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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, 2004
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.
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(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
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(Address of Principal Executive (Zip Code)
Offices)
Issuer's Telephone Number, Including Area Code: (817) 348-1600
Securities registered under Section 12(b) of the Exchange Act:
Title of Each Class Name of Each Exchange on Which Registered
--------------------------- -----------------------------------------
Common Stock $.03 par value American Stock Exchange Emerging Company
Marketplace
Securities registered under Section 12(g) of the Exchange Act: None
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 an accelerated filer (as
defined in Rule 12b-2 of the 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. $10,070,731
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date. Common stock, $.03
par value 36,497,291 shares outstanding as of March 17, 2005.
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.
PART I
Item 1. Business.
Introduction
Hallmark Financial Services, Inc. ("HFS") and its wholly owned
subsidiaries (collectively, the "Company") engage in the sale of property
and casualty insurance products. The Company's business involves marketing
and underwriting of non-standard personal automobile insurance in Texas, New
Mexico and Arizona; marketing commercial insurance in Texas, New Mexico,
Idaho, Oregon and Washington; affiliate and third party claims
administration; and other insurance related services.
Overview
The Company pursues its business activities through integrated insurance
groups handling non-standard personal automobile insurance (the "Personal
Lines Group") and commercial insurance (the "Commercial Lines Group"). The
members of the Personal Lines Group are a Texas domiciled property and
casualty insurance company, American Hallmark Insurance Company of Texas
("Hallmark"); an Arizona domiciled property and casualty insurance company,
Phoenix Indemnity Insurance Company ("Phoenix"); a managing general agency,
American Hallmark General Agency, Inc. ("AHGA"); a premium finance company,
Hallmark Finance Corporation ("HFC"); and an affiliate and third party
claims administrator, Hallmark Claims Services, Inc. ("HCS"). The members
of the Commercial Lines Group are a managing general agency, Hallmark
General Agency, Inc. ("HGA"), and a third party claims administrator,
Effective Claims Management, Inc. ("ECM").
Hallmark writes non-standard automobile liability and physical damage
coverage in Texas through a network of independent agents. Hallmark
currently provides insurance 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, Hallmark provided insurance through a reinsurance arrangement with an
unaffiliated company, State & County Mutual Fire Insurance Company ("State
& County"). Through either State & County or OACM, Hallmark provides
insurance for drivers who do not qualify for standard-rate insurance due to
driving record, claims history, residency status, or type of vehicle.
The Company acquired Phoenix effective as of January 1, 2003. Phoenix is
licensed in 24 states and writes non-standard automobile liability and
physical damage coverage in Arizona and New Mexico through a network of
independent agents. Phoenix underwrites its own policies and retains 100%
of the business it writes. Phoenix targets non-urban markets and underwrites
policies produced by approximately 150 independent agents.
AHGA holds a managing general agency appointment from OACM to manage the
sale and servicing of OACM policies. Effective October 1, 2004 Hallmark
reinsures 100% of the OACM policies produced by AHGA under a related
reinsurance agreement. Prior to October 1, 2004, Hallmark reinsured 45% of
the OACM policies produced by AHGA. AHGA markets OACM policies in Texas
through approximately 519 independent agents operating under their own
names.
HFC previously offered premium financing for policies sold by independent
agents managed by AHGA. The Company discontinued writing new and renewal
premium finance policies effective July 1, 2003.
HCS provides fee-based claims adjustment, salvage and subrogation
recovery, and litigation services to Hallmark and unaffiliated MGAs.
Effective December 1, 2002, the Company purchased HGA, ECM and a financial
administrative service company, Financial and Actuarial Resources, Inc.
("FAR"). Through approximately 150 independent agents operating under their
own names, HGA markets commercial insurance policies primarily in the
non-urban areas of Texas, New Mexico, Idaho, Oregon and Washington. HGA
currently produces policies on behalf of Clarendon National Insurance
Company ("CNIC"). HGA earns a commission based on a percentage of the earned
premium it produces for CNIC. The commission percentage is determined by
the underwriting results of the policies produced for CNIC.
ECM provides fee-based claims adjustment, salvage and subrogation
recovery, and litigation services on behalf of CNIC. The Company
discontinued the business of FAR during the third quarter of fiscal 2003.
Personal Lines Group Operations
Formed in 1987, HFS commenced its current operations in 1990 when it
acquired, through several transactions, most of the companies now referred
to as the Personal Lines Group. HFS manages Hallmark, Phoenix, AHGA, HFC
and HCS as an integrated Personal Lines Group that shares common management
and office space.
Hallmark offers both liability and physical damage (comprehensive and
collision) coverages. Hallmark's bodily injury liability coverage is limited
to $20,000 per person and $40,000 per accident, and property damage
liability coverage is limited to $15,000 per accident. Physical damage
coverage is limited to $40,000 and $30,000 for vehicles insured under six-
month and monthly policies, respectively.
Phoenix offers both liability and physical damage (comprehensive and
collision) coverages. Phoenix's bodily injury liability coverage is limited
to $15,000 per person and $30,000 per accident, and property damage
liability coverage is limited to $10,000 per accident, for the Arizona
direct bill program. Bodily injury liability coverage is limited to $25,000
per person and $50,000 per accident, and property damage liability coverage
is limited to $10,000 per accident, for the New Mexico direct bill program.
Physical damage coverage is limited to a vehicle value of $35,000 and
$30,000 for the Arizona and New Mexico direct bill programs, respectively.
Phoenix offers optional bodily injury liability coverage up to $100,000 per
person and $300,000 per accident, and property damage liability coverage up
to $50,000, for both programs.
All purchasers of Hallmark and Phoenix policies are individuals. No
single customer or group of related customers has accounted for more than 1%
of net premiums written during any of the last three years.
The Company currently writes monthly and six-month policies. The Company's
core net premium volume was composed of a policy mix of 51.8% monthly
and 48.2% six-month policies in 2004; 6.2% annual, 43.6% monthly and 50.2%
six-month policies in 2003; and 50.7% annual, 46.1% monthly and 3.2%
six-month policies in 2002. The Company discontinued writing annual premium
financed policies in July 2003 in order to focus on products which are more
competitive in the current marketplace. The Company's typical customer is
unable or unwilling to pay a half year's premium in advance. Accordingly,
the Company currently offers monthly policies and six-month policies, the
premiums for which are directly billed to the insured on a monthly basis.
HCS provides claims adjustment and related litigation services to both the
Company and unaffiliated MGAs. Fees are charged on a per-file basis, as a
percentage of earned premiums or, in certain instances, a combination of
both methods. When HCS receives notice of a loss, a claim file and an
estimated loss reserve are established. HCS's adjusters review, investigate
and initiate claim payments. The Company has an in-house litigation
department that closely manages its claims-related litigation. Management
believes that the Company achieves superior efficiency and cost
effectiveness by principally utilizing its trained employee-adjusters and
in-house litigation department.
The following table shows, for each of the years in the three year period
ended December 31, 2004 (i) the amount of the Personal Lines Group gross
premiums written, and (ii) the underwriting results, of the Personal Lines
Group, as measured by the net statutory loss and loss adjustment expense
("LAE") ratio, the statutory expense ratio, and the statutory combined ratio
for the calendar year. The loss and LAE ratio is the ratio of incurred
losses and LAE to net premiums earned, the statutory expense ratio is the
ratio of underwriting and operating expenses to net premiums written, and
the combined ratio is the sum of the loss and LAE ratio and the statutory
expense ratio.
2004 2003 2002
-------- -------- --------
Gross Premiums Written $ 33,389 $ 43,338 $ 51,643
======== ======== ========
Statutory Loss & LAE Ratio 60.4% 72.5% 76.8%
Statutory Expense Ratio 28.3% 28.6% 19.5%
-------- -------- --------
Statutory Combined Ratio 88.7% 101.1% 96.3%
======== ======== ========
Commercial Lines Group Operations
The Company's Commercial Lines Group consists of a regional managing
general agency and a third party claims administration company which were
acquired December 1, 2002. HGA markets commercial insurance policies
through an independent agency force primarily in the non-urban areas of
Texas, New Mexico, Idaho, Oregon, and Washington. ECM administers the
claims on insurance policies produced by HGA. These insurance policies
consist of small to medium sized commercial risks, which as a group have
relatively stable loss ratios. The Commercial Lines Group's 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. Selection criteria
include specific classes of businesses, occupancies, and operations with
lower hazard ratings, which present a relatively lower exposure to loss
and are charged a correspondingly lower premium. The lines of business
underwritten are primarily commercial auto, commercial multi-peril, business
owner's package policy, umbrella and other liability.
HGA currently markets these policies on behalf of CNIC. HGA earns a
commission based on a percentage of the earned premium it produces for CNIC.
The commission percentage is determined by the underwriting results of the
policies produced for CNIC. ECM receives a claim servicing fee based on a
percentage of the earned premium produced for CNIC, with a portion deferred
for casualty claims.
Underwriting and Other Ratios
An insurance company's underwriting performance is traditionally measured
by its statutory loss and 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.
During 2004, 2003 and 2002, the Company experienced statutory loss and LAE
ratios of 60.4%, 72.5% and 76.8%, respectively. During the same periods, it
experienced statutory expense ratios of 28.3%, 28.6% and 19.5%,
respectively, and statutory combined ratios of 88.7%, 101.1% and 96.3%,
respectively. 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 accounting principles
generally accepted in the United States of America ("GAAP").
The statutory expense ratio for 2003 increased over the 2002 statutory
expense ratio primarily as a result of the change in the reinsurance
structure effective April 1, 2003. Under the prior structure, Hallmark
assumed 100% of the Texas non-standard automobile business produced by AHGA
and underwritten by State & County and retroceded a portion to Dorinco
Reinsurance Company ("Dorinco"). Under this arrangement, the ceding
commission from Dorinco was treated as an offset to Hallmark's underwriting
expenses. Beginning April 1, 2003, Dorinco directly assumed its share of
the Texas non-standard automobile business produced by AHGA 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). Under this arrangement, ceding commissions
from Dorinco were treated as revenue to AHGA rather than an offset to the
underwriting expenses of Hallmark. Effective October 1, 2004, Hallmark
entered into a new quota share reinsurance agreement with OACM pursuant to
which Hallmark assumes and retains the reinsurance of 100% of the Texas non-
standard automobile policies produced by AHGA.
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 2004, 2003, and 2002, Hallmark's premium-to-surplus
percentages were 122%, 150% and 263%, respectively. Phoenix's premium-to-
surplus percentages were 135% and 215% for 2004 and 2003, respectively.
Reinsurance Arrangements
For policies originated prior to April 1, 2003, Hallmark assumed the
reinsurance of 100% of the Texas non-standard auto business produced by AHGA
and underwritten by State & County and retroceded 55% of the business
to Dorinco. Under this arrangement, Hallmark remained obligated to
policyholders in the event that Dorinco did not meet its obligations under
the retrocession agreement. From April 1, 2003 through September 30, 2004,
Hallmark assumed the reinsurance of 45% of the Texas non-standard automobile
policies produced by AHGA 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, Hallmark was obligated to
policyholders only for the portion of the risk assumed by Hallmark.
Effective October 1, 2004, Hallmark assumes and retains the reinsurance of
100% of the Texas non-standard automobile policies produced by AHGA and
underwritten by OACM. Phoenix underwrites its own policies and does not
cede any portion of the business to reinsurers.
Under Hallmark's prior insurance arrangements, the Company earned ceding
commissions based on Dorinco's loss ratio experience on the portion
of policies reinsured by Dorinco. The Company 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, 2004 and 2003, the accrued ceding commission payable to
Dorinco was $1.0 million and $1.2 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) 2004 2003 2002
-------- -------- --------
Gross premiums written $ 33,389 $ 43,338 $ 51,643
Ceded premiums written (322) (6,769) (29,611)
-------- -------- --------
Net premiums written $ 33,067 $ 36,569 $ 22,032
======== ======== ========
Gross premiums earned $ 33,058 $ 57,447 $ 52,486
Ceded premiums earned (613) (15,472) (32,273)
-------- -------- --------
Net premiums earned $ 32,445 $ 41,975 $ 20,213
======== ======== ========
Reinsurance recoveries $ 163 $ 11,071 $ 21,161
======== ======== ========
Marketing
The Company's customers for non-standard automobile insurance typically
fall into two groups. The first are drivers who do not meet the
underwriting qualifications for standard auto insurance due to driving
record, claims history, residency status, type of vehicle, or adverse credit
history. The second group is drivers who live in areas in which there is
limited availability of standard rate insurance.
AHGA acts as a managing general agency for OACM to manage 519 independent
agents in Texas writing non-standard automobile policies. Phoenix's
policies are generated through 150 independent agents in New Mexico and
Arizona. Field marketing representatives promote the Company's non-standard
automobile insurance programs to prospective independent agents and
service existing independent agents. The independent agents represent other
insurers and sell other insurance products in addition to the Company's
policies. During fiscal 2004, the top 10 independent agency groups
produced 21%, and no individual agency group produced more than 4%, of the
total premium volume of the Personal Lines Group.
HGA markets commercial insurance policies through a force of approximately
150 independent agencies primarily in the rural areas of Texas, New Mexico,
Idaho, Oregon, and Washington. HGA targets customers that are in low hazard
classifications in the standard commercial market (typically referred to as
"main street" accounts). The typical customer is a small to medium sized
business and will have a policy that covers property, general liability and
auto exposures. HGA has historically maintained excellent relationships with
its producing agents. During fiscal 2004, the top 10 independent agency
groups produced 32%, and no individual agency group produced more than 7%,
of the total premium volume of the Commercial Lines Group.
Competition
The property and casualty insurance market, the Company's 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 3,107 property and casualty insurance companies and 1,980 property and
casualty insurance groups operating in North America as of July 22, 2004.
Although the Company's Personal Lines Group competes with large national
insurers such as Allstate, State Farm and Progressive, as a participant in
the non-standard personal automobile marketplace, the Company's competition
is most directly associated with numerous regional companies and managing
general agencies. The Company's Commercial Lines Group 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. The Company's competitors include entities which have,
or are affiliated with entities which have, greater financial and other
resources than the Company.
Generally, the Company competes based upon price, customer service,
coverages offered, claims handling, financial stability, agent commission
and support, customer recognition and geographic coverage. The Company
competes with companies using independent agents, captive agent networks,
direct marketing channels, or a combination thereof.
The competitive environment in the personal non-standard automobile market
has historically been driven primarily by reinsurance capacity and terms,
but the current environment is increasingly impacted by newly capitalized or
recapitalized carriers or holding company groups, such as Direct General
Corporation, Bristol West Holdings, Infinity Property and Casualty, and
Affirmative Insurance Holdings. The current reinsurance market remains
disciplined and terms offered provide a barrier to entry for new programs
and/or limitations on an existing program manager's authority to reduce
premium rates without justification. Although the reinsurance market
remains a significant factor, the current competitive pressures are
perceived by management to be driven in large part by the newly capitalized
entities requiring premium growth either organically or through acquisitions
to meet expected revenue targets and return on equity. This pressure has
resulted in a general bias towards neutral overall rate adjustments with
targeted rate decreases.
The Commercial Lines Group experienced some increased rate pressure in
2004. However, because the Company focuses the distribution of its
commercial products to the smaller non-urban markets that are less price
sensitive, the Company was able to obtain an overall rate increase of
approximately 5% in 2004. Management believes this rate pressure will
continue through 2005 and is not projecting rate increases for its
commercial products for years beyond 2005.
Insurance Regulation
The operations of Hallmark, AHGA and HFC are regulated by the TDI. AZDOI
regulates the operations of Phoenix. Hallmark and Phoenix are required to
file quarterly and annual statements of their financial condition with TDI
and AZDOI, respectively, prepared in accordance with SAP. Hallmark's and
Phoenix's financial condition, including the adequacy of surplus, loss
reserves and investments, is subject to review by TDI and AZDOI,
respectively. Hallmark does not write its insurance directly, but assumes
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. AHGA is also subject to TDI licensing requirements.
