains	$	295		$	425
Gross realized investment losses:
Other-than-temporary impairment losses		—			(94	)
Realized losses from sales		(4	)		(19	)

Total gross realized investment losses		(4	)		(113	)

Net realized investment gains on fixed income securities		291			312


Equity securities:
Gross realized investment gains		22			11
Gross realized investment losses:
Other-than-temporary impairment losses		—			—
Realized losses from sales		—			—

Total gross realized investment losses		—			—

Net realized investment gains on equity securities		22			11


Net realized investment gains	$	313		$	323

Net change in unrealized gains (losses)
Fixed income securities	$	(6,159	)	$	2,569
Equity securities		11			21

Total net change in unrealized gains (losses)	$	(6,148	)	$	2,590


Net realized gains and change in unrealized gains (losses)	$	(5,835	)	$	2,913

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 and equity securities as available-for-sale, and as such, they are carried at fair value.

The amortized cost, gross unrealized gains, gross unrealized losses, estimated fair value and unrealized other-than-temporary (“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 March 31, 2011, by investment category, were as follows (dollars in thousands):


			Gross		Gross Unrealized Losses
	Amortized Cost		Unrealized		Less Than			More Than			Estimated		Unrealized
March 31, 2011	or Cost		Gains		12 Months			12 Months			Fair Value		OTTI Losses
Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government and agencies:
U.S. Treasury	$	17,289	$	775	$	—		$	—		$	18,064	$	—
U.S. Agencies		5,515		204		—			—			5,719		—
Collateralized mortgage obligations — residential		18,711		1,510		—			—			20,221		—
Mortgage pass-through securities — residential		63,956		2,854		—			—			66,810		—
Obligations of states and political subdivisions		742,575		29,256		(6,130	)		(2,083	)		763,618		—
Corporate bonds		494,708		19,459		(1,806	)		—			512,361		—
Collateralized mortgage obligations — commercial		10,016		581		—			—			10,597		—
Other asset-backed securities:
Second mortgages/home equity loans — residential		1,931		—		—			(267	)		1,664		(873	)^(a)
Consumer credit receivables		10,000		36		—			—			10,036		—
Other		20,164		523		(43	)		—			20,644		—

Total fixed income securities		1,384,865		55,198		(7,979	)		(2,350	)		1,429,734	$	(873	)

Equity securities		1,938		240		—			—			2,178

Total	$	1,386,803	$	55,438	$	(7,979	)	$	(2,350	)	$	1,431,912


^(a)		The unrealized loss position of this security was $0.3 million at March 31, 2011.

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):


			Gross		Gross Unrealized Losses
	Amortized Cost		Unrealized		Less Than			More Than			Estimated		Unrealized
December 31, 2010	or Cost		Gains		12 Months			12 Months			Fair Value		OTTI Losses
Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government and agencies:
U.S. Treasury	$	17,288	$	914	$	—		$	—		$	18,202	$	—
U.S. Agencies		6,518		250		—			—			6,768		—
Collateralized mortgage obligations — residential		20,769		1,558		—			—			22,327		—
Mortgage pass-through securities — residential		68,727		3,320		—			—			72,047		—
Obligations of states and political subdivisions		746,514		30,932		(5,096	)		(1,742	)		770,608		—
Corporate bonds		456,963		21,164		(1,249	)		(5	)		476,873		—
Collateralized mortgage obligations — commercial		10,018		567		—			—			10,585		—
Other asset-backed securities:
Second mortgages/home equity loans — residential		3,878		—		(84	)		(272	)		3,522		(927	)^(a)
Consumer credit receivables		9,998		158		—			—			10,156		—
Other		12,674		617		(4	)		—			13,287		—

Total fixed income securities		1,353,347		59,480		(6,433	)		(2,019	)		1,404,375	$	(927	)

Equity securities		1,687		229		—			—			1,916

Total	$	1,355,034	$	59,709	$	(6,433	)	$	(2,019	)	$	1,406,291


^(a)		The unrealized loss position of this security was $0.3 million at December 31, 2010.

As of March 31, 2011 and December 31, 2010, 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.

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.

When a security is placed on the watch list, it is monitored for further market value changes and additional news related to the issuer’s financial condition. The focus is on objective evidence that may influence the evaluation of impairment factors. The decision to record an other-than-temporary impairment loss incorporates both quantitative criteria and qualitative information.

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 Condensed Consolidated Statements of Income.

Based on the Company’s evaluation of this quantitative criteria and qualitative information, the Company recorded no OTTI losses on equity securities for the three months ended March 31, 2011 and 2010, respectively.

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 Condensed Consolidated Statements of Income.

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.

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.

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.

Based on the Company’s evaluation of this quantitative criteria and qualitative information, the Company did not record credit-related OTTI losses on fixed income securities during the three months ended March 31, 2011. During the three months ended March 31, 2010, the Company recorded credit-related OTTI losses of $0.1 million on a security collateralized by sub-prime home loans and rated below investment grade by Standard & Poor’s (“S&P”). The Company initially recorded credit-related OTTI losses on this security in the second quarter of 2009.

The following table presents a roll-forward of the Company’s cumulative credit losses recognized in net realized gains/ losses on the Condensed Consolidated Statements of Income on fixed income securities held as of March 31, 2011 and 2010, respectively (in thousands of dollars):


	Three Months Ended March 31,
	2011		2010
Beginning balance	$	238	$	116
Credit losses for which an OTTI loss was not previously recognized		—		—
Credit losses for which an OTTI loss was previously recognized		—		94

Ending balance	$	238	$	210

The amortized cost and estimated fair value of fixed income securities, by contractual maturity, at March 31, 2011 and December 31, 2010 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):


	March 31, 2011				December 31, 2010
	Amortized		Estimated Fair		Amortized		Estimated Fair
	Cost		Value		Cost		Value
Fixed income securities:
Due within one year	$	43,703	$	44,313	$	39,649	$	40,035
Due after one year but within five years		418,872		437,713		422,319		441,895
Due after five years but within ten years		529,294		552,111		480,548		507,793
Due after ten years		268,218		265,625		284,767		282,728

		1,260,087		1,299,762		1,227,283		1,272,451
Mortgage pass-through securities, collateralized mortgage obligations and asset-backed securities		124,778		129,972		126,064		131,924

	$	1,384,865	$	1,429,734	$	1,353,347	$	1,404,375

The following table provides the composition of fixed income securities with an unrealized loss at March 31, 2011 in relation to the total of all fixed income securities in an unrealized loss position by contractual maturities:


	% of
	Estimated			% of
	Fair			Unrealized
Contractual Maturity	Value			Loss
Due after one year through five years		16	%		6	%
Due after five years through ten years		37			24
Due after ten years		43			67
Asset-backed securities		4			3

Total		100	%		100	%

The following table summarizes for fixed income securities in an unrealized loss position at March 31, 2011 and December 31, 2010, 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):


	March 31, 2011				December 31, 2010
			Gross				Gross
	Estimated		Unrealized		Estimated		Unrealized
Unrealized Loss Aging	Fair Value		Loss		Fair Value		Loss
Fixed income securities:
Investment grade ^(a):
0-6 months	$	281,785	$	7,945	$	223,778	$	6,350
Greater than 24 months		4,785		760		7,903		663

Total investment grade		286,570		8,705		231,681		7,013
Non-investment grade:
0-6 months		6,208		25		11,256		83
7-12 months		1,532		9		—		—
Greater than 24 months		11,168		1,590		11,522		1,356

Total non-investment grade		18,908		1,624		22,778		1,439

Total	$	305,478	$	10,329	$	254,459	$	8,452


^(a)		Investment grade is determined by using the S&P rating. If a security is not rated by S&P, the Moody’s Investor Services (“Moody’s”) rating is used. As of March 31, 2011 and December 31, 2010, all of the Company’s fixed income securities were rated by S&P or Moody’s.

At March 31, 2011, the Company holds 275 fixed income securities in an unrealized gain position with a total estimated fair value of $1,124.3 million in a gross unrealized gain position of $55.2 million in the aggregate.

The following table summarizes securities in a gross unrealized loss position by investment category and by credit rating. The table also discloses the corresponding count of securities in an unrealized loss position and estimated fair value by category (in thousands of dollars):


	Gross Unrealized Losses												Estimated
March 31, 2011	AAA		AA		A		BBB		Total		Count		Fair Value
Fixed income securities:
Investment grade^(a):
Obligations of states and political subdivisions	$	577	$	4,170	$	2,143	$	—	$	6,890		34	$	173,884
Corporate bonds		—		39		1,405		328		1,772		22		102,232
Other asset-backed securities:
Other		43		—		—		—		43		2		10,454

Total investment grade		620		4,209		3,548		328		8,705		58		286,570
Non-investment grade:
Obligations of states and political subdivisions		—		—		—		—		1,323		1		9,504
Corporate bonds		—		—		—		—		34		5		7,740
Other asset-backed securities:
Second mortgages/home equity loans — residential		—		—		—		—		267		1		1,664

Total non-investment grade		—		—		—		—		1,624		7		18,908

Total	$	620	$	4,209	$	3,548	$	328	$	10,329		65	$	305,478


^(a)		Securities are categorized using the S&P rating. If a security is not rated by S&P, the Moody’s rating is used. At March 31, 2011, all of the Company’s fixed income securities were rated by S&P or Moody’s.

