CONFORMED COPY
U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-KSB
Annual Report under Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the fiscal year ended December 31, 2003
Commission file number 0-16090
HALLMARK FINANCIAL SERVICES, INC.
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(Name of Small Business Issuer in Its Charter)
Nevada 87-0447375
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(State or Other Jurisdiction (I.R.S. Employer I.D. No.)
of Incorporation Organization)
777 Main Street, Suite 1000, Fort Worth, Texas 76102
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(Address of Principal Executive Offices) (Zip Code)
Issuer's Telephone Number, Including Area Code: (817) 348-1600
Securities registered under Section 12(b) of the Exchange Act:
Title of Each Class Name of Each Exchange on Which Registered
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Common Stock $.03 par value American Stock Exchange Emerging Company
Marketplace
Securities registered under Section 12(g) of the Exchange Act: None
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 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 [ XX ] No [ ]
Check if there is no disclosure of delinquent filers in response to Item 405
of Regulation S-B contained in this form, and no disclosure will be
contained, to the best of the registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form
10-KSB or any amendment to this Form 10-KSB. [ ]
State issuer's revenues for its most recent fiscal year - $69,559,579.
State the aggregate market value of the voting and non-voting common equity
held by non-affiliates - $7,799,361 as of February 29, 2004.
State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date. Common Stock, $.03 par
value 36,447,291 shares outstanding as of March 22, 2004.
DOCUMENTS INCORPORATED BY REFERENCE
The information required by Part III is incorporated by reference from the
Registrant's definitive proxy statement to be filed with the Commission
pursuant to Regulation 14A not later than 120 days after the end of the
fiscal year covered by this report.
Risks Associated with Forward-Looking Statements Included in this Form 10-KSB
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This Form 10-KSB contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934, which are intended to be covered by the
safe harbors created thereby. These statements include the plans and
objectives of management for future operations, including plans and
objectives relating to future growth of the Company's business activities
and availability of funds. The forward-looking statements included herein
are based on current expectations that involve numerous risks and
uncertainties. Assumptions relating to the foregoing involve judgments with
respect to, among other things, future economic, competitive and market
conditions, regulatory framework, weather-related events and future business
decisions, all of which are difficult or impossible to predict accurately
and many of which are beyond the control of the Company. Although the
Company believes that the assumptions underlying the forward-looking
statements are reasonable, any of the assumptions could be inaccurate and,
therefore, there can be no assurance that the forward-looking statements
included in this Form 10-KSB will prove to be accurate. In light of the
significant uncertainties inherent in the forward-looking statements
included herein, the inclusion of such information should not be regarded as
a representation by the Company or any other person that the objectives and
plans of the Company will be achieved.
PART I
Item 1. Description of Business.
Introduction
Hallmark Financial Services, Inc. ("HFS") and its wholly owned
subsidiaries (collectively, the "Company") engage in the sale of property
and casualty insurance products. The Company's business involves marketing
and underwriting of non-standard personal automobile insurance in Texas, New
Mexico and Arizona, commercial insurance in Texas, New Mexico, Idaho, Oregon
and Washington, third party claims administration and other insurance
related services.
Overview
The Company pursues its business activities through integrated insurance
groups handling non-standard personal automobile insurance (the "Personal
Lines Group") and commercial insurance (the "Commercial Lines Group"). The
members of the Personal Lines group are a Texas domiciled property and
casualty insurance company, American Hallmark Insurance Company of Texas
("Hallmark"); an Arizona domiciled property and casualty insurance company,
Phoenix Indemnity Insurance Company ("Phoenix"), a managing general agency,
American Hallmark General Agency, Inc. ("AHGA"); a premium finance company,
Hallmark Finance Corporation ("HFC"); and an affiliated and third party
claims administrator, Hallmark Claims Services, Inc. ("HCS"). The members
of the Commercial Lines Group are a managing general agency, Hallmark
General Agency, Inc. ("HGA") and a third party claims administrator,
Effective Claims Management, Inc. ("ECM").
Hallmark writes non-standard automobile liability and physical damage
coverage in Texas. Hallmark currently provides insurance through a
reinsurance arrangement with an unaffiliated company, Old American County
Mutual Fire Insurance Company ("OACM") for policies written after September
30, 2003. Prior to October 1, 2003, Hallmark provided insurance through a
reinsurance arrangement with an unaffiliated company, State & County Mutual
Fire Insurance Company ("State & County"). Through either State & County or
OACM, Hallmark provides insurance for drivers who do not qualify for
standard-rate insurance due to driving record, claims history, residency
status, or type of vehicle.
On January 27, 2003, the Company received final approval from the Arizona
Department of Insurance ("AZDOI") for the acquisition of Phoenix, effective
as of January 1, 2003. Phoenix is licensed in 24 states and writes non-
standard automobile liability and physical damage coverage in Arizona and
New Mexico. Phoenix underwrites its own policies and retains 100% of the
business it writes. Phoenix targets non-urban markets and underwrites
policies produced by approximately 135 independent agents.
AHGA holds an appointment from OACM to manage the sale and servicing of
OACM policies. Hallmark reinsures 45% of the OACM policies produced by AHGA
under a related reinsurance agreement. AHGA markets OACM policies in Texas
through approximately 353 independent agents operating under their own
names.
HFC offered premium financing for policies sold by independent agents
managed by AHGA. The Company discontinued writing new and renewal premium
finance policies effective July 1, 2003.
HCS provides fee-based claims adjustment, salvage and subrogation
recovery, and litigation services to Hallmark and unaffiliated MGAs.
Effective December 1, 2002, the Company purchased HGA, ECM and a financial
administrative service company, Financial and Actuarial Resources, Inc.
("FAR"). HGA, through approximately 150 independent agents operating under
their own names, markets commercial insurance policies primarily in the
rural areas of Texas, New Mexico, Idaho, Oregon and Washington. HGA
currently produces policies on behalf of Clarendon National Insurance
Company ("CNIC") and assumes none of the underwriting risk. HGA earns a
commission based on a percentage of the earned premium it produces for CNIC.
ECM provides fee-based claims adjustment, salvage and subrogation
recovery, and litigation services on behalf of CNIC. The Company
discontinued the business of FAR during the third quarter of fiscal 2003.
Personal Lines Group Operations
Formed in 1987, HFS commenced its current operations in 1990 when it
acquired, through several transactions, most of the companies now referred
to as the Personal Lines Group. HFS manages Hallmark, Phoenix, AHGA, HFC
and HCS as an integrated Personal Lines Group that shares common management
and office space.
Hallmark offers both liability and physical damage (comprehensive and
collision) coverages. Hallmark's bodily injury liability coverage is limited
to $20,000 per person and $40,000 per accident, and property damage
liability coverage is limited to $15,000 per accident. Physical damage
coverage is limited to $40,000 and $30,000 for vehicles insured under six-
month and monthly policies, respectively.
Phoenix offers both liability and physical damage (comprehensive and
collision) coverages. Phoenix's bodily injury liability coverage is limited
to $15,000 per person and $30,000 per accident, and property damage
liability coverage is limited to $10,000 per accident, for the Arizona
direct bill program. Bodily injury liability coverage is limited to $25,000
per person and $50,000 per accident, and property damage liability coverage
is limited to $10,000 per accident, for the New Mexico direct bill program.
Physical damage coverage is limited to a vehicle value of $35,000 and
$30,000 for the Arizona and New Mexico direct bill programs, respectively.
Phoenix offers optional bodily injury liability coverage up to $100,000 per
person and $300,000 per accident, and property damage liability coverage up
to $50,000, for both programs.
All purchasers of Hallmark and Phoenix policies are individuals. No
single customer or group of related customers has accounted for more than 1%
of its net premiums written during any of the last three years.
The Company currently writes monthly and six-month policies. The
Company's core net premium volume was composed of a policy mix of 6.2%
annual, 43.6% monthly and 50.2% six-month policies in 2003, and 50.7%
annual, 46.1% monthly and 3.2% six-month policies in 2002. The Company
discontinued writing annual premium financed policies in July 2003 in order
to focus on products which are more competitive in the current marketplace.
The Company's typical customer is unable or unwilling to pay a half year's
premium in advance. Accordingly, the Company offers monthly policies and
six-month direct bill policies.
HCS provides claims adjustment and related litigation services to both the
Company and unaffiliated MGAs. Fees are charged on a per-file basis, as a
percentage of earned premiums or, in certain instances, a combination of
both methods. When HCS receives notice of a loss, a claim file and an
estimated loss reserve are established. HCS's adjusters review, investigate
and initiate claim payments. The Company has an in-house litigation
department that closely manages its claims-related litigation. Management
believes that the Company achieves superior efficiency and cost
effectiveness by principally utilizing its trained employee-adjusters and
in-house litigation department.
The following table shows, for each of the years in the three year period
ended December 31, 2003 (i) the amount of the Personal Lines Group gross
premiums written, and (ii) the underwriting results of the Personal Lines
Group, as measured by the net statutory loss and loss adjustment expense
("LAE") ratio, the statutory expense ratio, and the statutory combined ratio
for the calendar year. The loss and LAE ratio is the ratio of incurred
losses and LAE to net premiums earned, the statutory expense ratio is the
ratio of underwriting and operating expenses to net premiums written, and
the combined ratio is the sum of the loss and LAE ratio and the statutory
expense ratio.
2003 2002 2001
-------- -------- --------
Gross Premiums Written $ 43,338 $ 51,643 $ 49,614
======== ======== ========
Statutory Loss & LAE Ratio 72.5% 76.8% 98.6%
Statutory Expense Ratio 28.6% 19.5% 16.7%
-------- -------- --------
Statutory Combined Ratio 101.1% 96.3% 115.3%
======== ======== ========
Commercial Lines Group Operations
The Company's Commercial Lines Group consists of a regional managing
general agency, and a third party claims administration company which were
acquired December 1, 2002. HGA markets commercial insurance policies
through an independent agency force primarily in the rural areas of Texas,
New Mexico, Idaho, Oregon, and Washington. ECM administers the claims on
insurance policies produced by HGA. These insurance policies consist of
small to medium sized commercial risks, which as a group have relatively
stable loss ratios. The Commercial Lines Group's underwriting criteria
exclude lines of business and classes of risks that are considered to be
high hazard or volatile, or which involve latent injury potential or other
long-tail liability exposures. Selection criteria include specific classes
of businesses, occupancies, and operations with lower hazard ratings, which
present a relatively lower exposure to loss and are charged with a
correspondingly lower premium. The lines of business underwritten are
primarily commercial auto, commercial multi-peril, business owner's policy,
umbrella and other liability.
HGA currently markets and underwrites these policies on behalf of CNIC and
assumes none of the underwriting risk. HGA earns a commission based on a
percentage of the earned premium it produces for CNIC. ECM receives a claim
servicing fee based on a percentage of the earned premium it produces for
CNIC with a portion deferred for casualty claims.
Underwriting and Other Ratios
An insurance company's underwriting performance is traditionally measured
by its statutory loss and LAE ratio, its statutory expense ratio and its
statutory combined ratio. The statutory loss and LAE ratio, which is
calculated as the ratio of net losses and LAE incurred to net premiums
earned, helps to assess the adequacy of the insurer's rates, the propriety
of its underwriting guidelines and the performance of its claims department.
The statutory expense ratio, which is calculated as the ratio of
underwriting and operating expenses to net premiums written, assists in
measuring the insurer's cost of processing and managing the business. The
statutory combined ratio, which is the sum of the statutory loss and LAE
ratio and the statutory expense ratio, is indicative of the overall
profitability of an insurer's underwriting activities, with a combined ratio
of less than 100% indicating profitable underwriting results.
During 2003, 2002 and 2001, the Company experienced statutory loss and LAE
ratios of 72.5%, 76.8% and 98.6%, respectively. During the same periods, it
experienced statutory expense ratios of 28.6%, 19.5% and 16.7%,
respectively, and statutory combined ratios of 101.1%, 96.3% and 115.3%,
respectively. These statutory ratios do not reflect the deferral of policy
acquisition costs, investment income, premium finance revenues, or the
elimination of inter-company transactions required by accounting principles
generally accepted in the United States of America ("GAAP").
The statutory expense ratio for 2003 increased over the 2002 statutory
expense ratio primarily as a result of the change in the reinsurance
structure effective April 1, 2003. Under the prior structure, Hallmark
assumed 100% of the Texas non-standard automobile business produced by AHGA
and underwritten by State & County and retroceded a portion to Dorinco
Reinsurance Company ("Dorinco"). Under this arrangement, the ceding
commission from Dorinco was treated as an offset to Hallmark's underwriting
expenses. As of April 1, 2003, Dorinco directly assumes its share of the
Texas non-standard automobile business produced by AHGA and underwritten
either by State & County (for policies written from April 1, 2003 through
September 30, 2003) or OACM (for policies written after September 30, 2003).
Under this new arrangement, ceding commissions from Dorinco are treated as
revenue to AHGA rather than an offset to the underwriting expenses of
Hallmark.
Under Texas Department of Insurance ("TDI") and AZDOI guidelines, property
and casualty insurance companies are expected to maintain a premium-to-
surplus ratio of not more than 3 to 1. The premium-to-surplus ratio
measures the relationship between net premiums written in a given period
(premiums written, less returned premiums and reinsurance ceded to other
carriers) to surplus (admitted assets less liabilities), all determined on
the basis of statutory accounting practices ("SAP") prescribed or permitted
by insurance regulatory authorities. For 2003, 2002, and 2001, Hallmark's
premium-to-surplus ratios were 1.50, 2.63, and 2.62 to 1, respectively.
Phoenix's premium-to-surplus ratio was 2.15 to 1 for 2003.
Reinsurance Arrangements
For policies originated prior to April 1, 2003, Hallmark assumed the
reinsurance of 100% of the Texas non-standard auto business produced by AHGA
and underwritten by State & County and retroceded 55% of the business
to Dorinco. Under this arrangement, Hallmark remained obligated to
policyholders in the event that Dorinco did not meet its obligations under
the retrocession agreement. Effective April 1, 2003, Hallmark assumes the
reinsurance of 45% of the Texas non-standard automobile policies produced
by AHGA and underwritten either by State & County (for policies written from
April 1, 2003 through September 30, 2003) or OACM (for policies written
after September 30, 2003). The remaining 55% of each policy is directly
assumed by Dorinco. Under these new reinsurance arrangements, Hallmark is
obligated to policyholders only for the portion of the risk assumed by
Hallmark. Phoenix underwrites its own policies and does not cede any
portion of the business to reinsurers.
Under Hallmark's reinsurance arrangements, the Company earns ceding
commissions based on Dorinco's loss ratio experience on the portion
of policies reinsured by Dorinco. The Company receives a provisional
commission as policies are produced as an advance against the later
determination of the commission actually earned. The provisional commission
is adjusted periodically on a sliding scale based on expected loss ratios.
As of December 31, 2003 and 2002, the accrued ceding commission payable was
$1.2 million and $2.5 million, respectively. This accrual represents the
difference between the provisional ceding commission received and the ceding
commission earned based on current loss ratios.
The following table presents gross and net premiums written and earned and
reinsurance recoveries for each of the last three years:
(in thousands) 2003 2002 2001
-------- -------- --------
Gross premiums written $ 43,338 $ 51,643 $ 49,614
Ceded premiums written (6,769) (29,611) (33,822)
-------- -------- --------
Net premiums written $ 36,569 $ 22,032 $ 15,792
======== ======== ========
Gross premiums earned $ 57,447 $ 52,486 $ 49,525
Ceded premiums earned (15,472) (32,273) (33,149)
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Net premiums earned $ 41,975 $ 20,213 $ 16,376
======== ======== ========
Reinsurance recoveries $ 11,332 $ 21,161 $ 27,857
-------- -------- --------
Marketing
The Company's customers for non-standard automobile insurance typically
fall into two groups. The first are drivers who do not qualify for standard
auto insurance due to driving record, claims history, residency status, type
of vehicle or adverse credit history. The second group is drivers who live
in areas in which there is limited availability of standard rate insurance.
AHGA acts as a managing general agency for OACM to manage 353 independent
agents in Texas writing non-standard automobile policies. Phoenix's
policies are generated through 135 independent agents in New Mexico and
Arizona. Field marketing representatives promote the Company's non-standard
automobile insurance programs to prospective independent agents and service
existing independent agents. The independent agents represent other
insurers and sell other insurance products in addition to the Company's
policies. During fiscal 2003, the top 10 independent agency groups
produced 23%, and no individual agency group produced more than 4%, of the
total premium volume of the Personal Lines Group.
HGA markets commercial insurance policies through a force of approximately
150 independent agencies primarily in the rural areas of Texas, New Mexico,
Idaho, Oregon, and Washington. HGA targets customers that are in low hazard
classifications in the standard commercial market (typically referred to as
"main street" accounts). The typical customer is a small to medium sized
business and will have a policy that covers property, general liability and
auto exposures. HGA has historically maintained excellent relationships with
its producing agents. During fiscal 2003, the top 10 independent agency
groups produced 29%, and no individual agency group produced more than 5%,
of the total premium volume of the Commercial Lines Group.
Competition
The property and casualty insurance market, the Company's primary source
of revenue, is highly competitive and, except for regulatory considerations,
has very few barriers to entry. According to A.M. Best Company, Inc., there
were 3,072 property and casualty insurance companies and 1,911 property and
casualty insurance groups operating in North America as of July 22, 2003.