HFC is subject to licensing, financial reporting and certain financial
requirements imposed by TDI and is also regulated by the Texas Office of
Consumer Credit Commissioner.
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.
HFS is also regulated as an insurance holding company by TDI and AZDOI.
Financial transactions between HFS or any of its affiliates and Hallmark or
Phoenix are subject to regulation. Applicable regulations require approval
of management and expense sharing contracts, inter-company loans and asset
transactions, investments in the Company's securities by Hallmark or Phoenix
and similar transactions. Further, dividends and distributions to HFS by
Hallmark or Phoenix are restricted.
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. Hallmark's 2004, 2003 and 2002 adjusted capital under
the RBC calculation exceeded the minimum requirement by 412%, 186% and 143%,
respectively. Phoenix's 2004 and 2003 adjusted capital under the RBC
calculation exceeded the minimum requirement by 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. Claims adjusters employed by ECM and HCS are also subject to the
licensing requirements of each state in which they conduct business. Each
claims adjuster employed by the Company either holds or has applied for the
required licenses.
Analysis of Hallmark's Losses and LAE
The Company's consolidated financial statements include an estimated
reserve for unpaid losses and LAE. The Company estimates its reserve for
unpaid losses and LAE by using case-basis evaluations and statistical
projections, which include inferences from both losses paid and losses
incurred. The Company also uses recent historical cost data, periodic
reviews of underwriting standards and claims management to modify the
statistical projections. The Company gives consideration to the impact of
inflation in determining its loss reserves, but does not discount reserve
balances.
The amount of reserves represents management's estimates 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. Management continually reviews the estimates and adjusts
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. The Company seeks to continually improve its loss
estimation process by refining its 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 2004, 2003 and 2002 reconciliation of the beginning and ending
reserve balances, on a gross-of-reinsurance basis, to the gross amounts
reported in the Company's balance sheet at December 31, 2004, 2003 and 2002
(in thousands):
2004 2003 2002
-------- -------- --------
Reserve for unpaid losses and LAE, net
of reinsurance recoverables, January 1 $ 21,197 $ 8,411 $ 7,919
Acquisition of Phoenix January 1, 2003 - 10,338 -
Provision for losses and LAE for claims
occurring in the current period 20,331 29,724 15,125
Increase (decrease) in reserve for
unpaid losses and LAE for claims
occurring in prior periods (1,194) 464 177
Payments for losses and LAE, net
of reinsurance:
Current period (10,417) (21,895) (9,119)
Prior periods (12,217) (5,845) (5,691)
-------- -------- --------
Reserve for unpaid losses and LAE
at December 31, net of reinsurance
recoverable $ 17,700 $ 21,197 $ 8,411
Reinsurance recoverable on unpaid
losses and LAE at December 31 1,948 7,259 9,256
-------- -------- --------
Reserve for unpaid losses and LAE
at December 31, gross of reinsurance $ 19,648 $ 28,456 $ 17,667
======== ======== ========
The $1.2 million favorable development in prior accident years recognized
in 2004 represents normal changes in actuarial estimates which had a $0.8
million favorable impact on reinsurance recoverable. 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 the Company's 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 2004
and 2003 are summarized below (in thousands):
December 31
2004 2003
------ ------
Reserve for unpaid losses and LAE on a SAP basis
(net of reinsurance recoverables on unpaid losses) $16,416 $21,132
Loss reserve discount from the Phoenix acquisition (80) (155)
Unamortized risk premium reserve discount from the
Phoenix acquisition 114 220
Estimated future unallocated LAE reserve for HCS * 1,250 -
------ ------
Reserve for unpaid losses and LAE on a GAAP basis
(net of reinsurance recoverables on unpaid losses) $17,700 $21,197
====== ======
* New agreement for 2004
Analysis of Loss and LAE Reserve Development
The following table shows the development of the Company's loss reserves,
net of reinsurance, for 1994 through 2004. 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 Hallmark. 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 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
---------------------- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- -----
A. Reserve for $4,297 $5,923 $5,096 $4,668 $4,580 $5,409 $7,451 $7,919 $8,411 $21,197 $17,700
Unpaid Losses & LAE,
Net of Reinsurance
Recoverables
B. Net Reserve Re-
estimated as of :
One year later 5,175 5,910 6,227 4,985 4,594 5,506 7,974 8,096 8,875 20,003
Two years later 5,076 6,086 6,162 4,954 4,464 5,277 7,863 8,620 8,881
Three years later 5,029 6,050 6,117 4,884 4,225 5,216 7,773 8,856
Four years later 5,034 6,024 6,070 4,757 4,179 5,095 7,901
Five years later 5,031 6,099 5,954 4,732 4,111 5,028
Six years later 5,038 6,044 5,928 4,687 4,101
Seven years later 5,030 6,038 5,900 4,695
Eight years later 5,030 6,029 5,902
Nine years later 5,030 6,035
Ten years later 5,030
C. Net Cumulative (733) (112) (806) (27) 479 381 (450) (937) (470) 1,194
Redundancy
(Deficiency)
D. Cumulative
Amount of Claims
Paid, Net of Reserve
Recoveries, through:
One year later 3,313 3,783 4,326 3,326 2,791 3,229 5,377 5,691 5,845 12,217
Two years later 4,442 5,447 5,528 4,287 3,476 4,436 7,070 7,905 7,663
Three years later 4,861 5,856 5,860 4,387 3,911 4,909 7,584 8,603
Four years later 4,975 5,933 5,699 4,571 4,002 5,014 7,810
Five years later 5,005 6,018 5,818 4,618 4,051 4,966
Six years later 5,030 6,018 5,853 4,643 4,061
Seven years later 5,030 6,029 5,860 4,664
Eight years later 5,030 6,029 5,871
Nine years later 5,030 6,035
Ten years later 5,030
-----------------------------------
2003 2004 Estimated Future Payout
---- ---- -----------------------------------
<1 Yr 1-3 Yrs 3-5 Yrs Total
-----------------------------------
Net Reserve - December 31 $ 21,197 $17,700 $11,482 $6,094 $124 $17,700
-----------------------------------
Reinsurance Recoverables 7,259 1,948
------ ------
Gross Reserve - December 31 $ 28,456 $19,648
======= ======
Net Re-estimated Reserve 20,003
Re-estimated Reinsurance Recoverable 8,037
------
Gross Re-estimated Reserve $ 28,040
=======
Gross Cumulative Redundancy $ 416
=======
Investment Policy
The Company's investment objective is to maximize current yield while
maintaining safety of capital together with sufficient liquidity for ongoing
insurance operations. The investment portfolio is composed of fixed income
and equity securities. The fixed income securities are made up of 74.1%
state and local securities, 17.2% corporate securities, 8.6% U.S. Government
or U.S. Government agency securities and 0.1% mortgage-backed securities.
The average maturity of the Company's fixed income portfolio as of December
31, 2004 is 5.9 years. The fair value of the Company's fixed income
securities as of December 31, 2004 was $30.8 million, of which $2.6 million
is classified as restricted investments. If market rates were to change 1%,
the fair value of the company's fixed income securities would change
approximately $1.5 million as of December 31, 2004.
In addition, as part of the Company's overall investment strategy, the
Company maintains an integrated cash management system utilizing on-line
banking services and daily overnight investment accounts to maximize
investment earnings on all available cash. During 2004, the Company's
investment income totaled approximately $1.4 million compared to
approximately $1.2 million for 2003.
Employees
On December 31, 2004, the Company employed 179 people on a full-time basis
as compared to 186 people at December 31, 2003. None of the Company's
employees are represented by labor unions. The Company considers its
employee relations to be excellent.
Item 2. Properties.
The Company's corporate headquarters and Commercial Lines Group 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, the Company negotiated its
lease for a period of 97 months to expire June 30, 2011. The rent is
currently $31,168 per month.
The Company's Personal Lines Group 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. The
Company renegotiated its 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.
The Company is engaged in various legal proceedings which are routine in
nature and incidental to the Company's business. None of these proceedings,
either individually or in the aggregate, are believed, in the opinion of
management, to have a material adverse effect on the consolidated financial
position of the Company or the results of operations.
Item 4. Submission of Matters to a Vote of Security Holders.
During the fourth quarter of 2004, the Company did not submit any matter
to a vote of its security holders.
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters.
Market for Common Stock
The Company's common stock has traded on the American Stock Exchange's
Emerging Company Marketplace under the symbol "HAF.EC" since January 6,
1994. The following table shows the high and low sales prices of the
Company's common stock on the AMEX Emerging Company Marketplace for
each quarter since January 1, 2003.
Period High Sale Low Sale
2003
----
First Quarter $ 0.75 $ 0.50
Second Quarter 0.95 0.65
Third Quarter 1.15 0.31
Fourth Quarter 0.80 0.50
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 (through $ 1.60 $ 1.11
March 18, 2005)
As of February 28, 2005 there were approximately 156 shareholders of
record of the Company's common stock.
Dividends
The Company has never paid dividends on its Common Stock. The Board of
Directors intends to continue this policy for the foreseeable future in
order to retain earnings for development of the Company's business.
Equity Compensation Plan Information
The following table provides information as of December 31, 2004,
concerning common stock of the Company that may subsequently be issued upon
the exercise of incentive stock options and nonqualified stock options
granted to directors, officers and key employees of the Company:
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 1,208,500 $0.65 - 0 -
Equity compensation plans
not approved by security
holders1 150,000 $0.38 - 0 -
-----------------------------------------------
Total 1,358,500 $0.62 - 0 -
===============================================
1) Represents nonqualified options granted to independent directors in
lieu of fees for board service in 1999.
Item 6. Selected Financial Data.
(In thousands, except per share amounts)
2004 2003 1,2 2002 1,3 2001 2000
-------- -------- -------- -------- --------
Gross premiums written $ 33,389 $ 43,338 $ 51,643 $ 49,614 $ 50,469
Ceded premiums written (322) (6,769) (29,611) (33,822) (31,396)
----------------------------------------------------
Net premiums written 33,067 36,569 22,032 15,792 19,073
Change in unearned premiums (622) 5,406 (1,819) 584 (1,678)
----------------------------------------------------
Net premiums earned 32,445 41,975 20,213 16,376 17,395
Investment income, net of expenses 1,386 1,198 773 1,043 1,264
Realized losses (27) (88) (5) - -
Finance charges 2,183 3,544 2,503 3,095 2,926
Commission and fees 21,100 17,544 1,108 - -
Processing and service fees 6,003 4,900 921 1,120 1,952
Other income 31 486 284 368 348
----------------------------------------------------
Total revenues 63,121 69,559 25,797 22,002 23,885
Loss and loss adjustment expenses 19,137 30,188 15,302 15,878 14,558
Other operating costs and expenses 35,290 37,386 9,474 6,620 7,858
Interest expense 64 1,271 983 1,021 1,138
Amortization of intangible assets 28 28 2 157 157
Litigation costs - - - - 435
----------------------------------------------------
Total expenses 54,519 68,873 25,761 23,676 24,146
Income (loss) before income tax,
cumulative effect of change in
accounting principle and
extraordinary gain 8,602 686 36 (1,674) (261)
Income tax expense (benefit) 2,753 25 13 (544) (28)
----------------------------------------------------
Income (loss) before cumulative
effect of change in accounting
principle and extraordinary gain 5,849 661 23 (1,130) (233)
Cumulative effect of change in
accounting principle, net of tax - - (1,694) - -
Extraordinary gain - 8,084 - - -
----------------------------------------------------
Net income (loss) $ 5,849 $ 8,745 $ (1,671) $ (1,130) $ (233)
=====================================================
Basic earnings (loss) per share:
--------------------------------
Income before cumulative effect
of change in accounting principle
and extraordinary gain $0.16 $0.03 $0.00 ($0.10) ($0.02)
Cumulative effect of change
in accounting principle 0.00 0.00 (0.15) 0.00 0.00
Extraordinary gain 0.00 0.44 0.00 0.00 0.00
----------------------------------------------------
Net income (loss) $0.16 $0.47 ($0.15) ($0.10) ($0.02)
=====================================================
Diluted earnings (loss) per share:
---------------------------------
Income before cumulative effect
of change in accounting principle
and extraordinary gain $0.16 $0.03 $0.00 ($0.10) ($0.02)
Cumulative effect of change
in accounting principle 0.00 0.00 (0.15) 0.00 0.00
Extraordinary gain 0.00 0.43 0.00 0.00 0.00
----------------------------------------------------
Net income (loss) $0.16 $0.46 ($0.15) ($0.10) ($0.02)
=====================================================
2004 2003 1,2 2002 1,3 2001 2000
-------- -------- -------- -------- --------
Balance Sheet Items:
--------------------
Total investments $ 32,121 $ 29,855 $ 16,728 $ 16,223 $ 13,577
Total assets $ 82,511 $ 83,853 $ 83,761 $ 73,605 $ 75,553
Unpaid loss and loss
adjustment expenses $ 19,648 $ 28,456 $ 17,667 $ 20,089 $ 22,298
Unearned premiums $ 6,192 $ 5,862 $ 15,957 $ 16,793 $ 16,711
Total liabilities $ 49,855 $ 56,456 $ 75,226 $ 63,237 $ 64,065
Total stockholders' equity $ 32,656 $ 27,397 $ 8,535 $ 10,368 $ 11,488
Book value per share $0.90 $0.75 $0.77 $0.94 $1.04
=====================================================
Notes:
1) The acquisitions of the Commercial Lines Group and Phoenix were
financed through an $8.6 million loan from a related party that was
repaid from $10 million of proceeds from the Company's rights offering
in 2003.
2) In January 2003, the Company acquired Phoenix in satisfaction of $7.0
million of a $14.85 million balance on a note receivable due from
Millers American Group, Inc. This resulted in the Company recognizing
a $8.1 million extraordinary gain in 2003.
3) In 2002, the Company adopted Statement of Financial Accounting
Standards ("SFAS"), No. 142 "Goodwill and Other Intangible Assets"
which prohibits amortization of goodwill and requires annual testing
of goodwill for impairment. In the year of adoption, the Company
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, the Company acquired the
Commercial Lines Group from Millers American Group, Inc.
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations.
The following discussion of the Company's financial condition and the
results of its operations should be read in conjunction with the
consolidated financial statements and related notes included in this report.
Management Overview
The Company's business involves marketing and underwriting of non-standard
personal automobile insurance in Texas, New Mexico and Arizona; marketing
commercial insurance in Texas, New Mexico, Idaho, Oregon and Washington;
affiliate and third party claims administration; and other insurance related
services. The Company pursues its business activities through subsidiaries
organized into a Personal Lines Group, which handles non-standard personal
automobile insurance, and a Commercial Lines Group, which handles commercial
insurance.
For the year ended December 31, 2004, the Company reported income before
extraordinary gain of $5.8 million, representing a 785% increase over the
$0.7 million reported for the prior year. The Company reported net income
of $5.8 million for the year ended December 31, 2004, compared with net
income of $8.7 million for 2003, which included an $8.1 million
extraordinary gain related to the acquisition of a new Personal Lines Group
subsidiary.
On a diluted per share basis, net income was $0.16 for the year ended
December 31, 2004, compared with net income of $0.47 per diluted share in
2003. The decrease in net income per diluted share was primarily
attributable to the combined impact of the $8.1 million extraordinary gain
in 2003 and an increase in the weighted average shares outstanding to 36.7
million diluted shares during 2004, compared to 18.8 million diluted shares
during 2003, primarily as a result of a successful shareholder rights
offering completed in the third quarter of 2003.
The increased operating earnings in 2004 reflect benefits achieved from
the integration of recent acquisitions, ongoing initiatives to improve
underwriting performance and sustained favorable market conditions. Both
the Personal Lines Group and the Commercial Lines Group contributed to the
enhanced operating results for 2004. The improvement in the Personal Lines
Group operating earnings in 2004 was primarily driven by better underwriting
results. The improvement in the Commercial Lines Group operating earnings
in 2004 was driven largely by increased commission revenue attributable to
the combination of increased premiums written and favorable underwriting
performance.