While the overall unrealized loss position of obligations of states and political subdivisions grew from $5.8 million, or 3.4% of their amortized cost, at December 31, 2010 to $6.9 million, or 3.8% of their amortized cost at March 31, 2011, the Company continues to believe that all interest and principal will be paid according to their contractual terms. In addition to credit reviews, each municipal bond investment is reviewed as to the sources of debt service and the margins of safety around those sources. The Company’s municipal bond investments are focused in revenue bonds and full-faith-and-credit general obligation bonds. For revenue bonds, the focus is on bonds where the sources of debt service are from fees from public universities, transportation, such as toll ways and airports, and essential services, such as power, water and sewer. The Company focuses on bonds where there is a monopoly provider with ratemaking authority and where there are specific taxes pledged directly to bond repayments. 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 March 31, 2011.

Of the Company’s twenty-two investment grade corporate bond investments in an unrealized loss position at March 31, 2011, the largest unrealized loss was $0.3 million, or 4.8% of the amortized cost of a security issued by a public utility. Only one of these corporate bond investments was in an unrealized loss position that exceeded 5% of the security’s amortized cost. This security, also issued by a public utility, had an unrealized loss of $0.2 million, or 5.4% of the security’s amortized cost. Interest rate increases in the first quarter of 2011 caused the overall unrealized loss position on the Company’s investment grade corporate bond holdings to increase by $0.6 million at March 31, 2011 compared to December 31, 2010. 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 March 31, 2011.

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 March 31, 2011.

Only one of the Company’s investments in obligations of states and political subdivisions was rated below investment grade and was in an unrealized loss position at March 31, 2011. This security, issued by a governmental utility authority, was in an unrealized loss position of $1.3 million, or 12.2% of its amortized cost, at March 31, 2011. The Company believes that this security is rated below investment grade because an inconsequential contingency amount is insured with one of the major monoline insurers which is rated B by S&P. The Company believes that this insurer is the lowest rated source of security involved in the transaction and, despite the fact that the amount of security provided by this insurer is inconsequential, the entire transaction is rated to the lowest rated component. Based on the Company’s analysis of the sources of debt service on this bond and the fact that the security is current on all interest payments due through March 31, 2011, the Company continues to believe that all interest and principal will be paid according to their contractual terms. The Company has no current intent to sell this security, 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 loss on this security is indicative of credit loss and, as such, has not recorded an OTTI loss on this security at March 31, 2011.

During 2010, the Company began a program to invest a modest amount in non-investment grade corporate bonds due to the relative attractiveness of this sector. Five of the securities purchased under this program were in an unrealized loss position at March 31, 2011. In the aggregate, these five securities had an unrealized loss of less than $0.1 million as of March 31, 2011. Each of these securities was in an unrealized loss position representing 0.6% or less of that 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 an OTTI loss on these securities at March 31, 2011.

At March 31, 2011 the Company’s exposure to sub-prime home loans was limited to one asset-backed security collateralized by sub-prime home loans which originated prior to 2005. The estimated fair value of this non-investment grade security was $1.7 million at March 31, 2011. This security was in an unrealized loss position of $0.3 million, or 13.8% of its amortized cost at March 31, 2011. During 2011, the Company received repayments on this security of $0.1 million, or approximately 5% of the par value outstanding at December 31, 2010. As discussed previously, the Company previously recorded credit-related OTTI losses on this security, however, the Company determined that there were no additional credit losses during the first quarter of 2011. The Company believes the non-credit component of the unrealized loss on this security is primarily attributable to this asset class being out of favor with investors and is not indicative of the quality of the underlying collateral. The Company has no current intent to sell this security, nor is it more likely than not that it will be required to sell prior to recovery of the adjusted amortized cost.

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 March 31, 2011.

3. Reinsurance

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.

There were no amounts past due under reinsurance contracts and no allowances were established for uncollectible reinsurance receivables at March 31, 2011 or December 31, 2010.

The effect of reinsurance on the Company’s written and earned premium was as follows (dollars in thousands):


	Three Months Ended March 31,
	2011						2010
	Written			Earned			Written			Earned
Direct	$	88,882		$	80,602		$	91,963		$	81,879
Assumed		21,209			21,529			20,564			22,253
Ceded		(5,461	)		(5,473	)		(5,867	)		(5,880	)

Net premiums	$	104,630		$	96,658		$	106,660		$	98,252

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, 2011 through December 31, 2011 that covers certain contract surety business, FICOH retains losses of $2 million per principal and Western Surety assumes 80% of $5 million per principal in excess of $2 million subject to an aggregate annual limit of $8 million. Premiums assumed by Western Surety under this agreement were less than $0.1 million for both the three months ended March 31, 2011 and 2010.

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 three month periods ended March 31, 2011 and 2010, assumed premiums written under such arrangements were $1.1 million and $1.3 million, 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):


	Three Months Ended March 31,
	2011						2010
	$			Ratio			$		Ratio
Gross losses and loss adjustment expenses	$	29,618			29.0	%	$	27,815		26.7	%
Ceded amounts		(1,587	)		29.0	%		766		(13.0	)%

Net losses and loss adjustment expenses	$	28,031			29.0	%	$	28,581		29.1	%

The unusual impact of ceded amounts as an increase in net loss and loss adjustment expenses for the three months ended March 31, 2010 resulted from large indemnification recoveries on claims subject to excess of loss reinsurance contracts.

Excess of Loss Reinsurance

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.

2010 Third Party Reinsurance

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 excess of loss treaty effective in 2009. 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.

2011 Third Party Reinsurance

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.

Related Party Reinsurance

Reinsurance agreements together with the Services and Indemnity Agreement described below provide for the transfer of the surety business written by CCC and CIC to Western Surety. Agreements originally entered into on September 30, 1997 (the “Merger Date”) include: (i) the Surety Quota Share Treaty (the “Quota Share Treaty”) and (ii) the Aggregate Stop Loss Reinsurance Contract (the “Stop Loss Contract”). Although the contracts entered on the Merger Date have expired, some have been renewed on different terms as described below.

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, 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, this resulted in an override commission on their actual direct acquisition costs of 4.7% 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 March 31, 2011.

applicable Loss Ratio Cap, multiplied by (ii) the applicable net earned premiums. In consideration for the coverage provided by the Stop Loss Contract, the Company’s insurance subsidiaries paid CCC an annual premium of $20,000. The CNA Surety insurance subsidiaries have paid CCC all required annual premiums. Through March 31, 2011 and December 31, 2010, losses incurred under the Stop Loss Contract were $47.2 million. At March 31, 2011, the amount received under the Stop Loss Contract included $2.8 million held by the Company for losses covered under this contract that were incurred but not paid.

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 on January 1, 2011 and expires on December 31, 2011 and is annually renewable thereafter. As of March 31, 2011, there were no amounts due to the CNA Surety insurance subsidiaries under this agreement.

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. This agreement was renewed on January 1, 2011 and expires on December 31, 2011 and is annually renewable thereafter.

As of March 31, 2011 and December 31, 2010, CNA Surety had an insurance receivable balance from CCC and CIC of $8.9 million and $10.8 million, respectively, comprised of premiums receivable. At March 31, 2011 and December 31, 2010, CNA Surety had no reinsurance receivable from affiliates. CNA Surety had no reinsurance payables to CCC or CIC as of March 31, 2011 or December 31, 2010.

The Company’s Condensed Consolidated Balance Sheets also include a “Deposit with affiliated ceding company” of $17.4 million and $23.4 million at March 31, 2011 and December 31, 2010, 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.

4. Fair Value of Financial Instruments

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Company uses the following fair value hierarchy in selecting inputs, with the highest priority given to Level 1, as these are the most transparent or reliable:

	•		Level 1 — Quoted prices for identical instruments in active markets.

	•		Level 2 — Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs are observable in active markets.

	•		Level 3 — Valuations derived from valuation techniques in which one or more significant inputs are unobservable.

The Company utilizes a pricing service for the valuation of the majority of securities held. This pricing service is an independent, third party vendor recognized to be an industry leader with access to market information who obtains or computes fair market values from quoted market prices, pricing for similar securities, recently executed transactions, cash flow

models with yield curves and other pricing models. For valuations obtained from the pricing service, the Company performs due diligence to understand how the valuation was calculated or derived, focusing on the valuation technique used and the nature of the inputs.

The following section describes the valuation methodologies used to measure different financial instruments at fair value, including an indication of the level in the fair value hierarchy in which the instrument is generally classified.

Fixed Income Securities

Securities valued using Level 1 inputs include highly liquid government bonds for which quoted market prices are available. Securities using Level 2 inputs are valued using pricing for similar securities, recently executed transactions, cash flow models with yield curves and other pricing models utilizing observable inputs. Most fixed income securities are valued using Level 2 inputs. Level 2 includes corporate bonds, municipal bonds, asset-backed securities and mortgage pass-through securities.

Equity Securities

Level 1 includes publicly traded securities valued using quoted market prices.

Short-Term Investments

The valuation of securities that are actively traded and have quoted prices are classified as Level 1. These securities include money market funds and U.S. Treasury bills. Level 2 includes commercial paper, for which all significant inputs are observable.

Assets measured at fair value on a recurring basis as of March 31, 2011 and December 31, 2010 are summarized below (amounts in thousands):


	March 31, 2011
	Fair Value Measurement Using						Assets at Fair
	Level 1		Level 2		Level 3		Value

Assets:
Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government and agencies:
U.S. Treasury	$	18,064	$	—	$	—	$	18,064
U.S. Agencies		—		5,719		—		5,719
Collateralized mortgage obligations — residential		—		20,221		—		20,221
Mortgage pass-through securities — residential		—		66,810		—		66,810
Obligations of states and political subdivisions		—		763,618		—		763,618
Corporate bonds		—		512,361		—		512,361
Collateralized mortgage obligations — commercial		—		10,597		—		10,597
Other asset-backed securities:
Second mortgages/home equity loans — residential		—		1,664		—		1,664
Consumer credit receivables		—		10,036		—		10,036
Other		—		20,644		—		20,644

Total fixed income securities		18,064		1,411,670		—		1,429,734
Equity securities at fair value		2,178		—		—		2,178
Short-term investments at fair value ^(a)		24,397		19,989		—		44,386

Total assets	$	44,639	$	1,431,659	$	—	$	1,476,298


^(a)		Includes commercial paper, U.S. Government agency discount notes and money market funds.