The Company's Personal Lines Group competes with large national insurers
such as Allstate, State Farm and Progressive, as well as numerous regional
companies and managing general agencies. The Company's Commercial Lines
Group competes with large national carriers such as Hartford, Zurich and
Safeco, as well as numerous regional companies and managing general
agencies. The Company's competitors include entities which have, or are
affiliated with entities which have, greater financial and other resources
than the Company.
Generally, the Company competes based upon price, customer service,
coverages offered, claims handling, financial stability, agent commission
and support, customer recognition and geographic coverage. The Company
competes with companies using independent agents, captive agent networks,
direct marketing channels, or a combination thereof.
The current competitive environment in the personal non-standard auto
insurance market is driven largely by reinsurance capacity and terms.
Beginning in 2000, the reinsurance capacity and terms generally available
were not sufficient to continue to support programs with inadequate rates
and poor performance. The result has been a contraction of the marketplace,
allowing remaining competitors to obtain additional rate and/or premium
growth. These conditions continued into 2003, albeit at a diminished pace,
with the market moving into a more stabilized condition by the end of the
year. By the close of 2003, the frequency of market driven rate and
underwriting adjustments had slowed, and the degree of rate impact of these
actions had diminished, when compared to recent prior years.
The current competitive environment in the commercial insurance market is
being impacted by a reduction in capacity as insurers, following a prolonged
cyclical downturn in profitability, have reduced premium writing capacity in
areas that have been unprofitable. The Company's primary source of revenue
in this line of business has been the rural or non-urban markets which have
historically provided favorable underwriting results. As with the personal
non-standard auto industry, the commercial insurance marketplace has
contracted, allowing remaining competitors to obtain additional rate and/or
premium growth. Although these conditions continued during 2003, there is
currently more resistance to rate increases.
Insurance Regulation
The operations of Hallmark, AHGA and HFC are regulated by the TDI. AZDOI
regulates the operations of Phoenix. Hallmark and Phoenix are required to
file quarterly and annual statements of their financial condition with TDI
and AZDOI, respectively, prepared in accordance with SAP. Hallmark's and
Phoenix's financial condition, including the adequacy of surplus, loss
reserves and investments, is subject to review by TDI and AZDOI,
respectively. Hallmark does not write its insurance directly, but assumes
business written through a county mutual insurance company. Under Texas
insurance regulation, premium rates and underwriting guidelines of county
mutuals are not subject to the same degree of regulation imposed on standard
insurance companies. AHGA is also subject to TDI licensing requirements.
HFC is subject to licensing, financial reporting and certain financial
requirements imposed by TDI and is also regulated by the Texas Office of
Consumer Credit Commissioner.
On June 10, 2003, the Governor of Texas signed Senate Bill 14, which has
been described as comprehensive insurance reform affecting homeowners
and personal automobile business. With respect to personal automobile
insurance, the most significant provisions provide for additional rate
regulation and limitations on the use of credit scoring. With the new law,
broadened rulemaking authority has also been given to the Commissioner of
Insurance.
The Company currently writes all of its Texas personal automobile business
pursuant to a fronting arrangement with a Texas county mutual insurance
company. Although the new reforms are significant, the primary rate
regulation provisions do not apply directly to the Company due to an
exemption that applies to certain county mutual insurance companies.
Additionally, the Company does not currently use credit or insurance scoring
models. The Company does not believe the specific changes outlined in
Senate Bill 14 will have a material adverse affect on its operations.
However, the Company cannot determine the ultimate application of this
legislation or the impact it may have on its business until certain rules
are developed by the Commissioner. Any rule changes that would affect the
Company's ability to charge adequate rates for the non-standard automobile
line of business in the State of Texas would have a material adverse effect
on its operations.
TDI and AZDOI have broad authority to enforce insurance laws and
regulations through examinations, administrative orders, civil and criminal
enforcement proceedings, and suspension or revocation of an insurer's
certificate of authority or an agent's license. In extreme cases, including
actual or pending insolvency, they may take over, or appoint a receiver to
take over, the management or operations of an insurer or an agent's business
or assets. In addition, all insurance companies are subject to assessments
for state administered funds which cover the claims and expenses of
insolvent or impaired insurers. The size of the assessment is determined
each year by the total claims on the fund that year. Each insurer is
assessed a pro-rata share based on its direct premiums written. Payments to
the fund may be recovered by the insurer through deductions from its premium
taxes at a rate of 10% per year over ten years.
HFS is also regulated as an insurance holding company by TDI and AZDOI.
Financial transactions between HFS or any of its affiliates and Hallmark or
Phoenix are subject to regulation. Applicable regulations require approval
of management and expense sharing contracts, inter-company loans and asset
transactions, investments in the Company's securities by Hallmark or Phoenix
and similar transactions. Further, dividends and distributions to HFS by
Hallmark or Phoenix are restricted.
The National Association of Insurance Commissioners ("NAIC") requests
property/casualty insurers to file a risk-based capital ("RBC") calculation
according to a specified formula. The purpose of the NAIC-designed formula
is twofold: (1) to assess the adequacy of an insurer's statutory capital and
surplus based upon a variety of factors such as potential risks related to
investment portfolio, ceded reinsurance and product mix; and (2) to assist
state regulators under the RBC for Insurers Model Act (the "Model Act") by
providing thresholds at which a state commissioner is authorized and
expected to take regulatory action. Hallmark's 2003 and 2002 adjusted
capital under the RBC calculation exceeded the minimum requirement by 186.3%
and 142.9%, respectively. Phoenix's 2003 adjusted capital under the RBC
calculation exceeded the minimum requirement by 161.5%.
HGA is subject to and in compliance with the licensing requirements of
the department of insurance in each state in which it produces business.
Generally, each state requires one officer of HGA to maintain an agent
license. Claims adjusters employed by ECM and HCS are also subject to the
licensing requirements of each state in which they conduct business. Each
claims adjuster employed by the Company either holds or has applied for the
required licenses.
Analysis of Hallmark's Losses and LAE
The Company's consolidated financial statements include an estimated
reserve for unpaid losses and LAE. The Company estimates its reserve for
unpaid losses and LAE by using case-basis evaluations and statistical
projections, which include inferences from both losses paid and losses
incurred. The Company also uses recent historical cost data, periodic
reviews of underwriting standards and claims management to modify the
statistical projections. The Company gives consideration to the impact of
inflation in determining its loss reserves, but does not discount reserve
balances.
The amount of reserves represents management's estimates of the ultimate
net cost of all unpaid losses and LAE incurred through December of each
year. These estimates are subject to the effect of trends in claim severity
and frequency. Management continually reviews the estimates and adjusts
them as claims experience develops and new information becomes known. Such
adjustments are included in current operations, including increases and
decreases, net of reinsurance, in the estimate of ultimate liabilities for
insured events of prior years. (See Note 1 to the consolidated financial
statements included in this report.)
Changes in loss development patterns and claim payments can significantly
affect the ability of insurers to estimate reserves for unpaid losses and
related expenses. The Company seeks to continually improve its loss
estimation process by refining its ability to analyze loss development
patterns, claim payments and other information within a legal and regulatory
environment which affects development of ultimate liabilities. Future
changes in estimates of claim costs may adversely affect future period
operating results. However, such effects cannot be reasonably estimated
currently.
Reconciliation of Reserve for Unpaid Losses and LAE. The following table
provides a 2003 and 2002 reconciliation of the beginning and ending reserve
balances, on a gross-of-reinsurance basis, to the gross amounts reported in
the Company's balance sheet at December 31, 2003 and 2002 (in thousands):
2003 2002
-------- --------
Reserve for unpaid losses and LAE, net
of reinsurance recoverables, January 1 $ 8,411 $ 7,919
Acquisition of Phoenix January 1, 2003 10,338 -
Provision for losses and LAE for claims
occurring in the current period 29,724 15,125
Increase in reserve for unpaid losses and
LAE for claims occurring in prior periods 464 177
Payments for losses and LAE, net of reinsurance:
Current period (21,895) (9,119)
Prior periods (5,845) (5,691)
-------- --------
Reserve for unpaid losses and LAE, net of
reinsurance recoverable, December 31 $ 21,197 $ 8,411
Reinsurance recoverable on unpaid losses and
LAE at December 31 7,259 9,256
-------- --------
Reserve for unpaid losses and LAE, gross of
reinsurance at December 31 $ 28,456 $ 17,667
======== ========
The 2003 provision for losses and LAE for claims occurring in the current
period includes a $2.1 million settlement of a bad faith claim, net of
reinsurance, and adverse development primarily related to newly acquired
business. (See Item 3.)
SAP/GAAP Reserve Reconciliation. The differences between the reserves for
unpaid losses and LAE reported in the Company's consolidated financial
statements prepared in accordance with GAAP and those reported in the
annual statements filed with TDI and AZDOI in accordance with SAP for years
2003 and 2002 are summarized below (in thousands):
December 31
2003 2002
------ ------
Reserve for unpaid losses and LAE on a SAP basis
(net of reinsurance recoverables on unpaid losses) $21,132 $ 8,296
Loss reserve discount from the Phoenix acquisition (155) -
Unamortized risk premium reserve discount from the
Phoenix acquisition 220 -
Estimated future unallocated LAE reserve for HCS - 115
------ ------
Reserve for unpaid losses and LAE on a GAAP basis
(net of reinsurance recoverables on unpaid losses) $21,197 $ 8,411
====== ======
Analysis of Loss and LAE Reserve Development
The following table shows the development of the Company's loss reserves,
net of reinsurance, for 1993 through 2003. Section A of the table shows the
estimated liability for unpaid losses and LAE, net of reinsurance, recorded
at the balance sheet date for each of the indicated years. This liability
represents the estimated amount of losses and LAE for claims arising in
prior years that are unpaid at the balance sheet date, including losses that
have been incurred but not yet reported to Hallmark. Section B of the table
shows the re-estimated amount of the previously recorded liability, based on
experience as of the end of each succeeding year. The estimate is increased
or decreased as more information becomes known about the frequency and
severity of claims.
Cumulative Redundancy/Deficiency (Section C of the table) represents the
aggregate change in the estimates over all prior years. Thus, changes in
ultimate development estimates are included in operations over a number of
years, minimizing the significance of such changes in any one year. The
effects on income in the past two years of changes in estimates of the
liabilities for losses and LAE are shown in the table under reconciliation
of reserves for unpaid losses and LAE.
[This space left blank intentionally.]
ANALYSIS OF LOSS AND LAE DEVELOPMENT
(Thousands of dollars)
Year Ended December 31 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03
---------------------- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- -----
A. Reserve for 4321 4297 5923 5096 4668 4580 5409 7451 7919 8411 21197
Unpaid Losses & LAE,
Net of Reinsurance
Recoverables
B. Net Reserve Re-
estimated as of :
One year later 4626 5175 5910 6227 4985 4594 5506 7974 8096 8875
Two years later 4499 5076 6086 6162 4954 4464 5277 7863 8620
Three years later 4288 5029 6050 6117 4884 4225 5216 7773
Four years later 4251 5034 6024 6070 4757 4179 5095
Five years later 4238 5031 6099 5954 4732 4111
Six years later 4239 5038 6044 5928 4687
Seven years later 4234 5030 6038 5900
Eight years later 4234 5030 6029
Nine years later 4234 5030
Ten years later 4234
C. Net Cumulative
Redundancy (Deficiency) 87 (733) (106) (804) (19) 469 314 (322) (701) (464)
D. Cumulative Amount
of Claims Paid, Net
of Reserve
Recoveries, through:
One year later 3028 3313 3783 4326 3326 2791 3229 5377 5691 5845
Two years later 3883 4442 5447 5528 4287 3476 4436 7070 7905
Three years later 4147 4861 5856 5860 4387 3911 4909 7584
Four years later 4207 4975 5933 5699 4571 4002 5014
Five years later 4218 5005 6018 5818 4618 4051
Six years later 4223 5030 6018 5853 4643
Seven years later 4234 5030 6029 5860
Eight years later 4234 5030 6029
Nine years later 4234 5030
Ten years later 4234
2002 2003
------ ------
Net Reserve-December 31 $ 8,411 $21,197
Reinsurance Recoverables 9,256 7,259
------ ------
Gross Reserve - December 31 $17,667 $28,456
====== ======
Net Re-estimated Reserve 8,875
Re-estimated Reinsurance Recoverable 9,932
------
Gross Re-estimated Reserve $18,807
======
Gross Cumulative Deficiency $(1,140)
======
Investment Policy
The Company's investment objective is to maximize current yield while
maintaining safety of capital together with sufficient liquidity for ongoing
insurance operations. The investment portfolio is composed of fixed income
and equity securities. The fixed income securities are made up of 16% U.S.
Government or U.S. Government agency securities, 79% state and local
securities, and 5% other securities. The average maturity of the Hallmark
and Phoenix fixed income portfolios is 7.8 years and 7.0 years,
respectively. The fair value of the Company's fixed income securities as of
December 31, 2003 was $31.0 million, of which $5.1 million is classified as
restricted investments. If market rates were to change 1%, the fair value
of the company's fixed income securities would change approximately $1.7
million as of December 31, 2003. Maturities, bond calls and prepayments of
mortgage-backed securities totaled approximately $6.4 million in 2003.
In addition, as part of the Company's overall investment strategy, the
Company maintains an integrated cash management system utilizing on-line
banking services and daily overnight investment accounts to maximize
investment earnings on all available cash. During 2003, the Company's
investment income totaled approximately $1.2 million compared to
approximately $0.8 million for 2002. The increase in investment income from
2002 to 2003 was primarily attributable to the acquisition of Phoenix in
January 2003.
Employees
On December 31, 2003, the Company employed 186 people on a full-time
basis as compared to 203 people at December 31, 2002. None of the
Company's employees are represented by labor unions. The Company considers
its employee relations to be excellent.
Item 2. Description of Property.
The Company's corporate headquarters and commercial lines group are
located at 777 Main Street, Suite 1000, Fort Worth, Texas. The suite is
located in a high-rise office building and contains approximately 27,808
square feet of space. Effective June 1, 2003, the Company negotiated its
lease for a period of 97 months to expire June 30, 2011. The rent is
currently $31,168 per month.
The Company's personal lines group is located at 14651 Dallas Parkway,
Suite 400, Dallas, Texas. The suite is located in a high-rise office
building and contains approximately 25,559 square feet of space. The
Company renegotiated its lease on May 5, 2003 for a period of 66 months to
expire November 30, 2008. The rent is currently $50,075 per month.
Item 3. Legal Proceedings.
The Company is engaged in various legal proceedings which are routine in
nature and incidental to the Company's business. None of these proceedings,
either individually or in the aggregate, are believed, in the opinion of
management, to have a material adverse effect on the consolidated financial
position of the Company or the results of operations.
On May 30, 2003, Phoenix was served with a suit from the Superior Court of
the State of Arizona in and for the County of Pima, alleging breach of
contract and bad faith in connection with Phoenix's denial of coverage in an
automobile accident. The Company settled the suit in the first quarter of
2004 for $2.1 million, net of applicable reinsurance recoverable.
Item 4. Submission of Matters to a Vote of Security Holders.
During the fourth quarter of 2003, the Company did not submit any matter
to a vote of its security holders.
PART II
Item 5. Market for Common Equity and Related Stockholder Matters.
The Company's Common Stock has traded on the American Stock Exchange's
Emerging Company Marketplace under the symbol "HAF.EC" since January 6,
1994. The following table shows the Common Stock's high and low sales
prices on the AMEX Emerging Company Marketplace for each quarter since
January 1, 2002.
Period High Sale Low Sale
2002
----
First Quarter $ 0.60 $ 0.40
Second Quarter 0.60 0.40
Third Quarter 0.54 0.35
Fourth Quarter 0.70 0.30
2003
----
First Quarter $ 0.75 $ 0.50
Second Quarter 0.95 0.65
Third Quarter 1.15 0.31
Fourth Quarter 0.80 0.50
2004
----
First Quarter
(through March 22) $ 0.79 $ 0.50
As of February 27, 2003 there were approximately 155 shareholders of
record of the Company's common stock.
The Company has never paid dividends on its Common Stock. The Board of
Directors intends to continue this policy for the foreseeable future in
order to retain earnings for development of the Company's business.
Item 6. Management's Discussion and Analysis or Plan of Operation.
The following discussion of the Company's financial condition and the
results of its operations should be read in conjunction with the
consolidated financial statements and related notes included in this report.
Critical Accounting Policies
The following discussion provides management's assessment of financial
results and material changes in financial position for the Company. This
discussion is based upon the Company's consolidated financial statements,
which have been prepared in accordance with GAAP. The Company's significant
accounting policies requiring management estimates and judgments are
discussed below. Such estimates and judgments are based on historical
experience, changes in laws and regulations, observance of industry trends
and various information received from third parties. While the estimates
and judgments associated with the application of these accounting policies
may be affected by different assumptions or conditions, the Company believes
the estimates and judgments associated with the reported consolidated
financial statement amounts are appropriate in the circumstances.
Investments. Investment income is an important source of revenue, and the
Company's return on invested assets has a material effect on net income.
The Company's investment policy is subject to the requirements of regulatory
authorities. In addition, certain assets are held on deposit with various
states and invested in specified securities in order to comply with state
law. Although the Company closely monitors its investment portfolio,
available yields on newly-invested funds and gains or losses on existing
investments depend primarily on general market conditions. See Item 1 for
additional discussion of the Company's investment policy.
In 2003, the Company changed the classification of its investment
portfolio to available-for-sale. A classification of available-for-sale
means the changes in the fair market value of securities are reflected in
other comprehensive income, a component of stockholders' equity. Prior to
2003, the Company used an investment strategy classified as held-to-
maturity. A classification of held-to-maturity means that the Company
reported its securities at amortized cost rather than fair market value.