Critical Accounting Estimates and Judgments
The Company's significant accounting policies requiring management
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,
the Company believes the estimates and judgments associated with the
reported consolidated financial statement amounts are appropriate in the
circumstances. For additional discussion of the Company's accounting
policies, see Note 1 to the consolidated financial statements included in
this report.
Investments. The Company completes a detailed analysis each quarter to
assess whether the 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 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 the Company's 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. The Company
routinely evaluates the realizability of deferred policy acquisition costs.
At December 31, 2004 and 2003, there was no premium deficiency related to
deferred policy acquisition costs.
Goodwill. The Company's consolidated balance sheet as of December 31, 2004
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,
"Goodwill and Other Intangible Assets", which the Company adopted as of
January 1, 2002, goodwill is tested for impairment annually. The Company
completed its annual test for impairment during the fourth quarter of 2004
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 the
Company's reporting units. As required by SFAS 142, the Company compares
the estimated fair value of each reporting unit with its carrying amount,
including goodwill. Under Statement No. 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. The Company files 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 the Company's deferred
tax asset to the extent that management does 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, 2004
and 2003. 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 Phoenix acquisition.
Reserves for Unpaid Losses and Loss Adjustment Expenses. Reserves for
unpaid losses and LAE are established by the Company for claims which have
already been incurred by the policyholder but which have not been paid by
the Company. Losses and LAE represent the estimated ultimate net cost of
all reported and unreported losses incurred through December 31, 2004 and
2003. 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 Hallmark's Losses and LAE" and "-Analysis of Loss and
LAE Reserve."
Although considerable variability is inherent in such estimates,
management believes 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, 2004 unpaid losses and
LAE would produce a $196 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 the Company's actuaries as
of December 31, 2004 was $13.0 million to $22.3 million. Management's best
estimate of unpaid losses and LAE as of December 31, 2004 is $19.6 million.
In setting this estimate of unpaid losses and LAE, management has 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, management has established a best estimate
of unpaid losses and LAE, which is approximately $1.9 million higher than
the midpoint of the actuarial range. The actuarial range is determined
independently of management's best estimate and is only used to check the
reasonableness of that estimate. It would be expected that management's
best estimate would move within the actuarial range from year to year due to
changes in the Company's operations and changes within the marketplace.
The Company's reserve requirements are also interrelated with product
pricing and profitability. The Company must price its products at a level
sufficient to fund its policyholder benefits and still remain profitable.
Because the Company's claim expenses represent the single largest category
of its expenses, inaccuracies in the assumptions used to estimate the amount
of such benefits can result in the Company failing to price its products
appropriately and to generate sufficient premiums to fund its operations.
Ceding Commissions of the Personal Lines Group. Under Hallmark's
reinsurance arrangements prior to October 1, 2004, the Company earned 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. The Company 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 12/31/04 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
Lines Group. Profit sharing commission of the Commercial Lines Group
is calculated and recognized when the loss ratio, as determined by a
qualified actuary, deviates from contractual thresholds. 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 -
6/30/02 6/30/03 6/30/04 6/30/05
----------------------------------------------
Provisional loss ratio 60.0% 59.0% 59.0% 64.2%
Ultimate loss ratio booked ----------------------------------------------
to at 12/31/04 57.5% 58.5% 59.0% 62.2%
----------------------------------------------
Effect of actual 0.5% ----------------------------------------------
above provisional ($199,402) ($305,122) ($298,457) ($44,755)
Effect of actual 0.5% ----------------------------------------------
below provisional $139,581 $201,381 $196,982 $44,755
----------------------------------------------
Liquidity and Capital Resources
The Company's sources of funds are principally derived from insurance
related operations. The major sources of funds from operations include
premiums collected (net of policy cancellations and premiums ceded), ceding
commissions, and processing and service fees. Other sources of funds are
from financing and investment activities.
On a consolidated basis, the Company's cash and investments increased
approximately 11.5% as of December 31, 2004 as compared to December 31,
2003. This was primarily a result of improved underwriting results and
increased commercial premium volume in 2004. The Company's consolidated
cash, cash equivalents and investments at December 31, 2004 and 2003 were
$45.0 million and $40.4 million, respectively. These amounts exclude
restricted cash and investments of $6.5 million and $5.4 million,
respectively, which primarily secures the credit exposure of OACM and State
& County on their quota share reinsurance treaties with Hallmark.
The Company's operating activities provided $7.3 million in net cash
during 2004 as compared to $0.7 million in 2003. The Company collected $3.5
million more in ceding commissions in 2004 as a result of increased
commission premium volume, paid $2.0 million less in loss and LAE, net of
reinsurance, as a result of improved underwriting performance, and paid $1.4
million less in interest as a result of repaying a related party promissory
note in 2003. These cash flow improvements were partially offset by a $0.4
million reduction in other income collected due to the sale of the Company's
retail agencies in the first quarter of 2003.
Cash used in investing activities during 2004 was $4.0 million compared to
cash provided by investing activities of $11.7 million in 2003. Premium
finance notes repaid over notes originated decreased by $11.5 million in
2004 over 2003 due to the discontinuation of the premium finance program in
2003. During 2003, the Company received $6.9 million in cash from the
acquisition of Phoenix. During 2004, the Company purchased $0.2 million
more in investment securities than it redeemed whereas in 2003 the Company
purchased $2.0 million more in investment securities that it redeemed. The
Company also transferred $0.8 million less from cash and investments to
restricted trust accounts in 2004 than in 2003. These restricted trust
accounts are established to secure the credit exposure of OACM and State &
County from their quota share reinsurance treaties with Hallmark.
Cash used in financing activities decreased by $9.4 million during 2004 as
compared to 2003 primarily due to the discontinuation of the Company's
premium finance program in 2003. The Company had net repayments to the
premium finance lender of $10.9 million in 2003 which paid off all
outstanding advances. Also contributing to the decrease in cash used in
financing activities in 2004 was the repayment of an $8.6 million promissory
note to a related party in 2003 from $10.0 million in proceeds from a rights
offering the Company completed in the third quarter of 2003.
HFS is dependent on dividend payments and management fees from its
insurance company operations and free cash flow of its non-insurance
companies to meet operating expenses and debt obligations. As of December
31, 2004, cash and invested assets of HFS were $0.6 million. Cash and
invested assets of non-insurance subsidiaries were $8.1 million as of
December 31, 2004. Property and casualty insurance companies domiciled in
the State of Texas are limited in the payment of dividends to their
shareholders in any twelve-month period, without the prior written consent
of the Commissioner of Insurance, 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 2004, Hallmark's ordinary dividend capacity was $2.2 million. During
2004, Hallmark paid $0.2 million in dividends to HFS that were declared in
2003. Based on surplus at December 31, 2004, Hallmark could pay up to $1.5
million in dividends to HFS during 2005 without TDI approval. Phoenix,
domiciled in Arizona, is limited in the payment of dividends to the lesser
of 10% of prior year policyholder surplus or prior year's net investment
income, without prior written approval from the AZDOI. During 2004,
Phoenix's ordinary dividend capacity was $0.6 million. In order to
strengthen policyholder surplus, Phoenix did not declare any dividends in
2004. The maximum dividend that Phoenix can pay HFS in 2005 without prior
approval of the AZDOI is $0.8 million.
TDI regulates financial transactions between Hallmark, HFS and affiliated
companies. Applicable regulations require TDI's approval of management and
expense sharing contracts and similar transactions. Although TDI has
approved Hallmark's payment of management fees to HFS and commissions to
AHGA, since the second half of 2000 management has elected not to pay all
the approved commissions or management fees. AHGA paid management fees of
$0.6 million to HFS during 2004 and 2003.
The AZDOI regulates financial transactions between Phoenix and affiliated
companies. Applicable regulations require AZDOI's approval of management
and expense sharing contracts and similar transactions. Phoenix paid $1.2
million in management fees to AHGA during 2004 and paid no management fees
in 2003.
Statutory capital and surplus is calculated as statutory assets less
statutory liabilities. TDI requires that Hallmark maintain minimum
statutory capital and surplus of $2.0 million and AZDOI requires that
Phoenix maintain minimum statutory capital and surplus of $1.5 million. As
of December 31, 2004, Hallmark and Phoenix exceeded the minimum required
statutory capital and surplus by 477% and 836%, respectively. At December
31, 2004, Hallmark reported statutory capital and surplus of $11.5 million,
which reflects an increase of $1.5 million from the $10.0 million reported
at December 31, 2003. At December 31, 2004, Phoenix reported statutory
capital and surplus of $14.0 million, which is $3.9 million more than the
$10.1 million reported at December 31, 2003. Hallmark reported statutory
net income of $1.5 million during 2004 compared to $2.2 million in 2003.
Phoenix reported statutory net income of $3.4 million during 2004 compared
to a statutory net loss of $0.3 million in 2003. At December 31, 2004,
Hallmark's premium-to-surplus percentage was 122% as compared to 150% for
the year ended December 31, 2003. Phoenix's premium-to-surplus percentage
was 135% for the year ended December 31, 2004 as compared to 215% for the
year ended December 31, 2003.
Information regarding the Company's contractual obligations under
operating leases as of December 31, 2004 is incorporated by reference to
Note 13 of the consolidated financial statements included in this report.
Based on 2005 budgeted and year-to-date cash flow information, the Company
believes that it has sufficient liquidity to meet its projected insurance
obligations, operational expenses and capital expenditure requirements for
the foreseeable future. However, management is pursuing opportunities for
future growth, and additional capital may be required to fund further
expansion of the Company.
Results of Operations
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 the Personal Lines Group partially offset by a $3.7 million increase in
total revenues from the Commercial Lines Group. However, income before tax
and extraordinary gain for 2004 increased $7.9 million as compared to 2003.
The improvement in operating earnings in 2004 reflects better underwriting
results for the Personal Lines Group, additional commission revenue in the
Commercial Lines Group 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 Lines Group $ 39,555 $ 49,665
Commercial Lines Group 23,563 19,891
Corporate 3 3
-------- --------
Consolidated $ 63,121 $ 69,559
======== ========
Pre-tax Income
--------------
Personal Lines Group $ 8,109 $ 1,950
Commercial Lines Group 3,028 1,311
Corporate (2,535) (2,575)
-------- --------
Consolidated $ 8,602 $ 686
======== ========
Personal Lines Group
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 the Personal Lines Group decreased $10.1
million, or 20.4%, to $39.6 million in 2004 compared to $49.7 million in
2003.
Although revenue for the Personal Lines Group declined, its 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 Phoenix 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 Lines Group
Total revenue for the Commercial Lines Group 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 the Commercial
Lines Group for 2004 was $72.5 million compared to $62.9 million for 2003.
The Company does not bear the primary underwriting risk for this business
and, therefore, the resulting premiums and claims are not reflected in the
Company's reported results.
Pre-tax income for the Commercial Lines Group 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. The Company 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.
Fiscal 2003 versus Fiscal 2002
Income before tax, cumulative effect of change in accounting principle and
extraordinary gain was $0.7 million for 2003, compared to $36,000 in 2002.
The improvement in operating earnings in 2003 reflected better underwriting
results for Hallmark and the acquisition of the Commercial Lines Group in
December 2002, partially offset by the acquisition of Phoenix. Net income
for 2003 included $8.1 million of extraordinary gain resulting from the
acquisition of Phoenix. In consideration for Phoenix, the Company cancelled
$7.0 million of a $14.85 million note receivable from Millers American
Group, Inc. ("Millers"). The Company had valued the note receivable on its
balance sheet at its cost of $6.5 million. As of December 31, 2003, the
Company fully reserved for the remaining balance of the note receivable.
The gain was calculated as the difference between the fair value of the net
assets of Phoenix of $14.6 million and the $6.5 million cost of the note
receivable from Millers.
The following is additional business segment information for the twelve
months ended December 31, 2003 and 2002 (in thousands):
2003 2002
Revenues -------- --------
--------
Personal Lines Group $ 49,665 $ 23,999
Commercial Lines Group 19,891 1,561
Corporate 3 237
-------- --------
Consolidated $ 69,559 $ 25,797
======== ========
Pre-tax Income
--------------
Personal Lines Group $ 1,950 $ 1,595
Commercial Lines Group 1,311 3
Corporate (2,575) (1,562)
-------- --------
Consolidated $ 686 $ 36
======== ========
Personal Lines Group
Gross premiums written (prior to reinsurance) for 2003 decreased 16.1% and
net premiums written (after reinsurance) increased 66.0% in relation to
2002. The decrease in gross premiums written is primarily due to the change
in the reinsurance structure with Dorinco and the county mutual fronting
companies (State & County and OACM). Effective April 1, 2003, the Company
assumed a 45% share of the non-standard auto business produced by AHGA and
underwritten by either State & County or OACM instead of the 100% share it
assumed prior to that date. Also, effective April 1, 2003, Dorinco assumed
its 55% share of this business directly, where prior to this date the
Company retroceded 55% of the business to Dorinco. The decrease in gross
premiums written was also impacted by Hallmark's cancellation of
unprofitable agents, shift in marketing focus from annual term premium
financed policies to six month term direct bill policies and increases in
policy rates. These decreases were partially offset by the acquisition of
Phoenix in 2003, which contributed $22.4 million in gross premiums written.
The increase in net premiums written is due primarily to the acquisition of
Phoenix in 2003, which contributed $21.6 million in net premiums written.
Revenue for the Personal Lines Group increased 106.9% in 2003 to $49.7
million from $24.0 million in 2002. The increase is due mostly to the
acquisition of Phoenix, which contributed $24.3 million in revenue in 2003
and AHGA commission revenue of $2.5 million from Dorinco on policies
effective after March 31, 2003 due to the revised reinsurance structure.
Pre-tax income for the Personal Lines Group increased $0.4 million in 2003
to $2.0 million as compared to $1.6 million in 2002. Improved pricing in
2003 and Hallmark's termination of unprofitable agents in the first quarter
of 2003 helped improve underwriting results (excluding Phoenix) as evidenced
by a loss ratio of 66.3% in 2003 as compared to 75.9% in 2002. Partially
offsetting this improvement was increased salary and related expenses
(excluding Phoenix) of $0.3 million, the discontinuation of the premium
finance program which reduced finance charge revenue by $0.5 million,
partially offset by reduced interest expense of $0.3 million, and the
acquisition of Phoenix in 2003 which reported a $0.4 million pre-tax loss.
The results for Phoenix included a loss accrual of $2.1 million, net of
applicable reinsurance, for the settlement of a bad faith claim.
Commercial Lines Group
Revenue for the Commercial Lines Group of $19.9 million in 2003 was mostly
comprised of $15.0 million of commissions earned on policies serviced by HGA
for CNIC. Revenue also included $4.6 million of processing and service fees
earned by ECM for claims processing for CNIC and by FAR for accounting
administration for an unaffiliated third party, the contract for which ended
in April 2003. The Commercial Lines Group reported revenue of $1.6 million
for the one month ended December 31, 2002, which was mostly comprised of
$1.1 million of commissions and $0.4 million of processing and service fees.
These were new sources of revenue for the Company as a result of the
acquisition of the Commercial Lines Group in December 2002.
Pre-tax income for the Commercial Lines Group of $1.3 million in 2003 was
comprised of $19.9 million in revenue as discussed above and $18.6 million
in other operating costs and expenses. These costs primarily represented
expenses associated with the production and servicing of insurance policies
for CNIC, the largest component of which was independent retail agent
commissions.
Corporate
Corporate pre-tax loss of $2.6 million in 2003 increased $1.0 million as
compared to $1.6 million for 2002. Other operating costs and expenses
increased $0.5 million mostly as a result of legal and consulting fees
associated with acquisitions and other corporate matters. Additionally, the
shift in management structure from 2002 to 2003 increased salary related
expenses and other overhead during 2003. Interest expense was increased by
$0.6 million in 2003 due to interest on a related party note payable.