	December 31, 2010
	Fair Value Measurement Using						Assets at Fair
	Level 1		Level 2		Level 3		Value

Assets:
Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government and agencies:
U.S. Treasury	$	18,202	$	—	$	—	$	18,202
U.S. Agencies		—		6,768		—		6,768
Collateralized mortgage obligations — residential		—		22,327		—		22,327
Mortgage pass-through securities — residential		—		72,047		—		72,047
Obligations of states and political subdivisions		—		770,608		—		770,608
Corporate bonds		—		476,873		—		476,873
Collateralized mortgage obligations — commercial		—		10,585		—		10,585
Other asset-backed securities:
Second mortgages/home equity loans — residential		—		3,522		—		3,522
Consumer credit receivables		—		10,156		—		10,156
Other		—		13,287		—		13,287

Total fixed income securities		18,202		1,386,173		—		1,404,375
Equity securities at fair value		1,916		—		—		1,916
Short-term investments at fair value ^(a)		16,842		36,247		—		53,089

Total assets	$	36,960	$	1,422,420	$	—	$	1,459,380


^(a)		Includes commercial paper, U.S. Government agency discount notes and money market funds.

5. Reserves for Losses and Loss Adjustment Expenses

Activity in the reserves for unpaid losses and loss adjustment expenses was as follows (dollars in thousands):


	Three Months Ended
	March 31,
	2011		2010
Reserves at beginning of period:
Gross	$	389,089	$	406,123
Ceded reinsurance		43,007		50,968

Net reserves at beginning of period		346,082		355,155

Net incurred loss and loss adjustment expenses:
Provision for insured events of current year		28,031		28,581
Increase (decrease) in provision for insured events of prior years		—		—

Total net incurred		28,031		28,581

Net payments attributable to:
Current year events		778		690
Prior year events		16,568		8,092

Total net payments		17,346		8,782

Foreign currency transaction adjustments		98		74

Net reserves at end of period		356,865		375,028
Ceded reinsurance at end of period		44,238		51,430

Gross reserves at end of period	$	401,103	$	426,458

6. Debt

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. As of May 2009, the Company may redeem these securities, in whole or in part, at par value at any scheduled quarterly interest payment date. As of March 31, 2011, none of these preferred securities have been redeemed.

The Company’s investment of $0.9 million in the Issuer Trust is carried at cost in “Other assets” in the Company’s Condensed Consolidated Balance Sheets. The sole asset of the Issuer Trust consists of a $30.9 million junior subordinated debenture issued by the Company to the Issuer Trust. Due to the underlying characteristics of this debt, the carrying value of the debenture approximates its estimated fair value.

The Company has also guaranteed the dividend payments and redemption of the preferred securities issued by the Issuer Trust. The maximum amount of undiscounted future payments the Company could make under the guarantee is approximately $55.6 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.

The junior subordinated debenture bears interest at a rate of LIBOR plus 337.5 basis points and matures in April 2034. As of March 31, 2011 and 2010, the interest rate on the junior subordinated debenture was 3.688% and 3.625%, respectively.

7. Employee Benefits

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 March 31, 2011 or December 31, 2010.

The postretirement benefit plan that provides medical benefits has been determined to be actuarially equivalent to Medicare Part D on an estimated basis under the rules provided in final regulations issued in 2005. As such, the federal subsidy to plan sponsors under the Medicare Modernization Act has been recognized in the accounting for that plan. In 2010, enactment of the Patient Protection and Affordable Care Act (the “Act”) and the Healthcare and Education Affordability Reconciliation Act, which modified certain provisions of the Act, repealed the rule permitting deduction, for tax purposes, of the entire cost of providing prescription drug benefits even though a portion is offset by the federal subsidy. The impact of these provisions has been recognized in the accounting for this postretirement benefit plan and included recognition of additional tax expense of $0.5 million for the three months ended March 31, 2010.

The plans’ combined net periodic postretirement benefit cost included the following components (amounts in thousands):


	Three Months Ended
	March 31,
	2011			2010
Net periodic benefit cost:
Service cost	$	66		$	61
Interest cost		169			158
Amortization of prior service cost (benefit)		(14	)		(28	)
Net amortization of actuarial loss		16			1

Net periodic benefit cost	$	237		$	192

The Company expects to contribute $0.2 million to the postretirement benefit plans to pay benefits in 2011. As of March 31, 2011, less than $0.1 million of contributions have been made to the postretirement benefit plans.

8. Commitments and Contingencies

At March 31, 2011 the future minimum commitments under operating leases were as follows: 2011 — $1.6 million; 2012 — $1.1 million; 2013 — $0.2 million; 2014 — $0.2 million; 2015 — $0.2 million.

In addition to these operating lease commitments, in September 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.

The Company and its subsidiaries are parties 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.

9. Income Taxes

The Company is subject to taxation in the United States, Puerto Rico and various state jurisdictions. The Company’s tax years 2007 through 2010 remain open as to the applicable statute of limitations and are subject to examination by the Internal Revenue Service.

The Company has not recognized any liabilities for uncertain income taxes as of March 31, 2011 or December 31, 2010, respectively. Also, the Company does not anticipate any material change in the total amount of unrecognized tax benefits to occur within the next twelve months.

10. Stockholders’ Equity

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 (collectively, “awards”) 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 awards may be granted under the 2006 Plan was 3,000,000.

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 under the 2006 Plan expire ten years after the date of grant and vest ratably over the four-year period following the date of grant.

The 2006 Plan is administered by the Compensation Committee of the Board of Directors (the “Committee”), consisting of two or more directors of the Company. Subject to the provisions set forth in the 2006 Plan, all of the members of the Committee shall be independent members of the Board of Directors. The Committee determines the types and sizes of awards under the 2006 Plan.

Through 2010, only nonqualified stock options were awarded under the 2006 Plan. Based on an evaluation of current best practices for stock-based compensation plans and alignment with the Company’s goals, in 2011 awards to employees and officers under the 2006 Plan consisted solely of restricted stock.

For stock option awards, the Committee determines the exercise price, which may not be less than the fair market value of the Company’s common stock on the date of grant for incentive stock options and may not be less than the par value of the Company’s common stock for nonqualified stock options. For restricted stock awards, the Committee determines the amount paid by the grantee for the restricted stock, which may not be less than the par value of the Company’s common stock for shares to be settled in newly issued common shares. Both restricted stock awards and option exercises under the 2006 Plan are settled in newly issued common shares.

On February 4, 2011, 104,876 shares of restricted stock were granted under the 2006 Plan. The grant price per share was $25.08, which was the closing sale price for the Company’s common stock as reported on the New York Stock Exchange on the grant date. These restricted stock awards vest ratably over the four-year period following the date of the grant. As of March 31, 2011, the number of shares available for granting of awards under the 2006 Plan was 1,904,712.

On February 5, 2010, 281,260 options were granted under the 2006 Plan. The fair market value (at grant date) per option granted was $7.25 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 2.32%; dividend yield of 0.0%; expected option life of 5.3 years and volatility of 55.5%, which was based on historical volatility. The Company

estimated the expected option life of the 2010 grant based on its analysis of past exercise patterns for similar options. As of March 31, 2010, the number of shares available for granting of awards under the 2006 Plan was 1,980,165.

The compensation expense recorded for the Company’s stock-based compensation plans was $0.6 million and $0.4 million for the three months ended March 31, 2011 and 2010, respectively. The total income tax benefit recognized in the Condensed Consolidated Statements of Income for stock-based compensation arrangements was $0.2 million for both the three months ended March 31, 2011 and 2010. The amount of cash received from the exercise of stock options was $2.3 million and $0.3 million for the three months ended March 31, 2011 and 2010, respectively.

A summary of option activity for the three months ended March 31, 2011 is presented below:


				Weighted
				Average Option
	Shares Subject			Price per
	to Option			Share
Outstanding options at January 1, 2011		1,093,181		$	15.67
Options granted		—			—
Options forfeited		—			—
Options expired		—			—
Options exercised		(116,993	)	$	17.01

Outstanding options at March 31, 2011		976,188		$	15.51

A summary of the status of the Company’s non-vested options as of March 31, 2011 and changes during the three months then ended is presented below:


				Weighted
				Average
	Shares Subject			Grant Date
	to Option			Fair Value
Non-vested options at January 1, 2011		603,859		$	7.71
Options granted		—			—
Options vested		(243,984	)	$	7.90
Options forfeited		—			—

Non-vested options at March 31, 2011		359,875		$	7.58

A summary of the options vested or expected to vest and options exercisable as of March 31, 2011 is presented below:

Options Vested or Expected to Vest

Weighted

Weighted Average

Average

Aggregate

Remaining

Number

Exercise Price

Intrinsic Value

Contractual Life

March 31, 2011

938,153

15.49

9,166,415

6.3 years

Options Exercisable

Weighted

Weighted Average

Average

Aggregate

Remaining

Number

Exercise Price

Intrinsic Value

Contractual Life

March 31, 2011

616,313

15.27

2,728,695

5.3 years

The total intrinsic value of options exercised was $0.9 million and $0.1 million for the three months ended March 31, 2011 and 2010, respectively. The tax benefits recognized by the Company for these exercises were $0.3 million and less than $0.1 million for the three months ended March 31, 2011 and 2010, respectively.

