UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
Quarterly report pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the quarterly period ended September 30, 2005
Commission file number 0-16090
Hallmark Financial Services, Inc.
---------------------------------
(Exact name of registrant as specified in its charter)
Nevada 87-0447375
------------------------------- -------------------
(State or other jurisdiction of (I.R.S. Employer
Incorporation or organization) Identification No.)
777 Main Street, Suite 1000, Fort Worth, Texas 76102
---------------------------------------------- ----------
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (817) 348-1600
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 X No ___
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes ___ No X
Indicate by check mark whether the registrant is a shell company (as defined
in Rule 12b-2 of the Exchange Act). Yes ___ No X
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date: Common Stock, par value
$.03 per share - 86,841,791 shares outstanding as of November 14, 2005.
PART I
FINANCIAL INFORMATION
Item 1. Financial Statements
INDEX TO FINANCIAL STATEMENTS
Page Number
-----------
Consolidated Balance Sheets at September 30, 2005
(unaudited) and December 31, 2004 3
Consolidated Statements of Operations (unaudited)
for the three months and nine months ended September 30,
2005 and September 30, 2004 4
Consolidated Statements of Stockholders' Equity and
Comprehensive Income (unaudited) for the three months
and nine months ended September 30, 2005 and
September 30, 2004 5
Consolidated Statements of Cash Flows (unaudited) for
the nine months ended September 30, 2005 and
September 30, 2004 6
Notes to Consolidated Financial Statements (unaudited) 7
Hallmark Financial Services, Inc.
Consolidated Balance Sheets
($ in thousands)
September 30 December 31
ASSETS 2005 2004
------ ---------- ----------
(unaudited) (audited)
Investments:
Debt securities, available-for-sale,
at market value $ 82,414 $ 28,206
Equity securities, available-for-sale,
at market value 4,259 3,580
Short-term investments, available-for-sale,
at market value 12,171 335
---------- ----------
Total investments 98,844 32,121
Cash and cash equivalents 34,650 12,901
Restricted cash and investments 8,589 6,509
Premiums receivable 34,296 4,103
Accounts receivable 2,241 3,494
Prepaid reinsurance premium 297 -
Reinsurance recoverable 1,046 3,083
Deferred policy acquisition costs 13,605 7,475
Excess of cost over fair value
of net assets acquired 4,836 4,836
Intangible assets 466 486
Current federal income tax recoverable 779 -
Deferred federal income taxes 3,672 5,173
Other assets 5,848 2,330
---------- ----------
Total assets $ 209,169 $ 82,511
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Liabilities:
Unpaid losses and loss adjustment expenses $ 22,185 $ 19,648
Unearned premiums 30,195 6,192
Unearned revenue 9,598 11,283
Note payable 30,928 -
Accrued agent profit sharing 1,379 1,875
Accrued ceding commission payable 11,373 1,695
Pension liability 2,112 2,180
Current federal income tax payable - 1,343
Payable for securities 11,835 -
Accounts payable and other accrued expenses 6,489 5,639
---------- ----------
Total liabilities 126,094 49,855
Commitments and Contingencies
Stockholders' equity:
Common stock, $.03 par value (authorized
100,000,000 shares; issued 86,856,610
shares in 2005 and 36,856,610 shares
in 2004) 2,606 1,106
Additional paid in capital 62,887 19,647
Retained earnings 19,395 13,103
Accumulated other comprehensive income (loss) (1,796) (759)
Treasury stock, at cost (14,819 shares in
2005 and 379,319 in 2004) (17) (441)
---------- ----------
Total stockholders' equity 83,075 32,656
---------- ----------
$ 209,169 $ 82,511
========== ==========
The accompanying notes are an integral part
of the consolidated financial statements
Hallmark Financial Services, Inc.
Consolidated Statements of Operations
(Unaudited)
($ in thousands, except per share amounts)
Three Months Ended Nine Months Ended
September 30 September 30
--------------------- ---------------------
2005 2004 2005 2004
-------- -------- -------- --------
Gross premiums written $ 43,512 $ 7,410 $ 62,985 $ 23,174
Ceded premiums written (552) - (552) 25
-------- -------- -------- --------
Net premiums written 42,960 7,410 62,433 23,199
Change in unearned premiums (23,936) 54 (23,706) 473
-------- -------- -------- --------
Net premiums earned 19,024 7,464 38,727 23,672
Investment income, net of expenses 1,412 371 2,274 994
Realized gain (loss) 93 (57) 52 (57)
Finance charges 487 561 1,536 1,644
Commission and fees 3,094 5,745 13,534 16,235
Processing and service fees 1,048 1,556 4,252 4,560
Other income 9 6 22 21
-------- -------- -------- --------
Total revenues 25,167 15,646 60,397 47,069
Losses and loss adjustment expenses 11,043 4,451 22,584 14,100
Other operating costs and expenses 9,897 8,903 27,752 26,346
Interest expense 559 16 664 61
Amortization of intangible asset 17 7 31 21
-------- -------- -------- --------
Total expenses 21,516 13,377 51,031 40,528
Income before tax 3,651 2,269 9,366 6,541
Income tax expense 1,178 726 3,074 2,093
-------- -------- -------- --------
Net income $ 2,473 $ 1,543 $ 6,292 $ 4,448
======== ======== ======== ========
Net income per share:
Basic $ 0.03 $ 0.04 $ 0.10 $ 0.10
======== ======== ======== ========
Diluted $ 0.03 $ 0.04 $ 0.10 $ 0.10
======== ======== ======== ========
The accompanying notes are an integral part
of the consolidated financial statements
Hallmark Financial Services, Inc.