Proceeds from this note were used to acquire the Commercial Lines Group and
Phoenix. The Company repaid this note in September 2003 from the proceeds
of a rights offering of its stock in the third quarter of 2003. Investment
income decreased by $0.2 million due to a note receivable secured by the
stock of Phoenix acquired from a financial institution in the fourth quarter
of 2002 being satisfied by the acquisition of Phoenix in 2003. Partially
offsetting these increased expenses was $0.3 million of amortization of a
$0.5 million risk premium reserve established in 2003 for Phoenix unpaid
loss and LAE. The remainder of this reserve will be amortized into income
over the next five years.
Effects of Inflation
Management does not believe that inflation has a material effect on the
Company's 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, the
Company is exposed to the upward trend in the cost of judicial awards for
damages. The Company attempts 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.
Management believes that interest rate risk, credit risk and equity price
risk are the types of market risk to which the Company is principally
exposed.
Interest Rate Risk
The Company's 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, 2004 was $30.8 million. The effective duration of the
portfolio as of December 31, 2004 was 4.9 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 4.9%, or $1.5 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 4.9%, or $1.5 million, increase in the market value
of the fixed income investment portfolio.
Credit Risk
An additional exposure to the Company's fixed income securities portfolio
is credit risk. Management attempts to manage the credit risk by investing
only in investment-grade securities and limiting the Company's exposure to
a single issuer. As of December 31, 2004, the Company's fixed income
investments were invested in the following: municipal securities - 74.1%;
corporate securities - 17.2%; U.S. Treasury securities - 8.6%; and mortgage-
backed securities - 0.1%. As of December 31, 2004, all of the Company's
fixed income securities were rated investment grade by nationally recognized
statistical rating organizations.
The Company is also subject to credit risk with respect to reinsurers to
whom it has ceded underwriting risk. Although a reinsurer is liable for
losses to the extent of the coverage it assumes, the Company remains
obligated to its 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, the Company has used financially
strong reinsurers with an A.M. Best rating of "A-" or better. The Company
discontinued ceding underwriting risk to reinsurers effective April 1, 2003.
Equity Price Risk
Investments in equity securities which are subject to equity price risk
make up 10.4% of the Company's 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 the Company's equity securities as of December 31, 2004
was $3.6 million. The fair value of the Company's equity securities would
increase or decrease by $1.1 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 3.3%. 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
its subsidiaries are filed as part of this report.
Description Page Number
----------- -----------
Unaudited Selected Quarterly Information 26
Report of Independent Registered Public Accounting Firm F-2
Report of Independent Registered Public Accounting Firm F-3
Consolidated Balance Sheets at December 31, 2004 and 2003 F-4
Consolidated Statements of Operations for the Years Ended F-5
December 31, 2004, 2003 and 2002
Consolidated Statements of Stockholders' Equity and F-6
Comprehensive Income for the Years Ended
December 31, 2004, 2003 and 2002
Consolidated Statements of Cash Flows for the F-8
Years Ended December 31, 2004, 2003 and 2002
Notes to Consolidated Financial Statements F-9
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.
On October 10, 2003, the Company dismissed PricewaterhouseCoopers LLP
("PWC") as its independent accountants and retained KPMG LLP as its new
independent accountants to audit its financial statements beginning the
fiscal year ended December 31, 2003. The information required by Item 304
of Regulation S-K is incorporated by reference from the Company's Current
Report on Form 8-K filed October 17, 2003.
Item 9A. Controls and Procedures.
The Chief Executive Officer and the Chief Financial Officer of the Company
have evaluated the Company's 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 the Company's internal controls over financial
reporting that have materially affected, or are reasonably likely to
materially affect, the Company's internal control over financial reporting.
PART III
Item 10. Directors and Executive Officers of the Registrant.
The information required by Part III, 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 Part III, 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 Part III, 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 Part III, 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 Part III, 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 Part II, Item 8 of this
report:
Report of Independent Registered Public Accounting Firm
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets at December 31, 2004 and 2003
Consolidated Statements of Operations for the Years Ended
December 31, 2004, 2003 and 2002
Consolidated Statements of Shareholders' Equity and
Comprehensive Income for the Years Ended
December 31, 2004, 2003 and 2002
Consolidated Statements of Cash Flows for the Years Ended
December 31, 2004, 2003 and 2002
Notes to Consolidated Financial Statements
(a)(2) Financial Statement Schedules
Unaudited Selected Quarterly Information Page 26
Schedule II - Condensed Financial Information of
Registrant - Hallmark Financial Services, Inc.
(Parent Company Only) Page 26
Schedule III - Supplemental Insurance Information Page 29
Schedule IV - Reinsurance Page 30
Schedule VI - Supplemental Information Concerning
Property- Casualty Insurance Operations Page 31
(a)(3) The exhibits listed in the Exhibit Index appearing at page 34
of this report are filed with or incorporated by reference in
this report.
(b) Reports on Form 8-K
Form 8-K filed October 5, 2004. Item 1.01 Entry Into a Material
Definitive Agreement. Report announced a new quota share
reinsurance agreement between American Hallmark Insurance Company
of Texas and Old American County Mutual Fire Insurance Company
effective October 1, 2004.
Form 8-K filed November 12, 2004. Item 2.02 Results of Operations
and Financial Condition and Item 9.01 Financial Statements and
Exhibits. Report contained a press release dated November 11,
2004 announcing Hallmark's earnings for the third quarter ending
September 30, 2004.
Form 8-K filed December 21, 2004. Item 1.01 Entry Into a Material
Definitive Agreement. Report announced a new general agency
agreement between Hallmark General Agency, Inc. and Clarendon
National Insurance Company executed December 20, 2004 and
retroactive to July 1, 2004.
Unaudited Selected Quarterly Information
2004 2003
--------------------------------- ---------------------------------
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
Revenue $15,773 $15,650 $15,646 $16,052 $18,720 $18,045 $16,366 $16,428
Income (loss) before
extraordinary gain (loss) 1,412 1,493 1,543 1,401 403 435 220 (397)
Extraordinary gain (loss) - - - - 8,152 (36) - (32)
--------------------------------- ---------------------------------
Net income (loss) $ 1,412 $ 1,493 $ 1,543 $ 1,401 $ 8,555 $ 399 $ 220 $ (429)
================================= =================================
Basic earnings per share1:
Income (loss) before
extraordinary gain (loss) $0.04 $0.04 $0.04 $0.04 $0.04 $0.04 $0.01 ($0.01)
Extraordinary gain (loss) - - - - $0.73 - - -
--------------------------------- ---------------------------------
Net income (loss) $0.04 $0.04 $0.04 $0.04 $0.77 $0.04 $0.01 ($0.01)
================================= =================================
Diluted earnings per share1:
Income (loss) before
extraordinary gain (loss) $0.04 $0.04 $0.04 $0.04 $0.04 $0.04 $0.01 ($0.01)
Extraordinary gain (loss) - - - - $0.71 ($0.01) - -
--------------------------------- ---------------------------------
Net income (loss) $0.04 $0.04 $0.04 $0.04 $0.75 $0.03 $0.01 ($0.01)
================================= =================================
1. The Company issued 25.0 million shares of its common stock during the third quarter
of 2003 in connection with its shareholder rights offering.
Schedule II - Condensed Financial Information of Registrant
(Parent Company Only)
HALLMARK FINANCIAL SERVICES, INC.
BALANCE SHEET
December 31, 2004
(In thousands)
ASSETS
------
Equity securities, available-for-sale, at fair value $ 50
Cash and cash equivalents 578
Investment in subsidiaries 36,045
Deferred federal income taxes 983
Other assets 112
---------
$ 37,768
=========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Liabilities:
Unpaid losses and loss adjustment expenses $ 114
Current federal income tax payable 1,033
Accounts payable and other accrued expenses 3,965
---------
5,112
---------
Commitments and Contingencies
Stockholders' equity:
Common stock, $.03 par value, authorized 100,000,000 shares;
issued 36,856,610 shares in 2004 1,106
Capital in excess of par value 19,647
Retained earnings 13,103
Accumulated other comprehensive income (759)
Treasury stock, 379,319 shares in 2004, at cost (441)
---------
Total stockholders' equity 32,656
---------
$ 37,768
=========
Schedule II (Continued) - Condensed Financial Information of Registrant
(Parent Company Only)
HALLMARK FINANCIAL SERVICES, INC.
STATEMENT OF OPERATIONS
for the year ended December 31, 2004
(In thousands)
Investment income, net of expenses $ 3
Undistributed share of net earnings in subsidiaries 6,315
Management fee income 1,850
---------
Total revenues 8,168
Losses and loss adjustment expenses (106)
Other operating costs and expenses 2,593
Interest expense 51
---------
Total expenses 2,538
Income before income tax 5,630
Income tax benefit (219)
---------
Net income (loss) $ 5,849
=========
Schedule II (Continued) - Condensed Financial Information of Registrant
(Parent Company Only)
HALLMARK FINANCIAL SERVICES, INC.
STATEMENT OF CASH FLOW
For the year ended December 31, 2004
(In thousands)
Cash flows from operating activities:
Net income $ 5,849
Adjustments to reconcile net income to cash used in
operating activities:
Depreciation and amortization expense 39
Deferred income tax benefit (914)
Change in unpaid losses and loss adjustment expenses (106)
Undistributed share of net (earnings) loss of (6,315)
Change in current federal income tax payable/recoverable 1,169
Change in all other liabilities (72)
Change in all other assets (25)
---------
Net cash used in operating activities (375)
Cash flows from investing activities:
Purchases of property and equipment (14)
---------
Net cash used in investing activities (14)
Cash flows from financing activities:
Proceeds from exercise of employee stock options 48
Repayment of borrowings (991)
---------
Net cash used in financing activities (943)
Decrease in cash and cash equivalents (1,332)
Cash and cash equivalents at beginning of year 1,910
---------
Cash and cash equivalents at end of year $ 578
=========
Supplemental cash flow information:
Interest paid $ (51)
=========
Income taxes recovered $ 474
=========
Hallmark Financial Services
Schedule III - Supplementary Insurance Information
(In thousands)
Column A Column B Column C Column D Column E Column F Column G Column H Column I Column J Column K
----------------------------------------------------------------------------------------------------------------------------------
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 Payagle
Adjustment
Expenses
----------------------------------------------------------------------------------------------------------------------------------
2004
----
Personal
Lines Group $ 1,491 $ 19,534 $ 6,192 $ - $ 32,445 $ 1,372 $ 19,243 $ 10,176 $ 11,881 $ 33,067
Commercial
Lines Group 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
-----------------------------------------------------------------------------
---------------------------------------
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
2004 $ 7,475 $ 19,648 $ - $ 6,192 $ 32,445 $ 1,386 $ 20,331 $(1,194) $ 22,288 $ 22,634 $ 33,067
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 30, 2005 /s/ Mark E. Schwarz
------------------------------------------
Mark E. Schwarz, Chairman and Chief
Executive Officer
(Principal Executive Officer)
Date: March 30, 2005 /s/ Mark J. Morrison
------------------------------------------
Mark J. Morrison, EVP and Chief Financial
Officer (Principal Financial Officer)
Date: March 30, 2005 /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 and
on the dates indicated.
Date: March 30, 2005 /s/ Mark E. Schwarz
------------------------------------------
Mark E. Schwarz, Director
Date: March 30, 2005 /s/ James H. Graves
------------------------------------------
James H. Graves, Director
Date: March 30, 2005 /s/ George R. Manser
------------------------------------------
George R. Manser, Director
Date: March 30, 2005 /s/ Scott T. Berlin
------------------------------------------
Scott T. Berlin, Director
Date: March 30, 2005 /s/ James C. Epstein
------------------------------------------
James C. Epstein, Director
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) By-Laws of the registrant, as amended (incorporated by reference
to Exhibit 3(b) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 1993).
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 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).
10(a) Office Lease for 14651 Dallas Parkway, Suite 900, 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) General Agency Agreement, effective March 1, 1992, between State
& County Mutual Fire Insurance Company and Brokers General, Inc.
(incorporated by reference to Exhibit 10(b) to Amendment No. 1 on
Form 8 to the registrant's Quarterly Report on Form 10-QSB for
the quarter ended September 30, 1992).
10(c)* 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(d)* 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(e)* 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(f) Addendum No. 1 to the 100% Quota Share Reinsurance Agreement, as
restated between State & County Mutual Fire Insurance Company and
American Hallmark Insurance Company of Texas effective November
22, 1994 (incorporated by reference to Exhibit 10(q) to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1994).
10(g) Second, Third, Fourth and Fifth Amendments to Office Lease for
14651 Dallas Parkway, Suite 900, 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(t) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended December
31, 1995).
10(h) Quota Share Reinsurance Agreement between State & County Mutual
Fire Insurance Company and American Hallmark Insurance Company of
Texas effective July 1, 1996 (incorporated by reference to
Exhibit 10(a) to the registrant's Quarterly Report on Form 10-QSB
for the quarter ended June 30, 1996).
10(i) Quota Share Retrocession Agreement between American Hallmark
Insurance Company of Texas and the Reinsurer (specifically
identified as follows: Dorinco, Kemper and Skandia), effective
July 1, 1996 (incorporated by reference to Exhibit 10(b) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended June 30, 1996).
Exhibit
Number Description
------ -----------
10(j) Guaranty Agreement effective July 1, 1996 provided by Dorinco
Reinsurance Company in favor of State & County Mutual Fire
Insurance Company (incorporated by reference to Exhibit 10(c) to
the registrant's Quarterly Report on Form 10-QSB for the quarter
ended June 30, 1996).
10(k) Guaranty of Performance and Hold Harmless Agreement effective
July 1, 1996 between Hallmark Financial Services, Inc. and
Dorinco America Reinsurance Corporation (incorporated by
reference to Exhibit 10(f) to the registrant's Quarterly Report
on Form 10-QSB for the quarter ended June 30, 1996).
10(l) Addendum No. 3 - Termination to 100% Quota Share Reinsurance
Agreement between American Hallmark Insurance Company and State &
County Mutual Fire Insurance Company (incorporated by reference
to Exhibit 10(j) to the registrant's Quarterly Report on Form 10-
QSB for the quarter ended June 30, 1996).
10(m) 100% Quota Share Reinsurance Agreement, effective January 1,
1997, between State & County Mutual Fire Insurance Company,
Vaughn General Agency, Inc. and American Hallmark General
Agency, Inc. (incorporated by reference to Exhibit 10(am) to
the registrant's Annual Report on Form 10-KSB for the fiscal
year ended December 31, 1996).
10(n) General Agency Agreement, effective January 1, 1997, between
Dorinco Reinsurance Company, State & County Mutual Fire Insurance
Company and Vaughn General Agency, Inc. (incorporated by
reference to Exhibit 10(an) to the registrant's Annual Report on
Form 10-KSB for the fiscal year ended December 31, 1996).
10(o) Administrative Services Agreement between State & County Mutual
Fire Insurance Company, Vaughn General Agency, Inc. and American
Hallmark General Agency, Inc. (incorporated by reference to
Exhibit 10(ao) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 1996).
10(p) Endorsement No. 1, effective July 1, 1996, to the 100% Quota
Share Reinsurance Agreement between State & County Mutual Fire
Insurance Company and American Hallmark Insurance Company of
Texas, effective July 1, 1996 (incorporated by reference to
Exhibit 10(a) to the registrant's Quarterly Report on Form 10-QSB
for the quarter ended June 30, 1997).
10(q) Endorsement No. 1, effective July 1, 1997, to the Guaranty
Agreement provided by Dorinco Reinsurance Corporation in favor of
State & County Mutual Fire Insurance Company, effective July 1,
1996 (incorporated by reference to Exhibit 10(d) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended June 30, 1997).
10(r) Endorsement No. 1 - Termination, effective January 1, 1997, to
the Quota Share Retrocession Agreement between American Hallmark
Insurance Company of Texas and the Reinsurers (Dorinco
Reinsurance Company and Odyssey Reinsurance Corporation),
effective July 1, 1996 (incorporated by reference to Exhibit
10(e) to the registrant's Quarterly Report on Form 10-QSB for
the quarter ended June 30, 1997).