A summary of the status of the Company’s restricted stock awards as of March 31, 2011 and changes during the three months then ended is presented below:


	Shares Subject			Weighted Average Grant Date
	to Grant			Fair Value
Non-vested restricted stock awards at January 1, 2011		—			—
Restricted shares granted		104,876		$	25.08
Restricted shares vested		—			—
Restricted shares forfeited		(292	)	$	25.08

Non-vested restricted stock awards at March 31, 2011		104,584		$	25.08

As of March 31, 2011, there was $3.1 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 — $1.5 million; 2012 — $1.0 million; 2013 — $0.5 million and 2014 — $0.1 million.

CNA SURETY CORPORATION AND SUBSIDIARIES

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General

The following is a discussion and analysis of CNA Surety Corporation and its subsidiaries’ (collectively, “CNA Surety” or the “Company”) operating results, liquidity and capital resources, and financial condition. This discussion should be read in conjunction with the Condensed Consolidated Financial Statements in Item 1 of Part 1 of this Quarterly Report on Form 10-Q and the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

CNAF Merger Agreement and Tender Offer

Critical Accounting Policies

The Company’s accounting policies related to reserves and disclosures 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 critical 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, premiums receivable and deferred policy acquisition costs.

Reserves for Unpaid Losses and Loss Adjustment Expenses and Reinsurance

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 and the principal’s financial viability. To the extent it is determined that there are no bona fide defenses to the claim and the principal is unwilling or financially unable to resolve the claim, a case reserve is established on the claim file for the amount the Company estimates it will have to pay to honor its obligations under the provisions of the bond(s).

While the Company intends to establish initial case reserve estimates that are sufficient to cover the ultimate anticipated loss on a claim file, some estimates need to be adjusted during the life cycle of the claim file as matters continue to develop. Factors that can necessitate case reserve increases or decreases are the complexity of the bond(s) and/or underlying contract(s), if additional and/or unexpected claims are filed, if the financial condition of the principal or obligee changes or as claims develop and more information is discovered that was unknown and/or unexpected at the time the initial case reserve estimate was established. Ultimately, claims are resolved through payment and/or a determination that, based on the information available, a case reserve is no longer required.

As of any balance sheet date, not all claims have been reported and some claims may not be reported for many years. As a result, the liability for unpaid losses includes significant estimates for incurred-but-not-reported (“IBNR”) claims. The IBNR reserves also include provisions for losses in excess of the current case reserve for previously reported claims and for claims that may be reopened. The IBNR reserves also include offsets for anticipated indemnity recoveries.

In 2011, the Company changed its classification of LAE reserves to better reflect the methodologies used to estimate these reserves. Previously, the Company allocated a portion of the estimated LAE liability and classified it as a case LAE reserve. As of March 31, 2011, the estimated liability for LAE is classified only as IBNR reserve. Reported case LAE reserves at December 31, 2010 were $22.5 million. This change in classification had no impact on the total LAE reserve estimate as of March 31, 2011 nor did it have any impact on the Company’s results of operations for the three months ended March 31, 2011.

The following table shows the estimated liability as of March 31, 2011 for unpaid claims applicable to reported claims and to IBNR (dollars in thousands) for each sub-line of business:


	Gross Case Loss		Gross IBNR Loss		Total Gross
	Reserves		and LAE Reserves		Reserves
Contract	$	57,719	$	213,785	$	271,504
Commercial		38,688		79,941		118,629
Fidelity and other		2,265		8,705		10,970

Total	$	98,672	$	302,431	$	401,103

Periodic actuarial analyses of the Company’s loss reserves are performed. These analyses include a comprehensive review performed in the fourth quarter based on data as of September 30 and an update of the comprehensive review performed in January based on data as of December 31. In between these analyses, management monitors claim activity against benchmarks of expected claim activity prepared in connection with the comprehensive review and records adjustments as necessary.

The actuarial analysis is the primary tool that management utilizes in determining its best estimate of loss reserves. However, the carried reserve may differ from the actuarial point estimate as a result of management’s consideration of the impact of factors such as the following, especially as they relate to the current accident year:

	•		Current claim activity, including the frequency and severity of current claims;

	•		Changes in underwriting standards and business mix such as the Company’s efforts to reduce exposures to large commercial bonds;

	•		Changes in the claims handling process;

	•		Potential changes in the Company’s reinsurance program; and

	•		Current economic conditions, especially corporate default rates and the condition of the construction economy.

Management believes that the impact of the factors listed above, and others, may not be fully quantifiable through actuarial analysis. Accordingly, management applies its judgment of the impact of these factors, and others, to its selection of the recorded loss reserves.

Receivables recorded with respect to insurance losses ceded to reinsurers under reinsurance contracts are estimated in a manner similar to liabilities for insurance losses and, therefore, are also subject to uncertainty. In addition to the factors cited above, assumptions are made regarding the impact of reinsurance programs to be in place in future periods. Estimates of reinsurance recoveries may prove uncollectible if the reinsurer is unable to perform under the contract. Reinsurance contracts do not relieve the ceding company of its obligations to indemnify its own policyholders.

Casualty insurance loss reserves are subject to a significant amount of uncertainty. Given the nature of surety losses with its low frequency, high severity characteristics, this is particularly true for surety loss reserves. As a result, the range of reasonable loss reserve estimates may be broader than that associated with traditional property/casualty insurance products. While the loss reserve estimates represent the best professional judgments, arrived at after careful actuarial analysis of the available data, it is important to note that variation from the estimates is not only possible but, in fact, probable. The sources of this inherent variability are numerous — future economic conditions, court decisions, legislative actions and individual large claim impacts, for example.

Due to the inherent uncertainties in the process of establishing the liabilities for unpaid losses and loss adjustment expenses, the actual ultimate claims amounts will differ from the currently recorded amounts. This difference could have a material effect on reported earnings and financial condition. Future effects from changes in these estimates will be recorded in the period such changes are determined to be needed.

Investments

All securities transactions are recorded on the trade date. Investment gains or losses realized on the sale of securities are determined using the first-in, first-out method. Cash flows from purchases, sales and maturities of fixed income and equity securities are reported gross in the investing activities section of the Condensed Consolidated Statements of Cash Flows.

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 Condensed 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 expected 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.

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.

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.

Invested assets are exposed to various risks, such as interest rate risk, market risk and credit risk. Due to the level of risk associated with invested assets and the level of uncertainty related to changes in the value of these assets, it is possible that changes in risks in the near term may materially affect the amounts reported in the Condensed Consolidated Balance Sheets and Condensed Consolidated Statements of Income.

Goodwill and Other Intangible Assets

CNA Surety’s Condensed Consolidated Balance Sheets as of March 31, 2011 and December 31, 2010 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 an additional test must be performed to determine whether goodwill has been impaired and to calculate the amount of that impairment. To determine the implied value of intangible assets, 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.

Insurance Premiums

Insurance premiums are recognized as revenue ratably over the term of the related policies in proportion to the insurance protection provided. Contract bonds provide coverage for the length of the bonded project and not a fixed time period. As such, the Company uses estimates of the contract length as the basis for recognizing premium revenue on these bonds. Premium revenues are net of amounts ceded to reinsurers. Unearned premiums represent the portion of premiums written, before ceded reinsurance which is shown as an asset, applicable to the unexpired terms of policies in force determined on a pro rata basis.

Insurance premium receivables do not include financing costs or other fees and are presented net of an estimated allowance for doubtful accounts. This allowance is based on a periodic evaluation of the aging and collectibility of premium receivables. Premium receivables and any related allowance are written off after collection efforts have been exhausted.

Deferred Policy Acquisitions Costs

Policy acquisition costs, consisting of commissions, premium taxes and other underwriting expenses which vary with, and are primarily related to, the production of business, net of reinsurance commissions, are deferred and amortized as a charge to income as the related premiums are earned. The Company periodically tests that deferred policy acquisition costs are recoverable based on the expected profitability embedded in the reserve for unearned premium. If the expected profitability is less than the balance of deferred policy acquisition costs, a charge to net income is taken and the deferred policy acquisition cost balance is reduced to the amount determined to be recoverable. Anticipated investment income is considered in the determination of the recoverability of deferred policy acquisition costs.

Results of Operations

Financial Measures

The Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) discusses certain accounting principles generally accepted in the United States of America (“GAAP”) and non-GAAP financial measures in order to provide information used by management to monitor the Company’s operating performance. Management utilizes various financial measures to monitor the Company’s insurance operations and investment portfolio. Underwriting results, which are derived from certain income statement amounts, are considered a non-GAAP financial measure and are used by management to monitor performance of the Company’s insurance operations.

Underwriting results are computed as net earned premiums less net losses and loss adjustment expenses and net commissions, brokerage and other underwriting expenses. Management uses underwriting results to monitor its insurance operations’ results without the impact of certain factors, including net investment income, net realized investment gains (losses) and interest expense. Management excludes these factors in order to analyze the direct relationship between net earned premiums and the related net losses and loss adjustment expenses along with net commissions, brokerage and other underwriting expenses.

