UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended DECEMBER 31, 2005
Or
[ ] 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 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 Identification No.)
Incorporation or Organization)
777 Main Street, Suite 1000,
Fort Worth, Texas 76102
------------------------------- ---------
(Address of Principal Executive (Zip Code)
Offices)
Registrant's Telephone Number, Including Area Code: (817) 348-1600
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class Name of Each Exchange on Which Registered
--------------------------- -----------------------------------------
Common Stock $.03 par value American Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as
defined in Rule 405 of the Securities Act. Yes __ No X
Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. Yes __ No X
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 if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. ____
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 __ Accelerated filer __ Non-accelerated filer 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
State the aggregate market value of the voting and non-voting common equity
held by non-affiliates computed by reference to the price at which the
common equity was last sold, or the average bid and asked price of such
common equity, as of the last business day of the registrant's most recently
completed second fiscal quarter. $22,359,299
Indicate the number of shares outstanding of each of the registrant's
classes of common stock, as of the latest practicable date. Common stock,
$.03 par value 86,884,647 shares outstanding as of March 15, 2006.
DOCUMENTS INCORPORATED BY REFERENCE
The information required by Part III is incorporated by reference from the
Registrant's definitive proxy statement to be filed with the Commission
pursuant to Regulation 14A not later than 120 days after the end of the
fiscal year covered by this report.
Risks Associated with Forward-Looking Statements Included in this Form 10-K
---------------------------------------------------------------------------
This Form 10-K contains certain forward-looking statements within the
meaning of the Private Securities Litigation Reform Act of 1995, which are
intended to be covered by the safe harbors created thereby. Forward-looking
statements include statements which are predictive in nature, which depend
upon or refer to future events or conditions, or which include words such as
"expects", "anticipates", "intends", "plans", "believes", "estimates," or
similar expressions. 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-K
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.
Glossary of Terms
For convenient reference, the acronyms and other defined terms used in the
text of this report and the notes to our consolidated financial statements
have the following meanings:
* "2005 LTIP" means our 2005 Long Term Incentive Plan.
* "Aerospace" means Aerospace Holdings, LLC.
* "AHGA" means American Hallmark General Agency Inc.
* "AHIC" means American Hallmark Insurance Company of Texas.
* "APB" means Accounting Principles Board.
* "APB 25" means APB Opinion No. 25, "Accounting for Stock Issued to
Employees."
* "AZDOI" means Arizona Department of Insurance.
* "Clarendon" means Clarendon National Insurance Company.
* "Director Plan" means our 1994 Non-Employee Director Stock Option Plan.
* "Dorinco" means Dorinco Reinsurance Company.
* "ECM" means Effective Claims Management, Inc.
* "Employee Plan" means our 1994 Key Employee Long Term Incentive Plan.
* "FASB" means Financial Accounting Standards Board.
* "GAAP" means U.S. generally accepted accounting principles.
* "Hallmark" means Hallmark Financial Services, Inc.
* "HFC" means Hallmark Finance Corporation.
* "HGA" means Hallmark General Agency, Inc.
* "LAE" means loss adjustment expense.
* "Millers" means Millers American Group, Inc.
* "NAIC" means National Association of Insurance Commissioners.
* "Newcastle" means Newcastle Partners, L.P.
* "OACM" means Old American County Mutual Fire Insurance Company.
* "Opportunity Funds" means Newcastle Special Opportunity Fund I, L.P.
and Newcastle Special Opportunity Fund II, L.P.
* "PGA" means Phoenix General Agency.
* "PIIC" means Phoenix Indemnity Insurance Company.
* "RBC" means risk-based capital.
* "SAP" means statutory accounting practices.
* "SFAS 123" means FASB Statement of Financial Accounting Standards No.
123, "Accounting for Stock-Based Compensation."
* "SFAS 123R" means FASB Statement of Financial Accounting Standards No.
123R, "Share Based Payment."
* "SFAS 128" means FASB Statement of Financial Accounting Standards No.
128, "Earnings Per Share."
* "SFAS 141" means FASB Statement of Financial Accounting Standards No.
141, "Business Combinations."
* "SFAS 142" means FASB Statement of Financial Accounting Standards No.
142, "Goodwill and Other Intangible Assets."
* "SFAS 148" means FASB Statement of Financial Accounting Standards No.
148, "Accounting for Stock-Based Compensation - Transition and
Disclosure."
* "State & County" means State & County Mutual Fire Insurance Company.
* "TDI" means Texas Department of Insurance.
* "TGA" means Texas General Agency, Inc and certain affiliated companies.
* "We," "us" and "our" means Hallmark and its subsidiaries.
PART I
Item 1. Business.
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 to businesses and
individuals. Hallmark was formed in 1987 and commenced its insurance
operations in 1990. Our business involves marketing and underwriting
commercial insurance in Texas, New Mexico, Idaho, Oregon, Montana and
Washington; marketing and underwriting non-standard personal automobile
insurance in Texas, New Mexico and Arizona; marketing of general aviation
insurance in 44 states (effective January 1, 2006); claims administration;
and other insurance related services. We have pursued our business
activities through subsidiaries whose operations are organized into our
Commercial Insurance Operation segment, which handles commercial insurance
products and services, and our Personal Insurance Operation segment, which
handles non-standard personal automobile insurance products and services.
We expect to realign our operational segments during 2006 to reflect the
activities of newly acquired subsidiaries. (See, "Item 1. Business -
Recent Events.")
Recent Events
During the second quarter of 2005, we successfully completed a capital
plan which raised $45 million through a shareholder rights offering and $30
million through a private placement of trust preferred securities. Upon
completion of these capital enhancements, A.M. Best upgraded the financial
strength ratings of Hallmark's two insurance carrier subsidiaries. The
financial strength rating of American Hallmark Insurance Company of Texas
("AHIC") improved to A- (excellent) from B (fair) and the financial strength
rating of Phoenix Indemnity Insurance Company ("PIIC") improved to B+ (very
good) from B- (fair).
On November 14, 2005, we announced the signing of a definitive purchase
agreement to acquire Texas General Agency, Inc ("TGA"). This transaction
was closed effective January 1, 2006. TGA is a managing general agency
involved in the marketing, underwriting and servicing of property and
casualty insurance products, with a particular emphasis on commercial
automobile and general liability risks. The acquisition also included 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, and Pan American Acceptance
Corporation, which engages in financing premiums on property and casualty
insurance products marketed by TGA and TGA Special Risk, Inc. The
acquisition of TGA is expected to significantly expand the scope of
Hallmark's insurance marketing operations and provide opportunities for
increased underwriting by our Commercial Insurance Operation.
On December 13, 2005, we announced the signing of a definitive agreement
to acquire Aerospace Holdings, LLC ("Aerospace"). This transaction was also
closed effective January 1, 2006. Aerospace, through various wholly owned
subsidiaries, including Aerospace Insurance Managers, Inc., is involved in
the marketing and servicing of general aviation property and casualty
insurance products with a particular emphasis on private and small
commercial aircraft. With the acquisition of Aerospace, Hallmark entered
the general aviation market as part of our continuing strategy to expand
into specialty lines businesses.
We funded the acquisition of Aerospace by borrowing $12.5 million from
Newcastle Partners, L.P. on January 3, 2006. We funded the cash required to
close the acquisitions of TGA by borrowing $15.0 million under our revolving
credit facility with Frost National Bank on January 30, 2006. On January
27, 2006, we also issued an aggregate of $25.0 million in subordinated
convertible promissory notes to Newcastle Special Opportunity Fund I, L.P.
and Newcastle Special Opportunity Fund II, L.P. (collectively, "Opportunity
Funds"), the proceeds of which were used to establish a trust account
securing payment of future installments in connection with the TGA
acquisition. (See, "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations - Liquidity and Capital
Resources - Credit facility" and "- Other debt obligations.")
Commercial Insurance Operation
Our Commercial Insurance Operation markets and underwrites commercial
insurance policies through approximately 170 independent agencies operating
primarily in the non-urban areas of Texas, New Mexico, Idaho, Oregon,
Montana and Washington. During 2005, the members of the Commercial
Insurance Operation included a regional managing general agency, Hallmark
General Agency, Inc. ("HGA"), and a claims administration company, Effective
Claims Management, Inc. ("ECM"). HGA has historically maintained excellent
relationships with its producing agents. During fiscal 2005, the top 10
independent agency groups produced 35%, and no individual agency group
produced more than 8%, of the total premium volume of our Commercial
Insurance Operation. HGA targets customers that are in the low hazard
classifications in the standard commercial market, which as a group have
relatively stable loss results. The typical HGA customer is a small to
medium sized business with a policy that covers property, general liability
and auto exposures. The HGA underwriting criteria exclude lines of business
and classes of risks that are considered to be high hazard or volatile, or
which involve significant latent injury potential or other long-tail
liability exposures. ECM administers the claims on the insurance policies
produced by HGA. Products offered by HGA include the following:
* Commercial Auto - provides third party bodily injury and property
damage coverage and first party property damage coverage against
losses resulting from the ownership, maintenance or use of
automobiles and trucks in connection with an insured's business.
* General Liability - provides coverage for third party bodily injury
and property damage claims arising from accidents occurring on the
insured's premises or from their general business operations.
* Umbrella - provides coverage for third party liability claims where
the loss amount exceeds coverage limits provided by the insured's
underlying general liability and commercial auto policies.
* Commercial Property - provides first party coverage for the insured's
real property, business personal property, and business interruption
losses caused by fire, wind, hail, water damage, theft, vandalism and
other insured perils.
* Commercial Multi-Peril - provides a combination of property and
liability coverage that can include commercial auto coverage on a
single policy.
* Business Owner's Policy - provides a package of coverage designed for
small to medium sized businesses with homogeneous risk profiles.
Coverage includes general liability, commercial property and
commercial auto.
HGA writes most risks on a package basis using a commercial multi-peril
policy or a business owner's policy. Umbrella policies are written only
when HGA also writes the insured's underlying general liability and
commercial auto coverage. Through December 31, 2005, HGA marketed policies
on behalf of Clarendon National Insurance Company ("Clarendon"), a third
party insurer. On July 1, 2005, HGA began marketing new policies for AHIC.
Beginning in 2006, HGA will market new and renewal policies only for AHIC.
HGA earns a commission based on a percentage of the earned premium it
produces. The commission percentage is determined by the underwriting
results of the policies produced. ECM receives a claim servicing fee based
on a percentage of the earned premium produced, with a portion deferred for
casualty claims.
All of our commercial policies are for a term of twelve months. If the
insured is unable or unwilling to pay for the entire premium up front, we
provide an installment payment plan that allows the insured to pay 20% down
and the remaining payments over eight months. The terms of this plan were
changed in the first quarter of 2004. The prior plan allowed the insured to
pay 30% down and the remaining payments over six months. We charge a flat
$7.50 installment fee per payment for the installment payment plan. We
recognized $0.4 million, $0.3 million and $0.1 million in Commercial
Insurance Operation installment fee revenue in 2005, 2004 and 2003,
respectively.
Personal Insurance Operation
Our Personal Insurance Operation markets minimum limits non-standard
automobile policies through approximately 760 independent agents in Texas,
New Mexico and Arizona. We conduct this business under the name Phoenix
General Agency ("PGA"). PGA provides management, policy and claims services
to PIIC and includes the operations of American Hallmark General Agency Inc.
("AHGA") and Hallmark Claims Services, Inc. During fiscal 2005, the top 10
independent agency groups produced 26%, and no individual agency group
produced more than 4%, of the total premium volume of the Personal Insurance
Operation. Our non-standard automobile insurance provides for the minimum
limits of liability coverage mandated by state laws to drivers who find it
difficult to purchase automobile insurance from standard carriers as a
result of various factors, including driving record, vehicle, age, claims
history, or limited financial resources. Products offered by PGA include
the following:
* Personal Auto Liability - provides coverage for automobile liability
exposures including bodily injury and property damage arising from
accidents involving the insured.
* Personal Auto Physical Damage - provides collision and comprehensive
coverage for physical damage exposure to the insured vehicle as a
result of an accident with another vehicle or object, or as a result
of causes other than collision such as vandalism, theft, wind, hail
or water.
PGA currently offers one, two, three, six and twelve month policies. Net
premium volume was composed of a policy mix of 46.2% monthly and 53.8% six-
month policies in 2005; 51.8% monthly and 48.2% six-month policies in 2004;
and 6.2% annual, 43.6% monthly and 50.2% six-month policies in 2003.
Our typical non-standard auto customer is unable or unwilling to pay a
full or half year's premium in advance. Accordingly, we currently offer a
direct bill program where the premiums are directly billed to the insured on
a monthly basis. We charge an installment fee between $3.00 and $9.00 per
payment under the direct bill program. We recognized $1.6 million, $1.8
million, and $1.6 million in Personal Insurance Operation installment fee
revenue in 2005, 2004 and 2003, respectively. Prior to July 2003, we
offered premium financing for annual polices.
PGA markets our non-standard auto policies in Arizona and New Mexico
directly for PIIC. PGA currently provides non-standard auto insurance in
Texas through a reinsurance arrangement with an unaffiliated company, Old
American County Mutual Fire Insurance Company ("OACM"), for policies written
after September 30, 2003. Prior to October 1, 2003, we provided non-
standard auto insurance in Texas through a reinsurance arrangement with
another unaffiliated company, State & County Mutual Fire Insurance Company
("State & County"). PGA holds a managing general agency appointment from
OACM to manage the sale and servicing of OACM policies. Effective October
1, 2004, AHIC reinsures 100% of the OACM policies produced by PGA under a
related reinsurance agreement. Prior to October 1, 2004, AHIC reinsured 45%
of the OACM policies produced by PGA. PGA began marketing an additional
Texas non-standard auto insurance program directly for PIIC late in the
fourth quarter of 2005.
Underwriting and Other Ratios
An insurance company's underwriting performance is traditionally
measured by its statutory loss and loss adjustment expense ("LAE") ratio,
its statutory expense ratio and its statutory combined ratio. The statutory
loss and LAE ratio, which is calculated as the ratio of net losses and LAE
incurred to net premiums earned, helps to assess the adequacy of the
insurer's rates, the propriety of its underwriting guidelines and the
performance of its claims department. The statutory expense ratio, which is
calculated as the ratio of underwriting and operating expenses to net
premiums written, assists in measuring the insurer's cost of processing and
managing the business. The statutory combined ratio, which is the sum of
the statutory loss and LAE ratio and the statutory expense ratio, is
indicative of the overall profitability of an insurer's underwriting
activities, with a combined ratio of less than 100% indicating profitable
underwriting results.
The following table shows, for each of the years in the three year period
ended December 31, 2005, (i) our gross premiums written, and (ii) our
underwriting results as measured by the net statutory loss and LAE ratio,
the statutory expense ratio, and the statutory combined ratio for each
calendar year.
2005 2004 2003
-------- -------- --------
Gross Premiums Written $ 89,467 $ 33,389 $ 43,338
======== ======== ========
Statutory Loss & LAE Ratio 60.3% 60.4% 72.5%
Statutory Expense Ratio 32.8% 28.3% 28.6%
-------- -------- --------
Statutory Combined Ratio 93.1% 88.7% 101.1%
======== ======== ========
These statutory ratios do not reflect the deferral of policy
acquisition costs, investment income, premium finance revenues, or the
elimination of inter-company transactions required by U.S. generally
accepted accounting principles ("GAAP"). The increase in the statutory
expense ratio in 2005 was driven primarily by the assumption of commercial
premium from Clarendon. The decrease in the statutory loss and LAE ratio
from 2003 to 2004 was due largely to favorable loss development in prior
accident years as well as the settlement of a PIIC bad faith claim in 2003.
Under Texas Department of Insurance ("TDI") and Arizona Department of
Insurance ("AZDOI") guidelines, property and casualty insurance companies
are expected to maintain a premium-to-surplus percentage of not more than
300%. The premium-to-surplus percentage measures the relationship between
net premiums written in a given period (premiums written, less returned
premiums and reinsurance ceded to other carriers) to surplus (admitted
assets less liabilities), all determined on the basis of statutory
accounting practices ("SAP") prescribed or permitted by insurance regulatory
authorities. For 2005, 2004, and 2003, AHIC's premium-to-surplus
percentages were 94%, 122%, and 150%, respectively. Phoenix's premium-to-
surplus percentages were 79%, 135% and 215% for 2005, 2004 and 2003,
respectively. These declining premium-to-surplus percentages reflect added
underwriting capacity attributable to the increased surplus from profitable
operations and our 2005 capital plan. (See, "Item 1. Business - Recent
Events.")
Reinsurance
We reinsure a portion of the risk we underwrite in order to control the
exposure to losses and to protect capital resources. We cede to reinsurers
a portion of these risks and pay premiums based upon the risk and exposure
of the policies subject to such reinsurance. Ceded reinsurance involves
credit risk and is generally subject to aggregate loss limits. Although the
reinsurer is liable to us to the extent of the reinsurance ceded, we are
ultimately liable as the direct insurer on all risks reinsured. Reinsurance
recoverables are reported after allowances for uncollectible amounts. We
monitor the financial condition of reinsurers on an ongoing basis and review
our reinsurance arrangements periodically. Reinsurers are selected based on
their financial condition, business practices and the price of their product
offerings.
For policies originated prior to April 1, 2003, we assumed the reinsurance
of 100% of the Texas non-standard auto business produced by PGA and
underwritten by State & County and retroceded 55% of the business to
Dorinco Reinsurance Company ("Dorinco"). Under this arrangement, we remain
obligated to policyholders in the event that Dorinco does not meet its
obligations under the retrocession agreement. From April 1, 2003 through
September 30, 2004, we assumed the reinsurance of 45% of the Texas non-
standard automobile policies produced by PGA and underwritten either by
State & County (for policies written from April 1, 2003 through September
30, 2003) or OACM (for policies written from October 1, 2003 through
September 30, 2004). During this period, the remaining 55% of each policy
was directly assumed by Dorinco. Under these reinsurance arrangements, we
are obligated to policyholders only for the portion of the risk that we
assumed. Effective October 1, 2004, we assume and retain the reinsurance of
100% of the Texas non-standard automobile policies produced by PGA and
underwritten by OACM.
Under our prior insurance arrangements with Dorinco, we earned ceding
commissions based on loss ratio experience on the portion of policies
reinsured by Dorinco. We received a provisional commission as policies were
produced as an advance against the later determination of the commission
actually earned. The provisional commission is adjusted periodically on a
sliding scale based on expected loss ratios. As of December 31, 2005 and
2004, the accrued ceding commission payable to Dorinco was $0.4 million and
$1.0 million, respectively. This accrual represents the difference between
the provisional ceding commission received and the ceding commission earned
based on current loss ratios.
The following table presents gross and net premiums written and earned and
reinsurance recoveries for each of the last three years (in thousands):
2005 2004 2003
-------- -------- --------
Gross premiums written $ 89,467 $ 33,389 $ 43,338
Ceded premiums written (1,215) (322) (6,769)
-------- -------- --------
Net premiums written $ 88,252 $ 33,067 $ 36,569
======== ======== ========
Gross premiums earned $ 59,632 $ 33,058 $ 57,447
Ceded premiums earned (448) (613) (15,472)
-------- -------- --------
Net premiums earned $ 59,184 $ 32,445 $ 41,975
======== ======== ========
Reinsurance recoveries $ (492) $ 163 $ 11,071
======== ======== ========
The following table presents our reinsurance recoverable balance as of
December 31, 2005 by reinsurer (in thousands):
Reinsurance A.M. Best Rating
Reinsurer Recoverable of Reinsurer
Dorinco Reinsurance Company $ 426 A- (Excellent)
GE Reinsurance Corporation 10 A (Excellent)
Platinum Underwriters Reinsurance, Inc. 8 A (Excellent)
-------
Total Reinsurance Recoverable $ 444
=======
For additional information concerning reinsurance, see Note 6 of notes to
our consolidated financial statements.
Our Personal Insurance Operation presently retains 100% of the risk
associated with all non-standard auto policies marketed by PGA. Our
Commercial Insurance Operation currently purchases reinsurance for the
following exposures:
* Property Catastrophe - Our property catastrophe reinsurance reduces
the financial impact a catastrophe could have on our commercial
property insurance lines. Catastrophes might include multiple claims
and policyholders. Catastrophes include hurricanes, windstorms,
earthquakes, hailstorms, explosions, severe winter weather and fires.
Our property catastrophe reinsurance is excess-of-loss reinsurance,
which provides us reinsurance coverage for losses in excess of
an agreed-upon amount. We utilize catastrophe models to assist in
determining appropriate retention and limits to purchase. The terms
of our current property catastrophe reinsurance, effective October 1,
2005, are:
* We retain the first $1 million of property catastrophe losses; and
* Our reinsurers reimburse us 95% for each $1 of loss in excess of
our $1 million retention up to $4.75 million for each catastrophic
occurrence, subject to a two event maximum for the contractual term.
* Commercial Property - Our commercial property reinsurance reduces the
financial impact a single-event or catastrophic loss may have on our
results. It is excess-of-loss coverage. The terms of our current
commercial property reinsurance, effective July 1, 2005, are:
* We retain the first $500 thousand of loss for each commercial
property risk;
* Our reinsurers reimburse us for the next $4.5 million for each
commercial property risk; and
* Individual risk facultative reinsurance is purchased on any
commercial property with limits above $5 million.
* Commercial Umbrella - Our commercial umbrella reinsurance reduces the
financial impact of losses in this line of business. Our commercial
umbrella reinsurance is quota-share reinsurance, in which the
reinsurers share a proportional amount of the premiums and losses.
Under our current commercial umbrella reinsurance, effective July 1,
2005, we retain 10% of the premiums and losses and cede 90% to our
reinsurers.
