UNITED STATES

 

SECURITIES AND EXCHANGE COMMISSION

 

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

Quarterly report pursuant to Section 13 or 15(d) of the

 

Securities Exchange Act of 1934

 

For the quarterly period ended September 30, 2017

 

Commission file number 001-11252

 

Hallmark Financial Services, Inc.

 

(Exact name of registrant as specified in its charter)

 

Nevada		87-0447375
(State or other jurisdiction of		(I.R.S. Employer
Incorporation or organization)		Identification No.)
777 Main Street, Suite 1000, Fort Worth, Texas		76102
(Address of principal executive offices)		(Zip Code)

 

Registrant's telephone number, including area code: (817) 348-1600

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer ¨	Accelerated filer x
Non-accelerated filer ¨	Smaller reporting company ¨	Emerging growth company ¨

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 15(a) of the Exchange Act. ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

 

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: Common Stock, par value $.18 per share –18,157,929 shares outstanding as of November 1, 2017.

 

 

 

PART I

FINANCIAL INFORMATION

 

Item 1.

Financial Statements

 

INDEX TO FINANCIAL STATEMENTS

 

	Page Number
Consolidated Balance Sheets at September 30, 2017 (unaudited) and December 31, 2016	3
Consolidated Statements of Operations (unaudited) for the three months and nine months ended September 30, 2017 and September 30, 2016	4
Consolidated Statements of Comprehensive Income (unaudited) for the three months and nine months ended September 30, 2017 and September 30, 2016	5
Consolidated Statements of Stockholders’ Equity (unaudited) for the three months and nine months ended September 30, 2017 and September 30, 2016	6
Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2017 and September 30, 2016	7
Notes to Consolidated Financial Statements (unaudited)	8

 

  

Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Balance Sheets

($ in thousands, except par value)

 

		September 30, 2017				December 31, 2016
		(unaudited)
ASSETS
Investments:
Debt securities, available-for-sale, at fair value (cost: $616,885 in 2017 and $597,784 in 2016)		$	618,234			$	597,457
Equity securities, available-for-sale, at fair value (cost: $26,681 in 2017 and $31,449 in 2016)			47,799				51,711
Other investments (cost, $3,763 in 2017 and 2016)			4,221				4,951
Total investments			670,254				654,119
Cash and cash equivalents			89,770				79,632
Restricted cash			3,343				7,327
Ceded unearned premiums			103,970				81,482
Premiums receivable			101,658				89,715
Accounts receivable			1,934				2,269
Receivable for securities			1,709				3,047
Reinsurance recoverable			181,961				147,821
Deferred policy acquisition costs			19,245				19,193
Goodwill			44,695				44,695
Intangible assets, net			10,641				12,491
Deferred federal income taxes, net			2,345				1,365
Federal income tax recoverable			2,033				3,951
Prepaid expenses			1,677				1,552
Other assets			13,587				13,801
Total assets		$	1,248,822			$	1,162,460
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Revolving credit facility payable		$	30,000			$	30,000
Subordinated debt securities (less unamortized debt issuance cost of $962 in 2017 and $1,001 in 2016)			55,740				55,701
Reserves for unpaid losses and loss adjustment expenses			531,499				481,567
Unearned premiums			279,487				241,254
Reinsurance balances payable			57,023				46,488
Pension liability			2,049				2,203
Payable for securities			7,635				14,215
Accounts payable and other accrued expenses			23,916				25,296
Total liabilities		$	987,349			$	896,724
Commitments and Contingencies (Note 16)
Stockholders' equity:
Common stock, $.18 par value, authorized 33,333,333; issued 20,872,831 shares in 2017 and 2016			3,757				3,757
Additional paid-in capital			123,156				123,166
Retained earnings			147,103				148,027
Accumulated other comprehensive income			12,085				10,371
Treasury stock (2,714,902 shares in 2017 and  2,260,849 in 2016), at cost			(24,628	)			(19,585	)
Total stockholders' equity		$	261,473			$	265,736
Total liabilities and stockholders' equity		$	1,248,822			$	1,162,460

 

The accompanying notes are an integral part of the consolidated financial statements

 

  

Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Statements of Operations

(Unaudited)

($ in thousands, except per share amounts)

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2017				2016				2017				2016
Gross premiums written		$	161,151			$	147,065			$	458,319			$	419,549
Ceded premiums written			(66,102	)			(51,380	)			(173,857	)			(140,995	)
Net premiums written			95,049				95,685				284,462				278,554
Change in unearned premiums			(6,261	)			(4,890	)			(15,744	)			(15,734	)
Net premiums earned			88,788				90,795				268,718				262,820
Investment income, net of expenses			5,295				4,070				14,361				11,943
Net realized gains (losses)			2,110				1,105				691				(1,299	)
Finance charges			892				1,036				2,881				3,825
Commission and fees			570				546				1,295				1,278
Other income			68				66				200				131
Total revenues			97,723				97,618				288,146				278,698
Losses and loss adjustment expenses			72,379				62,337				204,925				176,234
Other operating expenses			25,071				26,344				78,445				82,563
Interest expense			1,181				1,144				3,530				3,398
Amortization of intangible assets			617				617				1,851				1,851
Total expenses			99,248				90,442				288,751				264,046
(Loss) income before tax			(1,525	)			7,176				(605	)			14,652
Income tax expense			35				2,128				319				4,464
Net (loss) income			(1,560	)			5,048				(924	)			10,188
Net (loss) income per share:
Basic		$	(0.09	)		$	0.27			$	(0.05	)		$	0.54
Diluted		$	(0.09	)		$	0.27			$	(0.05	)		$	0.54

 

The accompanying notes are an integral part of the consolidated financial statements

 

  

Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income

(Unaudited)

($ in thousands)

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2017				2016				2017				2016
Net (loss) income		$	(1,560	)		$	5,048			$	(924	)		$	10,188
Other comprehensive income:
Change in net actuarial gain			37				28				107				85
Tax effect on change in net actuarial gain			(13	)			(10	)			(37	)			(30	)
Unrealized holding gains arising during the period			308				2,039				8,208				7,767
Tax effect on unrealized holding gains arising during the period			(108	)			(714	)			(2,873	)			(2,718	)
Reclassification adjustment for (gains) losses included in net income			(3,188	)			(1,105	)			(5,679	)			(1,589	)
Tax effect on reclassification adjustment for losses (gains) included in net income			1,116				387				1,988				556
Other comprehensive (loss) income, net of tax			(1,848	)			625				1,714				4,071
Comprehensive (loss) income		$	(3,408	)		$	5,673			$	790			$	14,259

 

The accompanying notes are an integral part of the consolidated financial statements

 

  

Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Statements of Stockholders’ Equity

(Unaudited)

($ in thousands)

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2017				2016				2017				2016
Common Stock
Balance, beginning of period		$	3,757			$	3,757			$	3,757			$	3,757
Balance, end of period			3,757				3,757				3,757				3,757
Additional Paid-In Capital
Balance, beginning of period			123,110				123,650				123,166				123,480
Equity based compensation			51				(249	)			97				(21	)
Shares issued under employee benefit plans			(5	)			(138	)			(107	)			(196	)
Balance, end of period			123,156				123,263				123,156				123,263
Retained Earnings
Balance, beginning of period			148,663				146,641				148,027				141,501
Net (loss) income			(1,560	)			5,048				(924	)			10,188
Balance, end of period			147,103				151,689				147,103				151,689
Accumulated Other Comprehensive Income
Balance, beginning of period			13,933				10,864				10,371				7,418
Additional minimum pension liability, net of tax			24				18				70				55
Unrealized holding gains arising during period, net of tax			200				1,325				5,335				5,049
Reclassification adjustment for losses (gains) included in net income, net of tax			(2,072	)			(718	)			(3,691	)			(1,033	)
Balance, end of period			12,085				11,489				12,085				11,489
Treasury Stock
Balance, beginning of period			(23,763	)			(18,817	)			(19,585	)			(14,130	)
Acquisition of treasury stock			(883	)			(1,047	)			(5,308	)			(5,792	)
Shares issued under employee benefit plans			18				604				265				662
Balance, end of period			(24,628	)			(19,260	)			(24,628	)			(19,260	)
Total Stockholders' Equity		$	261,473			$	270,938			$	261,473			$	270,938

 

The accompanying notes are an integral part of the consolidated financial statements

 

  

Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

($ in thousands)

 

		Nine Months Ended September 30,
		2017				2016
Cash flows from operating activities:
Net (loss) income		$	(924	)		$	10,188
Adjustments to reconcile net (loss) income to net cash provided by operating activities:
Depreciation and amortization expense			3,467				2,927
Deferred federal income taxes			(1,903	)			196
Net realized (gains) losses			(691	)			1,299
Share-based payments expense			97				(21	)
Change in ceded unearned premiums			(22,488	)			(16,162	)
Change in premiums receivable			(11,943	)			(12,121	)
Change in accounts receivable			335				(128	)
Change in deferred policy acquisition costs			(52	)			(335	)
Change in unpaid losses and loss adjustment expenses			49,932				4,122
Change in unearned premiums			38,233				31,897
Change in reinsurance recoverable			(34,140	)			(19,192	)
Change in reinsurance balances payable			10,535				16,062
Change in current federal income tax recoverable			1,918				2,780
Change in all other liabilities			(1,495	)			468
Change in all other assets			3,448				3,552
Net cash provided by operating activities			34,329				25,532
Cash flows from investing activities:
Purchases of property and equipment			(1,576	)			(3,658	)
Net transfers from (into) restricted cash			3,984				(2,634	)
Purchases of investment securities			(196,976	)			(167,062	)
Maturities, sales and redemptions of investment securities			175,527				110,407
Net cash used in investing activities			(19,041	)			(62,947	)
Cash flows from financing activities:
Payment of contingent consideration			-				(1,784	)
Proceeds from exercise of employee stock options			158				466
Purchase of treasury shares			(5,308	)			(5,792	)
Net cash used in financing activities			(5,150	)			(7,110	)
Increase (decrease) in cash and cash equivalents			10,138				(44,525	)
Cash and cash equivalents at beginning of period			79,632				114,446
Cash and cash equivalents at end of period		$	89,770			$	69,921
Supplemental cash flow information:
Interest paid		$	3,505			$	3,143
Income taxes paid		$	304			$	1,488
Supplemental schedule of non-cash investing activities:
Change in receivable for securities related to investment disposals that settled  after the balance sheet date		$	1,338			$	9,739
Change in payable for securities related to investment purchases that settled after the balance sheet date		$	(6,580	)		$	2,858

 

 

The accompanying notes are an integral part of the consolidated financial statements

 

 

Hallmark Financial Services, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

 

1. General

 

Hallmark Financial Services, Inc. (“Hallmark” and, together with subsidiaries, “we,” “us” or “our”) is an insurance holding company engaged in the sale of property/casualty insurance products to businesses and individuals. Our business involves marketing, distributing, underwriting and servicing our insurance products, as well as providing other insurance related services.

 

We pursue our business activities primarily through subsidiaries whose operations are organized into product-specific operating units that are supported by our insurance company subsidiaries. Our Contract Binding operating unit (f/k/a MGA Commercial Products operating unit) offers commercial insurance products and services in the excess and surplus lines market. Our Specialty Commercial operating unit offers general aviation and satellite launch insurance products and services, low and middle market commercial umbrella and primary/excess liability insurance, medical and financial professional liability insurance products and services, and primary/excess commercial property coverages for both catastrophe and non-catastrophe exposures. Our Standard Commercial P&C operating unit offers industry-specific commercial insurance products and services in the standard market. Our Workers Compensation operating unit specializes in small and middle market workers compensation business. Effective July 1, 2015, this operating unit no longer markets or retains any risk on new or renewal policies. Our Specialty Personal Lines operating unit offers non-standard personal automobile and renters insurance products and services. Our insurance company subsidiaries supporting these operating units are American Hallmark Insurance Company of Texas (“AHIC”), Hallmark Insurance Company (“HIC”), Hallmark Specialty Insurance Company (“HSIC”), Hallmark County Mutual Insurance Company, Hallmark National Insurance Company and Texas Builders Insurance Company.

 

These operating units are segregated into three reportable industry segments for financial accounting purposes. The Specialty Commercial Segment includes our Contract Binding operating unit and our Specialty Commercial operating unit. The Standard Commercial Segment includes our Standard Commercial P&C operating unit and our Workers Compensation operating unit. The Personal Segment consists solely of our Specialty Personal Lines operating unit.

 

2. Basis of Presentation

 

Our unaudited consolidated financial statements included herein have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and include our accounts and the accounts of our subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to rules and regulations of the Securities and Exchange Commission (“SEC”) for interim financial reporting. These unaudited consolidated financial statements should be read in conjunction with our audited consolidated financial statements for the year ended December 31, 2016 included in our Annual Report on Form 10-K filed with the SEC.

 

The interim financial data as of September 30, 2017 and 2016 is unaudited. However, in the opinion of management, the interim data includes all adjustments, consisting of normal recurring adjustments, necessary for a fair statement of the results for the interim periods. The results of operations for the period ended September 30, 2017 are not necessarily indicative of the operating results to be expected for the full year.