Short-term investments are carried at market value. Short-term investments
are comprised of a certificate of deposit maturing in one year.
Realized investment gains and losses are recognized in operations on the
specific identification method.
Deferred Policy Acquisition Costs. Policy acquisition costs (mainly
commissions, underwriting and marketing expenses) that vary with and are
primarily related to the production of new and renewal business are deferred
and charged to operations over periods in which the related premiums
are earned. Ceding commissions from reinsurers, which include expense
allowances, are deferred and recognized over the period premiums are earned
for the underlying policies reinsured.
The method followed in computing deferred policy acquisition costs limits
the amount of such deferred costs to their estimated realizable value. A
premium deficiency exists if the sum of expected claim costs and claim
adjustment expenses, unamortized acquisition costs, and maintenance costs
exceeds related unearned premiums and expected investment income on those
unearned premiums. The Company routinely evaluates the realizability of
deferred policy acquisition costs. At December 31, 2003 and 2002, there was
no premium deficiency related to deferred policy acquisition costs.
Business Combinations. The Company accounts for business combinations
using the purchase method of accounting. The cost of an acquired entity is
allocated to the assets acquired (including identified intangible assets)
and liabilities assumed based on their estimated fair values. The excess of
the cost of an acquired entity over the net of the amounts assigned to
assets acquired and liabilities assumed is an asset referred to as "excess
of cost over net assets acquired" or "goodwill". Indirect and general
expenses related to business combinations are expensed as incurred.
Retirement Plans. Certain employees of the Commercial Lines Group were
participants in a defined benefit cash balance plan covering all full-time
employees who had completed at least 1,000 hours of service. The plan was
frozen in March 2001 in anticipation of distribution of plan assets to
members upon plan termination. All participants were vested when the plan
was frozen. Management, in conjunction with its consulting actuaries,
determined the appropriate assumptions to be used in valuing the projected
benefit obligation of the plan at December 31, 2003. Assumptions used
considered the expected payout period for the liabilities and underlying
assets held to fund the obligation.
Intangible Assets. On January 1, 2002, the Company adopted Statement of
Financial Accounting Standards No. 142 ("SFAS 142"), "Goodwill and Other
Intangible Assets". SFAS 142 supersedes Accounting Principles Board ("APB")
17, "Intangible Assets", and primarily addresses the accounting for goodwill
and intangible assets subsequent to their initial recognition. SFAS 142
(1) prohibits the amortization of goodwill and indefinite-lived intangible
assets, (2) requires testing of goodwill and indefinite-lived intangible
assets on an annual basis for impairment (and more frequently if
the occurrence of an event or circumstance indicates an impairment), (3)
requires that reporting units be identified for the purpose of assessing
potential future impairments of goodwill, and (4) removes the forty-year
limitation on the amortization period of intangible assets that have finite
lives.
Pursuant to SFAS 142, the Company has identified two components of
goodwill and assigned the carrying value of these components into two
reporting units: the Personal Lines Group and the Commercial Lines Group.
During 2003, the Company completed the first step prescribed by SFAS 142 for
testing for impairment and determined that there is no impairment. Prior
to the acquisitions of the Commercial Lines Group in December 2002 and
Phoenix in January 2003, the Company assigned the carrying value of goodwill
to the insurance company reporting unit and the finance company reporting
unit. In 2003, as a result of these acquisitions, the Company changed the
way it views its operating segments.
Effective December 1, 2002, the Company acquired the Commercial Lines
Group. At acquisition, the Company valued the relationships with its
independent agents at $542,580. This asset is classified as an other
intangible asset and is being amortized over twenty years. The Company
recognized $27,129 of amortization expense for the twelve months ending
December 31, 2003 and will recognize $27,129 in amortization expense for
each of the next five years and $377,545 for the remainder of the asset's
life.
Deferred Tax Assets. The Company files a consolidated federal income tax
return. Deferred federal income taxes reflect the future tax consequences
of differences between the tax bases of assets and liabilities and their
financial reporting amounts at each year end. Deferred taxes are recognized
using the liability method, whereby tax rates are applied to cumulative
temporary differences based on when and how they are expected to affect the
tax return. Deferred tax assets and liabilities are adjusted for tax rate
changes. A valuation allowance is provided against the Company's deferred
tax asset to the extent that management does not believe it is more likely
than not that future taxable income will be adequate to realize these future
tax benefits. This valuation allowance was $884,000 and $33,000 at December
31, 2003 and 2002, respectively.
Reserves for Unpaid Losses and Loss Adjustment Expenses. Reserves for
unpaid losses and LAE are established by the Company for claims which have
already been incurred by the policyholder but which have not been paid by
the Company. Losses and LAE represent the estimated ultimate net cost of
all reported and unreported losses incurred through December 31, 2003 and
2002. The reserves for unpaid losses and LAE are estimated using individual
case-basis valuations and statistical analyses. These estimates are subject
to the effects of trends in loss severity and frequency.
Although considerable variability is inherent in such estimates,
management believes that the reserves for unpaid losses and LAE are
adequate. The estimates are continually reviewed and adjusted as experience
develops or new information becomes known. Such adjustments are included in
current operations. The range of unpaid losses and LAE estimated by the
Company's actuaries as of December 31, 2003 was $21.3 million to $32.6
million. Management's best estimate of unpaid losses and LAE as of December
31, 2003 is $28.5 million. In setting this estimate of unpaid losses and
LAE, management has assumed, among other things, that current trends in loss
frequency and severity will continue and that the actuarial analysis was
empirically valid. In the absence of any specific factors indicating actual
experience at either extreme of the actuarial range, management has
established a moderately conservative estimate of unpaid losses and LAE,
which is approximately $1.5 million higher than the midpoint of the
actuarial range. This estimate of unpaid losses and LAE includes reserves
related to settlement of a bad faith claim of $2.1 million, net of
reinsurance and inadequate Phoenix pre-acquisition reserves. (See Item 3)
The Company's reserve requirements are also interrelated with product
pricing and profitability. The Company must price its products at a level
sufficient to fund its policyholder benefits and still remain profitable.
Because the Company's claim expenses represent the single largest category
of its expenses, inaccuracies in the assumptions used to estimate the amount
of such benefits can result in the Company failing to price its products
appropriately and to generate sufficient premiums to fund its operations.
Recognition of Premium Revenues. Insurance premiums and policy fees are
earned pro rata over the terms of the policies. Upon cancellation, any
unearned premium and policy fee is refunded to the insured. Insurance
premiums written include gross policy fees of $3.0 million and $5.1 million
and policy fees, net of reinsurance, of $2.3 million and $2.1 million for
the years ended December 31, 2003 and 2002, respectively.
Ceding Commissions of the Personal Lines Group. Ceding commissions from
reinsurers on retroceded business, which include expense allowances, are
deferred and recognized over the period premiums are earned for the
underlying policies reinsured. Deferred ceding commissions are netted
against deferred policy acquisition costs in the balance sheet. The change
in deferred ceding commission income is netted against the change in
deferred policy acquisition costs in the statement of operations. Under
Hallmark's reinsurance arrangements, the Company earns ceding commissions
based on Dorinco's loss ratio experience on the portion of policies
reinsured by Dorinco. The Company receives a provisional commission as
policies are produced as an advance against the later determination of
the commission actually earned. The provisional commission is adjusted
periodically on a sliding scale based on expected loss ratios.
Recognition of Commission Revenues and Expenses of the Commercial Lines
Group. Commission revenue and commission expense related to insurance
policies serviced by HGA are recognized during the period covered by the
policy. Profit sharing commission is calculated and recognized when the
ratio of ultimate losses and loss expenses incurred to earned premium ("loss
ratio") as determined by a qualified actuary deviate from contractual
thresholds. The profit sharing commission is an estimate that varies with
the estimated loss ratio and is sensitive to changes in that estimate. The
following table details the profit sharing commission revenue sensitivity to
the actual ultimate loss ratio for each effective quota share treaty at 0.5%
above and below the provisional loss ratio.
Treaty Effective Dates
--------------------------------
7/1/01 - 7/1/02 - 7/1/03 -
6/30/02 6/30/03 6/30/04
--------------------------------
Provisional loss ratio 60.0% 59.0% 59.0%
Ultimate loss ratio booked
to at 12/31/03 58.5% 59.0% 59.0%
Effect of actual 0.5% above
provisional ($206,115) ($270,254) ($40,099)
Effect of actual 0.5% below
provisional $144,280 $178,367 $26,465
As of December 31, 2003, the Company recorded a $0.4 million profit
sharing receivable for the quota share treaty effective July 1, 2001 through
June 30, 2002. The Company also recorded a $0.6 million receivable on the
quota share treaty effective July 1, 2001 through June 30, 2002 because the
Company has collected its commission on this treaty at the maximum loss
ratio of 61.5% equal to a commission rate of 30.0% per the contractual
commission slide.
Recognition of Claim Servicing Fees. Claim servicing fees are recognized
in proportion to the historical trends of the claim cycle. The Company uses
historical claim count data that measures the close rate of claims in
relation to the policy period covered to substantiate the service period.
The following table summarizes the years in which claim fee revenue is
recognized by type of business.
Year Claim Fee Revenue Recognized
---------------------------------
1st 2nd 3rd 4th
--------------------
Commercial property fees 80% 20% - -
Commercial liability fees 60% 30% 10% -
Personal property fees 90% 10% - -
Personal liability fees 49% 33% 12% 6%
Reinsurance. As is common in the insurance industry, prior to April 1,
2003, the Company reinsured, or ceded, portions of the coverage provided to
policyholders to other insurance companies. Cession of reinsurance is
utilized by an insurer to limit its maximum loss, thereby providing a
greater diversification of risk and minimizing exposures on larger risks.
Reinsurance does not discharge the primary liability of the original insurer
with respect to such insurance. See Item 1 for further discussion of the
Company's reinsurance arrangements.
Statutory Accounting Practices. The Company is required to report its
results of operations and financial position to TDI and AZDOI based upon
SAP. Under SAP, unlike GAAP, the Company is required to expense all sales
and other policy acquisition costs as they are incurred rather than
capitalizing and amortizing them over the expected life of the policy. The
immediate charge off of sales and acquisition expenses and other
conservative valuations under SAP generally cause a lag between the sale of
a policy and the emergence of reported earnings. Because this lag can
reduce the Company's gain from operations on a SAP basis, it can have the
effect of reducing the amount of funds available for dividend to HFS from
Hallmark and Phoenix.
Financial Condition and Liquidity
The Company's sources of funds are principally derived from insurance
related operations. The major sources of funds from operations include
premiums collected (net of policy cancellations and premiums ceded), ceding
commissions, and processing and service fees. Other sources of funds are
from financing and investment activities.
The following table shows future payments to be made under contractual
obligations as of December 31, 2003 (in thousands):
Payments by Period:
----------------------------------------------
Less than 1-3 3-5 More than
Total 1 Year Years Years 5 Years
----------------------------------------------
Contractual
obligations: (1)
Long-term
borrowings (2) $ 991 $ 728 $ 263 - -
(1) Information regarding the Company's contractual obligations
under operating leases as of December 31, 2003, is incorporated
by reference to Note 16 of the consolidated financial
statements included in this report.
(2) Long-term borrowings consists of a 8.25% promissory note
payable to Dorinco. Payments of principal and accrued interest
are due in quarterly installments on the last day of March,
June, September, and December with the last payment due June
30, 2005. (See Note 7 of the consolidated financial statements
included in this report)
On a consolidated basis, the Company's cash and investments increased
approximately 60.3% as of December 31, 2003 as compared to December 31,
2002. This was primarily a result of the acquisition of Phoenix, which
increased cash and investments by $24.7 million in 2003. Excluding Phoenix,
the Company's liquidity decreased by approximately $9.5 million or 37.7%,
primarily as a result of lower retained premium volume in Hallmark in 2003
as compared to 2002. The Company's consolidated cash, cash equivalents and
investments at December 31, 2003 and 2002 were $40.4 million and $25.2
million, respectively, excluding restricted cash and investments of $5.4
million and $1.1 million, respectively, to secure State & County's credit
exposure from the quota share reinsurance treaty with Hallmark effective
April 1, 2003.
The Company's operating activities provided $0.7 million in net cash
during 2003 as compared to $1.9 million in 2002. The Company paid $26.1
million more in operating expenses and $8.7 million more in losses and LAE
in 2003 as compared to 2002 primarily a result of the acquisitions of
Phoenix in 2003 and the Commercial Lines Group in December 2002. These
additional outlays of cash were partially offset by $18.2 million more
ceding commissions collected, $11.5 million more premiums collected, net of
reinsurance paid and $4.1 million more processing and service fees collected
in 2003 as compared to 2002.
Cash provided by investing activities during 2003 increased by $18.0
million as compared to 2002. Premium finance notes repaid over notes
originated increased by $9.4 million in 2003 over 2002. During 2003, the
Company received $6.9 million in cash from the acquisition of Phoenix and
received $4.9 million more in cash from redemptions and maturities of
investment securities than in 2002. The Company purchased $6.4 million more
in debt and equity securities than in 2002. The Company also transferred
$5.2 million more from cash and investments to restricted trust accounts in
2003 than in 2002 in connection with changes to the quota share reinsurance
treaty with State & County effective April 1, 2003. During 2002, the
Company purchased a note receivable in the amount of $6.5 million from a
financial institution, which was secured by the stock of Phoenix, and
purchased the Commercial Lines Group for $2.1 million plus assumption of
certain liabilities.
Cash used in financing activities increased by $17.6 million during 2003
as compared to 2002 primarily due to the repayment of a promissory note to a
related party initiated in 2002 and a $9.4 million increase in net
repayments to premium finance lender. Proceeds of the note were used to
purchase the note receivable and Commercial Lines Group discussed above.
The funds used to repay the promissory note were generated by a rights
offering the Company completed in the third quarter of 2003. Net repayments
to the premium finance lender increased as a result of the Company's
discontinuation of its writing of premium financed policies effective July
1, 2003.
HFS is dependent on dividend payments and management fees from its
insurance company operations and free cash flow of its non-insurance
companies to meet operating expenses and debt obligations. As of December
31, 2003, cash and invested assets of HFS were $1.9 million. Cash and
invested assets of non-insurance subsidiaries were $3.2 million as of
December 31, 2003. Property and casualty insurance companies domiciled in
the State of Texas are limited in the payment of dividends to their
shareholders in any twelve-month period, without the prior written consent
of the Commissioner of Insurance, to the greater of statutory net income for
the prior calendar year or 10% of statutory policyholders' surplus as of the
prior year end. Dividends may only be paid from unassigned surplus funds.
During 2003, Hallmark's ordinary dividend capacity was $0.8 million. During
2003, Hallmark declared dividends to HFS of $0.4 million of which $0.2
million was paid. Based on surplus at December 31, 2003, Hallmark could pay
up to $2.0 million in dividends to HFS during 2004 without TDI approval.
Phoenix, domiciled in Arizona, is limited in the payment of dividends to the
lesser of 10% of prior year policyholder surplus or prior year's net
investment income, without prior written approval from the AZDOI. During
2003, Phoenix's ordinary dividend capacity was $0.6 million. Phoenix paid
$0.6 million of dividends to HFS during 2003. The maximum dividend that
Phoenix can pay HFS in 2004 without prior approval of the AZDOI is $0.6
million.
TDI regulates financial transactions between Hallmark, HFS and affiliated
companies. Applicable regulations require TDI's approval of management and
expense sharing contracts and similar transactions. Although TDI has
approved Hallmark's payment of management fees to HFS and commissions to
AHGA, since the second half of 2000 management has elected not to pay all
the approved commissions or management fees. Hallmark paid management fees
of $0.6 million to HFS during 2003, as compared to $0.2 million in 2002.
The AZDOI regulates financial transactions between Phoenix and affiliated
companies. Applicable regulations require AZDOI's approval of management
and expense sharing contracts and similar transactions. Although the AZDOI
has approved payments of management fees to HFS, management elected not to
pay a management fee to HFS in 2003 in order to strengthen Phoenix's
surplus.
Statutory capital and surplus is calculated as statutory assets less
statutory liabilities. TDI requires that Hallmark maintain minimum
statutory capital and surplus of $2.0 million and AZDOI requires that
Phoenix maintain minimum statutory capital and surplus of $1.5 million.
Hallmark and Phoenix exceed the minimum required statutory capital and
surplus by 401% and 571%, respectively. At December 31, 2003, Hallmark
reported statutory capital and surplus of $10.0 million, which reflects an
increase of $1.6 million from the $8.4 million reported at December 31,
2002. At December 31, 2003, Phoenix reported statutory capital and surplus
of $10.1 million. Hallmark reported statutory net income of $2.0 million
during 2003 compared to $0.4 million in 2002. At December 31, 2003,
Hallmark's premium-to-surplus ratio was 1.50 to 1 as compared to 2.63 to 1
for the year ended December 31, 2002. Phoenix had statutory net loss of
$0.3 million for fiscal 2003. Phoenix's premium-to-surplus ratio was 2.15
to 1 for the year ended December 31, 2003.
HFC previously entered into a secured financing arrangement and a
servicing agreement with an unaffiliated third party, FPF, Inc., in order to
fund HFC's premium finance activities. The Company discontinued writing
premium financed policies in July 2003. The financing arrangement provided
that HFC sell to the third party all eligible premium finance notes
generated by HFC in connection with the financing of insurance policies. As
of December 31, 2003, HFC did not have an outstanding balance on advances
under the financing arrangement compared to an outstanding balance of $10.9
million as of December 31, 2002.