* Commercial Casualty - Our commercial casualty reinsurance reduces the
financial impact a single-event loss may have on our results. It is
excess-of-loss coverage. The terms of our current commercial casualty
reinsurance, effective July 1, 2005, are:
* We retain the first $500 thousand of any commercial liability loss,
including commercial automobile liability; and
* Our reinsurers reimburse us for the next $500 thousand for each
commercial liability loss, including commercial automobile liability.
Competition
The property and casualty insurance market, our primary source of revenue,
is highly competitive and, except for regulatory considerations, has very
few barriers to entry. According to A.M. Best Company, Inc., there were
3,120 property and casualty insurance companies and 2,019 property and
casualty insurance groups operating in North America as of July 22, 2005.
Our Commercial Insurance Operation competes with a variety of large national
standard commercial lines carriers such as Hartford, Zurich, St. Paul
Travelers and Safeco, as well as numerous smaller regional companies.
Although our Personal Insurance Operation competes with large national
insurers such as Allstate, State Farm and Progressive, as a participant in
the non-standard personal automobile marketplace our competition is most
directly associated with numerous regional companies and managing general
agencies. Our competitors include entities which have, or are affiliated
with entities which have, greater financial and other resources than we
have.
Generally, we compete based upon price, customer service, coverages
offered, claims handling, financial stability, agent commission and support,
customer recognition and geographic coverage. We compete with companies
using independent agents, captive agent networks, direct marketing channels,
or a combination thereof.
The Commercial Insurance Operation experienced moderate rate pressure in
2005 after three years of double digit rate growth. However, because we
focus the distribution of our commercial products in smaller non-urban
markets that are less price sensitive, we were able to keep our overall rate
levels relatively flat in 2005. We believe increased rate pressure will at
least continue through 2006.
The Personal Lines Operation competes primarily in the minimum limits
personal non-standard automobile market. Underwriters in this market
segment maintained moderate pricing discipline during 2005, with a bias
toward decreasing rates. We believe this rate pressure will continue at
least through 2006.
Insurance Regulation
Our insurance operations are regulated by the TDI and AZDOI. AHIC and
PIIC are required to file quarterly and annual statements of their financial
condition with TDI and AZDOI, respectively, prepared in accordance with SAP.
The financial conditions of AHIC and PIIC, including the adequacy of
surplus, loss reserves and investments, are subject to review by TDI and
AZDOI, respectively. We do not write our Texas non-standard automobile
insurance directly, but assume business written through a county mutual
insurance company. Under Texas insurance regulation, premium rates and
underwriting guidelines of county mutuals are not subject to the same degree
of regulation imposed on standard insurance companies. PGA is also subject
to TDI licensing requirements. Our premium finance company, Hallmark
Finance Corporation ("HFC"), is subject to licensing, financial reporting
and certain financial requirements imposed by TDI. HFC is also regulated by
the Texas Office of Consumer Credit Commissioner. Since we discontinued
writing annual premium financed policies in July 2003, HFC does not have any
ongoing operations.
TDI and AZDOI have broad authority to enforce insurance laws and
regulations through examinations, administrative orders, civil and criminal
enforcement proceedings, and suspension or revocation of an insurer's
certificate of authority or an agent's license. In extreme cases, including
actual or pending insolvency, they may take over, or appoint a receiver
to take over, the management or operations of an insurer or an agent's
business or assets. In addition, all insurance companies are subject to
assessments for state administered funds which cover the claims and expenses
of insolvent or impaired insurers. The size of the assessment is determined
each year by the total claims on the fund that year. Each insurer is
assessed a pro-rata share based on its direct premiums written. Payments
to the fund may be recovered by the insurer through deductions from its
premium taxes at a rate of 10% per year over ten years.
Hallmark is also regulated as an insurance holding company by TDI and
AZDOI. Financial transactions between Hallmark or any of its affiliates and
AHIC or PIIC are subject to regulation. Applicable regulations require
approval of management and expense sharing contracts, inter-company loans
and asset transactions, investments in Hallmark's securities by AHIC or PIIC
and similar transactions. Further, dividends and distributions to Hallmark
by AHIC or PIIC are restricted by TDI and AZDOI regulations.
The National Association of Insurance Commissioners ("NAIC") requires
property/casualty insurers to file a risk-based capital ("RBC") calculation
according to a specified formula. The purpose of the NAIC-designed formula
is twofold: (1) to assess the adequacy of an insurer's statutory capital and
surplus based upon a variety of factors such as potential risks related to
investment portfolio, ceded reinsurance and product mix; and (2) to assist
state regulators under the RBC for Insurers Model Act by providing
thresholds at which a state commissioner is authorized and expected to take
regulatory action. AHIC's 2005, 2004 and 2003 adjusted capital under the
RBC calculation exceeded the minimum requirement by 600%, 412% and 186%,
respectively. PIIC's 2005, 2004 and 2003 adjusted capital under the RBC
calculation exceeded the minimum requirement by 365%, 254% and 117%,
respectively.
HGA is subject to and in compliance with the licensing requirements of
the department of insurance in each state in which it produces business.
Generally, each state requires one officer of HGA to maintain an agent
license. Claim adjusters employed by us are also subject to the licensing
requirements of each state in which they conduct business. Each employed
claim adjuster either holds or has applied for the required licenses.
Analysis of Losses and LAE
Our consolidated financial statements include an estimated reserve for
unpaid losses and LAE. We estimate our reserve for unpaid losses and LAE by
using case-basis evaluations and statistical projections, which include
inferences from both losses paid and losses incurred. We also use recent
historical cost data, periodic reviews of underwriting standards and claims
management to modify the statistical projections. We give consideration to
the impact of inflation in determining our loss reserves, but do not
discount reserve balances.
The amount of reserves represents our estimate of the ultimate net cost
of all unpaid losses and LAE incurred through December of each year. These
estimates are subject to the effect of trends in claim severity and
frequency. We continually review the estimates and adjust them as claims
experience develops and new information becomes known. Such adjustments are
included in current operations, including increases and decreases, net of
reinsurance, in the estimate of ultimate liabilities for insured events of
prior years.
Changes in loss development patterns and claim payments can significantly
affect the ability of insurers to estimate reserves for unpaid losses
and related expenses. We seek to continually improve our loss estimation
process by refining our ability to analyze loss development patterns,
claim payments and other information within a legal and regulatory
environment which affects development of ultimate liabilities. Future
changes in estimates of claim costs may adversely affect future period
operating results. However, such effects cannot be reasonably estimated
currently.
Reconciliation of Reserve for Unpaid Losses and LAE. The following table
provides a 2005, 2004 and 2003 reconciliation of the beginning and ending
reserve balances, on a gross-of-reinsurance basis, to the gross amounts
reported in our balance sheet at December 31, 2005, 2004 and 2003 (in
thousands):
2005 2004 2003
-------- -------- --------
Reserve for unpaid losses and LAE, net
of reinsurance recoverables, January 1 $ 17,700 $ 21,197 $ 8,411
Acquisition of Phoenix January 1, 2003 - - 10,338
Provision for losses and LAE for claims
occurring in the current period 36,184 20,331 29,724
Increase (decrease) in reserve for
unpaid losses and LAE for claims
occurring in prior periods (2,400) (1,194) 464
Payments for losses and LAE, net
of reinsurance:
Current period (17,414) (10,417) (21,895)
Prior periods (8,073) (12,217) (5,845)
Reserve for unpaid losses and LAE
at December 31, net of reinsurance
recoverable $ 25,997 $ 17,700 $ 21,197
Reinsurance recoverable on unpaid
losses and LAE at December 31 324 1,948 7,259
-------- -------- --------
Reserve for unpaid losses and LAE
at December 31, gross of reinsurance $ 26,321 $ 19,648 $ 28,456
======== ======== ========
The $2.4 million and $1.2 million favorable development in prior accident
years recognized in 2005 and 2004, respectively, represent normal changes
in actuarial estimates. The 2003 provision for losses and LAE for claims
occurring in the current period includes a $2.1 million settlement of a bad
faith claim, net of reinsurance, and adverse development primarily related
to newly acquired business.
SAP/GAAP Reserve Reconciliation. The differences between the reserves for
unpaid losses and LAE reported in our consolidated financial statements
prepared in accordance with GAAP and those reported in the annual statements
filed with TDI and AZDOI in accordance with SAP for years 2005 and 2004 are
summarized below (in thousands):
December 31
2005 2004
------ ------
Reserve for unpaid losses and LAE on a SAP basis
(net of reinsurance recoverables on unpaid losses) $24,580 $16,416
Loss reserve discount from the PIIC acquisition (35) (80)
Unamortized risk premium reserve discount from the
PIIC acquisition 49 114
Estimated future unallocated LAE reserve for claim
service subsidiaries 1,403 1,250
------ ------
Reserve for unpaid losses and LAE on a GAAP basis
(net of reinsurance recoverables on unpaid losses) $25,997 $17,700
====== ======
Analysis of Loss and LAE Reserve Development
The following table shows the development of our loss reserves, net of
reinsurance, for 1995 through 2005. Section A of the table shows the
estimated liability for unpaid losses and LAE, net of reinsurance, recorded
at the balance sheet date for each of the indicated years. This liability
represents the estimated amount of losses and LAE for claims arising in
prior years that are unpaid at the balance sheet date, including losses that
have been incurred but not yet reported to us. Section B of the table shows
the re-estimated amount of the previously recorded liability, based on
experience as of the end of each succeeding year. The estimate is increased
or decreased as more information becomes known about the frequency and
severity of claims.
Cumulative Redundancy/Deficiency (Section C of the table) represents the
aggregate change in the estimates over all prior years. Thus, changes in
ultimate development estimates are included in operations over a number of
years, minimizing the significance of such changes in any one year.
[This space left blank intentionally.]
ANALYSIS OF LOSS AND LAE DEVELOPMENT
(Thousands of dollars)
Year Ended December 31 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
---------------------- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- -----
A. Reserve for $5,923 $5,096 $4,668 $4,580 $5,409 $7,451 $7,919 $8,411 $21,197 $17,700 $25,997
Unpaid Losses & LAE,
Net of Reinsurance
Recoverables
B. Net Reserve Re-
estimated as of :
One year later 5,910 6,227 4,985 4,594 5,506 7,974 8,096 8,875 20,003 15,300
Two years later 6,086 6,162 4,954 4,464 5,277 7,863 8,620 8,881 19,065
Three years later 6,050 6,117 4,884 4,225 5,216 7,773 8,856 8,508
Four years later 6,024 6,070 4,757 4,179 5,095 7,901 8,860
Five years later 6,099 5,954 4,732 4,111 5,028 7,997
Six years later 6,044 5,928 4,687 4,101 5,153
Seven years later 6,038 5,900 4,695 4,209
Eight years later 6,029 5,902 4,675
Nine years later 6,035 5,881
Ten years later 6,035
C. Net Cumulative (112) (785) (7) 371 256 (546) (941) (97) 2,132 2,400
Redundancy
(Deficiency)
D. Cumulative
Amount of Claims
Paid, Net of
Reinsurance
Recoveries
through:
One year later 3,783 4,326 3,326 2,791 3,229 5,377 5,691 5,845 12,217 8,073
Two years later 5,447 5,528 4,287 3,476 4,436 7,070 7,905 7,663 15,814
Three years later 5,856 5,860 4,387 3,911 4,909 7,584 8,603 8,228
Four years later 5,933 5,699 4,571 4,002 5,014 7,810 8,798
Five years later 6,018 5,818 4,618 4,051 4,966 7,960
Six years later 6,018 5,853 4,643 4,061 5,116
Seven years later 6,029 5,860 4,664 4,204
Eight years later 6,029 5,871 4,675
Nine years later 6,035 5,881
Ten years later 6,035
2004 2005
---- ----
Net Reserve-December 31 $ 17,700 $25,997
Reinsurance Recoverables 1,948 324
------ ------
Gross Reserve - December 31 $ 19,648 $26,321
======= ======
Net Re-estimated Reserve 15,300
Re-estimated Reinsurance Recoverable 2,246
------
Gross Re-estimated Reserve $17,546
=======
Gross Cumulative Redundancy $ 2,102
=======
Investment Policy
Our investment objective is to maximize current yield while maintaining
safety of capital together with sufficient liquidity for ongoing insurance
operations. Our investment portfolio is composed of fixed income and equity
securities. Our fixed income securities are made up of 62.4% corporate
securities, 32.8% state and local securities, and 4.8% U.S. Government or
U.S. Government agency securities. The average maturity of our fixed income
portfolio as of December 31, 2005 was 5.2 years. The fair value of our
fixed income securities as of December 31, 2005 was $87.3 million, of which
$7.9 million is classified as restricted investments. If market rates were
to change 1%, the fair value of our fixed income securities would change
approximately $3.6 million as of December 31, 2005.
In addition, as part of our overall investment strategy, we maintain an
integrated cash management system utilizing on-line banking services and
daily overnight investment accounts to maximize investment earnings on all
available cash. During 2005, our investment income totaled approximately
$3.8 million compared to approximately $1.4 million for 2004. The increase
in investment income in 2005 was due primarily to the infusion of $75
million in capital in the second quarter of 2005. For further discussion
see Liquidity and Capital Resources in Item 7 of this Form 10-K.
Employees
On December 31, 2005, we employed 165 people on a full-time basis as
compared to 179 people at December 31, 2004. None of our employees are
represented by labor unions. We consider our employee relations to be
excellent.
Item 1A. Risk Factors.
Our results may fluctuate as a result of cyclical changes in the property
and casualty insurance industry.
All of our revenue is attributable to property and casualty insurance,
which as an industry is cyclical in nature and has historically been
characterized by soft markets followed by hard markets. A soft market is a
period of relatively high levels of price competition, less restrictive
underwriting standards and generally low premium rates. A hard market is a
period of capital shortages resulting in lack of insurance availability,
relatively low levels of competition, more selective underwriting of risks
and relatively high premium rates.
Our industry is very competitive, which may unfavorably impact our results
of operations.
The property and casualty insurance market, our primary source of revenue,
is highly competitive and, except for regulatory considerations, has very
few barriers to entry. According to A.M. Best Company, Inc., there were
3,120 property and casualty insurance companies and 2,019 property and
casualty insurance groups operating in North America as of July 22, 2005.
Our Commercial Insurance Operation competes with a variety of large national
standard commercial lines carriers such as Hartford, Zurich, St. Paul
Travelers and Safeco, as well as numerous smaller regional companies.
Although our Personal Insurance Operation competes with large national
insurers such as Allstate, State Farm and Progressive, as a participant in
the non-standard personal automobile marketplace our competition is most
directly associated with numerous regional companies and managing general
agencies. Our competitors include entities which have, or are affiliated
with entities which have, greater financial and other resources than we
have.
Estimating reserves is inherently uncertain. If our loss reserves are not
adequate, it will have an unfavorable impact on our results.
We maintain loss reserves to cover estimated liability for unpaid losses
and LAE, for reported and unreported claims incurred as of the end of each
accounting period. Reserves represent management's estimates of what the
ultimate settlement and administration of claims will cost. These estimates,
which generally involve actuarial projections, are based on management's
assessment of facts and circumstances then known, as well as estimates of
future trends in claim severity and frequency, judicial theories of
liability, and other factors. These variables are affected by both internal
and external events, such as changes in claim handling procedures,
inflation, judicial trends and legislative changes. Many of these factors
are not quantifiable. Additionally, there may be a significant reporting lag
between the occurrence of an event and the time it is reported to us. The
inherent uncertainties of estimating reserves are greater for certain types
of liabilities, particularly those in which the various considerations
affecting the type of claim are subject to change and in which long periods
of time may elapse before a definitive determination of liability is made.
Reserve estimates are continually refined in a regular and ongoing process
as experience develops and further claims are reported and settled.
Adjustments to reserves are reflected in the results of the periods in which
such estimates are changed. Because setting reserves is inherently
uncertain, there can be no assurance that the current reserves will prove
adequate.
Our results may be unfavorably impacted if we are unable to obtain adequate
reinsurance.
If we are unable to obtain adequate reinsurance protection for the risks
we have underwritten, we will either be exposed to greater losses from
these risks or we will reduce the level of business that we underwrite,
which will reduce our revenue. The amount, availability and cost of
reinsurance are subject to prevailing market conditions beyond our control,
and may affect our ability to write additional premiums as well as our
profitability.
If the companies that provide our reinsurance do not pay all of our claims,
we could incur severe losses.
We purchase reinsurance by transferring, or ceding, part of the risk we
have assumed to a reinsurance company in exchange for part of the premium we
receive in connection with the risk. Although reinsurance makes the
reinsurer liable to us to the extent the risk is transferred or ceded to the
reinsurer, it does not relieve us of our liability to our policyholders.
Accordingly, we bear credit risk with respect to our reinsurers. We cannot
assure that our reinsurers will pay all of our reinsurance claims, or that
they will pay our claims on a timely basis.
Catastrophic losses may adversely affect our results of operations,
liquidity and financial condition.
Property and casualty insurance companies are subject to claims arising
out of catastrophes that may have a significant affect on their results of
operations, liquidity and financial condition. Catastrophes can be caused by
various events, including hurricanes, windstorms, earthquakes, hail storms,
explosions, severe winter weather and fires, and may include man-made
events, such as the September 11, 2001 terrorist attacks on the World Trade
Center. The incidence, frequency, and severity of catastrophes are
inherently unpredictable. The extent of losses from a catastrophe is a
function of both the total amount of insured exposure in the area affected
by the event and the severity of the event.
We are subject to comprehensive regulation, and our results may be
unfavorably impacted by these regulations.
We are subject to comprehensive governmental regulation and supervision.
Most insurance regulations are designed to protect the interests of
policyholders rather than of the stockholders and other investors of the
insurance companies. These regulations, generally administered by the
department of insurance in each state in which we do business, relate to,
among other things;
* Approval of policy forms and rates,
* Standards of solvency, including risk based capital measurements
(which are a measure developed by the National Association of
Insurance Commissioners and used by the state insurance regulators
to identify insurance companies that potentially are inadequately
capitalized),
* Licensing of insurers and their agents,
* Restrictions on the nature, quality and concentration of
investments,
* Restrictions on the ability of our insurance company subsidiaries to
pay dividends,
* Restrictions on transactions between the insurance company
subsidiaries and their affiliates,
* Requiring certain methods of accounting,
* Periodic examinations of operations and finances,
* Prescribing the form and content of records of financial condition
to be filed, and
* Requiring reserves for unearned premium, losses and other purposes.
State insurance departments also conduct periodic examinations of the
affairs of insurance companies and require filing of annual and other
reports relating to the financial condition of insurance companies, holding
company issues and other matters. Our business depends on compliance with
applicable laws and regulations and our ability to maintain valid licenses
and approvals for our operations. Regulatory authorities may deny or revoke
licenses for various reasons, including violations of regulations. Changes
in the level of regulation of the insurance industry or changes in laws or
regulations themselves or interpretations by regulatory authorities could
have a material adverse affect on our operations.
State statutes limit the aggregate amount of dividends that our subsidiaries
may pay Hallmark, thereby limiting its funds to pay expenses and dividends.
Hallmark is a holding company and a legal entity separate and distinct
from its subsidiaries. As a holding company without significant operations
of its own, Hallmark's principal sources of funds are dividends and other
sources of funds from its subsidiaries. State insurance laws limit the
ability of Hallmark's insurance company subsidiaries to pay dividends and
require the insurance companies to maintain specified levels of statutory
capital and surplus. These restrictions affect the ability of our insurance
company subsidiaries to pay dividends and use their capital in other ways.
Hallmark's right to participate in any distribution of assets of the
insurance company subsidiaries is subject to prior claims of policyholders
and creditors (except to the extent that its rights, if any, as a creditor
are recognized). Consequently, Hallmark's ability to pay debts, expenses and
cash dividends to our stockholders may be limited.
Our insurance company subsidiaries are subject to minimum capital and
surplus requirements. Failure to meet these requirements could subject us
to regulatory action.
Our insurance company subsidiaries are subject to minimum capital and
surplus requirements imposed under the laws of Texas and Arizona. Any
failure by one of our insurance company subsidiaries to meet minimum capital
and surplus requirements imposed by applicable state law will subject it to
corrective action, which may include requiring adoption of a comprehensive
financial plan, revocation of its license to sell insurance products or
placing the subsidiary under state regulatory control. Any new minimum
capital and surplus requirements adopted in the future may require us to
increase the capital and surplus of our insurance company subsidiaries,
which we may not be able to do.
The loss of key executives could disrupt our business.
Our success will depend in part upon the continued service of certain
key executives. Our success will also depend on our ability to attract and
retain additional executives and personnel. The loss of key personnel could
cause disruption in our business.
Adverse securities market conditions can have a significant and negative
impact on our investment portfolio.
Our results of operations depend in part on the performance of our
invested assets. As of December 31, 2005, 84.8% of our investment portfolio
was invested in fixed maturity securities. Certain risks are inherent in
connection with fixed maturity securities, including loss upon default and
price volatility in reaction to changes in interest rates and general market
factors. In general, the fair market value of a portfolio of fixed income
securities increases or decreases inversely with changes in the market
interest rates, while net investment income realized from future investments
in fixed income securities increases or decreases along with interest rates.
In addition, some of our fixed income securities have call or prepayment
options. This could subject us to reinvestment risk should interest rates
fall or issuers call their securities and we reinvest proceeds at lower
interest rates. We attempt to mitigate this risk by investing in securities
with varied maturity dates, so that only a portion of the portfolio will
mature at any point in time. Furthermore, actual net investment income
and/or cash flows from investments that carry prepayment risk (such as
mortgage-backed and other asset-backed securities) may differ from those
anticipated at the time of investment as a result of interest rate
fluctuations. An investment has prepayment risk when there is a risk that
cash flows from the repayment of principal might occur earlier than
anticipated because of declining interest rates or later than anticipated
because of rising interest rates. The fair value of our fixed income
securities as of December 31, 2005 was $87.3 million. If market interest
rates were to change 1%, (e.g. from 5% to 6%), the fair value of our fixed
income securities would change approximately $3.6 million as of December 31,
2005. The change in fair value was determined using duration modeling
assuming no prepayments.