Operating ratios are calculated using insurance results and are widely used by the insurance industry and regulators such as state departments of insurance and the National Association of Insurance Commissioners for financial regulation and as a basis of comparison among companies. The ratios discussed in the Company’s MD&A are calculated using GAAP financial results and include the net loss and loss adjustment expense ratio (“loss ratio”) as well as the net commissions, brokerage and other underwriting expense ratio (“expense ratio”) and combined ratio. The loss ratio is the percentage of net incurred losses and loss adjustment expenses to net earned premiums. The expense ratio is the percentage of net commissions, brokerage and other underwriting expenses, including the amortization of deferred policy acquisition costs, to net earned premiums. The combined ratio is the sum of the loss ratio and expense ratio.

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.

Comparison of CNA Surety Actual Results for the Three Months Ended March 31, 2011 and 2010

Analysis of Net Income

Net income for the three months ended March 31, 2011 was $20.8 million, or $0.46 per diluted share, compared to $20.8 million, or $0.47 per diluted share, for the same period in 2010.

The components of net income are discussed in the following sections.

Results of Insurance Operations

Underwriting components for the Company for the three months ended March 31, 2011 and 2010 are summarized in the following table (dollars in thousands):


	Three Months Ended March 31,
	2011			2010
Gross written premiums	$	110,091		$	112,527

Net written premiums	$	104,630		$	106,660

Net earned premiums	$	96,658		$	98,252

Net losses and loss adjustment expenses	$	28,031		$	28,581

Net commissions, brokerage and other underwriting expenses	$	52,266		$	52,788

Loss ratio		29.0	%		29.1	%
Expense ratio		54.1			53.7

Combined ratio		83.1	%		82.8	%

Premiums Written/Earned

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 insurance coverage.

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 three months ended March 31, 2011 and 2010, premiums assumed under such arrangements were $1.1 million and $1.3 million, respectively.

Gross written premium, which is the aggregate of direct written premiums and assumed written premiums, for the three months ended March 31, 2011 and 2010 is shown in the table below (dollars in thousands) for each sub-line of business:


	Three Months Ended March 31,
	2011		2010
Contract	$	66,212	$	68,457
Commercial		34,994		35,221
Fidelity and other		8,885		8,849

Total	$	110,091	$	112,527

For the three months ended March 31, 2011, gross written premiums decreased 2.2 percent to $110.1 million compared to $112.5 million for the three months ended March 31, 2010. Contract surety gross written premiums decreased 3.3 percent to $66.2 million due to continued challenges in the construction industry. Commercial surety gross written premiums decreased 0.6 percent to $35.0 million, reflecting a modest decline in the small commercial market, partially offset by selective growth in the corporate commercial market.

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 premium decreased from $5.9 million for the three months ended March 31, 2010 to $5.5 million for the three months ended March 31, 2011 due to the lower cost of the Company’s 2011 third party excess of loss reinsurance treaty.

Net written premium, which is gross written premiums less ceded written premiums, for the three months ended March 31, 2011 and 2010 are shown in the table below (dollars in thousands) for each sub-line of business:


	Three Months Ended March 31,
	2011		2010
Contract	$	61,439	$	63,313
Commercial		34,306		34,498
Fidelity and other		8,885		8,849

Total	$	104,630	$	106,660

Net written premiums decreased 1.9 percent to $104.6 million for the three months ended March 31, 2011 compared to the same period of 2010, reflecting the decrease in gross written premium partially offset by the reduction in ceded written premium discussed above.

Net written premiums are recognized as revenue over the policy term as net earned premiums. Net earned premiums for the three months ended March 31, 2011 and 2010 are shown in the table below (dollars in thousands) for each sub-line of business:


	Three Months Ended March 31,
	2011		2010
Contract	$	57,223	$	58,526
Commercial		31,937		32,276
Fidelity and other		7,498		7,450

Total	$	96,658	$	98,252

For the three months ended March 31, 2011, net earned premiums decreased by $1.6 million to $96.7 million as compared to the same period of 2010 reflecting the impact of adverse economic conditions on net written premiums in the current and prior periods. Net earned premiums for contract surety business decreased 2.2 percent to $57.2 million for the three months ended March 31, 2011 compared to the three months ended March 31, 2010. Net earned premiums for commercial surety decreased 1.1 percent to $31.9 million, while fidelity and other net earned premiums increased 0.6 percent to $7.5 million for the three months ended March 31, 2011 compared to the three months ended March 31, 2010.

Net Loss Ratio

The loss ratios for the three months ended March 31, 2011 and 2010 were 29.0% and 29.1%, respectively. These loss ratios typically include re-estimates of prior accident year reserves, known as reserve development. There were no revisions of prior year reserves for the three months ended March 31, 2011 and 2010. The Company’s estimates of losses for the current accident year as well as for accident years 2010 and 2009 continue to reflect the impact of difficult economic conditions.

Expense Ratio

The expense ratios for the three months ended March 31, 2011 and 2010 were 54.1% and 53.7%, respectively. Expected upward pressure on the expense ratio resulting from the impact on earned premiums of lower gross written premiums was partially offset by the impact of lower ceded written premium and the Company’s continued expense management.

Other Expense

As previously discussed, in October 2010, the Company received an unsolicited proposal from CNAF to acquire all of the outstanding shares of common stock that are not currently owned by subsidiaries of CNAF. The Special Committee appointed to review and evaluate the CNAF Proposal retained both legal and financial advisors to assist in their consideration of the CNAF Proposal. The Company incurred expenses of $2.0 million in the three months ended March 31, 2011 related to the evaluation of the CNAF Proposal. These expenses are shown as “Other expense” in the Condensed Consolidated Statements of Income and are not included in the expense ratio discussed above.

Investment Income and Realized Investment Gains/Losses

Net investment income was $14.4 million for the three months ended March 31, 2011 compared to $13.4 million for the three months ended March 31, 2010. This increase is due to an increase in invested assets resulting from cash flows from operations partially offset by a decline in yields. The annualized pre-tax yield was 4.1% and 4.2% for the three months ended March 31, 2011 and 2010, respectively. The annualized after-tax yield was 3.3% and 3.4% for the three months ended March 31, 2011 and 2010, respectively.

The following summarizes net realized investment gains (losses) activity (dollars in thousands):


	Three Months Ended
	March 31,
	2011			2010
Net realized investment gains (losses):
Fixed income securities:
Gross realized investment gains	$	295		$	425
Gross realized investment losses:
Other-than-temporary impairment losses		—			(94	)
Realized losses from sales		(4	)		(19	)

Total gross realized investment losses		(4	)		(113	)

Net realized investment gains on fixed income securities		291			312


Equity securities:
Gross realized investment gains		22			11
Gross realized investment losses:
Other-than-temporary impairment losses		—			—
Realized losses from sales		—			—

Total gross realized investment losses		—			—

Net realized investment gains on equity securities		22			11


Net realized investment gains	$	313		$	323

The Company’s investment portfolio is generally managed to maximize after-tax investment return, while minimizing credit risk with investments concentrated in high quality fixed income securities. CNA Surety’s portfolio is managed to provide diversification by limiting exposures to any one industry, issue or issuer, and to provide liquidity by investing in the public securities markets. The portfolio is structured to support CNA Surety’s insurance underwriting operations and to consider the expected duration of liabilities and short-term cash needs. In achieving these goals, assets may be sold to take advantage of market conditions or other investment opportunities or regulatory, credit and tax considerations. These activities will produce realized gains and losses.

Interest Expense

Interest expense was $0.3 million for both the three months ended March 31, 2011 and 2010. The benchmark interest rate for the Company’s variable interest rate debt is the London Interbank Offered Rate (“LIBOR”). The weighted average interest rate for the three months ended March 31, 2011 was 3.7% as compared with 3.6% for the same period in 2010. Weighted average debt outstanding was $30.9 million for each of these periods.

Income Taxes

The Company’s income tax expense for the three months ended March 31, 2011 was $8.0 million compared to $9.5 million for the three months ended March 31, 2010. The effective income tax rates for these periods were 27.9% and 31.3%, 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. Tax-exempt investment income was $6.5 million and $6.3 million for the three months ended March 31, 2011 and 2010, respectively.

Income tax expense for the three months ended March 31, 2010 also included additional income tax expense of $0.5 million as the result of enacted health care reform legislation. The Patient Protection and Affordable Care Act and the Healthcare and Education Affordability Reconciliation Act repealed the rule permitting deduction, for tax purposes, of the entire cost of providing prescription drug benefits even though a portion is offset by a federal subsidy. The Company’s postretirement benefit plan that provides medical benefits includes such prescription drug coverage.

Exposure Management

The Company’s business is subject to certain risks and uncertainties associated with the current economic environment and corporate credit conditions. In response to these risks and uncertainties, the Company has enacted various exposure

management initiatives. With respect to risks on large commercial accounts, the Company generally limits its exposure to $50.0 million per account, but will selectively accept higher exposures.

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 has accounts with bonded backlogs significantly greater than $30.0 million, and in 2010 extended its strategy to also target contractors with the largest work programs. Often referred to as “jumbo” contractors, these accounts are typically served by a group of sureties with each surety taking a share of bonds written for the account.

The Company manages its exposure on each account 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.