Based on 2004 budgeted and year-to-date cash flow information, the Company
believes that it has sufficient liquidity to meet its projected insurance
obligations, operational expenses and capital expenditure requirements for
the foreseeable future. However, management is continuing to investigate
opportunities for future growth and additional capital may be required to
fund further expansion of the Company.
Results of Operations
Income before tax, cumulative effect of change in accounting principle and
extraordinary gain was $0.7 million for 2003, compared to $36,000 in 2002.
The improvement in operating earnings in 2003 reflects better underwriting
results for Hallmark and the acquisition of the Commercial Lines Group in
December 2002, partially offset by the acquisition of Phoenix. Net income
for 2003 includes $8.1 million of extraordinary gain resulting from the
acquisition of Phoenix. In consideration for Phoenix, the Company retired
$7.0 million of a $14.85 million note receivable from Millers American
Group, Inc. ("Millers"). The Company had valued the note receivable on its
balance sheet at its cost of $6.5 million. As of December 31, 2003, the
Company fully allowed for the remaining balance of the note receivable. The
gain is calculated as the difference between the fair value of the net
assets of Phoenix of $14.6 million and the $6.5 million cost of the note
receivable from Millers.
The following is additional business segment information for the twelve
months ended December 31 (in thousands):
2003 2002
Revenues -------- --------
--------
Personal Lines Group $ 49,665 $ 23,999
Commercial Lines Group 19,891 1,561
Corporate 3 237
-------- --------
Consolidated $ 69,559 $ 25,797
======== ========
Pre-tax Income
--------------
Personal Lines Group $ 1,350 $ (203)
Commercial Lines Group 1,311 3
Corporate (1,975) 236
-------- --------
Consolidated $ 686 $ 36
======== ========
Personal Lines Group
Gross premiums written (prior to reinsurance) for 2003 decreased 16% and
net premiums written (after reinsurance) increased 66% in relation to 2002.
The decrease in gross premiums written is primarily due to the change in the
reinsurance structure with Dorinco and the county mutual fronting companies
(State & County and OACM). Effective April 1, 2003, the Company assumed a
45% share of the non-standard auto business produced by AHGA and
underwritten by either State & County or OACM instead of the 100% share it
assumed prior to that date. Also, effective April 1, 2003, Dorinco assumed
its 55% share of this business directly, where prior to this date the
Company retroceded 55% of the business to Dorinco. The decrease in gross
premiums written is also impacted by Hallmark's cancellation of unprofitable
agents, shift in marketing focus from annual term premium financed policies
to six month term direct bill policies and increases in policy rates. These
decreases are partially offset by the acquisition of Phoenix in 2003, which
contributed $22.4 million in gross premiums written. The increase in net
premiums written is due primarily to the acquisition of Phoenix in 2003,
which contributed $21.6 million in 2003.
Revenue for the Personal Lines Group increased 107% in 2003 to $49.7
million from $24.0 million in 2002. The increase is due mostly to the
acquisition of Phoenix, which contributed $24.3 million in revenue in 2003
and AHGA commission revenue of $2.5 million from Dorinco on policies
effective after March 31, 2003 due to the new reinsurance structure.
Pre-tax income for the Personal Lines Group increased $1.6 million in 2003
to $1.4 million as compared to a pre-tax loss of $0.2 million in 2002.
Contributing to the increased pre-tax income are lower Hallmark loss and LAE
of $13.1 million in 2003 as compared to $15.3 million in 2002. Improved
pricing in 2003 and Hallmark's termination of unprofitable agents in the
first quarter of 2003 helped cause the Company's statutory loss and LAE
ratio to improve to 72.5% for 2003 as compared to 76.8% for 2002. Partially
offsetting these increases in pre-tax income is the acquisition of Phoenix,
which reported a $0.4 million pre-tax loss. The results for Phoenix include
a loss accrual of $2.1 million, net of applicable reinsurance, for the
settlement of a bad faith claim. (See Item 3.)
Commercial Lines Group
Revenue for the Commercial Lines Group of $19.9 million in 2003 is mostly
comprised of $15.0 million of commissions earned on policies serviced by HGA
for CNIC. Revenue also includes $4.6 million of processing and service fees
earned by ECM for claims processing for CNIC and by FAR for accounting
administration for an unaffiliated third party, the contract for which ended
in April 2003. The Commercial Lines Group reported revenue of $1.6 million
for the one month ended December 31, 2002, which was mostly comprised of
$1.1 million of commissions and $0.4 million of processing and service fees.
These were new sources of revenue for the Company as a result of the
acquisition of the Commercial Lines Group in December 2002.
Pre-tax income for the Commercial Lines Group of $1.3 million in 2003 is
comprised of $19.9 million in revenue as discussed above and $18.6 million
in other operating costs and expenses. These costs primarily represent
expenses associated with the production and servicing of insurance policies
for CNIC, the largest component of which is independent retail agent
commissions.
Corporate
Corporate pre-tax loss of $2.0 million in 2003 increased $2.2 million as
compared to pre-tax income of $0.2 million for 2002. The primary reason for
the increase in corporate pre-tax loss is because HFS took $1.2 million less
in management fees from the Personal Lines Group in 2003 than it did in
2002. Other operating costs and expenses increased $0.5 million mostly as a
result of legal and consulting fees associated with acquisitions and other
corporate matters. Additionally, the shift in management structure from
2002 to 2003 increased salary related expenses and other overhead during
2003. Interest expense increased by $0.6 million in 2003 due to interest on
a related party note payable. Proceeds from this note were used to acquire
the Commercial Lines Group and Phoenix. The Company repaid this note in
September 2003 from the proceeds of a rights offering of its stock in the
third quarter of 2003. Investment income decreased by $0.2 million due to a
note receivable secured by the stock of Phoenix acquired from a financial
institution in the fourth quarter of 2002 being satisfied by the acquisition
of Phoenix in 2003. Partially offsetting these increased expenses is $0.3
million of amortization of a $0.5 million risk premium reserve established
in 2003 for Phoenix unpaid loss and LAE. The remainder of this reserve
will be amortized into income over the next five years.
Item 7. Financial Statements
The following consolidated financial statements of the Company
and its subsidiaries are filed as part of this report.
Description Page Number
----------- -----------
Independent Auditors' Report F-2
Report of Independent Accountants F-3
Consolidated Balance Sheets at December 31, 2003 and 2002 F-4
Consolidated Statements of Operations for the Years Ended
December 31, 2003 and 2002 F-5
Consolidated Statements of Stockholders' Equity for the
Years Ended December 31, 2003 and 2002 F-6
Consolidated Statements of Cash Flows for the Years Ended
December 31, 2003 and 2002 F-7
Notes to Consolidated Financial Statements F-9
Item 8. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.
On October 10, 2003, the Company dismissed PricewaterhouseCoopers LLP
("PWC") as its independent accountants and retained KPMG LLP as its new
independent accountants to audit its financial statements for the fiscal
year ended December 31, 2003. The information required by Item 304 of
Regulation S-B is incorporated by reference from the Company's Current
Report on Form 8-K filed October 17, 2003.
Item 8A. Controls and Procedures.
The Chief Executive Officer and the Chief Financial Officer of the Company
have evaluated the Company's disclosure controls and procedures and have
concluded that such controls and procedures are effective as of the end of
the period covered by this report. During the most recent fiscal quarter,
there have been no changes in the Company's internal controls over financial
reporting that have materially affected, or are reasonably likely to
materially affect, the Company's internal control over financial reporting.
PART III
Item 9. Directors, Executive Officers, Promoters and Control Persons;
Compliance with Section 16(a) of the Exchange Act.
The information required by Part III, Item 9 is incorporated by reference
from the Registrant's definitive proxy statement to be filed with the
Commission pursuant to Regulation 14A not later than 120 days after the end
of the fiscal year covered by this report.
Item 10. Executive Compensation.
The information required by Part III, Item 10 is incorporated by reference
from the Registrant's definitive proxy statement to be filed with the
Commission pursuant to Regulation 14A not later than 120 days after the end
of the fiscal year covered by this report.
Item 11. Security Ownership of Certain Beneficial Owners and Management.
The information required by Part III, Item 11 is incorporated by reference
from the Registrant's definitive proxy statement to be filed with the
Commission pursuant to Regulation 14A not later than 120 days after the end
of the fiscal year covered by this report.
Item 12. Certain Relationships and Related Transactions.
The information required by Part III, Item 12 is incorporated by reference
from the Registrant's definitive proxy statement to be filed with the
Commission pursuant to Regulation 14A not later than 120 days after the end
of the fiscal year covered by this report.
Item 13. Exhibits and Reports on Form 8-K.
(a) The exhibits listed in the Exhibit Index appearing at page 23 of
this report are filed with or incorporated by reference in this
report.
(b) The Company filed the following reports on Form 8-K during the
fourth quarter of 2003:
Form 8-K filed October 17, 2003 announcing a change in the
Company's certifying accountant.
Form 8-K filed November 14, 2003 containing a press release
announcing financial results for the third quarter ended
September 30, 2003.
Form 8-K filed November 18, 2003 containing a press release
announcing the resignation of President, Chief Operating Officer
and member of the Board of Directors, Timothy A. Bienek.
Item 14. Principal Accountant Fees and Services.
The information required by Part III, Item 14 is incorporated by
reference from the Registrant's definitive proxy statement to be filed with
the Commission pursuant to Regulation 14A not later than 120 days after the
end of the fiscal year covered by this report.
[This space left blank intentionally.]
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.
HALLMARK FINANCIAL SERVICES, INC.
(Registrant)
Date: March 30, 2004 /s/ Mark E. Schwarz
------------------------------------------
Mark E. Schwarz, Chairman (Chief Executive
Officer)
Date: March 30, 2004 /s/ Mark J. Morrison
------------------------------------------
Mark J. Morrison, Executive Vice President
(Principal Financial Officer)
Date: March 30, 2004 /s/ Jeffrey R. Passmore
------------------------------------------
Jeffrey R. Passmore, Senior Vice President
(Principal Accounting Officer)
In accordance with the Exchange Act, this report has been signed below by
the following persons on behalf of the registrant and in the capacities
and on the dates indicated.
Date: March 30, 2004 /s/ Mark E. Schwarz
------------------------------------------
Mark E. Schwarz, Director
Date: March 30, 2004 /s/ James H. Graves
------------------------------------------
James H. Graves, Director
Date: March 30, 2004 /s/ George R. Manser
------------------------------------------
George R. Manser, Director
Date: March 30, 2004 /s/ Scott T. Berlin
------------------------------------------
Scott T. Berlin, Director
Date: March 30, 2004 /s/ James C. Epstein
------------------------------------------
James C. Epstein, Director
EXHIBIT INDEX
The following exhibits are either filed with this report or incorporated by
reference.
Exhibit
Number Description
------ -----------
3(a) Articles of Incorporation of the registrant, as amended
(incorporated by reference to Exhibit 3(a) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended December
31, 1993).
3(b) By-Laws of the registrant, as amended (incorporated by reference
to Exhibit 3(b) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 1993).
3(c) Amendment of Article VII of the Amended and Restated Bylaws
of Hallmark Financial Services, Inc., adopted July 19, 2002
(incorporated by reference to Exhibit 10(b) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended September
30, 2002).
4 Specimen certificate for Common Stock, $.03 par value, of
the registrant (incorporated by reference to Exhibit 4 to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1991).
10(a) Office Lease for 14651 Dallas Parkway, Suite 900, dated January 1,
1995, between American Hallmark Insurance Company of Texas and
Fults Management Company, as agent for The Prudential Insurance
Company of America (incorporated by reference to Exhibit 10(a) to
the registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1994).
10(b) General Agency Agreement, effective March 1, 1992, between State
& County Mutual Fire Insurance Company and Brokers General, Inc.
(incorporated by reference to Exhibit 10(b) to Amendment No. 1 on
Form 8 to the registrant's Quarterly Report on Form 10-QSB for the
quarter ended September 30, 1992).
10(c) 1991 Key Employee Stock Option Plan of the registrant
(incorporated by reference to Exhibit C to the definitive
Proxy Statement relating to the registrant's Annual Meeting
of Shareholders held May 20, 1991).
10(d) 1994 Key Employee Long Term Incentive Plan (incorporated by
reference to Exhibit 10(f) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 1994).
10(e) 1994 Non-Employee Director Stock Option Plan (incorporated by
reference to Exhibit 10(g) to the registrant's Annual Report on
Form 10-KSB for the fiscal year ended December 31, 1994).
10(f) Addendum No. 1 to the 100% Quota Share Reinsurance Agreement, as
restated between State & County Mutual Fire Insurance Company and
American Hallmark Insurance Company of Texas effective November
22, 1994 (incorporated by reference to Exhibit 10(q) to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1994).
10(g) Second, Third, Fourth and Fifth Amendments to Office Lease for
14651 Dallas Parkway, Suite 900, dated January 1, 1995, between
American Hallmark Insurance Company of Texas and Fults Management
Company, as agent for The Prudential Insurance Company of America
(incorporated by reference to Exhibit 10(t) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended December
31, 1995).
10(h) Quota Share Reinsurance Agreement between State & County Mutual
Fire Insurance Company and American Hallmark Insurance Company of
Texas effective July 1, 1996 (incorporated by reference to Exhibit
10(a) to the registrant's Quarterly Report on Form 10-QSB for the
quarter ended June 30, 1996).
10(i) Quota Share Retrocession Agreement between American Hallmark
Insurance Company of Texas and the Reinsurer (specifically
identified as follows: Dorinco, Kemper and Skandia), effective
July 1, 1996 (incorporated by reference to Exhibit 10(b) to the
registrant's Quarterly Report on Form 10-QSB for the quarter ended
June 30, 1996).
Exhibit
Number Description
------ -----------
10(j) Guaranty Agreement effective July 1, 1996 provided by Dorinco
Reinsurance Company in favor of State & County Mutual Fire
Insurance Company (incorporated by reference to Exhibit 10(c) to
the registrant's Quarterly Report on Form 10-QSB for the quarter
ended June 30, 1996).
10(k) Guaranty of Performance and Hold Harmless Agreement effective
July 1, 1996 between Hallmark Financial Services, Inc. and Dorinco
America Reinsurance Corporation (incorporated by reference to
Exhibit 10(f) to the registrant's Quarterly Report on Form 10-QSB
for the quarter ended June 30, 1996).
10(l) Addendum No. 3 - Termination to 100% Quota Share Reinsurance
Agreement between American Hallmark Insurance Company and State &
County Mutual Fire Insurance Company (incorporated by reference to
Exhibit 10(j) to the registrant's Quarterly Report on Form 10-QSB
for the quarter ended June 30, 1996).
10(m) 100% Quota Share Reinsurance Agreement, effective January 1, 1997,
between State & County Mutual Fire Insurance Company, Vaughn
General Agency, Inc. and American Hallmark General Agency, Inc.
(incorporated by reference to Exhibit 10(am) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended December
31, 1996).
10(n) General Agency Agreement, effective January 1, 1997, between
Dorinco Reinsurance Company, State & County Mutual Fire Insurance
Company and Vaughn General Agency, Inc. (incorporated by reference
to Exhibit 10(an) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 1996).
10(o) Administrative Services Agreement between State & County Mutual
Fire Insurance Company, Vaughn General Agency, Inc. and American
Hallmark General Agency, Inc. (incorporated by reference to
Exhibit 10(ao) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 1996).
10(p) Loan Agreement dated March 11, 1997, between Hallmark Financial
Services, Inc. and Dorinco Reinsurance Company (incorporated by
reference to Exhibit 10(ap) to the registrant's Annual Report on
Form 10-KSB for the fiscal year ended December 31, 1996).
10(q) Stock Pledge and Security Agreement dated March 11, 1997, between
ACO Holdings, Inc. and Dorinco Reinsurance Company (incorporated
by reference to Exhibit 10(ar) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 1996).
10(r) Endorsement No. 1, effective July 1, 1996, to the 100% Quota Share
Reinsurance Agreement between State & County Mutual Fire Insurance
Company and American Hallmark Insurance Company of Texas,
effective July 1, 1996 (incorporated by reference to Exhibit
10(a) to the registrant's Quarterly Report on Form 10-QSB for
the quarter ended June 30, 1997).
10(s) Endorsement No. 1, effective July 1, 1997, to the Guaranty
Agreement provided by Dorinco Reinsurance Corporation in favor
of State & County Mutual Fire Insurance Company, effective
July 1, 1996 (incorporated by reference to Exhibit 10(d) to the
registrant's Quarterly Report on Form 10-QSB for the quarter ended
June 30, 1997).
10(t) Endorsement No. 1 - Termination, effective January 1, 1997, to
the Quota Share Retrocession Agreement between American Hallmark
Insurance Company of Texas and the Reinsurers (Dorinco Reinsurance
Company and Odyssey Reinsurance Corporation), effective July 1,
1996 (incorporated by reference to Exhibit 10(e) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended June 30, 1997).
10(u) Endorsement No. 1, effective July 1, 1997, to the Quota Share
Retrocession Agreement between American Hallmark Insurance Company
of Texas and the Reinsurer (Dorinco Reinsurance Company) effective
July 1, 1996 (incorporated by reference to Exhibit 10(h) to the
registrant's Quarterly Report on Form 10-QSB for the quarter ended
June 30, 1997).