 

  

Income Taxes

 

We file a consolidated federal income tax return. Deferred federal income taxes reflect the future tax consequences of differences between the tax basis 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.

 

Use of Estimates in the Preparation of the Financial Statements

 

Our preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect our reported amounts of assets and liabilities and our disclosure of contingent assets and liabilities at the date of our consolidated financial statements, as well as our reported amounts of revenues and expenses during the reporting period. Refer to “Critical Accounting Estimates and Judgments” under Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2016 for information on accounting policies that we consider critical in preparing our consolidated financial statements. Actual results could differ materially from those estimates.

 

Fair Value of Financial Instruments

 

Fair value estimates are made at a point in time based on relevant market data as well as the best information available about the financial instruments. Fair value estimates for financial instruments for which no or limited observable market data is available are based on judgments regarding current economic conditions, credit and interest rate risk. These estimates involve significant uncertainties and judgments and cannot be determined with precision. As a result, such calculated fair value estimates may not be realizable in a current sale or immediate settlement of the instrument. In addition, changes in the underlying assumptions used in the fair value measurement technique, including discount rate and estimates of future cash flows, could significantly affect these fair value estimates.

 

Cash and Cash Equivalents: The carrying amounts reported in the balance sheet for these instruments approximate their fair values.

 

Restricted Cash: The carrying amount for restricted cash reported in the balance sheet approximates the fair value.

 

Revolving Credit Facility Payable: A revolving credit facility with Frost Bank had a carried value of $30.0 million and a fair value of $30.2 million as of September 30, 2017.  The fair value is based on discounted cash flows using a discount rate derived from LIBOR spot rates plus a market spread resulting in discount rates ranging between 3.4% to 4.1% for each future payment date.  This revolving credit facility would be included in Level 3 of the fair value hierarchy if it was reported at fair value.

 

Subordinated Debt Securities: Our trust preferred securities have a carried value of $55.7 million and a fair value of $43.4 million as of September 30, 2017. The fair value of our trust preferred securities is based on discounted cash flows using a current yield to maturity of 8.0%, which is based on similar issues to discount future cash flows. Our trust preferred securities would be included in Level 3 of the fair value hierarchy if they were reported at fair value.

 

  

For reinsurance balances, premiums receivable, federal income tax payable, other assets and other liabilities, the carrying amounts approximate fair value because of the short maturity of such financial instruments.

 

Variable Interest Entities

 

On June 21, 2005, we formed Hallmark Statutory Trust I (“Trust I”), an unconsolidated trust subsidiary, for the sole purpose of issuing $30.0 million in trust preferred securities. Trust I used the proceeds from the sale of these securities and our initial capital contribution to purchase $30.9 million of subordinated debt securities from Hallmark. The debt securities are the sole assets of Trust I, and the payments under the debt securities are the sole revenues of Trust I.

 

On August 23, 2007, we formed Hallmark Statutory Trust II (“Trust II”), an unconsolidated trust subsidiary, for the sole purpose of issuing $25.0 million in trust preferred securities. Trust II used the proceeds from the sale of these securities and our initial capital contribution to purchase $25.8 million of subordinated debt securities from Hallmark. The debt securities are the sole assets of Trust II, and the payments under the debt securities are the sole revenues of Trust II.

 

We evaluate on an ongoing basis our investments in Trust I and Trust II (collectively the “Trusts”) and have determined that we do not have a variable interest in the Trusts.  Therefore, the Trusts are not included in our consolidated financial statements.

 

We are also involved in the normal course of business with variable interest entities (“VIE’s”) primarily as a passive investor in mortgage-backed securities and certain collateralized corporate bank loans issued by third party VIE’s. The maximum exposure to loss with respect to these investments is the investment carrying values included in the consolidated balance sheets.

 

Recently Issued Accounting Pronouncements

 

In March 2017, the FASB issued ASU 2017-08, “Premium Amortization on Purchased Callable Securities” (Subtopic 310-20). ASU 2017-08 is intended to enhance the accounting for amortization of premiums for purchased callable debt securities. The guidance amends the amortization period for certain purchased callable debt securities held at a premium. Securities that contain explicit, noncontingent call features that are callable at fixed prices and on preset dates should shorten the amortization period for the premium to the earliest call date (and if the call option is not exercised, the effective yield is reset using the payment terms of the debt security). The standard is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018, and is to be applied on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings. We are currently evaluating the impact that the adoption of ASU 2017-08 will have on our financial results and disclosures.

 

In January 2017, the FASB issued ASU 2017-01, “Clarifying the Definition of a Business” (Topic 715). ASU 2017-01 is intended to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. ASU 2017-01 is effective for annual periods beginning after December 15, 2017, including interim periods within those annual periods. We do not expect the adoption of this standard to have a material impact on our financial condition or results of operations.

 

  

In January 2017, the FASB issued ASU 2017-04, “Simplifying the Test for Goodwill Impairment” (Topic 350). ASU 2017-04 requires only a one-step quantitative impairment test, whereby a goodwill impairment loss will be measured as the excess of a reporting unit’s carrying amount over its fair value (not to exceed the total goodwill allocated to that reporting unit). It eliminates Step 2 of the current two-step goodwill impairment test, under which a goodwill impairment loss is measured by comparing the implied fair value of a reporting unit’s goodwill. The ASU is effective for annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019. We are currently evaluating the impact that the adoption of ASU 2017-04 will have on our financial results and disclosures.

 

In August 2016, the FASB issued ASU 2016-15, “Classification of Certain Cash Receipts and Cash Payments” (Topic 230). ASU 2016-15 will reduce diversity in practice on how eight specific cash receipts and payments are classified on the statement of cash flows. The ASU will be effective for fiscal years beginning after December 15, 2017, including interim periods within those years. We are currently evaluating the impact that the adoption of ASU 2016-15 will have on our financial results and disclosures.

 

In June 2016, the FASB issued ASU 2016-13, “Measurement of Credit Losses on Financial Instruments” (Topic 326). ASU 2016-13 requires organizations to estimate credit losses on certain types of financial instruments, including receivables and available-for-sale debt securities, by introducing an approach based on expected losses. The expected loss approach will require entities to incorporate considerations of historical information, current information and reasonable and supportable forecasts. ASU 2016-13 is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. ASU 2016-13 requires a modified retrospective transition method and early adoption is permitted. We are currently evaluating the impact that the adoption of this standard will have on our financial results and disclosures, but do not anticipate that any potential impact would be material.

 

In February 2016, the FASB issued ASU 2016-02, “Leases” (Topic 842). ASU 2016-02 requires organizations that lease assets to recognize on the balance sheet the assets and liabilities for the rights and obligations created by those leases. Additionally, ASU 2016-02 modifies current guidance for lessors' accounting. ASU 2016-02 is effective for interim and annual reporting periods beginning on or after January 1, 2019, with early adoption permitted. We do not anticipate that this standard will have a material impact on our results of operations, but we anticipate an increase to the value of our assets and liabilities related to leases, with no material impact to equity.

 

In January 2016, the FASB issued ASU 2016-01, “Recognition and Measurement of Financial Assets and Financial Liabilities” (Subtopic 825-10). ASU 2016-01 will require equity investments that are not consolidated or accounted for under the equity method of accounting to be measured at fair value with changes in fair value recognized in net income. ASU 2016-01 will also require us to assess the ability to realize our deferred tax assets (“DTAs”) related to an available-for-sale debt security in combination with our other DTAs. ASU 2016-01 will be effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. While we continue to evaluate the impact of this standard, we anticipate the standard will increase the volatility of our consolidated statements of income, resulting from the remeasurement of our equity investments.

 

In May 2014, the FASB issued guidance which revises the criteria for revenue recognition. Under the guidance, the transaction price is attributed to underlying performance obligations in the contract and revenue is recognized as the entity satisfies the performance obligations and transfers control of a good or service to the customer. Incremental costs of obtaining a contract may be capitalized to the extent the entity expects to recover those costs. The guidance is effective for reporting periods beginning after December 15, 2017 and is to be applied retrospectively. Revenue from insurance contracts is excluded from the scope of this new guidance. While insurance contracts are excluded from this guidance, policy fee income, billing and other fees and fee income related to property business written as a cover-holder through a Lloyds Syndicate will be subject to this updated guidance. We continue to evaluate what impact this guidance will have on our financial results and disclosures and which adoption method to apply, but do not anticipate such impact being material based on the limited revenue streams subject to the guidance.

 

  

Adoption of New Accounting Pronouncements

 

In March 2016, the FASB issued ASU 2016-09, “Improvements to Employee Share-Based Payment Accounting” (Topic 718). ASU 2016-09 simplifies the accounting for share-based payment award transactions including income tax consequences, classification of awards as either equity or liabilities, classification on the statement of cash flows, and accounting for forfeitures. The guidance was effective for annual periods beginning after December 15, 2016, and interim periods within those fiscal years. Effective January 2017, we adopted this new guidance on stock compensation which requires recognition of the excess tax benefits or deficiencies of share-based compensation awards to employees through net income rather than through additional paid in capital. The impact of this adoption did not have a material impact on our financial results or disclosures.

 

3. Fair Value

 

  ASC 820 defines fair value, establishes a consistent framework for measuring fair value and expands disclosure requirements about fair value measurements. ASC 820, among other things, requires us to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. In addition, ASC 820 precludes the use of block discounts when measuring the fair value of instruments traded in an active market, which were previously applied to large holdings of publicly traded equity securities.

 

We determine the fair value of our financial instruments based on the fair value hierarchy established in ASC 820. In accordance with ASC 820, we utilize the following fair value hierarchy:

 

·

Level 1: quoted prices in active markets for identical assets;

 

·

Level 2: inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, inputs of identical assets for less active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the instrument; and

 

·

Level 3: inputs to the valuation methodology that are unobservable for the asset or liability.

 

This hierarchy requires the use of observable market data when available.

 

Under ASC 820, we determine fair value based on the price that would be received for an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date. It is our policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements, in accordance with the fair value hierarchy described above. Fair value measurements for assets and liabilities where there exists limited or no observable market data are calculated based upon our pricing policy, the economic and competitive environment, the characteristics of the asset or liability and other factors as appropriate. These estimated fair values may not be realized upon actual sale or immediate settlement of the asset or liability.

 

  

Where quoted prices are available on active exchanges for identical instruments, investment securities are classified within Level 1 of the valuation hierarchy. Level 1 investment securities include common and preferred stock.

 

Level 2 investment securities include corporate bonds, collateralized corporate bank loans, municipal bonds, and U.S. Treasury securities for which quoted prices are not available on active exchanges for identical instruments. We use third party pricing services to determine fair values for each Level 2 investment security in all asset classes. Since quoted prices in active markets for identical assets are not available, these prices are determined using observable market information such as quotes from less active markets and/or quoted prices of securities with similar characteristics, among other things. We have reviewed the processes used by the pricing services and have determined that they result in fair values consistent with the requirements of ASC 820 for Level 2 investment securities.

 

In cases where there is limited activity or less transparency around inputs to the valuation, investment securities are classified within Level 3 of the valuation hierarchy. Level 3 investments are valued based on the best available data in order to approximate fair value. This data may be internally developed and consider risk premiums that a market participant would require. Investment securities classified within Level 3 include other less liquid investment securities.

 

There were no transfers between Level 1 and Level 2 securities during the periods presented.

 

  

The following table presents for each of the fair value hierarchy levels, our assets that are measured at fair value on a recurring basis at September 30, 2017 and December 31, 2016 (in thousands):

 

		As of September 30, 2017
		Quoted Prices in				Other
		Active Markets for				Observable				Unobservable
		Identical Assets				Inputs				Inputs
		(Level 1)				(Level 2)				(Level 3)				Total
U.S. Treasury securities and obligations of U.S. Government		$	-			$	42,034			$	-			$	42,034
Corporate bonds			-				283,858				763				284,621
Collateralized corporate bank loans			-				123,243				-				123,243
Municipal bonds			-				143,190				5,793				148,983
Mortgage-backed			-				19,353				-				19,353
Total debt securities			-				611,678				6,556				618,234
Total equity securities			47,178				-				621				47,799
Total other investments			4,221				-				-				4,221
Total investments		$	51,399			$	611,678			$	7,177			$	670,254

 

		As of December 31, 2016
		Quoted Prices in				Other
		Active Markets for				Observable				Unobservable
		Identical Assets				Inputs				Inputs
		(Level 1)				(Level 2)				(Level 3)				Total
U.S. Treasury securities and obligations of U.S. Government		$	-			$	42,022			$	-			$	42,022
Corporate bonds			-				226,062				-				226,062
Collateralized corporate bank loans			-				106,009				-				106,009
Municipal bonds			-				158,216				5,679				163,895
Mortgage-backed			-				59,469				-				59,469
Total debt securities			-				591,778				5,679				597,457
Total equity securities			51,445				-				266				51,711
Total other investments			4,951				-				-				4,951
Total investments		$	56,396			$	591,778			$	5,945			$	654,119

 

  

Due to significant unobservable inputs into the valuation model for certain municipal bonds, one corporate bond and one equity security, as of September 30, 2017 and December 31, 2016, we classified these investments as Level 3 in the fair value hierarchy. We used an income approach in order to derive an estimated fair value of the municipal bonds classified as Level 3, which included inputs such as expected holding period, benchmark swap rate, benchmark discount rate and a discount rate premium for illiquidity. The corporate bond is a convertible senior note and its fair value was estimated by the sum of the bond value using an income approach discounting the scheduled interest and principal payments and the conversion feature utilizing a binomial lattice model. We also estimated the fair value of the corporate bond utilizing an as-if converted basis into the underlying securities. The equity security classified as Level 3 in the fair value hierarchy is an investment in a non-public entity. Given the size of this investment and since there was not an observable market for the security, we estimated its fair value as the fair value on the date we acquired the investment. Changes in the unobservable inputs in the fair value measurement of these investments could result in a significant change in the fair value measurement.

