Edgar Filing: CNA SURETY CORP

e10vq

FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549


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

For the quarterly period ended September 30, 2007


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		36-4144905
(State or other jurisdiction of incorporation or organization)		(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 is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o Accelerated filer þ Non-accelerated filer 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:

44,029,609 shares of Common Stock, $.01 par value as of October 19, 2007.

CNA SURETY CORPORATION AND SUBSIDIARIES

INDEX


	Page
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements (Unaudited):
Condensed Consolidated Balance Sheets at September 30, 2007 and at December 31, 2006		3
Condensed Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2007 and 2006		4
Condensed Consolidated Statements of Stockholders’ Equity for the Nine Months Ended September 30, 2007 and 2006		5
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2007 and 2006		6
Notes to Condensed Consolidated Financial Statements		7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		16
Item 3. Quantitative and Qualitative Disclosures About Market Risk		33
Item 4. Controls and Procedures		35
PART II. OTHER INFORMATION
Item 1. Legal Proceedings		35
Item 1A. Risk Factors		35
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		35
Item 3. Defaults Upon Senior Securities		35
Item 4. Submission of Matters to a Vote of Security Holders		35
Item 5. Other Information		35
Item 6. Exhibits		35
Certification
Certification
Certification
Certification

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CNA SURETY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)


	September 30,			December 31,
	2007			2006
ASSETS
Invested assets:
Fixed income securities, at fair value (amortized cost: $877,796 and $773,178)	$	883,533		$	784,791
Equity securities, at fair value (cost: $1,583 and $1,508)		1,784			1,668
Short-term investments, at cost (approximates fair value)		77,937			103,640
Other investments, at cost		57			22

Total invested assets		963,311			890,121
Cash		16,574			7,164
Deferred policy acquisition costs		108,800			102,937
Insurance receivables:
Premiums, including $12,732 and $6,885 from affiliates, (net of allowance for doubtful accounts: $1,230 and $1,369)		48,478			37,205
Reinsurance, including $50,055 and $55,023 from affiliates		112,882			118,412
Deposit with affiliated ceding company		34,279			33,145
Intangible assets (net of accumulated amortization: $25,523 and $25,523)		138,785			138,785
Current income taxes receivable		—			323
Property and equipment, at cost (less accumulated depreciation and amortization: $28,278 and $24,466)		24,855			24,807
Prepaid reinsurance premiums (including $517 and $1,702 from affiliates)		752			2,165
Accrued investment income		10,916			10,089
Other assets		2,090			3,180

Total assets	$	1,461,722		$	1,368,333

LIABILITIES
Reserves:
Unpaid losses and loss adjustment expenses	$	447,458		$	434,224
Unearned premiums		273,750			253,803

Total reserves		721,208			688,027
Debt		30,766			30,690
Deferred income taxes, net		13,745			17,298
Current income taxes payable		4,026			—
Reinsurance and other payables to affiliates		2,227			166
Accrued expenses		15,084			20,247
Liability for postretirement benefits		14,312			12,466
Other liabilities		24,469			33,537

Total liabilities		825,837			802,431
Commitments and contingencies (See Notes 3, 4, & 7)
STOCKHOLDERS’ EQUITY
Common stock, par value $.01 per share, 100,000 shares authorized; 45,406 shares issued and 44,022 shares outstanding at September 30, 2007 and 45,263 shares issued and 43,872 shares outstanding at December 31, 2006		454			453
Additional paid-in capital		272,253			268,651
Retained earnings		377,385			306,745
Accumulated other comprehensive income		653			4,993
Treasury stock, 1,384 and 1,391 shares, at cost		(14,860	)		(14,940	)

Total stockholders’ equity		635,885			565,902

Total liabilities and stockholders’ equity	$	1,461,722		$	1,368,333

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

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CNA SURETY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)


	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2007		2006			2007			2006
Revenues:
Net earned premium	$	113,617	$	102,798		$	317,607		$	291,727
Net investment income		11,328		9,850			32,792			29,021
Net realized investment gains (losses)		65		(999	)		(486	)		(894	)

Total revenues		125,010		111,649			349,913			319,854

Expenses:
Net losses and loss adjustment expenses		23,835		21,133			75,632			69,674
Net commissions, brokerage and other underwriting expenses		59,952		56,527			170,870			160,954
Interest expense		745		967			2,194			2,931

Total expenses		84,532		78,627			248,696			233,559

Income before income taxes		40,478		33,022			101,217			86,295
Income tax expense		12,481		9,402			30,577			25,185

Net income	$	27,997	$	23,620		$	70,640		$	61,110

Earnings per common share	$	0.64	$	0.54		$	1.61		$	1.40

Earnings per common share, assuming dilution	$	0.63	$	0.54		$	1.60		$	1.39

Weighted average shares outstanding		43,954		43,558			43,975			43,602

Weighted average shares outstanding, assuming dilution		44,194		43,897			44,248			43,879

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

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CNA SURETY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(AMOUNTS IN THOUSANDS)
(UNAUDITED)


	Common											Accumulated
	Stock				Additional							Other			Treasury			Total
	Shares		Common		Paid-In		Comprehensive			Retained		Comprehensive			Stock			Stockholders’
	Outstanding		Stock		Capital		Income (Loss)			Earnings		Income (Loss)			At Cost			Equity
Balance, December 31, 2005		43,334	$	447	$	259,684				$	223,927	$	7,546		$	(15,029	)	$	476,575
Comprehensive income:
Net income		—		—		—	$	61,110			61,110		—			—			61,110
Other comprehensive income:
Change in unrealized gains on securities, after income tax expense of $166 (net of reclassification adjustment of $892, after income tax expense of $480)		—		—		—		308			—		308			—			308

Total comprehensive income							$	61,418

Stock-based compensation		—		—		983					—		—			—			983
Stock options exercised and other		411		4		5,892							—			89			5,985

Balance, September 30, 2006		43,745	$	451	$	266,559				$	285,037	$	7,854		$	(14,940	)	$	544,961


Balance, December 31, 2006		43,872	$	453	$	268,651				$	306,745	$	4,993		$	(14,940	)	$	565,902
Comprehensive income:
Net income		—		—		—	$	70,640			70,640		—			—			70,640
Other comprehensive income:
Change in unrealized gains on securities, after income tax benefit of $2,042 (net of reclassification adjustment of ($120), after income tax benefit of $65)		—		—		—		(3,793	)		—		(3,793	)		—			(3,793	)
Adjustment to recognize re-measurement of accumulated postretirement benefit obligations, net of tax benefit of $563		—		—		—		(684	)		—		(684	)		—			(684	)
Adjustment to postretirement benefit plan net periodic cost, after income tax expense of $74		—		—		—		137			—		137			—			137

Total comprehensive income							$	66,300

Stock-based compensation		—		—		1,456					—		—			—			1,456
Stock options exercised and other		150		1		2,146					—		—			80			2,227

Balance, September 30, 2007		44,022	$	454	$	272,253				$	377,385	$	653		$	(14,860	)	$	635,885

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

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CNA SURETY CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
(UNAUDITED)


	Nine Months Ended
	September 30,
	2007			2006
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	70,640		$	61,110
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for doubtful accounts		332			657
Depreciation and amortization		4,723			3,911
Amortization (accretion) of bond premium (discount), net		(70	)		119
Loss on disposal of property and equipment		1			149
Net realized investment losses		486			894
Stock-based compensation		1,456			983
Changes in:
Insurance receivables		(6,075	)		(10,041	)
Reserve for unearned premiums		19,947			22,221
Reserve for unpaid losses and loss adjustment expenses		13,234			(4,212	)
Deposits with affiliated ceding company		(1,134	)		654
Deferred policy acquisition costs		(5,863	)		(3,757	)
Deferred income taxes, net		(1,097	)		(1,887	)
Reinsurance and other payables to affiliates		2,061			(2	)
Prepaid reinsurance premiums		1,413			2,222
Accrued expenses		(5,163	)		(304	)
Other assets and liabilities		(3,570	)		7,808

Net cash provided by operating activities		91,321			80,525

CASH FLOWS FROM INVESTING ACTIVITIES:
Fixed income securities:
Purchases		(224,087	)		(210,631	)
Maturities		46,459			18,730
Sales		70,103			124,077
Purchases of equity securities		(714	)		(1,117	)
Proceeds from the sale of equity securities		757			962
Changes in short-term investments		28,069			7,428
Purchases of property and equipment, net		(4,696	)		(8,444	)
Other, net		(29	)		631

Net cash used in investing activities		(84,138	)		(68,364	)

CASH FLOWS FROM FINANCING ACTIVITIES:
Principal payments on debt		—			(20,000	)
Employee stock option exercises and other		2,227			5,985

Net cash provided by financing activities		2,227			(14,015	)

Increase (decrease) in cash		9,410			(1,854	)
Cash at beginning of period		7,164			8,323

Cash at end of period	$	16,574		$	6,469

Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for:
Interest	$	2,110		$	2,913
Income taxes		26,898			27,938

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

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CNA SURETY CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2007
(UNAUDITED)

1. SIGNIFICANT ACCOUNTING POLICIES

FORMATION OF CNA SURETY CORPORATION AND MERGER

In December 1996, CNA Financial Corporation (“CNAF”) and Capsure Holdings Corp. (“Capsure”) agreed to merge (the “Merger”) the surety business of CNAF with Capsure’s insurance subsidiaries, Western Surety Company (“Western Surety”), Surety Bonding Company of America (“Surety Bonding”) and Universal Surety of America (“Universal Surety”), into CNA Surety Corporation (“CNA Surety” or the “Company”). CNAF, through its operating subsidiaries, writes multiple lines of property and casualty insurance, including surety business that is reinsured by Western Surety. CNAF owns approximately 62% of the outstanding common stock of CNA Surety. Loews Corporation (“Loews”) owns approximately 89% of the outstanding common stock of CNAF. The principal operating subsidiaries of CNAF that wrote the surety line of business for their own account prior to the Merger were Continental Casualty Company and its property and casualty affiliates (collectively, “CCC”) and The Continental Insurance Company and its property and casualty affiliates (collectively, “CIC”).