Exhibit
Number Description
------ -----------
10(v) Endorsement No. 2, effective January 1, 1997, to the Quota Share
Retrocession Agreement between American Hallmark Insurance Company
of Texas and Dorinco Reinsurance Company, effective January 1,
1997 (incorporated by reference to Exhibit 10(bh) to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1997).
10(w) Endorsement No. 1, effective January 1, 1997, to the 100% Quota
Share Reinsurance Agreement between State & County Mutual Fire
Insurance Company, Vaughn General Agency, Inc. and American
Hallmark General Agency, Inc. (incorporated by reference to
Exhibit 10(bi) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 1997).
10(x) Endorsement No. 2, effective July 1, 1997, to the 100% Quota Share
Reinsurance Agreement between State & County Mutual Fire Insurance
Company, Vaughn General Agency, Inc., American Hallmark General
Agency, Inc. and the Reinsurers (Dorinco Reinsurance Company and
Kemper Reinsurance Company) effective July 1, 1997 (incorporated
by reference to Exhibit 10(bj) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 1997).
10(y) Amendment No. 1 to the Loan Agreement dated March 11, 1997,
between Hallmark Financial Services, Inc. and Dorinco Reinsurance
Company (incorporated by reference to Exhibit 10(bg) to the
registrant's annual Report on Form 10-KSB for the fiscal year
ended December 31, 1998).
10(z) Retrocession Agreement effective March 1, 1998, between American
Hallmark Insurance Company of Texas, Dorinco Reinsurance Company
and Associated General Agency, Inc. (incorporated by reference to
Exhibit 10(bh) to the registrant's annual Report on Form 10-KSB
for the fiscal year ended December 31, 1998).
10(aa) Quota Share Retrocession Agreement effective September 1, 1998,
between American Hallmark Insurance Company of Texas, Dorinco
Reinsurance Company and Van Wagoner Companies, Inc. (incorporated
by reference to Exhibit 10(bj) to the registrant's annual Report
on Form 10-KSB for the fiscal year ended December 31, 1998).
10(ab) Endorsement No. 5, effective January 1, 1999, to the Quota
Share Retrocession Agreement between American Hallmark Insurance
Company of Texas and the Reinsurer (Dorinco Reinsurance Company),
effective January 1, 1997 (incorporated by reference to Exhibit
10(a) to the registrant's Quarterly Report on Form 10-QSB for the
quarter ended June 30, 1999).
10(ac) Endorsement No. 4, effective January 1, 1999, to the Quota Share
Retrocession Agreement between American Hallmark Insurance Company
of Texas and the Reinsurer (GE Reinsurance Company), effective
January 1, 1996 (incorporated by reference to Exhibit 10(b) to the
registrant's Quarterly Report on Form 10-QSB for the quarter ended
June 30, 1999).
10(ad) Endorsement No. 2, effective July 1, 1997, to the 100% Quota Share
Reinsurance Agreement between State & County Mutual Fire Insurance
Company, Vaughn General Agency, Inc. and American Hallmark General
Agency, Inc. (incorporated by reference to Exhibit 10(bg) to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1999).
10(ae) Amendment No. 3 to the Loan Agreement dated March 11, 1997,
between Hallmark Financial Services, Inc. and Dorinco Reinsurance
Company (incorporated by reference to Exhibit 10(bh) to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1999).
10(af) Endorsement No. 6, effective January 1, 1999, to the Quota Share
Retrocession Agreement between American Hallmark Insurance Company
of Texas and Dorinco Reinsurance Company, effective January 1,
1997 (incorporated by reference to Exhibit 10(bi) to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1999).
10(ag) Sale and Assignment Agreement dated November 18, 1999, with
Hallmark Finance Corporation as Seller and FPF, Inc. (incorporated
by reference to Exhibit 10(bk) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 1999).
Exhibit
Number Description
------ -----------
10(ah) Premium Receivable Servicing Agreement dated November 18, 1999
between Hallmark Finance Corporation and FPF, Inc. (incorporated
by reference to Exhibit 10(bl) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 1999).
10(ai) Seventh Amendment to Office Lease for 14651 Dallas Parkway, Suite
900, dated January 1, 1995, between American Hallmark Insurance
Company of Texas and Fults Management Company, as agent for The
Prudential Insurance Company of America (incorporated by reference
to Exhibit 10(a) to the registrant's Quarterly Report on Form
10-QSB for the quarter ended June 30, 2000).
10(aj) Quota Share Retrocession Agreement, effective July 1, 2000,
between American Hallmark Insurance Company of Texas and Dorinco
Reinsurance Company (incorporated by reference to Exhibit 10(a) to
the registrant's Quarterly Report on Form 10-QSB for the quarter
ended September 30, 2000).
10(ak) Addendum No. 2 to the Retrocession Contract, effective June 1,
1998, issued to Dorinco Reinsurance Company by American
Hallmark Insurance Company of Texas, effective October 1, 1999
(incorporated by reference to Exhibit 10(b) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended September
30, 2000).
10(al) Eighth Amendment to Office Lease for 14651 Dallas Parkway, Suite
900, dated January 1, 1995, between American Hallmark Insurance
Company of Texas and Fults Management Company, as agent for The
Prudential Insurance Company of America (incorporated by reference
to Exhibit 10(br) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 2000).
10(am) Quota Share Retrocession Contract between Dorinco Reinsurance
Company and American Hallmark Insurance Company of Texas,
effective September 1, 2000 (incorporated by reference to Exhibit
10(bs) to the registrant's Annual Report on Form 10-KSB for the
fiscal year ended December 31, 2000).
10(an) Endorsement No. 5, effective July 1, 2000, to the 100% Quota Share
Reinsurance Agreement issued to State and County Mutual Fire
Insurance Company, effective January 1, 1997 (incorporated by
reference to Exhibit 10(bt) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 2000).
10(ao) Endorsement No. 4, effective July 1, 2000, to the 100% Quota Share
Reinsurance Agreement between State and County Mutual Fire
Insurance Company and American Hallmark Insurance Company of
Texas, effective July 1,1996 (incorporated by reference to Exhibit
10(bu) to the registrant's Annual Report on Form 10-KSB for the
fiscal year ended December 31, 2000).
10(ap) Termination Addendum to the Quota Share Retrocession Agreement,
effective May 28, 1999, issued to American Hallmark Insurance
Company of Texas by Kemper Reinsurance Company, effective July 1,
1996 (incorporated by reference to Exhibit 10(bv) to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 2000).
10(aq) Termination Addendum to the Quota Share Retrocession Agreement,
effective June 30, 2000, issued to Dorinco Reinsurance Company by
American Hallmark Insurance Company of Texas, effective January 1,
1997 (incorporated by reference to Exhibit 10(bw) to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 2000).
10(ar) Termination Addendum to the Quota Share Retrocession Contract,
effective September 1, 2000, issued to Dorinco Reinsurance Company
by American Hallmark Insurance Company of Texas, effective
September 1, 1998 (incorporated by reference to Exhibit 10(bx) to
the registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 2000).
10(as) Termination Addendum to the Interests and Liability Agreement,
effective June 30, 2000, of GE Reinsurance Corporation with
respect to the 100% Quota Share Reinsurance Agreement, effective
January 1, 1997 (incorporated by reference to Exhibit 10(by) to
the registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 2001).
Exhibit
Number Description
------ -----------
10(at) Termination Endorsement, effective July 1, 2000, to the Guaranty
of Performance and Hold Harmless Agreement between Hallmark
Financial Services, Inc. and GE Reinsurance Corporation (formerly
Kemper Reinsurance Company), effective July 1, 1996 (incorporated
by reference to Exhibit 10(cb) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 2001).
10(au) Termination Endorsement, effective July 1, 2000, to the Guaranty
Agreement provided by GE Reinsurance Corporation (formerly Kemper
Reinsurance Company) in favor of State and County Mutual Fire
Insurance Company, effective July 1, 1996 (incorporated by
reference to Exhibit 10(cc) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 2001).
10(av) Endorsement No. 2, effective July 1, 2000, to the Guaranty
Agreement provided by Dorinco Reinsurance Company in favor
of State and County Mutual Fire Insurance Company, effective
July 1, 1996 (incorporated by reference to Exhibit 10(a) to the
registrant's Quarterly Report on Form 10-QSB for the quarter ended
March 31, 2001).
10(aw) Cut-Through Agreement, dated as of June 26, 2001, by and among
American Hallmark Insurance Company of Texas, American Hallmark
General Agency, Inc., Hallmark Finance Corporation and FPF, Inc.
(incorporated by reference to Exhibit 10(c) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended June 30,
2001).
10(ax) First Modification Agreement to the Cut-Through Agreement dated as
of June 26, 2001, by and among American Hallmark Insurance Company
of Texas, American Hallmark General Agency, Inc., Hallmark
Finance Corporation and FPF, Inc., entered into June 27, 2001
(incorporated by reference to Exhibit 10(d) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended June 30,
2001).
10(ay) Letter of Agreement, dated August 3, 2001, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(f) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended June 30,
2001).
10(az) Letter of Agreement, dated August 6, 2001, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(g) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended June 30,
2001).
10(ba) Addendum No. 1 to the Quota Share Retrocession Agreement,
effective July 1, 2000, between American Hallmark Insurance
Company of Texas and Dorinco Reinsurance Company, effective
January 1, 2001 (incorporated by reference to Exhibit 10(a) to the
registrant's Quarterly Report on Form 10-QSB for the quarter ended
September 30, 2001).
10(bb) Addendum No. 2 to the Quota Share Retrocession Agreement,
effective July 1, 2000, between American Hallmark Insurance
Company of Texas and Dorinco Reinsurance Company, effective
July 1, 2001 (incorporated by reference to Exhibit 10(b) to the
registrant's Quarterly Report on Form 10-QSB for the quarter ended
September 30, 2001).
10(bc) Endorsement No. 1 to the Guaranty of Performance and Hold Harmless
Agreement, effective July 1, 1996 between Hallmark Financial
Services, Inc. and Dorinco Reinsurance Company, effective July 1,
2000 (incorporated by reference to Exhibit 10(c) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended September 30, 2001).
10(bd) Letter of Agreement, dated November 7, 2001 between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(d) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended September
30, 2001).
Exhibit
Number Description
------ -----------
10(be) Second Amendment to Hallmark Financial Services, Inc. 1994 Non-
Employee Director Stock Option Plan (incorporated by reference to
Exhibit 10(e) to the registrant's Quarterly Report on Form 10-QSB
for the quarter ended September 30, 2001).
10(bf) Letter of Agreement, dated January 23, 2002, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(bl) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended December
31, 2001).
10(bg) Amendment No. 4 to the Loan Agreement dated March 10, 1997,
between Hallmark Financial Services, Inc. and Dorinco Reinsurance
Company (incorporated by reference to Exhibit 10(bm) to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 2001).
10(bh) Second Modification Agreement, entered into December 11, 2001, to
the Sale and Assignment Agreement, dated November 18, 1999, with
Hallmark Finance Corporation as Seller and FPF, Inc. (incorporated
by reference to Exhibit 10(bn) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 2001).
10(bi) Addendum No. 2, entered into January 9, 2001, to the General
Agency Agreement, effective March 1, 1992, between State &
County Mutual Fire Insurance Company and Brokers General, Inc.
(incorporated by reference to Exhibit 10(bo) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended December
31, 2001).
10(bj) Third Renewal Promissory Note, dated November 8, 2001, with
Hallmark Financial Services, Inc. as Maker and Dorinco Reinsurance
Company as Payee (incorporated by reference to Exhibit 10(bp) to
the registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 2001).
10(bk) Addendum No. 3 to the Quota Share Retrocession Agreement,
effective July 1, 2000, between American Hallmark Insurance
Company of Texas and Dorinco Reinsurance Company, effective
June 30, 2001 (incorporated by reference to Exhibit 10(a) to the
registrant's Quarterly Report on Form 10-QSB for the quarter ended
September 30, 2002).
10(bl) Form of Indemnification Agreement between Hallmark Financial
Services, Inc. and its officers and directors, adopted July 19,
2002 (incorporated by reference to Exhibit 10(c) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended September 30, 2002).
10(bm) Loan Purchase and Sale Agreement, between Hallmark Financial
Services, Inc and LaSalle Bank National Association dated
November 1, 2002 (incorporated by reference to Exhibit 2 to the
registrant's current report on Form 8-K filed November 8, 2002).
10(bn) Purchase Agreement dated November 26, 2002 between Hallmark
Financial Services, Inc., Millers American Group, Inc. and The
Millers Insurance Company (incorporated by reference to Exhibit
2(a) to the registrant's current report on Form 8-K filed December
4, 2002).
10(bo) Assumption Agreement dated December 1, 2002 between Millers
Insurance Company, Millers General Agency, Inc. and Phoenix
Indemnity Insurance Company (incorporated by reference to Exhibit
2(b) to the registrant's current report on Form 8-K filed December
4, 2002).
10(bp) First Amendment to Hallmark Financial Services, Inc. 1994 Key
Employee Long Term Incentive Plan (incorporated by reference to
Exhibit 10(bm) to the registrant's Annual Report on Form 10-KSB
for the fiscal ended December 31, 2002).
10(bq) First Amendment to Hallmark Financial Services, Inc. 1994 Non-
Employee Director Stock Option Plan (incorporated by reference to
Exhibit 10(bn) to the registrant's Annual Report on Form 10-KSB
for the fiscal ended December 31, 2002).
Exhibit
Number Description
------ -----------
10(br) Addendum No. 1 to the Quota Share Retrocession Contract between
Dorinco Reinsurance Company and American Hallmark Insurance
Company of Texas, effective September 1, 2000 (incorporated by
reference to Exhibit 10(bo) to the registrant's Annual Report on
Form 10-KSB for the fiscal ended December 31, 2002).
10(bs) Letter of Agreement, dated October 31, 2002, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(bp) to the registrant's
Annual Report on Form 10-KSB for the fiscal ended December 31,
2002).
10(bt) Third Modification Agreement, entered into November 1, 2002, to
the Sale and Assignment Agreement, dated November 18, 1999, with
Hallmark Finance corporation as Seller and FPF, Inc. (incorporated
by reference to Exhibit 10(bq) to the registrant's Annual Report
on Form 10-KSB for the fiscal ended December 31, 2002).
10(bu) Letter of Agreement, dated December 30, 2002, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(br) to the registrant's
Annual Report on Form 10-KSB for the fiscal ended December 31,
2002).
10(bv) Letter of Agreement, dated December 30, 2002, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(bs) to the registrant's
Annual Report on Form 10-KSB for the fiscal ended December 31,
2002).
10(bw) Termination Agreement dated December 30, 2002, between Hallmark
Financial Services, Inc. and Linda H. Sleeper (incorporated by
reference to Exhibit 10(bt) to the registrant's Annual Report on
Form 10-KSB for the fiscal ended December 31, 2002).
10(bx) Tenth Amendment to Office Lease for 14651 Dallas Parkway, Suite
900, dated May 5th, 2003, between American Hallmark Insurance
Company of Texas and Fults Management Company, as agent for The
Prudential Insurance Company of America (incorporated by reference
to Exhibit 10(a) to the registrant's Quarterly Report on Form
10-QSB for the quarter ended March 31, 2003).
10(by) General Agency Agreement between Millers General Agency, Inc and
Clarendon National Insurance Company, effective August 15, 2001
(incorporated by reference to Exhibit 10(b) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended March 31,
2003).
10(bz) Claims Administration Agreement between Millers General Agency,
Inc. and Clarendon National Insurance Company, effective August
15, 2001 (incorporated by reference to Exhibit 10(c) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended March 31, 2003).
10(ca) Claims Services Agreement between Millers General Agency, Inc.
and Effective Claims Management, Inc., effective March 25, 2003
(incorporated by reference to Exhibit 10(d) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended March 31,
2003).
10(cb) Lease Agreement for 777 Main Street, Suite 1000, Fort Worth, Texas
76102, dated June 12, 2003 between Hallmark Financial Services,
Inc. and Crescent Real Estate Funding I, L.P. (incorporated by
reference to Exhibit 10(a) to the registrant's Quarterly Report
on Form 10-QSB for the quarter ended June 30, 2003).
10(cc) Termination Addendum to the Quota Share Retrocession Agreement,
effective March 31, 2003 between American Hallmark Insurance
Company of Texas and Dorinco Reinsurance Company (incorporated by
reference to Exhibit 10(b) to the registrant's Quarterly Report on
Form 10-QSB for the quarter ended June 30, 2003).
Exhibit
Number Description
------ -----------
10(cd) General Agency Agreement by and among American Hallmark General
Agency, Inc., State and County Mutual Fire Insurance Company,
American Hallmark Insurance Company of Texas and Dorinco
Reinsurance Company, effective April 1, 2003 (incorporated by
reference to Exhibit 10(c) to the registrant's Quarterly Report
on Form 10-QSB for the quarter ended June 30, 2003).
10(ce) Security Fund Agreement between American Hallmark Insurance
Company of Texas and State and County Mutual Fire Insurance
Company, effective April 1, 2003 (incorporated by reference to
Exhibit 10(d) to the registrant's Quarterly Report on Form 10-QSB
for the quarter ended June 30, 2003).
10(cf) Quota Share Reinsurance Agreement by and among American Hallmark
Insurance Company of Texas, American Hallmark General Agency, Inc.
and State and County Mutual Insurance Company, effective April 1,
2003 (incorporated by reference to Exhibit 10(e) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended June 30, 2003).