10(s) Endorsement No. 1, effective July 1, 1997, to the Quota Share
Retrocession Agreement between American Hallmark Insurance
Company of Texas and the Reinsurer (Dorinco Reinsurance Company)
effective July 1, 1996 (incorporated by reference to Exhibit
10(h) to the registrant's Quarterly Report on Form 10-QSB for
the quarter ended June 30, 1997).
10(t) Endorsement No. 2, effective January 1, 1997, to the Quota Share
Retrocession Agreement between American Hallmark Insurance
Company of Texas and Dorinco Reinsurance Company, effective
January 1, 1997 (incorporated by reference to Exhibit 10(bh) to
the registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1997).
Exhibit
Number Description
------ -----------
10(u) Endorsement No. 1, effective January 1, 1997, to the 100% Quota
Share Reinsurance Agreement between State & County Mutual Fire
Insurance Company, Vaughn General Agency, Inc. and American
Hallmark General Agency, Inc. (incorporated by reference to
Exhibit 10(bi) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 1997).
10(v) Endorsement No. 2, effective July 1, 1997, to the 100% Quota
Share Reinsurance Agreement between State & County Mutual Fire
Insurance Company, Vaughn General Agency, Inc., American Hallmark
General Agency, Inc. and the Reinsurers (Dorinco Reinsurance
Company and Kemper Reinsurance Company) effective July 1, 1997
(incorporated by reference to Exhibit 10(bj) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended December
31, 1997).
10(w) Retrocession Agreement effective March 1, 1998, between American
Hallmark Insurance Company of Texas, Dorinco Reinsurance Company
and Associated General Agency, Inc. (incorporated by reference to
Exhibit 10(bh) to the registrant's annual Report on Form 10-KSB
for the fiscal year ended December 31, 1998).
10(x) Quota Share Retrocession Agreement effective September 1, 1998,
between American Hallmark Insurance Company of Texas, Dorinco
Reinsurance Company and Van Wagoner Companies, Inc. (incorporated
by reference to Exhibit 10(bj) to the registrant's annual Report
on Form 10-KSB for the fiscal year ended December 31, 1998).
10(y) Endorsement No. 5, effective January 1, 1999, to the Quota Share
Retrocession Agreement between American Hallmark Insurance
Company of Texas and the Reinsurer (Dorinco Reinsurance Company),
effective January 1, 1997 (incorporated by reference to Exhibit
10(a) to the registrant's Quarterly Report on Form 10-QSB for the
quarter ended June 30, 1999).
10(z) Endorsement No. 4, effective January 1, 1999, to the Quota Share
Retrocession Agreement between American Hallmark Insurance
Company of Texas and the Reinsurer (GE Reinsurance Company),
effective January 1, 1996 (incorporated by reference to Exhibit
10(b) to the registrant's Quarterly Report on Form 10-QSB for the
quarter ended June 30, 1999).
10(aa) Endorsement No. 2, effective July 1, 1997, to the 100% Quota
Share Reinsurance Agreement between State & County Mutual Fire
Insurance Company, Vaughn General Agency, Inc. and American
Hallmark General Agency, Inc. (incorporated by reference to
Exhibit 10(bg) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 1999).
10(ab) Endorsement No. 6, effective January 1, 1999, to the Quota
Share Retrocession Agreement between American Hallmark Insurance
Company of Texas and Dorinco Reinsurance Company, effective
January 1, 1997 (incorporated by reference to Exhibit 10(bi) to
the registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1999).
10(ac) Seventh Amendment to Office Lease for 14651 Dallas Parkway, Suite
900, 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 Quarterly Report
on Form 10-QSB for the quarter ended June 30, 2000).
10(ad) Quota Share Retrocession Agreement, effective July 1, 2000,
between American Hallmark Insurance Company of Texas and Dorinco
Reinsurance Company (incorporated by reference to Exhibit 10(a)
to the registrant's Quarterly Report on Form 10-QSB for the
quarter ended September 30, 2000).
10(ae) Addendum No. 2 to the Retrocession Contract, effective June 1,
1998, issued to Dorinco Reinsurance Company by American Hallmark
Insurance Company of Texas, effective October 1, 1999
(incorporated by reference to Exhibit 10(b) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended September
30, 2000).
Exhibit
Number Description
------ -----------
10(af) Eighth Amendment to Office Lease for 14651 Dallas Parkway, Suite
900, 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(br) to the registrant's Annual Report on
Form 10-KSB for the fiscal year ended December 31, 2000).
10(ag) Quota Share Retrocession Contract between Dorinco Reinsurance
Company and American Hallmark Insurance Company of Texas,
effective September 1, 2000 (incorporated by reference to Exhibit
10(bs) to the registrant's Annual Report on Form 10-KSB for the
fiscal year ended December 31, 2000).
10(ah) Endorsement No. 5, effective July 1, 2000, to the 100% Quota
Share Reinsurance Agreement issued to State and County Mutual
Fire Insurance Company, effective January 1, 1997 (incorporated
by reference to Exhibit 10(bt) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 2000).
10(ai) Endorsement No. 4, effective July 1, 2000, to the 100% Quota
Share Reinsurance Agreement between State and County Mutual Fire
Insurance Company and American Hallmark Insurance Company of
Texas, effective July 1,1996 (incorporated by reference to
Exhibit 10(bu) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 2000).
10(aj) Termination Addendum to the Quota Share Retrocession Agreement,
effective May 28, 1999, issued to American Hallmark Insurance
Company of Texas by Kemper Reinsurance Company, effective
July 1, 1996 (incorporated by reference to Exhibit 10(bv) to
the registrant's Annual Report on Form 10-KSB for the fiscal
year ended December 31, 2000).
10(ak) Termination Addendum to the Quota Share Retrocession Agreement,
effective June 30, 2000, issued to Dorinco Reinsurance Company by
American Hallmark Insurance Company of Texas, effective January
1, 1997 (incorporated by reference to Exhibit 10(bw) to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 2000).
10(al) Termination Addendum to the Quota Share Retrocession Contract,
effective September 1, 2000, issued to Dorinco Reinsurance
Company by American Hallmark Insurance Company of Texas,
effective September 1, 1998 (incorporated by reference to Exhibit
10(bx) to the registrant's Annual Report on Form 10-KSB for the
fiscal year ended December 31, 2000).
10(am) Termination Addendum to the Interests and Liability Agreement,
effective June 30, 2000, of GE Reinsurance Corporation with
respect to the 100% Quota Share Reinsurance Agreement, effective
January 1, 1997 (incorporated by reference to Exhibit 10(by) to
the registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 2001).
10(an) Termination Endorsement, effective July 1, 2000, to the Guaranty
of Performance and Hold Harmless Agreement between Hallmark
Financial Services, Inc. and GE Reinsurance Corporation (formerly
Kemper Reinsurance Company), effective July 1, 1996 (incorporated
by reference to Exhibit 10(cb) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 2001).
10(ao) Termination Endorsement, effective July 1, 2000, to the Guaranty
Agreement provided by GE Reinsurance Corporation (formerly Kemper
Reinsurance Company) in favor of State and County Mutual Fire
Insurance Company, effective July 1, 1996 (incorporated by
reference to Exhibit 10(cc) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 2001).
10(ap) Endorsement No. 2, effective July 1, 2000, to the Guaranty
Agreement provided by Dorinco Reinsurance Company in favor of
State and County Mutual Fire Insurance Company, effective July 1,
1996 (incorporated by reference to Exhibit 10(a) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended March 31, 2001).
Exhibit
Number Description
------ -----------
10(aq) Letter of Agreement, dated August 3, 2001, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(f) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended June 30,
2001).
10(ar) Letter of Agreement, dated August 6, 2001, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(g) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended June 30,
2001).
10(as) Addendum No. 1 to the Quota Share Retrocession Agreement,
effective July 1, 2000, between American Hallmark Insurance
Company of Texas and Dorinco Reinsurance Company, effective
January 1, 2001 (incorporated by reference to Exhibit 10(a) to
the registrant's Quarterly Report on Form 10-QSB for the quarter
ended September 30, 2001).
10(at) Addendum No. 2 to the Quota Share Retrocession Agreement,
effective July 1, 2000, between American Hallmark Insurance
Company of Texas and Dorinco Reinsurance Company, effective
July 1, 2001 (incorporated by reference to Exhibit 10(b) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended September 30, 2001).
10(au) Endorsement No. 1 to the Guaranty of Performance and Hold
Harmless Agreement, effective July 1, 1996 between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company,
effective July 1, 2000 (incorporated by reference to Exhibit
10(c) to the registrant's Quarterly Report on Form 10-QSB for
the quarter ended September 30, 2001).
10(av) Letter of Agreement, dated November 7, 2001 between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(d) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended September
30, 2001).
10(aw)* 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(ax) Letter of Agreement, dated January 23, 2002, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(bl) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended December
31, 2001).
10(ay) Addendum No. 2, entered into January 9, 2001, to the General
Agency Agreement, effective March 1, 1992, between State &
County Mutual Fire Insurance Company and Brokers General, Inc.
(incorporated by reference to Exhibit 10(bo) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended December
31, 2001).
10(az) Addendum No. 3 to the Quota Share Retrocession Agreement,
effective July 1, 2000, between American Hallmark Insurance
Company of Texas and Dorinco Reinsurance Company, effective June
30, 2001 (incorporated by reference to Exhibit 10(a) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended September 30, 2002).
10(ba) 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(bb)* 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 ended December 31, 2002).
10(bc)* 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 ended December 31, 2002).
Exhibit
Number Description
------ -----------
10(bd) Addendum No. 1 to the Quota Share Retrocession Contract between
Dorinco Reinsurance Company and American Hallmark Insurance
Company of Texas, effective September 1, 2000 (incorporated by
reference to Exhibit 10(bo) to the registrant's Annual Report on
Form 10-KSB for the fiscal year ended December 31, 2002).
10(be) Letter of Agreement, dated October 31, 2002, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(bp) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended
December 31, 2002).
10(bf) Letter of Agreement, dated December 30, 2002, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(br) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended
December 31, 2002).
10(bg) Letter of Agreement, dated December 30, 2002, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(bs) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended
December 31, 2002).
10(bh) Tenth Amendment to Office Lease for 14651 Dallas Parkway, Suite
900, 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(bi) General Agency Agreement between Millers General Agency, Inc and
Clarendon National Insurance Company, effective August 15, 2001
(incorporated by reference to Exhibit 10(b) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended March 31,
2003).
10(bj) Claims Administration Agreement between Millers General Agency,
Inc. and Clarendon National Insurance Company, effective August
15, 2001 (incorporated by reference to Exhibit 10(c) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended March 31, 2003).
10(bk) Claims Services Agreement between Millers General Agency, Inc.
and Effective Claims Management, Inc., effective March 25, 2003
(incorporated by reference to Exhibit 10(d) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended March 31,
2003).
10(bl) 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(bm) Termination Addendum to the Quota Share Retrocession Agreement,
effective March 31, 2003 between American Hallmark Insurance
Company of Texas and Dorinco Reinsurance Company (incorporated by
reference to Exhibit 10(b) to the registrant's Quarterly Report
on Form 10-QSB for the quarter ended June 30, 2003).
10(bn) General Agency Agreement by and among American Hallmark General
Agency, Inc., State and County Mutual Fire Insurance Company,
American Hallmark Insurance Company of Texas and Dorinco
Reinsurance Company, effective April 1, 2003 (incorporated by
reference to Exhibit 10(c) to the registrant's Quarterly Report
on Form 10-QSB for the quarter ended June 30, 2003).
10(bo) Security Fund Agreement between American Hallmark Insurance
Company of Texas and State and County Mutual Fire Insurance
Company, effective April 1, 2003 (incorporated by reference to
Exhibit 10(d) to the registrant's Quarterly Report on Form 10-QSB
for the quarter ended June 30, 2003).
Exhibit
Number Description
------ -----------
10(bp) Quota Share Reinsurance Agreement by and among American Hallmark
Insurance Company of Texas, American Hallmark General Agency,
Inc. and State and County Mutual Insurance Company, effective
April 1, 2003 (incorporated by reference to Exhibit 10(e) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended June 30, 2003).
10(bq) Quota Share Reinsurance Agreement by and among American Hallmark
General Agency, Inc., State and County Mutual Insurance Company
and Dorinco Reinsurance Company, effective April 1, 2003
(incorporated by reference to Exhibit 10(f) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended June 30,
2003).
10(br) Technology Processing Services Agreement, effective December 1,
2003 between Phoenix Indemnity Insurance Company and CGI
Information Systems & Management Consultants, Inc. (incorporated
by reference to Exhibit 10(a) to the registrant's Quarterly
Report on Form 10-QSB for the quarter ended September 30, 2003).
10(bs) Policy and Claims Processing Services Agreement, effective
September 1, 2003 between Phoenix Indemnity Insurance Company
and CGI Information Systems & Management Consultants, Inc.
(incorporated by reference to Exhibit 10(b) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended September
30, 2003).
10(bt) Processing Services Agreement, effective July 1, 2003 between
Hallmark General Agency, Inc., Effective Claims Management, Inc.
and CGI Information Systems & Management Consultants, Inc.
(incorporated by reference to Exhibit 10(c) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended September
30, 2003).
10(bu) Managing General Agency Agreement, effective October 1, 2003,
between Old American County Mutual Fire Insurance Company and
American Hallmark General Agency, Inc. (incorporated by reference
to Exhibit 10(cl) to the registrant's Annual Report on Form
10-KSB for the fiscal year ended December 31, 2003).
10(bv) Addendum No. 1 to the Managing General Agency Agreement,
effective October 1, 2003, between Old American County Mutual
Fire Insurance Company and American Hallmark General Agency, Inc.
(incorporated by reference to Exhibit 10(cm) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended December
31, 2003).
10(bw) Guaranty Agreement, effective September 1, 2003, between Old
American County Mutual Fire Insurance Company and Hallmark
Financial Services, Inc. (incorporated by reference to Exhibit
10(cn) to the registrant's Annual Report on Form 10-KSB for the
fiscal year ended December 31, 2003).
10(bx) 45% Quota Share Reinsurance Agreement, effective October 1, 2003,
between Old American County Mutual Fire Insurance Company and
American Hallmark General Agency, Inc. (incorporated by reference
to Exhibit 10(co) to the registrant's Annual Report on Form 10-
KSB for the fiscal year ended December 31, 2003).
10(by) Addendum No. 1 to the 45% Quota Share Reinsurance Agreement,
effective October 1, 2003, between Old American County Mutual
Fire Insurance Company and American Hallmark General Agency, Inc.
(incorporated by reference to Exhibit 10(cp) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended December
31, 2003).
10(bz) 55% Quota Share Reinsurance Agreement, effective October 1, 2003,
between Old American County Mutual Fire Insurance Company and
Dorinco Reinsurance Company (incorporated by reference to Exhibit
10(cq) to the registrant's Annual Report on Form 10-KSB for the
fiscal year ended December 31, 2003).
Exhibit
Number Description
------ -----------
10(ca) Blanket Retrocession Agreement, effective October 1, 2003,
between Dorinco Reinsurance Company and American Hallmark
Insurance Company of Texas (incorporated by reference to Exhibit
10(cr) to the registrant's Annual Report on Form 10-KSB for the
fiscal year ended December 31, 2003).
10(cb) Quota Share Reinsurance Agreement dated September 30, 2004
between Old American County Mutual Fire Insurance Company and
American Hallmark Insurance Company of Texas (incorporated by
reference to Exhibit 10 to the registrant's Quarterly Report on
Form 10-Q for the quarter ended September 30, 2004).
10(cc) General Agency Agreement between Hallmark General Agency, Inc.
and Clarendon National Insurance Company, effective July 1, 2004
(incorporated by reference to Exhibit 10.1 to the registrant's
current report on Form 8-K filed December 21, 2004).