In addition to the general risks described above, although we maintain
an investment grade portfolio, our fixed income securities are also subject
to credit risk. If any of the issuers of our fixed income securities suffer
financial set backs, the ratings on the fixed income securities could fall
(with a concurrent fall in market value) and, in a worst case scenario, the
issuer could default on its obligations. Future changes in the fair market
value of our available-for-sale securities will be reflected in other
comprehensive income. Similar treatment is not available for liabilities.
Therefore, interest rate fluctuations could adversely affect our
shareholders' equity, total comprehensive income and/or our cash flows.
We are reliant on independent agents to market our products and their
failure to do so would have a material adverse effect on our results of
operations.
We principally market our insurance programs through independent
insurance agents. As a result, our business depends in large part on the
marketing efforts of these agents and on our ability to offer insurance
products and services that meet the requirements of the agents and their
customers. The agents, however, are not obligated to sell or promote our
products and many sell or promote competitors' insurance products in
addition to our products. The failure or inability of insurance agents to
market our insurance products successfully could have a material adverse
impact on our business, financial condition and results of operations.
We may experience difficulty in integrating recent acquisitions into our
operations.
We completed the acquisitions of both Aerospace and TGA during January,
2006. The successful integration of these newly acquired businesses into
our operations will require, among other things, the retention and
assimilation of their key management, sales and other personnel; the
coordination of their lines of insurance products and services; the
adaptation of their technology, information systems and other processes; and
the retention and transition of their customers. Unexpected difficulties in
integrating these acquisitions could result in increased expenses and the
diversion of management time and resources. If we do not successfully
integrate these acquired businesses into our operations, we may not realize
the anticipated benefits of one or both of the acquisitions, which could
have a material adverse impact on our financial condition and results of
operations.
Mark E. Schwarz, our Chairman and Chief Executive Officer, through his
affiliation with Newcastle Partners, L.P., and the Opportunity Funds, has
the ability to exert significant influence over our operations and may have
interests that differ from those of our other stockholders.
Newcastle Partners, L.P. ("Newcastle") beneficially owns approximately
78% of our common stock. In addition, the Opportunity Funds hold convertible
promissory notes which, subject to shareholder approval and certain anti-
dilution provisions, are convertible into approximately 19.5 million shares
of our common stock. Mark E. Schwarz has sole investment and voting control
over the shares beneficially owned by Newcastle and the Opportunity Funds
and thus has the ability to exert significant influence over our policies
and affairs, including the election of our board of directors and the
approval of any action requiring stockholder vote. The interests of Mr.
Schwarz, Newcastle and the Opportunity Funds may differ from the interests
of our other stockholders in some respects. Therefore, Mr. Schwarz,
Newcastle and the Opportunity Funds may take action adverse to our other
stockholders.
If we are unable to raise additional capital or restructure our indebtedness
to Newcastle, we may have difficulty satisfying current liquidity
requirements.
We funded the acquisition of Aerospace by borrowing $12.5 million from
Newcastle on January 3, 2006. The principal and accrued interest of this
bridge loan are payable on demand at any time after June 30, 2006. We have
previously announced our intention to retire this debt through a rights
offering of our common stock to existing shareholders during 2006. However,
if we are unable to complete the rights offering or restructure the payment
schedule of the bridge loan, we may be unable to repay the bridge loan when
demand is made. Any default under the bridge loan to Newcastle would also
be an event of default under our primary secured credit facility and,
therefore, could have a material adverse effect on our liquidity and
operations.
If our shareholders do not approve the conversion of the convertible
promissory notes issued to the Opportunity Funds, we may be unable to
satisfy future liquidity requirements.
In connection with the acquisition of TGA, we issued $25.0 million in
convertible promissory notes to the Opportunity Funds, the principal of
which becomes due on July 27, 2007. If conversion is approved by our
shareholders, these convertible notes will be automatically converted to
shares of our common stock at their maturity to the extent not previously
converted by the holders. Newcastle owns sufficient shares of our common
stock to assure shareholder approval and has an agreement with the
Opportunity Funds to vote its shares in favor of such approval.
Nonetheless, if we do not obtain such shareholder approval, we may be unable
to repay the convertible notes at maturity. Any default under the
convertible notes would also be an event of default under our primary
secured credit facility and, therefore, could have a material adverse effect
on our liquidity and operations.
Conversion of the convertible promissory notes issued to the Opportunity
Funds will dilute the percentage ownership of our other shareholders.
Subject to shareholder approval, the convertible notes issued to the
Opportunity Funds will become convertible by the holders into approximately
19.5 million shares of our common stock (subject to certain anti-dilution
provisions), and will be automatically converted to such common stock at
their maturity in July, 2007. Upon such conversion, the proportionate
voting and ownership interest of all other shareholders will be reduced and
the percentage of our equity attributable to previously issued shares of our
common stock will be diluted.
Item 1B. Unresolved Staff Comments
Not applicable.
Item 2. Properties.
Our corporate headquarters and Commercial Insurance Operation are located
at 777 Main Street, Suite 1000, Fort Worth, Texas. The suite is located in a
high-rise office building and contains approximately 27,808 square feet of
space. Effective June 1, 2003, we renegotiated our lease for a period of 97
months to expire June 30, 2011. The rent is currently $32,327 per month.
Our Personal Insurance Operation is located at 14651 Dallas Parkway,
Suite 400, Dallas, Texas. The suite is located in a high-rise office
building and contains approximately 25,559 square feet of space. We
renegotiated our lease on May 5, 2003 for a period of 66 months to expire
November 30, 2008. The rent is currently $50,075 per month.
Item 3. Legal Proceedings.
We are engaged in various legal proceedings which are routine in nature
and incidental to our business. None of these proceedings, either
individually or in the aggregate, are believed, in our opinion, to have a
material adverse effect on our consolidated financial position or our
results of operations.
Item 4. Submission of Matters to a Vote of Security Holders.
During the fourth quarter of 2005, we did not submit any matter to a vote
of our security holders.
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters
and Issuer Purchases of Equity Securities.
Market for Common Stock
Our common stock is traded on the American Stock Exchange under the
symbol "HAF". The following table shows the high and low sales
prices of our common stock on the AMEX for each quarter since January
1, 2004.
Period High Sale Low Sale
2004
----
First Quarter $ 0.79 $ 0.45
Second Quarter 0.90 0.60
Third Quarter 1.20 0.75
Fourth Quarter 1.40 0.75
2005
----
First Quarter $ 1.60 $ 1.11
Second Quarter 1.50 0.95
Third Quarter 1.39 1.09
Fourth Quarter 1.37 1.05
2006
----
First Quarter (through $ 2.05 $ 1.36
March 6, 2006)
As of February 28, 2006 there were approximately 156 shareholders of
record of our common stock.
Dividends
We have never paid dividends on our Common Stock. The Board of Directors
intends to continue this policy for the foreseeable future in order to
retain earnings for development of our business.
Equity Compensation Plan Information
The following table provides information as of December 31, 2005,
concerning our common stock that may subsequently be issued upon the
exercise of incentive stock options and nonqualified stock options granted
to our directors, officers and key employees:
Number of
securities
Number of remaining
securities available
to be issued Weighted- for future
upon average issuance
exercise of exercise under equity
outstanding price of compensation
Options, outstanding plans [excluding
warrants options, securities
and warrants and reflected in
Plan Category Rights rights column (a)]
-------------------------- -----------------------------------------------
(a) (b) (c)
-----------------------------------------------
Equity compensation
plans approved by
security holders 1,416,500 $0.85 4,470,000
Equity compensation
plans not approved
by security holders1 100,000 $0.38 - 0 -
-----------------------------------------------
Total 1,516,500 $0.82 4,470,000
===============================================
1) Represents nonqualified options granted to independent directors in
lieu of fees for board service in 1999.
Issuer Repurchases
We did not repurchase any shares of our common stock during the fourth
quarter of 2005.
Item 6. Selected Financial Data.
(In thousands, except per share amounts)
2005 2004 2003 2002 2001
1 1,2,3 1,2,4 1
-------- -------- -------- -------- --------
Gross premiums written $ 89,467 $ 33,389 $ 43,338 $ 51,643 $ 49,614
Ceded premiums written (1,215) (322) (6,769) (29,611) (33,822)
----------------------------------------------------
Net premiums written 88,252 33,067 36,569 22,032 15,792
Change in unearned premiums (29,068) (622) 5,406 (1,819) 584
----------------------------------------------------
Net premiums earned 59,184 32,445 41,975 20,213 16,376
Investment income, net of expenses 3,836 1,386 1,198 773 1,043
Realized gains (losses) 58 (27) (88) (5) -
Finance charges 2,044 2,183 3,544 2,503 3,095
Commission and fees 16,703 21,100 17,544 1,108 -
Processing and service fees 5,183 6,003 4,900 921 1,120
Other income 27 31 486 284 368
----------------------------------------------------
Total revenues 87,035 63,121 69,559 25,797 22,002
Loss and loss adjustment expenses 33,784 19,137 30,188 15,302 15,878
Other operating costs and expenses 38,492 35,290 37,386 9,474 6,620
Interest expense 1,264 64 1,271 983 1,021
Amortization of intangible assets 27 28 28 2 157
----------------------------------------------------
Total expenses 73,567 54,519 68,873 25,761 23,676
Income (loss) before income tax,
cumulative effect of change
in accounting principle and
extraordinary gain 13,468 8,602 686 36 (1,674)
Income tax expense (benefit) 4,282 2,753 25 13 (544)
----------------------------------------------------
Income (loss) before cumulative
effect of change in accounting
principle and extraordinary gain 9,186 5,849 661 23 (1,130)
Cumulative effect of change in
accounting principle, net of tax - - - (1,694) -
Extraordinary gain - - 8,084 - -
----------------------------------------------------
Net income (loss) $ 9,186 $ 5,849 $ 8,745 $ (1,671) $ (1,130)
=====================================================
Basic earnings (loss) per share:
--------------------------------
Income before cumulative effect
of change in accounting principle
and extraordinary gain $0.13 $0.14 $0.02 - ($0.06)
Cumulative effect of change
in accounting principle - - - (0.08) -
Extraordinary gain - - 0.28 - -
----------------------------------------------------
Net income (loss) $0.13 $0.14 $0.30 ($0.08) ($0.06)
====================================================
Diluted earnings (loss) per share:
----------------------------------
Income before cumulative effect
of change in accounting principle
and extraordinary gain $0.13 $0.14 $0.02 - ($0.06)
Cumulative effect of change
in accounting principle - - - (0.08) -
Extraordinary gain - - 0.28 - -
----------------------------------------------------
Net income (loss) $0.13 $0.14 $0.30 ($0.08) ($0.06)
====================================================
2005 2004 2003 2002 2001
1 1,2,3 1,2,4 1
-------- -------- -------- -------- --------
Balance Sheet Items:
--------------------
Total investments $ 95,044 $ 32,121 $ 29,855 $ 16,728 $ 16,223
Total assets $ 208,906 $ 82,511 $ 83,853 $ 83,761 $ 73,605
Unpaid loss and loss
adjustment expenses $ 26,321 $ 19,648 $ 28,456 $ 17,667 $ 20,089
Unearned premiums $ 36,027 $ 6,192 $ 5,862 $ 15,957 $ 16,793
Total liabilities $ 123,718 $ 49,855 $ 56,456 $ 75,226 $ 63,237
Total stockholders' equity $ 85,188 $ 32,656 $ 27,397 $ 8,535 $ 10,368
Book value per share $0.98 $0.90 $0.75 $0.77 $0.94
====================================================
Notes:
------
1) In accordance with Financial Accounting Standards Board ("FASB")
Statement of Financial Accounting Standards No. 128 "Earnings Per Share"
("SFAS 128"), we have restated the basic and diluted weighted average
shares outstanding for the years 2004 and prior for the effect of a bonus
element from our stockholder rights offerings that were successfully
completed in 2005 and 2003. According to SFAS 128, there is an assumed
bonus element in a rights issue whose exercise price is less than 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.
2) The acquisitions of HGA, ECM and PIIC were financed through an $8.6
million loan from a related party that was repaid from $10 million of
proceeds from a rights offering in 2003.
3) In January 2003, we acquired PIIC in satisfaction of $7.0 million of a
$14.85 million balance on a note receivable due from Millers American
Group, Inc. ("Millers"). This resulted in us recognizing an $8.1 million
extraordinary gain in 2003.
4) In 2002, we adopted FASB Statement of Financial Accounting Standards,
No. 142 "Goodwill and Other Intangible Assets" ("SFAS 142"), which
prohibits amortization of goodwill and requires annual testing of
goodwill for impairment. In the year of adoption, we recognized a charge
to earnings of $1.7 million to reflect an impairment loss that was
reported as a cumulative effect of change in accounting principle. In
December 2002, we acquired HGA and ECM from Millers.
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations.
The following discussion of our financial condition and results of
operations should be read in conjunction with our consolidated financial
statements and related notes included in this report.
Management Overview
Our business involves marketing and underwriting commercial insurance in
Texas, New Mexico, Idaho, Oregon, Montana and Washington; marketing and
underwriting non-standard personal automobile insurance in Texas, New Mexico
and Arizona; marketing of general aviation insurance in 44 states (effective
January 1, 2006); claims administration; and other insurance related
services. We have pursued our business activities through subsidiaries
whose operations are organized into our Commercial Insurance Operation
segment, which handles commercial insurance products and services, and our
Personal Insurance Operation segment, which handles non-standard personal
automobile insurance products and services. We expect to realign our
operational segments during 2006 to reflect the activities of newly acquired
subsidiaries. (See, "Item 1. Business - Recent Events.")
For the year ended December 31, 2005, we reported net income of $9.2
million, representing a 57.1% increase over the $5.8 million reported for
the prior year. On a diluted per share basis, net income was $0.13 for the
year ended December 31, 2005, compared with net income of $0.14 per diluted
share in 2004. The decrease in net income per diluted share was primarily
attributable to an increase in the weighted average shares outstanding to
72.6 million diluted shares during 2005, compared to 42.8 million diluted
shares during 2004, primarily as a result of a successful stockholder rights
offering completed in the second quarter of 2005. In accordance with SFAS
128, we have restated the basic and diluted weighted average shares
outstanding for 2004 and prior years for the effect of a bonus element from
our stockholder rights offerings that were successfully completed in 2005
and 2003. 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.
The increase in earnings in 2005 reflects increased investment income
attributable to additional capital raised from our shareholder rights
offering and issuance of trust preferred securities in the second quarter of
2005. The improvement in 2005 earnings also reflects additional profit
sharing commission revenue in the Commercial Insurance Operation due to
favorable loss development in prior accident years, as well as improved loss
experience on prior accident years in the Personal Insurance Operation.
Critical Accounting Estimates and Judgments
The significant accounting policies requiring our estimates and judgments
are discussed below. Such estimates and judgments are based on historical
experience, changes in laws and regulations, observance of industry trends
and information received from third parties. While the estimates and
judgments associated with the application of these accounting policies may
be affected by different assumptions or conditions, we believe the estimates
and judgments associated with the reported consolidated financial statement
amounts are appropriate in the circumstances. For additional discussion of
our accounting policies, see Note 1 to the consolidated financial statements
included in this report.
Investments. We complete a detailed analysis each quarter to assess
whether any decline in the fair value of any investment below cost is deemed
other-than-temporary. All securities with an unrealized loss are reviewed.
Unless other factors cause us to reach a contrary conclusion, investments
with a fair market value significantly less than cost for more than 180 days
are deemed to have a decline in value that is other-than-temporary. A
decline in value that is considered to be other-than-temporary is charged to
earnings based on the fair value of the security at the time of assessment,
resulting in a new cost basis for the security.
Risks and uncertainties are inherent in our other-than-temporary decline
in value assessment methodology. Risks and uncertainties include, but are
not limited to, incorrect or overly optimistic assumptions about financial
condition or liquidity, incorrect or overly optimistic assumptions about
future prospects, unfavorable changes in economic or social conditions and
unfavorable changes in interest rates or credit ratings.
Deferred Policy Acquisition Costs. Policy acquisition costs (mainly
commission, underwriting and marketing expenses) that vary with and are
primarily related to the production of new and renewal business are deferred
and charged to operations over periods in which the related premiums
are earned. Ceding commissions from reinsurers, which include expense
allowances, are deferred and recognized over the period premiums are earned
for the underlying policies reinsured.
The method followed in computing deferred policy acquisition costs limits
the amount of such deferred costs to their estimated realizable value. A
premium deficiency exists if the sum of expected claim costs and claim
adjustment expenses, unamortized acquisition costs, and maintenance costs
exceeds related unearned premiums and expected investment income on those
unearned premiums, as computed on a product line basis. We routinely
evaluate the realizability of deferred policy acquisition costs. At
December 31, 2005 and 2004, there was no premium deficiency related to
deferred policy acquisition costs.
Goodwill. Our consolidated balance sheet as of December 31, 2005 includes
goodwill of acquired businesses of approximately $4.8 million. This amount
has been recorded as a result of prior business acquisitions accounted for
under the purchase method of accounting. Under SFAS 142, which we adopted as
of January 1, 2002, goodwill is tested for impairment annually. We completed
our annual test for impairment during the fourth quarter of 2005 and
determined that there was no indication of impairment.
A significant amount of judgment is required in performing goodwill
impairment tests. Such tests include estimating the fair value of our
reporting units. As required by SFAS 142, we compare the estimated fair
value of each reporting unit with its carrying amount, including goodwill.
Under SFAS 142, fair value refers to the amount for which the entire
reporting unit may be bought or sold. Methods for estimating reporting unit
values include market quotations, asset and liability fair values and other
valuation techniques, such as discounted cash flows and multiples of
earnings or revenues. With the exception of market quotations, all of these
methods involve significant estimates and assumptions.
Deferred Tax Assets. We file a consolidated federal income tax return.
Deferred federal income taxes reflect the future tax consequences of
differences between the tax bases of assets and liabilities and their
financial reporting amounts at each year end. Deferred taxes are recognized
using the liability method, whereby tax rates are applied to cumulative
temporary differences based on when and how they are expected to affect the
tax return. Deferred tax assets and liabilities are adjusted for tax rate
changes. A valuation allowance is provided against our deferred tax asset
to the extent that we do not believe it is more likely than not that future
taxable income will be adequate to realize these future tax benefits. This
valuation allowance was $884,000 at December 31, 2005 and 2004. This
valuation allowance was necessary due to the limitation imposed by Section
382 of the Internal Revenue Code on utilizing the net operating loss
acquired as part of the PIIC acquisition.
Reserves for Unpaid Losses and Loss Adjustment Expenses. Reserves for
unpaid losses and LAE are established for claims which have already been
incurred by the policyholder but which we have not yet paid. Losses and LAE
represent the estimated ultimate net cost of all reported and unreported
losses incurred through December 31, 2005 and 2004. The reserves for unpaid
losses and LAE are estimated using individual case-basis valuations and
statistical analyses. These estimates are subject to the effects of trends
in loss severity and frequency. (See, "Item 1. Business - Analysis of
Losses and LAE" and "-Analysis of Loss and LAE Reserve Development.")
Although considerable variability is inherent in such estimates, we
believe that the reserves for unpaid losses and LAE are adequate. Due to
the inherent uncertainty in estimating unpaid losses and LAE, the actual
ultimate amounts may differ from the recorded amounts. A small percentage
change could result in a material effect on reported earnings. For example,
a 1% change in December 31, 2005 unpaid losses and LAE would produce a $263
thousand change to pre-tax earnings. The estimates are continually reviewed
and adjusted as experience develops or new information becomes known. Such
adjustments are included in current operations.
The range of unpaid losses and LAE estimated by our actuary as of December
31, 2005 was $17.8 million to $31.5 million. Our best estimate of unpaid
losses and LAE as of December 31, 2005 is $26.3 million. Our carried
reserve for unpaid losses and LAE as of December 31, 2005 is comprised of
$14.5 million in case reserves and $11.8 million in incurred but not
reported reserves. In setting this estimate of unpaid losses and LAE, we
have assumed, among other things, that current trends in loss frequency and
severity will continue and that the actuarial analysis was empirically
valid. In the absence of any specific factors indicating actual experience
at either extreme of the actuarial range, we have established a best
estimate of unpaid losses and LAE which is approximately $1.7 million
higher than the midpoint of the actuarial range. It would be expected that
management's best extimate would move within the actuarial range from year
to year due to changes in our operations and changes within the marketplace.
The actuarial range is determined independently of management's best
estimate and is only used to check the reasonableness of that estimate.
There is no set method for determining ranges, and judgment enters into the
process. The range was estimated primarily by measuring the variability
of loss development patterns over time within each line of business.
The results generated by multiple methods were also considered when
determining the overall range. In light of the inherent uncertainty in
the reserve estimates there can be no assurance that the actual losses
ultimately experienced will fall within the actuarial range. However in
light of the breath of the actuarial range, we believe that it is reasonably
likely that actual losses will fall within such range.
Our reserve requirements are also interrelated with product pricing and
profitability. We must price our products at a level sufficient to fund our
policyholder benefits and still remain profitable. Because claim expenses
represent the single largest category of our expenses, inaccuracies in the
assumptions used to estimate the amount of such benefits can result in our
failing to price our products appropriately and to generate sufficient
premiums to fund our operations.