10(cg) Quota Share Reinsurance Agreement by and among American Hallmark
General Agency, Inc., State and County Mutual Insurance Company
and Dorinco Reinsurance Company, effective April 1, 2003
(incorporated by reference to Exhibit 10(f) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended June 30,
2003).
10(ch) Fourth Modification Agreement effective June 19, 2003 by and among
Hallmark Finance Corporation and FPF, Inc. (incorporated by
reference to Exhibit 10(g) to the registrant's Quarterly Report
on Form 10-QSB for the quarter ended June 30, 2003).
10(ci) Technology Processing Services Agreement, effective December 1,
2003 between Phoenix Indemnity Insurance Company and CGI
Information Systems & Management Consultants, Inc. (incorporated
by reference to Exhibit 10(a) to the registrant's Quarterly Report
on Form 10-QSB for the quarter ended September 30, 2003).
10(cj) Policy and Claims Processing Services Agreement, effective
September 1, 2003 between Phoenix Indemnity Insurance Company
and CGI Information Systems & Management Consultants, Inc.
(incorporated by reference to Exhibit 10(b) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended September
30, 2003).
10(ck) Processing Services Agreement, effective July 1, 2003 between
Hallmark General Agency, Inc., Effective Claims Management, Inc.
and CGI Information Systems & Management Consultants, Inc.
(incorporated by reference to Exhibit 10(c) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended September
30, 2003).
10(cl) * Managing General Agency Agreement, effective October 1, 2003,
between Old American County Mutual Fire Insurance Company and
American Hallmark General Agency, Inc.
10(cm) * Addendum No. 1 to the Managing General Agency Agreement ,
effective October 1, 2003, between Old American County Mutual Fire
Insurance Company and American Hallmark General Agency, Inc.
10(cn) * Guaranty Agreement, effective September 1, 2003, between Old
American County Mutual Fire Insurance Company and Hallmark
Financial Services, Inc.
10(co) * 45% Quota Share Reinsurance Agreement, effective October 1, 2003,
between Old American County Mutual Fire Insurance Company and
American Hallmark General Agency, Inc.
Exhibit
Number Description
------ -----------
10(cp) * Addendum No. 1 to the 45% Quota Share Reinsurance Agreement,
effective October 1, 2003, between Old American County Mutual Fire
Insurance Company and American Hallmark General Agency, Inc.
10(cq) * 55% Quota Share Reinsurance Agreement, effective October 1, 2003,
between Old American County Mutual Fire Insurance Company and
Dorinco Reinsurance Company.
10(cr) * Blanket Retrocession Agreement, effective October 1, 2003,
between Dorinco Reinsurance Company and American Hallmark
Insurance Company of Texas.
10(cs) * Letter of Termination dated November 2, 2003, to the Sale and
Assignment Agreement dated November 17, 1999 by and among Hallmark
Finance Corporation and FPF, Inc.
16 Letter from PricewaterhouseCoopers LLP to Securities and Exchange
Commission dated October 15, 2003 (incorporated by reference from
the Company's Current Report on Form 8-K filed October 17, 2003).
21 * List of subsidiaries of the registrant.
23.1 * Independent Auditors' Consent
23.2 * Consent of Independent Accountants.
31(a) * Certification of Chief Executive Officer required by Rule
13a-14(a) or Rule 15d-14(b).
31(b) * Certification of Chief Financial Officer required by Rule
13a-14(a) or Rule 15d-14(b).
32(a) * Certification of Chief Executive Officer pursuant to 18 U.S.C.
1350.
32(b) * Certification of Chief Financial Officer pursuant to 18 U.S.C.
1350.
* Filed herewith
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Description Page Number
----------- -----------
Independent Auditors' Report F-2
Report of Independent Accountants F-3
Consolidated Balance Sheets at December 31, 2003 and 2002 F-4
Consolidated Statements of Operations for the Years Ended
December 31, 2003 and 2002 F-5
Consolidated Statements of Stockholders' Equity for the Years
Ended December 31, 2003 and 2002 F-6
Consolidated Statements of Cash Flows for the Years Ended
December 31, 2003 and 2002 F-7
Notes to Consolidated Financial Statements F-9
INDEPENDENT AUDITORS' REPORT
----------------------------
The Board of Directors and Stockholders
Hallmark Financial Services, Inc.:
We have audited the consolidated balance sheet of Hallmark Financial
Services, Inc. and subsidiaries as of December 31, 2003 and the
related consolidated statements of operations, stockholders' equity
and comprehensive income and cash flows for the year then ended. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these
consolidated financial statements and financial statement schedules
based on our audit.
We conducted our audit in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures
in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management,
as well as evaluating the overall financial statement presentation. We
believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of
Hallmark Financial Services, Inc. and subsidiaries as of December 31, 2003,
and the results of their operations and their cash flows for the year ended
December 31, 2003, in conformity with accounting principles generally
accepted in the United States of America.
As described in note 1 to the consolidated financial statements, effective
January 1, 2003 the Company adopted the prospective method provisions of
Statement of Financial Standards No. 148, Accounting for Stock-Based
Compensation - Transition and Disclosure.
/s/ KPMG LLP
------------
KPMG LLP
Dallas, Texas
March 24, 2004
Report of Independent Accountants
---------------------------------
To the Board of Directors
Hallmark Financial Services, Inc.:
In our opinion, the accompanying consolidated balance sheet and the related
consolidated statements of operation, stockholders' equity and cash flows,
present fairly, in all material respects, the financial position of Hallmark
Financial Services, Inc. and subsidiaries (the "Company") at December 31,
2002, and the results of their operations and their cash flows for the year
then ended in conformity with accounting principles generally accepted
in the United States of America. These financial statements are the
responsibility of the Company's management; our responsibility is to express
an opinion on these financial statements based on our audits. We conducted
our audit of these statements in accordance with auditing standards
generally accepted in the United States of America, which require that we
plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures
in the financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
As discussed in Note 1, during 2002 the Company adopted Statement of
Financial Accounting Standards No. 142, "Goodwill and Other Intangible
Assets."
/s/ PricewaterhouseCoopers LLP
------------------------------
PricewaterhouseCoopers LLP
Dallas, Texas
March 16, 2003
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 2003 and 2002
(In thousands)
---------------------------
ASSETS 2003 2002
------ ---------- ----------
Investments:
Debt securities, available-for-sale, at
fair value in 2003 and held-to-maturity,
at amortized cost in 2002 $ 25,947 $ 7,679
Equity securities, available-for-sale,
at fair value 3,573 122
Short-term investments, available-for-sale,
at fair value 335 8,927
---------- ----------
Total investments 29,855 16,728
Cash and cash equivalents 10,520 8,453
Restricted cash and investments 5,366 1,072
Prepaid reinsurance premiums 291 8,956
Premiums receivable encumbered by premium
financing activity (net of allowance for
doubtful accounts of $3 in 2003 and $115
in 2002) 43 11,593
Premiums receivable 4,033 1,012
Accounts receivable 3,395 2,129
Reinsurance recoverable 10,516 12,929
Deferred policy acquisition costs 7,146 5,266
Excess of cost over fair value of net
assets acquired 4,836 5,171
Intangible assets 513 540
Note receivable - 6,500
Current federal income tax recoverable 625 33
Deferred federal income taxes 3,961 1,021
Other assets 2,753 2,358
---------- ----------
$ 83,853 $ 83,761
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Liabilities:
Notes payable $ 991 $ 1,803
Note payable to related party - 8,600
Net advances from lender for financed premiums - 10,905
Unpaid losses and loss adjustment expenses 28,456 17,667
Unearned premiums 5,862 15,957
Reinsurance balances payable - 3,764
Unearned revenue 10,190 6,872
Accrued agent profit sharing 1,511 450
Accrued ceding commission payable 1,164 2,536
Pension liability 1,237 604
Accounts payable and other accrued expense 7,045 6,068
---------- ----------
56,456 75,226
---------- ----------
Commitments and Contingencies - -
Stockholders' equity:
Common stock, $.03 par value, authorized
100,000,000 shares; issued 36,856,610
shares in 2003 and 11,855,610 shares
in 2002 1,106 356
Capital in excess of par value 19,693 10,875
Retained earnings (deficit) 7,254 (1,491)
Accumulated other comprehensive income (93) (162)
Treasury stock, 484,319 shares in 2003
and 806,477 shares in 2002, at cost (563) (1,043)
---------- ----------
Total stockholders' equity 27,397 8,535
---------- ----------
$ 83,853 $ 83,761
========== ==========
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
for the years ended December 31, 2003 and 2002
(In thousands, except per share amounts)
----------------------------
2003 2002
---------- ----------
Gross premiums written $ 43,338 $ 51,643
Ceded premiums written (6,769) (29,611)
---------- ----------
Net premiums written 36,569 22,032
Change in unearned premiums 5,406 (1,819)
---------- ----------
Net premiums earned 41,975 20,213
Investment income, net of expenses 1,198 773
Realized losses (88) (5)
Finance charges 3,544 2,503
Commission and fees 17,544 1,108
Processing and service fees 4,900 921
Other income 486 284
---------- ----------
Total revenues 69,559 25,797
Losses and loss adjustment expenses 30,188 15,302
Other operating costs and expenses 37,386 9,474
Interest expense 1,271 983
Amortization of intangible asset 28 2
---------- ----------
Total expenses 68,873 25,761
Income before income tax, and cumulative
effect of change in accounting principle
and extraordinary gain 686 36
Income tax expense 25 13
---------- ----------
Income before cumulative effect of change in
accounting principle and extraordinary gain $ 661 $ 23
Cumulative effect of change in accounting
principle, net of tax - (1,694)
Extraordinary gain 8,084 -
---------- ----------
Net income (loss) $ 8,745 $ (1,671)
========== ==========
Basic earnings (loss) per share:
Income before cumulative effect of change in
accounting principle and extraordinary gain $ 0.03 $ -
Cumulative effect of change in accounting
principle - (0.15)
Extraordinary gain 0.44 -
---------- ----------
Net income (loss) $ 0.47 $ (0.15)
========== ==========
Diluted earnings (loss) per share:
Income before cumulative effect of change in
accounting principle and extraordinary gain $ 0.03 $ -
Cumulative effect of change in accounting
principle - (0.15)
Extraordinary gain 0.43 -
---------- ----------
Net income (loss) $ 0.46 $ (0.15)
========== ==========
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
for the years ended December 31, 2003 and 2002
(in thousands)
---------------------------------------
Capital Accum.
# In Other # Total Comp.
of Par Excess of Retained Comp. Treasury of Stockholders' Income
Shares Value Par Value Earnings Income Stock Shares Equity (Loss)
------ ----- --------- -------- ------ --------- ------ -------- --------
Balance at December 31, 2001 11,856 $ 356 $ 10,875 $ 180 - ($1,043) 806 $ 10,368
Comprehensive loss:
Net loss (1,671) (1,671) $ (1,671)
Other comprehensive income, (162) (162) (162)
Additional minimum --------
pension liability,
net of tax of $94
Comprehensive loss $ (1,833)
------ ----- --------- -------- ------ --------- ------ -------- ========
Balance at December 31, 2002 11,856 $ 356 $ 10,875 ($1,491) ($162) ($1,043) 806 $ 8,535
Rights offering 25,000 750 9,250 10,000
Issuance of common stock 1 - -
Amortization of fair value
of stock options granted 31 31
Stock options exercised (463) 480 (322) 17
Comprehensive income:
Net income 8,745 8,745 $ 8,745
Other comprehensive income,
Minimum pension liability (646) (646) (646)
Net unrealized holding gains
arising during period 667 667 667
Reclassification adjustment
for losses included in net
net income 88 88 88
------ -------- --------
Net unrealized gains on
securities 755 755 755
------ -------- --------
Total other comprehensive
income before tax 109 109 109
Tax effect on other
comprehensive income (40) (40) (40)
------ -------- --------
Other comprehensive
income after tax 69 69 69
Comprehensive income $ 8,814
------ ----- --------- -------- ------ --------- ------ -------- ========
Balance at December 31, 2003 36,857 $1,106 $ 19,693 $ 7,254 ($93) ($563) 484 $ 27,397
====== ===== ========= ======== ====== ========= ====== ========
The accompanying notes are an integral
part of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the years ended December 31, 2003 and 2002
(In thousands)
----------------------------
2003 2002
-------- --------
Cash flows from operating activities:
Net income (loss) $ 8,745 $ (1,671)
Adjustments to reconcile net loss to cash
provided by (used in) operating activities:
Depreciation and amortization expense 621 195
Change in deferred income taxes 114 48
Change in prepaid reinsurance premiums 8,297 3,061
Change in premiums receivable (1,276) (598)
Change in accounts receivable (1,266) (170)
Change in deferred policy acquisition costs (1,340) (641)
Change in unpaid losses and loss
adjustment expenses (5,097) (2,422)
Change in unearned premiums (12,785) (1,242)
Change in unearned revenue 3,271 183
Change in accrued agent profit sharing 944 72
Change in reinsurance recoverable 12,817 3,942
Change in reinsurance balances payable (3,082) (662)
Cumulative effect of change
in accounting principle - 1,694
Change in current federal income tax
payable/recoverable (592) 662
Change in accrued ceding commission payable (1,372) (2,062)
Gain on acquisition of subsidiary (8,084) -
Change in all other liabilities 419 1,117
Change in all other assets 365 443
-------- --------
Net cash provided by operating activities 699 1,949
-------- --------
Cash flows from investing activities:
Purchases of property and equipment (476) (254)
Purchase of note receivable - (6,500)
Acquisition of subsidiary, net of cash received 6,945 (2,100)
Premium finance notes originated (15,734) (41,273)
Premium finance notes repaid 27,284 43,420
Change in restricted cash and investments (4,294) 918
Purchases of debt and equity securities (19,075) (12,639)
Maturities and redemptions of investment securities 8,131 5,858
Net redemptions of short-term investments 8,904 6,276
-------- --------
Net cash provided by (used in)
investing activities 11,685 (6,294)
-------- --------
Cash flows from financing activities:
Proceeds from note payable - 8,600
Net repayments to premium finance lender (10,905) (1,308)
Proceeds from rights offering 10,000 -
Repayment of borrowings (9,412) (27)
-------- --------
Net cash (used in) provided
by financing activities (10,317) 7,265
-------- --------
Increase in cash and cash equivalents 2,067 2,920
Cash and cash equivalents at beginning of year 8,453 5,533
-------- --------
Cash and cash equivalents at end of year $ 10,520 $ 8,453
======== ========
Supplemental cash flow information:
Interest paid $ (1,456) $ (833)
======== ========
Income taxes recovered/(paid) $ (475) $ 696
======== ========
In the first quarter of 2003, the Company retired a portion of a note
receivable in consideration for all the stock of Phoenix as further
explained in Note 1 Accounting Policy for Business Combinations.
In conjunction with the acquisition, cash and cash equivalents were
provided as follows:
Value of note receivable exchanged $ 6,500
Extraordinary gain on acquisition 8,084
Fair value of tangible assets acquired excluding cash (27,167)
Liabilities assumed 19,528
--------
Cash and cash equivalents provided by acquisition $ 6,945
========
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
___________
1. Accounting Policies:
-------------------
General
-------
Hallmark Financial Services, Inc. ("HFS") and its wholly owned
subsidiaries (collectively, the "Company") engage in the sale of
property and casualty insurance products. The Company's business
involves marketing and underwriting of non-standard personal automobile
insurance in Texas, New Mexico and Arizona, commercial insurance in
Texas, New Mexico, Idaho, Oregon and Washington, third party claims
administration and other insurance related services. The Company
discontinued producing new premium financed non-standard personal
automobile insurance in July 2003. The Company pursues its business
activities through integrated insurance groups handling non-standard
personal automobile insurance (the "Personal Lines Group") and
commercial insurance (the "Commercial Lines Group").
The Personal Lines Group focuses on providing non-standard automobile
liability and physical damage insurance in Texas, New Mexico and
Arizona for drivers who do not qualify for or cannot obtain standard
rate insurance. The members of the Personal Lines group are a Texas
domiciled property and casualty insurance company, American Hallmark
Insurance Company of Texas ("Hallmark"); an Arizona domiciled property
and casualty insurance company, Phoenix Indemnity Insurance Company
("Phoenix"); a managing general agency, American Hallmark General
Agency, Inc. ("AHGA"); a premium finance company, Hallmark Finance
Corporation ("HFC"); and a third party claims administrator, Hallmark
Claims Service, Inc. ("HCS"). Once the premium financed business
completely runs off, HFC will discontinue operations.
The Commercial Lines Group markets, underwrites and administers low
hazard commercial insurance policies primarily in the rural areas of
Texas, New Mexico, Idaho, Oregon and Washington. The members of the
Commercial Lines Group are a managing general agency, Hallmark General
Agency, Inc. ("HGA", formerly known as Millers General Agency, Inc.);
and a third party claims administrator, Effective Claims Management,
Inc. ("ECM", formerly known as Effective Litigation Management, Inc.).
Principles of Consolidation
---------------------------
The accompanying consolidated financial statements include the accounts
and operations of HFS and its subsidiaries. Inter-company accounts and
transactions have been eliminated.
Basis of Presentation
---------------------
The accompanying consolidated financial statements have been prepared
in conformity with accounting principles generally accepted in the
United States of America ("GAAP") which, as to Hallmark and Phoenix,
differ from statutory accounting practices prescribed or permitted for
insurance companies by insurance regulatory authorities.