 

The following table summarizes the changes in fair value for all financial assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the nine months ended September 30, 2017 and 2016 (in thousands):

 

Beginning balance as of January 1, 2017		$	5,945
Sales			-
Settlements			(150	)
Purchases			775
Issuances			-
Total realized/unrealized gains included in net income			-
Net gains included in other comprehensive income			607
Transfers into Level 3			-
Transfers out of Level 3			-
Ending balance as of September 30, 2017		$	7,177
Beginning balance as of January 1, 2016		$	14,087
Sales			-
Settlements			(6,025	)
Purchases			-
Issuances			-
Total realized/unrealized gains included in net income			-
Net gains included in other comprehensive income			160
Transfers into Level 3			265
Transfers out of Level 3			-
Ending balance as of September 30, 2016		$	8,487

 

  

4. Investments

 

The amortized cost and estimated fair value of investments in debt and equity securities by category is as follows (in thousands):

 

						Gross				Gross
		Amortized				Unrealized				Unrealized				Fair
As of September 30, 2017		Cost				Gains				Losses				Value
U.S. Treasury securities and obligations of U.S. Government		$	42,034			$	6			$	(6	)		$	42,034
Corporate bonds			283,851				1,810				(1,040	)			284,621
Collateralized corporate bank loans			123,070				628				(455	)			123,243
Municipal bonds			148,473				917				(407	)			148,983
Mortgage-backed			19,457				64				(168	)			19,353
Total debt securities			616,885				3,425				(2,076	)			618,234
Total equity securities			26,681				22,237				(1,119	)			47,799
Total other investments			3,763				458				-				4,221
Total investments		$	647,329			$	26,120			$	(3,195	)		$	670,254
As of December 31, 2016
U.S. Treasury securities and obligations of U.S. Government		$	41,976			$	66			$	(20	)		$	42,022
Corporate bonds			224,915				1,722				(575	)			226,062
Collateralized corporate bank loans			105,220				959				(170	)			106,009
Municipal bonds			165,900				956				(2,961	)			163,895
Mortgage-backed			59,773				49				(353	)			59,469
Total debt securities			597,784				3,752				(4,079	)			597,457
Total equity securities			31,449				21,052				(790	)			51,711
Total other investments			3,763				1,188				-				4,951
Total investments		$	632,996			$	25,992			$	(4,869	)		$	654,119

 

  

Major categories of net realized gains (losses) on investments are summarized as follows (in thousands):

 

		Three Months Ended September 30,								Nine Months Ended September 30,
		2017				2016				2017				2016
U.S. Treasury securities and obligations of U.S. Government		$	-			$	-			$	-			$	-
Corporate bonds			(107	)			(81	)			(125	)			(1	)
Collateralized corporate bank loans			8				(98	)			56				(116	)
Municipal bonds			120				(97	)			204				(165	)
Mortgage-backed			(1	)			(1	)			(1	)			(1	)
Equity securities			3,168				1,382				5,545				1,872
Gain on investments			3,188				1,105				5,679				1,589
Change in unrealized losses on other investments			(228	)			-				(731	)			-
Other-than-temporary impairments			(850	)			-				(4,257	)			(2,888	)
Net realized gains (losses)		$	2,110			$	1,105			$	691			$	(1,299	)

 

We realized gross gains on investments of $3.4 million and $1.4 million during the three months ended September 30, 2017 and 2016, respectively, and $6.4 million and $2.1 million for the nine months ended September 30, 2017 and 2016, respectively.  We realized gross losses on investments of $0.2 million and $0.3 million for the three months ended September 30, 2017 and 2016, respectively, and $0.7 million and $0.5 million for the nine months ended September 30, 2017 and 2016, respectively. We recorded proceeds from the sale of investment securities of $11.4 million and $5.4 million during the three months ended September 30, 2017 and 2016, respectively, and $19.4 million and $21.3 million for the nine months ended September 30, 2017 and 2016, respectively. Realized investment gains and losses are recognized in operations on the specific identification method. 

 

The following schedules summarize the gross unrealized losses showing the length of time that investments have been continuously in an unrealized loss position as of September 30, 2017 and December 31, 2016 (in thousands):

 

  

		As of September 30, 2017
		12 months or less								Longer than 12 months								Total
						Unrealized								Unrealized								Unrealized
		Fair Value				Losses				Fair Value				Losses				Fair Value				Losses
U.S. Treasury securities and obligations of U.S. Government		$	36,977			$	(6	)		$	-			$	-			$	36,977			$	(6	)
Corporate bonds			99,803				(1,040	)			-				-				99,803				(1,040	)
Collateralized corporate bank loans			33,925				(385	)			2,474				(70	)			36,399				(455	)
Municipal bonds			27,971				(355	)			2,707				(52	)			30,678				(407	)
Mortgage-backed			12,886				(166	)			1,228				(2	)			14,114				(168	)
Total debt securities			211,562				(1,952	)			6,409				(124	)			217,971				(2,076	)
Total equity securities			3,251				(1,119	)			-				-				3,251				(1,119	)
Total other investments			582				-				-				-				582				-
Total investments		$	215,395			$	(3,071	)		$	6,409			$	(124	)		$	221,804			$	(3,195	)

 

		As of December 31, 2016
		12 months or less								Longer than 12 months								Total
						Unrealized								Unrealized								Unrealized
		Fair Value				Losses				Fair Value				Losses				Fair Value				Losses
U.S. Treasury securities and obligations of U.S. Government		$	7,037			$	(20	)		$	-			$	-			$	7,037			$	(20	)
Corporate bonds			86,592				(575	)			-				-				86,592				(575	)
Collateralized corporate bank loans			2,637				(7	)			8,314				(163	)			10,951				(170	)
Municipal bonds			70,633				(1,327	)			13,574				(1,634	)			84,207				(2,961	)
Mortgage-backed			29,475				(348	)			2,430				(5	)			31,905				(353	)
Total debt securities			196,374				(2,277	)			24,318				(1,802	)			220,692				(4,079	)
Total equity securities			4,109				(483	)			2,037				(307	)			6,146				(790	)
Total other investments			-				-				-				-				-				-
Total investments		$	200,483			$	(2,760	)		$	26,355			$	(2,109	)		$	226,838			$	(4,869	)

 

At September 30, 2017, the gross unrealized losses more than twelve months old were attributable to 17 debt security positions. At December 31, 2016, the gross unrealized losses more than twelve months old were attributable to 28 debt security positions and one equity position. We consider these losses as a temporary decline in value as they are predominately on bonds that we do not intend to sell and do not believe we will be required to sell prior to recovery of our amortized cost basis. We see no other indications that the decline in values of these securities is other-than-temporary. We recognized $4.3 million of other-than-temporary impairments for the nine months ended September 30, 2017 related to six municipal bond securities.

 

We complete a detailed analysis each quarter to assess whether any decline in the fair value of any investment below cost is deemed other-than-temporary. All securities with an unrealized loss are reviewed. We recognize an impairment loss when an investment's value declines below cost, adjusted for accretion, amortization and previous other-than-temporary impairments, and it is determined that the decline is other-than-temporary.

 

  

Debt Investments:   We assess whether we intend to sell, or it is more likely than not that we will be required to sell, a fixed maturity investment before recovery of its amortized cost basis less any current period credit losses.  For fixed maturity investments that are considered other-than-temporarily impaired and that we do not intend to sell and will not be required to sell, we separate the amount of the impairment into the amount that is credit related (credit loss component) and the amount due to all other factors.  The credit loss component is recognized in earnings and is the difference between the investment’s amortized cost basis and the present value of its expected future cash flows.  The remaining difference between the investment’s fair value and the present value of future expected cash flows is recognized in other comprehensive income.

 

Equity Investments:  Some of the factors considered in evaluating whether a decline in fair value for an equity investment is other-than-temporary include: (1) our ability and intent to retain the investment for a period of time sufficient to allow for an anticipated recovery in value; (2) the recoverability of cost; (3) the length of time and extent to which the fair value has been less than cost; and (4) the financial condition and near-term and long-term prospects for the issuer, including the relevant industry conditions and trends, and implications of rating agency actions and offering prices. When it is determined that an equity investment is other-than-temporarily impaired, the security is written down to fair value, and the amount of the impairment is included in earnings as a realized investment loss. The fair value then becomes the new cost basis of the investment, and any subsequent recoveries in fair value are recognized at disposition. We recognize a realized loss when impairment is deemed to be other-than-temporary even if a decision to sell an equity investment has not been made. When we decide to sell a temporarily impaired available-for-sale equity investment and we do not expect the fair value of the equity investment to fully recover prior to the expected time of sale, the investment is deemed to be other-than-temporarily impaired in the period in which the decision to sell is made.

 

Details regarding the carrying value of the other investments portfolio as of September 30, 2017 and December 31, 2016 were as follows (in thousands):

 

		September 30,				December 31,
		2017				2016
Investment Type
Equity warrant		$	4,221			$	4,951
Total other investments		$	4,221			$	4,951

 

We acquired this warrant in an active market. The warrant entitles us to buy the underlying common stock of a publicly traded company at a fixed price until the expiration date of January 19, 2021.

 

  

The amortized cost and estimated fair value of debt securities at September 30, 2017 by contractual maturity are as follows. Expected maturities may differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties.

 

		Amortized				Fair
		Cost				Value
		(in thousands)
Due in one year or less		$	163,460			$	163,697
Due after one year through five years			254,385				255,618
Due after five years through ten years			134,207				134,902
Due after ten years			45,376				44,664
Mortgage-backed			19,457				19,353
		$	616,885			$	618,234

 

5. Pledged Investments

 

We have pledged certain of our securities for the benefit of various state insurance departments and reinsurers. These securities are included with our available-for-sale debt securities because we have the ability to trade these securities. We retain the interest earned on these securities. These securities had a carrying value of $26.5 million and $21.1 million at September 30, 2017 and December 31, 2016, respectively.

 

6. Reserves for Unpaid Losses and Loss Adjustment Expenses

 

Activity in the consolidated reserves for unpaid losses and LAE is summarized as follows (in thousands):

 

		September 30,				September 30,
		2017				2016
Balance at January 1		$	481,567			$	450,878
Less reinsurance recoverable			123,237				102,791
Net balance at January 1			358,330				348,087
Incurred related to:
Current year			184,685				177,017
Prior years			20,240				(783	)
Total incurred			204,925				176,234
Paid related to:
Current year			61,288				65,339
Prior years			128,329				116,488
Total paid			189,617				181,827
Net balance at September 30			373,638				342,494
Plus reinsurance recoverable			157,861				112,506
Balance at September 30		$	531,499			$	455,000

 

  

The impact from the unfavorable (favorable) net prior years’ loss development on each reporting segment is presented below:

 

		Nine Months Ended September 30,
		2017				2016
Specialty Commercial Segment		$	17,824			$	1,938
Standard Commercial Segment			1,594				(6,370	)
Personal Segment			822				3,649
Corporate			-				-
Total unfavorable (favorable) net prior year development		$	20,240			$	(783	)

 

The following describes the primary factors behind each segment’s prior accident year reserve development for the nine months ended September 30, 2017 and 2016:

 

Nine months ended September 30, 2017:

 

·

Specialty Commercial Segment. Our Contract Binding operating unit experienced net unfavorable development primarily in the commercial auto liability line of business in the 2015 and prior accident years, partially offset by favorable development in the 2016 accident year. Our Specialty Commercial operating unit experienced net unfavorable development in general aviation primarily in the 2010 accident year, commercial excess liability primarily in the 2013 accident year and specialty risk programs primarily in the 2015 and prior accident years, partially offset by net favorable development in the medical professional liability and primary/excess commercial property lines of business primarily in the 2016 accident years.

 

·

Standard Commercial Segment. Our Standard Commercial P&C operating unit experienced net unfavorable development in the 2016 and prior accident years in the occupational accident line of business, partially offset by net favorable development primarily in the general liability line of business in the 2016 and prior accident years.

 

·

Personal Segment. Net unfavorable development in our Specialty Personal Lines operating unit was mostly attributable to the 2016, 2014 and 2013 accident years, partially offset by favorable development in the 2015 accident year.

