July 3, 2006
VIA EDGAR AND FACSIMILE
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Mr. Jim B. Rosenberg
Senior Assistant Chief Accountant
Division of Corporation Finance
U.S. Securities and Exchange Commission
Washington, D.C. 20549
RE: Hallmark Financial Services, Inc.
Form 10-K for the Fiscal Year Ended December 31, 2005
Filed March 23, 2006
File No. 001-11252
Dear Mr. Rosenberg:
On behalf of Hallmark Financial Services, Inc. (the "Company"), set
forth below are responses to the comments of the Staff of the Securities and
Exchange Commission regarding the above-referenced filing set forth in your
letter dated June 20, 2006. For your convenience, we have repeated each of
the comments set forth in the Staff's letter and followed each comment with
the Company's response.
* * * * *
Form 10-K for the Fiscal Year Ended December 31, 2005
Management's Discussion and Analysis of Financial Condition and Results of
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Operations
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Critical Accounting Estimates and Judgments
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Reserves for Unpaid Losses and Loss Adjustment Expense
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1. Please provide us, in disclosure-type format the specific actuarial
techniques and assumptions you use when estimating the liability for
losses and LAE.
RESPONSE:
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The reserves for unpaid losses and LAE are estimated by management
using individual case-basis valuations and statistical analyses.
An actuarial range of ultimate unpaid loss and LAE is developed
independent of management's best estimate and is only used to check
the reasonableness of that estimate. There is no exclusive method
for determining this range, and judgment enters into the process.
The primary actuarial technique utilized is a loss development
analysis in which ultimate losses are projected based upon
historical development patterns. The primary assumption underlying
this loss development analysis is that the historical development
patterns will be a reasonable predictor of the future development
of losses for accident years which are less mature.
An alternate actuarial technique known as the Bornhuetter-Ferguson
method combines an analysis of loss development patterns with an
initial estimate of expected losses or loss ratios. This approach
is most useful for recent accident years. In addition to assuming
the stability of loss development patterns, this technique is
heavily dependent on the accuracy of the initial estimate of
expected losses or loss ratios. Consequently, the Bornhuetter-
Ferguson method is primarily used to confirm the results derived
from the loss development analysis.
We will expand our critical accounting estimate and judgment
disclosures in future filings to better explain our actuarial
techniques and assumptions.
2. It appears that you have significantly revised your estimate of loss
reserves recorded in prior years. We believe that beneficial disclosure
should explain the lines of business and policy years in which the
changes took place and the actual factors or events that caused the
changes. Please provide us the following in disclosure-type format
to explain the reasons for your change in estimates:
a. Identify and describe in reasonable specificity the nature and extent
of a) new events that occurred or b) additional experience/information
obtained since the last reporting date that led to the change in
estimates.
b. Ensure your disclosure clarifies the timing of the change in estimate
such as why recognition occurred in the periods that it did and why
recognition in earlier periods was not required.
RESPONSE:
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The decreases in reserves for losses and LAE for claims occurring
in prior years which were recorded in 2005 and 2004 represent normal
changes in our loss reserve estimates primarily attributable to
favorable loss development in our personal lines auto segment for
accident years 2002 through 2004. At the time these loss reserves
were initially established, new management was in the process of
implementing operational changes designed to improve operating
results. These operational changes included the cancellation of
unprofitable agents, shift in marketing focus to direct bill
policies, increases in policy rates and using our own personnel
and processes to settle claims on policies issued by our recently
acquired Phoenix Indemnity Insurance Company subsidiary rather
than using an outside claims adjustment vendor. However, the
effectiveness of these operational changes could not be accurately
predicted at that time.
As additional data emerged, it became increasingly clear that the
actual results from these operational enhancements were developing
more favorably than originally projected. Therefore, the loss
reserve estimates for these prior years were decreased to reflect
this favorable loss development when the available information
indicated a reasonable likelihood that the ultimate losses would be
less than the previous estimates.
3. We note that you assume a large amount of business from third parties
which would require you to set your claim reserves for assumed
reinsurance operations based upon information received from cedants. As
this appears to pose a potential for a higher degree of uncertainty in
establishing the estimate of assumed loss reserves as compared to direct
loss reserves, please provide us, in disclosure-type format proposed
disclosure for the critical accounting estimates section of MD&A related
to this uncertainty. Also, please consider including the following:
a. Include in this discussion the risks associated with making this
estimate and the effects and expected effects this uncertainty has or
will have on management's judgments and assumptions in establishing
the assumed loss reserve.
b. The nature and extent of the information received from cedants related
to policies, claims, unearned premiums and loss reserves;
c. The time lag from when claims are reported cedant to when the cedant
reports them to the company and whether, how, and to what extent this
time lag effects the loss reserve estimate;
d. How management uses the information received from the cedants in its
determination of its assumed loss reserves, whether reinsurance
intermediaries are used to transact and service reinsurance policies,
and how that impacts the loss reserving methodology;
e. The amount of any backlog related to the processing of assumed
reinsurance information, whether the backlog has been reserved for in
the financial statements and, if applicable, when the backlog will be
resolved;
f. What process management performs to determine the accuracy and
completeness of the information received from the cedants;
g. How management resolves disputes with cedants, how often disputes
occur, and the magnitude of any current, material disputes; and
h. Whether management uses historical loss information to validate its
existing reserves and/or as a means of noticing unusual trends in the
information received from the pool and cedants.