PRINCIPLES OF CONSOLIDATION

The 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 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 2006 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. 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 is computed using the treasury stock method.

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


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2007		2006		2007		2006
Net income	$	27,997	$	23,620	$	70,640	$	61,110

Shares:
Weighted average shares outstanding		43,938		43,519		43,872		43,334
Weighted average shares of options exercised and additional stock issuance		16		39		103		268

Total weighted average shares outstanding		43,954		43,558		43,975		43,602
Effect of dilutive options		240		339		273		277

Total weighted average shares outstanding, assuming dilution		44,194		43,897		44,248		43,879

Earnings per share	$	0.64	$	0.54	$	1.61	$	1.40

Earnings per share, assuming dilution	$	0.63	$	0.54	$	1.60	$	1.39

No adjustments were made to reported net income in the computation of earnings per share. Options to purchase shares of common stock of 0.3 million were excluded from the calculation of diluted earnings per share for the three and nine months ended September 30, 2007 because the exercise price of these options was greater than the average market price of CNA Surety’s common stock. There were no options excluded from the calculation of diluted earnings per share for the three and nine months ended September 30, 2006.

ACCOUNTING PRONOUNCEMENTS

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 prescribes a comprehensive model for how a company should recognize, measure, present, and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return. FIN 48 states that a tax benefit from an uncertain position may be recognized only if it is “more likely than not” that the position is sustainable, based on its technical merits. The tax benefit of a qualifying position is the largest amount of tax benefit that is greater than 50 percent likely of being realized upon ultimate settlement with a taxing authority having full knowledge of all relevant information. FIN 48 is effective for fiscal years beginning after December 15, 2006 and was adopted by the Company as of January 1, 2007. The Company has elected to classify interest, if any, recognized in accordance with FIN 48 as interest expense. Likewise, penalties, if any, recognized in accordance with FIN 48 will be classified as miscellaneous expense. No amounts have been recognized subject to these provisions as of September 30, 2007. As of September 30, 2007, the tax years 2004 and beyond remain subject to examination by the Internal Revenue Service. Adoption and subsequent application of this standard did not have an impact on the Company’s results of operations and financial condition.

In February 2006, the FASB issued Statement of Accounting Financial Standards (“SFAS”) No. 155, “Accounting for Certain Hybrid Financial Instruments” (“SFAS 155”). SFAS 155 amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“SFAS 140”). SFAS 155 also resolves issues addressed in SFAS 133 Implementation Issue No. D1, Application of Statement 133 to Beneficial Interests in Securitized Financial Assets. SFAS 155 eliminates the exemption from applying SFAS 133 to interests in certain securitized financial assets so that similar instruments are accounted for in the same manner regardless of the form of the instruments. SFAS 155 also allows a preparer to elect fair value measurement at acquisition, at issuance, or when a previously recognized financial instrument is subject to a re-measurement (new basis) event, on an instrument-by-instrument basis. The fair value election provided for in paragraph 4(c) of SFAS 155 may also be applied upon adoption of SFAS 155 for hybrid financial instruments that had been bifurcated under paragraph 12 of SFAS 133 prior to the adoption of this Statement. SFAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006, and was adopted by the Company as of January 1, 2007. Adoption and subsequent application of this standard did not have an impact on the Company’s results of operations and financial condition.

In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts” (“SOP 05-1”). SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments”. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occur by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a

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contract, or by the election of a feature or coverage within a contract. SOP 05-1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006 and was adopted by the Company as of January 1, 2007. Adoption and subsequent application of this standard did not have an impact on the Company’s results of operations and financial condition.

2. INVESTMENTS

The estimated fair value and amortized cost or cost of fixed income and equity securities held by CNA Surety at September 30, 2007 and December 31, 2006, by investment category, were as follows (dollars in thousands):


			Gross		Gross Unrealized Losses
	Amortized Cost		Unrealized		Less Than			More Than			Estimated
September 30, 2007	or Cost		Gains		12 Months			12 Months			Fair Value
Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government and agencies:
U.S. Treasury	$	14,789	$	67	$	—		$	(44	)	$	14,812
U.S. Agencies		28,026		206		—			(79	)		28,153
Collateralized mortgage obligations		30,777		373		(102	)		(297	)		30,751
Mortgage pass-through securities		41,849		145		—			(1,153	)		40,841
Obligations of states and political subdivisions		645,678		11,387		(3,533	)		(5	)		653,527
Corporate bonds		43,622		877		—			(1,458	)		43,041
Non-agency collateralized mortgage obligations		35,025		194		—			(912	)		34,307
Other asset-backed securities:
Second mortgages/home equity loans		10,000		—		—			(112	)		9,888
Credit card receivables		17,233		207		—			—			17,440
Other		10,797		103		—			(127	)		10,773

Total fixed income securities		877,796		13,559		(3,635	)		(4,187	)		883,533
Equity securities		1,583		201		—			—			1,784

Total	$	879,379	$	13,760	$	(3,635	)	$	(4,187	)	$	885,317


			Gross		Gross Unrealized Losses
	Amortized Cost		Unrealized		Less Than			More Than			Estimated
December 31, 2006	or Cost		Gains		12 Months			12 Months			Fair Value
Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government and agencies:
U.S. Treasury	$	14,832	$	—	$	—		$	(327	)	$	14,505
U.S. Agencies		62,106		14		(96	)		(260	)		61,764
Collateralized mortgage obligations		16,969		294		—			(326	)		16,937
Mortgage pass-through securities		38,851		77		—			(1,129	)		37,799
Obligations of states and political subdivisions		492,640		13,833		(118	)		(10	)		506,345
Corporate bonds		66,943		1,375		(5	)		(1,059	)		67,254
Non-agency collateralized mortgage obligations		37,069		210		—			(817	)		36,462
Other asset-backed securities:
Second mortgages/home equity loans		20,925		—		(26	)		(150	)		20,749
Credit card receivables		17,230		211		—			—			17,441
Other		5,613		62		—			(140	)		5,535

Total fixed income securities		773,178		16,076		(245	)		(4,218	)		784,791
Equity securities		1,508		160		—			—			1,668

Total	$	774,686	$	16,236	$	(245	)	$	(4,218	)	$	786,459

CNA Surety classifies its fixed income securities and its equity securities as available-for-sale, and as such, they are carried at fair value. The amortized cost of fixed income securities is adjusted for amortization of premiums and accretion of discounts which are included in net investment income. Changes in fair value are reported as a component of other comprehensive income, exclusive of other-than-temporary impairment losses, if any.

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future interest rates, the Company did not have the intention of holding these securities to their anticipated recovery. These securities were sold during the third quarter. The other-than-temporary impairment losses on these securities were $0.9 million for the nine months ended September 30, 2007.

In response to the significant change in interest rates during the third quarter of 2006, the Company recognized impairment losses on 21 municipal fixed income securities that were in an unrealized loss position at September 30, 2006. The Company did not have the intention of holding these securities to their anticipated recovery and recorded $0.9 million other-than-temporary impairment losses on these securities for the three and nine months ended September 30, 2006.

As of September 30, 2007, 66 securities held by the Company were in an unrealized loss position. The Company believes that 64 of these securities are in an unrealized loss position because of changes in interest rates and therefore expects these securities will recover in value at or before maturity. Of these 64 securities, 41 were rated “AAA” by Standard & Poor’s (“S&P”) and “Aaa” by Moody’s Investor Services (“Moody’s”) and all were investment grade. Only five of these 64 securities were in a loss position that exceeded 5% of its book value, with the largest percentage unrealized loss being 8.6% of that security’s book value resulting in an unrealized loss of $0.5 million. The largest unrealized loss was $0.6 million, which was 6.0% of that security’s book value.

Of the two remaining securities that were in an unrealized loss position, one was issued by the financing subsidiary of a large domestic automaker. The security was in an unrealized loss position of 4.9% ($0.2 million) of its book value and was rated below investment grade by S&P and Moody’s. The other security, rated above investment grade by S&P and Moody’s, was issued by a large student loan provider and was in an unrealized loss position of 13.4% ($0.4 million) of its book value. The Company believes that the financial condition and near-term prospects of these issuers are strong, and expects that these unrealized losses will reverse.

The Company intends and believes it has the ability to hold these investments until the expected recovery in value, which may be at maturity.

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.

3. REINSURANCE

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


	Three Months Ended September 30,
	2007						2006
	Written			Earned			Written			Earned
Direct	$	93,169		$	93,729		$	85,663		$	85,766
Assumed		30,380			29,735			30,241			28,933
Ceded		(9,572	)		(9,847	)		(10,837	)		(11,901	)

	$	113,977		$	113,617		$	105,067		$	102,798


	Nine Months Ended September 30,
	2007						2006
	Written			Earned			Written			Earned
Direct	$	280,916		$	262,353		$	259,015		$	240,823
Assumed		86,986			85,602			88,932			84,903
Ceded		(28,935	)		(30,348	)		(31,777	)		(33,999	)

	$	338,967		$	317,607		$	316,170		$	291,727

Assumed premiums primarily includes all surety business written or renewed, net of reinsurance, by CCC and CIC, and their affiliates, after September 30, 1997 that is reinsured by Western Surety pursuant to reinsurance and related agreements. Because of certain regulatory restrictions that limit the Company’s ability to write business on a direct basis, the Company continues to utilize the underwriting capacity available through these agreements. The Company is in full control of all aspects of the underwriting and claim management of the business assumed from affiliates.