 

Nine months ended September 30, 2016:

 

·

Specialty Commercial Segment. Our Contract Binding operating unit experienced net favorable development primarily in the commercial auto liability line of business in the 2015 and 2010 accident years, partially offset by net unfavorable development in the 2014, 2013, 2012 and 2009 and prior accident years. Our Specialty Commercial operating unit experienced net favorable development primarily in the general aviation, commercial excess liability, specialty risks programs and medical professional liability lines of business.

 

  

·

Standard Commercial Segment. Our Standard Commercial P&C operating unit experienced net favorable development primarily in the general liability line of business in the 2015 and prior accident years, partially offset by net unfavorable development in the occupational accident line of business in the 2015 and prior accident years. Our Workers Compensation operating unit experienced net favorable development in the 2015 and prior accident years.

 

·

Personal Segment. Our Specialty Personal Lines operating unit experienced net unfavorable development attributable to the 2015 and prior accident years.

 

7. Share-Based Payment Arrangements

 

Our 2005 Long Term Incentive Plan (“2005 LTIP”) is a stock compensation plan for key employees and non-employee directors that was initially approved by the shareholders on May 26, 2005 and expired by its terms on May 27, 2015. As of September 30, 2017, there were outstanding incentive stock options to purchase 158,673 shares of our common stock, non-qualified stock options to purchase 259,157 shares of our common stock and restricted stock units representing the right to receive up to 77,640 shares of our common stock. The exercise price of all such outstanding stock options is equal to the fair market value of our common stock on the date of grant.

 

Our 2015 Long Term Incentive Plan (“2015 LTIP”) was approved by shareholders on May 29, 2015. There are 2,000,000 shares authorized for issuance under the 2015 LTIP. As of September 30, 2017, restricted stock units representing the right to receive up to 501,029 shares of our common stock were outstanding under the 2015 LTIP. There were no stock option awards granted under the 2015 LTIP as of September 30, 2017.

 

Stock Options:

 

Incentive stock options granted under the 2005 LTIP prior to 2009 vest 10%, 20%, 30% and 40% on the first, second, third and fourth anniversary dates of the grant, respectively, and terminate five to ten years from the date of grant. Incentive stock options granted in 2009 vest in equal annual increments on each of the first seven anniversary dates and terminate ten years from the date of grant. One grant of 25,000 incentive stock options in 2010 vests in equal annual increments on each of the first three anniversary dates and terminates ten years from the date of grant. Non-qualified stock options granted under the 2005 LTIP generally vest 100% six months after the date of grant and terminate ten years from the date of grant. One grant of 200,000 non-qualified stock options in 2009 vests in equal annual increments on each of the first seven anniversary dates and terminates ten years from the date of grant.

 

  

A summary of the status of our stock options as of September 30, 2017 and changes during the nine months then ended is presented below:

 

										Average
						Weighted				Remaining				Aggregate
						Average				Contractual				Intrinsic
		Number of				Exercise				Term				Value
		Shares				Price				(Years)				($000)
Outstanding at January 1, 2017			624,231			$	9.14
Granted			-
Exercised			(23,901	)		$	6.61
Forfeited or expired			(182,500	)		$	12.49
Outstanding at September 30, 2017			417,830			$	7.82				1.5			$	1,585
Exercisable at September 30, 2017			417,830			$	7.82				1.5			$	1,585

 

The following table details the intrinsic value of options exercised, total cost of share-based payments charged against income before income tax benefit and the amount of related income tax benefit recognized in income for the periods indicated (in thousands):

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2017				2016				2017				2016
Intrinsic value of options exercised		$	9			$	250			$	110			$	250
Cost of share-based payments (non-cash)		$	-			$	-			$	-			$	38
Income tax benefit of share-based payments recognized in income		$	-			$	-			$	-			$	8

 

As of September 30, 2017, there was no unrecognized compensation cost related to non-vested stock options granted under our plans which is expected to be recognized in the future.

 

The fair value of each stock option granted is estimated on the date of grant using the Black-Scholes option pricing model. Expected volatilities are based on the historical volatility of Hallmark’s and similar companies’ common stock for a period equal to the expected term. The risk-free interest rates for periods within the contractual term of the options are based on rates for U.S. Treasury Notes with maturity dates corresponding to the options expected lives on the dates of grant. Expected term is determined based on the simplified method as we do not have sufficient historical exercise data to provide a basis for estimating the expected term. There were no stock options granted during the first nine months of 2017 or 2016.

 

  

Restricted Stock Units:

 

Restricted stock units awarded under the 2005 LTIP and 2015 LTIP represent the right to receive shares of common stock upon the satisfaction of vesting requirements, performance criteria and other terms and conditions. Restricted stock units generally vest and, if performance criteria have been satisfied, shares of common stock become issuable on March 31 of the third calendar year following the year of the grant. If and to the extent specified performance criteria have been achieved, one grant of restricted stock units granted on September 8, 2014 will vest on March 31, 2018.

 

The performance criteria for all restricted stock units require that we achieve certain compound average annual growth rates in book value per share over the vesting period in order to receive shares of common stock in amounts ranging from 50% to 150% of the number of restricted stock units granted. In addition, certain restricted stock unit grants contain an additional performance criteria related to the attainment of an average combined ratio percentage over the vesting period. Grantees of restricted stock units do not have any rights of a stockholder, and do not participate in any distributions to our common stockholders, until the award fully vests upon satisfaction of the vesting schedule, performance criteria and other conditions set forth in their award agreement. Therefore, unvested restricted stock units are not considered participating securities under ASC 260, “Earnings Per Share.”

 

Compensation cost is measured as an amount equal to the fair value of the restricted stock units on the date of grant and is expensed over the vesting period if achievement of the performance criteria is deemed probable, with the amount of the expense recognized based on our best estimate of the ultimate achievement level. The grant date fair value of restricted stock units granted in 2015, 2016 and 2017 is $11.10 per unit, $11.41 and $10.20 per unit, respectively. We incurred compensation expense of $51 thousand and $97 thousand related to restricted stock units during the three months and nine months ended September 30, 2017, respectively. We incurred compensation benefit of $249 thousand and $59 thousand related to restricted stock units during the three months and nine months ended September 30, 2016, respectively. We recorded income tax benefit of $18 thousand and $34 thousand related to restricted stock units during the three months and nine months ended September 30, 2017, respectively. We recorded income tax expense of $88 thousand and $21 thousand related to restricted stock units during the three months and nine months ended September 30, 2016.

 

A summary of the status of our restricted stock units as of September 30, 2017 and 2016 and changes during the nine months then ended is presented below:

 

		Number of
		Restricted
		Stock Units
		2017				2016
Non-vested at January 1			296,574				296,571
Granted			138,712				122,770
Vested			(5,998	)			(7,144	)
Forfeited			(43,509	)			(94,880	)
Non-vested at September 30			385,779				317,317

 

As of September 30, 2017, there was $1.4 million of total unrecognized compensation cost related to unvested restricted stock units, of which $0.2 million is expected to be recognized during the remainder of 2017, $0.6 million is expected to be recognized in 2018, $0.5 million is expected to be recognized in 2019 and $0.1 million is expected to be recognized in 2020.

 

  

8. Segment Information

 

The following is business segment information for the three and nine months ended September 30, 2017 and 2016 (in thousands):

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2017				2016				2017				2016
Revenues:
Specialty Commercial Segment		$	69,721			$	65,855			$	205,057			$	189,478
Standard Commercial Segment			17,401				18,253				52,449				54,464
Personal Segment			9,404				12,759				31,951				36,996
Corporate			1,197				751				(1,311	)			(2,240	)
Consolidated		$	97,723			$	97,618			$	288,146			$	278,698
Pre-tax income (loss):
Specialty Commercial Segment		$	1,288			$	8,245			$	13,018			$	25,843
Standard Commercial Segment			229				3,195				881				7,623
Personal Segment			(661	)			(1,750	)			(2,311	)			(3,847	)
Corporate			(2,381	)			(2,514	)			(12,193	)			(14,967	)
Consolidated		$	(1,525	)		$	7,176			$	(605	)		$	14,652

 

The following is additional business segment information as of the dates indicated (in thousands):

 

		September 30,				December 31,
		2017				2016
Assets:
Specialty Commercial Segment		$	814,220			$	734,763
Standard Commercial Segment			167,274				164,295
Personal Segment			243,031				241,686
Corporate			24,297				21,716
		$	1,248,822			$	1,162,460

 

9. Reinsurance

 

We reinsure a portion of the risk we underwrite in order to control the exposure to losses and to protect capital resources. We cede to reinsurers a portion of these risks and pay premiums based upon the risk and exposure of the policies subject to such reinsurance. Ceded reinsurance involves credit risk and is generally subject to aggregate loss limits. Although the reinsurer is liable to us to the extent of the reinsurance ceded, we are ultimately liable as the direct insurer on all risks reinsured. Reinsurance recoverables are reported after allowances for uncollectible amounts. We monitor the financial condition of reinsurers on an ongoing basis and review our reinsurance arrangements periodically. Reinsurers are selected based on their financial condition, business practices and the price of their product offerings. In order to mitigate credit risk to reinsurance companies, most of our reinsurance recoverable balance as of September 30, 2017 was with reinsurers that had an A.M. Best rating of “A–” or better.

 

  

The following table shows earned premiums ceded and reinsurance loss recoveries by period (in thousands):

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2017				2016				2017				2016
Ceded earned premiums		$	54,769			$	44,733			$	151,370			$	124,832
Reinsurance recoveries		$	45,122			$	29,954			$	103,552			$	78,323

 

10. Revolving Credit Facility

 

Our Second Restated Credit Agreement with Frost Bank (“Frost”) dated June 30, 2015, reinstated the credit facility with Frost which expired by its terms on April 30, 2015. The Second Restated Credit Agreement also amended certain provisions of the credit facility and restated the agreement with Frost in its entirety.  The Second Restated Credit Agreement provides a $15.0 million revolving credit facility (“Facility A”), with a $5.0 million letter of credit sub-facility. The outstanding balance of the Facility A bears interest at a rate equal to the prime rate or LIBOR plus 2.5%, at our election. We pay an annual fee of 0.25% of the average daily unused balance of Facility A and letter of credit fees at the rate of 1.00% per annum.  As of September 30, 2017, we had no outstanding borrowings under Facility A.

 

On December 17, 2015, we entered into a First Amendment to Second Restated Credit Agreement and a Revolving Facility B Agreement (the “Facility B Agreement”) with Frost to provide a new $30.0 million revolving credit facility (“Facility B”), in addition to Facility A. On November 1, 2016, we amended the Facility B Agreement with Frost to extend by one year the termination date for draws under Facility B and the maturity date for amounts outstanding thereunder. We paid Frost a commitment fee of $75,000 when Facility B was established and an additional $30,000 fee when Facility B was extended.

 

We may use Facility B loan proceeds solely for the purpose of making capital contributions to AHIC and HIC. As amended, we may borrow, repay and reborrow under Facility B until December 17, 2018, at which time all amounts outstanding under Facility B are converted to a term loan. Through December 17, 2018, we pay Frost a quarterly fee of 0.25% per annum of the average daily unused balance of Facility B. Facility B bears interest at a rate equal to the prime rate or LIBOR plus 3.00%, at our election. Until December 17, 2018, interest only on amounts from time to time outstanding under Facility B are payable quarterly. Any amounts outstanding on Facility B as of December 17, 2018 are converted to a term loan payable in quarterly installments over five years based on a seven year amortization of principal plus accrued interest. All remaining principal and accrued interest on Facility B become due and payable on December 17, 2023. As of September 30, 2017, we had $30.0 million outstanding under Facility B.

 

The obligations under both Facility A and Facility B are secured by a security interest in the capital stock of AHIC and HIC.  Both Facility A and Facility B contain covenants that, among other things, require us to maintain certain financial and operating ratios and restrict certain distributions, transactions and organizational changes. We are in compliance with or have obtained a waiver of all of these covenants.

 

  

11. Subordinated Debt Securities

 

On June 21, 2005, we entered into a trust preferred securities transaction pursuant to which we issued $30.9 million aggregate principal amount of subordinated debt securities due in 2035. To effect the transaction, we formed Trust I as a Delaware statutory trust. Trust I issued $30.0 million of preferred securities to investors and $0.9 million of common securities to us. Trust I used the proceeds from these issuances to purchase the subordinated debt securities. The interest rate on our Trust I subordinated debt securities was 7.725% until June 15, 2015, after which interest adjusts quarterly to the three-month LIBOR rate plus 3.25 percentage points. Trust I pays dividends on its preferred securities at the same rate. Under the terms of our Trust I subordinated debt securities, we pay interest only each quarter and the principal of the note at maturity. The subordinated debt securities are uncollaterized and do not require maintenance of minimum financial covenants. As of September 30, 2017, the principal balance of our Trust I subordinated debt was $30.9 million and the interest rate was 4.57% per annum.