Excess of Loss Reinsurance

2010 Third Party Reinsurance

2011 Third Party Reinsurance

Related Party Reinsurance

Through the Stop Loss Contract, the Company’s insurance subsidiaries were protected from adverse loss development on certain business underwritten after the Merger Date. The Stop Loss Contract between the Company’s insurance subsidiaries and CCC limited the insurance subsidiaries’ prospective net loss ratios with respect to certain accounts and lines of insured business for three full accident years following the Merger Date. In the event the insurance subsidiaries’ accident year net loss ratio exceeds 24% in any of the accident years 1997 through 2000 on certain insured accounts (the “Loss Ratio Cap”), the Stop Loss Contract requires CCC at the end of each calendar quarter following the Merger Date, to pay to the insurance subsidiaries a dollar amount equal to (i) the amount, if any, by which the Company’s actual accident year net loss ratio exceeds the applicable Loss Ratio Cap, multiplied by (ii) the applicable net earned premiums. In consideration for the coverage provided by the Stop Loss Contract, the Company’s insurance subsidiaries paid CCC an annual premium of $20,000. The CNA Surety insurance subsidiaries have paid CCC all required annual premiums. Through March 31, 2011 and December 31, 2010, losses incurred under the Stop Loss Contract were $47.2 million. At March 31, 2011, the amount received under the Stop Loss Contract included $2.8 million held by the Company for losses covered under this contract that were incurred but not paid.

As of March 31, 2011 and December 31, 2010, CNA Surety had an insurance receivable balance from CCC and CIC of $8.9 million and $10.8 million, respectively, comprised of premiums receivable. CNA Surety had no reinsurance payables to CCC or CIC as of March 31, 2011 or December 31, 2010.

Liquidity and Capital Resources

It is anticipated that the liquidity requirements of CNA Surety will be met primarily by funds generated from operations. The principal sources of operating cash flows are premiums, investment income and recoveries under reinsurance contracts. The primary cash flow uses are payments for claims, operating expenses, federal income taxes and debt service. In general,

surety operations generate premium collections from customers in advance of cash outlays for claims. Premiums are invested until such time as funds are required to pay claims and claims adjusting expenses.

The Company believes that total invested assets, including cash and short-term investments, are sufficient in the aggregate and have suitably scheduled maturities to satisfy all policy claims and other operating liabilities, including dividend and income tax sharing payments of its insurance subsidiaries. If cash requirements unexpectedly exceed cash inflows, the Company may raise additional cash by liquidating fixed income securities ahead of their scheduled maturity. Depending on the interest rate environment at that time, the Company could generate realized gains or losses that would increase or decrease net income for the period. The extent of these gains or losses 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.

At March 31, 2011, the carrying value of the Company’s insurance subsidiaries’ invested assets was comprised of $1,430.0 million of fixed income securities, $35.9 million of short-term investments and $3.0 million of cash. At December 31, 2010, the carrying value of the Company’s insurance subsidiaries’ invested assets was comprised of $1,404.4 million of fixed income securities, $39.7 million of short-term investments and $3.4 million of cash.

Cash flow at the parent company level is derived principally from dividend and tax sharing payments from its insurance subsidiaries, and to a lesser extent, investment income. During the first three months of 2011, parent company cash flows included significant cash flows from the exercise of stock options under the Company’s stock-based compensation plan. The principal obligations at the parent company level are to service debt and pay operating expenses, including income taxes. At March 31, 2011, the parent company’s invested assets consisted of $2.2 million of equity securities and $10.4 million of short-term investments and cash. At December 31, 2010, the parent company’s invested assets consisted of $1.9 million of equity securities and $16.7 million of short-term investments and cash. At March 31, 2011 and December 31, 2010, parent company short-term investments and cash included $5.6 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.

The Company’s consolidated net cash flow provided by operating activities was $20.9 million for the three months ended March 31, 2011 compared to net cash flow provided by operating activities of $26.3 million for the comparable period in 2010. The decrease in net cash flow provided by operating activities primarily relates to higher claim payments and expense payments related to the CNAF Proposal discussed previously.

In May 2004, the Company, through a wholly-owned trust, privately issued $30.0 million of preferred securities through two pooled transactions. These securities, issued by CNA Surety Capital Trust I (the “Issuer Trust”), bear interest at LIBOR plus 337.5 basis points with a 30-year term. As of May 2009, the Company may redeem these securities, in whole or in part, at par value at any scheduled quarterly interest payment date. As of March 31, 2011, none of these preferred securities have been redeemed.

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 commitments as of March 31, 2011 is presented in the following table (in millions):


Contractual Obligations as of March 31, 2011	2011		2012		2013		2014		2015		Thereafter		Total
	(In millions)
Debt^(a)	$	0.9	$	1.1	$	1.1	$	1.1	$	1.1	$	52.1	$	57.4
Operating leases		1.6		1.1		0.2		0.2		0.2		—		3.3
Loss and loss adjustment expense reserves		84.1		101.4		73.9		47.2		30.1		64.4		401.1
Other long-term liabilities^(b)		0.3		1.4		1.0		0.5		0.5		11.6		15.3

Total	$	86.9	$	105.0	$	76.2	$	49.0	$	31.9	$	128.1	$	477.1


^(a)		Reflects expected principal and interest payments.

^(b)		Reflects unfunded postretirement benefit plans and long-term incentive plan payments to certain executives.

In addition to the operating lease obligations included in the table above, in September 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’ state 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.

The dividends that may be paid without prior regulatory approval are determined by formulas established by the applicable insurance regulations, as described above. The formulas that determine dividend capacity in the current year are dependent on, among other items, the prior year’s ending statutory surplus and statutory net income. Dividend capacity for 2011 is based on statutory surplus and income at and for the year ended December 31, 2010. Without prior regulatory approval in 2011, Western Surety may pay dividends of $140.2 million to CNA Surety. CNA Surety received no dividends from its insurance subsidiaries or its non-insurance subsidiaries during the first three months of 2011 or 2010.

Combined statutory surplus totaled $846.2 million at March 31, 2011, resulting in a net written premium to statutory surplus ratio of to 0.5 to 1. Insurance regulations restrict Western Surety’s maximum net retention on a single surety bond to 10 percent of statutory surplus. Under the 2011 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 March 31, 2011, this regulation would limit Western Surety’s largest gross risk to $170.1 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 $15.1 million and $14.0 million from its subsidiaries for the three months ended March 31, 2011 and 2010, respectively.

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, 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.

Insurance Regulation and Supervision

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. In March 2011, the California Department of Insurance began preliminary work on a market conduct examination of Western Surety as of and for the period February 1, 2010 through January 31, 2011. To date, no issues have been brought to the attention of management.

The reports for the most recent financial examinations of Western Surety, Surety Bonding and Universal Surety by the South Dakota Division of Insurance, as of and for the period January 1, 2004 through December 31, 2008, were adopted as filed by the Director of the South Dakota Division of Insurance in January, 2010. No adverse findings were included in the final examination reports.

Financial Condition

Investment Portfolio

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 March 31, 2011, by investment category, were as follows (dollars in thousands):


			Gross		Gross Unrealized Losses
	Amortized Cost		Unrealized		Less Than			More Than			Estimated		Unrealized
March 31, 2011	or Cost		Gains		12 Months			12 Months			Fair Value		OTTI Losses
Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government and agencies:
U.S. Treasury	$	17,289	$	775	$	—		$	—		$	18,064	$	—
U.S. Agencies		5,515		204		—			—			5,719		—
Collateralized mortgage obligations — residential		18,711		1,510		—			—			20,221		—
Mortgage pass-through securities — residential		63,956		2,854		—			—			66,810		—
Obligations of states and political subdivisions		742,575		29,256		(6,130	)		(2,083	)		763,618		—
Corporate bonds		494,708		19,459		(1,806	)		—			512,361		—
Collateralized mortgage obligations — commercial		10,016		581		—			—			10,597		—
Other asset-backed securities:
Second mortgages/home equity loans — residential		1,931		—		—			(267	)		1,664		(873	)^(a)
Consumer credit receivables		10,000		36		—			—			10,036		—
Other		20,164		523		(43	)		—			20,644		—

Total fixed income securities		1,384,865		55,198		(7,979	)		(2,350	)		1,429,734	$	(873	)

Equity securities		1,938		240		—			—			2,178

Total	$	1,386,803	$	55,438	$	(7,979	)	$	(2,350	)	$	1,431,912


^(a)		The unrealized loss position of this security was $0.3 million at March 31, 2011.


			Gross		Gross Unrealized Losses
	Amortized Cost		Unrealized		Less Than			More Than			Estimated		Unrealized
December 31, 2010	or Cost		Gains		12 Months			12 Months			Fair Value		OTTI Losses
Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government and agencies:
U.S. Treasury	$	17,288	$	914	$	—		$	—		$	18,202	$	—
U.S. Agencies		6,518		250		—			—			6,768		—
Collateralized mortgage obligations — residential		20,769		1,558		—			—			22,327		—
Mortgage pass-through securities — residential		68,727		3,320		—			—			72,047		—
Obligations of states and political subdivisions		746,514		30,932		(5,096	)		(1,742	)		770,608		—
Corporate bonds		456,963		21,164		(1,249	)		(5	)		476,873		—
Collateralized mortgage obligations — commercial		10,018		567		—			—			10,585		—
Other asset-backed securities:
Second mortgages/home equity loans — residential		3,878		—		(84	)		(272	)		3,522		(927	)^(a)
Consumer credit receivables		9,998		158		—			—			10,156		—
Other		12,674		617		(4	)		—			13,287		—

Total fixed income securities		1,353,347		59,480		(6,433	)		(2,019	)		1,404,375	$	(927	)

Equity securities		1,687		229		—			—			1,916

Total	$	1,355,034	$	59,709	$	(6,433	)	$	(2,019	)	$	1,406,291


^(a)		The unrealized loss position of this security was $0.3 million at December 31, 2010.