Consolidated Statements of Stockholders' Equity and Comprehensive Income
(Unaudited)
($ in thousands)
Three Months Ended Nine Months Ended
September 30, September 30,
2005 2004 2005 2004
-------- -------- -------- --------
Common Stock
Balance, beginning of period $ 2,606 $ 1,106 $ 1,106 $ 1,106
Issuance of common stock in
rights offering (50,000,000
shares in 2005) - - 1,500 -
-------- -------- -------- --------
Balance, end of period 2,606 1,106 2,606 1,106
Additional Paid-In Capital
Balance, beginning of period 62,898 19,648 19,647 19,693
Issuance of common stock in
rights offering (50,000,000
shares in 2005), net of $109
in expenses (31) - 43,391 -
Equity based compensation 20 6 43 20
Exercise of stock options - (15) (194) (74)
-------- -------- -------- --------
Balance, end of period 62,887 19,639 62,887 19,639
Retained Earnings
Balance, beginning of period 16,922 10,159 13,103 7,254
Net income 2,473 1,543 6,292 4,448
-------- -------- -------- --------
Balance, end of period 19,395 11,702 19,395 11,702
Accumulated Other Comprehensive
Income (Loss)
Balance, beginning of period (964) (471) (759) (93)
Additional minimum pension liability,
net of tax - - 30 -
Unrealized gains (losses) on
securities, net of tax (832) 460 (1,067) 82
-------- -------- -------- --------
Balance, end of period (1,796) (11) (1,796) (11)
Treasury Stock
Balance, beginning of period (17) (476) (441) (563)
Exercise of stock options - 35 424 122
-------- -------- -------- --------
Balance, end of period (17) (441) (17) (441)
-------------------------------------------------
Stockholders' Equity $ 83,075 $ 31,995 $ 83,075 $ 31,995
=================================================
Net income $ 2,473 $ 1,543 $ 6,292 $ 4,448
Additional minimum pension
liability, net of tax - - 30 -
Unrealized gains (losses)
on securities, net of tax (832) 460 (1,067) 82
-------------------------------------------------
Comprehensive Income $ 1,641 $ 2,003 $ 5,255 $ 4,530
=================================================
The accompanying notes are an integral part
of the consolidated financial statements
Hallmark Financial Services, Inc.
Consolidated Statement of Cash Flows
(Unaudited)
($ in thousands)
Nine Months Ended
September 30
------------------------
2005 2004
---------- ----------
Cash flows from operating activities:
Net income $ 6,292 $ 4,448
Adjustments to reconcile net income to cash
provided by (used in) operating activities:
Depreciation and amortization expense 289 341
Deferred federal income tax expense 2,051 (124)
Realized (gain) loss on investments (52) 57
Change in prepaid reinsurance premiums (297) 281
Change in premiums receivable (30,193) 664
Change in accounts receivable 1,253 1,324
Change in deferred policy acquisition costs (6,130) (493)
Change in unpaid losses and loss adjustment
expenses 2,537 (7,486)
Change in unearned premiums 24,003 (754)
Change in unearned revenue (1,685) 1,482
Change in accrued agent profit sharing (496) (512)
Change in reinsurance recoverable 2,037 5,541
Change in current federal income tax
payable/recoverable (2,121) 1,717
Change in accrued ceding commission payable 9,678 (142)
Change in all other liabilities 812 (989)
Change in all other assets (2,354) (394)
---------- ----------
Net cash provided by operating activities 5,624 4,961
---------- ----------
Cash flows from investing activities:
Purchases of property and equipment (275) (364)
Premium finance notes repaid,
net of finance notes originated - 52
Change in restricted cash and investments (2,080) (3,467)
Purchases of debt and equity securities (57,901) (2,506)
Maturities and redemptions of investment
securities 1,237 3,411
Net purchases of short-term investments 2 (2,376)
---------- ----------
Net cash used in investing activities (59,017) (5,250)
---------- ----------
Cash flows from financing activities:
Proceeds from exercise of employee stock options 230 48
Proceeds from stockholder rights offering 44,891 -
Proceeds of borrowings 30,928 -
Debt issuance costs (907) (991)
---------- ----------
Net cash provided by (used in)
financing activities 75,142 (943)
---------- ----------
Increase (decrease) in cash and cash equivalents 21,749 (1,232)
Cash and cash equivalents at beginning of period 12,901 10,520
---------- ----------
Cash and cash equivalents at end of period $ 34,650 $ 9,288
========== ==========
Supplemental Cash Flow Information:
Interest paid $ 567 $ 61
---------- ----------
Taxes paid $ 3,144 $ 500
---------- ----------
The accompanying notes are an integral part
of the consolidated financial statements
Hallmark Financial Services, Inc.
Notes to Consolidated Financial Statements (Unaudited)
1. General
Hallmark Financial Services, Inc., ("Hallmark" and, together with
subsidiaries, "we", "us", "our") is an insurance holding company engaged in
the sale of property and casualty insurance products. Our business involves
marketing and underwriting non-standard personal automobile insurance in
Texas, New Mexico and Arizona; marketing and underwriting commercial
insurance in Texas, New Mexico, Idaho, Oregon, Montana and Washington;
affiliate and third party claims administration; and other insurance related
services. We pursue our business activities through integrated insurance
groups handling non-standard personal automobile insurance (the "Personal
Lines Group") and commercial insurance (the "Commercial Lines Group"). The
members of the Personal Lines Group are currently American Hallmark
Insurance Company of Texas ("AHIC"), an authorized Texas property and
casualty insurance company; Phoenix Indemnity Insurance Company ("PIIC"), an
authorized Arizona property and casualty insurance company; American
Hallmark General Agency, Inc. ("AHGA"), a managing general agency; and
Hallmark Claims Services, Inc. ("HCS"), an affiliate and third party claims
administrator. The members of the Commercial Lines Group are AHIC, Hallmark
General Agency, Inc. ("HGA"), a managing general agency, and Effective
Claims Management, Inc. ("ECM"), a third party claims administrator. AHIC
began transitioning to the Commercial Lines Group during the third quarter
of 2005.