Investments
-----------
Debt and equity securities available for sale are reported at market
value. Unrealized gains and losses are recorded as a component of
stockholders' equity, net of related tax effects. Prior to 2003, debt
securities were reported at amortized cost and classified as held-to-
maturity. Debt and equity securities that are determined to have other
than temporary impairment are recognized as a realized loss in the
Statement of Operations.
Short-term investments consist of a certificate of deposit carried at
amortized cost, which approximates market.
Realized investment gains and losses are recognized in operations on
the specific identification method.
Cash Equivalents
----------------
The Company considers all highly liquid investments with an original
maturity of three months or less to be cash equivalents.
Recognition of Premium Revenues
-------------------------------
Insurance premiums and policy fees are earned pro rata over the terms
of the policies. Upon cancellation, any unearned premium and policy fee
is refunded to the insured. Insurance premiums written include gross
policy fees of $3.0 million and $5.1 million and policy fees, net of
reinsurance, of $2.3 million and $2.1 million for the years ended
December 31, 2003 and 2002, respectively.
Recognition of Commission Revenues and Expenses of the Commercial
-----------------------------------------------------------------
Lines Group
-----------
Commission revenue and commission expense related to insurance policies
serviced by HGA are recognized during the period covered by the policy.
Profit sharing commission is calculated and recognized when the ratio
of ultimate losses and loss expenses incurred to earned premium ("loss
ratio") as determined by a qualified actuary deviate from contractual
thresholds. The profit sharing commission is an estimate that varies
with the estimated loss ratio and is sensitive to changes in that
estimate. The following table details the profit sharing commission
revenue sensitivity to the actual ultimate loss ratio for each
effective quota share treaty at 0.5% above and below the provisional
loss ratio.
Treaty Effective Dates
--------------------------------
7/1/01 - 7/1/02 - 7/1/03 -
6/30/02 6/30/03 6/30/04
--------------------------------
Provisional loss ratio 60.0% 59.0% 59.0%
Ultimate loss ratio booked
to at 12/31/03 58.5% 59.0% 59.0%
Effect of actual 0.5% above
provisional ($206,115) ($270,254) ($40,099)
Effect of actual 0.5% below
provisional $144,280 $178,367 $26,465
As of December 31, 2003, the Company recorded a $0.4 million profit
sharing receivable for the quota share treaty effective July 1, 2001
through June 30, 2002. The Company also recorded a $0.6 million
receivable on the quota share treaty effective July 1, 2001 through
June 30, 2002 because the Company has collected its commission on this
treaty at the maximum loss ratio of 61.5% equal to a commission rate of
30.0% per the contractual commission slide.
Recognition of Claim Servicing Fees
-----------------------------------
Claim servicing fees are recognized in proportion to the historical
trends of the claim cycle. The Company uses historical claim count
data that measures the close rate of claims in relation to the policy
period covered to substantiate the service period. The following table
summarizes the year in which claim fee revenue is recognized by type of
business.
Year Claim Fee Revenue Recognized
---------------------------------
1st 2nd 3rd 4th
--------------------
Commercial property fees 80% 20% - -
Commercial liability fees 60% 30% 10% -
Personal property fees 90% 10% - -
Personal liability fees 49% 33% 12% 6%
Finance Charges
---------------
The majority of Hallmark's annual insurance premiums are financed
through the Company's premium finance program offered by its wholly-
owned subsidiary, HFC. Hallmark discontinued producing new premium
financed annual term policies in July 2003. Finance charges on the
premium finance notes are recorded as interest earned. This interest
is earned on the Rule of 78's method which approximates the interest
method for such short-term notes.
The Company receives premium installment fees between $3.00 and $12.50
per direct bill payment from policyholders. Installment fee income is
classified as finance charges on the statement of operations and is
recognized as the fee is invoiced.
Property and Equipment
----------------------
Property and equipment (including leasehold improvements), aggregating
$3.1 million and $3.2 million, at December 31, 2003 and 2002,
respectively, which is included in other assets, is recorded at cost
and is depreciated using the straight-line method over the estimated
useful lives of the assets (three to ten years). Depreciation expense
for 2003 and 2002 was $0.6 million and $0.2 million, respectively.
Accumulated depreciation was $2.2 million and $2.0 million at December
31, 2003 and 2002, respectively.
Premiums Receivable Encumbered by Premium Financing Activity
------------------------------------------------------------
Receivable from lender for financed premiums represents payments due to
HFC as a result of a secured financing agreement with an unaffiliated
third party which are carried at cost net of allowance for doubtful
accounts. Hallmark discontinued producing new premium financed annual
term policies in July 2003. (See Note 9.)
Premiums Receivable
-------------------
Premiums receivable represent amounts due from either non-standard
automobile policyholders directly or independent agents for premiums
written and uncollected. These balances are carried at net realizable
value.
Deferred Policy Acquisition Costs and Ceding Commissions of the Personal
------------------------------------------------------------------------
Lines Group
-----------
Policy acquisition costs (mainly commissions, underwriting and
marketing expenses) that vary with and are primarily related to the
production of new and renewal business are deferred and charged to
operations over periods in which the related premiums are earned. The
method followed in computing deferred policy acquisition costs limits
the amount of such deferred costs to their estimated realizable value.
In determining estimated realizable value, the computation gives effect
to the premium to be earned, related investment income, losses and loss
expenses and certain other costs expected to be incurred as the
premiums are earned. If the computation results in an estimated net
realizable value less than zero, a liability will be accrued for the
premium deficiency.
Ceding commissions from reinsurers on retroceded business, which
include expense allowances, are deferred and recognized over the period
premiums are earned for the underlying policies reinsured. Deferred
ceding commissions from this business are netted against deferred
policy acquisition costs in the accompanying balance sheet. The change
in deferred ceding commission income is netted against the change in
deferred policy acquisition costs in the accompanying income statement.
During 2003 and 2002, the Company amortized ($0.4) million and ($0.6)
million of deferred policy acquisition costs, respectively.
Under Hallmark's reinsurance arrangements, the Company earns ceding
commissions based on the reinsurer's loss ratio experience on the
portion of policies reinsured. The Company receives a provisional
commission as policies are produced as an advance against the later
determination of the commission actually earned. The provisional
commission is adjusted periodically on a sliding scale based on
expected loss ratios.
Losses and Loss Adjustment Expenses
-----------------------------------
Losses and loss adjustment expenses represent the estimated ultimate
net cost of all reported and unreported losses incurred through
December 31, 2003 and 2002. The reserves for unpaid losses and loss
adjustment expenses are estimated using individual case-basis valuations
and statistical analyses.
These estimates are subject to the effects of trends in loss severity
and frequency. Although considerable variability is inherent in such
estimates, management believes that the reserves for unpaid losses and
loss adjustment expenses are adequate. The estimates are continually
reviewed and adjusted as experience develops or new information becomes
known. Such adjustments are included in current operations.
Agent Profit Sharing Commissions
--------------------------------
Both the Personal Lines and Commercial Lines Groups annually pay a
profit sharing commission to their independent agency force based upon
the results of the business produced by each agent. The Company
estimates and accrues this liability to commission expense in the year
the business is produced.
Reinsurance
-----------
Hallmark is routinely involved in reinsurance transactions with other
companies. Reinsurance premiums, losses, and loss adjustment expenses
are accounted for on bases consistent with those used in accounting for
the original policies issued and the terms of the reinsurance
contracts. (See Note 5.)
Income Taxes
------------
The Company files a consolidated federal income tax return. Deferred
federal income taxes reflect the future tax consequences of differences
between the tax bases of assets and liabilities and their financial
reporting amounts at each year end. Deferred taxes are recognized
using the liability method, whereby tax rates are applied to cumulative
temporary differences based on when and how they are expected to affect
the tax return. Deferred tax assets and liabilities are adjusted for
tax rate changes in effect for the year in which these temporary
differences are expected to be recovered or settled.
Net Income Per Share
--------------------
The computation of net income per share is based upon the weighted
average number of common shares outstanding during the period, plus (in
periods in which they have a dilutive effect) the effect of common
shares potentially issuable, primarily from stock options. (See Notes
11 and 13.)
Business Combinations
---------------------
The Company accounts for business combinations using the purchase
method of accounting. The cost of an acquired entity is allocated to
the assets acquired (including identified intangible assets) and
liabilities assumed based on their estimated fair values. The excess
of the cost of an acquired entity over the net of the amounts assigned
to assets acquired and liabilities assumed is an asset referred to as
"excess of cost over net assets acquired" or "goodwill". Indirect and
general expenses related to business combinations are expensed as
incurred.
On January 27, 2003, the Company received final approval from the
Arizona Department of Insurance ("AZDOI") for the acquisition of
Phoenix from Millers effective January 1, 2003. In consideration for
Phoenix, the Company retired $7.0 million of a $14.85 million balance
on a note receivable from Millers. The Company had valued the note
receivable on its balance sheet at its cost of $6.5 million. As of
December 31, 2003, the Company fully allowed for the remaining balance
of the note receivable.
The results of operations of Phoenix are included in the Consolidated
Statement of Operations from the effective date of the acquisition.
The pro forma results for the twelve months ended December 31, 2002 as
if the Company had acquired Phoenix at January 1, 2002 are as follows
(in thousands, except per share amounts):
2002
--------
Revenues $ 43,143
Loss before cumulative effect of change in
accounting principle (1,397)
Net loss (3,091)
Basic loss per share $ (0.28)
Diluted loss per share $ (0.28)
The acquisition of Phoenix was accounted for in accordance with
Statement of Financial Accounting Standards No. 141, "Business
Combinations" ("SFAS 141"). This statement requires that the Company
estimate the fair value of assets acquired and liabilities assumed by
the Company as of the date of the acquisition. In accordance with the
application of SFAS 141, the Company recognized an extraordinary gain
of $8.1 million for the acquisition of Phoenix in its Consolidated
Statement of Operations for the twelve months ended December 31, 2003.
The gain is calculated as the difference between the fair value of the
net assets of Phoenix of $14.6 million and the $6.5 million cost of the
note receivable from Millers.
Intangible Assets
-----------------
On January 1, 2002, the Company adopted Statement of Financial
Accounting Standards No. 142 ("SFAS 142"), "Goodwill and Other
Intangible Assets". SFAS 142 supersedes APB 17, "Intangible Assets",
and primarily addresses the accounting for goodwill and intangible
assets subsequent to their initial recognition. SFAS 142 (1) prohibits
the amortization of goodwill and indefinite-lived intangible assets,
(2) requires testing of goodwill and indefinite-lived intangible assets
on an annual basis for impairment (and more frequently if the
occurrence of an event or circumstance indicates an impairment), (3)
requires that reporting units be identified for the purpose of
assessing potential future impairments of goodwill and (4) removes the
forty-year limitation on the amortization period of intangible assets
that have finite lives.
Pursuant to SFAS 142, the Company has identified two components of
goodwill and assigned the carrying value of these components into two
reporting units: the Personal Lines Group and the Commercial Lines
Group. During 2003, the Company completed the first step prescribed
by SFAS 142 for testing for impairment and determined that there is no
impairment. Prior to the acquisitions of the Commercial Lines Group in
December 2002 and Phoenix in January 2003, the Company assigned the
carrying value of goodwill to the insurance company reporting unit and
the finance company reporting unit. In 2003, as a result of these
acquisitions, the Company changed the way it views its operating
segments. During 2002, the Company recorded a charge to earnings that
is reported as a cumulative effect of change in accounting principle of
$1.7 million to reflect an impairment loss determined by the two step
process prescribed by SFAS 142.
Effective December 1, 2002, the Company acquired the Commercial Lines
Group. At acquisition, the Company valued the relationships with its
independent agents at $542,580. This asset is classified as an other
intangible asset and is being amortized over twenty years. The Company
recognized $27,129 of amortization expense for the twelve months ending
December 31, 2003 and will recognize $27,129 in amortization expense
for each of the next five years and $377,545 for the remainder of the
asset's life.
Use of Estimates in the Preparation of Financial Statements
-----------------------------------------------------------
The preparation of financial statements in conformity with GAAP
requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities at the date(s) of the
financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates.
Fair Value of Financial Instruments
-----------------------------------
Cash and Short-term Investments: The carrying amounts reported in the
balance sheet for these instruments approximate their fair values.
Investment Securities: Fair values are obtained from an independent
pricing service. (See Note 2.)
Receivable from Lender for Financed Premiums: The carrying amount
reported in the balance sheet for this instrument approximates its fair
value as the term of the receivable is less than one year.
Notes Payable: The carrying amounts reported in the balance sheet for
these instruments approximate their fair values. (See Note 7.)
Stock-based Compensation
------------------------
In December 2002, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standards No. 148, "Accounting
for Stock-Based Compensation - Transition and Disclosure" ("SFAS 148").
The statement amends FASB Statement No. 123 ("SFAS 123") to provide
alternative methods of transition for voluntary change to the fair
value based method of accounting for stock-based employee compensation.
In addition, SFAS 148 amends the disclosure requirements of SFAS 123 to
require prominent disclosures in both annual and interim financial
statements about the method of accounting for stock-based employee
compensation and the effect of the method used on reported results.
SFAS 148 is effective for financial statements for fiscal years ending
after December 15, 2002. Effective January 1, 2003, the Company
adopted the prospective method provisions of SFAS 148.
At December 31, 2003, the Company had two stock-based employee
compensation plans, which are described more fully in Note 13. Prior
to 2003, the Company accounted for those plans under the recognition
and measurement provisions of APB Opinion No. 25, "Accounting for Stock
Issued to Employees", and related Interpretations. No stock-based
employee compensation cost was reflected in 2002 net income. Effective
January 1, 2003, the Company adopted the fair value recognition
provisions of SFAS 123. Under the prospective method of adoption
selected by the Company under the provisions of SFAS 148, compensation
cost is recognized for all employee awards granted, modified, or settled
after the beginning of the fiscal year in which the recognition
provisions are first applied. Results for prior years have not been
restated.
The following table illustrates the effect on net income (loss) and net
income (loss) per share if the fair value based method had been applied
to all outstanding and unvested awards in each period.
2003 2002
-------- --------
Net income (loss) $ 8,745 $ (1,671)
Add: Stock-based employee compensation
expenses included in reported net income,
net of related tax effects 30 -
Deduct: Total stock-based employee
compensation expense determined under
fair value based method for all awards,
net of related tax effects (84) (32)
-------- --------
Pro Forma net income $ 8,691 $ (1,703)
======== ========
Net income (loss) per share:
Basic - as reported $ 0.47 $ (0.15)
Basic - pro forma $ 0.47 $ (0.15)
Diluted - as reported $ 0.46 $ (0.15)
Diluted - pro forma $ 0.46 $ (0.15)
Reclassification
----------------
Certain previously reported amounts have been reclassified to conform
to current year presentation. Such reclassification had no effect on
net income (loss) or stockholders' equity.
2. Investments:
------------
Major categories of net investment income (in thousands) are
summarized as follows:
Years ended December 31,
------------------------
2003 2002
-------- --------
Debt securities $ 752 $ 421
Equity securities 189 5
Short-term investments 102 163
Cash equivalents 171 186
-------- --------
1,214 775
Investment expenses (16) (2)
-------- --------
Net investment income $ 1,198 $ 773
======== ========
No investment in any entity or its affiliates exceeded 10% of
stockholders' equity at December 31, 2003 or 2002.
The amortized cost and estimated market value of investments in debt
and equity securities (in thousands) by category is as follows:
Gross Gross
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
-------- ------ ------- ---------
At December 31, 2003
--------------------
U.S. Treasury securities
and obligations of U.S.
government corporations
and agencies $ 5,004 $ 23 $ 45 $ 4,982
Corporate debt securities 1,122 - - 1,122
Municipal bonds 19,339 525 21 19,843
Mortgage backed securities - - - -
-------- ------ ------- ---------
Total debt securities 25,465 548 66 25,947
Equity securities 3,396 326 149 3,573
-------- ------ ------- ---------
Total debt and equity
securities $ 28,861 $ 874 $ 215 $ 29,520
======== ====== ======= =========
At December 31, 2002
--------------------
U.S. Treasury securities
and obligations of U.S.
government corporations
and agencies $ 7,221 $ 38 $ - $ 7,259
Mortgage backed securities 458 - - 458
-------- ------ ------- ---------
Total debt securities 7,679 38 - 7,717
Equity securities 122 - - 122
-------- ------ ------- ---------
Total debt and equity
securities $ 7,801 $ 38 $ - $ 7,839
======== ====== ======= =========
The amortized cost and estimated market value of investments in debt
and equity securities with a gross unrealized loss position at December
31, 2003 (in thousands) is as follows:
Gross
Amortized Market Unrealized
Cost Value Loss
------ ------ ------
5 Equity Positions $ 1,024 $ 875 $ (149)
7 Bond Positions 7,681 7,615 (66)
------ ------ ------
$ 8,705 $ 8,490 $ (215)
====== ====== ======
All of the $0.2 million unrealized loss recorded at December 31, 2003 is
less than twelve months old and is considered a temporary decline in
value. In 2003, the Company realized an impairment loss of $0.3 million
on certain securities acquired in the Phoenix acquisition. The Company
also realized a $0.2 million gain on sale of securities in 2003.
Prior to 2003, the Company used an investment strategy classified
as held-to-maturity. Held-to-maturity securities were reported at
amoritized cost. In 2003, due to the change in the Company's
management philosophy, the Company changed the classification of
the investment portfolio to available-for-sale. Available-for-sale
securities are reported at their fair market value. Changes in fair
market values are reflected in other comprehensive income, a component
of stockholders' equity.