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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 September 30,
	2007					2006
	$		Ratio			$		Ratio
Gross losses and loss adjustment expenses	$	20,828		16.9	%	$	9,900		8.6	%
Ceded amounts		3,007		(30.5	)%		11,233		(94.4	%)

Net losses and loss adjustment expenses	$	23,835		21.0	%	$	21,133		20.6	%


	Nine Months Ended September 30,
	2007						2006
	$			Ratio			$		Ratio
Gross losses and loss adjustment expenses	$	79,401			22.8	%	$	65,082		20.0	%
Ceded amounts		(3,769	)		12.4	%		4,592		(13.5	%)

Net losses and loss adjustment expenses	$	75,632			23.8	%	$	69,674		23.9	%

During the three months ended September 30, 2007 and 2006, the Company, based on independent actuarial reviews performed during the respective quarters, reduced gross reserves by approximately $11.4 million and $17.0 million, respectively. These adjustments reflect changes in estimates of incurred-but-not-reported reserves. The corresponding change in ceded reserves was such that net reserves were reduced by $5.0 million and $5.1 million for the three months ended September 30, 2007 and 2006, respectively. These actions resulted in the unusual relationships in the gross and ceded amounts shown above.

2007 THIRD PARTY REINSURANCE COMPARED TO 2006 THIRD PARTY REINSURANCE

Effective January 1, 2007, CNA Surety entered into an excess of loss treaty (“2007 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the 2006 Excess of Loss Treaty. Under the 2007 Excess of Loss Treaty, the Company’s net retention per principal remained at $10 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company’s retention. The contract 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 2007 on bonds that were in force during 2007. The primary difference between the 2007 Excess of Loss Treaty and the Company’s 2006 Excess of Loss Treaty is as follows. The base annual premium for the 2007 Excess of Loss Treaty is $36.6 million compared to the actual cost of the 2006 Excess of Loss Treaty of $39.9 million. The large national contractor that was excluded from the 2006 treaty remained excluded from the 2007 Excess of Loss Treaty.

RELATED PARTY REINSURANCE

Reinsurance agreements together with the Services and Indemnity Agreement that are described below provide for the transfer of the surety business written by CCC and CIC to Western Surety.

The Services and Indemnity Agreement provides the Company’s insurance subsidiaries the authority to perform various administrative, management, underwriting and claim functions in order to conduct the business of CCC and CIC and to be reimbursed by CCC for services rendered. In consideration for providing the foregoing services, CCC has agreed to pay Western Surety a quarterly fee of $50,000. This agreement was renewed on January 1, 2007 and expires on December 31, 2007 and is annually renewable thereafter.

Through a surety quota share treaty (the “Quota Share Treaty”), CCC and CIC transfer to Western Surety all surety business written or renewed by CCC and CIC after September 30, 1997 (the “Merger Date”). The Quota Share Treaty was renewed on January 1, 2007 and expires on December 31, 2007 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. This contemplates an approximate 4% override commission for fronting fees to CCC and CIC on their actual direct acquisition costs.

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 September 30, 2007.

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Through a stop loss contract entered into at the Merger Date (the “Stop Loss Contract”), the Company’s insurance subsidiaries were protected from adverse loss experience on certain business underwritten after the Merger Date. The Stop Loss Contract between the 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 exceeded 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 the insurance subsidiaries a dollar amount equal to (i) the amount, if any, by which their actual accident year net loss ratio exceeds the applicable Loss Ratio Cap, multiplied by (ii) the applicable net earned premiums. As of September 30, 2007, the Company had billed and received $47.6 million under the Stop Loss Contract. The amount received under the Stop Loss Contract included $28.0 million held by the Company for losses covered by this contract that were incurred but not paid as of September 30, 2007. Also, due to favorable development of losses subject to the Stop Loss Contract as a result of the independent actuarial review performed in the third quarter of 2007, the Company has a payable of $1.7 million to CCC at September 30, 2007. As of December 31, 2006, the Company had billed $47.9 million and had received $45.9 million under the Stop Loss Contract.

The Company and CCC previously participated in a $40 million excess of $60 million reinsurance contract effective from January 1, 2005 to December 31, 2005 providing coverage exclusively for the one large national contractor excluded from the Company’s third party reinsurance. The premium for this contract was $3.0 million plus an additional premium of $6.0 million if a loss was ceded under this contract. In the second quarter of 2005, this contract was amended to provide unlimited coverage in excess of the $60 million retention, to increase the premium to $7.0 million, and to eliminate the additional premium provision. This treaty provides coverage for the life of bonds either in force or written during the term of the treaty which was from January 1, 2005 to December 31, 2005. In November 2005, the Company and CCC agreed by addendum to extend this contract for twelve months. This extension, which expired on December 31, 2006, was for an additional premium of $1.5 million, as adjusted based on the level of actual premiums written on bonds for the large national contractor. In January 2007, the Company and CCC agreed by addendum to extend this contract for another twelve months. This extension, which will expire on December 31, 2007, was for an additional premium subject to the level of actual premiums written on bonds for the large national contractor. As of September 30, 2007, this premium was $0.4 million. As of September 30, 2007 and December 31, 2006, the Company had ceded losses of $50.0 million under the terms of this contract.

As of September 30, 2007 and December 31, 2006, CNA Surety had an insurance receivable balance from CCC and CIC of $62.8 million and $61.9 million, respectively. As discussed above, the Company has a reinsurance payable of $1.7 million to CCC as of September 30, 2007. CNA Surety had no reinsurance payables to CCC and CIC as of December 31, 2006.

4. 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						Nine Months Ended
	September 30,						September 30,
	2007			2006			2007			2006
Reserves at beginning of period:
Gross	$	435,569		$	435,725		$	434,224		$	424,449
Ceded reinsurance		142,976			155,237			144,858			147,435

Net reserves at beginning of period		292,593			280,488			289,366			277,014

Net incurred loss and loss adjustment expenses:
Provision for insured events of current period		28,863			26,266			80,710			74,974
Decrease in provision for insured events of prior periods		(5,028	)		(5,133	)		(5,078	)		(5,300	)

Total net incurred		23,835			21,133			75,632			69,674

Net payments attributable to:
Current period events		1,470			2,525			7,044			4,076
Prior period events		5,852			21,929			48,848			65,445

Total net payments		7,322			24,454			55,892			69,521

Net reserves at end of period		309,106			277,167			309,106			277,167
Ceded reinsurance at end of period		138,352			143,070			138,352			143,070

Gross reserves at end of period	$	447,458		$	420,237		$	447,458		$	420,237

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5. DEBT

On July 27, 2005, the Company refinanced $30.0 million in outstanding borrowings under its previous credit facility with a new credit facility (the “2005 Credit Facility”). The 2005 Credit Facility provided an aggregate of up to $50.0 million in borrowings under a revolving credit facility. In September 2006, the Company reduced the available aggregate revolving credit facility to $25.0 million in borrowings. The 2005 Credit Facility matures on June 30, 2008. No other debt matures in the next five years.

The term of borrowings under the 2005 Credit Facility may be fixed, at the Company’s option, for a period of one, two, three, or six months. The interest rate is based on, among other rates, the London Interbank Offered Rate (“LIBOR”) plus the applicable margin. The margin, including a utilization fee, can vary based on the Company’s leverage ratio (debt to total capitalization) from 0.80% to 1.00%. There was no outstanding balance under the 2005 Credit Facility during the three and nine months ended September 30, 2007. In the third quarter of 2006, the outstanding Credit Facility balance of $20.0 million was paid. As such, the Company paid only the facility fee of 0.325% at both September 30, 2007 and 2006.

The 2005 Credit Facility contains, among other conditions, limitations on the Company with respect to the incurrence of additional indebtedness and maintenance of a rating of at least A- by A.M. Best Company, Inc. (“A.M. Best”) for each of the Company’s insurance subsidiaries. The 2005 Credit Facility also requires the maintenance of certain financial ratios as follows: a) maximum funded debt to total capitalization ratio of 25%, b) minimum net worth of $375.0 million and c) minimum fixed charge coverage ratio of 2.5 times. The Company was in compliance with all covenants as of and for the three and nine months ended September 30, 2007.

In May 2004, the Company, through a wholly-owned trust, privately issued $30.0 million of preferred securities through two pooled transactions. These securities bear interest at a rate of LIBOR plus 337.5 basis points with a 30-year term and are redeemable at par value after five years. The securities were issued by CNA Surety Capital Trust I (the “Issuer Trust”). The Company’s investment of $0.9 million in the Issuer Trust is carried at cost in “Other assets” in the Company’s Condensed Consolidated Balance Sheet. The sole asset of the Issuer Trust consists of a $30.9 million junior subordinated debenture issued by the Company to the Issuer Trust. 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 $75.0 million, consisting of annual dividend payments of $1.5 million over 30 years and the redemption value of $30.0 million. Because payment under the guarantee would only be required if the Company does not fulfill its obligations under the debentures held by the Issuer Trust, the Company has not recorded any additional liabilities related to this guarantee.

The subordinated debenture bears interest at a rate of LIBOR plus 337.5 basis points and matures in April 2034. As of September 30, 2007 and 2006, the interest rate on the junior subordinated debenture was 8.933% and 8.780%, respectively.

6. 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 postretirement health care plan is contributory and the sick leave plan is non-contributory. Western Surety uses a December 31 measurement date for both of its postretirement benefit plans. There were no plan assets for either of the postretirement benefit plans.