During the second quarter of 2005, we completed a $45.0 million
shareholder rights offering and a $30.0 million private placement of trust
preferred securities. As a result of these capital enhancements, A.M. Best
announced on June 21, 2005 the upgrades of the financial strength ratings of
AHIC to A- (excellent) from B (fair) and PIIC to B+ (very good) from B-
(fair).
During the third quarter of 2005, we began underwriting and issuing
AHIC policies for the commercial insurance business produced by HGA, in
order to capture the underwriting margin that had previously been paid to
a third party insurer. After we have obtained all required regulatory
approvals, we intend to consolidate the underwriting of our non-standard
personal automobile insurance business into PIIC, at which time AHIC will
solely be a member of the Commercial Lines Group.
2. Basis of Presentation
Our unaudited consolidated financial statements included herein have
been prepared in accordance with accounting principles generally accepted in
the United States of America ("GAAP") and include our accounts and the
accounts of our subsidiaries. All significant intercompany accounts and
transactions have been eliminated in consolidation. Certain information and
footnote disclosures normally included in financial statements prepared
in accordance with GAAP have been condensed or omitted pursuant to rules
and regulations of the Securities and Exchange Commission ("SEC") for
interim financial reporting. These financial statements should be read in
conjunction with our audited financial statements for the year ended
December 31, 2004 included in our Annual Report on Form 10-K filed with the
SEC.
The interim financial data as of September 30, 2005 and 2004 is
unaudited. However, in the opinion of management, the interim data includes
all adjustments, consisting only of normal recurring adjustments, necessary
for a fair statement of the results for the interim periods. The results of
operations for the period ended September 30, 2005 are not necessarily
indicative of the operating results to be expected for the full year.
Reclassification
Certain previously reported amounts have been reclassified in order to
conform to current year presentation. Such reclassification had no effect
on net income or stockholders' equity.
Use of Estimates in the Preparation of the Financial Statements
Our preparation of financial statements in conformity with GAAP
requires us to make estimates and assumptions that affect our reported
amounts of assets and liabilities and our disclosure of contingent assets
and liabilities at the date of our financial statements, as well as our
reported amounts of revenues and expenses during the reporting period.
Actual results could differ materially from those estimates.
Recently Issued Accounting Standards
In December 2004, the Financial Accounting Standards Board ("FASB")
issued Statement No. 123R "Share-Based Payment" ("SFAS 123R"), which revises
FASB Statement No. 123 ("SFAS 123") and supersedes APB 25. SFAS 123R
eliminates an entity's ability to account for share-based payments using APB
25 and requires that all such transactions be accounted for using a fair
value based method. In April 2005, the SEC deferred the effective date of
SFAS 123R from the first interim or annual period beginning after June 15,
2005 to the next fiscal year beginning after June 15, 2005. SFAS 123R is
not expected to have a material impact on our results of operations or
financial position.
3. Equity Compensation Plans
We have stock options outstanding under stock-based compensation plans
for key employees and non-employee directors. Effective January 1, 2003, we
adopted the fair value recognition provisions of SFAS 123, and the
prospective method of adoption provided under FASB Statement No. 148,
"Accounting for Stock-Based Compensation - Transition and Disclosure" ("SFAS
148"). The following table illustrates the effect on net income and
earnings per share if the fair value based method had been applied to all
outstanding and unvested awards in each period.
Three Months Ended Nine Months Ended
September 30 September 30
-------------------- --------------------
(in thousands) 2005 2004 2005 2004
------- ------- ------- -------
Net income as reported $ 2,473 $ 1,543 $ 6,292 $ 4,448
Add: Stock-based employee
compensation expenses
included in reported net
income, net of related
tax effects 13 5 28 15
Deduct: Total stock-based
employee compensation expense
determined under fair value
based method for all awards,
net of related tax effect (16) (8) (37) (25)
------- ------- ------- -------
Pro forma net income $ 2,470 $ 1,540 $ 6,283 $ 4,438
======= ======= ======= =======
Earnings per share:
Basic-as reported $ 0.03 $ 0.04 $ 0.10 $ 0.10
======= ======= ======= =======
Basic-pro forma $ 0.03 $ 0.04 $ 0.10 $ 0.10
======= ======= ======= =======
Diluted-as reported $ 0.03 $ 0.04 $ 0.10 $ 0.10
======= ======= ======= =======
Diluted-pro forma $ 0.03 $ 0.04 $ 0.10 $ 0.10
======= ======= ======= =======
4. Segment Information
The following is business segment information for the three and nine
months ended September 30, 2005 and 2004 (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------- --------------------
2005 2004 2005 2004
------- ------- ------- -------
Revenues
--------
Personal Lines Group $ 10,814 $ 9,321 $ 33,169 $ 29,538
Commercial Lines Group 14,339 6,325 27,194 17,529
Corporate 14 - 34 2
------- ------- ------- -------
Consolidated $ 25,167 $ 15,646 $ 60,397 $ 47,069
======= ======= ======= =======
Pre-tax income (loss)
---------------------
Personal Lines Group $ 2,790 $ 1,873 $ 7,666 $ 5,759
Commercial Lines Group 2,196 1,167 4,761 2,719
Corporate (1,335) (771) (3,061) (1,937)
------- ------- ------- -------
Consolidated $ 3,651 $ 2,269 $ 9,366 $ 6,541
======= ======= ======= =======
The following is additional business segment information as of the
dates indicated (in thousands):
Sept. 30, 2005 Dec. 31, 2004
------------- -------------
Assets
------
Personal Lines Group $ 80,050 $ 63,136
Commercial Lines Group 126,202 18,557
Corporate 2,917 818
--------- ---------
Consolidated $ 209,169 $ 82,511
========= =========
5. Reinsurance
Prior to April 1, 2003, AHIC ceded reinsurance to other companies.