10(cd)*+ Management Bonus Plan for Fiscal Year 2004 adopted January 26,
2004
16 Letter from PricewaterhouseCoopers LLP to Securities and
Exchange Commission dated October 15, 2003 (incorporated by
reference from the Company's Current Report on Form 8-K filed
October 17, 2003).
21+ List of subsidiaries of the registrant.
23.1+ Consent of KPMG LLP
23.2+ Consent of PricewaterhouseCoopers 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.
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Description Page Number
----------- -----------
Report of Independent Registered Public Accounting Firm F-2
Report of Independent Registered Public Accounting Firm F-3
Consolidated Balance Sheets at December 31, 2004 and 2003 F-4
Consolidated Statements of Operations for the Years Ended
December 31, 2004, 2003 and 2002 F-5
Consolidated Statements of Stockholders' Equity and
Comprehensive Income for the Years Ended
December 31, 2004, 2003 and 2002 F-6
Consolidated Statements of Cash Flows for the Years Ended
December 31, 2004, 2003 and 2002 F-8
Notes to Consolidated Financial Statements F-9
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors
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,
2004 and 2003, and the related consolidated statements of operations,
stockholders' equity and comprehensive income, and cash flows for each of
the years in the two-year period ended December 31, 2004. 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, 2004 and 2003, and the results of their operations and their
cash flows for each of the years in the two-year period ended December 31,
2004, 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 30, 2005
Report of Independent Registered Public Accounting Firm
-------------------------------------------------------
To the Board of Directors & Stockholders of
Hallmark Financial Services, Inc.:
In our opinion, the accompanying consolidated statements of operations, of
changes in stockholders' equity and of cash flows for the year ended
December 31, 2002 present fairly, in all material respects, the results of
operations and cash flows of Hallmark Financial Services, Inc. (the
"Company") for the year ended December 31, 2002 in conformity with
accounting principles generally accepted in the United States of America.
These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audit. We conducted our audit of these statements
in accordance with the 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, assessing the accounting principles used and significant
estimates made by management, and evaluating the overall financial statement
presentation. We believe that our audit provides a reasonable basis for our
opinion.
As discussed in Note 1, during 2002 the Company adopted Statement of
Financial Accounting Standards No. 142, "Goodwill and Other Intangible
Assets."
/s/ PricewaterhouseCoopers LLP
------------------------------
PricewaterhouseCoopers LLP
Dallas, Texas
March 16, 2003
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 2004 and 2003
(In thousands)
----------------------------
ASSETS 2004 2003
------ ---------- ----------
Investments:
Debt securities, available-for-sale,
at fair value $ 28,206 $ 25,947
Equity securities, available-for-sale,
at fair value 3,580 3,573
Short-term investments, available-for-sale,
at fair value 335 335
---------- ----------
Total investments 32,121 29,855
Cash and cash equivalents 12,901 10,520
Restricted cash and investments 6,509 5,366
Prepaid reinsurance premiums - 291
Premiums receivable encumbered by premium financing
activity (net of allowance for doubtful accounts
of $-0- in 2004 and $3 in 2003) - 43
Premiums receivable 4,103 4,033
Accounts receivable 3,494 3,395
Reinsurance recoverable 3,083 10,516
Deferred policy acquisition costs 7,475 7,146
Excess of cost over fair value of net
assets acquired 4,836 4,836
Intangible assets 486 513
Current federal income tax recoverable - 625
Deferred federal income taxes 5,173 3,961
Other assets 2,330 2,753
---------- ----------
$ 82,511 $ 83,853
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Notes payable $ - $ 991
Unpaid losses and loss adjustment expenses 19,648 28,456
Unearned premiums 6,192 5,862
Unearned revenue 11,283 10,190
Accrued agent profit sharing 1,875 1,511
Accrued ceding commission payable 1,695 1,164
Pension liability 2,180 1,237
Current federal income tax payable 1,343 -
Accounts payable and other accrued expenses 5,639 7,045
---------- ----------
49,855 56,456
---------- ----------
Commitments and Contingencies (Note 13)
Stockholders' equity:
Common stock, $.03 par value, authorized
100,000,000 shares; issued 36,856,610
shares in 2004 and 2003 1,106 1,106
Capital in excess of par value 19,647 19,693
Retained earnings 13,103 7,254
Accumulated other comprehensive loss (759) (93)
Treasury stock, 379,319 shares in 2004
and 484,319 shares in 2003, at cost (441) (563)
---------- ----------
Total stockholders' equity 32,656 27,397
---------- ----------
$ 82,511 $ 83,853
========== ==========
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, 2004, 2003 and 2002
(In thousands, except per share amounts)
----------------------------
2004 2003 2002
-------- -------- --------
Gross premiums written $ 33,389 $ 43,338 $ 51,643
Ceded premiums written (322) (6,769) (29,611)
-------- -------- --------
Net premiums written 33,067 36,569 22,032
Change in unearned premiums (622) 5,406 (1,819)
-------- -------- --------
Net premiums earned 32,445 41,975 20,213
Investment income, net of expenses 1,386 1,198 773
Realized losses (27) (88) (5)
Finance charges 2,183 3,544 2,503
Commission and fees 21,100 17,544 1,108
Processing and service fees 6,003 4,900 921
Other income 31 486 284
-------- -------- --------
Total revenues 63,121 69,559 25,797
Losses and loss adjustment expenses 19,137 30,188 15,302
Other operating costs and expenses 35,290 37,386 9,474
Interest expense 64 1,271 983
Amortization of intangible asset 28 28 2
-------- -------- --------
Total expenses 54,519 68,873 25,761
Income before income tax, cumulative
effect of change in accounting
principle and extraordinary gain 8,602 686 36
Income tax expense 2,753 25 13
-------- -------- --------
Income before cumulative effect of change in
accounting principle and extraordinary gain 5,849 661 23
Cumulative effect of change in accounting
principle, net of tax - - (1,694)
Extraordinary gain - 8,084 -
-------- -------- --------
Net income (loss) $ 5,849 $ 8,745 $ (1,671)
======== ======== ========
Basic earnings (loss) per share:
Income before cumulative effect
of change in accounting principle
and extraordinary gain $ 0.16 $ 0.03 $ -
Cumulative effect of change in accounting
principle - - (0.15)
Extraordinary gain - 0.44 -
-------- -------- --------
Net income (loss) $ 0.16 $ 0.47 $ (0.15)
======== ======== ========
Diluted earnings (loss) per share:
Income before cumulative effect
of change in accounting principle
and extraordinary gain $ 0.16 $ 0.03 $ -
Cumulative effect of change in accounting
principle - - (0.15)
Extraordinary gain - 0.43 -
-------- -------- --------
Net income (loss) $ 0.16 $ 0.46 $ (0.15)
======== ======== ========
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, 2004, 2003 and 2002
(in thousands)
---------------------------------------
Capital Accum.
# In Other # Total Comp.
of Par Excess of Retained Comp. Treasury of Stockholders' Income
Shares Value Par Value Earnings Income Stock Shares Equity (Loss)
------ ----- --------- -------- ------ --------- ------ -------- --------
Balance at December 31, 2001 11,856 $ 356 $ 10,875 $ 180 - ($1,043) 806 $ 10,368
Comprehensive loss:
Net loss (1,671) (1,671) $ (1,671)
Other comprehensive loss:
Additional minimum (162) (162) (162)
pension liability, --------
net of tax of $94
Comprehensive loss $ (1,833)
------ ----- --------- -------- ------ --------- ------ -------- ========
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
====== ===== ========= ======== ====== ========= ====== ========
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME
for the years ended December 31, 2004, 2003 and 2002
(in thousands)
(Continued)
---------------------------------------
Capital Accum.
# In Other # Total Comp.
of Par Excess of Retained Comp. Treasury of Stockholders' Income
Shares Value Par Value Earnings Income Stock Shares Equity (Loss)
------ ----- --------- -------- ------ --------- ------ -------- --------
Balance at December 31, 2003 36,857 $1,106 $ 19,693 $ 7,254 ($93) ($563) 484 $ 27,397
Amortization of fair value of 28 28
stock options granted
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 gains included in net
income (218) (218) (218)
------ -------- --------
Net unrealized gains on
securities 220 220 220
------ -------- --------
Total other comprehensive
loss before tax (978) (978) (978)
Tax effect on other
comprehensive income 312 312 312
------ -------- --------
Other comprehensive
loss 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
====== ===== ========= ======== ====== ========= ====== ========
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, 2004, 2003 and 2002
(In thousands)
----------------------------
2004 2003 2002
-------- -------- --------
Cash flows from operating activities:
Net income (loss) $ 5,849 $ 8,745 $ (1,671)
Adjustments to reconcile net income (loss)
to cash provided by operating activities:
Depreciation and amortization expense 450 621 195
Deferred income tax expense (benefit) (787) 114 48
Change in prepaid reinsurance premiums 291 8,297 3,061
Change in premiums receivable (70) (1,276) (598)
Change in accounts receivable (99) (1,266) (170)
Change in deferred policy acquisition costs (329) (1,340) (641)
Change in unpaid losses and loss adjustment
expenses (8,808) (5,097) (2,422)
Change in unearned premiums 330 (12,785) (1,242)
Change in unearned revenue 1,093 3,271 183
Change in accrued agent profit sharing 364 944 72
Change in reinsurance recoverable 7,433 12,817 3,942
Change in reinsurance balances payable - (3,082) (662)
Cumulative effect of change in accounting
principle - - 1,694
Change in current federal income tax
payable/recoverable 1,968 (592) 662
Change in accrued ceding commission payable 531 (1,372) (2,062)
Gain on acquisition of subsidiary - (8,084) -
Change in all other liabilities (1,661) 419 1,117
Change in all other assets 761 348 443
-------- -------- --------
Net cash provided by operating activities 7,316 682 1,949
Cash flows from investing activities:
Purchases of property and equipment (389) (476) (254)
Purchase of note receivable - - (6,500)
Acquisition of subsidiary, net of cash
received - 6,945 (2,100)
Premium finance notes repaid, net of
finance notes originated 43 11,550 2,147
Change in restricted cash and investments (3,458) (4,294) 918
Purchases of debt and equity securities (6,670) (19,075) (12,639)
Maturities and redemptions of investment
securities 6,138 8,131 5,858
Net redemptions of short-term investments 344 8,904 6,276
-------- -------- --------
Net cash provided by (used in)
investing activities (3,992) 11,685 (6,294)
Cash flows from financing activities:
Proceeds from note payable - - 8.600
Net repayments to premium finance lender - (10,905) (1,308)
Proceeds from rights offering - 10,000 -
Proceeds from exercise of employee
stock options 48 17 -
Repayment of borrowings (991) (9,412) (27)
-------- -------- --------
Net cash provided by (used in)
financing activities (943) (10,300) 7,265
Increase in cash and cash equivalents 2,381 2,067 2,920
Cash and cash equivalents at beginning of year 10,520 8,453 5,533
-------- -------- --------
Cash and cash equivalents at end of year $ 12,901 $ 10,520 $ 8,453
======== ======== ========
Supplemental cash flow information:
Interest paid $ (64) $ (1,456) $ (833)
======== ======== ========
Income taxes recovered (paid) $ (1,700) $ (475) $ 696
======== ======== ========
The Company transferred $2.4 million of fixed maturity investments 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
___________
1. Accounting Policies:
-------------------
General
-------
Hallmark Financial Services, Inc. ("HFS") and its wholly owned
subsidiaries (collectively, the "Company") engage in the sale of
property and casualty insurance products. The Company's business
involves marketing and underwriting of non-standard personal automobile
insurance in Texas, New Mexico and Arizona; marketing commercial
insurance in Texas, New Mexico, Idaho, Oregon and Washington;
affiliate and third party claims administration; and other insurance
related services. The Company pursues its business activities through
integrated insurance groups handling non-standard personal automobile
insurance (the "Personal Lines Group") and commercial insurance (the
"Commercial Lines Group").
The Personal Lines Group focuses on providing non-standard automobile
liability and physical damage insurance in Texas, New Mexico and Arizona
for drivers who do not qualify for or cannot obtain standard rate
insurance. The members of the Personal Lines group are a Texas
domiciled property and casualty insurance company, American Hallmark
Insurance Company of Texas ("Hallmark"); an Arizona domiciled property
and casualty insurance company, Phoenix Indemnity Insurance Company
("Phoenix"); a managing general agency, American Hallmark General
Agency, Inc. ("AHGA"); an affiliate and third party claims
administrator, Hallmark Claims Service, Inc. ("HCS"); and a premium
finance company, Hallmark Finance Corporation ("HFC"). The Company
discontinued HFC's premium finance activities in July 2003.
The Commercial Lines Group markets and administers low hazard
commercial insurance policies primarily in the rural areas of Texas,
New Mexico, Idaho, Oregon and Washington. The members of the
Commercial Lines Group are a managing general agency, Hallmark General
Agency, Inc. ("HGA"); and a third party claims administrator, Effective
Claims Management, Inc. ("ECM").
Principles of Consolidation
---------------------------
The accompanying consolidated financial statements include the accounts
and operations of HFS and its subsidiaries. Intercompany accounts and
transactions have been eliminated.
Basis of Presentation
---------------------
The accompanying consolidated financial statements have been prepared
in conformity with accounting principles generally accepted in the
United States of America ("GAAP") which, as to Hallmark and Phoenix,
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 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
----------------
The Company considers 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 and policy fee
is refunded to the insured. Insurance premiums written include gross
policy fees of $2.7 million, $3.0 million and $5.1 million and policy
fees, net of reinsurance, of $2.7 million, $2.3 million and $2.1
million for the years ended December 31, 2004, 2003 and 2002,
respectively.
Recognition of Commission Revenues and Expenses of the Commercial
-----------------------------------------------------------------
Lines Group
-----------
Commission revenues and commission expenses related to insurance
policies serviced by HGA are recognized during the period covered by
the policy. Profit sharing commission is calculated and recognized
when the ratio of ultimate losses and loss expenses incurred to earned
premium ("loss ratio") as determined by a qualified actuary deviate
from contractual thresholds. 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 -
6/30/02 6/30/03 6/30/04 6/30/05
--------------------------------------------
Provisional loss ratio 60.0% 59.0% 59.0% 64.2%
--------------------------------------------
Ultimate loss ratio
booked to at 12/31/04 57.5% 58.5% 59.0% 62.2%
--------------------------------------------
--------------------------------------------
Effect of actual 0.5%
above provisional ($199,402) ($305,122) ($298,457) ($44,755)
--------------------------------------------
Effect of actual 0.5%
below provisional $139,581 $201,381 $196,982 $44,755
--------------------------------------------
As of December 31, 2004, the Company recorded a $0.7 million profit
sharing payable for the quota share treaty effective July 1, 2001
through June 30, 2002. The Company received $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. The Company also recorded a $0.2 million receivable on the
quota share treaty effective July 1, 2002 through June 30, 2003 and a
$0.2 million receivable on the quota share treaty effective July 1,
2004 through June 30, 2005.
Recognition of Claim Servicing Fees
-----------------------------------
Claim servicing fees are recognized in proportion to the historical
trends of the claim cycle. The Company uses 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 Hallmark's annual insurance premiums were financed
through the Company's premium finance program offered by its wholly-
owned subsidiary, HFC. Hallmark ceased offering premium financing on
new annual term policies in July 2003. Finance charges on the premium
finance notes are recorded as interest earned. This interest is earned
on the Rule of 78's method which approximates the interest method for
such short-term notes.
The Company receives premium installment fees between $3.00 and $12.50
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
$3.6 million and $3.2 million, at December 31, 2004 and 2003,
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 2004, 2003 and 2002 was $0.4 million, $0.6 million and $0.2
million, respectively. Accumulated depreciation was $2.6 million and
$2.2 million at December 31, 2004 and 2003, respectively.