Ceding Commissions of the Personal Insurance Operation. Under our
reinsurance arrangements with Dorinco prior to October 1, 2004, we earn
ceding commissions based on Dorinco's loss ratio (ultimate losses and loss
expenses incurred to earned premium) experience on the portion of policies
reinsured by Dorinco. We received a provisional commission as policies were
produced as an advance against the later determination of the commission
actually earned. The ceding commission is an estimate that varies with the
estimated loss ratio and is sensitive to changes in that estimate. The
provisional commission is adjusted periodically on a sliding scale based on
expected loss ratios. The following table details the ceding commission
sensitivity to the actual ultimate loss ratio for each effective quota share
treaty with Dorinco at 0.5% above and below the provisional loss ratio.
Treaty Effective Dates
-------------------------------------------------------------------
4/1/01- 7/1/01- 10/1/01- 10/1/02- 4/1/03- 10/1/03-
6/30/01 9/30/01 9/30/02 3/31/03 9/30/03 9/30/04
-------------------------------------------------------------------
Provisional loss ratio 65.0% 65.0% 65.5% 65.5% 61.0% 62.5%
Ultimate loss ratio -------------------------------------------------------------------
booked at 12/31/05 77.0% 78.3% 67.5% 61.0% 65.5% 65.5%
-------------------------------------------------------------------
Effect of actual 0.5% -------------------------------------------------------------------
above provisional ($45,359) ($37,073) ($157,346) ($76,516) ($40,717) ($69,411)
Effect of actual 0.5% -------------------------------------------------------------------
below provisional $45,359 $37,073 $157,346 $76,516 $40,717 $69,411
-------------------------------------------------------------------
Recognition of Profit Sharing Commission Revenues of the Commercial
Insurance Operation. Profit sharing commission of the Commercial Insurance
Operation is calculated and recognized when the loss ratio, as determined by
a qualified actuary, deviates from contractual targets. We receive a
provisional commission as policies are produced as an advance against the
later determination of the profit sharing commission actually earned. The
profit sharing commission is an estimate that varies with the estimated loss
ratio and is sensitive to changes in that estimate. The following table
details the profit sharing commission revenue sensitivity to the actual
ultimate loss ratio for each effective quota share treaty at 0.5% above and
below the provisional loss ratio.
Treaty Effective Dates
---------------------------------------------
7/1/01 7/1/02 7/1/03 7/1/04
Provisional loss ratio 60.0% 59.0% 59.0% 64.2%
Ultimate loss ratio ---------------------------------------------
booked to at 12/31/05 60.8% 57.5% 56.5% 62.2%
---------------------------------------------
Effect of actual 0.5% ---------------------------------------------
above provisional ($201,899) ($306,424) ($346,720) ($167,653)
Effect of actual 0.5% below ---------------------------------------------
provisional $141,329 $202,240 $228,835 $167,653
---------------------------------------------
Liquidity and Capital Resources
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 increased $94.6 million
to $139.6 million as of December 31, 2005 as compared to $45.0 million at
December 31, 2004. This 210% increase is mostly 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 2005. These
amounts exclude restricted cash and investments of $13.8 million and $6.5
million at December 31, 2005 and 2004, respectively, which secure the credit
exposure of third parties arising from our various quota share reinsurance
treaties and agency agreements.
Net cash provided by our consolidated operating activities was $29.5
million during 2005 compared to $7.3 million during 2004. The increase in
operating cash flow primarily resulted from increased premiums collected of
$32.9 million due largely 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 PGA. Prior to October 1, 2004, we retained only 45% of this
business. Partially offsetting the increased operating cash flow is a $4.6
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 $4.0 million
increase in paid loss and loss adjustment expenses due mostly to the AHIC
direct and assumed business produced by HGA during the last half of 2005 as
well as the 100% retention of the Texas non-standard auto premium produced
by PGA. Additional paid interest of $1.1 million from the trust preferred
securities and $1.1 million in additional tax deposits also partially offset
the increase in collected premium.
Cash used by investing activities during 2005 was $73.1 million as
compared to $4.0 million used during 2004. The increase in cash used in
investing activities is mainly due to increased purchases of debt and equity
securities of $51.9 million, increased net purchases of short-term
investments of $12.2 million, a decrease in net maturities and redemptions
of securities of $4.4 million and a $0.4 million increase in cash and
investments transferred to restricted accounts.
Cash provided by financing activities during 2005 was $75.1 million as
compared to cash used in financing activities of $0.9 million during 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 December 31, 2005, Hallmark had $2.0 million in cash and
invested assets. Cash and invested assets of our non-insurance subsidiaries
were $3.6 million as of December 31, 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 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 was $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 AZDOI. During 2005, PIIC's ordinary dividend capacity was
$0.8 million. Neither AHIC nor PIIC paid a dividend to Hallmark during
2005. The maximum dividend that AHIC can pay Hallmark in 2006 without prior
approval from TDI is $6.4 million. The maximum dividend that PIIC can pay
Hallmark in 2006 without prior approval from AZDOI is $1.6 million.
TDI regulates financial transactions between AHIC and affiliated
companies. Applicable regulations require TDI's approval of management fees,
expense sharing contracts and similar transactions. PGA paid $1.8 million
and $0.6 million in management fees to Hallmark during 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 $1.2 million in management fees to PGA during each of 2005 and 2004.
Statutory capital and surplus is calculated as statutory assets less
statutory liabilities. TDI requires that AHIC maintain minimum statutory
capital and surplus of $2.0 million and AZDOI requires that PIIC maintain
minimum statutory capital and surplus of $1.5 million. As of December 31,
2005, AHIC and PIIC each significantly exceeded the minimum required
statutory capital and surplus. At December 31, 2005, AHIC reported
statutory capital and surplus of $63.7 million, which reflects an increase
of $52.2 million from the $11.5 million reported at December 31, 2004. At
December 31, 2005, PIIC reported statutory capital and surplus of $36.3
million, which is $22.3 million more than the $14.0 million reported at
December 31, 2004. AHIC reported a statutory net loss of $4.6 million
during 2005 compared to statutory net income of $1.5 million in 2004. The
net loss was primarily due to the statutory recognition of acquisition costs
from the retention of business produced by HGA. These costs are deferred
over the life of the underlying policies under GAAP. PIIC reported
statutory net income of $2.7 million during 2005 compared to $3.4 million in
2004. At December 31, 2005, AHIC's premium-to-surplus percentage was 94% as
compared to 122% for the year ended December 31, 2004. PIIC's premium-to-
surplus percentage was 79% for the year ended December 31, 2005 as compared
to 135% for the year ended December 31, 2004.
Credit facility. On June 29, 2005, we entered into a credit facility with
The Frost National Bank. The credit agreement was amended on July 15, 2005,
and was further amended and restated on January 27, 2006. The restated
credit agreement provides for a $20.0 million revolving credit facility,
with a $5.0 million letter of credit sub-facility. The borrowings under the
revolving 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 restated credit agreement 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 (subject to applicable insurance law and
regulations). The restated credit agreement 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 December 31, 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 the sub-facility to collateralize certain
obligations under the agency agreement between HGA and Clarendon effective
July 1, 2004. In January, 2006, we borrowed $15.0 million under the
revolving credit facility in connection with the TGA acquisition. (See,
"Item 1. Business - Recent Events.")
Trust preferred securities. On June 21, 2005, our newly formed trust
entity 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. Under the terms
of the note, we pay interest only each quarter and the principal of the note
at maturity. As of December 31, 2005, the note balance was $30.9 million.
Other debt obligations. On January 3, 2006, we executed a promissory note
payable to Newcastle in the amount of $12.5 million in order to obtain
funding to complete the acquisition of Aerospace. The promissory note bears
interest at 10% per annum prior to maturity and at the maximum rate allowed
under applicable law upon default. Interest is payable on the first
business day of each month. The principal of the promissory note, together
with accrued but unpaid interest, is due on demand at any time after June
30, 2006.
On January 27, 2006, we issued $25.0 million in subordinated convertible
promissory notes to the Opportunity Funds. Each convertible note bears
interest at 4% per annum, which rate increases to 10% per annum in the event
of default. Interest is payable quarterly in arrears commencing March 31,
2006. Principal and all accrued but unpaid interest is due at maturity on
July 27, 2007. Subject to shareholder approval, the convertible notes are
convertible by the holders into approximately 19.5 million shares of our
common stock (subject to certain anti-dilution provisions), and will be
automatically converted to such common stock at maturity.
Long-term contractual obligations. Set forth below is a summary of
long-term contractual obligations as of December 31, 2005 (in thousands).
Amounts represent estimates of gross undiscounted amounts payable over time.
In addition, certain losses and LAE are ceded to others under reinsurance
contracts and are therefore recoverable. Such potential recoverables are
not reflected in the table.
Estimated Payments by Period
--------------------------------------------------
Total 2006 2007-2008 2009-2010 After 2010
------- ------- --------- --------- ----------
Notes payable $30,928 $ - $ - $ - $30,928
Interest on note payable 68,366 2,318 4,635 4,635 56,778
Unpaid losses and loss
adjustment expenses 26,321 15,187 8,739 1,737 658
Operating leases 4,027 1,103 1,964 773 187
Conclusion. Based on 2006 budgeted and year-to-date cash flow information,
we believe that we have sufficient liquidity to meet our projected insurance
obligations, operational expenses and capital expenditure requirements for
the foreseeable future. However, we expect additional capital to be
required to satisfy the debt obligations to Newcastle which are payable on
demand after June 30, 2006. We presently intend to retire this debt through
a rights offering of our common stock to existing shareholders during the
first half of 2006. However, there can be no assurance that we will be able
to successfully complete such rights offering.
Results of Operations
Fiscal 2005 versus Fiscal 2004
Total revenues for 2005 increased $23.9 million, or 37.9%, as compared
to 2004, primarily as a result of a $19.5 million increase in revenues from
our Commercial Insurance Operation due to the transition which began in
the third quarter of 2005 of our premium produced by HGA from Clarendon to
AHIC. Income before tax for 2005 increased $4.9 million over 2004. The
improvement in operating earnings reflects additional investment income on
capital raised in 2005, the transition of the commercial business and
improved underwriting results.
The following is additional business segment information for the twelve
months ended December 31, 2005 and 2004 (in thousands):
2005 2004
-------- --------
Revenues
--------
Personal Insurance Operation $ 43,907 $ 39,555
Commercial Insurance Operation 43,067 23,563
Corporate 61 3
-------- --------
Consolidated $ 87,035 $ 63,121
======== ========
Pre-tax Income
--------------
Personal Insurance Operation $ 11,647 $ 8,109
Commercial Insurance Operation 6,651 3,028
Corporate (4,830) (2,535)
-------- --------
Consolidated $ 13,468 $ 8,602
======== ========
Personal Insurance Operation
Net premium written by our Personal Insurance Operation increased $3.9
million during 2005 to $37.0 million compared to $33.1 million during 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 2005 declined $6.6 million,
or 15.4%, to $36.4 million from the $43.0 million produced in 2004. The
decline in produced premium reflected increased rate competition.
Revenue for our Personal Insurance Operation increased 11.0% to $43.9
million for 2005 from $39.6 million for 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 $0.9 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 $1.2 million decrease in ceding commission income resulting from
AHIC assuming 100% of the Texas non-standard automobile business effective
October 1, 2004.
Pre-tax income for our Personal Insurance Operation increased $3.5
million, or 43.6%, for 2005 compared to 2004. Net investment income and
realized gains and losses contributed $1.0 million to the increase in pre-
tax income for 2005 over 2004. Improved underwriting results as evidenced
by a loss ratio of 56.7% in 2005 as compared to 59.3% in 2004 contributed
$1.0 million to the increase in pre-tax income in 2005. Taking into
consideration the effect on ceding commissions, loss and LAE and premium
production costs, the changes in premium volume produced and assumed
contributed approximately $0.9 million to the increase in pre-tax income.
Lower technical service costs from integrating PIIC's back office systems
that were previously outsourced contributed $0.4 million and lower salary
and related expenses contributed $0.3 million to the increase in pre-tax
income.
Commercial Insurance Operation
Beginning in the third quarter of 2005, our Commercial Insurance
Operation began retaining written premium through AHIC. Our Commercial
Insurance Operation 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 of $51.2 million for
2005.
Total revenue for our Commercial Insurance Operation of $43.1 million
for 2005 was $19.5 million more than the $23.6 million reported in 2004.
This 82.8% increase in total revenue was primarily due to net premiums
earned of $21.8 million from the issuance of AHIC policies and the
assumption of premium from Clarendon for business produced by HGA. Increased
net investment income contributed $1.5 million to the increase in revenue.
These increases in revenue were partially offset by lower ceding commission
revenue of $3.2 million and lower processing and service fees of $0.6
million, in both cases due to the shift from a third party agency structure
to an insurance underwriting structure. Total earned premium generated by
our Commercial Insurance Operation (including premium retained by Clarendon)
for 2005 was $78.1 million as compared to $72.5 million for 2004.
Pre-tax income for our Commercial Insurance Operation of $6.6 million
for 2005 increased $3.6 million, or 119.6%, over the $3.0 million reported
for 2004. Increased revenue, as discussed above, was the primary reason for
the increase in pre-tax income, partially offset by loss and LAE of $12.6
million and additional production expenses of $3.2 million caused by
increased retail agent commissions from higher premium production as well as
additional ceding commission expense from the assumption of premium from
Clarendon.
Corporate
Corporate pre-tax loss was $4.8 million for 2005 as compared to $2.5
million for 2004. The increase was due mostly to additional interest
expense of $1.2 million from the issuance of trust preferred securities in
June 2005, increased salary expense of $0.6 million from increased headcount
(including the transfer of accounting positions from both operations to
Corporate late in 2004) and additional audit and legal fees of $0.2 million
due primarily to the implementation of our capital plan in 2005.
Fiscal 2004 versus Fiscal 2003
Total revenues for 2004 decreased $6.4 million, or 9.3%, as compared to
2003, primarily as a result of a $10.1 million decline in total revenues
from our Personal Insurance Operation partially offset by a $3.7 million
increase in total revenues from our Commercial Insurance Operation.
However, income before tax and extraordinary gain for 2004 increased $7.9
million as compared to 2003. The improvement in operating earnings in 2004
reflected better underwriting results for our Personal Insurance Operation,
additional commission revenue in our Commercial Insurance Operation and an
overall reduction in interest expense as a result of the repayment of a
related party note in September 2003.
The following is additional business segment information for the twelve
months ended December 31, 2004 and 2003 (in thousands):
2004 2003
Revenues -------- --------
--------
Personal Insurance Operation $ 39,555 $ 49,665
Commercial Insurance Operation 23,563 19,891
Corporate 3 3
-------- --------
Consolidated $ 63,121 $ 69,559
======== ========
Pre-tax Income
--------------
Personal Insurance Operation $ 8,109 $ 1,950
Commercial Insurance Operation 3,028 1,311
Corporate (2,535) (2,575)
-------- --------
Consolidated $ 8,602 $ 686
======== ========
Personal Insurance Operation
Net premiums written decreased $3.5 million, or 9.6% during 2004 to
$33.1 million compared to $36.6 million in 2003. The decrease in net
premiums written was primarily attributable to the cancellation of
unprofitable agents and programs, a shift in marketing focus from annual
term premium financed policies to six month term direct bill policies, a
reduction in policy counts caused by targeted rate adjustments and increased
competition from newly capitalized entities entering the marketplace. Net
premiums earned decreased $9.6 million, or 22.7%, to $32.4 million in 2004
compared to $42.0 million in 2003. Primarily as a result of the decline in
net premiums earned, total revenue for our Personal Insurance Operation
decreased $10.1 million, or 20.4%, to $39.6 million in 2004 compared to
$49.7 million in 2003.
Although revenue for our Personal Insurance Operation declined, our
pre-tax income increased $6.2 million, or 315.8%, to $8.1 million in
2004 as compared to $2.0 million in 2003. The increase in pre-tax income
was primarily due to improved underwriting results, as evidenced by a loss
and LAE ratio of 59.3% for 2004 as compared to 72.5% for 2003. Also
contributing to the improved pre-tax results were reduced salary and related
expenses of $1.0 million due to the successful integration of the PIIC
operations in late 2003 and the overall reduction in premium volume and
increased net investment income of $0.2 million. These improvements were
partially offset by the discontinuation of the premium finance program which
caused finance charge revenue to decrease by $1.5 million which was
partially offset by reduced interest expense of $0.4 million.
Commercial Insurance Operation
Total revenue for our Commercial Insurance Operation of $23.6 million
for 2004 was $3.7 million, or 18.5%, more than the $19.9 million reported
for 2003. The improvement was primarily due to a $2.9 million increase in
commission revenue and a $0.7 million increase in claim servicing revenue.
Commercial premium volume growth was the primary cause of the increased
commission and claim fee revenue for 2004. Earned premium generated by our
Commercial Insurance Operation for 2004 was $72.5 million compared to $62.9
million for 2003. We did not bear the primary underwriting risk for this
business in 2004 or 2003 and, therefore, the resulting premiums and claims
are not reflected in our reported results.
Pre-tax income for the Commercial Insurance Operation of $3.0 million
in 2004 increased $1.7 million, or 131.0%, over the $1.3 million reported in
2003. Increased revenue, as discussed above, was the primary reason for the
increase in pre-tax income, partially offset by additional compensation and
production related costs of $2.1 million attributable to the increased
premium volume.
Corporate
Corporate pre-tax loss was $2.5 million for 2004 as compared to $2.6
million for 2003. We saved $0.8 million in interest expense in 2004 due to
the repayment of a related party note in September 2003. This was partially
offset by a $0.7 million increase in salary and related expenses in 2004.
Effects of Inflation
We do not believe that inflation has a material effect on our results
of operations, except for the effect that inflation may have on interest
rates and claim costs. The effects of inflation are considered in pricing
and estimating reserves for unpaid losses and LAE. The actual effects of
inflation on results of operations are not known until claims are ultimately
settled. In addition to general price inflation, we are exposed to the
upward trend in the cost of judicial awards for damages. We attempt to
mitigate the effects of inflation in the pricing of policies and
establishing loss and LAE reserves.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
We believe that interest rate risk, credit risk and equity price risk
are the types of market risk to which we are principally exposed.
Interest Rate Risk
Our investment portfolio consists principally of investment-grade,
fixed income securities, all of which are classified as available-for-sale.
Accordingly, the primary market risk exposure to these securities is
interest rate risk. In general, the fair market value of a portfolio of
fixed income securities increases or decreases inversely with changes in
market interest rates, while net investment income realized from future
investments in fixed income securities increases or decreases along with
interest rates. The fair value of the Company's fixed income securities as
of December 31, 2005 was $87.3 million. The effective duration of the
portfolio as of December 31, 2005 was 4.2 years. Should the market interest
rates increase 1.0%, the Company's fixed income investment portfolio would
be expected to decline in market value by 4.2%, or $3.6 million,
representing the effective duration multiplied by the change in market
interest rates. Conversely, a 1.0% decline in interest rates would be
expected to result in a 4.2%, or $3.6 million, increase in the market value
of the fixed income investment portfolio.
Credit Risk
An additional exposure to our fixed income securities portfolio is
credit risk. We attempt to manage the credit risk by investing only in
investment-grade securities and limiting our exposure to a single issuer.
As of December 31, 2005, our fixed income investments were in the following:
corporate securities - 62.4%; municipal securities - 32.8%; and U.S.
Treasury securities - 4.8%. As of December 31, 2005, all of our fixed
income securities were rated investment grade by nationally recognized
statistical rating organizations.
We are also subject to credit risk with respect to reinsurers to whom
we have ceded underwriting risk. Although a reinsurer is liable for losses
to the extent of the coverage it assumes, we remain obligated to our
policyholders in the event that the reinsurers do not meet their obligations
under the reinsurance agreements. In order to mitigate credit risk to
reinsurance companies, we use financially strong reinsurers with an A.M.
Best rating of "A-" or better.
Equity Price Risk
Investments in equity securities which are subject to equity price risk
make up 3.3% of our portfolio. The carrying values of equity securities are
based on quoted market prices as of the balance sheet date. Market prices
are subject to fluctuation and, consequently, the amount realized in the
subsequent sale of an investment may significantly differ from the reported
market value. Fluctuation in the market price of a security may result from
perceived changes in the underlying economic characteristics of the issuer,
the relative price of alternative investments and general market conditions.
Furthermore, amounts realized in the sale of a particular security may be
affected by the relative quantity of the security being sold.
The fair value of our equity securities as of December 31, 2005 was
$3.4 million. The fair value of our equity securities would increase or
decrease by $1.0 million assuming a hypothetical 30.0% increase or decrease
in market prices as of the balance sheet date. This would increase or
decrease shareholders' equity by 1.2%. The selected hypothetical change
does not reflect what should be considered the best or worse case scenario.
Item 8. Financial Statements and Supplementary Data.
The following consolidated financial statements of the Company and it
subsidiaries are filed as part of this report.
Description Page Number
----------- -----------
Report of Independent Registered Public Accounting Firm F-2
Consolidated Balance Sheets at December 31, 2005 and 2004 F-3
Consolidated Statements of Operations for the Years Ended
December 31, 2005, 2004 and 2003 F-4
Consolidated Statements of Stockholders' Equity and F-5
Comprehensive Income for the Years Ended
December 31, 2005, 2004 and 2003
Consolidated Statements of Cash Flows for the F-7
Years Ended December 31, 2005, 2004 and 2003
Notes to Consolidated Financial Statements F-8
Unaudited Selected Quarterly Information F-33
Financial Statement Schedules F-33
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.
None.
Item 9A. Controls and Procedures.