Invested assets are exposed to various risks, such as interest rate, market and credit risks. Due to the level of risk associated with certain of these invested assets and the level of uncertainty related to changes in the value of these assets, it is possible that changes in risks in the near term may significantly affect the amounts reported in the Condensed Consolidated Balance Sheets and Condensed Consolidated Statements of Income. The Company’s Quantitative and Qualitative Disclosures about Market Risk is contained in Item 3 of this Form 10-Q. The Company’s investments in fixed income securities do not contain any industry concentration of credit risk.

The following table sets forth the ratings assigned by Standard & Poor’s (“S&P”) or Moody’s Investor Services, Inc. (“Moody’s”) of the fixed income securities portfolio of the Company as of March 31, 2011 and December 31, 2010 (dollars in thousands):


	March 31, 2011					December 31, 2010
Credit Rating^(a)	Estimated Fair Value		% of Total			Estimated Fair Value		% of Total
AAA	$	373,210		26.1	%	$	377,757		26.9	%
AA		586,965		41.1			597,065		42.5
A		389,320		27.2			360,128		25.7
BBB		35,829		2.5			31,439		2.2
Non-investment grade		44,410		3.1			37,986		2.7

Total	$	1,429,734		100.0	%	$	1,404,375		100.0	%


^(a)		Securities are categorized using the S&P rating. If a security is not rated by S&P, the Moody’s rating is used. At March 31, 2011 and December 31, 2010, all of the Company’s fixed income securities were rated by S&P or Moody’s.

As of March 31, 2011, $398.5 million of the Company’s investments were guaranteed by one of three major monoline bond insurers. This includes $396.8 million of bonds of states and political obligations, or about 52% of the Company’s investments in this type of security. Investments in obligations of states and political subdivisions represent approximately 53% of the Company’s invested assets. The ratings on these securities reflect the higher of the underlying rating of the issuer or the insurer’s rating. Of the $396.8 million of bonds of states and political subdivisions that were insured, $45.0 million of these securities reflect credit rating enhancement due to the guarantee. The underlying ratings of the enhanced securities is A. The underlying ratings of all municipal holdings remain very strong and carry an average rating of AA. The Company views bond insurance as credit enhancement and not credit substitution and a credit review is performed on each issuer of bonds purchased. Based on the strong underlying credit quality of its insured bonds of states and political subdivisions, the Company believes that any impact of additional ratings downgrades or other difficulties of the monoline bond insurers would not have a significant impact on the Company’s financial position or results of operations.

Beginning in 2010, municipal securities have come under increased investor scrutiny and heightened concerns of default. In addition to the credit reviews noted above, each municipal bond investment is reviewed as to the sources of debt service and the margins of safety around those sources. The Company’s municipal bond investments are focused in revenue bonds and full-faith-and-credit general obligation bonds. For revenue bonds, the focus is on bonds where the sources of debt service are from fees from public universities, transportation, such as toll ways and airports, and essential services, such as power, water and sewer. The Company focuses on bonds where there is a monopoly provider with ratemaking authority and where there are specific taxes pledged directly to bond repayments. The Company’s municipal bond investments are widely diversified with a largest single exposure of $15.9 million and an average exposure of approximately $5.1 million per issuer. Also, approximately $72.6 million of the Company’s municipal bonds are secured by U.S. Treasury obligations that are held in escrow pending the retirement of the municipal bonds, typically at a future call date.


	% of
	Estimated			% of
	Fair			Unrealized
Contractual Maturity	Value			Loss
Due after one year through five years		16	%		6	%
Due after five years through ten years		37			24
Due after ten years		43			67
Asset-backed securities		4			3

Total		100	%		100	%


	March 31, 2011				December 31, 2010
			Gross				Gross
	Estimated		Unrealized		Estimated		Unrealized
Unrealized Loss Aging	Fair Value		Loss		Fair Value		Loss
Fixed income securities:
Investment grade ^(a):
0-6 months	$	281,785	$	7,945	$	223,778	$	6,350
Greater than 24 months		4,785		760		7,903		663

Total investment grade		286,570		8,705		231,681		7,013
Non-investment grade:
0-6 months		6,208		25		11,256		83
7-12 months		1,532		9		—		—
Greater than 24 months		11,168		1,590		11,522		1,356

Total non-investment grade		18,908		1,624		22,778		1,439

Total	$	305,478	$	10,329	$	254,459	$	8,452


^(a)		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 March 31, 2011 and December 31, 2010, all of the Company’s fixed income securities were rated by S&P or Moody’s.

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 OTTI losses. When a security is impaired, the impairment is evaluated to determine whether it is temporary or other-than-temporary.


	Gross Unrealized Losses
													Estimated
March 31, 2011	AAA		AA		A		BBB		Total		Count		Fair Value
Fixed income securities:
Investment grade^(a):
Obligations of states and political subdivisions	$	577	$	4,170	$	2,143	$	—	$	6,890		34	$	173,884
Corporate bonds		—		39		1,405		328		1,772		22		102,232
Other asset-backed securities:
Other		43		—		—		—		43		2		10,454

Total investment grade		620		4,209		3,548		328		8,705		58		286,570
Non-investment grade:
Obligations of states and political subdivisions		—		—		—		—		1,323		1		9,504
Corporate bonds		—		—		—		—		34		5		7,740
Other asset-backed securities:
Second mortgages/home equity loans — residential		—		—		—		—		267		1		1,664

Total non-investment grade		—		—		—		—		1,624		7		18,908

Total	$	620	$	4,209	$	3,548	$	328	$	10,329		65	$	305,478


^(a)		Securities are categorized using the S&P rating. If a security is not rated by S&P, the Moody’s rating is used. At March 31, 2011, all of the Company’s fixed income securities were rated by S&P or Moody’s.

The Company has no current intent to sell any of the securities in an unrealized loss position, nor is it more likely than not that it will be required to sell these securities prior to recovery of amortized cost. The Company believes that all of the securities in an unrealized loss position will recover in value and that none of these unrealized losses were indicative of credit losses. Based on the current facts and circumstances of the Company’s particular security holdings, the Company has determined that no additional OTTI losses related to the securities in an unrealized loss position are required to be recorded.

Obligations of States and Political Subdivisions

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 thirty-four investment grade obligations of states and political subdivisions in an unrealized loss position at March 31, 2011, only nine were in an unrealized loss position exceeding 5% of the security’s amortized cost. The largest unrealized loss, $0.8 million, or 13.7% of the security’s amortized cost, was on a security issued by a governmental utility authority. The unrealized loss position of this security has deteriorated slightly compared to December 31, 2010 when it was $0.7 million, or 11.9% of the security’s amortized cost. While the overall unrealized loss position of obligations of states and political subdivisions grew from $5.8 million, or 3.4% of their amortized cost, at December 31, 2010 to $6.9 million, or 3.8% of their amortized cost, at March 31, 2011 the Company continues to believe that all interest and principal will be paid according to their contractual terms. The Company has no current intent to sell these securities, nor is it more likely than not that it will be required to sell prior to recovery of amortized cost. 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 March 31, 2011.

Only one of the Company’s investments in obligations of states and political subdivisions was rated below investment grade at March 31, 2011. This security, issued by a governmental utility authority, was in an unrealized loss position of $1.3 million, or 12.2% of amortized cost, at March 31, 2011. The Company believes that this security is rated below investment grade because an inconsequential contingency amount is insured with one of the major monoline insurers which is rated B by S&P. The Company believes that this insurer is the lowest rated source of security involved in the transaction and, despite the fact that the amount of security provided by this insurer is inconsequential, the entire transaction is rated to the lowest rated component. Based on the Company’s analysis of the sources of debt service on this bond and the fact that the security is current on all interest payments due through March 31, 2011, the Company continues to believe that all interest and principal will be paid according to their contractual terms. The Company has no current intent to sell this security, 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 loss on this security is indicative of credit loss and, as such, has not recorded an OTTI loss on this security at March 31, 2011.

Corporate Bonds

Other Asset-backed Securities

Two investment grade asset-backed securities held by the Company were in an unrealized loss position at March 31, 2011. 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 March 31, 2011.

At March 31, 2011 the Company’s exposure to sub-prime home loans was limited to one asset-backed security collateralized by sub-prime home loans which originated prior to 2005. The estimated fair value of this non-investment grade security was $1.7 million at March 31, 2011. This security was in an unrealized loss position of $0.3 million, or 13.8% of its amortized cost at March 31, 2011. During 2011, the Company received repayments on this security of $0.1 million, or approximately 5% of the par value outstanding at December 31, 2010. This security was determined to have credit losses totaling $0.2 million during 2009 and 2010. The non-credit component of this security’s OTTI recognized in accumulated other comprehensive income at March 31, 2011 was $0.3 million. The Company believes the non-credit component of the unrealized loss on this security is primarily attributable to this asset class being out of favor with investors and is not indicative of the quality of the underlying collateral. The Company has no current intent to sell this security, nor is it more likely than not that it will be required to sell prior to recovery of the adjusted amortized cost.

Pending Accounting Pronouncements

In October 2010, the Financial Accounting Standards Board issued Accounting Standards Update 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 fiscal years, beginning after December 15, 2011 with prospective or retrospective application allowed. The Company is currently assessing the available application methods as well as the impact this accounting guidance will have on its financial condition and results of operations.

FORWARD-LOOKING STATEMENTS

This report includes a number of statements, which relate to anticipated future events (forward-looking statements) rather than actual present conditions or historical events. Forward-looking statements generally include words such as “believes,” “expects,” “intends,” “anticipates,” “estimates” and similar expressions. Forward-looking statements in this report include expected developments in the Company’s insurance business, including losses and loss reserves; the impact of routine ongoing insurance reserve reviews being conducted by the Company; the routine state regulatory examinations of the Company’s primary insurance company subsidiaries, and the Company’s responses to the results of those reviews and examinations; the Company’s expectations concerning its revenues, earnings, expenses and investment activities; expected cost savings and other results from the Company’s expense reduction and restructuring activities; and the Company’s proposed actions in response to trends in its business.