These reinsurance arrangements are more fully described in Note 5 to the
Company's Form 10-K for the year ended December 31, 2004. In the third
quarter of 2005, AHIC began ceding reinsurance to other companies for
coverage on AHIC policies issued by HGA. We remain obligated to our
policyholders in the event that the reinsurers do not meet their obligations
under the reinsurance agreements.
Under some of our reinsurance arrangements, we continue to earn ceding
commissions based on incurred loss experience on the portion of the policies
ceded. We received a provisional commission as policies were produced as an
advance against the later determination of the commission actually earned.
The following table shows earned premiums ceded and reinsurance loss
recoveries by period (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------- --------------------
2005 2004 2005 2004
------- ------- ------- -------
Ceded earned premiums $ 255 $ (2) $ 255 $ 256
Reinsurance recoveries $ (118) $ 563 $ (499) $ 774
6. Note Payable
On June 21, 2005, our newly formed trust subsidiary completed a private
placement of $30.0 million of 30-year floating rate trust preferred
securities. Simultaneously, we borrowed $30.9 million from the trust
subsidiary and contributed $30.0 million to AHIC in order to increase
policyholder surplus. The note bears an initial interest rate of 7.725%
until June 15, 2015, at which time interest will adjust quarterly to the
three month LIBOR rate plus 3.25 percentage points. As of September 30,
2005, the note balance was $30.9 million.
7. Credit Facility
On June 29, 2005, we entered into a credit facility with The Frost
National Bank. The credit facility was amended on July 15, 2005, to reduce
the interest rate. Under this credit facility, the maximum amount available
to us from time to time is $7.5 million, which may include up to $2.0
million under a revolving line of credit, up to $3.5 million in five-year
term loans and up to $7.5 million in five-year stand-by letters of credit.
The borrowings under our credit facility will accrue interest at an annual
rate of three month LIBOR plus 2.00% and we will pay letter of credit fees
at the rate of 1.00% per annum. Our obligations under the credit facility
are secured by a security interest in the capital stock of all of our
subsidiaries, guaranties of all of our subsidiaries and the pledge of
substantially all of our assets. The credit facility contains covenants
which, among other things, require us to maintain certain financial and
operating ratios and restrict certain distributions, transactions and
organizational changes. As of September 30, 2005, there were no outstanding
amounts due under our credit facility, and we were in compliance with or had
obtained waivers of all of our covenants. In the third quarter of 2005, we
issued a $4.0 million letter of credit under this facility to collateralize
certain obligations under the agency agreement between HGA and Clarendon
National Insurance Company ("Clarendon") effective July 1, 2004.
8. Deferred Policy Acquisition Costs
The following table shows total deferred and amortized policy
acquisition costs by period (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------- --------------------
2005 2004 2005 2004
------- ------- ------- -------
Deferred $(14,252) $ (5,940) $(25,877) $(17,277)
Amortized 8,751 6,044 19,747 16,784
------- ------- ------- -------
Net Deferred $ (5,501) $ 104 $ (6,130) $ (493)
======= ======= ======= =======
9. Earnings per Share
The following table sets forth basic and diluted weighted average
shares outstanding for the periods indicated (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------- --------------------
2005 2004 2005 2004
------- ------- ------- -------
Weighted average shares - basic 86,842 42,430 65,045 42,407
Effect of dilutive securities 624 283 602 193
------- ------- ------- -------
Weighted average shares -
assuming dilution 87,466 42,713 65,647 42,600
======= ======= ======= =======
For the three and nine months ended September 30, 2004, 100,000 shares
and 125,000 shares, respectively, attributable to outstanding stock options
were excluded from the calculation of diluted earnings per share because the
exercise prices of the stock options were greater than or equal to the
average price of the common shares and, therefore, their inclusion would
have been anti-dilutive. There were no outstanding stock options that were
excluded from the calculation of diluted earnings per share for the three
and nine months ended September 30, 2005.
In accordance with FASB Statement No. 128 "Earnings Per Share" ("SFAS
128"), we have restated the basic and diluted weighted average shares
outstanding for the three months and nine months ended September 30, 2004
for the effect of a bonus element from our stockholder rights offering that
was successfully completed in the second quarter of 2005. According to SFAS
128, there is an assumed bonus element in a rights issue whose exercise
price is less than the market value of the stock at the close of the rights
offering period. This bonus element is treated as a stock dividend for
reporting earnings per share.
10. Net Periodic Pension Cost
We have recognized $49 thousand in net periodic pension cost during the
first nine months of 2005. The components of this cost are interest cost of
$544 thousand, amortization of net loss of $57 thousand and expected return
on plan assets of ($552) thousand.
11. Subsequent Event
On November 9, 2005 we executed a definitive agreement to acquire Texas
General Agency, Inc. ("TGA") and certain affiliates. TGA is a managing
general agency involved in the marketing and servicing of property and
casualty insurance products, with a particular emphasis on commercial
automobile and general liability risks. The acquisition will also include
TGA's wholly-owned insurance subsidiary, Gulf States Insurance Company,
which reinsures a portion of the business written by TGA, as well as TGA
Special Risk, Inc., which brokers mobile home insurance. Closing conditions
include, among other things, execution of employment agreements between
TGA and the three individual sellers, obtaining consent to the transaction
from the Oklahoma Commissioner of Insurance, and Hallmark's prior or
contemporaneous acquisition of an affiliated entity, Pan American Acceptance
Corporation. The transaction is expected to be effective as of January 1,
2006.
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.