Our Chief Executive Officer and Chief Financial Officer have evaluated
our disclosure controls and procedures and have concluded that such controls
and procedures are effective as of the end of the period covered by this
report. During the most recent fiscal quarter, there have been no changes in
our internal controls over financial reporting that have materially
affected, or are reasonably likely to materially affect, our internal
control over financial reporting.
PART III
Item 10. Directors and Executive Officers of the Registrant.
The information required by Item 10 is incorporated by reference from the
Registrant's definitive proxy statement to be filed with the Commission
pursuant to Regulation 14A not later than 120 days after the end of the
fiscal year covered by this report.
Item 11. Executive Compensation.
The information required by Item 11 is incorporated by reference from the
Registrant's definitive proxy statement to be filed with the Commission
pursuant to Regulation 14A not later than 120 days after the end of the
fiscal year covered by this report.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
The information required by Item 12 is incorporated by reference from the
Registrant's definitive proxy statement to be filed with the Commission
pursuant to Regulation 14A not later than 120 days after the end of the
fiscal year covered by this report.
Item 13. Certain Relationships and Related Transactions.
The information required by Item 13 is incorporated by reference from the
Registrant's definitive proxy statement to be filed with the Commission
pursuant to Regulation 14A not later than 120 days after the end of the
fiscal year covered by this report.
Item 14. Principal Accounting Fees and Services.
The information required by Item 14 is incorporated by reference from the
Registrant's definitive proxy statement to be filed with the Commission
pursuant to Regulation 14A not later than 120 days after the end of the
fiscal year covered by this report.
PART IV
Item 15. Exhibits and Financial Statement Schedules and Reports.
(a)(1) Financial Statements
The following consolidated financial statements, notes thereto
and related information are included in Item 8 of this report:
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets at December 31, 2005 and 2004
Consolidated Statements of Operations for the Years Ended
December 31, 2005, 2004 and 2003
Consolidated Statements of Shareholders' Equity and Comprehensive
Income for the Years Ended December 31, 2005, 2004 and 2003
Consolidated Statements of Cash Flows for the Years Ended
December 31, 2005, 2004 and 2003
Notes to Consolidated Financial Statements
(a)(2) Financial Statement Schedules
The following financial statement schedules are included in this
report:
Unaudited Selected Quarterly Information Page F-33
Schedule II - Condensed Financial Information of
Registrant - Hallmark Financial Services, Inc.
(Parent Company Only) Page F-33
Schedule III - Supplemental Insurance Information Page F-36
Schedule IV - Reinsurance Page F-37
Schedule VI - Supplemental Information Concerning
Property- Casualty Insurance Operations Page F-38
(a)(3) Exhibit index
The following exhibits are either filed with this report or incorporated
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) Amended and Restated By-Laws of the registrant, (incorporated by
reference to Exhibit 3(b) to the registrant's Quarterly Report on
Form 10-Q for the quarter ended June 30, 2005).
3(c) Amendment of Article VII of the Amended and Restated Bylaws
of Hallmark Financial Services, Inc., adopted July 19, 2002
(incorporated by reference to Exhibit 10(b) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended September
30, 2002).
4(a) Specimen certificate for Common Stock, $.03 par value, 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 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 Current Report on 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 Current Report on Form 8-K filed June 27, 2005).
4(d) Form of Junior Subordinated Debt Security Due 2035 [included in
Exhibit 4(b) above].
4(e) Form of Capital Security Certificate [included in Exhibit 4(c)
above].
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 Current Report
on 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
Quarterly Report on Form 10-Q for the quarter ended June 30, 2005).
4(h) First Restated Credit Agreement dated January 27, 2006, between
Hallmark Financial Services, Inc. and The Frost National Bank
(incorporated by reference to Exhibit 4.1 to the registrant's
Current Report on Form 8-K filed February 2, 2006).
4(i) Promissory Note dated January 3, 2006, in the amount of $12,500,000
payable to Newcastle Partners, L.P. (incorporated by reference to
Exhibit 4.1 to the registrant's Current Report on Form 8-K filed
January 5, 2006).
4(j) Form of Convertible Promissory Note dated January 27, 2006, payable
to Newcastle Special Opportunity Fund I, L.P. and Newcastle Special
Opportunity Fund II, L.P. (incorporated by reference to Exhibit 4.1
to the registrant's Current Report on Form 8-K filed February 2,
2006).
10(a) Office Lease for 14651 Dallas Parkway, dated January 1,
1995, between American Hallmark Insurance Company of Texas and
Fults Management Company, as agent for The Prudential Insurance
Company of America (incorporated by reference to Exhibit 10(a) to
the registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1994).
10(b) Tenth Amendment to Office Lease for 14651 Dallas Parkway,
dated May 5th, 2003, between American Hallmark Insurance
Company of Texas and Fults Management Company, as agent for
The Prudential Insurance Company of America (incorporated by
reference to Exhibit 10(a) to the registrant's Quarterly Report
on Form 10-QSB for the quarter ended March 31, 2003).
10(c) Lease Agreement for 777 Main Street, Suite 1000, Fort Worth,
Texas 76102, dated June 12, 2003 between Hallmark Financial
Services, Inc. and Crescent Real Estate Funding I, L.P.
(incorporated by reference to Exhibit 10(a) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended June 30,
2003).
10(d)* 1991 Key Employee Stock Option Plan of the registrant
(incorporated by reference to Exhibit C to the definitive
Proxy Statement relating to the registrant's Annual Meeting
of Shareholders held May 20, 1991).
10(e)* 1994 Key Employee Long Term Incentive Plan (incorporated by
reference to Exhibit 10(f) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 1994).
10(f)* First Amendment to Hallmark Financial Services, Inc. 1994 Key
Employee Long Term Incentive Plan (incorporated by reference to
Exhibit 10(bm) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 2002).
10(g)* 1994 Non-Employee Director Stock Option Plan (incorporated by
reference to Exhibit 10(g) to the registrant's Annual Report on
Form 10-KSB for the fiscal year ended December 31, 1994).
10(h)* First Amendment to Hallmark Financial Services, Inc. 1994 Non-
Employee Director Stock Option Plan (incorporated by reference to
Exhibit 10(bn) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 2002).
10(i)* Second Amendment to Hallmark Financial Services, Inc. 1994 Non-
Employee Director Stock Option Plan (incorporated by reference to
Exhibit 10(e) to the registrant's Quarterly Report on Form 10-QSB
for the quarter ended September 30, 2001).
10(j)* Form of Indemnification Agreement between Hallmark Financial
Services, Inc. and its officers and directors, adopted July 19,
2002 (incorporated by reference to Exhibit 10(c) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended September 30, 2002).
10(k)* Hallmark Financial Services, Inc. 2005 Long Term Incentive Plan
(incorporated by reference to Exhibit 10.1 to the registrant's
Current Report on Form 8-K filed June 3, 2005).
10(l)* Form of Incentive Stock Option Grant Agreement (incorporated by
reference to Exhibit 10.2 to the registrant's Current Report on
Form 8-K filed June 3, 2005).
10(m)* Form of Non-qualified Stock Option Agreement (incorporated by
reference to Exhibit 10.3 to the registrant's Current Report on
Form 8-K filed June 3, 2005).
10(n) Guarantee Agreement dated as of June 21, 2005, by Hallmark
Financial Services, Inc. for the benefit of the holders of
trust preferred securities (incorporated by reference to Exhibit
10.1 to the registrant's Current Report on Form 8-K filed June
27, 2005).
10(o) Form of Purchase Agreement dated January 27, 2006, between
Hallmark Financial Services, Inc. and Newcastle Special
Opportunity Fund I, Ltd. and Newcastle Special Opportunity
Fund II, L.P. (incorporated by reference to Exhibit 4.1 to the
registrant's Current Report on Form 8-K filed February 2, 2006).
10(p) Form of Registration Rights Agreement dated January 27, 2006,
between Hallmark Financial Services, Inc. and Newcastle Special
Opportunity Fund I, Ltd. and Newcastle Special Opportunity Fund
II, L.P. (incorporated by reference to Exhibit 4.1 to the
registrant's Current Report on Form 8-K filed February 2, 2006).
21+ List of subsidiaries of the registrant.
23+ Consent of KPMG LLP
31(a)+ Certification of Chief Executive Officer required by Rule 13a-14(a)
or Rule 15d-14(b).
31(b)+ Certification of Chief Financial Officer required by Rule 13a-14(a)
or Rule 15d-14(b).
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.
* Management contract or compensatory plan or arrangement.
+ Filed herewith.
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.
HALLMARK FINANCIAL SERVICES, INC.
(Registrant)
Date: March 22, 2006 /s/ Mark E. Schwarz
------------------------------------------
Mark E. Schwarz, Chairman and Chief
Executive Officer
(Principal Executive Officer)
Date: March 22, 2006 /s/ Mark J. Morrison
------------------------------------------
Mark J. Morrison, EVP,
Chief Operating Officer and
Chief Financial Officer
(Principal Financial Officer)
Date: March 22, 2006 /s/ Jeffrey R. Passmore
------------------------------------------
Jeffrey R. Passmore, SVP and Chief
Accounting Officer
(Principal Accounting Officer)
In accordance with the Exchange Act, this report has been signed below by
the following persons on behalf of the registrant and in the capacities an
on the dates indicated.
Date: March 22, 2006 /s/ Mark E. Schwarz
------------------------------------------
Mark E. Schwarz, Director
Date: March 22, 2006 /s/ James H. Graves
------------------------------------------
James H. Graves, Director
Date: March 22, 2006 /s/ George R. Manser
------------------------------------------
George R. Manser, Director
Date: March 22, 2006 /s/ Scott T. Berlin
------------------------------------------
Scott T. Berlin, Director
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Description Page Number
----------- -----------
Report of Independent Registered Public Accounting Firm F-2
Consolidated Balance Sheets at December 31, 2005 and 2004 F-3
Consolidated Statements of Operations for the Years Ended
December 31, 2005, 2004 and 2003 F-4
Consolidated Statements of Stockholders' Equity and
Comprehensive Income for the Years Ended
December 31, 2005, 2004 and 2003 F-5
Consolidated Statements of Cash Flows for the Years Ended
December 31, 2005, 2004 and 2003 F-7
Notes to Consolidated Financial Statements F-8
Unaudited Selected Quarterly Information F-33
Financial Statement Schedules F-33
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
Hallmark Financial Services, Inc.:
We have audited the accompanying consolidated balance sheets of Hallmark
Financial Services, Inc. and subsidiaries (the "Company") as of December 31,
2005 and 2004, and the related consolidated statements of operations,
stockholders' equity and comprehensive income, and cash flows for each of
the years in the three-year period ended December 31, 2005. In connection
with our audits of the consolidated financial statements, we also have
audited the financial statement schedules II, III, IV and VI. These
consolidated financial statements and financial statement schedules are the
responsibility of the Company's management. Our responsibility is to
express an opinion on these consolidated financial statements and financial
statement schedules based on our audits.
We conducted our audits in accordance with the auditing standards of the
Public Company Accounting Oversight Board (United States). Those standards
require that we plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatement.
An audit includes examining, on a test basis, evidence supporting the
amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial
position of Hallmark Financial Services, Inc. and subsidiaries as of
December 31, 2005 and 2004, and the results of their operations and their
cash flows for each of the years in the three-year period ended December 31,
2005, in conformity with U.S. generally accepted accounting principles.
Also, in our opinion, the related financial statement schedules, when
considered in relation to the basic consolidated financial statements taken
as a whole, present fairly, in all material respects, the information set
forth therein.
As described in note 1 to the consolidated financial statements, effective
January 1, 2003, the Company adopted the prospective method provisions of
Statement of Financial Accounting Standards No. 148, Accounting for Stock-
Based Compensation - Transition and Disclosure.
/s/ KPMG LLP
------------
KPMG LLP
Dallas, Texas
March 17, 2006
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 2005 and 2004
(In thousands)
ASSETS 2005 2004
------ ---------- ----------
Investments:
Debt securities, available-for-sale,
at fair value $ 79,360 $ 28,206
Equity securities, available-for-sale,
at fair value 3,403 3,580
Short-term investments, available-for-sale,
at fair value 12,281 335
---------- ----------
Total investments 95,044 32,121
Cash and cash equivalents 44,528 12,901
Restricted cash and investments 13,802 6,509
Prepaid reinsurance premiums 767 -
Premiums receivable 26,530 4,103
Accounts receivable 2,083 3,494
Reinsurance recoverable 444 3,083
Deferred policy acquisition costs 9,164 7,475
Excess of cost over fair value of net
assets acquired 4,836 4,836
Intangible assets 459 486
Deferred federal income taxes 3,992 5,173
Prepaid expenses 802 813
Other assets 6,455 1,517
---------- ----------
$ 208,906 $ 82,511
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Liabilities:
Notes payable $ 30,928 $ -
Unpaid losses and loss adjustment expenses 26,321 19,648
Unearned premiums 36,027 6,192
Unearned revenue 4,055 11,283
Reinsurance balances payable 116 -
Accrued agent profit sharing 2,173 1,875
Accrued ceding commission payable 11,430 1,695
Pension liability 2,932 2,180
Current federal income tax payable 300 1,343
Accounts payable and other accrued expenses 9,436 5,639
---------- ----------
123,718 49,855
---------- ----------
Commitments and contingencies (Note 15)
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
Capital in excess of par value 62,907 19,647
Retained earnings 22,289 13,103
Accumulated other comprehensive loss (2,597) (759)
Treasury stock, 14,819 shares in 2005
and 379,319 shares in 2004, at cost (17) (441)
---------- ----------
Total stockholders' equity 85,188 32,656
---------- ----------
$ 208,906 $ 82,511
========== ==========
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
for the years ended December 31, 2005, 2004 and 2003
(In thousands, except per share amounts)
2005 2004 2003
-------- -------- --------
Gross premiums written $ 89,467 $ 33,389 $ 43,338
Ceded premiums written (1,215) (322) (6,769)
-------- -------- --------
Net premiums written 88,252 33,067 36,569
Change in unearned premiums (29,068) (622) 5,406
-------- -------- --------
Net premiums earned 59,184 32,445 41,975
Investment income, net of expenses 3,836 1,386 1,198
Realized gains (losses) 58 (27) (88)
Finance charges 2,044 2,183 3,544
Commission and fees 16,703 21,100 17,544
Processing and service fees 5,183 6,003 4,900
Other income 27 31 486
-------- -------- --------
Total revenues 87,035 63,121 69,559
Losses and loss adjustment expenses 33,784 19,137 30,188
Other operating costs and expenses 38,492 35,290 37,386
Interest expense 1,264 64 1,271
Amortization of intangible asset 27 28 28
-------- -------- --------
Total expenses 73,567 54,519 68,873
Income before income tax and
extraordinary gain 13,468 8,602 686
Income tax expense 4,282 2,753 25
-------- -------- --------
Income before extraordinary gain 9,186 5,849 661
Extraordinary gain - - 8,084
-------- -------- --------
Net income $ 9,186 $ 5,849 $ 8,745
======== ======== ========
Basic earnings per share:
Income before extraordinary gain $ 0.13 $ 0.14 $ 0.02
Extraordinary gain - - 0.28
-------- -------- --------
Net income $ 0.13 $ 0.14 $ 0.30
======== ======== ========
Diluted earnings per share:
Income before extraordinary gain $ 0.13 $ 0.14 $ 0.02
Extraordinary gain - - 0.28
-------- -------- --------
Net income $ 0.13 $ 0.14 $ 0.30
======== ======== ========
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME
for the years ended December 31, 2005, 2004 and 2003
(in thousands)
---------------------------------------
Accumulated
Capital Other Compre-
Number In Compre- Number Total hensive
of Par Excess of Retained hensive Treasury of Stockholders' Income
Shares Value Par Value Earnings Income Stock Shares Equity (Loss)
------ ----- --------- -------- ------ --------- ------ -------- --------
Balance at December 31, 2002 11,856 $ 356 $ 10,875 $ (1,491) $ (162) $ (1,043) 806 $ 8,535
Rights offering 25,000 750 9,250 10,000
Issuance of common stock 1 - -
Amortization of fair value
of stock options granted 31 31
Stock options exercised (463) 480 (322) 17
Comprehensive income:
Net income 8,745 8,745 $ 8,745
Other comprehensive income:
Additional minimum
pension liability (646) (646) (646)
Net unrealized holding gains
arising during period 667 667 667
Reclassification adjustment
for losses included in net
income 88 88 88
------ -------- --------
Net unrealized gains on
securities 755 755 755
------ -------- --------
Total other comprehensive
income before tax 109 109 109
Tax effect on other
comprehensive income (40) (40) (40)
------ -------- --------
Other comprehensive
income after tax 69 69 69
Comprehensive income $ 8,814
------ ----- --------- -------- ------ --------- ------ -------- ========
Balance at December 31, 2003 36,857 $1,106 $ 19,693 $ 7,254 $ (93) $ (563) 484 $ 27,397
Amortization of fair value
of stock options granted 28 28
Stock options exercised (74) 122 (105) 48
Comprehensive income:
Net income 5,849 5,849 $ 5,849
Other comprehensive income:
Additional minimum
pension liability (1,198) (1,198) (1,198)
Net unrealized holding gains
arising during period 438 438 438
Reclassification adjustment
for losses included in net
income (218) (218) (218)
------ -------- --------
Net unrealized gains on
securities 220 220 220
------ -------- --------
Total other comprehensive
income before tax (978) (978) (978)
Tax effect on other
comprehensive income 312 312 312
------ -------- --------
Other comprehensive
income after tax (666) (666) (666)
Comprehensive income $ 5,183
------ ----- --------- -------- ------ --------- ------ -------- ========
Balance at December 31, 2004 36,857 $1,106 $ 19,647 $ 13,103 $ (759) $ (441) 379 $ 32,656
====== ===== ========= ======== ====== ========= ====== ========
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME (Continued)
for the years ended December 31, 2005, 2004 and 2003
(in thousands)
---------------------------------------
Accumulated
Capital Other Compre-
Number In Compre- Number Total hensive
of Par Excess of Retained hensive Treasury of Stockholders' Income
Shares Value Par Value Earnings Income Stock Shares Equity (Loss)
------ ----- --------- -------- ------ --------- ------ -------- --------
Balance at December 31, 2004 36,857 $1,106 $ 19,647 $ 13,103 $ (759) $ (441) 379 $ 32,656
Rights offering 50,000 1,500 43,391 44,891
Amortization of fair value
of stock options granted 63 63
Stock options exercised (194) 424 (364) 230
Comprehensive income:
Net income 9,186 9,186 $ 9,186
Other comprehensive income:
Additional minimum
pension liability (761) (761) (761)
Net unrealized holding
gains (losses) arising
during period (1,932) (1,932) (1,932)
Reclassification adjustment
for losses included in
net income (107) (107) (107)
------ -------------------
Net unrealized gains
(losses) on securities (2,039) (2,039) (2,039)
------ -------------------
Total other comprehensive
income before tax (2,800) (2,800) (2,800)
Tax effect on other
comprehensive income 962 962 962
------ -------------------
Other comprehensive
income after tax (1,838) (1,838) (1,838)
Comprehensive income $ 7,348
------ ----- --------- -------- ------ --------- ------ --------===========
Balance at December 31, 2005 86,857 $2,606 $ 62,907 $ 22,289 $(2,597) $ (17) 15 $ 85,188
====== ===== ========= ======== ====== ========= ====== ========
The accompanying notes are an integral
part of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the years ended December 31, 2005, 2004 and 2003
(In thousands)
2005 2004 2003
-------- -------- --------
Cash flows from operating activities:
Net income $ 9,186 $ 5,849 $ 8,745
Adjustments to reconcile net income
to cash provided by operating activities:
Depreciation and amortization expense 413 450 621
Deferred income tax expense (benefit) 2,143 (787) 114
Realized (gain) loss on investments (58) 27 88
Change in prepaid reinsurance premiums (767) 291 8,297
Change in premiums receivable (22,427) (70) (1,276)
Change in accounts receivable 1,411 (99) (1,266)
Change in deferred policy acquisition costs (1,689) (329) (1,340)
Change in unpaid losses and loss adjustment
expenses 6,673 (8,808) (5,097)
Change in unearned premiums 29,835 330 (12,785)
Change in unearned revenue (7,228) 1,093 3,271
Change in accrued agent profit sharing 298 364 944
Change in reinsurance recoverable 2,639 7,433 12,817
Change in reinsurance balances payable 116 - (3,082)
Change in current federal income tax
payable/recoverable (1,043) 1,968 (592)
Change in accrued ceding commission payable 9,735 531 (1,372)
Gain on acquisition of subsidiary - - (8,084)
Change in all other liabilities 3,817 (1,661) 419
Change in all other assets (3,512) 757 44
-------- -------- --------
Net cash provided by operating activities 29,542 7,339 466
Cash flows from investing activities:
Purchases of property and equipment (532) (389) (476)
Acquisition of subsidiary, net of cash
received - - 6,945
Premium finance notes repaid, net of
finance notes originated - 43 11,550
Change in restricted cash and investments (3,835) (3,458) (4,294)
Purchases of debt and equity securities (58,605) (6,670) (19,075)
Maturities of fixed income securities 10 5,034 1,403
Redemptions of investment securities 1,737 1,081 6,944
Net (purchases) redemptions of
short-term investments (11,832) 344 8,904
-------- -------- --------
Net cash provided by (used in)
investing activities (73,057) (4,015) 11,901
Cash flows from financing activities:
Proceeds from borrowings 30,928 - -
Debt issuance costs (907) - -
Net repayments to premium finance lender - - (10,905)
Proceeds from rights offering 44,891 - 10,000
Proceeds from exercise of employee
stock options 230 48 17
Repayment of borrowings - (991) (9,412)
-------- -------- --------
Net cash provided by (used in)
financing activities 75,142 (943) (10,300)
Increase in cash and cash equivalents 31,627 2,381 2,067
Cash and cash equivalents at beginning of year 12,901 10,520 8,453
-------- -------- --------
Cash and cash equivalents at end of year $ 44,528 $ 12,901 $ 10,520
======== ======== ========
Supplemental cash flow information:
Interest (paid) $ (1,167) $ (64) $ (1,456)
======== ======== ========
Income taxes (paid) $ (3,182) $ (1,700) $ (475)
======== ======== ========
We transferred $3.4 million of fixed maturity investments from debt
securities, available-for-sale to restricted investments during 2005
and transferred $2.4 million of fixed maturity investment from restricted
investments to debt securities, available-for-sale during 2004.