 

On August 23, 2007, we entered into a trust preferred securities transaction pursuant to which we issued $25.8 million aggregate principal amount of subordinated debt securities due in 2037. To effect the transaction, we formed Trust II as a Delaware statutory trust. Trust II issued $25.0 million of preferred securities to investors and $0.8 million of common securities to us. Trust II used the proceeds from these issuances to purchase the subordinated debt securities. The interest rate on our Trust II subordinated debt securities was 8.28% until September 15, 2017, after which interest adjusts quarterly to the three-month LIBOR rate plus 2.90 percentage points. Trust II pays dividends on its preferred securities at the same rate. Under the terms of our Trust II subordinated debt securities, we pay interest only each quarter and the principal of the note at maturity. The subordinated debt securities are uncollaterized and do not require maintenance of minimum financial covenants. As of September 30, 2017, the principal balance of our Trust II subordinated debt was $25.8 million and the interest rate was 4.22% per annum.

 

12. Deferred Policy Acquisition Costs

 

The following table shows total deferred and amortized policy acquisition cost activity by period (in thousands):

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2017				2016				2017				2016
Deferred		$	(9,759	)		$	(15,233	)		$	(31,472	)		$	(35,949	)
Amortized			9,849				15,156				31,420				35,614
Net		$	90			$	(77	)		$	(52	)		$	(335	)

 

  

13. Earnings per Share

 

The following table sets forth basic and diluted weighted average shares outstanding for the periods indicated (in thousands):

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2017				2016				2017				2016
Weighted average shares - basic			18,180				18,617				18,404				18,835
Effect of dilutive securities			-				186				-				174
Weighted average shares - assuming dilution			18,180				18,803				18,404				19,009

 

For each of the three and nine months ended September 30, 2017, 417,830 shares of common stock potentially issuable upon the exercise of stock options were excluded from the weighted average number of shares outstanding on a diluted basis because the effect of such options would be anti-dilutive. For each of the three and nine months ended September 30, 2017, 385,779 restricted stock units were excluded from the weighted average number of shares outstanding on a diluted basis because the effect of such restricted stock units would be anti-dilutive. For each of the three and nine months ended September 30, 2016, 385,000 shares of common stock potentially issuable upon the exercise of stock options were excluded from the weighted average number of shares outstanding on a diluted basis because the effect of such options would be anti-dilutive.

 

14. Net Periodic Pension Cost

 

The following table details the net periodic pension cost incurred by period (in thousands):

 

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2017				2016				2017				2016
Interest cost		$	111			$	128			$	333			$	384
Amortization of net loss			37				28				107				85
Expected return on plan assets			(164	)			(162	)			(487	)			(485	)
Net periodic pension cost		$	(16	)		$	(6	)		$	(47	)		$	(16	)
Contributed amount		$	-			$	409			$	-			$	409

 

15. Income Taxes

 

Our effective income tax rate for the nine months ended September 30, 2017 and 2016 was -52.7% and 30.5%, respectively. The rate for 2017 varied from the statutory tax rate primarily due to a correction of an immaterial error in prior years’ deferred tax on bond premium amortization, partially offset by the amount of tax exempt income in relation to total pre-tax income.  The rate for 2016 varied from the statutory tax rate primarily due to the amount of tax exempt income in relation to total pre-tax income.

 

  

16. Commitments and Contingencies

 

We are engaged in various legal proceedings in the ordinary course of business, none of which, either individually or in the aggregate, are believed likely to have a material adverse effect on our consolidated financial position or results of operations, in the opinion of management. The various legal proceedings to which we are a party are routine in nature and incidental to our business.

 

In November 2015, one of the subsidiaries in our Contract Binding operating unit, Hallmark Specialty Underwriters, Inc. (“HSU”), was informed by the Texas Comptroller of Public Accounts that a surplus lines tax audit covering the period January 1, 2010 through December 31, 2013 was complete. HSU frequently acts as a managing general underwriter (“MGU”) authorized to underwrite policies on behalf of Republic Vanguard Insurance Company and HSIC, both Texas eligible surplus lines insurance carriers. In its role as the MGU, HSU underwrites policies on behalf of these carriers while other agencies located in Texas (generally referred to as “producing agents”) deliver the policies to the insureds and collect all premiums due from the insureds. During the period under audit, the producing agents also collected the surplus lines premium taxes due on the policies from the insureds, held them in trust, and timely remitted those taxes to the Comptroller. We believe this system for collecting and paying the required surplus lines premium taxes complies in all respects with the Texas Insurance Code and other regulations, which clearly require that the same party who delivers the policies and collects the premiums will also collect premium taxes, hold premium taxes in trust, and pay premium taxes to the Comptroller. It also complies with long standing industry practice. In addition, effective January 1, 2012 the Texas legislature enacted House Bill 3410 (HB3410) which allows an MGU to contractually pass the collection, payment and administration of surplus lines taxes down to another Texas licensed surplus line agent.

 

The Comptroller asserted that HSU was liable for the surplus lines premium taxes related to policy transactions and premiums collected from surplus lines insureds during January 1, 2010 through December 31, 2011, the period prior to the passage of HB3410, and that HSU therefore owed $2.5 million in premium taxes, as well as $0.7 million in penalties and interest for the audit period. During the second quarter of 2017, we reached an agreement with the Comptroller to settle the matter for $0.2 million, which was accrued as of June 30, 2017 and paid during the third quarter of 2017.

 

  

17. Changes in Accumulated Other Comprehensive Income Balances

 

The changes in accumulated other comprehensive income balances as of September 30, 2017 and 2016 were as follows (in thousands):

 

		Minimum								Accumulated Other
		Pension				Unrealized				Comprehensive
		Liability				Gains (Loss)				Income
Balance at December 31, 2015		$	(2,572	)		$	9,990			$	7,418
Other comprehensive income:
Change in net actuarial gain			85				-				85
Tax effect on change in net actuarial gain			(30	)			-				(30	)
Net unrealized holding gains arising during the period			-				7,767				7,767
Tax effect on unrealized gains arising during the period			-				(2,718	)			(2,718	)
Reclassification adjustment for gains included in net realized gains			-				(1,589	)			(1,589	)
Tax effect on reclassification adjustment for gains included in income tax expense			-				556				556
Other comprehensive income, net of tax			55				4,016				4,071
Balance at September 30, 2016		$	(2,517	)		$	14,006			$	11,489
Balance at December 31, 2016		$	(2,666	)		$	13,037			$	10,371
Other comprehensive income:
Change in net actuarial gain			107				-				107
Tax effect on change in net actuarial gain			(37	)			-				(37	)
Net unrealized holding gains arising during the period			-				8,208				8,208
Tax effect on unrealized gains arising during the period			-				(2,873	)			(2,873	)
Reclassification adjustment for gains included in net realized gains			-				(5,679	)			(5,679	)
Tax effect on reclassification adjustment for gains included in income tax expense			-				1,988				1,988
Other comprehensive income, net of tax			70				1,644				1,714
Balance at September 30, 2017		$	(2,596	)		$	14,681			$	12,085

 

  

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

 

The following discussion should be read together with our consolidated financial statements and the notes thereto. This discussion contains forward-looking statements. Please see “Risks Associated with Forward-Looking Statements in this Form 10-Q” for a discussion of some of the uncertainties, risks and assumptions associated with these statements.

 

Introduction

 

Hallmark Financial Services, Inc. (“Hallmark” and, together with subsidiaries, “we,” “us” or “our”) is an insurance holding company that, through its subsidiaries, engages in the sale of property/casualty insurance products to businesses and individuals. Our business involves marketing, distributing, underwriting and servicing our insurance products, as well as providing other insurance related services. Our business is geographically concentrated in the south central and northwest regions of the United States, except for our Specialty Commercial business which is written on a national basis. We pursue our business activities through subsidiaries whose operations are organized into product-specific operating units, which are supported by our insurance company subsidiaries.

 

Our non-carrier insurance activities are segregated by operating units into the following reportable segments:

 

·

Specialty Commercial Segment. Our Specialty Commercial Segment includes the excess and surplus lines commercial property/casualty insurance products and services handled by our Contract Binding operating unit (f/k/a MGA Commercial Products operating unit) and the general aviation, satellite launch, commercial umbrella and primary/excess liability, medical and financial professional liability and primary/excess commercial property insurance products and services handled by our Specialty Commercial operating unit, as well as certain specialty risk programs which are managed at the parent level.

 

·

Standard Commercial Segment. Our Standard Commercial Segment includes the standard lines commercial property/casualty and occupational accident insurance products and services handled by our Standard Commercial P&C operating unit and the workers compensation insurance products handled by our Workers Compensation operating unit. We discontinued marketing new and renewal occupational accident policies effective June 1, 2016. During 2015, we discontinued our workers’ compensation line of business by transferring all renewal rights and ceding substantially all unearned premiums to a third party. As a result, effective July 1, 2015, the Workers Compensation operating unit no longer retains any risk on new or renewal policies.

 

·

Personal Segment. Our Personal Segment includes the non-standard personal automobile and renters insurance products and services handled by our Specialty Personal Lines operating unit.

 

The retained premium produced by these reportable segments is supported by our American Hallmark Insurance Company of Texas (“AHIC”), Hallmark Specialty Insurance Company (“HSIC”), Hallmark Insurance Company (“HIC”), Hallmark National Insurance Company (“HNIC”) and Texas Builders Insurance Company (“TBIC”) insurance subsidiaries. In addition, control and management of Hallmark County Mutual (“HCM”) is maintained through our wholly owned subsidiary, CYR Insurance Management Company (“CYR”). CYR has as its primary asset a management agreement with HCM which provides for CYR to have management and control of HCM. HCM is used to front certain lines of business in our Specialty Commercial and Personal Segments in Texas. HCM does not retain any business.

 

  

AHIC, HIC, HSIC and HNIC have entered into a pooling arrangement pursuant to which AHIC retains 34% of the total net premiums written by any of them, HIC retains 32% of our total net premiums written by any of them, HSIC retains 24% of our total net premiums written by any of them and HNIC retains 10% of our total net premiums written by any of them. Neither HCM nor TBIC is a party to the intercompany pooling arrangement.

 

Results of Operations

 

Management overview. During the three and nine months ended September 30, 2017, our total revenues were $97.7 million and $288.1 million, representing an increase of $0.1 million and $9.4 million, respectively, from the $97.6 million and $278.7 million in total revenues for the same periods of 2016.  This increase in revenue was primarily attributable to higher net earned premiums in our Specialty Commercial Segment, partially offset by lower net earned premiums in our Standard Commercial Segment and our Personal Segment during the three and nine months ended September 30, 2017 as compared to the same periods during 2016. Net earned premiums for the three and nine months ended September 30, 2017 include the impact of $1.5 million of ceded reinstatement premium attributable to Hurricane Harvey. Further contributing to this increase in revenues was higher net investment income and higher net realized gains recognized on our investment portfolio during the three and nine months ended September 30, 2017 as compared to the same periods during 2016. These increases in revenue during the three and nine months ended September 30, 2017 were partially offset by lower finance charges.

 

The increase in revenue for the three and nine months ended September 30, 2017 was offset by higher losses and loss adjustment expenses (“LAE”) of $10.0 million and $28.7 million, respectively, as compared to the same periods in 2016. The increase in losses and LAE was primarily the result of unfavorable net prior year loss reserve development of $10.6 million and $20.2 million for the three and nine months ended September 30, 2017 as compared to unfavorable net prior year loss reserve development of $2.0 million during the third quarter of 2016 and $0.8 million of favorable net prior year loss reserve development during the nine months ended September 30, 2016, as well as higher current accident year loss trends in our Contract Binding operating unit. We reported $4.4 million and $6.3 million of net catastrophe losses during the three and nine months ended September 30, 2017, of which $3.1 million was attributable in both periods to Hurricane Harvey, as compared to $2.2 million and $10.4 million of net catastrophe losses during the same periods of 2016. Other operating expenses decreased mostly as a result of a $1.8 million payment to settle the earn-out related to the previous acquisition of TBIC during the second quarter of 2016 and lower production related expenses due primarily to increased ceding commissions in our Specialty Commercial Segment, partially offset by increased salary and related expenses and other operating expenses driven by our investment in technology for the three and nine months ended September 30, 2017 as compared to the same periods during 2016.

 

We reported a net loss of $1.6 million for the three months ended September 30, 2017 as compared to net income of $5.0 million for the same period of 2016. We reported a net loss of $0.9 million for the nine months ended September 30, 2017 as compared to net income of $10.2 million for the same period of 2016. On a diluted basis per share, we reported a net loss of $0.09 per share for the three months ended September 30, 2017, as compared to net income of $0.27 per share for the same period in 2016.  On a diluted basis per share, we reported a net loss of $0.05 per share for the nine months ended September 30, 2017, as compared to net income of $0.54 per share for the same period in 2016.