Introduction
Hallmark Financial Services, Inc., ("Hallmark" and, together with
subsidiaries, "we", "us", "our") is an insurance holding company engaged in
the sale of property and casualty insurance products. Our business involves
marketing and underwriting non-standard personal automobile insurance in
Texas, New Mexico and Arizona; marketing and underwriting commercial
insurance in Texas, New Mexico, Idaho, Oregon, Montana and Washington;
affiliate and third party claims administration; and other insurance related
services. We pursue our business activities through integrated insurance
groups handling non-standard personal automobile insurance (the "Personal
Lines Group") and commercial insurance (the "Commercial Lines Group"). The
members of the Personal Lines Group are currently American Hallmark
Insurance Company of Texas ("AHIC"), an authorized Texas property and
casualty insurance company; Phoenix Indemnity Insurance Company ("PIIC"), an
authorized Arizona property and casualty insurance company; American
Hallmark General Agency, Inc. ("AHGA"), a managing general agency; and
Hallmark Claims Services, Inc. ("HCS"), an affiliate and third party claims
administrator. The members of the Commercial Lines Group are AHIC, Hallmark
General Agency, Inc. ("HGA"), a managing general agency, and Effective
Claims Management, Inc. ("ECM"), a third party claims administrator. AHIC
began transitioning to the Commercial Lines Group during the third quarter
of 2005.
During the second quarter of 2005, we completed a $45.0 million
shareholder rights offering and a $30.0 million private placement of trust
preferred securities. As a result of these capital enhancements, A.M. Best
announced on June 21, 2005 the upgrades of the financial strength ratings of
AHIC to A- (excellent) from B (fair) and PIIC to B+ (very good) from B-
(fair).
During the third quarter of 2005, we began underwriting and issuing
AHIC policies for the commercial insurance business produced by HGA, in
order to capture the underwriting margin that had previously been paid to a
third party insurer. After we have obtained all required regulatory
approvals, we intend to consolidate the underwriting of our non-standard
personal automobile insurance business into PIIC, at which time AHIC will
solely be a member of the Commercial Lines Group.
Financial Condition and Liquidity
Sources and uses of funds. Our sources of funds are from insurance
related operations, financing activities and investing activities. Major
sources of funds from operations include premiums collected (net of policy
cancellations and premiums ceded), commissions, and processing and service
fees. On a consolidated basis, our cash and investments (excluding
restricted cash and investments) at September 30, 2005 were $133.5 million
compared to $45.0 million at December 31, 2004. Most of this increase is
attributable to net proceeds of $44.9 million from a stockholder rights
offering and $29.1 million from the issuance of trust preferred securities
during the second quarter of 2005.
Net cash provided by our consolidated operating activities was $5.6
million for the first nine months of 2005 compared to $5.0 million for the
first nine months of 2004. The increase in operating cash flow primarily
resulted from increased premiums collected of $8.4 million due to the
assumption from Clarendon of business produced by HGA and the issuance of
AHIC policies for business produced by HGA since July 1, 2005. Also
contributing to the increase in collected premium is the 100% retention of
the Texas non-standard auto premium produced by AHGA. Prior to October 1,
2004, we retained only 45% of this business. Partially offsetting the
increased operating cash flow is a $5.5 million increase in paid operating
expenses due mostly to additional ceding commissions paid to Clarendon for
the assumed premium, paid incentive compensation and paid retail agent
profit sharing commissions. Also partially offsetting the increased
operating cash flow is a $2.2 million increase in paid loss and loss
adjustment expenses due mostly to the AHIC direct and assumed business
produced by HGA in the third quarter of 2005.
Cash used by investing activities during the first nine months of 2005
was $59.0 million as compared to $5.3 million for the same period in 2004.
The increase in cash used in investing activities is mainly due to increased
purchases of debt and equity securities of $55.4 million and a decrease in
net maturities and redemptions of securities of $2.2 million. These uses of
cash were partially offset by a $2.4 million decrease in net purchases of
short-term investments and a $1.4 million decrease in cash and investments
transferred to restricted accounts.
Cash provided by financing activities during the first nine months of
2005 was $75.1 million as compared to cash used in financing activities of
$0.9 million for the same period of 2004. The cash provided in 2005 was
from net proceeds of $44.9 million from the stockholder rights offering,
$30.0 million from the issuance of trust preferred securities net of debt
issuance costs and $0.2 million from the exercise of stock options. The
cash used in 2004 was from $1.0 million repaid on a note payable that was
partially offset by $48 thousand in proceeds from the exercise of stock
options.
As a holding company, Hallmark is dependent on dividend payments and
management fees from its subsidiaries to meet operating expenses and debt
obligations. As of September 30, 2005, Hallmark had $1.4 million in cash
and invested assets. Cash and invested assets of our non-insurance
subsidiaries were $3.6 million as of September 30, 2005.
Property and casualty insurance companies domiciled in the State of
Texas are limited in the payment of dividends to their shareholders in any
twelve-month period, without the prior written consent of the Texas
Department of Insurance ("TDI"), to the greater of statutory net income for
the prior calendar year or 10% of statutory policyholders' surplus as of the
prior year end. Dividends may only be paid from unassigned surplus funds.
During 2005, AHIC's ordinary dividend capacity is $1.5 million. PIIC,
domiciled in Arizona, is limited in the payment of dividends to the lesser
of 10% of prior year policyholder's surplus or prior year's net investment
income, without prior written approval from the Arizona Department of
Insurance ("AZDOI"). During 2005, PIIC's ordinary dividend capacity is $0.8
million. Neither AHIC nor PIIC paid a dividend to Hallmark during the first
nine months of 2005.
TDI regulates financial transactions between AHIC and affiliated
companies. Applicable regulations require TDI's approval of management
fees, expense sharing contracts and similar transactions. AHGA paid $1.2
million and $0.5 million in management fees to Hallmark during the first
nine months of 2005 and 2004, respectively.
AZDOI regulates financial transactions between PIIC and affiliated
companies. Applicable regulations require AZDOI's approval of management
fees, expense sharing contracts and similar transactions. PIIC paid $0.9
million in management fees to AHGA during the first nine months of 2005 and
2004, respectively.