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005
1. Accounting Policies:
-------------------
Basis of Presentation
---------------------
The accompanying consolidated financial statements include the
accounts and operations of Hallmark Financial Services, Inc. and its
subsidiaries. Intercompany accounts and transactions have been
eliminated. The accompanying consolidated financial statements have
been prepared in conformity with U.S. generally accepted accounting
principles ("GAAP") which, as to American Hallmark Insurance Company
of Texas ("AHIC") and Phoenix Indemnity Insurance Company ("PIIC"),
differ from statutory accounting practices prescribed or permitted for
insurance companies by insurance regulatory authorities.
Investments
-----------
Debt and equity securities available for sale are reported at market
value. Unrealized gains and losses are recorded as a component of
stockholders' equity, net of related tax effects. Debt and equity
securities that are determined to have other than temporary impairment
are recognized as a realized loss in the Statement of Operations. Debt
security premium and discounts are amortized into earnings using the
effective interest method.
Short-term investments consist of treasury bills which are reported at
market value and a certificate of deposit carried at amortized cost,
which approximates market.
Realized investment gains and losses are recognized in operations on the
specific identification method.
Cash Equivalents
----------------
We consider all highly liquid investments with an original maturity of
three months or less to be cash equivalents.
Recognition of Premium Revenues
-------------------------------
Insurance premiums and policy fees are earned pro rata over the terms of
the policies. Upon cancellation, any unearned premium is refunded to the
insured. Insurance premiums written include gross policy fees of
$3.9 million, $2.7 million and $3.0 million and policy fees, net of
reinsurance, of $3.9 million, $2.7 million and $2.3 million for the
years ended December 31, 2005, 2004 and 2003, respectively.
Recognition of Commission Revenues and Expenses of Commercial Insurance
-----------------------------------------------------------------------
Operation
---------
Commission revenues and commission expenses related to insurance
policies issued by Hallmark General Agency, Inc. ("HGA") on behalf of
Clarendon National Insurance Company ("Clarendon") are recognized pro
rata during the period covered by the policy. Profit sharing commission
is calculated and recognized when the loss ratio, as determined by a
qualified actuary, deviates from contractual targets. We receive a
provisional commission as policies are produced as an advance against
the later determination of the profit sharing commission actually
earned. The profit sharing commission is an estimate that varies with
the estimated loss ratio and is sensitive to changes in that estimate.
The following table details the profit sharing commission revenue
sensitivity to the actual ultimate loss ratio for each effective quota
share treaty at 0.5% above and below the provisional loss ratio.
Treaty Effective Dates
---------------------------------------------
7/1/01 7/1/02 7/1/03 7/1/04
Provisional loss ratio 60.0% 59.0% 59.0% 64.2%
Ultimate loss ratio ---------------------------------------------
booked to at 12/31/05 60.8% 57.5% 56.5% 62.2%
---------------------------------------------
Effect of actual 0.5% ---------------------------------------------
above provisional ($201,899) ($306,424) ($346,720) ($167,653)
Effect of actual 0.5% ---------------------------------------------
below provisional $141,329 $202,240 $228,835 $167,653
---------------------------------------------
As of December 31, 2005, we recorded a $1.7 million profit sharing
payable for the quota share treaty effective July 1, 2001. We
received a $2.0 million initial settlement on this treaty in 2004
based on actual incurred loss experience. The payable is the
difference between the cash received and the recognized commission
revenue based on the estimated ultimate loss ratio. We also recorded
a $0.6 million receivable on the quota share treaty effective July 1,
2002, a $1.1 million receivable on the quota share treaty effective
July 1, 2003 and a $1.0 million receivable on the quota share treaty
effective July 1, 2004.
Recognition of Claim Servicing Fees
-----------------------------------
Claim servicing fees are recognized in proportion to the historical
trends of the claim cycle. We use historical claim count data that
measures the close rate of claims in relation to the policy period
covered to substantiate the service period. The following table
summarizes the year in which claim fee revenue is recognized by type
of business.
Year Claim Fee Revenue Recognized
---------------------------------
1st 2nd 3rd 4th
---------------------------------
Commercial property fees 80% 20% - -
---------------------------------
Commercial liability fees 60% 30% 10% -
---------------------------------
Personal property fees 90% 10% - -
---------------------------------
Personal liability fees 49% 33% 12% 6%
---------------------------------
Finance Charges
---------------
The majority of AHIC's annual insurance premiums were previously
financed through our premium finance program offered by our wholly-
owned subsidiary, Hallmark Finance Corporation. AHIC discontinued
offering premium financing on new annual term policies in July 2003.
Finance charges on the premium finance notes were recorded as interest
earned. This interest was earned on the Rule of 78's method which
approximates the interest method for such short-term notes.
We receive premium installment fees between $3.00 and $9.00 per direct
bill payment from policyholders. Installment fee income is classified
as finance charges on the statement of operations and is recognized as
the fee is invoiced.
Property and Equipment
----------------------
Property and equipment (including leasehold improvements), aggregating
$4.1 million and $3.6 million, at December 31, 2005 and 2004,
respectively, which is included in other assets, is recorded at cost
and is depreciated using the straight-line method over the estimated
useful lives of the assets (three to ten years). Depreciation expense
for 2005, 2004 and 2003 was $0.4 million, $0.4 million and $0.6
million, respectively. Accumulated depreciation was $3.0 and $2.6
million at December 31, 2005 and 2004, respectively.
Premiums Receivable
-------------------
Premiums receivable represent amounts due from policyholders directly
or independent agents for premiums written and uncollected. These
balances are carried at net realizable value.
Deferred Policy Acquisition Costs
---------------------------------
Policy acquisition costs (mainly commission, underwriting and
marketing expenses) that vary with and are primarily related to the
production of new and renewal business are deferred and charged to
operations over periods in which the related premiums are earned. The
method followed in computing deferred policy acquisition costs limits
the amount of such deferred costs to their estimated realizable value.
In determining estimated realizable value, the computation gives
effect to the premium to be earned, related investment income, losses
and loss expenses and certain other costs expected to be incurred as
the premiums are earned. If the computation results in an estimated
net realizable value less than zero, a liability will be accrued for
the premium deficiency.
Ceding commissions from reinsurers on retroceded business, which
include expense allowances, are deferred and recognized over the
period premiums are earned for the underlying policies reinsured.
Deferred ceding commissions from this business are netted against
deferred policy acquisition costs in the accompanying balance sheet.
The change in deferred ceding commission income is netted and included
in other operating costs and expenses in the accompanying income
statement. During 2005 we deferred $4.8 million of ceding commissions
on the AHIC commercial business. As of December 31, 2005, we netted
this $4.8 million of deferred ceding commissions against our deferred
policy acquisition cost balance. During 2005, 2004 and 2003, the
Company deferred ($33.3) million, ($22.6) million and ($21.0) million
of policy acquisition costs and amortized $26.8 million, $22.3 million
and $20.6 million of deferred policy acquisition costs, respectively.
The net deferrals of policy acquisition costs were ($6.5) million,
($0.3) million and ($0.4) million for 2005, 2004 and 2003, respectively.
Losses and Loss Adjustment Expenses
-----------------------------------
Losses and loss adjustment expenses represent the estimated ultimate
net cost of all reported and unreported losses incurred through
December 31, 2005, 2004 and 2003. The reserves for unpaid losses and
loss adjustment expenses are estimated using individual case-basis
valuations and statistical analyses. These estimates are subject
to the effects of trends in loss severity and frequency. Although
considerable variability is inherent in such estimates, we believe
that the reserves for unpaid losses and loss adjustment expenses are
adequate. The estimates are continually reviewed and adjusted as
experience develops or new information becomes known. Such adjustments
are included in current operations.
Agent Profit Sharing Commissions
--------------------------------
We annually pay a profit sharing commission to our independent agency
force based upon the results of the business produced by each agent.
We estimate and accrue this liability to commission expense in the
year the business is produced.
Reinsurance
-----------
We are routinely involved in reinsurance transactions with other
companies. Reinsurance premiums, losses, and LAE are accounted for on
bases consistent with those used in accounting for the original
policies issued and the terms of the reinsurance contracts. (See Note
6.)
Leases
------
We have several leases, primarily for office facilities and computer
equipment, which expire in various years through 2011. Some of these
leases include rent escalation provisions throughout the term of the
lease. We expense the average annual cost of the lease with the
difference to the actual rent invoices recorded as deferred rent which
is classified as other accrued expenses on our consolidated balance
sheet.
Income Taxes
------------
We file a consolidated federal income tax return. Deferred federal
income taxes reflect the future tax consequences of differences
between the tax bases of assets and liabilities and their financial
reporting amounts at each year end. Deferred taxes are recognized
using the liability method, whereby tax rates are applied to
cumulative temporary differences based on when and how they are
expected to affect the tax return. Deferred tax assets and
liabilities are adjusted for tax rate changes in effect for the year
in which these temporary differences are expected to be recovered or
settled.
Earnings Per Share
------------------
The computation of earnings per share is based upon the weighted
average number of common shares outstanding during the period, plus
(in periods in which they have a dilutive effect) the effect of common
shares potentially issuable, primarily from stock options. (See Notes
10 and 12.)
Business Combinations
---------------------
We account for business combinations using the purchase method of
accounting. The cost of an acquired entity is allocated to the assets
acquired (including identified intangible assets) and liabilities
assumed based on their estimated fair values. The excess of the cost
of an acquired entity over the net of the amounts assigned to assets
acquired and liabilities assumed is an asset referred to as "excess of
cost over net assets acquired" or "goodwill". Indirect and general
expenses related to business combinations are expensed as incurred.
We acquired PIIC effective January 1, 2003. In consideration for
PIIC, we cancelled $7.0 million of a $14.85 million balance on a note
receivable from Millers American Group, Inc. ("Millers"). We had
valued the note receivable on our balance sheet at its cost of $6.5
million. As of December 31, 2003, we fully reserved for the remaining
balance of the note receivable.
The calculation of the fair value of the Company's net assets acquired
at January 1, 2003 and the determination of excess of fair value of
net assets acquired over cost is as follows (in thousands):
Net assets acquired at 1/1/03 (historical basis) $ 11,520
Fair value of acquired identified intangible assets 706
Fair value adjustment to unearned premium 918
Fair value adjustment to loss reserves (146)
Reversal of valuation allowance on net deferred tax
asset acquired 3,365
-------
Fair value of net assets acquired in 1/1/03 before
basis adjustments 16,363
Consideration paid in form of debt incurred to complete
the acquisition (6,500)
-------
Excess of fair value of net assets acquired over cost
at 1/1/03 before basis adjustments 9,863
Pro rata reduction of assets acquired other than
specified exceptions:
Identified intangible assets (706)
Deferred policy acquisition costs (918)
Fixed assets (65)
Other assets (90)
-------
Excess of fair value of net assets acquired over cost
at 1/1/03 $ 8,084
=======
The acquisition of PIIC was accounted for in accordance with FASB
Statement of Financial Accounting Standards No. 141, "Business
Combinations" ("SFAS 141"). This statement requires that we estimate
the fair value of assets acquired and liabilities assumed by us as of
the date of the acquisition. In accordance with SFAS 141, we recognized
an extraordinary gain of $8.1 million for the acquisition of PIIC in
our Consolidated Statement of Operations for the twelve months ended
December 31, 2003. The gain was calculated as the difference between
the fair value of the net assets of PIIC of $14.6 million and the $6.5
million cost of the note receivable from Millers.
Intangible Assets
-----------------
We account for our intangible assets according to SFAS 142. SFAS 142
supersedes Accounting Principles Boards ("APB") Opinion No. 17,
"Intangible Assets," and primarily addresses the accounting for
goodwill and intangible assets subsequent to their initial recognition.
SFAS 142 (1) prohibits the amortization of goodwill and indefinite-
lived intangible assets, (2) requires testing of goodwill and
indefinite-lived intangible assets on an annual basis for impairment
(and more frequently if the occurrence of an event or circumstance
indicates an impairment), (3) requires that reporting units be
identified for the purpose of assessing potential future impairments of
goodwill and (4) removes the forty-year limitation on the amortization
period of intangible assets that have finite lives.
Pursuant to SFAS 142, we have identified two components of goodwill and
assigned the carrying value of these components into two reporting
units: the Personal Insurance Operation, $2.7 million; and the
Commercial Insurance Operation, $2.1 million. During 2005, 2004 and
2003, we completed the first step prescribed by SFAS 142 for testing
for impairment and determined that there was no impairment.
Effective December 1, 2002, we acquired HGA and ECM. At acquisition, we
valued the relationships with HGA's independent agents at $542,580.
This asset is classified as an intangible asset and is being amortized
on a straight-line basis over twenty years. We recognized $27,129 of
amortization expense for the twelve months ending December 31, 2005 and
will recognize $27,129 in amortization expense for each of the next
five years and $323,287 for the remainder of the asset's life.
Use of Estimates in the Preparation of Financial Statements
-----------------------------------------------------------
The preparation of financial statements in conformity with GAAP
requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities at the date(s) of the
financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates.
Fair Value of Financial Instruments
-----------------------------------
Cash and Short-term Investments: The carrying amounts reported in the
balance sheet for these instruments approximate their fair values.
Investment Securities: Fair values for fixed income securities and
equity securities are obtained from an independent pricing service or
based on quoted market prices. (See Note 2.)
Restricted Cash and Investments: The carrying amount for restricted
cash reported in the balance sheet approximates the fair value. Fair
values for restricted fixed income securities are obtained from an
independent pricing service or based on quoted market prices. (See Note
3.)
Notes Payable: The fair value for the notes payable as of December 31,
2005 was $30.9 million, calculated by discounting the future cash flows
at our current fixed interest rate of 7.725%.
For accrued investment income, amounts recoverable from reinsurers,
federal income tax payable and receivable and other liabilities, the
carrying amounts approximate fair value because of the short maturity
of such financial instruments.
Stock-based Compensation
------------------------
In December 2004, the FASB issued Statement of Financial Accounting
Standards No. 123R, "Share-Based Payment" ("SFAS 123R"), which revises
FASB Statement of Financial Accounting Standards No. 123, "Accounting
for Stock Based Compensation" ("SFAS 123") and supersedes APB Opinion
No. 25, "Accounting for Stock Issued to Employees" ("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.
In December 2002, the FASB issued Statement of Financial Accounting
Standards No. 148, "Accounting for Stock-Based Compensation -
Transition and Disclosure" ("SFAS 148"). The statement amends SFAS 123
to provide alternative methods of transition for voluntary change to
the fair value based method of accounting for stock-based employee
compensation. In addition, SFAS 148 amends the disclosure requirements
of SFAS 123 to require prominent disclosures in both annual and interim
financial statements about the method of accounting for stock-based
employee compensation and the effect of the method used on reported
results. Effective January 1, 2003, we adopted the prospective method
provisions of SFAS 148.
We have a stock compensation plan for key employees and non-employee
directors that was approved by the shareholders on May 26, 2005. We
had an employee stock option plan and a non-qualified stock option plan
for non-employee directors, both of which expired in 2004. These plans
are described more fully in Note 11. Prior to 2003, we accounted for
these plans under the recognition and measurement provisions of APB 25,
and related Interpretations. Effective January 1, 2003, we adopted, in
accordance with SFAS 148, the fair value recognition provisions of SFAS
123. Under the prospective method of adoption selected by us under
the provisions of SFAS 148, compensation cost is recognized for all
employee awards granted, modified, or settled after the beginning of
the fiscal year in which the recognition provisions are first applied.
Compensation cost is recognized pro rata over the vesting period as the
awards vest. Results for prior years have not been restated.
The following table illustrates the effect on net income and net income
per share if the fair value based method had been applied to all
outstanding and unvested awards in each period.
2005 2004 2003
-------- -------- --------
Net income $ 9,186 $ 5,849 $ 8,745
Add: stock-based employee compensation
expenses included in reported net
income, net of tax 41 20 30
Deduct: total stock-based employee
compensation expense determined under
fair value based method for all
awards, net of tax (48) (27) (68)
-------- -------- --------
Pro forma net income $ 9,179 $ 5,842 $ 8,707
======== ======== ========
Net income per share:
Basic - as reported $ 0.13 $ 0.14 $ 0.30
Basic - pro forma $ 0.13 $ 0.14 $ 0.30
Diluted - as reported $ 0.13 $ 0.14 $ 0.30
Diluted - pro forma $ 0.13 $ 0.14 $ 0.29
Reclassification
----------------
Certain previously reported amounts have been reclassified to conform
to current year presentation. Such reclassification had no effect on
net income or stockholders' equity.
2. Investments:
Major categories of net investment income (in thousands) are
summarized as follows:
Years ended December 31,
--------------------------------
2005 2004 2003
-------- -------- --------
Debt securities $ 2,806 $ 1,127 $ 752
Equity securities 90 109 189
Short-term investments 161 82 102
Cash equivalents 832 82 171
-------- -------- --------
3,889 1,400 1,214
Investment expenses (53) (14) (16)
-------- -------- --------
Net investment income $ 3,836 $ 1,386 $ 1,198
======== ======== ========
No investment in any entity or its affiliates exceeded 10% of
stockholders' equity at December 31, 2005 or 2004.
The amortized cost and estimated fair value of investments in
debt and equity securities (in thousands) by category is as
follows:
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
-------- ------ ------- ---------
As of December 31, 2005
-----------------------
U.S. Treasury securities
and obligations of U.S.
government corporations
and agencies $ 4,331 $ - $ 153 $ 4,178
Corporate debt securities 51,191 26 843 50,374
Municipal bonds 24,837 174 217 24,794
Mortgage backed securities 13 1 - 14
-------- ------ ------- ---------
Total debt securities 80,372 201 1,213 79,360
Equity securities 3,505 270 372 3,403
-------- ------ ------- ---------
Total debt and equity
securities $ 83,877 $ 471 $ 1,585 $ 82,763
======== ====== ======= =========
As of December 31, 2004
-----------------------
U.S. Treasury securities
and obligations of U.S.
government corporations
and agencies $ 2,752 $ 3 $ 93 $ 2,662
Corporate debt securities 5,278 24 12 5,290
Municipal bonds 19,788 443 2 20,229
Mortgage backed securities 23 2 - 25
-------- ------ ------- ---------
Total debt securities 27,841 472 107 28,206
Equity securities 3,015 569 4 3,580
-------- ------ ------- ---------
Total debt and equity
securities $ 30,856 $ 1,041 $ 111 $ 31,786
======== ====== ======= =========
The amortized cost and estimated fair value of investments in
debt and equity securities with a gross unrealized loss position
at December 31, 2005 and 2004 (in thousands) is as follows:
Gross
Unrealized
Amortized Cost Fair Value Loss
-------------- ---------- ----------
As of December 31, 2005
-----------------------
4 Equity Positions $ 1,677 $ 1,305 $ (372)
67 Bond Positions 70,956 69,684 (1,272)
------- ------- -------
$ 72,633 $ 70,989 $ (1,644)
======= ======= =======
As of December 31, 2004
-----------------------
1 Equity Position $ 31 $ 27 $ (4)
6 Bond Positions 7,323 7,216 (107)
------- ------- -------
$ 7,354 $ 7,243 $ (111)
======= ======= =======
The gross unrealized loss recorded at December 31, 2005 includes $59
thousand from securities placed in the restricted investment
portfolio. All of the gross unrealized loss at December 31, 2005 is
less than twelve months old and is considered a temporary decline in
value as we see no other indications that the decline in value of
these securities is permanent.
The amortized cost and estimated fair value of debt securities at
December 31, 2005 by contractual maturity are as follows. Expected
maturities may differ from contractual maturities because certain
borrowers may have the right to call or prepay obligations with or
without penalties.
Amortized Fair
Maturity (in thousands): Cost Value
----------------------- -------- --------
Due in one year or less $ 10,188 $ 9,930
Due after one year through five years 27,245 26,697
Due after five years through ten years 39,669 39,518
Due after ten years 3,257 3,201
Mortgage-backed securities 13 14
-------- --------
$ 80,372 $ 79,360
======== ========
At December 31, 2005 and 2004, investments in debt securities with an
approximate carrying value of $6.2 million and $2.6 million were on
deposit with various state insurance departments as required by state
insurance regulations.
3. Restricted Cash and Investments;
-------------------------------
We have cash and investments held in trust accounts to secure the
credit exposure of third parties arising from our various quota share
reinsurance treaties and agency agreements. These funds are recorded
on our balance sheet at fair value, with unrealized gains and losses
reported as accumulated other comprehensive income, a component of
shareholders' equity. The fair value of these funds as of December 31,
2005 and 2004 was $13.8 million and $6.5 million, respectively.