RESPONSE:
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We do not set our claim reserves for assumed reinsurance operations
based upon information received from cedants. All reinsurance
assumed by us is on policies developed, marketed, underwritten and
serviced by our subsidiaries and, consequently, all information
necessary to establish our loss reserves is generated and maintained
in-house. Therefore, we do not believe that the additional
disclosure that you have requested is material to an understanding
of our critical accounting estimates.
Ceding Commissions of the Personal Insurance Operations and Recognition of
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Profit Sharing Commission Revenues of the Commercial Insurance Operation.
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4. We note you provide a sensitivity analysis for your ceding commissions.
Please tell us, in disclosure-type format, if the 0.5% changes reflect
reasonably likely changes in the provisional loss ratio. If the changes
are not reasonably likely, please provide us a revised analysis that
discloses the reasonably likely changes in your provisional loss ratios
and the effect that these changes would have on your ceding commission.
RESPONSE:
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The sensitivity analysis is not intended and does not purport to
reflect changes in the provisional loss ratio. As reflected in the
tables, the provisional loss ratio is fixed by contract for each
treaty period and does not vary. Rather, as indicated in the third
sentence of the explanatory paragraph preceding each table, the
sensitivity analysis is intended to illustrate the impact on
commission income that would result from a change in our estimate
of the ultimate loss ratio. In this regard, we believe that our
current estimates of the ultimate loss ratios are reasonably likely
to vary within the 0.5% range that is illustrated.
Consolidated Financial Statements
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Consolidated Balance Sheets
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5. Please explain to us why your deferred policy acquisition costs
balance is higher than your unearned premiums balance as of December
31, 2004. In your response please also tell us how you are able to
amortize the deferred acquisition costs in accordance with paragraph 29
of SFAS 60 given the fact the deferred acquisition costs are in excess
of related the unearned premiums.
RESPONSE:
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The deferred policy acquisition costs balance as of December 31,
2004 includes approximately $6.0 million of prepaid commission
expenses from the production of commercial policies by Hallmark
General Agency, Inc. for a third party insurance carrier, Clarendon
National Insurance Company. The premiums on these policies were
not retained or assumed by the Company and, therefore, the related
unearned premiums were not reflected in the Company's balance sheet
as of December 31, 2004. The commission revenue and expense related
to these policies are deferred and recognized pro rata over the
period covered by the underlying policies. We are currently
retaining 100% of these policies and, therefore, reflecting the
related unearned premiums on these policies in our balance sheet.
The remaining balance of $1.5 million in deferred policy acquisition
costs as of December 31, 2004 relates to expenses to produce non-
standard automobile policies that were retained by the Company.
This amount is 24.1% of the unearned premium balance of $6.2
million as of December 31, 2004, all of which relates to the
retained non-standard automobile premiums.
We have separated prepaid commissions on new business written and
not retained in 2006 from deferred policy acquisition costs. We
have classified this balance in other assets on our March 31, 2006
balance sheet. In future filings, we will report this balance as a
separate caption on our balance sheet.
* * * * *
In connection with our response to the Staff's comments, the Company
acknowledges that (i) the Company is responsible for the adequacy and
accuracy of the disclosure in the filing; (ii) Staff comments or changes
to disclosure in response to Staff comments do not foreclose the Commission
from taking any action with respect to the filing; and (iii) the Company may
not assert Staff comments as a defense in any proceeding initiated by the
Commission or any person under the federal securities laws of the United
States.
We trust that the foregoing responds sufficiently to the Staff's
comments. If you have any questions concerning the Company's responses,
please do not hesitate to contact our Chief Accounting Officer, Jeffrey R.
Passmore, or the undersigned at 817-348-1600.
Very truly yours,
/s/ Mark J. Morrison
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Mark J. Morrison
President, Chief Operating Officer and
Chief Financial Officer
cc: Mark E. Schwarz, Chief Executive Officer
Jeffrey R. Passmore, Chief Accounting Officer
Cecil R. Wise, General Counsel
Steven D. Davidson, Esq.
Anne M. Mascarenhas, CPA