Credit facility. On June 29, 2005, we entered into a credit facility
with The Frost National Bank. The credit facility was amended on July 15,
2005, to reduce the interest rate. Under this credit facility, the maximum
amount available to us from time to time is $7.5 million, which may include
up to $2.0 million under a revolving line of credit, up to $3.5 million in
five-year term loans and up to $7.5 million in five-year stand-by letters of
credit. The borrowings under our credit facility will accrue interest at an
annual rate of three month LIBOR plus 2.00% and we will pay letter of credit
fees at the rate of 1.00% per annum. Our obligations under the credit
facility are secured by a security interest in the capital stock of all of
our subsidiaries, guaranties of all of our subsidiaries and the pledge of
substantially all of our assets. The credit facility contains covenants
which, among other things, require us to maintain certain financial and
operating ratios and restrict certain distributions, transactions and
organizational changes. As of September 30, 2005, there were no outstanding
amounts due under our credit facility, and we were in compliance with or had
obtained waivers all of our covenants. In the third quarter of 2005, we
issued a $4.0 million letter of credit under this facility to collateralize
certain obligations under the agency agreement between HGA and Clarendon
effective July 1, 2004.
Trust preferred securities. On June 21, 2005, our newly formed trust
subsidiary completed a private placement of $30.0 million of 30-year
floating rate trust preferred securities. Simultaneously, we borrowed $30.9
million from the trust subsidiary and contributed $30.0 million to AHIC in
order to increase policyholder surplus. The note bears an initial interest
rate of 7.725% until June 15, 2015, at which time interest will adjust
quarterly to the three month LIBOR rate plus 3.25 percentage points. As of
September 30, 2005, the note balance was $30.9 million.
Results of Operations
Management Overview. During the third quarter of fiscal 2005, our
total revenues were $25.2 million, representing a 60.9% increase over the
$15.6 million in total revenues for the comparable period of fiscal 2004.
For the first nine months of fiscal 2005, our total revenues were $60.4
million, which was 28.3% more than the $47.1 million in total revenues for
the comparable period in fiscal 2004. We reported net income of $2.5
million and $6.3 million for the three and nine months ended September 30,
2005, respectively. This represents a 60.3% and 41.5% increase over our net
income for the three and nine months ended September 30, 2004, respectively.
On a diluted per share basis, net income was $0.03 and $0.10 for the three
and nine months ended September 30, 2005, respectively, as compared to $0.04
and $0.10 for the same periods in the prior year. During the second quarter
of 2005, we issued 50.0 million shares in a stockholder rights offering,
resulting in a decrease in the per share results between periods.
The increase in total revenues for the first nine months of fiscal 2005
as compared to the first nine months of fiscal 2004 was primarily
attributable to the issuance of AHIC policies for the commercial insurance
business produced by HGA and the assumption of premium from Clarendon for
business produced by HGA . Also contributing to the increase in revenues is
increased premium assumed by the Personal Lines Group as a result of changes
in Hallmark's reinsurance arrangements. The increase in net income for the
first nine months of 2005 versus the same period in 2004 reflects ongoing
initiatives to improve underwriting performance in both operating units,
increased premium assumption by the Personal Lines Group, and increased
investment income.
The following is additional business segment information for the three
and nine months ended September 30, 2005 and 2004 (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------- --------------------
2005 2004 2005 2004
------- ------- ------- -------
Revenues
--------
Personal Lines Group $ 10,814 $ 9,321 $ 33,169 $ 29,538
Commercial Lines Group 14,339 6,325 27,194 17,529
Corporate 14 - 34 2
------- ------- ------- -------
Consolidated $ 25,167 $ 15,646 $ 60,397 $ 47,069
======= ======= ======= =======
Pre-tax income (loss)
---------------------
Personal Lines Group $ 2,790 $ 1,873 $ 7,666 $ 5,759
Commercial Lines Group 2,196 1,167 4,761 2,719
Corporate (1,335) (771) (3,061) (1,937)
------- ------- ------- -------
Consolidated $ 3,651 $ 2,269 $ 9,366 $ 6,541
======= ======= ======= =======
Third Quarter 2005 as compared to the Third Quarter 2004
Personal Lines Group
Net premium written increased $1.2 million during the third quarter of
2005 to $8.6 million compared to $7.4 million in the third quarter of 2004.
The increase was due mainly to AHIC assuming 100% of the Texas non-standard
automobile business produced by AHGA and underwritten by a third party,
effective October 1, 2004. Prior to October 1, 2004, AHIC assumed only 45%
of this business. Total premium production for the third quarter of 2005
declined $1.8 million, or 17.1%, from the $10.5 million produced in the
third quarter of 2004. The decline in produced premium was reflective of
increased competition.
Revenue for the Personal Lines Group increased 16.0% to $10.8 million
for the third quarter of 2005 from $9.3 million for the same period in 2004.
Increased net premium earned of $1.5 million due to higher assumed premium
volume was the primary cause of this increase. Also driving the increased
revenue was a $0.4 million increase in investment income due to an increase
in the investment portfolio from the completion of our capital plan. These
increases were partially offset by a $0.4 million decrease in ceding
commission income due to AHIC assuming 100% of the Texas non-standard
automobile business effective October 1, 2004.
Pre-tax income for the Personal Lines Group increased $0.9 million, or
49.0%, for the third quarter of 2005 compared to the third quarter of 2004.
Net investment income and realized gains and losses contributed $0.6
million to the increase in pre-tax income for the quarter. Taking into
consideration the effect on ceding commissions, loss and loss adjustment
expenses and premium production costs, the changes in premium volume
produced and assumed contributed $0.2 million to the increase in pre-tax
income. Lower salary and related expenses contributed $0.1 million and
lower technical service costs from integrating PIIC's back office systems
that were previously outsourced contributed $0.1 million. These increases
were partially offset by a loss ratio (defined as loss and loss adjustment
expenses divided by net premiums earned) of 60.6% for the third quarter of
2005 as compared to 60.0% for the same period in 2004, which decreased pre-
tax income by $0.1 million.