The amortized cost and estimated fair value of cash and investments
in debt securities held in trust by category is as follows (in
thousands):
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
----------------------------------------
As of December 31, 2005
-----------------------
Municipal bonds $ 3,875 $ - $ 23 $ 3,852
Corporate debt securities 4,096 - 36 4,060
----------------------------------------
Total debt securities $ 7,971 $ - $ 59 $ 7,912
==============================
Cash 5,890
--------
Total restricted cash
and investments $ 13,802
========
As of December 31, 2004
-----------------------
Municipal bonds $ 2,561 $ 45 $ - $ 2,606
Corporate debt securities - - - -
----------------------------------------
Total debt securities $ 2,561 $ 45 $ - $ 2,606
==============================
Cash 3,903
--------
Total restricted cash
and investments $ 6,509
========
The amortized cost and estimated fair value of investments in debt
securities held in trust as of December 31, 2005 by contractual
maturity are as follows (in thousands):
Amortized Fair
Cost Value
------------------------
Due in one year or less $ 2,966 $ 2,947
Due after one year through 5 years 1,130 1,113
Due after 5 years through 10 years 3,875 3,852
Due after 10 years - -
------------------------
$ 7,971 $ 7,912
========================
4. Other Assets:
------------
The following table details our other assets as of December 31, 2005
and 2004 (in thousands):
2005 2004
-------- --------
Profit sharing commission receivable $ 2,793 $ 380
Accrued investment income 1,562 417
Debt issuance costs 856 -
Fixed assets 1,148 693
Other assets 96 27
-------- --------
$ 6,455 $ 1,517
======== ========
Our profit sharing commission receivable increased $2.4 million in
2005 due to favorable loss development and improved commission terms
negotiated in the middle of 2004. Our accrued investment income
increased $1.1 million due to the investment of funds received in our
capital plan implemented in 2005.
5. Reserves for Unpaid Losses and Loss Adjustment Expenses:
Activity in the reserves for unpaid losses and loss adjustment
expenses (in thousands) is summarized as follows:
2005 2004 2003
-------- -------- --------
Balance at January 1 $ 19,648 $ 28,456 $ 17,667
Plus acquisition of Phoenix
at January 1 - - 10,338
-------- -------- --------
Less reinsurance recoverables 1,948 7,259 9,256
-------- -------- --------
Net Balance at January 1 17,700 21,197 18,749
-------- -------- --------
Incurred related to:
Current year 36,184 20,331 29,724
Prior years (2,400) (1,194) 464
-------- -------- --------
Total incurred 33,784 19,137 30,188
-------- -------- --------
Paid related to:
Current year 17,414 10,417 21,895
Prior years 8,073 12,217 5,845
-------- -------- --------
Total paid 25,487 22,634 27,740
-------- -------- --------
Net Balance at December 31 25,997 17,700 21,197
Plus reinsurance recoverables 324 1,948 7,259
-------- -------- --------
Balance at December 31 $ 26,321 $ 19,648 $ 28,456
======== ======== ========
The $2.4 million and $1.2 million favorable development in prior
accident years recognized in 2005 and 2004, respectively, represent
normal changes in actuarial estimates. The 2003 provision for losses
and LAE for claims occurring in the current period includes a $2.1
million settlement of a bad faith claim, net of reinsurance, and
adverse development primarily related to newly acquired business.
6. Reinsurance:
------------
We reinsure a portion of the risk we underwrite in order to control
the exposure to losses and to protect capital resources. We cede to
reinsurers a portion of these risks and pay premiums based upon the
risk and exposure of the policies subject to such reinsurance. Ceded
reinsurance involves credit risk and is generally subject to aggregate
loss limits. Although the reinsurer is liable to us to the extent of
the reinsurance ceded, we are ultimately liable as the direct insurer
on all risks reinsured. Reinsurance recoverables are reported after
allowances for uncollectible amounts. We monitor the financial
condition of reinsurers on an ongoing basis and review our reinsurance
arrangements periodically. Reinsurers are selected based on their
financial condition, business practices and the price of their product
offerings.
For policies originated prior to April 1, 2003, we assumed the
reinsurance of 100% of the Texas non-standard auto business produced
by Phoenix General Agency ("PGA") and underwritten by State &
County and retroceded 55% of the business to Dorinco Reinsurance
Company ("Dorinco"). Under this arrangement, we remain obligated to
policyholders in the event that Dorinco does not meet its obligations
under the retrocession agreement. From April 1, 2003 through September
30, 2004, we assumed the reinsurance of 45% of the Texas non-standard
automobile policies produced by PGA and underwritten either by State &
County (for policies written from April 1, 2003 through September 30,
2003) or Old American County Mutual Fire insurance Company ("OACM")
(for policies written from October 1, 2003 through September 30, 2004).
During this period, the remaining 55% of each policy was directly
assumed by Dorinco. Under these reinsurance arrangements, we are
obligated to policyholders only for the portion of the risk that
we assumed. Effective October 1, 2004, we assume and retain the
reinsurance of 100% of the Texas non-standard automobile policies
produced by PGA and underwritten by OACM.
Under our prior insurance arrangements with Dorinco, we earned ceding
commissions based on loss ratio experience on the portion of policies
reinsured by Dorinco. We received a provisional commission as
policies were produced as an advance against the later determination
of the commission actually earned. The provisional commission is
adjusted periodically on a sliding scale based on expected loss
ratios. As of December 31, 2005 and 2004, the accrued ceding
commission payable to Dorinco was $0.4 million and $1.0 million,
respectively. This accrual represents the difference between the
provisional ceding commission received and the ceding commission
earned based on current loss ratios.
The following table shows premiums directly written, assumed and ceded
and reinsurance loss recoveries by period (in thousands):
Twelve Months Ended December 31,
--------------------------------
2005 2004 2003
------------------------------
Written premium:
Direct $ 44,237 $ 18,941 $ 22,359
Assumed 45,230 14,448 20,979
Ceded (1,215) (322) (6,769)
------------------------------
Net written premium $ 88,252 $ 33,067 $ 36,569
==============================
Earned premium:
Direct $ 23,747 $ 19,028 $ 23,067
Assumed 35,885 14,030 34,380
Ceded (448) (613) (15,472)
------------------------------
Net earned premium $ 59,184 $ 32,445 $ 41,975
==============================
Reinsurance recoveries $ (492) $ 163 $ 11,071
==============================
The following table presents our reinsurance recoverable balance
as of December 31, 2005 by reinsurer (in thousands):
Reinsurance A.M. Best Rating
Reinsurer Recoverable of Reinsurer
Dorinco Reinsurance Company $ 426 A- (Excellent)
GE Reinsurance Corporation 10 A (Excellent)
Platinum Underwriters
Reinsurance, Inc. 8 A (Excellent)
-----
Total Reinsurance Recoverable $ 444
=====
Our Personal Insurance Operation presently retains 100% of the risk
associated with all non-standard auto policies marketed by PGA. Our
Commercial Insurance Operation currently purchases reinsurance for the
following exposures:
* Property Catastrophe - Our property catastrophe reinsurance reduces
the financial impact a catastrophe could have on our commercial
property insurance lines. Catastrophes might include multiple
claims and policyholders. Catastrophes include hurricanes,
windstorms, earthquakes, hailstorms, explosions, severe winter
weather and fires. Our property catastrophe reinsurance is excess-
of-loss reinsurance, which provides us reinsurance coverage for
losses in excess of an agreed-upon amount. We utilize catastrophe
models to assist in determining appropriate retention and limits
to purchase. The terms of our current property catastrophe
reinsurance effective, October 1, 2005, are:
* We retain the first $1 million of property catastrophe losses;
and
* Our reinsurers reimburse us 95% for each $1 of loss in excess
of our $1 million retention up to $4.75 million for each
catastrophic occurrence, subject to a two event maximum for
the contractual term.
* Commercial Property - Our commercial property reinsurance reduces
the financial impact a single-event or catastrophic loss may have
on our results. It is excess-of-loss coverage. The terms of our
current commercial property reinsurance effective, July 1, 2005,
are:
* We retain first $500 thousand of loss for each commercial
property risk;
* Our reinsurers reimburse us for the next $4.5 million for
each commercial property risk; and
* Individual risk facultative reinsurance is purchased on any
commercial property with limits above $5 million.
* Commercial Umbrella - Our commercial umbrella reinsurance reduces
the financial impact of losses in this line of business. Our
commercial umbrella reinsurance is quota-share reinsurance, in
which the reinsurers share a proportional amount of the premiums
and losses. Under our current commercial umbrella reinsurance
effective, July 1, 2005, we retain 10% of the premiums and losses
and cede 90% to our reinsurers.
* Commercial Casualty - Our commercial casualty reinsurance reduces
the financial impact a single-event loss may have on our results.
It is excess-of-loss coverage. The terms of our current commercial
casualty reinsurance effective, July 1, 2005, are:
* We retain the first $500 thousand of any commercial liability
loss, including commercial automobile liability; and
* Our reinsurers reimburse us for the next $500 thousand for
each commercial liability loss, including commercial automobile
liability.
7. Notes Payable:
--------------
On June 21, 2005, our newly formed trust entity 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. Under the
terms of the note we pay interest only each quarter and the principal
of the note at maturity. As of December 31, 2005, the note balance was
$30.9 million.
8. Credit Facility:
----------------
On June 29, 2005, we entered into a credit facility with The Frost
National Bank. The credit agreement 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 during 2005 was $7.5 million,
which could 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
this credit facility accrued interest at an annual rate of three month
LIBOR plus 2.00% and we paid 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 December 31, 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,
effective July 1, 2004. This credit agreement was amended and restated
in January, 2006. (See Note 17.)
9. Segment Information:
--------------------
We have pursued our business activities through subsidiaries whose
operations are organized into our Commercial Insurance Operation
segment, which handles commercial insurance products and services, and
our Personal Insurance Operation segment, which handles non-standard
personal automobile insurance products and services. Our Commercial
Insurance Operation markets and underwrites commercial insurance
policies through approximately 170 independent agencies operating
primarily in the non-urban areas of Texas, New Mexico, Idaho, Oregon,
Montana and Washington. Our Personal Insurance Operation markets
minimum limits non-standard automobile policies through approximately
760 independent agents in Texas, New Mexico and Arizona.
The following is additional business segment information for the
twelve months ended December 31, 2005, 2004 and 2003 (in thousands):
2005 2004 2003
-------- -------- --------
Revenues
--------
Personal Insurance Operation $ 43,907 $ 39,555 $ 49,665
Commercial Insurance Operation 43,067 23,563 19,891
Corporate 61 3 3
-------- -------- --------
Consolidated $ 87,035 $ 63,121 $ 69,559
======== ======== ========
Depreciation Expense
--------------------
Personal Insurance Operation $ 226 $ 266 $ 218
Commercial Insurance Operation 144 144 370
Corporate 16 13 6
-------- -------- --------
Consolidated $ 386 $ 423 $ 594
======== ======== ========
Interest Expense
----------------
Personal Insurance Operation $ 10 $ 14 $ 389
Commercial Insurance Operation - - 1
Corporate 1,254 50 881
-------- -------- --------
Consolidated $ 1,264 $ 64 $ 1,271
======== ======== ========
Tax Expense
-----------
Personal Insurance Operation $ 3,225 $ 2,403 $ 432
Commercial Insurance Operation 1,194 569 420
Corporate (137) (219) (827)
-------- -------- --------
Consolidated $ 4,282 $ 2,753 $ 25
======== ======== ========
Pre-tax Income
Personal Insurance Operation $ 11,647 $ 8,109 $ 1,950
Commercial Insurance Operation 6,651 3,028 1,311
Corporate (4,830) (2,535) (2,575)
-------- -------- --------
Consolidated $ 13,468 $ 8,602 $ 686
======== ======== ========
The $8.1 million extraordinary gain reported in 2003 from the
acquisition of PIIC was attributed to the Corporate segment.
The following is additional business segment information as of the
following dates (in thousands):
December 31,
------------------------
2005 2004
Assets -------- --------
------
Personal Insurance Operation $ 91,625 $ 63,136
Commercial Insurance Operation 112,859 18,557
Corporate 4,422 818
-------- --------
Consolidated $ 208,906 $ 82,511
======== ========
10. Earnings Per Share
------------------
We have adopted the provisions of SFAS 128 requiring presentation of
both basic and diluted earnings per share. A reconciliation of the
numerators and denominators of the basic and diluted per share
calculations (in thousands, except per share amounts) is presented
below:
2005 2004 2003
------------------------------
Numerator for both basic and
----------------------------
diluted earnings per share:
---------------------------
Income before cumulative effect
of change in accounting principle
and extraordinary gain $ 9,186 $ 5,849 $ 661
Extraordinary gain - - 8,084
------------------------------
Net income $ 9,186 $ 5,849 $ 8,745
==============================
Denominator, basic shares 72,051 42,417 29,151
Effect of dilutive securities:
Stock options 575 364 408
------------------------------
Denominator, diluted shares 72,626 42,781 29,559
==============================
Basic earnings (loss) per share:
--------------------------------
Income before cumulative effect
of change in accounting principle
and extraordinary gain $ 0.13 $ 0.14 $ 0.02
Extraordinary gain - - 0.28
------------------------------
Net income $ 0.13 $ 0.14 $ 0.30
==============================
Diluted earnings (loss) per share:
----------------------------------
Income before cumulative effect of
change in accounting principle
and extraordinary gain $ 0.13 $ 0.14 $ 0.02
Extraordinary gain - - 0.28
------------------------------
Net income $ 0.13 $ 0.14 $ 0.30
==============================
Options to purchase 125,000 and 126,000 shares of common stock at
prices ranging from $0.85 to $1.00 and $0.75 to $1.00 were outstanding
at December 31, 2004 and 2003, respectively, but were not included in
the computation of diluted earnings per share because the inclusion
would result in an anti-dilutive effect in periods where the option
exercise price exceeded the average market price per share for the
period.
In accordance with SFAS 128, we have restated the basic and diluted
weighted average shares outstanding for the twelve months ended
December 31, 2004 and 2003 for the effect of a bonus element from our
stockholder rights offerings that were successfully completed in 2005
and 2003. 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.
11. Regulatory Capital Restrictions:
--------------------------------
AHIC's 2005, 2004 and 2003 net income (loss) and stockholders' equity
(capital and surplus), as determined in accordance with statutory
accounting practices, were ($4.6) million, $1.5 million and $2.0
million, and $63.7 million, $11.5 million and $10.0 million,
respectively. The minimum statutory capital and surplus required for
Hallmark by the Texas Department of Insurance ("TDI") is $2.0 million.
Texas state law limits the payment of dividends to stockholders by
property and casualty insurance companies. The maximum dividend that
may be paid without prior approval of the Commissioner of Insurance is
limited to the greater of 10% of statutory policyholders surplus as of
the preceding calendar year end or the statutory net income of the
preceding calendar year. AHIC did not pay any dividends to Hallmark in
2005. AHIC paid a dividend of $0.2 million in 2004 to Hallmark that
was declared in 2003. Based on surplus at December 31, 2005, Hallmark
could pay a dividend of up to $6.4 million to Hallmark during 2006
without TDI approval.
PIIC's 2005, 2004 and 2003 net income (loss) and stockholders' equity
(capital and surplus), as determined in accordance with statutory
accounting practices, were $2.7 million, $3.4 million and ($0.3)
million, and $36.2 million, $14.0 million and $10.1 million,
respectively. The minimum statutory capital and surplus required
for PIIC by AZDOI is $1.5 million. Arizona insurance regulations
generally limit distributions made by property and casualty insurers
in any one year, without prior regulatory approval, to the lesser of
10% of statutory policyholders surplus as of the previous year end or
net investment income for the prior year. Based on net investment
income for 2005, the maximum dividend that may be paid by PIIC in
2006 without prior approval of the AZDOI is $1.6 million. PIIC did
not pay any dividends to Hallmark during 2005 in order to strengthen
policyholders' surplus.
National Association of Insurance Commissioners ("NAIC") requests
property/casualty insurers to file a RBC calculation according to
a specified formula. The purpose of the NAIC-designed formula is
twofold: (1) to assess the adequacy of an insurer's statutory capital
and surplus based upon a variety of factors such as potential risks
related to investment portfolio, ceded reinsurance and product mix; and
(2) to assist state regulators under the RBC for Insurers Model Act
by providing thresholds at which a state commissioner is authorized
and expected to take regulatory action. AHIC's 2005, 2004 and 2003
adjusted capital under the RBC calculation exceeded the minimum
requirement by 600%, 412% and 186%, respectively. PIIC's 2005, 2004
and 2003 adjusted capital under the RBC calculation exceeded the
minimum requirement by 365%, 254% and 117%, respectively.
12. Stock Compensation Plans:
-------------------------
We have a stock compensation plan for key employees and non-employee
directors, the 2005 Long Term Incentive Plan ("2005 LTIP"), that was
approved by the shareholders on May 26, 2005. There are 5,000,000
shares authorized for issuance under the 2005 LTIP and 4,470,000
shares reserved for future issuance as of December 31, 2005. Our 1994
Key Employee Long Term Incentive Plan (the "Employee Plan") and 1994
Non-Employee Director Stock Option Plan (the "Director Plan") both
expired in 2004. As of December 31, 2005, there were incentive stock
options to purchase 530,000 shares of our common stock outstanding
under the 2005 LTIP, incentive stock options to purchase 636,500
shares outstanding under the Employee Plan and non-qualified stock
options to purchase 250,000 shares outstanding under the Director
Plan. In addition, as of December 31, 2005, there were outstanding
non-qualified stock options to purchase 100,000 shares of our common
stock granted to certain non-employee directors outside the Director
Plan in lieu of fees for service on our board of directors in 1999.
The exercise price of all such outstanding stock options is equal to
the fair market value of our common stock on the date of grant.
Options granted under the Employee Plan prior to October 31, 2003,
vest 40% six months from the date of grant and an additional 20% on
each of the first three anniversary dates of the grant and terminate
ten years from the date of grant. Options granted under the 2005 LTIP
and the Employee Plan after October 31, 2003, vest 10% ,20%, 30% and
40% on the first, second, third and fourth anniversary dates of the
grant, respectively, and terminate five years from the date of grant.
All options granted under the Director Plan vest 40% six months from
the date of grant and an additional 10% on each of the first six
anniversary dates of the grant and terminate ten years from the date
of grant. The options granted to non-employee directors outside the
Director Plan fully vested six months after the date of grant and
terminate ten years from the date of grant.
A summary of the status of the Company's stock options as of December
31, 2005, 2004 and 2003 and the changes during the years ended on
those dates is presented below:
2005 2004 2003
----------------------- ---------------------- ----------------------
Number Weighted Number Weighted Number Weighted
of Shares of Average of Shares of Average of Shares of Average
Underlying Exercise Underlying Exercise Underlying Exercise
Options Prices Options Prices Options Prices
------- ------ ------- ------ ------- ------
Outstanding at beginning 1,358,500 $ 0.62 1,263,500 $ 0.58 2,379,000 $ 0.50
of the year
Granted 530,000 $ 1.19 475,000 $ 0.59 205,000 $ 0.67
Exercised (364,500) $ 0.63 (105,000) $ 0.45 (575,000) $ 0.39
Forfeited (7,500) $ 0.44 (275,000) $ 0.45 (745,500) $ 0.49
Outstanding at end of
the year 1,516,500 $ 0.82 1,358,500 $ 0.62 1,263,500 $ 0.58
Exercisable at end of
the year 473,000 $ 0.63 744,000 $ 0.63 1,051,500 $ 0.56
Weighted average fair value $ 0.67 $ 0.34 $ 0.36
of all options granted
The fair value of each stock option granted is estimated on the date of
grant using the Black-Scholes option-pricing model with the following
weighted-average assumptions:
2005 2004 2003
-------- -------- --------
Expected Term 5.00 5.00 5.00
Expected Volatility 62.50% 67.45% 61.05%
Risk-Free Interest Rate 3.88% 3.12% 2.97%
The following table summarizes information about stock options
outstanding at December 31, 2005:
Options Outstanding Options Exercisable
------------------- ---------------------
Weighted Avg. Weighted
Number Remaining Number Avg.
Range of Outstanding Contractual Weighted Avg. Exercisable Exercise
Exercise Prices at 12/31/05 Actual Life Exercise Price at 12/31/05 Price
--------------- ----------- ----------- -------------- ----------- --------
$ .37 to $ .57 552,500 3.5 $ .51 215,000 $ .42
$ .58 to $ .69 308,000 3.6 $ .66 142,000 $ .67
$ .70 to $1.19 656,000 7.9 $ 1.15 116,000 $ .98
--------- ---------
$ .37 to $1.19 1,516,500 5.4 $ .82 473,000 $ .63
========= =========
13. Retirement Plans:
-----------------
Certain employees of the Commercial Insurance Operation were
participants in a defined benefit cash balance plan covering all full-
time employees who had completed at least 1,000 hours of service. This
plan was frozen in March 2001 in anticipation of distribution of plan
assets to members upon plan termination. All participants were vested
when the plan was frozen.
The following tables provide detail of the changes in benefit
obligations, components of benefit costs and weighted-average
assumptions, and plan assets for the retirement plan as of and for the
twelve months ending December 31, 2005, 2004 and 2003 (in thousands)
using a measurement date of December 31.