Premiums Receivable Encumbered by Premium Financing Activity
------------------------------------------------------------
Premiums receivable encumbered by premium financing activity represents
payments due to HFC as a result of a secured financing agreement with
an unaffiliated third party which are carried at cost net of allowance
for doubtful accounts. Hallmark discontinued producing new premium
financed annual term policies in July 2003.
Premiums Receivable
-------------------
Premiums receivable represent amounts due from either non-standard
automobile policyholders directly or independent agents for premiums
written and uncollected. These balances are carried at net realizable
value.
Deferred Policy Acquisition Costs and Ceding Commissions of the Personal
------------------------------------------------------------------------
Lines Group
-----------
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 2004, 2003 and 2002, the Company deferred ($22.6) million,
($21.0) million and ($7.3) million of policy acquisition costs and
amortized $22.3 million, $20.6 million and $6.7 million of deferred
policy acquisition costs, respectively. The net deferral of acquisition
costs were ($0.3) million, ($0.4) million and ($0.6) million for 2004,
2003 and 2002, respectively.
Under Hallmark's reinsurance arrangements, the Company earns ceding
commissions based on the reinsurer's loss ratio experience on the
portion of policies reinsured. The Company receives a provisional
commission as policies are 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.
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, 2004, 2003 and 2002. 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, management
believes 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
--------------------------------
Both the Personal Lines and Commercial Lines Groups annually pay a
profit sharing commission to their independent agency force based upon
the results of the business produced by each agent. The Company
estimates and accrues this liability to commission expense in the year
the business is produced.
Reinsurance
-----------
Hallmark is routinely involved in reinsurance transactions with other
companies. Reinsurance premiums, losses, and loss adjustment expenses
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 5.)
Income Taxes
------------
The Company files 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.
Net Income Per Share
--------------------
The computation of net income 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
8 and 10.)
Business Combinations
---------------------
The Company accounts 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.
The Company acquired Phoenix effective January 1, 2003. In consideration
for Phoenix, the Company cancelled $7.0 million of a $14.85 million
balance on a note receivable from Millers American Group, Inc. The
Company had valued the note receivable on its balance sheet at its cost
of $6.5 million. As of December 31, 2003, the Company 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 results of operations of Phoenix are included in the Consolidated
Statement of Operations from the effective date of the acquisition. The
pro forma results for the twelve months ended December 31, 2002 as if
the Company had acquired Phoenix at January 1, 2002 are as follows (in
thousands, except per share amounts):
2002
--------
Revenues $ 43,143
Loss before cumulative effect of change
in accounting principle $ (1,397)
Net loss $ (3,091)
Basic loss per share $ (0.28)
Diluted loss per share $ (0.28)
The acquisition of Phoenix was accounted for in accordance with
Statement of Financial Accounting Standards No. 141, "Business
Combinations" ("SFAS 141"). This statement requires that the Company
estimate the fair value of assets acquired and liabilities assumed by
the Company as of the date of the acquisition. In accordance with the
application of SFAS 141, the Company recognized an extraordinary gain
of $8.1 million for the acquisition of Phoenix in its Consolidated
Statement of Operations for the twelve months ended December 31, 2003.
The gain is calculated as the difference between the fair value of the
net assets of Phoenix of $14.6 million and the $6.5 million cost of the
note receivable from Millers.
Intangible Assets
-----------------
On January 1, 2002, the Company adopted Statement of Financial
Accounting Standards No. 142 ("SFAS 142"), "Goodwill and Other
Intangible Assets." SFAS 142 supersedes APB 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, the Company has identified two components of
goodwill and assigned the carrying value of these components into two
reporting units: the Personal Lines Group, $2.7 million, and the
Commercial Lines Group, $2.1 million. During 2004 and 2003, the Company
completed the first step prescribed by SFAS 142 for testing for
impairment and determined that there is no impairment. Prior to the
acquisitions of the Commercial Lines Group in December 2002 and Phoenix
in January 2003, the Company assigned the carrying value of goodwill to
the insurance company reporting unit and the finance company reporting
unit. In 2003, as a result of these acquisitions, the Company changed
the way it views its operating segments. During 2002, the Company
recorded a charge to earnings that is reported as a cumulative effect
of change in accounting principle of $1.7 million to reflect an
impairment loss determined by the two step process prescribed by SFAS
142.
Effective December 1, 2002, the Company acquired the Commercial Lines
Group. At acquisition, the Company valued the relationships with its
independent agents at $542,580. This asset is classified as an other
intangible asset and is being amortized on a straight-line basis over
twenty years. The Company recognized $27,129 of amortization expense
for the twelve months ending December 31, 2004 and will recognize
$27,129 in amortization expense for each of the next five years and
$350,416 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 are obtained from an independent
pricing service. (See Note 2.)
Notes Payable: The carrying amounts reported in the balance sheet for
these instruments approximate their fair values. (See Note 6.)
Stock-based Compensation
------------------------
In December 2002, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standards No. 148, "Accounting
for Stock-Based Compensation - Transition and Disclosure" ("SFAS 148").
The statement amends FASB Statement No. 123 ("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.
SFAS 148 is effective for financial statements for fiscal years ending
after December 15, 2002. Effective January 1, 2003, the Company
adopted the prospective method provisions of SFAS 148.
At December 31, 2004, the Company had a non-qualified stock option plan
for non-employee directors, which is described more fully in Note 10.
The Company also had an employee stock option plan that expired in
March 2004. Prior to 2003, the Company accounted for these plans
under the recognition and measurement provisions of APB Opinion
No. 25, "Accounting for Stock Issued to Employees," and related
Interpretations. No stock-based employee compensation cost was
reflected in 2002 net income. Effective January 1, 2003, the Company
adopted the fair value recognition provisions of SFAS 123. Under the
prospective method of adoption selected by the Company 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 (loss) and net
income (loss) per share if the fair value based method had been applied
to all outstanding and unvested awards in each period.
2004 2003 2002
-------- -------- --------
Net income (loss) $ 5,849 $ 8,745 $ (1,671)
Add: stock-based employee compensation
expenses included in reported net
income, net of tax 20 30 -
Deduct: total stock-based employee
compensation expense determined under
fair value based method for all
awards, net of tax (33) (84) (32)
-------- -------- --------
Pro forma net income (loss) $ 5,836 $ 8,691 $ (1,703)
======== ======== ========
Net income (loss) per share:
Basic - as reported $ 0.16 $ 0.47 $ (0.15)
Basic - pro forma $ 0.16 $ 0.47 $ (0.15)
Diluted - as reported $ 0.16 $ 0.46 $ (0.15)
Diluted - pro forma $ 0.16 $ 0.46 $ (0.15)
Reclassification
----------------
Certain previously reported amounts have been reclassified to conform
to current year presentation. Such reclassification had no effect on
net income (loss) or stockholders' equity.
2. Investments:
-----------
Major categories of net investment income (in thousands) are
summarized as follows:
Years ended December 31,
--------------------------------
2004 2003 2002
-------- -------- --------
Debt securities $ 1,127 $ 752 $ 421
Equity securities 109 189 5
Short-term investments 82 102 163
Cash equivalents 82 171 186
-------- -------- --------
1,400 1,214 775
Investment expenses (14) (16) (2)
-------- -------- --------
Net investment income $ 1,386 $ 1,198 $ 773
======== ======== ========
No investment in any entity or its affiliates exceeded 10% of
stockholders' equity at December 31, 2004 or 2003.
The amortized cost and estimated market value of investments in debt
and equity securities (in thousands) by category is as follows:
Gross Gross
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
-------- ------ ------- ---------
At 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
======== ====== ======= =========
At December 31, 2003
--------------------
U.S. Treasury securities
and obligations of U.S.
government corporations
and agencies $ 5,004 $ 23 $ 45 $ 4,982
Corporate debt securities 1,122 - - 1,122
Municipal bonds 19,339 525 21 19,843
Mortgage backed securities - - -
-------- ------ ------- ---------
Total debt securities 25,465 548 66 25,947
Equity securities 3,396 326 149 3,573
-------- ------ ------- ---------
Total debt and equity
securities $ 28,861 $ 874 $ 215 $ 29,520
======== ====== ======= =========
The amortized cost and estimated market value of investments in debt
and equity securities with a gross unrealized loss position at December
31, 2004 (in thousands) is as follows:
Gross
Amortized Market Unrealized
Cost Value Loss
------ ------ ------
1 Equity Position $ 31 $ 27 $ (4)
6 Bond Positions 7,323 7,216 (107)
------ ------ ------
$ 7,354 $ 7,243 $ (111)
====== ====== ======
All of the $0.1 million unrealized loss recorded at December 31, 2004
is less than twelve months old and is considered a temporary decline in
value.
The amortized cost and estimated market value of debt securities at
December 31, 2004 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 Market
Maturity (in thousands): Cost Value
----------------------- -------- --------
Due in one year or less $ - $ -
Due after one year through five years 10,068 9,934
Due after five years through ten years 17,750 18,247
Due after ten years - -
Mortgage-backed securities 23 25
-------- --------
$ 27,841 $ 28,206
======== ========
At December 31, 2004 and 2003, investments in debt securities with an
approximate carrying value of $100,000 were on deposit with the Texas
Department of Insurance ("TDI") as required by insurance regulations.
Proceeds from investment securities of $0.1 million and $6.4 million
during 2004 and 2003, respectively, were from maturities, bond calls
and prepayments of mortgage-backed securities.
3. Restricted Cash and Investments;
-------------------------------
The Company has cash and investments held in trust accounts to secure
the credit exposure of State & County Mutual Fire Insurance Company
("State & County") and Old American County Mutual Fire Insurance
Company ("OACM") from their quota share reinsurance treaties with
Hallmark. These funds are recorded on the Company's balance sheet at
fair value, with unrealized gains and losses reported as accumulated
other comprehensive income, a component of shareholders' equity. The
market value of these funds as of December 31, 2004 was $6.3 million.
The amortized cost and estimated market value of cash and investments
in debt securities held in trust for State & County and OACM (in
thousands) by category as of December 31, 2004 is as follows:
Gross Gross
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
----------------------------------------
Municipal bonds $ 2,561 $ 45 $ - $ 2,606
Corporate debt securities - - - -
----------------------------------------
Total debt securities $ 2,561 $ 45 $ - $ 2,606
==============================
Cash 3,711
--------
Total funds held in trust for
State & County and OACM $ 6,317
========
The amortized cost and estimated market value of cash and investments
in debt securities held in trust for State & County and OACM (in
thousands) by category as of December 31, 2003 is as follows:
Gross Gross
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
----------------------------------------
Municipal bonds $ 4,500 $ 96 $ - $ 4,596
Corporate debt securities 507 - - 507
----------------------------------------
Total debt securities $ 5,007 $ 96 $ - $ 5,103
==============================
Cash (3)
--------
Total funds held in trust for
State & County and OACM $ 5,100
========
The amortized cost and estimated market value of investments in debt
securities held in trust for State & County and OACM (in thousands) as
of December 31, 2004 by contractual maturity are as follows:
Amortized Market
Cost Value
------------------------
Due in one year or less $ - $ -
Due after one year through 5 years - -
Due after 5 years through 10 years 2,561 2,606
Due after 10 years - -
------------------------
$ 2,561 $ 2,606
========================
The Company also has funds held for Dorinco Reinsurance Company
("Dorinco") and the State of Kentucky in cash of $192 thousand as of
December 31, 2004 and funds held for Dorinco in cash of $266 thousand
as of December 31, 2003.
4. 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:
2004 2003 2002
-------- -------- --------
Balance at January 1 $ 28,456 $ 17,667 $ 20,089
Plus acquisition of Phoenix at January 1 - 10,338 -
Less reinsurance recoverables 7,259 9,256 12,170
-------- -------- --------
Net Balance at January 1 21,197 18,749 7,919
-------- -------- --------
Incurred related to:
Current year 20,331 29,724 15,125
Prior years (1,194) 464 177
-------- -------- --------
Total incurred 19,137 30,188 15,302
-------- -------- --------
Paid related to:
Current year 10,417 21,895 9,119
Prior years 12,217 5,845 5,691
-------- -------- --------
Total paid 22,634 27,740 14,810
-------- -------- --------
Net Balance at December 31 17,700 21,197 8,411
Plus reinsurance recoverables 1,948 7,259 9,256
-------- -------- --------
Balance at December 31 $ 19,648 $ 28,456 $ 17,667
======== ======== ========
The $1.2 million favorable development in prior accident years recognized
in 2004 represents normal changes in actuarial estimates which had a $0.8
million favorable impact on reinsurance recoverable. The 2003 increase
in current year incurred includes a $2.1 million settlement of a bad
faith claim, net of reinsurance, and adverse development primarily
related to newly acquired business.
5. Reinsurance:
------------
For policies originated prior to April 1, 2003, Hallmark assumed the
reinsurance of 100% of the Texas non-standard auto business produced
by AHGA and underwritten by State & County and retroceded 55% of
the business to Dorinco. Under this arrangement, Hallmark remained
obligated to policyholders in the event that Dorinco did not meet
its obligations under the retrocession agreement. From April 1, 2003
through September 30, 2004, Hallmark assumed the reinsurance of 45% of
the Texas non-standard automobile policies produced by AHGA 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, Hallmark was obligated to policyholders
only for the portion of the risk assumed by Hallmark. Effective
October 1, 2004, Hallmark assumes and retains the reinsurance of 100%
of the Texas non-standard automobile policies produced by AHGA and
underwritten by OACM. Phoenix underwrites its own policies and does
not cede any portion of the business to reinsurers.
Under Hallmark's prior reinsurance arrangements, the Company earned
ceding commissions based on Dorinco's loss ratio experience on
the portion of policies reinsured by Dorinco. The Company 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.
The following table shows premiums directly written, assumed and ceded
and reinsurance loss recoveries by period (in thousands):
Twelve Months Ended December 31,
--------------------------------
2004 2003 2002
------------------------------
Written premium:
Direct $ 18,941 $ 22,359 $ -
Assumed 14,448 20,979 51,643
Ceded (322) (6,769) (29,611)
------------------------------
Net written premium $ 33,067 $ 36,569 $ 22,032
==============================
Earned premium:
Direct $ 19,028 $ 23,067 $ -
Assumed 14,030 34,380 52,486
Ceded (613) (15,472) (32,273)
------------------------------
Net earned premium $ 32,445 $ 41,975 $ 20,213
==============================
Reinsurance recoveries $ 163 $ 11,071 $ 21,161
==============================
6. Notes Payable:
--------------
Effective March 11, 1997, the Company entered into a loan agreement with
Dorinco, whereby the Company borrowed $7.0 million to contribute to
HFC. Proceeds from this loan were used by HFC primarily to fund premium
finance notes. The loan agreement provided for a seven-year term at a
fixed interest rate of 8.25%. This note was repaid in September 2004.
7. Segment Information:
--------------------
The Company pursues its business activities through integrated
insurance groups managing non-standard automobile insurance (the
"Personal Lines Group") and commercial insurance (the "Commercial Lines
Group"). The members of the Personal Lines Group are Hallmark, an
authorized Texas property and casualty insurance company; Phoenix, an
authorized Arizona property and casualty insurance company; AHGA, a
managing general agency; and HCS, a claims administrator. Effective
December 1, 2002, the Company purchased the Commercial Lines Group.
The members of the Commercial Lines Group are HGA, a managing general
agency, and ECM, a third party claims administrator. The Company
changed the segment structure in 2003 with the acquisitions of Phoenix
and the Commercial Lines Group. Prior year information has been
restated for the new structure.