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


	Three Months Ended September 30,					Nine Months Ended September 30,
	2007		2006			2007			2006
Net periodic benefit cost:
Service cost	$	97	$	46		$	250		$	194
Interest cost		227		152			572			438
Prior service cost		—		(41	)		(80	)		(121	)
Recognized net actuarial loss		127		78			290			203

Net periodic benefit cost	$	451	$	235		$	1,032		$	714

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The Company uses a rollforward technique to develop its year-end measurement of the accumulated postretirement benefit obligation and subsequently performs a valuation as of January 1 of the following year using updated data. This valuation was completed during the third quarter of 2007. As a result, in the third quarter of 2007, the liability for postretirement benefits and the 2007 net periodic benefit costs have been adjusted. The postretirement benefit liability increased $1.2 million. Net periodic benefit costs also increased $0.2 million for the three months ended September 30, 2007 due to this remeasurement. These increases were driven by changes in the design of the postretirement healthcare plan for 2007.

As a result of adopting SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (an amendment of FASB Statements No. 87, 88, 106, and 132(R) (“SFAS 158”) as of December 31, 2006, amortization of prior service costs and net actuarial (gains)/losses recognized through the statement of income for the three and nine months ended September 30, 2007 are also adjusted through other comprehensive income.

The Company expects to contribute $0.1 million to the postretirement benefit plans to pay benefits for the remainder of 2007. As of September 30, 2007, $0.2 million of contributions have been made to the postretirement benefit plans.

7. COMMITMENTS AND CONTINGENCIES

The Company is party to various lawsuits arising in the normal course of business. The Company believes the resolution of these lawsuits will not have a material adverse effect on its financial condition or its results of operations.

8. STOCK-BASED COMPENSATION

The compensation expense recorded for the Company’s stock-based compensation plans was $0.5 million and $0.3 million for the three months ended September 30, 2007 and 2006, respectively, and $1.5 million and $1.0 million for the nine months ended September 30, 2007 and 2006, respectively. The total income tax benefit recognized in the statement of income for stock-based compensation arrangements was $0.2 million and $0.1 million for the three months ended September 30, 2007 and 2006, respectively, and $0.5 million and $0.3 million for the nine months ended September 30, 2007 and 2006, respectively . The amount of cash received from the exercise of stock options was $0.4 million and $1.0 million for the three months ended September 30, 2007 and 2006, respectively, and $2.2 million and $5.8 million for the nine months ended September 30, 2007 and 2006, respectively.

EQUITY COMPENSATION PLANS

The Company previously reserved shares of its common stock for issuance to directors, officers, employees and certain advisors of the Company through incentive stock options, non-qualified stock options and stock appreciation rights (“SARs”) to be granted under the CNA Surety 1997 Long-Term Equity Compensation Plan (the “1997 Plan”). Option exercises under the 1997 Plan were settled in newly issued common shares. No options were granted under the 1997 Plan during the three or nine months ended September 30, 2006.

The Company’s 2006 Long-Term Equity Compensation Plan (the “2006 Plan”), approved by shareholders on April 25, 2006, replaced the 1997 Plan. Incentive stock options, non-qualified stock options, restricted stock, bonus shares, or SARs may be granted to directors, officers, employees and certain advisors of the Company under the 2006 Plan. The aggregate number of shares initially available for which options may be granted under the 2006 Plan was 3,000,000. Option exercises under the 2006 Plan are settled in newly issued common shares.

The 2006 Plan is administered by a committee (the “Committee”) of the Board of Directors, 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 option exercise prices. Exercise prices 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 non-qualified stock options.

The 2006 Plan provides for the granting of incentive stock options as defined under Section 382 of the Internal Revenue Code of 1986, as amended. All non-qualified 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.

On February 13, 2007, 334,100 options were granted under the 2006 Plan. The fair market value (at grant date) per option granted was $9.04 for these options. The fair value of these options was estimated at grant date using a Black-Scholes option pricing model

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with the following weighted average assumptions: risk free interest rate of 4.8%; dividend yield of 0.0%; expected option life of 6.3 years; and volatility of 34.7%. As of September 30, 2007, the number of shares available for granting of options under the 2006 Plan was 2,673,700.

A summary of option activity for the nine months ended September 30, 2007 and 2006 is presented below:


				Weighted
				Average
	Shares			Exercise
	Subject			Price Per
	To Option			Share
Outstanding options at January 1, 2006		1,587,909		$	12.41
Options granted		—			—
Options forfeited		(29,175	)	$	12.32
Options expired		(21,275	)	$	14.04
Options exercised		(401,859	)	$	13.21

Outstanding options at September 30, 2006		1,135,600		$	12.09

Outstanding options at January 1, 2007		1,008,525		$	12.02
Options granted		334,100		$	20.70
Options forfeited		(32,075	)	$	14.36
Options expired		(790	)	$	15.20
Options exercised		(141,160	)	$	12.49

Outstanding options at September 30, 2007		1,168,600		$	14.38

A summary of the status of the Company’s non-vested options as of September 30, 2007 and 2006 and changes during the nine months then ended is presented below:


				Weighted
	Shares			Average
	Subject			Grant Date
	To Option			Fair Value
Non-vested options at January 1, 2006		785,845		$	4.40
Options granted		—			—
Options vested		(14,750	)	$	3.73
Options forfeited		(29,175	)	$	4.53

Non-vested options at September 30, 2006		741,920		$	4.41

Non-vested options at January 1, 2007		481,613		$	4.51
Options granted		334,100		$	9.04
Options vested		(14,750	)	$	3.73
Options forfeited		(32,075	)	$	5.67

Non-vested options at September 30, 2007		768,888		$	6.45

A summary of the options vested or expected to vest and options exercisable as of September 30, 2007 is presented below:

Options Vested or Expected to Vest

Weighted

Weighted Average

Average

Aggregate

Remaining

Number

Exercise Price

Intrinsic Value

Contractual Life

September 30, 2007

1,099,242

14.01

4,803,674

7.2 years

Options Exercisable

Weighted

Weighted Average

Average

Aggregate

Remaining

Number

Exercise Price

Intrinsic Value

Contractual Life

September 30, 2007

399,712

11.51

2,444,597

5.4 years

The total intrinsic value of options exercised was $0.1 million and $0.3 million for the three months ended September 30, 2007 and 2006, respectively, and $1.2 million and $1.6 million for the nine months ended September 30, 2007 and 2006, respectively. The tax benefits recognized by the Company for these exercises were less than $0.1 million for the three months ended September 30, 2007. Tax benefits recognized by the Company were $0.2 million for the three months ended September 2006. Tax benefits recognized by the Company were $0.4 million and $0.6 million for the nine months ended September 30, 2007 and 2006 respectively.

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As of September 30, 2007, there was $1.9 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: 2007 — $0.4 million; 2008 — $0.9 million; 2009 — $0.4 million; and 2010 — $0.2 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, 2006.

CRITICAL ACCOUNTING POLICIES

Management believes the most significant accounting policies and related disclosures for purposes of understanding the Company’s results of operations and financial condition pertain to reserves for unpaid losses and loss adjustment expenses and reinsurance, investments, goodwill and other intangible assets, recognition of premium revenue and the related unearned premium liability, and deferred policy acquisition costs. The Company’s accounting policies related to reserves for unpaid losses and loss adjustment expenses and related estimates of reinsurance recoverables are particularly critical to an assessment of the Company’s financial results. Given the nature of the surety business, the determination of these balances is inherently a highly subjective exercise, which requires management to analyze, weigh, and balance numerous macroeconomic, customer specific, and claim specific factors and trends, most of which, in themselves, are inherently uncertain and difficult to predict.

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 estimate is established on the claim file for the amount the Company estimates it will have to pay to honor its obligations under the provisions of the bond(s).

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

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 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 indemnification recoveries.

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The following table shows the estimated liability as of September 30, 2007 for unpaid claims applicable to reported claims and to IBNR for each sub-line of business (dollars in thousands):


	Gross Case Loss		Gross IBNR Loss		Total Gross
	and LAE Reserves		and LAE Reserves		Reserves
Contract	$	115,343	$	158,073	$	273,416
Commercial		104,596		57,338		161,934
Fidelity and other		4,015		8,093		12,108

Total	$	223,954	$	223,504	$	447,458

The Company retains an independent actuarial firm of national standing to perform periodic actuarial analyses of the Company’s loss reserves. These analyses typically include a comprehensive review performed in the third quarter based on data as of June 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 prepared by the independent actuarial firm based on expected claim activity and consults with the actuarial firm as necessary.

The independent actuarial firm’s analyses are based upon multiple projection methodologies that involve detailed statistical analysis of past claim reporting, settlement activity, and indemnification activity, as well as claim frequency and severity data when sufficient information exists to lend statistical credibility to the analysis. The analysis may be based upon internal loss experience or industry experience. Methodologies may vary depending on the type of claim being estimated. While methodologies may vary, each employs significant judgments and assumptions.

In estimating the unpaid claim liabilities, the independent actuarial firm employed the following projection methodologies:

	-		Historical development method, sometimes referred to as a link ratio method;

	-		Bornhuetter-Ferguson method on both a paid and incurred basis;

	-		Average hindsight outstanding projection method;

	-		Frequency-severity method; and

	-		Loss ratio method.

The following provides a summary of these projection methodologies:

Historical Development Method

As a group of claims matures, their collective value changes. This change in value over time is referred to as loss development. The loss development method is a traditional actuarial approach which relies on the historical changes in losses from one evaluation point to another to project the current valuation of losses to ultimate settlement values. Development patterns which have been exhibited by more mature (older) years are used to estimate the expected development of the less mature (more recent) years. The strength of this method is that it is very responsive to emerging loss experience for each accident year. The weakness is that this method can become highly leveraged and volatile for less mature accident years.