Commercial Lines Group
Beginning in the third quarter of 2005, the Commercial Lines Group
began retaining written premium through AHIC. The Commercial Lines Group
written premium was accomplished through the assumption of in-force policies
from Clarendon at July 1, 2005, the assumption of Clarendon policies issued
subsequent to July 1, 2005, and the issuance of AHIC policies. This
resulted in net written premium for the Commercial Lines Group of $34.3
million for the quarter ended September 30, 2005.
Total revenue for the Commercial Lines Group of $14.3 million for the
third quarter of 2005 was $8.0 million more than the $6.3 million reported
in the third quarter of 2004. This 126.7% increase in total revenue was
primarily due to net premiums earned of $10.1 million for the quarter from
the issuance of AHIC policies and the assumption of premium from Clarendon
for business produced by HGA. Increased net investment income contributed
$0.6 million to the increase in revenue for the quarter. These increases in
revenue were partially offset by lower ceding commission revenue of $2.3
million and lower processing and service fees of $0.4 million, in both cases
due to the shift from a third party agency structure to an insurance
underwriting structure. Total earned premium generated by the Commercial
Lines Group (including premium retained by Clarendon) for the third quarter
of 2005 was $19.8 million as compared to $18.3 million in the third quarter
of 2004.
Pre-tax income for the Commercial Lines Group of $2.2 million for the
third quarter of 2005 increased $1.0 million, or 88.2%, over the $1.2
million reported for the third quarter of 2004. Increased revenue, as
discussed above, was the primary reason for the increase in pre-tax income,
partially offset by loss and loss adjustment expenses of $5.6 million and
additional production expenses of $1.3 million.
Corporate
Corporate pre-tax loss was $1.3 million for the third quarter of 2005
as compared to $0.8 million for the same period in 2004. The increase was
primarily due to additional interest expense on the trust preferred
securities issued in June 2005.
Year-to-Date 2005 as compared to Year-to-Date 2004
Personal Lines Group
Net premium written increased $4.9 million during the first nine months
of 2005 to $28.1 million compared to $23.2 million in the same period of
2004. The increase was due mainly to AHIC assuming 100% of the Texas non-
standard automobile business produced by AHGA and underwritten by a third
party, effective October 1, 2004. Prior to October 1, 2004, AHIC assumed
only 45% of this business. Total premium production for the first nine
months of 2005 declined $5.6 million, or 16.6%, from the $33.7 million
produced in the first nine months of 2004. The decline in produced premium
was reflective of increased competition.
Revenue for the Personal Lines Group increased 12.3% to $33.2 million
for the first nine months of 2005 from $29.5 million for the same period in
2004. Increased net premium earned of $5.0 million due to higher assumed
premium volume was the primary cause of this increase. Also driving the
increased revenue was a $0.6 million increase in investment income due to an
increase in the investment portfolio from the completion of our capital
plan. These increases were partially offset by a $1.7 million decrease in
ceding commission income due to AHIC assuming 100% of the Texas non-standard
automobile business effective October 1, 2004.
Pre-tax income for the Personal Lines Group increased $1.9 million, or
33.1%, for the first nine months of 2005 compared to the same period of
2004. Net investment income and realized gains and losses contributed $0.7
million to the increase in pre-tax income for the first nine months of 2005.
Taking into consideration the effect on ceding commissions, loss and loss
adjustment expenses and premium production costs, the changes in premium
volume produced and assumed contributed approximately $0.5 million to the
increase in pre-tax income. Lower technical service costs from integrating
PIIC's back office systems that were previously outsourced contributed $0.3
million, lower salary and related expenses contributed $0.3 million, and a
loss ratio of 59.3% for the first nine months of 2005 as compared to 59.9%
for the same period in 2004 contributed $0.2 million to the increase in pre-
tax income.
Commercial Lines Group
Beginning in the third quarter of 2005, the Commercial Lines Group
began retaining written premium through AHIC. The Commercial Lines Group
written premium was accomplished through the assumption of in-force policies
from Clarendon at July 1, 2005, the assumption of Clarendon policies issued
subsequent to July 1, 2005, and the issuance of AHIC policies. This
resulted in net written premium for the Commercial Lines Group of $34.3
million for the year ended September 30, 2005.
Total revenue for the Commercial Lines Group of $27.2 million for the
first nine months of 2005 was $9.7 million more than the $17.5 million
reported in the first nine months of 2004. This 55.1% increase in total
revenue was primarily due to net premiums earned of $10.1 million for the
first nine months of 2005 from the issuance of AHIC policies and the
assumption of premium from Clarendon for business produced by HGA.
Increased net investment income contributed $0.7 million to the increase in
revenue. These increases in revenue were partially offset by lower ceding
commission revenue of $1.0 million and lower processing and service fees of
$0.1 million, in both cases due to the shift from a third party agency
structure to an insurance underwriting structure. Total earned premium
generated by the Commercial Lines Group (including premium retained by
Clarendon) for the first nine months of 2005 was $57.9 million as compared
to $53.9 million for the first nine months of 2004.
Pre-tax income for the Commercial Lines Group of $4.8 million for the
first nine months of 2005 increased $2.0 million, or 75.1%, over the $2.7
million reported for the same period of 2004. Increased revenue, as
discussed above, was the primary reason for the increase in pre-tax income,
partially offset by loss and loss adjustment expenses of $5.6 million and
additional production expenses of $1.9 million.