2005 2004 2003
-------- -------- --------
Assumptions (end of period):
Discount rate used in determining
benefit obligation 5.50% 5.75% 6.00%
Rate of compensation increase N/A N/A N/A
Reconciliation of funded status
(end of period):
Vested benefit obligation $ (12,936) $ (13,052) $(12,482)
Accumulated benefit obligation (12,959) (13,081) (12,517)
Projected benefit obligation (12,959) (13,081) (12,517)
Fair value of plan assets 10,027 10,901 11,280
-------- -------- --------
Funded status $ (2,932) $ (2,180) $ (1,237)
Unrecognized net obligation - - -
Unrecognized prior service cost - - -
Unrecognized actuarial (gain)/loss 2,847 2,086 887
-------- -------- --------
Prepaid/(accrued) pension cost $ (85) $ (94) $ (350)
======== ======== ========
Changes in projected benefit obligation:
Benefit obligation as of
beginning of period $ 13,081 $ 12,517 $ 11,758
Interest cost 724 752 762
Actuarial liability (gain)/loss 352 830 1,085
Benefits paid (1,198) (1,018) (1,088)
-------- -------- --------
Benefit obligation as of end of period $ 12,959 $ 13,081 $ 12,517
======== ======== ========
2005 2004 2003
-------- -------- --------
Change in plan assets:
Fair value of plan assets as
of beginning of period $ 10,901 $ 11,280 $ 11,154
Actual return on plan assets
(net of expenses) 192 388 1,214
Employer contributions 132 251 -
Benefits paid (1,198) (1,018) (1,088)
-------- -------- --------
Fair value of plan assets as
of end of period $ 10,027 $ 10,901 $ 11,280
======== ======== ========
Net periodic pension cost:
Service cost - benefits earned
during the period $ - $ - $ -
Interest cost on projected
benefit obligation 724 752 762
Expected return on plan assets (682) (764) (749)
Amortizations
Net obligation/(asset) - - -
Unrecognized prior service cost - - -
Unrecognized (gain)/loss 81 7 -
-------- -------- --------
Net periodic pension cost (credit) $ 123 $ (5) $ 13
======== ======== ========
Discount rate 5.75% 6.00% 6.50%
Expected return on plan assets 6.50% 7.00% 7.00%
Rate of compensation increase N/A N/A N/A
The expected benefit payments under the plan are as follows
(in thousands):
2006 $ 966
2007 $ 959
2008 $ 939
2009 $ 920
2010 $ 908
2011-2015 $ 4,463
As of December 31, 2005, the fair value of the plan assets was composed
of cash and cash equivalents of $0.2 million, bonds and notes of $3.9
million and equity securities of $5.9 million. As of December 31,
2004, the fair value of the plan assets was composed of cash and cash
equivalents of $0.3 million, bonds and notes of $4.4 million and equity
securities of $6.2 million. We recorded a $2.9 million pension
liability at December 31, 2005, of which, $2.8 million was additional
minimum pension liability.
Our investment objectives are to preserve capital and to achieve long-
term growth through a favorable rate of return equal to or greater than
5% over the long-term (60 yr.) average inflation rate as measured by
the consumer price index. We prohibit investments in options, futures,
precious metals, short sales and purchase on margin. In 2003, we
instructed an asset allocation of 50% to 55% in equity securities to
take a more conservative investment strategy.
To develop the expected long-term rate of return on assets assumption,
we consider the historical returns and the future expectations for
returns for each asset class, as well as the target asset allocation of
the pension portfolio. This resulted in the selection of the 6.5%
long-term rate of return on assets assumption. To develop the discount
rate used in determining the benefit obligation we used Moody's Aaa
corporate bond yields at the measurement date to match the timing and
amounts of projected future benefits.
We estimate contributing $0.3 million to the defined benefit cash
balance plan during 2006.
The following table shows the weighted-average asset allocation for the
defined benefit cash balance plan held as of December 31, 2005 and
2004.
12/31/05 12/31/04
-----------------------
Asset Category:
Debt securities 39% 41%
Equity securities 59% 57%
Other 2% 2%
-----------------------
Total 100% 100%
=======================
We sponsor a defined contribution plan. Under this plan, employees may
contribute a portion of their compensation on a tax-deferred basis, and
we may contribute a discretionary amount each year. We contributed
$0.1 million for each of the twelve months ended December 31, 2005,
2004 and 2003.
14. Income Taxes:
-------------
The composition of deferred tax assets and liabilities and the related
tax effects (in thousands) as of December 31, 2005 and 2004, are as
follows:
2005 2004
-------- --------
Deferred tax liabilities:
Deferred policy acquisition costs $ ( 3,089) $ ( 2,715)
Profit sharing commission ( 1,033) ( 74)
Agency relationship ( 211) ( 208)
Goodwill - ( 59)
Unrealized holding gains on
investments - ( 312)
Fixed asset depreciation ( 112) ( 131)
Loss reserve discount ( 12) ( 27)
Other ( 97) ( 93)
-------- --------
Total deferred tax liabilities $ ( 4,554) $ ( 3,619)
======== ========
Deferred tax assets:
Unearned premiums $ 2,398 $ 421
Deferred ceding commissions 788 3,182
Pension liability 1,097 806
Net operating loss carry-forward 1,796 1,796
Unrealized holding losses on investments 360 -
Allowance for bad debt 9 189
Unpaid loss and loss adjustment expense 1,064 846
Goodwill 1,502 1,700
Rent reserve 107 126
Investment impairments 201 188
Unearned revenue 67 289
Risk premium reserve 18 42
Other 23 91
-------- --------
Total deferred tax assets $ 9,430 $ 9,676
======== ========
Net deferred tax asset before
valuation allowance 4,876 6,057
Valuation allowance 884 884
-------- --------
Net deferred tax asset $ 3,992 $ 5,173
======== ========
A valuation allowance is provided against our deferred tax asset to the
extent that we do not believe it is more likely than not that future
taxable income will be adequate to realize these future tax benefits.
This allowance was $0.9 million at December 31, 2005 and December 31,
2004. The valuation allowance is provided against a net operating loss
carry-forward subject to limitations on its utilization. Based on the
evidence available as of December 31, 2005, we believe that it is more
likely than not that the remaining net deferred tax assets will be
realized. However, this assessment may change during 2006 if our
financial results do not meet our current expectations.
A reconciliation of the income tax provisions (in thousands) based on
the statutory tax rate to the provision reflected in the consolidated
financial statements for the years ended December 31, 2005, 2004 and
2003, is as follows:
2005 2004 2003
-------- -------- --------
Computed expected income tax expense
at statutory regulatory tax rate $ 4,579 $ 2,925 $ 233
Meals and entertainment 6 6 5
Tax exempt interest ( 302) ( 309) ( 122)
Dividends received deduction ( 11) 33 ( 28)
State taxes (net of federal benefit) 158 69 ( 6)
Other ( 148) 29 ( 57)
-------- -------- --------
Income tax expense $ 4,282 $ 2,753 $ 25
======== ======== ========
Current income tax expense (benefit) $ 2,139 $ 3,540 $ ( 89)
Deferred tax expense (benefit) 2,143 ( 787) 114
-------- -------- --------
Income tax expense $ 4,282 $ 2,753 $ 25
======== ======== ========
Approximately $0.1 million of the 2005 current income tax provision
results from tax deductible goodwill from the PIIC acquisition.
We have available, for federal income tax purposes, unused net operating
loss of approximately $5.3 million at December 31, 2005. The losses
were acquired as part of the PIIC acquisition and may be used to offset
future taxable income. Utilization of the losses is limited under
Internal Revenue Code Section 382. Due to this limitation, we believe
that $2.6 million of the net operating loss carry-forwards may expire
unutilized. Therefore, a valuation allowance of $2.6 million has been
established against these net operating loss carry-forwards. The
Internal Revenue Code has provided that effective with tax years
beginning September 1997, the carry-back and carry-forward periods are
2 years and 20 years, respectively, with respect to newly generated
operating losses. The net operating losses (in thousands) will expire,
if unused, as follows:
Year
----
2021 $ 2,600
2022 2,700
------
$ 5,300
======
15. Commitments and Contingencies:
------------------------------
We have several leases, primarily for office facilities and
computer equipment, which expire in various years through 2011.
Certain of these leases contain renewal options. Rental expense
amounted to $1.2 million, $1.2 million and $1.3 million for the
years ended December 31, 2005, 2004 and 2003, respectively.
Future minimum lease payments (in thousands) under non-cancelable
operating leases as of December 31, 2005 are as follows:
Year
----
2006 $ 1,103
2007 1,021
2008 943
2009 390
2010 383
2011 and thereafter 187
-------
Total minimum lease payments $ 4,027
=======
From time to time, assessments are levied on us by the guaranty
association of the State of Texas. Such assessments are made
primarily to cover the losses of policyholders of insolvent or
rehabilitated insurers. Since these assessments can be recovered
through a reduction in future premium taxes paid, we capitalize the
assessments as they are paid and amortize the capitalized balance
against our premium tax expense. There were no assessments during
2005, 2004 or 2003.
16. Concentrations of Credit Risk:
------------------------------
We maintain cash equivalents in accounts with six financial
institutions in excess of the amount insured by the Federal Deposit
Insurance Corporation. We monitor the financial stability of the
depository institutions regularly and do not believe excessive risk of
depository institution failure exists at December 31, 2005.
We are also subject to credit risk with respect to reinsurers to whom
we have ceded underwriting risk. Although a reinsurer is liable for
losses to the extent of the coverage it assumes, we remain obligated
to our policyholders in the event that the reinsurers do not meet
their obligations under the reinsurance agreements. In order to
mitigate credit risk to reinsurance companies, we use financially
strong reinsurers with an A.M. Best rating of "A-" or better.
Our reinsurance coverage has historically been provided primarily by
Dorinco since July 1, 2000. Effective October 1, 2004, we do not
utilize any quota share reinsurance. Our reinsurance recoverable
balance at December 31, 2005 is due from three reinsurers.
17. Subsequent Events:
------------------
On November 14, 2005, we announced the signing of a definitive
purchase agreement to acquire all of the issued and outstanding
capital stock of Texas General Agency, Inc. and certain affiliated
companies for an aggregate cash purchase price of up to $45.6 million,
consisting of unconditional consideration of $37.6 million and
contingent consideration of $8.0 million. Of the unconditional
consideration $13.9 million was paid at closing and $14.3 million
will be paid on or before January 1, 2007 and $9.5 million will be
paid on or before January 1, 2008. The payment of any contingent
consideration is conditioned on the sellers complying with certain
restrictive covenants and TGA achieving certain operational objectives
related to premium production and loss ratios. The contingent
consideration, if any, will be payable on or before March 30, 2009,
unless the sellers elect to defer payment until March 30 of any
subsequent year in order to permit further development of the loss
ratios. In addition to the purchase price, we will pay $2.0 million
to the sellers in consideration of their compliance with certain
restrictive covenants, including a covenant not to compete for a
period of five years after closing. Of this additional amount, $750
thousand was paid at closing, $750 thousand will be paid on or before
January 1, 2007 and $500 thousand will be paid on or before January 1,
2008. This transaction was closed effective January 1, 2006. We have
not finalized TGA's purchase price allocation as of the date of this
report.
On December 13, 2005, we announced the signing of a definitive
agreement to acquire all of the issued and outstanding membership
interests in Aerospace Holdings, LLC for an aggregate consideration of
up to $15.0 million, consisting of unconditional consideration of $12.5
million due in cash at closing and contingent consideration of up to
$2.5 million. The unconditional consideration is allocated $11.9
million to the purchase price and $0.6 million to the seller's
compliance with certain restrictive covenants, including a covenant
not to compete for a period of five years after closing. The payment
of contingent consideration is conditioned on the seller complying
with its restrictive covenants and Aerospace achieving certain
operational objectives related to premium production and loss ratios.
The contingent consideration, if any, will be payable in cash on or
before March 30, 2009, unless the seller elects to defer a portion of
the payment in order to permit further development of loss ratios.
This transaction was also closed effective January 1, 2006. We have
not finalized Aerospace's purchase price allocation as of the date of
this report.
On January 3, 2006, we executed a promissory note payable to Newcastle
Partners, L.P. in the amount of $12.5 million in order to obtain
funding to complete the acquisition of Aerospace. The promissory note
bears interest at the rate of 10% per annum. The unpaid principal
balance of the promissory note, together with all accrued and unpaid
interest, is due and payable on demand at any time after June 30, 2006.
We intend to retire the promissory note with proceeds from a rights
offering to our shareholders during 2006.
On January 27, 2006, we amended and restated the credit agreement with
Frost National Bank to a $20.0 million revolving credit facility, with
a $5.0 million letter of credit sub-facility. We borrowed $15.0
million under the revolving credit facility to fund the cash required
to close the TGA acquisition. Principal outstanding under the
revolving credit facility generally bears interest at the three month
Eurodollar rate plus 2.00%, payable quarterly in arrears. The amended
and restated credit agreement terminates on January 27, 2008.
On January 27, 2006, we issued $25.0 million in subordinated
convertible promissory notes to the Opportunity Funds. Each
convertible note bears interest at 4% per annum, which rate increases
to 10% per annum in the event of default. Interest is payable
quarterly in arrears commencing March 31, 2006. Principal and all
accrued but unpaid interest is due at maturity on July 27, 2007.
Subject to shareholder approval, the convertible notes are convertible
by the holders into approximately 19.5 million shares of our common
stock (subject to certain anti-dilution provisions), and will be
automatically converted to such common stock at maturity.
FINANCIAL STATEMENT SCHEDULES
Unaudited Selected Quarterly Information
2005 2004
--------------------------------- ---------------------------------
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
Total revenue $17,445 $17,785 $25,167 $26,638 $15,773 $15,650 $15,646 $16,052
Total expense 14,741 14,774 21,516 22,536 13,697 13,454 13,377 13,991
--------------------------------- ---------------------------------
Income before tax 2,704 3,011 3,651 4,102 2,076 2,196 2,269 2,061
Income tax expense 889 1,007 1,178 1,208 664 703 726 660
--------------------------------- ---------------------------------
Net income $ 1,815 $ 2,004 $ 2,473 $ 2,894 $ 1,412 $ 1,493 $1,543 $1,401
================================= =================================
Basic earnings per share1: $0.04 $0.03 $0.03 $0.03 $0.03 $0.04 $0.04 $0.03
================================= =================================
Diluted earnings per share1: $0.04 $0.03 $0.03 $0.03 $0.03 $0.03 $0.04 $0.03
================================= =================================
1. We issued 50.0 million shares of our common stock during the second
quarter of 2005 in connection with our shareholder rights offering.
In accordance with SFAS 128, we have restated the basic and diluted
weighted average shares outstanding for prior periods for the effect
of a bonus element from the rights offering. 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.
Schedule II - Condensed Financial Information of Registrant
(Parent Company Only)
HALLMARK FINANCIAL SERVICES, INC.
BALANCE SHEETS
December 31, 2005 and 2004
(In thousands)
2005 2004
-------- --------
ASSETS
Equity securities, available-for-sale,
at fair value $ 986 $ 50
Cash and cash equivalents 1,941 578
Investment in subsidiaries 118,250 36,045
Deferred federal income taxes 969 983
Other assets 1,379 112
-------- --------
$ 123,525 $ 37,768
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Liabilities:
Notes payable $ 30,928 $ -
Unpaid losses and loss adjustment expenses 49 114
Current federal income tax payable 467 1,033
Accounts payable and other accrued expenses 6,893 3,965
-------- --------
38,337 5,112
-------- --------
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
Capital in excess of par value 62,907 19,647
Retained earnings 22,289 13,103
Accumulated other comprehensive income (2,597) (759)
Treasury stock, 14,819 shares in 2005
and 379,319 shares in 2004, at cost (17) (441)
-------- --------
Total stockholders' equity 85,188 32,656
-------- --------
$ 123,525 $ 37,768
======== ========
Schedule II (Continued) - Condensed Financial Information of Registrant
(Parent Company Only)
HALLMARK FINANCIAL SERVICES, INC.
STATEMENT OF OPERATIONS
for the years ended December 31, 2005 and 2004
(In thousands)
2005 2004
-------- --------
Investment income, net of expenses $ 61 $ 3
Undistributed share of net earnings in subsidiaries 9,048 6,315
Management fee income 4,830 1,850
-------- --------
Total revenues 13,939 8,168
Losses and loss adjustment expenses (65) (106)
Other operating costs and expenses 3,701 2,593
Interest expense 1,254 51
-------- --------
Total expenses 4,890 2,538
Income before income tax 9,049 5,630
Income tax benefit (137) (219)
-------- --------
Net income $ 9,186 $ 5,849
======== ========
Schedule II (Continued) - Condensed Financial Information of Registrant
(Parent Company Only)
HALLMARK FINANCIAL SERVICES, INC.
STATEMENT OF CASH FLOW
For the years ended December 31, 2005 and 2004
(In thousands)
2005 2004
-------- --------
Cash flows from operating activities:
Net income $ 9,186 $ 5,849
Adjustments to reconcile net income to cash
used in operating activities:
Depreciation and amortization expense 16 39
Deferred income tax benefit 14 (914)
Change in unpaid losses and loss
adjustment expenses (65) (106)
Undistributed share of net (earnings)
loss of subsidiaries (9,048) (6,315)
Change in current federal income tax
payable/recoverable (566) 1,169
Change in all other liabilities 2,928 (72)
Change in all other assets (286) (25)
-------- --------
Net cash provided by (used in)
operating activities 2,179 (375)
Cash flows from investing activities:
Purchases of property and equipment (30) (14)
Purchase of equity securities (928) -
Capital contributed to insurance
company subsidiaries (75,000) -
-------- --------
Net cash used in investing activities (75,958) (14)
Cash flows from financing activities:
Proceeds from exercise of employee stock options 230 48
Proceeds from borrowings 30,928 -
Debt issuance costs (907) -
Proceeds from rights offering 44,891 -
Repayment of borrowings - (991)
-------- --------
Net cash used in financing activities 75,142 (943)
Decrease in cash and cash equivalents 1,363 (1,332)
Cash and cash equivalents at beginning of year 578 1,910
-------- --------
Cash and cash equivalents at end of year $ 1,941 $ 578
======== ========
Supplemental cash flow information:
Interest (paid) $ (1,157) $ (51)
======== ========
Income taxes (paid) recovered $ (415) $ 474
======== ========
Hallmark Financial Services
Schedule III - Supplementary Insurance Information
(In thousands)
----------------------------------------------------------------------------------------------------------------------------------
Segment Deferred Future Unearned Other Premium Net Benefits, Amortization Other Premiums
Policy Policy Premiums Policy Revenue Investment Claims, Losses of Deferred Operating Written
Acquisition Benefits, Claims Income and Settlement Policy Expenses
Cost Losses, and Expenses Acquisition
Claims and Benefits Costs
Loss Payable
Adjustment
Expenses
----------------------------------------------------------------------------------------------------------------------------------
2005
----
Personal
Insurance
Operation $ 1,318 $ 16,457 $ 5,762 $ - $ 37,433 $ 2,283 $ 21,239 $ 11,626 $ 10,839 $ 37,003
Commercial Ins.
Operation 7,846 9,815 30,265 - 21,751 1,492 12,610 15,216 30,448 51,249
Corporate - 49 - - - 61 (65) - 3,701 -
----------------------------------------------------------------------------------------------------------------
Consolidated $ 9,164 $ 26,321 $ 36,027 $ - $ 59,184 $ 3,836 $ 33,784 $ 26,842 $ 44,988 $ 88,252
================================================================================================================
2004
----
Personal
Insurance
Operation $ 1,491 $ 19,534 $ 6,192 $ - $ 32,445 $ 1,372 $ 19,243 $ 10,176 $ 11,881 $ 33,067
Commercial Ins.
Operation 5,984 - - - - 11 - 12,112 21,145 -
Corporate - 114 - - - 3 (106) - 2,593 -
----------------------------------------------------------------------------------------------------------------
Consolidated $ 7,475 $ 19,648 $ 6,192 $ - $ 32,445 $ 1,386 $ 19,137 $ 22,288 $ 35,619 $ 33,067
================================================================================================================
Hallmark Financial Services
Schedule IV - Reinsurance
(In thousands)
Column A Column B Column C Column D Column E Column F
Gross Ceded to Assumed Net Percentage
Amount Other From Other Amount of Amount
Companies Companies Assumed to
Net
-----------------------------------------------------------------------------
Year Ended December 31, 2005
-----------------------------------------------------------------
Life insurance in force $ - $ - $ - $ -
---------------------------------------
Premiums
Life insurance - - - -
Accident and health
insurance - - - -
Property and liability
insurance 23,747 448 35,885 59,184 60.6%
Title Insurance - - - -
---------------------------------------
Total premiums $ 23,747 $ 448 $ 35,885 $ 59,184 60.6%
=======================================
Year Ended December 31, 2004
-----------------------------------------------------------------
Life insurance in force $ - $ - $ - $ -
---------------------------------------
Premiums
Life insurance - - - -
Accident and health
insurance - - - -
Property and liability
insurance 19,028 613 14,030 32,445 43.2%
Title Insurance - - - -
---------------------------------------
Total premiums $ 19,028 $ 613 $ 14,030 $ 32,445 43.2%
=======================================
Hallmark Financial Services
Schedule VI - Supplemental Information Concerning Property-
Casualty Insurance Operations
(In thousands)
Column A Column B Column C Column D Column E Column F Column G Column H Column I Column J Column K
----------------------------------------------------------------------------------------------------------------------------------
Affiliation Deferred Reserves Discount Unearned Earned Net Claims and Claim Amortization Paid Premiums
With Policy for Unpaid if any, Premiums Premiums Investment Adjustment of Claims Written
Registrant Acquisition Claims and Deducted Income Expenses Incurred Deferred and
Costs Claim In Related to Policy Claims
Adjustment Column C (1) (2) Acquisition Adjustment
Expenses Current Prior Costs Expenses
Year Years
----------------------------------------------------------------------------------------------------------------------------------
(a) Consolidated
property-
casualty
entities
2005 $ 9,164 $ 26,321 $ - $ 36,027 $ 59,184 $ 3,836 $ 36,184 $(2,400) $ 26,842 $ 25,487 $ 88,252
2004 $ 7,475 $ 19,648 $ - $ 6,192 $ 32,445 $ 1,386 $ 20,331 $(1,194) $ 22,288 $ 22,634 $ 33,067