Bornhuetter-Ferguson Method

The incurred Bornhuetter-Ferguson (“B-F”) method is commonly used to provide a more stable estimate of ultimate losses in situations where loss development is volatile, substantial and/or immature. The method calculates IBNR (or unpaid loss when conducting a paid B-F projection) directly as the product of:

Expected Ultimate Losses multiplied by IBNR (or Unpaid) Percentage.

The IBNR (or unpaid) percentage is derived from the incurred (or paid) loss development patterns. Various approaches can be used to determine the expected ultimate losses (e.g., prior year estimates, pricing assumptions, etc.). To obtain an estimate of expected ultimate losses, the independent actuarial firm utilized an expected loss ratio (ultimate losses divided by earned premium) based on review of prior accident years’ loss ratio experience. This estimate was then applied to the more recent accident years’ earned premium. The strength of the B-F method is that it is less leveraged than the historical development method and thus does not result in an overreaction to an unusual claim occurrence (or an unusual lack of claims). The weakness of the method is that it is reliant on an initial expectation of ultimate losses.

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Average Hindsight Outstanding Method

This method relies on the older, more mature accident years’ ultimate loss estimates to restate what the outstanding losses should have been, with hindsight, by accident year by stage of development. These restated hindsight outstanding losses are then trended to the appropriate cost levels for the accident years being projected and added to the paid to date losses in order to generate indicated ultimate losses for the more recent accident years. The strength of this method is that it is relatively unaffected by changes in a company’s case reserving practices. The weaknesses of this method are that it is sensitive to payment pattern shifts and that the average hindsight severities can become highly variable for certain datasets.

Frequency-Severity Method

This method first projects the expected number of claims for each accident year and then multiplies this estimate by the expected average cost of claims for the applicable accident year. The number of claims can be projected using the historical development technique or other methodology. The average cost of claims for the more recent accident years is estimated by observing the estimated average cost of claims for the older more mature accident years and trending those values to appropriate cost levels for the more recent accident years. The strength of this method is that it is not reliant on loss development factors for less mature accident years which can become highly leveraged and volatile. The weakness is that this method is slow to react to an abrupt change in claim severities.

Loss Ratio Method

This method relies on historical projected ultimate loss ratios for the more mature accident years to estimate the more recent, less mature accident years’ ultimate losses. Applying a selected loss ratio (by reviewing more mature years) to the more recent years’ earned premium results in an indication of the more recent years’ ultimate losses. The strength of this method is that it can be used in connection with a company’s pricing targets and can be used when the historical data has limited credibility. The weakness of this method is that it is slow to react to the emerging loss experience for a particular accident year.

Each of the projection methodologies employed rely to varying degrees on the basic assumption that the Company’s historical claim experience is indicative of the Company’s future claim development. The amount of weight given to any individual projection method is based on an assessment of the volatility of the historical data and development patterns, an understanding of the changes in the overall surety industry over time and the resultant potential impact of these changes on the Company’s prospective claims development, an understanding of the changes to the Company’s processes and procedures within its underwriting, claims handling and data systems functions, among other things. The decision as to how much weight to give to any particular projection methodology is ultimately a matter of experience and professional judgment.

Surety results, especially for contract and certain commercial products like insurance program bonds, workers compensation insurance bonds and reclamation bonds, tend to be impacted by fewer, but more severe, losses. With this type of loss experience, it is more difficult to estimate the required reserves, particularly for the most current accident years which may have few reported claims. Therefore, assumptions related to the frequency and magnitude of severe loss are key in estimating surety loss reserves. The Company experienced a period of unusually high frequency of severe loss in accident years 2002 and 2003. The Company’s claim experience improved dramatically since 2004. As a result, the independent actuarial firm’s current analysis places less reliance on the severe loss experience in accident years 2002 and 2003.

The indicated reserve was developed by reviewing the Company’s claims experience by accident year for several individual sub-lines of business. Within each sub-line, the selection of the point estimate was made after consideration of the appropriateness of the various projection methodologies in light of the sub-line’s loss characteristics and historical data. In general, for the older, more mature, accident years the historical development method (i.e., link ratio method) was relied upon more heavily. For the more recent years, the indicated reserves were more heavily based on the Bornhuetter-Ferguson and loss ratio methods since these are not as reliant on the Company’s large (i.e., leveraged) development factors and thus are believed to represent a more stable set of methods from which to select indicated reserves for the more recent years.

The independent actuarial firm’s analysis is the primary tool that management utilizes in determining its best estimate of loss reserves. However, the carried reserve may differ from the independent actuarial firm’s 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;

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	-		Changes in the claims handling process; 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 may apply its judgment of the impact of these factors, and others, to its selection of the recorded loss reserves.

The following table shows the point estimate as determined by the Company’s independent actuarial firm at December 31, 2006 and as of their most recent analysis, June 30, 2007, which was completed during the third quarter of 2007, compared to the actual loss reserve established by management, both gross and net of reinsurance (dollars in thousands):


Gross Basis:
Recorded loss reserves at December 31, 2006	$	434,224
Actuarial point estimate at December 31, 2006		438,313

Difference at December 31, 2006	$	(4,089	)

Difference as a % of actuarial point estimate		(0.9	)%

Recorded loss reserves at June 30, 2007	$	435,569
Actuarial point estimate at June 30, 2007		422,169

Difference at June 30, 2007	$	13,400

Difference as a % of actuarial point estimate		3.2	%

Recorded loss reserves at September 30, 2007	$	447,458


Net Basis:
Recorded loss reserves at December 31, 2006	$	289,366
Actuarial point estimate at December 31, 2006		292,703

Difference at December 31, 2006	$	(3,337	)

Difference as a % of actuarial point estimate		(1.1	)%

Recorded loss reserves at June 30, 2007	$	292,593
Actuarial point estimate at June 30, 2007		284,975

Difference at June 30, 2007	$	7,618

Difference as a % of actuarial point estimate		2.7	%

Recorded loss reserves at September 30, 2007	$	309,106

At December 31, 2006, management’s recorded gross and net reserves were slightly lower than the point estimate determined by the independent actuarial firm, with the percentage difference being somewhat larger on a net basis. At December 31, 2006, management believed continued improvement in economic conditions, lower corporate default rates and fewer reported severe claims indicated a lower provision for severe losses was appropriate. Management believed that the actuarial point estimates included provisions in the most recent accident year for severe losses that continue to be influenced by the Company’s experience in accident years 2002 and 2003 and did not fully reflect the favorable economic conditions, changes in the Company’s exposures and favorable claim experience during the most recent accident years.

The conclusion of the independent actuarial firm’s analyses conducted during the third quarter of 2007 with data as of June 30, 2007 resulted in lower point estimates, confirming the positive loss trends noted by management. These positive loss trends include improvement in the most recent accident years due to fewer reported severe claims and better than expected indemnification recoveries in the more mature accident years of 2003 and prior. As a result of the actuarial analysis, management’s recorded reserves, as of September 30, 2007, on both a gross and net basis, reflect the improvement of these older accident years but also reflect provisions in the more recent accident years primarily in consideration of the volatility of economic conditions evidenced by current events in the sub-prime mortgage industry and residential construction economy.

Receivables recorded with respect to insurance losses ceded to reinsurers under reinsurance contracts are estimated in a manner

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similar to liabilities for insurance losses and, therefore, are also subject to uncertainty. In addition to the factors cited above, 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 degree of such variation could be significant and in either direction from the estimates and could result in actual losses outside of the estimated reserve range. The sources of this inherent variability are numerous — future economic conditions, court decisions, legislative actions, and individual large claim impacts, for example.

The range of reasonable reserve estimates is not intended to reflect the maximum and/or minimum possible outcomes; but rather reflects a range of reasonable estimates given the uncertainty in estimating unpaid claim liabilities for surety business. Further, there is no generally accepted method to estimating reserve ranges, but rather many concepts are currently being vetted within actuarial literature.

In developing the indicated range of reserve estimates for the Company, the independent actuarial firm utilized the Mack methodology and their point estimate analysis in order to estimate the requisite reserve distribution parameters. The Mack methodology is premised on the idea that the volatility in a company’s historical paid loss development is representative of the variability in a company’s future payments and thus can be used to estimate the variability within a company’s reserve estimate. Given the dispersion of the reserve indications, along with its experience and professional judgment, the independent actuarial firm selected the 50th and 75th percentile as representing a reasonable range of reserve estimates.

At December 31, 2006, the range of reasonable loss reserve estimates, net of reinsurance receivables, calculated by the independent actuarial firm and adopted by management was from $247 million to $353 million. The 2007 interim review of loss reserves includes only an actuarial point estimate. A new reserve range will be calculated as a part of the December 31, 2007 actuarial review. Ranges of reasonable loss reserve estimates are not calculated for the sub-lines of business. Management believes that the range calculated over total reserves provides the most meaningful information due to the importance of correlation of losses between the sub-lines of business related to the impact of general economic conditions.

The primary factors that would result in the Company’s actual losses being closer to either end of the reserve range is the emergence of (or lack thereof) a small number of large claims, as well as the recovery of (or lack thereof) a small number of large indemnification amounts. In other words, the primary factors that, if they were to occur, would result in the Company’s actual payments being at the high end of the indicated range are if the Company experiences an unusually high number of large claims and/or an unusually low number of large indemnification recoveries. Conversely, if the Company were to experience an unusually low number of large claims and/or an unusually high number of large indemnification recoveries, the Company’s actual payments would tend to be at the low end of the range. These variations in outcomes could be driven by broader issues such as the state of the construction economy or the level of corporate defaults, or by the specific facts and circumstances surrounding individual claims. Again, it is important to note that it is possible that the actual payments could fall outside of the estimated range.