 

  

Third Quarter 2017 as Compared to Third Quarter 2016

 

The following is additional business segment information for the three months ended September 30, 2017 and 2016 (in thousands):

 

		Three Months Ended September 30
		Specialty								Standard
		Commercial Segment								Commercial Segment								Personal Segment								Corporate								Consolidated
		2017				2016				2017				2016				2017				2016				2017				2016				2017				2016
Gross premiums written		$	127,062			$	104,087			$	19,240			$	18,579			$	14,849			$	24,399			$	-			$	-			$	161,151			$	147,065
Ceded premiums written			(56,200	)			(38,064	)			(2,889	)			(1,925	)			(7,013	)			(11,391	)			-				-				(66,102	)			(51,380	)
Net premiums written			70,862				66,023				16,351				16,654				7,836				13,008				-				-				95,049				95,685
Change in unearned premiums			(6,274	)			(3,661	)			(420	)			258				433				(1,487	)			-				-				(6,261	)			(4,890	)
Net premiums earned			64,588				62,362				15,931				16,912				8,269				11,521				-				-				88,788				90,795
Total revenues			69,721				65,855				17,401				18,253				9,404				12,759				1,197				751				97,723				97,618
Losses and loss adjustment expenses			53,899				41,478				11,760				9,622				6,720				11,237				-				-				72,379				62,337
Pre-tax income (loss)			1,288				8,245				229				3,195				(661	)			(1,750	)			(2,381	)			(2,514	)			(1,525	)			7,176
Net loss ratio (1)			83.5	%			66.5	%			73.8	%			56.9	%			81.3	%			97.5	%											81.5	%			68.7	%
Net expense ratio (1)			21.9	%			25.3	%			34.2	%			32.3	%			31.2	%			21.9	%											27.1	%			27.9	%
Net combined ratio (1)			105.4	%			91.8	%			108.0	%			89.2	%			112.5	%			119.4	%											108.6	%			96.6	%
Favorable (Unfavorable) Prior Year Development			(9,492	)			(3,532	)			(1,330	)			2,696				266				(1,138	)											(10,556	)			(1,974	)

 

(1)

The net loss ratio is calculated as incurred losses and LAE divided by net premiums earned, each determined in accordance with GAAP. The net expense ratio is calculated as total underwriting expenses offset by agency fee income divided by net premiums earned, each determined in accordance with GAAP. Net combined ratio is calculated as the sum of the net loss ratio and the net expense ratio.

 

Specialty Commercial Segment

 

Gross premiums written for the Specialty Commercial Segment were $127.1 million for the three months ended September 30, 2017, which was $23.0 million, or 22%, more than the $104.1 million reported for the same period of 2016. Net premiums written were $70.9 million for the three months ended September 30, 2017 as compared to $66.0 million for the same period of 2016. The increase in gross and net premiums written were primarily the result of increased premium production in our Specialty Commercial operating unit.

 

The $69.7 million of total revenue for the three months ended September 30, 2017 was $3.8 million more than the $65.9 million reported by the Specialty Commercial Segment for the same period in 2016. This increase in revenue was primarily due to higher net premiums earned of $2.2 million due mostly to increased premium production in our Specialty Commercial operating unit. Further contributing to the increased revenue was higher net investment income of $1.5 million and higher commission and fees of $0.1 million for the three months ended September 30, 2017 as compared to the same period of 2016.

 

  

Pre-tax income for the Specialty Commercial Segment of $1.3 million for the third quarter of 2017 was $6.9 million lower than the $8.2 million reported for the same period in 2016. The decrease in pre-tax income was primarily the result of higher losses and LAE of $12.4 million, partially offset by lower operating expenses of $1.7 million and the increased revenue discussed above.

 

Our Contract Binding operating unit reported an $8.9 million increase in losses and LAE due largely to $8.9 million unfavorable prior year net loss reserve development recognized during the three months ended September 30, 2017 as compared to $3.8 million unfavorable prior year net loss reserve development during the same period of 2016, as well as higher current accident year loss trends. Our Specialty Commercial operating unit reported a $3.5 million increase in losses and LAE which consisted of (a) a $1.2 million increase in our general aviation line of business due mostly to $0.8 million of net unfavorable prior year loss reserve development during the third quarter of 2017 as well as higher current accident year loss trends, (b) a $1.1 million increase in losses and LAE attributable to our primary/excess property insurance products due primarily to net catastrophe related losses, (c) a $0.9 million increase in losses and LAE in our commercial umbrella and primary/excess liability line of business due primarily to increased premium production, (d) a $0.2 million increase in losses and LAE in our specialty programs, (e) a $0.2 million increase in losses and LAE attributable to our professional liability insurance products, partially offset by (f) a $0.1 million decrease in losses and LAE in our satellite launch insurance line of business. The $1.7 million decrease in operating expense was primarily the result of lower production related expenses of $2.2 million due primarily to increased ceding commissions in our Specialty Commercial operating unit, partially offset by increased salary and related expenses of $0.5 million.

 

The Specialty Commercial Segment reported a net loss ratio of 83.5% for the three months ended September 30, 2017 as compared to 66.5% for the same period during 2016. The gross loss ratio before reinsurance was 83.0% for the three months ended September 30, 2017 as compared to 64.3% for the same period in 2016. The higher gross and net loss ratios were largely the result of $9.5 million of unfavorable prior year net loss reserve development for the three months ended September 30, 2017 as compared to unfavorable prior year net loss reserve development of $3.5 million for the same period of 2016 as well as higher current accident year loss trends driven mostly by commercial auto lines of business as well as net catastrophe losses. The Specialty Commercial Segment reported $2.2 million of net catastrophe losses during the third quarter of 2017, of which $1.2 million was attributable to Hurricane Harvey, as compared to $0.5 million of net catastrophe losses during the same period of 2016. The Specialty Commercial Segment reported a net expense ratio of 21.9% for the third quarter of 2017 as compared to 25.3% for the same period of 2016. The decrease in the expense ratio was due predominately to the impact of higher net premiums earned as well as increased ceding commissions in our Specialty Commercial operating unit.

 

Standard Commercial Segment

 

Gross premiums written for the Standard Commercial Segment were $19.2 million for the three months ended September 30, 2017, which was $0.6 million, or 4%, more than the $18.6 million reported for the same period in 2016. The increase in gross premiums was primarily due to higher premium production in our Standard Commercial P&C Operating unit of $1.9 million, partially offset by a $1.3 million reduction from the impact of the discontinued marketing of new and renewal occupational accident policies effective June 1, 2016. Net premiums written were $16.4 million for the three months ended September 30, 2017 as compared to $16.7 million for the same period in 2016. The decrease in net premiums written was primarily attributable to a $1.1 million reduction from the impact of the discontinued marketing of new and renewal occupational accident policies, partially offset by higher net premiums written in our Standard Commercial P&C Operating unit of $0.8 million. The net premiums written in our Standard Commercial P&C Operating unit includes the impact of $0.9 million of ceded reinstatement premium attributable to Hurricane Harvey.

 

  

Total revenue for the Standard Commercial Segment of $17.4 million for the three months ended September 30, 2017, was $0.9 million, or 5%, less than the $18.3 million reported for the same period in 2016. This decrease in total revenue was due to lower net premiums earned of $1.0 million resulting primarily from a $1.2 million impact to net premiums earned due to the discontinued marketing of new and renewal occupational accident policies and lower commissions and fees of $0.1 million, partially offset by higher net premiums earned of $0.2 million in our Standard Commercial P&C Operating unit (which includes the impact of $0.9 million of ceded reinstatement premium attributable to Hurricane Harvey) and higher net investment income of $0.2 million for the three months ended September 30, 2017 as compared to the same period during 2016.

 

Our Standard Commercial Segment reported pre-tax income of $0.2 million for the three months ended September 30, 2017 as compared to $3.2 million reported for the same period of 2016. The lower pre-tax income was the result of higher losses and LAE of $2.1 million and the decreased revenue discussed above.

 

The Standard Commercial Segment reported a net loss ratio of 73.8% for the three months ended September 30, 2017 as compared to 56.9% for the same period of 2016. The gross loss ratio before reinsurance for the three months ended September 30, 2017 was 78.5% as compared to the 54.6% reported for the same period of 2016. During the three months ended September 30, 2017, the Standard Commercial Segment reported unfavorable net loss reserve development of $1.3 million, of which $1.0 million resulted from the discontinued occupational accident business, as compared to favorable net loss reserve development of $2.7 million during the same period of 2016. The Standard Commercial Segment reported $2.1 million of net catastrophe losses during the third quarter of 2017, of which $1.7 million was attributable to Hurricane Harvey, as compared to $1.6 million of net catastrophe losses during the same period of 2016. The Standard Commercial Segment reported a net expense ratio of 34.2% for the third quarter of 2017 as compared to 32.3% for the same period of 2016. The increase in the expense ratio was primarily due to the decreased earned premium.

 

Personal Segment

 

Gross premiums written for the Personal Segment were $14.8 million for the three months ended September 30, 2017 as compared to $24.4 million for the same period in the prior year. Net premiums written for our Personal Segment were $7.8 million in the third quarter of 2017, which was a decrease of $5.2 million, or 40%, from the $13.0 million reported for the third quarter of 2016. The decline in gross and net written premiums was primarily due to the intentional reduction in certain underperforming portions of this business to address loss ratio performance.

 

Total revenue for the Personal Segment was $9.4 million for the third quarter of 2017 as compared to $12.8 million for the same period in 2016. The $3.4 million decrease in revenue was primarily the result of lower net premiums earned of $3.3 million and lower finance charges of $0.1 million reported during the third quarter of 2017 as compared to the same period during 2016.

 

Pre-tax loss for the Personal Segment was $0.7 million for the three months ended September 30, 2017 as compared to pre-tax loss of $1.7 million for the same period of 2016. The decrease in the pre-tax loss was primarily the result of decreased losses and LAE of $4.5 million for the three months ended September 30, 2017 as compared to the same period during 2016, partially offset by higher operating expenses of $0.1 million and the decreased revenue discussed above.

 

  

The Personal Segment reported a net loss ratio of 81.3% for the three months ended September 30, 2017 as compared to 97.5% for the same period of 2016. The gross loss ratio before reinsurance was 79.7% for the three months ended September 30, 2017 as compared to 95.2% for the same period in 2016. The lower gross and net loss ratios were primarily the result of favorable prior year net loss reserve development of $0.3 million during the three months ended September 30, 2017 as compared to unfavorable net loss reserve development of $1.1 million reported during the same period of 2016, as well as lower current accident year loss trends. The Personal Segment reported $0.1 million of net catastrophe losses during the third quarter of 2017, of which $0.2 million was attributable to Hurricane Harvey, as compared to $0.1 million of net catastrophe losses during the same period of 2016. The Personal Segment reported a net expense ratio of 31.2% for the third quarter of 2017 as compared to 21.9% for the same period of 2016. The increase in the expense ratio was due predominately to the lower finance charges and lower net premiums earned.

 

Corporate

 

Total revenue for Corporate increased by $0.4 million for the three months ended September 30, 2017 as compared to the same period the prior year. This increase in total revenue was due predominately to net realized gains recognized on our investment portfolio of $2.1 million for the three months ended September 30, 2017 as compared to net realized gains of $1.1 million for the same period of 2016, partially offset by lower net investment income of $0.6 million.

 

Corporate pre-tax loss was $2.4 million for the three months ended September 30, 2017 as compared to pre-tax loss of $2.5 million for the same period of 2016. The decrease in pre-tax loss was primarily due to the higher revenue discussed above, partially offset by higher operating expenses of $0.3 million. The higher operating expenses of $0.3 million were primarily a result of higher salary and related expenses during the third quarter of 2017 as compared to the same period of 2016 due primarily to adjustments to incentive compensation accruals during the third quarter of 2016.

 

  

Nine Months Ended September 30, 2017 as Compared to Nine Months Ended September 30, 2016

 

The following is additional business segment information for the nine months ended September 30, 2017 and 2016 (in thousands):

 

		Nine Months Ended September 30
		Specialty								Standard
		Commercial Segment								Commercial Segment								Personal Segment								Corporate								Consolidated
		2017				2016				2017				2016				2017				2016				2017				2016				2017				2016
Gross premiums written		$	350,374			$	295,204			$	59,702			$	59,701			$	48,243			$	64,644			$	-			$	-			$	458,319			$	419,549
Ceded premiums written			(144,510	)			(104,265	)			(6,816	)			(6,487	)			(22,531	)			(30,243	)			-				-				(173,857	)			(140,995	)
Net premiums written			205,864				190,939				52,886				53,214				25,712				34,401				-				-				284,462				278,554
Change in unearned premiums			(14,563	)			(11,555	)			(3,859	)			(2,311	)			2,678				(1,868	)			-				-				(15,744	)			(15,734	)
Net premiums earned			191,301				179,384				49,027				50,903				28,390				32,533				-				-				268,718				262,820
Total revenues			205,057				189,478				52,449				54,464				31,951				36,996				(1,311	)			(2,240	)			288,146				278,698
Losses and loss adjustment expenses			146,018				115,409				34,669				30,060				24,238				30,765				-				-				204,925				176,234
Pre-tax income (loss)			13,018				25,843				881				7,623				(2,311	)			(3,847	)			(12,193	)			(14,967	)			(605	)			14,652
Net loss ratio (1)			76.3	%			64.3	%			70.7	%			59.1	%			85.4	%			94.6	%											76.3	%			67.1	%
Net expense ratio (1)			23.6	%			26.4	%			34.9	%			33.5	%			27.7	%			21.6	%											27.9	%			28.9	%
Net combined ratio (1)			99.9	%			90.7	%			105.6	%			92.6	%			113.1	%			116.2	%											104.2	%			96.0	%
Favorable (Unfavorable) Prior Year Development			(17,824	)			(1,938	)			(1,594	)			6,370				(822	)			(3,649	)											(20,240	)			783

 

(1) The net loss ratio is calculated as incurred losses and LAE divided by net premiums earned, each determined in accordance with GAAP. The net expense ratio is calculated as total underwriting expenses offset by agency fee income divided by net premiums earned, each determined in accordance with GAAP. Net combined ratio is calculated as the sum of the net loss ratio and the net expense ratio.