The following is additional business segment information for the twelve
months ended December 31, 2004, 2003 and 2002 (in thousands):
2004 2003 2002
-------- -------- --------
Revenues
--------
Personal Lines Group $ 39,555 $ 49,665 $ 23,999
Commercial Lines Group 23,563 19,891 1,561
Corporate 3 3 237
-------- -------- --------
Consolidated $ 63,121 $ 69,559 $ 25,797
======== ======== ========
Depreciation Expense
--------------------
Personal Lines Group $ 266 $ 218 $ 144
Commercial Lines Group 144 370 37
Corporate 13 6 -
-------- -------- --------
Consolidated $ 423 $ 594 $ 181
======== ======== ========
Interest Expense
----------------
Personal Lines Group $ 14 $ 389 $ 689
Commercial Lines Group - 1 1
Corporate 50 881 293
-------- -------- --------
Consolidated $ 64 $ 1,271 $ 983
======== ======== ========
Tax Expense
-----------
Personal Lines Group $ 2,403 $ 432 $ 218
Commercial Lines Group 569 420 1
Corporate (219) (827) (206)
-------- -------- --------
Consolidated $ 2,753 $ 25 $ 13
======== ======== ========
Pre-tax Income
--------------
Personal Lines Group $ 8,109 $ 1,950 $ 1,595
Commercial Lines Group 3,028 1,311 3
Corporate (2,535) (2,575) (1,562)
-------- -------- --------
Consolidated $ 8,602 $ 686 $ 36
======== ======== ========
The $8.1 million extraordinary gain reported in 2003 from the
acquisition of Phoenix was attributed to the Corporate segment.
The following is additional business segment information as of the
following dates (in thousands):
December 31,
------------------------
2004 2003
Assets -------- --------
------
Personal Lines Group $ 63,136 $ 68,247
Commercial Lines Group 18,557 13,365
Corporate 818 2,241
-------- --------
Consolidated $ 82,511 $ 83,853
======== ========
8. Earnings Per Share:
-------------------
The Company has adopted the provisions of Statement of Financial
Accounting Standards No. 128 ("SFAS No. 128"), "Earnings Per Share,"
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:
2004 2003 2002
------------------------------
Numerator for both basic and
----------------------------
diluted earnings per share:
---------------------------
Income before cumulative effect
of change in accounting principle
and extraordinary gain $ 5,849 $ 661 $ 23
Cumulative effect of change
in accounting principle - - (1,694)
Extraordinary gain - 8,084 -
------------------------------
Net income $ 5,849 $ 8,745 $ (1,671)
==============================
Denominator, basic shares 36,448 18,518 11,049
Effect of dilutive securities:
Stock options 240 269 78
------------------------------
Denominator, diluted shares 36,688 18,787 11,127
==============================
Basic earnings (loss) per share:
--------------------------------
Income before cumulative effect
of change in accounting principle
and extraordinary gain $ 0.16 $ 0.03 $ -
Cumulative effect of change
in accounting principle - - (0.15)
Extraordinary gain - 0.44 -
------------------------------
Net income $ 0.16 $ 0.47 $ (0.15)
==============================
Diluted earnings (loss) per share:
----------------------------------
Income before cumulative effect
of change in accounting principle
and extraordinary gain $ 0.16 $ 0.03 $ -
Cumulative effect of change
in accounting principle - - (0.15)
Extraordinary gain - 0.43 -
------------------------------
Net income $ 0.16 $ 0.46 $ (0.15)
==============================
Options to purchase 125,000, 126,000 and 1,532,000 shares of common
stock at prices ranging from $0.85 to $1.00, $0.75 to $1.00, and
$0.44 to $1.00 were outstanding at December 31, 2004, 2003 and 2002,
respectively, but were not included in the computation of diluted
earnings per share because the inclusion would result in an
antidilutive effect in periods where the option exercise price exceeded
the average market price per share for the period.
9. Regulatory Capital Restrictions:
--------------------------------
Hallmark's 2004, 2003 and 2002 net income and stockholders' equity
(capital and surplus), as determined in accordance with statutory
accounting practices, were $1.5 million, $2.0 million and $0.4 million,
and $11.5 million, $10.0 million and $8.4 million, respectively. The
minimum statutory capital and surplus required for Hallmark by the 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. Hallmark paid a dividend of
$0.2 million in 2004 to HFS that was declared in 2003. Based on
surplus at December 31, 2004, Hallmark could pay a dividend of up to
$1.5 million to HFS during 2005 without TDI approval.
Phoenix's 2004 and 2003 net income (loss) and stockholders' equity
(capital and surplus), as determined in accordance with statutory
accounting practices, were $3.4 million and ($0.3) million, and $14.0
million and $10.1 million, respectively. The minimum statutory capital
and surplus required for Phoenix by the Arizona Department of Insurance
("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. The maximum dividend that may
be paid in 2005 without prior approval of the AZDOI is $0.8 million.
Phoenix did not pay any dividends to HFS during 2004 in order to
strengthen policyholders' surplus.
The National Association of Insurance Commissioners ("NAIC") requests
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.
Hallmark's 2004, 2003 and 2002 adjusted capital under the RBC
calculation exceeded the minimum requirement by 412%, 186% and 143%,
respectively. Phoenix's 2004 and 2003 adjusted capital under the RBC
calculation exceeded the minimum requirement by 254% and 117%,
respectively.
10. Stock Option Plans:
The Company's 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, 2004, there were
incentive stock options to purchase 683,500 shares of the Company's
common stock outstanding under the Employee Plan and non-qualified
stock options to purchase 525,000 shares of the Company's common stock
outstanding under the Director Plan. In addition, as of December 31,
2004, there were outstanding non-qualified stock options to purchase
150,000 shares of the Company's common stock granted to certain non-
employee directors outside the Director Plan in lieu of fees for
service on the Company's board of directors in 1999. The exercise
price of all such outstanding stock options is equal to the fair market
value of the Company's 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 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, 2004, 2003 and 2002 and the changes during the years ended on those
dates is presented below:
2004 2003 2002
----------------------- ---------------------- ----------------------
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
of the year 1,263,500 $ 0.58 2,379,000 $ 0.50 2,679,000 $ 0.49
Granted 475,000 $ 0.59 205,000 $ 0.67 200,000 $ 0.43
Exercised (105,000) $ 0.45 (575,000) $ 0.39 - -
Forfeited (275,000) $ 0.45 (745,500) $ 0.49 (500,000) $ 0.41
Expired - - - - - -
Outstanding at end of
the year 1,358,500 $ 0.62 1,263,500 $ 0.58 2,379,000 $ 0.50
Exercisable at end of
the year 744,000 $ 0.63 1,051,500 $ 0.56 1,973,000 $ 0.50
Weighted average fair value
of all options granted $ 0.34 $ 0.36 $ 0.22
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:
2004 2003 2002
-------- -------- --------
Expected Term 5.00 5.00 5.00
Expected Volatility 67.45% 61.05% 53.37%
Risk-Free Interest Rate 3.12% 2.97% 4.91%
The following table summarizes information about stock options
outstanding at December 31, 2004:
Options Outstanding Options Exercisable
------------------- ---------------------
Weighted Avg. Weighted
Number Remaining Number Avg.
Range of Outstanding Contractual Weighted Avg. Exercisable Exercise
Exercise Prices at 12/31/04 Actual Life Exercise Price at 12/31/04 Price
--------------- ----------- ----------- -------------- ----------- --------
$ .37 to $ .57 632,500 4.6 $ .50 257,500 $ .40
$ .58 to $ .69 600,000 3.8 $ .67 373,000 $ .68
$ .70 to $1.00 126,000 2.5 $ .97 113,500 $ .98
--------- ---------
$ .37 to $1.00 1,358,500 4.1 $ .62 744,000 $ .63
========= =========
11. Retirement Plans
----------------
Certain employees of the Commercial Lines Group 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, 2004 and 2003 and for the one month
ending December 31, 2002 (in thousands) using a measurement date of
November 30. The Company acquired this plan on December 2, 2002 with
the acquisition of the Commercial Lines Group.
12 Months 12 Months 1 month
Ending Ending Ending
12/31/04 12/31/03 12/31/02
-------- -------- --------
Assumptions (end of period):
Discount rate used in determining
benefit obligation 5.75% 6.00% 6.50%
Rate of compensation increase N/A N/A N/A
Reconciliation of funded status
(end of period):
Vested benefit obligation $ (13,052) $ (12,482) $(11,756)
Accumulated benefit obligation (13,081) (12,517) (11,758)
Projected benefit obligation (13,081) (12,517) (11,758)
Fair value of plan assets 10,901 11,280 11,154
-------- -------- --------
Funded status $ (2,180) $ (1,237) $ (604)
Unrecognized net obligation - - -
Unrecognized prior service cost - - -
Unrecognized actuarial (gain)/loss 2,086 887 268
-------- -------- --------
Prepaid/(accrued) pension cost $ (94) $ (350) $ (336)
======== ======== ========
Changes in projected benefit obligation:
Benefit obligation as of
beginning of period $ 12,517 $ 11,758 $ 11,794
Interest cost 752 762 64
Actuarial liability (gain)/loss 830 1,085 (4)
Benefits paid (1,018) (1,088) (96)
-------- -------- --------
Benefit obligation as of end of period $ 13,081 $ 12,517 $ 11,758
======== ======== ========
12 Months 12 Months 1 month
Ending Ending Ending
12/31/04 12/31/03 12/31/02
-------- -------- --------
Change in plan assets:
Fair value of plan assets as of
beginning of period $ 11,280 $ 11,154 $ 11,446
Actual return on plan assets
(net of expenses) 388 1,214 (196)
Employer contributions 251 - -
Benefits paid (1,018) (1,088) (96)
-------- -------- --------
Fair value of plan assets as
of end of period $ 10,901 $ 11,280 $ 11,154
======== ======== ========
Net periodic pension cost:
Service cost - benefits earned
during the period $ - $ - $ -
Interest cost on projected
benefit obligation 752 762 64
Expected return on plan assets (764) (749) (76)
Amortizations
Net obligation/(asset) - - -
Unrecognized prior service cost - - -
Unrecognized (gain)/loss 7 - -
-------- -------- --------
Net periodic pension cost (credit) $ (5) $ 13 $ (12)
======== ======== ========
Discount rate 6.00% 6.50% 6.50%
Expected return on plan assets 7.00% 7.00% 8.00%
Rate of compensation increase N/A N/A N/A
The expected benefit payments under the plan are as follows
(in thousands):
2005 $ 910
2006 $ 919
2007 $ 916
2008 $ 896
2009 $ 883
2010-2014 $ 4,321
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. As of December 31,
2003, the fair value of the plan assets was composed of cash and cash
equivalents of $0.4 million, bonds and notes of $5.2 million and equity
securities of $5.7 million. The Company recorded a $2.2 million
pension liability at December 31, 2004, of which, $2.1 million was
additional minimum pension liability.
The investment objectives of the Company 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 consumers price index. The Company has prohibited all
investments in options, futures, precious metals, short sales and
purchase on margin. In 2003, management 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,
the Company considered 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 7% long-term rate of return on assets assumption.
The Company estimates it will contribute $0.1 million to the defined
benefit cash balance plan during 2005.
The following table shows the weighted-average asset allocation for the
defined benefit cash balance plan held as of December 31, 2004 and
2003.
12/31/04 12/31/03
-------------------
Asset Category:
Debt securities 41% 46%
Equity securities 57% 51%
Other 2% 3%
-------------------
Total 100% 100%
===================
The Company sponsors a defined contribution plan. Under this plan,
employees may contribute a portion of their compensation on a tax-
deferred basis, and the Company may contribute a discretionary amount
each year. The Company contributed $0.1 million for each of the twelve
months ended December 31, 2004 and 2003.
12. Income Taxes:
-------------
The composition of deferred tax assets and liabilities and the related
tax effects (in thousands) as of December 31, 2004 and 2003, are as
follows:
2004 2003
-------- --------
Deferred tax liabilities:
Deferred policy acquisition costs $ ( 2,715) $ ( 2,429)
Profit sharing commission ( 74) ( 357)
Agency relationship ( 208) ( 188)
Goodwill ( 59) -
Unrealized holding gains on
investments ( 312) ( 239)
Guaranty assessment fund - ( 39)
Fixed asset depreciation ( 131) ( 130)
Loss reserve discount ( 27) ( 53)
Other ( 93) ( 286)
-------- --------
Total deferred tax liabilities $ ( 3,619) $ ( 3,721)
======== ========
Deferred tax assets:
Unearned premiums $ 421 $ 379
Deferred ceding commissions 3,182 2,839
Pension liability 806 421
Net operating loss carryforward 1,796 1,796
Allowance for bad debt 189 141
Unpaid loss and loss adjustment expense 846 489
Goodwill 1,700 1,782
Rent reserve 126 133
Investment impairments 188 207
Unearned revenue 289 81
Risk premium reserve 42 75
Other 91 223
-------- --------
Total deferred tax assets $ 9,676 $ 8,566
======== ========
Net deferred tax asset before
valuation allowance $ 6,057 $ 4,845
Valuation allowance 884 884
-------- --------
Net deferred tax asset $ 5,173 $ 3,961
======== ========
A valuation allowance is provided against the Company's deferred tax
asset to the extent that management does 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,
2004 and December 31, 2003. The valuation allowance is provided against
a net operating loss carryforward subject to limitations on its
utilization. Based on the evidence available as of December 31, 2004,
management believes that it is more likely than not that the remaining
net deferred tax assets will be realized. However, this assessment may
change during 2005 if the Company's financial results do not meet
management's 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, 2004, 2003 and
2002, is as follows:
2004 2003 2002
-------- -------- --------
Computed expected income tax provision
(benefit) at statutory regulatory
tax rate $ 3,013 $ 233 $ 12
Meals and entertainment 6 5 1
Tax exempt interest ( 309) ( 122) -
Dividends received deduction 33 ( 28) -
State taxes (net of federal benefit) ( 19) ( 6) -
Other 29 ( 57) -
-------- -------- --------
Income tax provision (benefit) $ 2,753 $ 25 $ 13
======== ======== ========
Current income tax provision (benefit) $ 3,540 $ ( 89) $ ( 32)
Deferred tax provision (benefit) ( 787) 114 45
-------- -------- --------
Income tax provision (benefit) $ 2,753 $ 25 $ 13
======== ======== ========
Approximately $0.1 million of the 2004 current income tax provision
results from tax deductible goodwill from the Phoenix acquisition.
The company has available, for federal income tax purposes, unused net
operating loss of approximately $5.3 million at December 31, 2004. The
losses were acquired as part of the Phoenix 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,
the company believes that $2.6 million of the net operating loss
carryforwards may expire unutilized. Therefore, a valuation allowance
of $2.6 million has been established against these net operating loss
carryforwards. The Internal Revenue Code has provided that effective
with tax years beginning September 1997, the carryback and carryforward
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
=======
13 Commitments and Contingencies:
------------------------------
The Company has 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, $1.3 million and $0.8 million for the
years ended December 31, 2004, 2003 and 2002, respectively.
Future minimum lease payments (in thousands) under noncancellable
operating leases as of December 31, 2004 are as follows:
Year
----
2005 $ 1,100
2006 1,037
2007 1,007
2008 928
2009 375
2010 and thereafter 563
-------
Total minimum lease payments $ 5,010
=======
From time to time, assessments are levied on the Company 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, the Company
capitalizes the assessments as they are paid and amortizes the
capitalized balance against its premium tax expense. There were no
assessments during 2004, 2003 or 2002.
14. Concentrations of Credit Risk:
------------------------------
The Company maintains cash equivalents in accounts with four financial
institutions in excess of the amount insured by the Federal Deposit
Insurance Corporation. The Company monitors the financial stability of
the depository institutions regularly, and management does not believe
excessive risk of depository institution failure exists at December 31,
2004.
The Company is also subject to credit risk with respect to reinsurers
to whom it has ceded underwriting risk. Although a reinsurer is liable
for losses to the extent of the coverage it assumes, the Company
remains obligated to its 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, the Company has
used financially strong reinsurers with an A.M. Best rating of "A-"
or better. The Company discontinued ceding underwriting risk to
reinsurers effective April 1, 2003.
The Company's reinsurance coverage has been substantially provided by
Dorinco since July 1, 2000. Effective October 1, 2004, the Company
does not utilize any quota share reinsurance. Substantially all of the
Company's reinsurance recoverable balance at December 31, 2004 is due
from two reinsurers.