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

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 classifies all of its fixed income securities (bonds and redeemable preferred stocks) and equity securities as available-for-sale. These securities are reported at fair value, with unrealized gains and losses, net of deferred income taxes, reported in stockholders’ equity as a separate component of accumulated other comprehensive income. Cash flows from purchases, sales and maturities are reported gross in the investing activities section of the Condensed Consolidated Statements of Cash Flows.

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The amortized cost of fixed income securities is determined based on cost and the cumulative effect of amortization of premiums and accretion of discounts. Such amortization and accretion are included in investment income. For mortgage-backed and certain asset-backed securities, the Company recognizes income using the effective-yield method based on estimated cash flows. All securities transactions are recorded on the trade date. Investment gains or losses realized on the sale of securities are determined using the specific identification method. Investments with an other-than-temporary decline in value are written down to fair value, resulting in losses that are included in realized investment gains and losses.

Short-term investments, which generally include U.S. Treasury bills, corporate notes, money market funds, and investment grade commercial paper are carried at amortized cost that 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 significantly affect the amounts reported in the Condensed Consolidated Balance Sheets and Condensed Consolidated Statements of Income.

INTANGIBLE ASSETS

CNA Surety’s Condensed Consolidated Balance Sheet as of September 30, 2007 and December 31, 2006 includes intangible assets of approximately $138.8 million. These amounts represent goodwill and identified intangibles arising from the acquisition of Capsure Holdings Corp.

A significant amount of judgment is required in performing intangible asset impairment tests. Such tests are performed annually on October 1, or more frequently if events or changes indicate that the estimated fair value of an intangible asset might be impaired. Under the relevant standard, fair value refers to the amount for which the entire reporting unit may be bought or sold. There are several methods of estimating fair value, including market quotations, asset and liability fair values and other valuation techniques, such as discounted cash flows and multiples of earnings or revenues. The Company uses a valuation technique based on discounted cash flows. If the carrying amount of a reporting unit, including goodwill, exceeds the estimated fair value, then individual assets, including identifiable intangible assets, and liabilities of the reporting unit are estimated at fair value. The excess of the estimated fair value of the reporting unit over the estimated fair value of net assets would establish the implied value of intangible assets. The excess of the recorded amount of intangible assets over the implied value of intangible assets is recorded as an impairment loss.

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.

DEFERRED POLICY ACQUISITION 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 acquisition costs are recoverable based on the expected profitability embedded in the reserve for unearned premium. If the expected profitability is less than the balance of deferred acquisition costs, a charge to net income is taken and the deferred 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 acquisition costs.

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

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 acquisition costs, to net earned premiums. The combined ratio is the sum of the loss and expense ratios.

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 RESULTS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006

ANALYSIS OF NET INCOME

Net income for the three months ended September 30, 2007 was $28.0 million, or $0.63 per diluted share, compared to $23.6 million, or $0.54 per diluted share, for the same period in 2006. The increase in net income reflects higher earned premium, higher net investment income, and the impact of a lower expense ratio.

Net income for the nine months ended September 30, 2007 was $70.6 million, or $1.60 per diluted share, compared to $61.1 million, or $1.39 per diluted share, in 2006. The increase in net income reflects higher earned premium, higher net investment income, and the impacts of lower loss and expense ratios.

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

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RESULTS OF INSURANCE OPERATIONS

Underwriting components for the Company for the three and nine months ended September 30, 2007 and 2006 are summarized in the following table (dollars in thousands):


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2007			2006			2007			2006
Gross written premiums	$	123,549		$	115,904		$	367,902		$	347,947

Net written premiums	$	113,977		$	105,067		$	338,967		$	316,170

Net earned premiums	$	113,617		$	102,798		$	317,607		$	291,727

Net losses and loss adjustment expenses	$	23,835		$	21,133		$	75,632		$	69,674

Net commissions, brokerage and other expenses	$	59,952		$	56,527		$	170,870		$	160,954

Loss ratio		21.0	%		20.6	%		23.8	%		23.9	%
Expense ratio		52.8			55.0			53.8			55.2

Combined ratio		73.8	%		75.6	%		77.6	%		79.1	%

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 (“E&O”) insurance coverage.

The Company assumes significant amounts of premiums primarily from affiliates. This includes all 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 (the “Merger Date”) that is reinsured by Western Surety Company (“Western Surety”) pursuant to reinsurance and related agreements. Because of certain regulatory restrictions that limit the Company’s ability to write business on a direct basis, the Company continues to utilize the underwriting capacity available through these agreements. The Company is in full control of all aspects of the underwriting and claim management of the assumed business.

Gross written premiums are summarized in the following table (dollars in thousands):


	Three Months Ended September 30,				Nine Months Ended September 30,
	2007		2006		2007		2006
Contract	$	82,381	$	74,444	$	240,397	$	220,646
Commercial		33,361		33,862		103,048		102,734
Fidelity and other		7,807		7,598		24,457		24,567

	$	123,549	$	115,904	$	367,902	$	347,947

For the quarter ended September 30, 2007, gross written premiums increased 6.6 percent to $123.5 million compared to the quarter ended September 30, 2006. Gross written premiums for contract surety increased 10.7 percent to $82.4 million primarily due to the strength of the non-residential construction economy and the success of the Company’s small contractor product. Commercial surety gross written premiums decreased slightly for the quarter as selective underwriting in the large commercial market resulted in lower premium production. Small commercial and related fidelity and other premiums returned to a more normal growth rate of 3% as prior period comparisons are no longer impacted by the loss of a large notary bond producer in 2006.

For the nine months ended September 30, 2007, gross written premiums increased 5.7 percent to $367.9 million compared to the nine-month period ended September 30, 2006. Gross written premiums for contract surety increased 9.0 percent to $240.4 million primarily due to the strength of the non-residential construction economy and the success of the Company’s small contractor product. Both large and small commercial surety gross written premiums increased slightly for the first nine months of 2007. Fidelity and other premiums decreased slightly for the first nine months of 2007.

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Net written premiums are summarized in the following table (dollars in thousands):


	Three Months Ended September 30,				Nine Months Ended September 30,
	2007		2006		2007		2006
Contract	$	73,824	$	64,896	$	214,344	$	192,299
Commercial		32,346		32,573		100,166		99,304
Fidelity and other		7,807		7,598		24,457		24,567

	$	113,977	$	105,067	$	338,967	$	316,170

For the quarter ended September 30, 2007, net written premiums increased 8.5 percent to $114.0 million compared to the third quarter of 2006, primarily due to the increase in gross written premiums as described above.

For the nine months ended September 30, 2007, net written premiums increased 7.2 percent to $339.0 million, primarily due to the increase in gross written premiums described above and a decrease in ceded written premiums. Ceded written premiums decreased $2.8 million to $28.9 million for the first nine months of 2007 compared to the same period last year. This decrease reflects lower costs for reinsurance for a specific account and savings on the core reinsurance program.

Net earned premiums are summarized in the following table (dollars in thousands):


	Three Months Ended September 30,				Nine Months Ended September 30,
	2007		2006		2007		2006
Contract	$	72,482	$	61,553	$	196,424	$	170,046
Commercial		33,162		32,848		97,545		96,261
Fidelity and other		7,973		8,397		23,638		25,420

	$	113,617	$	102,798	$	317,607	$	291,727

For the quarter ended September 30, 2007, net earned premiums increased 10.5 percent to $113.6 million compared to the third quarter of 2006, primarily due to the increase in gross written premiums as described above.

For the nine months ended September 30, 2007, net earned premiums increased 8.9 percent to $317.6 million, primarily due to the increase in gross written premiums and the decrease in ceded written premiums described above.

EXCESS OF LOSS REINSURANCE

The Company’s reinsurance program is predominantly comprised of excess of loss reinsurance contracts that limit the Company’s retention on a per principal basis. The Company’s reinsurance coverage is provided by third party reinsurers and related parties.

2007 THIRD PARTY REINSURANCE COMPARED TO 2006 THIRD PARTY REINSURANCE

Effective January 1, 2007, CNA Surety entered an excess of loss treaty (“2007 Excess of Loss Treaty”) with a group of third party reinsurers on terms similar to the 2006 Excess of Loss Treaty. Under the 2007 Excess of Loss Treaty, the Company’s net retention per principal remained at $10 million with a 5% co-participation in the $90 million layer of third party reinsurance coverage above the Company’s retention. The contract 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 2007 on bonds that were in force during 2007. The primary difference between the 2007 Excess of Loss Treaty and the Company’s 2006 Excess of Loss Treaty is as follows. The base annual premium for the 2007 Excess of Loss Treaty is $36.6 million compared to the actual cost of the 2006 Excess of Loss Treaty of $39.9 million. The large national contractor that was excluded from the 2006 treaty remained excluded from the 2007 Excess of Loss Treaty.

RELATED PARTY REINSURANCE

Reinsurance agreements together with the Services and Indemnity Agreement that are described below provide for the transfer of the surety business written by CCC and CIC to Western Surety.

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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 $25.0 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 does have accounts with bonded backlogs greater than $30.0 million.

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The Company manages its exposure to any one contract credit and aggressively looks for co-surety, shared accounts and other means to support or reduce larger exposures. Reinsurance and indemnification rights, including rights to contract proceeds on construction projects in the event of default, exist that substantially reduce CNA Surety’s exposure to loss.

NET LOSS RATIO

The net loss ratio was 21.0% for the three months ended September 30, 2007 compared with 20.6% for the same period in 2006. These loss ratios include favorable development on prior accident years of $5.0 million, or approximately 4 percentage points, compared to $5.1 million, or approximately 5 percentage points, in the same period last year. The favorable loss development in 2007 resulted primarily from decreased severity due to better than expected indemnification recoveries in the more mature accident years of 2003 and prior. The favorable development in 2006 was primarily due to decreased severity of contract claims in the 2005 accident year.