 

Specialty Commercial Segment

 

Gross premiums written for the Specialty Commercial Segment were $350.4 million for the nine months ended September 30, 2017, which was $55.2 million, or 19%, more than the $295.2 million reported for the same period in 2016. Net premiums written were $205.9 million for the nine months ended September 30, 2017 as compared to $190.9 million reported for the same period in 2016. The increase in gross and net premiums written was due to increased premium production in both our Specialty Commercial and our Contract Binding operating units.

 

The $205.1 million of total revenue for the Specialty Commercial Segment for the nine months ended September 30, 2017 was $15.6 million higher than the $189.5 million reported for the same period in 2016. This increase in revenue was due to higher net premiums earned of $11.9 million due mostly to increased premium production in both our Specialty Commercial operating unit and our Contract Binding operating unit. Further contributing to the increased revenue was higher net investment income of $3.2 million and higher commission and fees of $0.5 million for the nine months ended September 30, 2017 as compared to the same period of 2016.

 

  

Pre-tax income for the Specialty Commercial Segment of $13.0 million for the nine months ended September 30, 2017 was $12.8 million lower than the $25.8 million reported for the same period in 2016. The decrease in pre-tax income was primarily the result of higher losses and LAE of $30.6 million, partially offset by lower operating expenses of $2.2 million and the increased revenue discussed above.

 

Our Contract Binding operating unit reported a $24.6 million increase in losses and LAE due primarily to $16.4 million of unfavorable prior year net loss reserve development recognized for the nine months ended September 30, 2017 as compared to $2.7 million favorable prior year net loss reserve development recognized for the same period of 2016, as well as higher current accident year loss trends. Our Specialty Commercial operating unit reported a $6.0 million increase in losses and LAE which consisted of (a) a $3.5 million increase in losses and LAE in our commercial umbrella and primary/excess liability line of business, (b) a $1.6 million increase in losses and LAE attributable to our primary/excess property insurance products due primarily to increased premium production and higher net catastrophe losses, (c) a $1.6 million increase in our general aviation line of business, (d) a $0.6 million increase in losses and LAE in our satellite launch insurance line of business, partially offset by (e) a $1.2 million decrease in losses and LAE attributable to our professional liability insurance products and (f) a $0.1 million decrease in losses and LAE in our specialty programs. The $2.2 million decrease in operating expense was primarily the result of lower production related expenses of $4.4 million due primarily to increased ceding commissions in our Specialty Commercial operating unit, partially offset by increased salary and related expenses of $1.5 million, higher occupancy and other operating expenses of $0.5 million and higher travel related expenses of $0.2 million.

 

The Specialty Commercial Segment reported a net loss ratio of 76.3% for the nine months ended September 30, 2017 as compared to 64.3% for the same period during 2016. The gross loss ratio before reinsurance was 73.5% for the nine months ended September 30, 2017 as compared to 61.7% for the same period in 2016. The higher gross and net loss ratios for the nine months ended September 30, 2017 were primarily the result of $17.8 million unfavorable prior year net loss reserve development recognized for the nine months ended September 30, 2017 as compared to $1.9 million unfavorable prior year net loss reserve development for the same period of 2016 as well as higher current accident year loss trends driven mostly by our commercial auto line of business as well as increased net catastrophe losses. The Specialty Commercial Segment reported $2.6 million of net catastrophe losses during the nine months ended September 30, 2017, of which $1.2 million was attributable to Hurricane Harvey, as compared to $1.3 million of net catastrophe losses during the same period of 2016. The Specialty Commercial Segment reported a net expense ratio of 23.6% during the nine months ended September 30, 2017 as compared to 26.4% for the same period of 2016. The decrease in the expense ratio was due predominately to the impact of higher net premiums earned as well as increased ceding commission in our Specialty Commercial operating unit.

 

Standard Commercial Segment

 

Gross premiums written for the Standard Commercial Segment of $59.7 million for the nine months ended September 30, 2017 were unchanged from the same period of 2016. The gross premiums written for the Standard Commercial P&C operating unit increased $4.8 million, offset by a decrease of $4.3 million due to the discontinued marketing of new and renewal occupational accident policies and a $0.5 million decrease in gross premiums written due to the discontinued marketing of workers compensation policies. Net premiums written were $52.9 million for the nine months ended September 30, 2017 as compared to $53.2 million reported for the same period in 2016. The net premiums written include a $3.8 million increase in our Standard Commercial P&C operating unit for the nine months ended September 30, 2017 as compared to the same period during 2016, offset by a decrease in premium volume of $4.1 million due to the discontinued marketing of new and renewal occupational accident policies. The net premiums written in our Standard Commercial P&C Operating unit includes the impact of $0.9 million of ceded reinstatement premium attributable to Hurricane Harvey.

 

  

Total revenue for the Standard Commercial Segment of $52.4 million for the nine months ended September 30, 2017 was $2.1 million less than the $54.5 million reported during the same period in 2016. This 4% decrease in total revenue was mostly due to a $1.9 million decrease in net premiums earned primarily as a result of a $3.9 million decrease in net premiums earned due to the discontinued marketing of new and renewal occupational accident policies, partially offset by $2.0 million higher net premiums earned in our Standard Commercial P&C operating unit due to increased premium production, which includes the impact of $0.9 million of ceded reinstatement premium attributable to Hurricane Harvey. Further contributing to the decrease in revenue was lower commission and fees of $0.5 million, partially offset by higher net investment income of $0.3 million for the nine months ended September 30, 2017 as compared to the same period in 2016.

 

Our Standard Commercial Segment reported pre-tax income of $0.9 million for the nine months ended September 30, 2017 as compared to $7.6 million for the same period during 2016. The lower pre-tax income was the result of higher losses and LAE expenses of $4.6 million and the decreased revenue discussed above.

 

The Standard Commercial Segment reported a net loss ratio of 70.7% for the nine months ended September 30, 2017 as compared to 59.1% for the same period in 2016. The gross loss ratio before reinsurance for the nine months ended September 30, 2017 was 66.8% as compared to the 56.0% reported for the same period of 2016. Our Standard Commercial Segment’s net loss ratio included 6.6 additional loss ratio points attributable to the discontinued workers compensation and occupational accident business for the nine months ended September 30, 2017 as compared to 2.7 fewer loss ratio points for the same period the prior year. During the nine months ended September 30, 2017 the Standard Commercial Segment reported unfavorable prior year net loss reserve development of $1.6 million as compared to favorable prior year net loss reserve development of $6.4 million for the same period of 2016. The Standard Commercial Segment reported $3.4 million of net catastrophe losses during the nine months ended September 30, 2017, of which $1.7 million was attributable to Hurricane Harvey, as compared to $8.3 million of net catastrophe losses during the same period of 2016. The Standard Commercial Segment reported a net expense ratio of 34.9% for the nine months ended September 30, 2017 as compared to 33.5% for the same period of 2016. The increase in the expense ratio is primarily due to the decreased earned premium.

 

Personal Segment

 

Gross premiums written for the Personal Segment were $48.2 million for the nine months ended September 30, 2017, which was $16.4 million, or 25%, less than the $64.6 million reported for the same period in 2016. Net premiums written for our Personal Segment were $25.7 million for the nine months ended September 30, 2017, which was a decrease of $8.7 million, or 25%, from the $34.4 million reported for the same period of 2016. The decline in gross and net written premiums was primarily due to the intentional reduction in certain underperforming portions of this business to address loss ratio performance.

 

Total revenue for the Personal Segment decreased 14% to $32.0 million for the nine months ended September 30, 2017 from $37.0 million for the same period during 2016. The decrease in revenue was primarily due to lower net premiums earned of $4.1 million as a result of lower premiums written and lower finance charges of $0.9 million.

 

  

Pre-tax loss for the Personal Segment was $2.3 million for the nine months ended September 30, 2017 as compared to pre-tax loss of $3.8 million for the same period of 2016. The lower pre-tax loss was the result of decreased losses and LAE of $6.5 million partially offset by the decreased revenue discussed above.

 

The Personal Segment reported a net loss ratio of 85.4% for the nine months ended September 30, 2017 as compared to 94.6% for the same period of 2016. The gross loss ratio before reinsurance was 82.1% for the nine months ended September 30, 2017 as compared to 91.6% for the same period in 2016. The lower gross and net loss ratios were primarily the result of lower unfavorable prior year net loss reserve development of $0.8 million for the nine months ended September 30, 2017 as compared to unfavorable development of $3.6 million for the same period in the prior year as well as lower current accident year loss trends. The Personal Segment reported $0.3 million of net catastrophe losses for the nine months ended September 30, 2017, of which $0.2 million was attributable to Hurricane Harvey, as compared to $0.8 million of net catastrophe losses during the same period of 2016. The Personal Segment reported a net expense ratio of 27.7% for the nine months ended September 30, 2017 as compared to 21.6% for the same period of 2016. The increase in the expense ratio was due predominately to the lower finance charges and lower net premiums earned.

 

Corporate

 

Total revenue for Corporate increased by $0.9 million for the nine months ended September 30, 2017 as compared to the same period the prior year. This increase in total revenue was due to net realized gains recognized on our investment portfolio of $0.7 million for the nine months ended September 30, 2017 as compared to the net realized losses of $1.3 million for the same period of 2016, partially offset by lower net investment income of $1.1 million.

 

Corporate pre-tax loss was $12.2 million for the nine months ended September 30, 2017 as compared to pre-tax loss of $15.0 million for the same period of 2016. The decrease in pre-tax loss was primarily due to the increased revenue discussed above and lower operating expenses of $1.9 million. The lower operating expenses of $1.9 million were primarily a result of an additional $1.8 million earn-out payment in 2016 related to the previous acquisition of TBIC and lower salary and related expenses of $0.5 million for the nine months ended September 30, 2017 as compared to the same period during 2016, partially offset by higher professional service fees of $0.1 million and other operating expenses of $0.3 million.

 

Financial Condition and Liquidity

 

Sources and Uses of Funds

 

Our sources of funds are from insurance-related operations, financing activities and investing activities. Major sources of funds from operations include premiums collected (net of policy cancellations and premiums ceded), commissions, and processing and service fees. As a holding company, Hallmark is dependent on dividend payments and management fees from its subsidiaries to meet operating expenses and debt obligations. As of September 30, 2017, we had $17.9 million in unrestricted cash and cash equivalents, as well as $0.4 million in debt securities, at the holding company and our non-insurance subsidiaries. As of that date, our insurance subsidiaries held $71.9 million of unrestricted cash and cash equivalents, as well as $617.8 million in debt securities with an average modified duration of 2.0 years. Accordingly, we do not anticipate selling long-term debt instruments to meet any liquidity needs.

 

  

AHIC and TBIC, domiciled in Texas, are limited in the payment of dividends to their stockholders in any 12-month period, without the prior written consent of the Texas Department 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. HIC and HNIC, both domiciled in Arizona, are limited in the payment of dividends to the lesser of 10% of prior year policyholders’ surplus or prior year's net investment income, without prior written approval from the Arizona Department of Insurance. HSIC, domiciled in Oklahoma, is limited in the payment of dividends to the greater of 10% of prior year policyholders’ surplus or prior year’s statutory net income, not including realized capital gains, without prior written approval from the Oklahoma Insurance Department. During 2017, the aggregate ordinary dividend capacity of these subsidiaries is $28.0 million, of which $19.4 million is available to Hallmark. As a county mutual, dividends from HCM are payable to policyholders. During the first nine months of 2017 and 2016, our insurance company subsidiaries paid $9.8 million and $7.5 million in dividends to Hallmark, respectively.

 

Comparison of September 30, 2017 to December 31, 2016

 

On a consolidated basis, our cash (excluding restricted cash) and investments at September 30, 2017 were $760.0 million compared to $733.8 million at December 31, 2016. The primary reasons for this increase in unrestricted cash and investments were cash flow from operations, the collection of an unsettled investment disposal and an increase in investment fair values, partially offset by capital expenditures and repurchases of our common stock.