Corporate
Corporate pre-tax loss was $3.1 million for the first nine months of
2005 as compared to $1.9 million for the same period in 2004. The increase
was due to additional interest expense of $0.6 million from the issuance of
trust preferred securities in June 2005, as well as the transfer of
accounting positions from both the Personal Lines Group and Commercial Lines
Group to Corporate.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
As of September 30, 2005, there had been no material changes in the
market risks described in the Company's Form 10-K for the year ended
December 31, 2004.
Item 4. Controls and Procedures.
The Chief Executive Officer and Chief Financial Officer of the Company
have evaluated the Company's disclosure controls and procedures and have
concluded that, as of the end of the period covered by this report, such
disclosure controls and procedures were effective in ensuring that
information required to be disclosed by the Company in the reports that it
files or submits under the Securities Exchange Act of 1934 is timely
recorded, processed, summarized and reported. The Chief Executive Officer
and Chief Financial Officer also concluded that such disclosure controls and
procedures were effective in ensuring that information required to be
disclosed by the Company in the reports that it files or submits under such
Act is accumulated and communicated to the Company's management, including
its Chief Executive Officer and Chief Financial Officer, as appropriate, to
allow timely decisions regarding required disclosure. During the most
recent fiscal quarter, there have been no changes in the Company's internal
controls over financial reporting that have materially affected, or are
reasonably likely to materially affect, the Company's internal control over
financial reporting.
Risks Associated with Forward-Looking Statements Included in this Form 10-Q
This Form 10-Q contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934, which are intended to be covered by the
safe harbors created thereby. These statements include the plans and
objectives of management for future operations, including plans and
objectives relating to future growth of the Company's business activities
and availability of funds. The forward-looking statements included herein
are based on current expectations that involve numerous risks and
uncertainties. Assumptions relating to the foregoing involve judgments with
respect to, among other things, future economic, competitive and market
conditions, regulatory framework, weather-related events and future business
decisions, all of which are difficult or impossible to predict accurately
and many of which are beyond the control of the Company. Although the
Company believes that the assumptions underlying the forward-looking
statements are reasonable, any of the assumptions could be inaccurate and,
therefore, there can be no assurance that the forward-looking statements
included in this Form 10-Q will prove to be accurate. In light of the
significant uncertainties inherent in the forward-looking statements
included herein, the inclusion of such information should not be regarded as
a representation by the Company or any other person that the objectives and
plans of the Company will be achieved.
PART II
OTHER INFORMATION
Item 1. Legal Proceedings.
The Company is engaged in legal proceedings in the ordinary
course of business, none of which, either individually or
in the aggregate, are believed likely to have a material
adverse effect on the consolidated financial position of
the Company or the results of operations, in the opinion
of management. The various legal proceedings to which the
Company is a party are routine in nature and incidental to
the Company's business.
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.
None.
Item 6. Exhibits.
The following exhibits are filed herewith or incorporated
herein by reference:
Exhibit
Number Description
------ -----------
3(a) Articles of Incorporation of the registrant, as
amended (incorporated by reference to Exhibit 3(a) to
the registrant's Annual Report on Form 10-KSB for the
fiscal year ended December 31, 1993).
3(b) By-Laws of the registrant, as amended (incorporated
by reference to Exhibit 3(b) to the registrant's Form
10-Q for the quarter ended June 30, 2005).
4(a) Specimen certificate for Common Stock, $0.03 par
value per share, of the registrant (incorporated by
reference to Exhibit 4 to the registrant's Annual
Report on Form 10-KSB for the fiscal year ended
December 31, 1991).
4(b) Indenture dated as of June 21, 2005, between Hallmark
Financial Services, Inc. and JPMorgan Chase Bank,
National Association (incorporated by reference to
Exhibit 4.1 to the registrant's Form 8-K filed June 27,
2005).
4(c) Amended and Restated Declaration of Trust of Hallmark
Statutory Trust I dated as of June 21, 2005, among
Hallmark Financial Services, Inc., as sponsor, Chase
Bank USA, National Association, as Delaware trustee,
and JPMorgan Chase Bank, National Association, as
institutional trustee, and Mark Schwarz and Mark
Morrison, as administrators (incorporated by reference
to Exhibit 4.2 to the registrant's Form 8-K filed June
27, 2005).
4(d) Form of Junior Subordinated Debt Security Due 2035
(incorporated by reference to Exhibit 4.1 to the
registrant's Form 8-K filed June 27, 2005).
4(e) Form of Capital Security Certificate (incorporated by
reference to Exhibit 4.2 to the registrant's Form 8-K
filed June 27, 2005).
4(f) Credit Agreement dated June 29, 2005, between
Hallmark Financial Services, Inc. and The Frost
National Bank (incorporated by reference to Exhibit
4.1 to the registrant's Form 8-K filed July 6, 2005).
4(g) First Amendment to Credit Agreement dated July 15,
2005, between Hallmark Financial Services, Inc. and
The Frost National Bank (incorporated by reference to
Exhibit 4(g) to the registrant's Form 10-Q filed
August 5, 2005).
Exhibit
Number Description
------ -----------
31(a) Certification of Chief Executive Officer required by
Rule 13a-14(a) or Rule 15d-14(a).
31(b) Certification of Chief Financial Officer required by
Rule 13a-14(a) or Rule 15d-14(a).
32(a) Certification of Chief Executive Officer Pursuant to
18 U.S.C. 1350.
32(b) Certification of Chief Financial Officer Pursuant to
18 U.S.C. 1350.
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant has
caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.
HALLMARK FINANCIAL SERVICES, INC.
(Registrant)
Date: November 14, 2005 /s/ Mark E. Schwarz
---------------------------------------------
Mark E. Schwarz, Chairman
(Chief Executive Officer)
Date: November 14, 2005 /s/ Mark J. Morrison
---------------------------------------------
Mark J. Morrison, Executive Vice President
(Chief Operating Officer and Chief Financial
Officer)