The net loss ratio was 23.8% for the nine months ended September 30, 2007 compared with 23.9% for the same period in 2006. The improved loss ratio primarily reflects overall improved claim experience.

EXPENSE RATIO

The expense ratio was 52.8% for the three months ended September 30, 2007 compared to 55.0% for the same period in 2006. The expense ratio was 53.8% for the nine months ended September 30, 2007 compared to 55.2% for the same period in 2006. The improvement in the ratio reflects earned premium growth as discussed above and continued focus on expense management.

INVESTMENT INCOME AND REALIZED INVESTMENT GAINS/LOSSES

Net investment income was $11.3 million for the three months ended September 30, 2007, compared to $9.8 million for the same period in 2006. This increase is due to an increase in invested assets and higher yields. The annualized pre-tax yield was 4.6% and 4.5% for the three months ended September 30, 2007 and 2006, respectively. The annualized after-tax yield was 3.8% and 3.7% for the three months ended September 30, 2007 and 2006, respectively. Net realized investment gains were $0.1 million for the quarter ended September 30, 2007 compared to net realized investment losses of $1.0 million in the same period of 2006. This change was primarily due to the recognition of impairment losses on certain fixed income securities in the third quarter of 2006.

Net investment income was $32.8 million for the nine months ended September 30, 2007 compared with $29.0 million for the same period of 2006. The increase is due to the impact of higher overall invested assets and higher yields. The annualized pre-tax yields were 4.6% and 4.5% for the nine months ended September 30, 2007 and 2006, respectively. The annualized after-tax yields were 3.8% and 3.7% for the nine months ended September 30, 2007 and 2006, respectively. Net realized investment losses were $0.5 million and $0.9 million for the first nine months of 2007 and 2006 respectively.

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


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2007			2006			2007			2006
Gross realized investment gains	$	123		$	41		$	514		$	155
Gross realized investment losses		(58	)		(1,040	)		(1,000	)		(1,049	)

Net realized investment gains (losses)	$	65		$	(999	)	$	(486	)	$	(894	)

The gross realized investment losses for the nine months ended September 30, 2007 resulted from impairment of certain fixed income securities which are discussed in the Financial Condition section of this MD&A. The gross realized investment losses for the three and nine months ended September 30, 2006 resulted from impairment of certain fixed income securities in the third quarter of 2006 which are discussed in the Financial Condition section of this MD&A.

The Company’s investment portfolio generally is 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.

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Invested assets are exposed to various risks, such as interest rate, market and credit. 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.

INTEREST EXPENSE

Interest expense decreased by 23.0 percent for the three months ended September 30, 2007 compared with the same period in 2006, due to a reduction in weighted average debt outstanding during 2006. Weighted average debt outstanding was $30.9 million for the three months ended September 30, 2007 compared to $44.1 million for the same period in 2006. The weighted average interest rate for the three months ended September 30, 2007 was 8.8% as compared with 8.0% for the same period in 2006.

Interest expense decreased by 25.1 percent for the nine months ended September 30, 2007 compared with the same period in 2006. Weighted average debt outstanding was $30.9 million for the nine months ended September 30, 2007 compared to $50.9 million in the same period in 2006. The weighted average interest rate for the nine months ended September 30, 2007 was 8.8% as compared with 7.5% for the same period in 2006.

INCOME TAXES

For the three and nine months ended September 30, 2007 and 2006, respectively, the Company’s effective tax rate differs from the statutory tax rate due primarily to tax-exempt investment income. Tax-exempt investment income was $5.5 million and $15.4 million for the three and nine months ended September 30, 2007. Tax-exempt investment income was $4.5 million and $13.3 million for the three and nine months ended September 30, 2006.

LIQUIDITY AND CAPITAL RESOURCES

It is anticipated that the liquidity requirements of CNA Surety will be met primarily with funds generated from its insurance operations. The principal sources of consolidated cash flows are premiums, investment income, sales and maturities of investments, and reinsurance recoveries. CNA Surety also may generate funds from additional borrowings under the credit facility described below. The primary cash flow uses are payments for claims, operating expenses, reinsurance premiums, 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. At September 30, 2007, the carrying value of the Company’s insurance subsidiaries’ invested assets was comprised of $882.9 million of fixed income securities, $74.7 million of short-term investments and $12.0 million of cash. At December 31, 2006, the carrying value of the Company’s insurance subsidiaries’ invested assets was comprised of $784.0 million of fixed income securities, $94.2 million of short-term investments and $3.5 million of cash.

Cash flow at the parent company level is derived principally from dividend and tax sharing payments from its insurance subsidiaries. The principal obligations at the parent company level are to service debt and pay operating expenses, including income taxes. At September 30, 2007, the parent company’s invested assets consisted of $0.6 million of fixed income securities, $1.8 million of equity securities, $3.2 million of short-term investments and $3.8 million of cash. At December 31, 2006, the parent company’s invested assets consisted of $0.8 million of fixed income securities, $1.7 million of equity securities, $9.5 million of short-term investments and $2.9 million of cash. At September 30, 2007 and December 31, 2006 respectively, parent company short-term investments and cash included $3.9 million and $9.4 million of restricted cash 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 $58.2 million for the three months ended September 30, 2007 compared to net cash flow provided by operating activities of $42.9 million for the comparable period in 2006. The increase in net cash flow provided by operating activities primarily relates to lower loss payments.

The Company’s consolidated net cash flow provided by operating activities was $91.3 million for the nine months ended September 30, 2007 compared to net cash flow provided by operating activities of $80.5 million for the comparable period in 2006. The increase in net cash flow provided by operating activities primarily relates to lower loss payments.

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A summary of the Company’s commitments as of September 30, 2007 is presented in the following table (in millions):


Contractual Obligations as of September 30, 2007	2007		2008		2009		2010		2011		Thereafter		Total
Debt (a)	$	0.7	$	2.8	$	2.8	$	2.8	$	2.8	$	92.9	$	104.8
Operating leases		0.5		2.0		2.0		1.9		1.8		0.8		9.0
Loss and loss adjustment expense reserves		32.9		186.2		100.8		52.3		25.7		49.6		447.5
Other long-term liabilities (b)		0.1		1.2		1.1		0.7		0.6		13.5		17.2

Total	$	34.2	$	192.2	$	106.7	$	57.7	$	30.9	$	156.8	$	578.5


(a)		Reflects expected principal and interest payments.

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

As an insurance holding company, CNA Surety is dependent upon dividends and other permitted payments from its insurance subsidiaries to pay operating expenses, meet debt service requirements, as well as to pay cash dividends. The payment of dividends by the insurance subsidiaries is subject to varying degrees of supervision by the insurance regulatory authorities in South Dakota and Texas. In South Dakota, where Western Surety and Surety Bonding Company of America (“Surety Bonding”) are domiciled, insurance companies may only pay dividends from earned surplus excluding surplus arising from unrealized capital gains or revaluation of assets. In Texas, where Universal Surety of America is domiciled, an insurance company may only declare or pay dividends to stockholders from the insurer’s earned surplus. The insurance subsidiaries may pay dividends without obtaining prior regulatory approval only if such dividend or distribution (together with dividends or distributions made within the preceding 12-month period) is less than, as of the end of the immediately preceding year, the greater of (i) 10% of the insurer’s surplus to policyholders 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 appropriate insurance department prior to payment.

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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 2007 is based on statutory surplus and income at and for the year ended December 31, 2006. Without prior regulatory approval in 2007, Western Surety may pay dividends of $87.7 million to CNA Surety. CNA Surety received $2.0 million of dividends from its insurance subsidiaries and no dividends from its non-insurance subsidiaries during the first nine months of 2007. CNA Surety received dividends of $10.5 million from its insurance subsidiaries and $0.1 million from its non-insurance subsidiaries during the first nine months of 2006.

Combined statutory surplus totaled $413.3 million at September 30, 2007, resulting in an annualized net written premium to statutory surplus ratio of to 1.0 to 1.0. Insurance regulations restrict Western Surety’s maximum net retention on a single surety bond to 10 percent of statutory surplus. Under the 2007 Excess of Loss Treaty, the Company’s net retention on new bonds would generally be $10 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 September 30, 2007, this regulation would limit Western Surety’s largest gross risk to $126.8 million. This surplus requirement may limit the amount of future dividends Western Surety could otherwise pay to CNA Surety.

In accordance with the provisions of intercompany tax sharing agreements between CNA Surety and its subsidiaries, the tax of each subsidiary shall be determined based upon each subsidiary’s separate return liability. Intercompany tax payments are made at such times when estimated tax payments would be required by the Internal Revenue Service. CNA Surety received $28.6 million and $31.4 million from its subsidiaries for the nine months ended September 30, 2007 and September 30, 2006, 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 are based on an insurer’s statutory surplus. Effective July 1, 2006 through June 30, 2007, the underwriting limitations of Western Surety and Surety Bonding were $26.8 million and $0.7 million, respectively. Effective July 1, 2007 through June 30, 2008, the underwriting limitations of Western Surety and Surety Bonding are $34.2 million and $0.7 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, 2006 through June 30, 2007, the underwriting limitations of CCC and its affiliates utilized under the Quota Share Treaty totaled $549.0 million. Effective July 1, 2007 through June 30, 2008, the underwriting limitations of CCC and its affiliates total $739.9 million. CNA Surety management believes that the foregoing U.S. Treasury underwriting limitations are sufficient for the conduct of its business.

Subject to the aforementioned uncertainties concerning the Company’s per principal net retentions, 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.