Forward-looking statements, by their nature, are subject to a variety of inherent risks and uncertainties that could cause actual results to differ materially from the results projected. Many of these risks and uncertainties cannot be controlled by the Company.

Some examples of these risks and uncertainties are:

	•		general economic and business conditions;

	•		changes in financial markets such as fluctuations in interest rates, long-term periods of low interest rates, credit conditions and currency, commodity and stock prices;

	•		the ability of the Company’s contract principals to fulfill their bonded obligations;

	•		the effects of corporate bankruptcies on surety bond claims, as well as on capital markets;

	•		changes in foreign or domestic political, social and economic conditions;

	•		regulatory initiatives and compliance with governmental regulations, judicial decisions, including interpretation of policy provisions, decisions regarding coverage, trends in litigation and the outcome of any litigation involving the Company, and rulings and changes in tax laws and regulations;

	•		regulatory limitations, impositions and restrictions upon the Company, including the effects of assessments and other surcharges for guaranty funds and other mandatory pooling arrangements;

	•		the impact of competitive products, policies and pricing and the competitive environment in which the Company operates, including changes in the Company’s books of business;

	•		product and policy availability and demand and market responses, including the level of ability to obtain rate increases and decline or non-renew underpriced accounts, to achieve premium targets and profitability and to realize growth and retention estimates;

	•		development of claims and the impact on loss reserves, including changes in claim settlement practices;

	•		the performance of reinsurance companies under reinsurance contracts with the Company;

	•		results of financing efforts, including the Company’s ability to access capital markets;

	•		changes in the Company’s composition of operating segments;

	•		the actual closing of contemplated transactions and agreements;

	•		the sufficiency of the Company’s loss reserves and the possibility of future increases in reserves;

	•		the risks and uncertainties associated with the Company’s loss reserves; and,

	•		the possibility of changes in the Company’s ratings by ratings agencies, including the inability to access certain markets or distribution channels and the required collateralization of future payment obligations as a result of such changes, and changes in rating agency policies and practices.

Any forward-looking statements made in this report are made by the Company as of the date of this report. The Company does not have any obligation to update or revise any forward-looking statement contained in this report, even if the Company’s expectations or any related events, conditions or circumstances change.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

CNA Surety’s investment portfolio is subject to economic losses due to adverse changes in the fair value of its financial instruments, or market risk. Interest rate risk represents the largest market risk factor affecting the Company’s consolidated financial condition due to its significant level of investments in fixed income securities. Increases and decreases in prevailing interest rates generally translate into decreases and increases in the fair value of the Company’s fixed income portfolio. The fair value of these interest rate sensitive instruments may also be affected by the credit-worthiness of the issuer, prepayment options, relative value of alternative investments, the liquidity of the instrument, income tax considerations and general market conditions. The Company manages its exposure to interest rate risk primarily through an asset/liability matching strategy. The Company’s exposure to interest rate risk is mitigated by the relative short-term nature of its insurance and other liabilities. The targeted effective duration of the Company’s investment portfolio is approximately 5, consistent with the expected duration of its insurance and other liabilities.

The tables below summarize the estimated effects of certain hypothetical changes in interest rates. It is assumed that the changes occur immediately and uniformly across each investment category. The selected hypothetical changes in market interest rates reflect the Company’s expectations of the reasonably possible scenarios over a one-year period and the hypothetical fair values are based upon the same prepayment assumptions that were utilized in computing fair values at March 31, 2011 and December 31, 2010. Significant variations in market interest rates could produce changes in the timing of repayments due to prepayment options available. The fair value of such instruments could be affected and therefore actual results might differ from those reflected in the following tables.


				Estimated Fair		Hypothetical
			Hypothetical	Value After		Percentage
	Fair Value at		Change in	Hypothetical		Decrease in
	March 31,		Interest Rate	Change in		Stockholders’
	2011		(bp=basis points)	Interest Rate		Equity
			(Dollars in thousands)

U.S. Government and government agencies and authorities	$	110,814
			200 bp increase	$	102,644		(0.5	)%
			150 bp increase		104,855		(0.4	)
			100 bp increase		107,004		(0.2	)
			50 bp increase		109,021		(0.1	)

States, municipalities and political subdivisions		763,618
			200 bp increase		678,213		(5.1	)
			150 bp increase		698,418		(3.9	)
			100 bp increase		719,395		(2.6	)
			50 bp increase		741,128		(1.3	)

Corporate bonds		512,361
			200 bp increase		468,782		(2.6	)
			150 bp increase		479,193		(2.0	)
			100 bp increase		489,925		(1.3	)
			50 bp increase		500,984		(0.7	)

Mortgage-backed and asset-backed		42,941

			200 bp increase		41,264		(0.1	)
			150 bp increase		41,672		(0.1	)
			100 bp increase		42,087		(0.1	)
			50 bp increase		42,510		—

Total fixed income securities available-for-sale	$	1,429,734

			200 bp increase		1,290,903		(8.3	)
			150 bp increase		1,324,138		(6.3	)
			100 bp increase		1,358,411		(4.3	)
			50 bp increase		1,393,643		(2.2	)


				Estimated Fair		Hypothetical
			Hypothetical	Value After		Percentage
	Fair Value at		Change in	Hypothetical		Decrease in
	December 31,		Interest Rate	Change in		Stockholders’
	2010		(bp=basis points)	Interest Rate		Equity
			(Dollars in thousands)

U.S. Government and government agencies and authorities	$	119,344
			200 bp increase	$	111,034		(0.5	)%
			150 bp increase		113,329		(0.4	)
			100 bp increase		115,538		(0.2	)
			50 bp increase		117,578		(0.1	)

States, municipalities and political subdivisions		770,608
			200 bp increase		682,531		(5.4	)
			150 bp increase		703,332		(4.1	)
			100 bp increase		724,944		(2.8	)
			50 bp increase		747,360		(1.4	)

Corporate bonds		476,873
			200 bp increase		436,507		(2.5	)
			150 bp increase		446,132		(1.9	)
			100 bp increase		456,064		(1.3	)
			50 bp increase		466,309		(0.6	)

Mortgage-backed and asset-backed		37,550

			200 bp increase		36,031		(0.1	)
			150 bp increase		36,400		(0.1	)
			100 bp increase		36,776		—
			50 bp increase		37,159		—

Total fixed income securities available-for-sale	$	1,404,375

			200 bp increase		1,266,103		(8.4	)
			150 bp increase		1,299,193		(6.4	)
			100 bp increase		1,333,322		(4.3	)
			50 bp increase		1,368,406		(2.2	)

ITEM 4. CONTROLS AND PROCEDURES

The Company maintains a system of disclosure controls and procedures which are designed to ensure that information required to be disclosed by the Company in reports that it files or submits to the Securities and Exchange Commission under the Securities and Exchange Act of 1934 as amended (the “Exchange Act”), including this report, is recorded, processed, summarized and reported on a timely basis. These disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed under the Exchange Act is accumulated and communicated to the Company’s management on a timely basis to allow decisions regarding required disclosure.

The Company’s principal executive officer and its principal financial officer undertook an evaluation of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a - 15(e) and 15d - 15(e)) as of the end of the period covered by this report and concluded that the Company’s controls and procedures were effective.

There were no changes in the Company’s internal control over financial reporting that occurred during the Company’s last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II — OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS — Information on the Company’s legal proceedings is set forth in Note 8 of the Condensed Consolidated Financial Statements included under Part 1, Item 1.

ITEM 1A. RISK FACTORS — Information on the Company’s risk factors is set forth in Item 1A “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS — None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES — None.

ITEM 5. OTHER INFORMATION — Reports on Form 8-K:

February 4, 2011; CNA Surety Corporation Earnings Press Release and CNA Surety Corporation Special Committee Press Release issued on February 4, 2011.

ITEM 6. EXHIBITS


	Exhibit Number
Certification pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 — Chief Executive Officer.		31	(1)

Certification pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 — Chief Financial Officer.		31	(2)

Written Statement of the Chief Executive Officer of CNA Surety Corporation pursuant to 18 U.S.C. 1350 (as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002).		32	(1)*

Written Statement of the Chief Financial Officer of CNA Surety Corporation pursuant to 18 U.S.C. 1350 (as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002).		32	(2)*


*		Exhibits 32(1) and 32(2) are being furnished and shall not be deemed “filed” for the purpose of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to the liabilities of that Section. These Exhibits shall not be incorporated by reference into any registration statement or other document pursuant to the Securities Act of 1933, as amended.

SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.


CNA SURETY CORPORATION (Registrant)
/s/ John F. Welch
John F. Welch
President and Chief Executive Officer

/s/ John F. Corcoran
John F. Corcoran
Senior Vice President and Chief Financial Officer

Date: April 29, 2011

EXHIBIT INDEX


31(1)		Certification pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 — Chief Executive Officer.

31(2)		Certification pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 — Chief Financial Officer.

32(1)		Written Statement of the Chief Executive Officer of CNA Surety Corporation pursuant to 18 U.S.C. 1350 (as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002).

32(2)		Written Statement of the Chief Financial Officer of CNA Surety Corporation pursuant to 18 U.S.C. 1350 (as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002).

CNA SURETY CORP 10-Q