 

Comparison of Nine Months Ended September 30, 2017 and September 30, 2016

 

During the nine months ended September 30, 2017, our cash flow provided by operations was $34.3 million compared to cash flow provided by operations of $25.5 million during the same period the prior year.  The increase in operating cash flow was primarily due to higher collected net investment income, higher collected ceding commissions, decreased paid losses (including timing of reinsurance claim settlements), lower income taxes paid and higher collected net premiums (including timing of reinsurance payments), partially offset by lower collected finance charges and higher paid interest expense.

 

Net cash used in investing activities during the first nine months of 2017 was $19.0 million as compared to $62.9 million during the first nine months of 2016.  The decrease in cash used by investing activities during the first nine months of 2017 was comprised of an increase of $65.1 million in maturities, sales and redemptions of investment securities, a decrease in purchases of property and equipment of $2.1 million and an increase in transfers from restricted cash of $6.6 million, partially offset by an increase in purchases of debt and equity securities of $29.9 million.

 

Cash used in financing activities during the first nine months of 2017 was $5.2 million primarily as a result of $5.3 million related to repurchases of our common stock, partially offset by $0.1 million related to proceeds from the exercise of employee stock options. Cash used in financing activities during the first nine months of 2016 was $7.1 million as a result of $5.8 million related to the repurchase of our common stock and $1.8 million payment of the settlement of contingent consideration to the sellers of TBIC, partially offset by $0.5 million related to proceeds from the exercise of employee stock options.

 

  

Credit Facilities

 

Our Second Restated Credit Agreement with Frost Bank (“Frost”) dated June 30, 2015, reinstated the credit facility with Frost which expired by its terms on April 30, 2015. The Second Restated Credit Agreement also amended certain provisions of the credit facility and restated the agreement with Frost in its entirety.  The Second Restated Credit Agreement provides a $15.0 million revolving credit facility (“Facility A”), with a $5.0 million letter of credit sub-facility. The outstanding balance of the Facility A bears interest at a rate equal to the prime rate or LIBOR plus 2.5%, at our election. We pay an annual fee of 0.25% of the average daily unused balance of Facility A and letter of credit fees at the rate of 1.00% per annum.  As of September 30, 2017, we had no outstanding borrowings under Facility A.

 

On December 17, 2015, we entered into a First Amendment to Second Restated Credit Agreement and a Revolving Facility B Agreement (the “Facility B Agreement”) with Frost to provide a new $30.0 million revolving credit facility (“Facility B”), in addition to Facility A. On November 1, 2016, we amended the Facility B Agreement with Frost to extend by one year the termination date for draws under Facility B and the maturity date for amounts outstanding thereunder. We paid Frost a commitment fee of $75,000 when Facility B was established and an additional $30,000 fee when Facility B was extended.

 

We may use Facility B loan proceeds solely for the purpose of making capital contributions to AHIC and HIC. As amended, we may borrow, repay and reborrow under Facility B until December 17, 2018, at which time all amounts outstanding under Facility B are converted to a term loan. Through December 17, 2018, we pay Frost a quarterly fee of 0.25% per annum of the average daily unused balance of Facility B. Facility B bears interest at a rate equal to the prime rate or LIBOR plus 3.00%, at our election. Until December 17, 2018, interest only on amounts from time to time outstanding under Facility B are payable quarterly. Any amounts outstanding on Facility B as of December 17, 2018 are converted to a term loan payable in quarterly installments over five years based on a seven year amortization of principal plus accrued interest. All remaining principal and accrued interest on Facility B become due and payable on December 17, 2023. As of September 30, 2017, we had $30.0 million outstanding under Facility B.

 

The obligations under both Facility A and Facility B are secured by a security interest in the capital stock of AHIC and HIC.  Both Facility A and Facility B contain covenants that, among other things, require us to maintain certain financial and operating ratios and restrict certain distributions, transactions and organizational changes. We are in compliance with or have obtained waivers of all of these covenants.

 

Subordinated Debt Securities

 

On June 21, 2005, we entered into a trust preferred securities transaction pursuant to which we issued $30.9 million aggregate principal amount of subordinated debt securities due in 2035. To effect the transaction, we formed a Delaware statutory trust, Hallmark Statutory Trust I (“Trust I”). Trust I issued $30.0 million of preferred securities to investors and $0.9 million of common securities to us. Trust I used the proceeds from these issuances to purchase the subordinated debt securities. The interest rate on our Trust I subordinated debt securities was 7.725% until June 15, 2015, after which interest adjusts quarterly to the three-month LIBOR rate plus 3.25 percentage points. Trust I pays dividends on its preferred securities at the same rate. Under the terms of our Trust I subordinated debt securities, we pay interest only each quarter and the principal of the note at maturity. The subordinated debt securities are uncollaterized and do not require maintenance of minimum financial covenants. As of September 30, 2017, the principal balance of our Trust I subordinated debt was $30.9 million and the interest rate was 4.57% per annum.

 

  

On August 23, 2007, we entered into a trust preferred securities transaction pursuant to which we issued $25.8 million aggregate principal amount of subordinated debt securities due in 2037. To effect the transaction, we formed a Delaware statutory trust, Hallmark Statutory Trust II (“Trust II”). Trust II issued $25.0 million of preferred securities to investors and $0.8 million of common securities to us. Trust II used the proceeds from these issuances to purchase the subordinated debt securities. The interest rate on our Trust II subordinated debt securities was 8.28% until September 15, 2017, after which interest adjusts quarterly to the three-month LIBOR rate plus 2.90 percentage points. Trust II pays dividends on its preferred securities at the same rate. Under the terms of our Trust II subordinated debt securities, we pay interest only each quarter and the principal of the note at maturity. The subordinated debt securities are uncollaterized and do not require maintenance of minimum financial covenants. As of September 30, 2017, the principal balance of our Trust II subordinated debt was $25.8 million and the interest rate was 4.22% per annum.

 

Item 3.  Quantitative and Qualitative Disclosures About Market Risk.

 

There have been no material changes to the market risks discussed in Item 7A to Part II of our Form 10-K for the fiscal year ended December 31, 2016.

  

Item 4.  Controls and Procedures.

 

The principal executive officer and principal financial officer of Hallmark have evaluated our disclosure controls and procedures and have concluded that, as of the end of the period covered by this report, such disclosure controls and procedures were effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is timely recorded, processed, summarized and reported. The principal executive officer and principal financial officer also concluded that such disclosure controls and procedures were effective in ensuring that information required to be disclosed by us in the reports that we file or submit under such Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. During the most recent fiscal quarter, there have been no changes in our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

Risks Associated with Forward-Looking Statements Included in this Form 10-Q

 

This Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created thereby. These statements include the plans and objectives of management for future operations, including plans and objectives relating to future growth of our 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 our control. Although we believe that the assumptions underlying the forward-looking statements are reasonable, any of the assumptions could be inaccurate and, therefore, there can be no assurance that the forward-looking statements included in this Form 10-Q will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and plans will be achieved.

 

  

PART II

OTHER INFORMATION

 

Item 1.

Legal Proceedings.

 

During the third quarter of 2015, we paid $1.2 million to the sellers of the subsidiaries comprising our Workers Compensation operating unit pursuant to the terms of the acquisition agreement. The sellers disputed the calculation of the amount paid and, pursuant to the terms of the acquisition agreement, an independent actuary was engaged to resolve this matter. In accordance with the report of the independent actuary, we accrued during the second quarter of 2016 and paid during the third quarter of 2016 an additional $1.8 million to the sellers.

 

In November 2015, one of the subsidiaries in our Contract Binding operating unit, Hallmark Specialty Underwriters, Inc. (“HSU”), was informed by the Texas Comptroller of Public Accounts that a surplus lines tax audit covering the period January 1, 2010 through December 31, 2013 was complete. HSU frequently acts as a managing general underwriter (“MGU”) authorized to underwrite policies on behalf of Republic Vanguard Insurance Company and HSIC, both Texas eligible surplus lines insurance carriers. In its role as the MGU, HSU underwrites policies on behalf of these carriers while other agencies located in Texas (generally referred to as “producing agents”) deliver the policies to the insureds and collect all premiums due from the insureds. During the period under audit, the producing agents also collected the surplus lines premium taxes due on the policies from the insureds, held them in trust, and timely remitted those taxes to the Comptroller. We believe this system for collecting and paying the required surplus lines premium taxes complies in all respects with the Texas Insurance Code and other regulations, which clearly require that the same party who delivers the policies and collects the premiums will also collect premium taxes, hold premium taxes in trust, and pay premium taxes to the Comptroller. It also complies with long standing industry practice. In addition, effective January 1, 2012 the Texas legislature enacted House Bill 3410 (HB3410) which allows an MGU to contractually pass the collection, payment and administration of surplus lines taxes down to another Texas licensed surplus line agent.

 

The Comptroller asserted that HSU was liable for the surplus lines premium taxes related to policy transactions and premiums collected from surplus lines insureds during January 1, 2010 through December 31, 2011, the period prior to the passage of HB3410, and that HSU therefore owed $2.5 million in premium taxes, as well as $0.7 million in penalties and interest for the audit period. During the second quarter of 2017, we reached an agreement with the Comptroller to settle the matter for $0.2 million, which was accrued as of June 30, 2017 and paid during the third quarter of 2017.

 

We are engaged in various legal proceedings that are routine in nature and incidental to our business. None of these proceedings, either individually or in the aggregate, are believed, in our opinion, to have a material adverse effect on our consolidated financial position or our results of operations.

 

Item 1A.

Risk Factors.

 

There have been no material changes to the risk factors discussed in Item 1A to Part I of our Form 10-K for the fiscal year ended December 31, 2016.

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds.

 

Our stock buyback program initially announced on April 18, 2008, authorized the repurchase of up to 1,000,000 shares of our common stock in the open market or in privately negotiated transactions (the “Stock Repurchase Plan”). On January 24, 2011, we announced an increased authorization to repurchase up to an additional 3,000,000 shares. The Stock Repurchase Plan does not have an expiration date.

 

  

The following table furnishes information for purchases made pursuant to the Stock Repurchase Plan during the quarter ended September 30, 2017: 

 

										Cumulative Number				Maximum Number of
						Average				of Shares Purchased				Shares that May Yet
		Total Number of				Price Paid				as Part of Publicly				Be Purchased Under
Period		Shares Purchased				Per Share				Announced Plan				the Plan
July 1st- July 31st			60,331			$	11.37				3,054,934				945,066
August 1st- August 31st			4,836			$	10.27				3,059,770				940,230
September 1st- September 30th			14,315			$	10.27				3,074,085				925,915

 

Item 3.

Defaults Upon Senior Securities.

 

None.

 

Item 4.

Mine Safety Disclosures.

 

None.

 

Item 5.

Other Information.

 

None.

 

Item 6.

Exhibits.

 

The following exhibits are filed herewith or incorporated herein by reference:

 

Exhibit Number		Description
3(a)		Restated Articles of Incorporation of the registrant, as amended (incorporated by reference to Exhibit 3.1 to the registrant’s Registration Statement on Form S-1 [Registration No. 333-136414] filed September 8, 2006).
3(b)		Amended and Restated By-Laws of the registrant (incorporated by reference to Exhibit 3.1 to the registrant’s Current Report on Form 8-K filed March 28, 2017).
31(a)		Certification of principal executive officer required by Rule 13a-14(a) or Rule 15d-14(a).
31(b)		Certification of principal financial officer required by Rule 13a-14(a) or Rule 15d-14(a).
32(a)		Certification of principal executive officer Pursuant to 18 U.S.C. § 1350.
32(b)		Certification of principal financial officer Pursuant to 18 U.S.C. § 1350.
101 INS+		XBRL Instance Document.
101 SCH+		XBRL Taxonomy Extension Schema Document.
101 CAL+		XBRL Taxonomy Extension Calculation Linkbase Document.
101 LAB+		XBRL Taxonomy Extension Label Linkbase Document.
101 PRE+		XBRL Taxonomy Extension Presentation Linkbase Document.
101 DEF+		XBRL Taxonomy Extension Definition Linkbase Document.
+		Filed with this Quarterly Report on Form 10-Q and included in Exhibit 101 to this report are the following documents formatted in XBRL (Extensible Business Reporting Language): (i) Consolidated Balance Sheets as of September 30, 2017 and December 31, 2016, (ii) Consolidated Statements of Operations for the three and nine months ended September 30, 2017 and 2016, (iii) Consolidated Statements of Comprehensive Income  for the three and nine months ended September 30, 2017 and 2016, (iv) Consolidated Statements of Stockholder’s Equity for the three and nine months ended September 30, 2017 and 2016, (v)  Consolidated Statements of Cash Flows for the nine months ended September 30, 2017 and 2016 and (vi) related notes.

 

  

SIGNATURES

 

In accordance with the requirements of the Exchange Act, the registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

HALLMARK FINANCIAL SERVICES, INC.

(Registrant) 

 

Date: November 8, 2017		/s/ Naveen Anand
		Naveen Anand, Chief Executive Officer and President
Date: November 8, 2017		/s/ Jeffrey R. Passmore
		Jeffrey R. Passmore, Chief Accounting Officer and Senior Vice President