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FINANCIAL CONDITION

INVESTMENT PORTFOLIO


			Gross		Gross Unrealized Losses
	Amortized Cost		Unrealized		Less Than			More Than			Estimated
September 30, 2007	or Cost		Gains		12 Months			12 Months			Fair Value

Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government and agencies:
U.S. Treasury	$	14,789	$	67	$	—		$	(44	)	$	14,812
U.S. Agencies		28,026		206		—			(79	)		28,153
Collateralized mortgage obligations		30,777		373		(102	)		(297	)		30,751
Mortgage pass-through securities		41,849		145		—			(1,153	)		40,841
Obligations of states and political subdivisions		645,678		11,387		(3,533	)		(5	)		653,527
Corporate bonds		43,622		877		—			(1,458	)		43,041
Non-agency collateralized mortgage obligations		35,025		194		—			(912	)		34,307
Other asset-backed securities:
Second mortgages/home equity loans		10,000		—		—			(112	)		9,888
Credit card receivables		17,233		207		—			—			17,440
Other		10,797		103		—			(127	)		10,773

Total fixed income securities		877,796		13,559		(3,635	)		(4,187	)		883,533
Equity securities		1,583		201		—			—			1,784

Total	$	879,379	$	13,760	$	(3,635	)	$	(4,187	)	$	885,317


			Gross		Gross Unrealized Losses
	Amortized Cost		Unrealized		Less Than			More Than			Estimated
December 31, 2006	or Cost		Gains		12 Months			12 Months			Fair Value

Fixed income securities:
U.S. Treasury securities and obligations of U.S. Government and agencies:
U.S. Treasury	$	14,832	$	—	$	—		$	(327	)	$	14,505
U.S. Agencies		62,106		14		(96	)		(260	)		61,764
Collateralized mortgage obligations		16,969		294		—			(326	)		16,937
Mortgage pass-through securities		38,851		77		—			(1,129	)		37,799
Obligations of states and political subdivisions		492,640		13,833		(118	)		(10	)		506,345
Corporate bonds		66,943		1,375		(5	)		(1,059	)		67,254
Non-agency collateralized mortgage obligations		37,069		210		—			(817	)		36,462
Other asset-backed securities:
Second mortgages/home equity loans		20,925		—		(26	)		(150	)		20,749
Credit card receivables		17,230		211		—			—			17,441
Other		5,613		62		—			(140	)		5,535

Total fixed income securities		773,178		16,076		(245	)		(4,218	)		784,791
Equity securities		1,508		160		—			—			1,668

Total	$	774,686	$	16,236	$	(245	)	$	(4,218	)	$	786,459

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The following table summarizes for fixed income securities in an unrealized loss position at September 30, 2007 and December 31, 2006 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):


	September 30, 2007				December 31, 2006
	Estimated		Gross		Estimated		Gross
Unrealized Loss Aging	Fair Value		Unrealized Loss		Fair Value		Unrealized Loss
Fixed income securities:
Investment grade:
0-6 months	$	92,097	$	1,484	$	75,215	$	205
7-12 months		77,850		2,151		10,104		40
13-24 months		22,396		339		137,954		3,457
Greater than 24 months		86,341		3,650		16,206		684

Total investment grade		278,684		7,624		239,479		4,386
Non-investment grade		3,833		198		3,960		77

Total	$	282,517	$	7,822	$	243,439	$	4,463

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 impairing 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. 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, (d) whether the debtor is current on interest and principal payments and (e) general market conditions and industry or sector specific factors.

For securities for which an other-than-temporary impairment loss has been recorded, 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.

No other than temporary impairments were recorded for the three months ended September 30, 2007. During the second quarter of 2007, the Company recognized impairment losses on 13 fixed income securities of various categories of investments that were in an unrealized loss position. In response to the significant change in interest rates in the second quarter, as well as a revised outlook on future interest rates, the Company did not have the intention of holding these securities to their anticipated recovery. These securities were sold during the third quarter. The other-than-temporary impairment losses on these securities were $0.9 million for the nine months ended September 30, 2007.

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investment grade by S&P and Moody’s. The other security, rated above investment grade by S&P and Moody’s, was issued by a large student loan provider and was in an unrealized loss position of 13.4% ($0.4 million) of its book value. The Company believes that the financial condition and near-term prospects of these issuers are strong, and expects that these unrealized losses will reverse.

The Company intends and believes it has the ability to hold these investments until the expected recovery in value, which may be at maturity.

At September 30, 2007, the Company has limited exposure to sub-prime home loans. The securities in an unrealized loss position include two asset-backed securities with an aggregate fair value of $9.9 million and are in an unrealized loss position of approximately $0.1 million at September 30, 2007. Other-than-temporary impairment losses recorded in the second quarter discussed above included charges of $0.1 million for two other securities with exposure to sub-prime home loans. These two securities were sold during the third quarter of 2007. Management believes that the remaining two securities were in unrealized loss positions because of low yields and not due to credit concerns.

IMPACT OF PENDING ACCOUNTING STANDARDS

In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”), which provides companies with an option to report selected financial assets and liabilities at fair value, with changes in fair value recorded in earnings. SFAS 159 helps to mitigate this type of accounting-induced earnings volatility by enabling companies to report related assets and liabilities at fair value, which would likely reduce the need for companies to comply with detailed rules for hedge accounting. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 requires companies to provide additional information that will help investors and other users of financial statements to more easily understand the effect of the company’s choice to use fair value on its earnings. It also requires entities to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet. SFAS 159 does not eliminate disclosure requirements included in other accounting standards, including requirements for disclosures about fair value measurements included in SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), discussed below, or SFAS No. 107, “Disclosures about Fair Value of Financial Instruments”. SFAS 159 is effective for fiscal years ending after November 15, 2007. The Company is currently evaluating the impact that adopting SFAS 159 will have on the Company’s results of operations and financial condition, if any.

In September 2006, the FASB issued SFAS 157. SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with GAAP and expands disclosures about fair value measurements. SFAS 157 retains the exchange price notion in the definition of fair value and clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability. SFAS 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement and the fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. SFAS 157 expands disclosures surrounding the use of fair value to measure assets and liabilities and specifically focuses on the sources used to measure fair value. In instances of recurring use of fair value measures using unobservable inputs, SFAS 157 requires separate disclosure of the effect on earnings for the period. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within the year of adoption. The Company is currently evaluating the impact that adopting SFAS 157 will have on the Company’s results of operations and financial condition, if any.

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.

- 32 -

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 availability of bank credit facilities;

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

•		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 further 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 years, consistent with the expected duration of its insurance and other liabilities.

- 33 -

The tables below summarize the estimated effects of certain hypothetical increases and decreases in interest rates. It is assumed that the changes occur immediately and uniformly across each investment category. The hypothetical changes in market interest rates selected reflect the Company’s expectations of the reasonably possible best or worst case scenarios over a one-year period. The hypothetical fair values are based upon the same prepayment assumptions that were utilized in computing fair values as of September 30, 2007. 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.


						Hypothetical
				Estimated Fair		Percentage
			Hypothetical	Value After		Increase
	Fair Value at		Change in	Hypothetical		(Decrease) in
	September 30,		Interest Rate	Change in		Stockholders’
	2007		(bp=basis points)	Interest Rate		Equity
	(Dollars in thousands)
U.S. Government and government agencies and authorities	$	114,557	200 bp increase	$	103,243		(1.2	)%
			100 bp increase		109,289		(0.5	)
			100 bp decrease		118,112		0.4
			200 bp decrease		119,995		0.6
States, municipalities and political subdivisions		653,527	200 bp increase		579,365		(7.6	)
			100 bp increase		615,409		(3.9	)
			100 bp decrease		693,820		4.1
			200 bp decrease		737,200		8.6
Corporate bonds and all other		115,449	200 bp increase		106,647		(0.9	)

			100 bp increase		110,928		(0.5	)
			100 bp decrease		120,225		0.5
			200 bp decrease		125,226		1.0
Total fixed income securities available-for-sale	$	883,533	200 bp increase		789,255		(9.6	)
			100 bp increase		835,626		(4.9	)
			100 bp decrease		932,167		5.0
			200 bp decrease		982,421		10.1


						Hypothetical
				Estimated Fair		Percentage
			Hypothetical	Value After		Increase
	Fair Value at		Change in	Hypothetical		(Decrease) in
	December 31,		Interest Rate	Change in		Stockholders’
	2006		(bp=basis points)	Interest Rate		Equity
	(Dollars in thousands)
U.S. Government and government agencies and authorities	$	131,005	200 bp increase	$	120,310		(1.2	)%
			100 bp increase		126,070		(0.6	)
			100 bp decrease		134,299		0.4
			200 bp decrease		136,143		0.6
States, municipalities and political subdivisions		506,345	200 bp increase		447,610		(6.7	)
			100 bp increase		476,768		(3.4	)
			100 bp decrease		537,633		3.6
			200 bp decrease		571,614		7.5
Corporate bonds and all other		147,441	200 bp increase		136,456		(1.3	)

			100 bp increase		141,804		(0.6	)
			100 bp decrease		153,399		0.7
			200 bp decrease		159,611		1.4
Total fixed income securities available-for-sale	$	784,791	200 bp increase		704,376		(9.2	)
			100 bp increase		744,642		(4.6	)
			100 bp decrease		825,331		4.7
			200 bp decrease		867,368		9.5

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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, 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 7 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, 2006.

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

ITEM 3. DEFAULTS UPON SENIOR SECURITIES — None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS — None.

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

July 27, 2007; CNA Surety Corporation Earnings Press Release issued on July 27, 2007.

ITEM 6. EXHIBITS


	Exhibit Number
Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002		31.1

Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002		31.2

Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002		32.1

Certification of Chief Financial Officer 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.

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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: October 26, 2007

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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)		Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 — Chief Executive Officer.

32(2)		Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 — Chief Financial Officer.

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