The amortized cost and estimated market value of debt securities at
December 31, 2003 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.
Maturity (in thousands): Cost Value
----------------------- -------- --------
Due in one year or less $ 4,222 $ 4,191
Due after one year through five years 4,215 4,195
Due after five years through ten years 14,600 15,072
Due after ten years 2,278 2,329
Mortgage backed securities 150 160
-------- --------
$ 25,465 $ 25,947
======== ========
At December 31, 2003 and 2002, investments in debt securities with an
approximate carrying value of $100,000 were on deposit with TDI as
required by insurance regulations.
Proceeds from investment securities of $6.4 million and $5.9 million
during 2003 and 2002, respectively, were from maturities, bond calls
and prepayments of mortgage-backed securities.
3. Restricted Cash and Investments;
-------------------------------
The Company has cash and investments held in a trust account, to secure
State & County Mutual Fire Insurance Company's ("State & County")
credit exposure from the quota share reinsurance treaty with Hallmark
effective April 1, 2003. These funds are recorded on the Company's
balance sheet at fair value, with unrealized gains and losses reported
as accumulated other comprehensive income; a component of shareholders'
equity. The market value of these funds as of December 31, 2003 was
$5.1 million.
The amortized cost and estimated market value of cash and investments
in debt securities held in trust for State & County (in thousands) by
category as of December 31, 2003 is as follows:
Gross Gross
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
----------------------------------------
Municipal bonds $ 4,500 $ 96 $ - $ 4,596
Corporate debt securities 507 - - 507
----------------------------------------
Total debt securities $ 5,007 $ 96 $ - $ 5,103
Cash (3)
--------
Total funds held in trust
for State & County $ 5,100
========
The amortized cost and estimated market value of investments in
debt securities held in trust for State & County (in thousands)
by contractual maturity are as follows:
Amortized Market
Cost Value
------------------
Due in one year or less $ 507 $ 507
Due after one yearthrough 5 years - -
Due after 5 years through 10 years 2,747 2,826
Due after 10 years 1,753 1,770
------------------
$ 5,007 $ 5,103
==================
The Company also has funds held for Dorinco Reinsurance Company in cash
of $266 thousand as of December 31, 2003.
4. Reserves for Unpaid Losses and Loss Adjustment Expenses:
--------------------------------------------------------
Activity in the reserves for unpaid losses and loss adjustment expenses
(in thousands) is summarized as follows:
2003 2002
-------- --------
Balance at January 1 $ 17,667 $ 20,089
Plus acquisition of Phoenix at January 1 10,338 -
Less reinsurance recoverables 9,256 12,170
-------- --------
Net Balance at January 1 18,749 7,919
-------- --------
Incurred related to:
Current year 29,724 15,125
Prior years 464 177
-------- --------
Total incurred 30,188 15,302
-------- --------
Paid related to:
Current year 21,895 9,119
Prior years 5,845 5,691
-------- --------
Total paid 27,740 14,810
-------- --------
Net Balance at December 31 21,197 8,411
Plus reinsurance recoverables 7,259 9,256
-------- --------
Balance at December 31 $ 28,456 $ 17,667
======== ========
The 2003 increase in current year incurred includes a $2.1 million
settlement of a bad faith claim, net of reinsurance, and adverse
development primarily related to newly acquired business.
5. Reinsurance:
------------
For policies originated prior to April 1, 2003, Hallmark assumed the
reinsurance of 100% of the Texas non-standard auto business produced
by AHGA and underwritten by State & County and retroceded 55% of
the business to Dorinco. Under this arrangement, Hallmark remained
obligated to policyholders in the event that Dorinco did not meet its
obligations under the retrocession agreement. Effective April 1, 2003,
Hallmark assumes the reinsurance of 45% of the Texas non-standard
automobile policies produced by AHGA and underwritten either by State &
County (for policies written from April 1, 2003 through September 30,
2003) or OACM (for policies written after September 30, 2003). The
remaining 55% of each policy is directly assumed by Dorinco. Under
these new reinsurance arrangements, Hallmark is obligated to
policyholders only for the portion of the risk assumed by Hallmark.
Phoenix underwrites its own policies and does not cede any portion of
the business to reinsurers.
Under Hallmark's reinsurance arrangements, the Company earns ceding
commissions based on Dorinco's loss ratio experience on the portion of
policies reinsured by Dorinco. The Company receives a provisional
commission as policies are produced as an advance against the
later determination of the commission actually earned. The provisional
commission is adjusted periodically on a sliding scale based on
expected loss ratios.
The following table shows earned premiums ceded and reinsurance loss
recoveries by period (in thousands):
Twelve Months Ended December 31,
2003 2002
------------------------
Ceded earned premiums $ 15,472 $ 32,273
Reinsurance recoveries $ 11,332 $ 21,161
6. Note Receivable:
----------------
On November 1, 2002, the Company purchased from a major bank all of the
right, title and interest in a promissory note (the "Millers Note")
payable to the bank by Millers American Group, Inc. ("Millers"),
together with all related loan documentation and collateral, for a cash
purchase price of $6.5 million. At the time of such acquisition, the
Millers Note was in default and had an outstanding balance of
approximately $15.1 million. The Company had valued the Millers Note
on its balance sheet at its $6.5 million cost. The Millers Note was
guaranteed by Trilogy Holdings, Inc. ("Trilogy"), a wholly-owned
subsidiary of Millers, and secured by all of the issued and outstanding
capital stock of Millers Insurance Company ("MIC"), a Texas-based
property and casualty insurance carrier, and Phoenix, each of which was
a wholly-owned subsidiary of Trilogy at the time of the acquisition.
Effective January 1, 2003, the Company acquired all of the outstanding
capital stock of Phoenix in satisfaction of $7.0 million of the
outstanding balance of the Millers Note. The remaining Millers Note
balance is carried at no value as a result of credit concerns with
respect to remaining collateral.
7. Notes Payable:
--------------
Effective March 11, 1997, the Company entered into a loan agreement with
Dorinco, whereby the Company borrowed $7.0 million (the "Dorinco Loan")
to contribute to HFC. Proceeds from this loan were used by HFC primarily
to fund premium finance notes. The loan agreement provides for a seven-
year term at a fixed interest rate of 8.25%. In November 2001 the note
was amended to provide for interest only payments from December 2001
through and including December 2002 with a final principal pay-off date
of June 30, 2005.
As long as certain financial covenants defined as "triggering events"
are maintained, collateral for the Dorinco Loan is limited to the stock
of HFC and a covenant by the Company not to pledge the stock of Hallmark
or AHGA. To avoid a triggering event, Hallmark must (1) maintain a
combined ratio and loss ratio which do not exceed 107.0% and 83.0%,
respectively, and (2) maintain statutory surplus of $4.2 million and
experience no decreases to surplus in any one year that exceeds 15% of
the prior year surplus. If a triggering event should occur, the Company
has ten days to pledge the stock of AHGA and Hallmark as additional
collateral for the Dorinco Loan. There were no triggering events
during 2002 or 2003. The loan agreement also contains covenants which
require the Company to satisfy certain financial ratios which are less
restrictive than the triggering event ratios and, among other things,
restrict capital expenditures, payment of dividends, and incurrence of
additional debt.
The Company also carried two notes payable to MIC at December 31, 2002.
Each of these notes carried an interest rate of 9% and matured in March
2003.
A summary of the Company's notes payable (in thousands) is as follows:
December 31,
------------------------
2003 2002
-------- --------
Note payable to Dorinco $ 991 $ 1,720
Notes payable to MIC - 83
-------- --------
$ 991 $ 1,803
======== ========
Scheduled annual principal payments on the note payable (in thousands)
to Dorinco are as follows at December 31, 2003:
2004 $ 728
2005 263
--------
Total $ 991
========
8. Note Payable to Related Party:
------------------------------
On November 1, 2002, the Company entered into a promissory note with
Newcastle (a related party) whereby the Company could borrow up to $9.0
million. The Company borrowed $6.5 million on November 1, 2002 to
purchase the Millers Note. (See further discussion of note receivable
in Note 6.) On December 3, 2002, the Company borrowed an additional
$2.1 million to purchase the Commercial Lines Group from MIC. The note
agreement provided for a fixed interest rate of 11.75%. The Company
retired this note with the majority of the proceeds received from the
completion of its rights offering in September 2003.
9. Net Advances from Lender for Financed Premiums:
-----------------------------------------------
Effective November 18, 1999, HFC entered into a secured financing
arrangement (the "Financing Arrangement") and a servicing agreement
with an unaffiliated third party in order to fund HFC's premium finance
activities. As a result of the Company ceasing to provide new premium
financed policies beginning in July 2003, the Company terminated the
Financing Arrangement effective December 31, 2003. As of December 31,
2003 and 2002, HFC had an outstanding balance on advances under the
Financing Arrangement of zero and $10.9 million, respectively.
10. Segment Information:
--------------------
The Company pursues its business activities through integrated
insurance groups managing non-standard automobile insurance (the
"Personal Lines Group") and commercial insurance (the "Commercial Lines
Group"). The members of the Personal Lines Group are Hallmark, an
authorized Texas property and casualty insurance company; Phoenix, an
authorized Arizona property and casualty insurance company; AHGA, a
managing general agency; and HCS, a claims administrator. Effective
February 28, 2003, the Company sold its four Hallmark Agencies offices
(Amarillo, Corpus Christi, Lubbock and Lancaster) for a total purchase
price of $0.2 million to three unaffiliated third parties. Effective
December 1, 2002, the Company purchased the Commercial Lines Group.
The members of the Commercial Lines Group are HGA, a managing general
agency, and ECM, a third party claims administrator. The Company
changed the segment structure in 2003 with the acquisitions of Phoenix
and the Commercial Lines Group. Prior year information has been
restated for the new structure.
The following is additional business segment information for the twelve
months ended December 31 (in thousands):
2003 2002
Revenues -------- --------
--------
Personal Lines Group $ 49,665 $ 23,999
Commercial Lines Group 19,891 1,561
Corporate 3 237
-------- --------
Consolidated $ 69,559 $ 25,797
======== ========
Pre-tax Income
--------------
Personal Lines Group $ 1,350 $ (203)
Commercial Lines Group 1,311 3
Corporate (1,975) 236
-------- --------
Consolidated $ 686 $ 36
======== ========
The following is additional business segment information as of the
following dates (in thousands):
December 31,
------------------------
2003 2002
Assets -------- --------
------
Personal Lines Group $ 68,247 $ 64,488
Commercial Lines Group 13,365 11,839
Corporate 2,241 7,434
-------- --------
Consolidated $ 83,853 $ 83,761
======== ========
11. Earnings per Share:
-------------------
The Company has adopted the provisions of Statement of Financial
Accounting Standards No. 128 (" SFAS No. 128"), "Earnings Per Share,"
requiring presentation of both basic and diluted earnings per share.
A reconciliation of the numerators and denominators of the basic and
diluted per-share computations (in thousands, except per share amounts)
as required by SFAS No. 128 is presented below:
Income Shares Per-Share
(Numerator) (Denominator) Amount
----------- ------------- ------
For the year ended December 31, 2003:
Basic Earnings per Share
Income available to common
stockholders:
Income before extraordinary gain $ 661 18,518 $ 0.03
Extraordinary gain 8,084 18,518 0.44
------- ------- ------
Net income $ 8,745 18,518 $ 0.47
======= ======= ======
Diluted Earnings per Share
Income available to common
stockholders:
Income before extraordinary gain $ 661 18,518 $ 0.03
Effect of Dilutive Securities:
Stock options - 269 -
------- ------- ------
Income before extraordinary gain 661 18,787 0.03
Extraordinary gain 8,084 18,787 0.43
------- ------- ------
Net income $ 8,745 18,787 $ 0.46
======= ======= ======
For the year ended December 31, 2002:
Basic Earnings per Share
Income available to common
stockholders:
Income before cumulative effect $ 23 11,049 $ -
of change in accounting principle
Cumulative effect of change in
accounting principle (1,694) 11,049 (.15)
------- ------- ------
Net loss $ (1,671) 11,049 $ (.15)
======= ======= ======
Diluted Earnings per Share
Income available to common
stockholders:
Income before cumulative effect
of change in accounting principle $ 23 11,049 $ -
Effect of Dilutive Securities:
Options and warrants - 78 -
------- ------- ------
Income before cumulative effect
of change in accounting principle 23 11,127 -
Cumulative effect of change in
accounting principle (1,694) 11,127 (.15)
------- ------- ------
Net loss $ (1,671) 11,127 $ (.15)
======= ======= ======
Options to purchase 126,000 and 1,532,000 shares of common stock at
prices ranging from $0.75 to $1.00 and $0.44 to $1.00 were outstanding
at December 31, 2003 and December 31, 2002, respectively, but were not
included in the computation of diluted earnings per share because the
inclusion would result in an antidilutive effect in periods where the
option exercise price exceeded the average market price per share for
the period.
12. Regulatory Capital Restrictions:
--------------------------------
Hallmark's 2003 and 2002 net income and stockholders' equity (capital
and surplus), as determined in accordance with statutory accounting
practices, were $2.0 million and $0.4 million, and $10.0 million and
$8.4 million, respectively. The minimum statutory capital and surplus
required for Hallmark by the TDI is $2.0 million. Texas state law
limits the payment of dividends to stockholders by property and
casualty insurance companies. The maximum dividend that may be paid
without prior approval of the Commissioner of Insurance is limited to
the greater of 10% of statutory surplus as regards policyholders as of
the preceding calendar year end or the statutory net income of the
preceding calendar year. During 2003, Hallmark declared dividends to
HFS of $0.4 million of which $0.2 million was paid. Based on surplus
at December 31, 2003, Hallmark could pay a dividend of up to $2.0
million to HFS during 2004 without TDI approval. Hallmark paid
management fees of $0.6 million to HFS during 2003 as compared to $0.2
million in 2002.
Phoenix's 2003 net loss and stockholders' equity (capital and surplus),
as determined in accordance with statutory accounting practices, were
$0.3 million and $10.1 million, respectively. The minimum statutory
capital and surplus required for Phoenix by AZDOI is $1.5 million.
Arizona insurance regulations generally limit distributions made by
property and casualty insurers in any one year, without prior
regulatory approval, to the lesser of 10% of statutory surplus of the
previous year end or net investment income for the prior year. The
maximum dividend that may be paid in 2004 without prior approval of the
AZDOI is $0.6 million. Phoenix paid dividends of $0.6 million to HFS
during 2003.
The NAIC requests property/casualty insurers to file a risk-based
capital ("RBC") calculation according to a specified formula. The
purpose of the NAIC-designed formula is twofold: (1) to assess the
adequacy of an insurer's statutory capital and surplus based upon a
variety of factors such as potential risks related to investment
portfolio, ceded reinsurance and product mix; and (2) to assist state
regulators under the RBC for Insurers Model Act (the "Model Act") by
providing thresholds at which a state commissioner is authorized and
expected to take regulatory action. Hallmark's 2003 and 2002 adjusted
capital under the RBC calculation exceeded the minimum requirement by
186.3% and 142.9%, respectively. Phoenix's 2003 adjusted capital under
the RBC calculation exceeded the minimum requirement by 116.8%.
13. Stock Option Plans:
-------------------
The Company has a stock option plan for key employees, the 1994 Key
Employee Long Term Incentive Plan, and a non-qualified plan for non-
employee directors. The number of shares reserved for future issuance
under the 1994 employee plan and the non-employee director plan is
603,500 and 775,000, respectively. The option prices under the plans
are not to be less than the closing price of the common stock on the
day preceding the grant date. Pursuant to the stock option plans, the
Company has granted incentive stock options under Section 422 of the
Internal Revenue Code of 1986. The stock options granted to employees
vest over a 3 year period on a graded schedule, 40% in the first 6
months and 20% on each anniversary date of the grant date. The stock
options granted to the directors vest over a 6 year period on a graded
schedule, 40% in the first 6 months and 10% on each anniversary date of
the grant date.
A summary of the status of the Company's stock options as of December
31, 2003 and December 31, 2002 and the changes during the years ended
on those dates is presented below:
2003 2002
----------------------- ----------------------
Number Weighted Number Weighted
of Shares of Average of Shares of Average
Underlying Exercise Underlying Exercise
Options Prices Options Prices
------- ------ ------- ------
Outstanding at beginning
of the year 2,379,000 $ 0.50 2,679,000 $ 0.49
Granted 205,000 $ 0.67 200,000 $ 0.43
Exercised (575,000) $ 0.39 - $ -
Forfeited (745,500) $ 0.49 (500,000) $ 0.41
Expired - $ - - $ -
Outstanding at end of year 1,263,500 $ 0.58 2,379,000 $ 0.50
Exercisable at end of year 1,006,500 $ 0.57 1,913,000 $ 0.50
Weighted-average fair value
of all options granted $ 0.36 $ 0.22
The fair value of each stock option granted is estimated on the date of
grant using the Black-Scholes option-pricing model with the following
weighted-average assumptions:
2003 2002
---- ----
Expected Term 5.00 5.00
Expected Volatility 61.05% 53.37%
Risk-Free Interest Rate 2.97% 4.91%
The following table summarizes information about stock options
outstanding at December 31, 2003:
Options Outstanding Options Exercisable
------------------- ---------------------
Weighted Avg. Weighted
Number Remaining Number Avg.
Range of Outstanding Contractual Weighted Avg. Exercisable Exercise
Exercise Prices at 12/31/03 Actual Life Exercise Price at 12/31/03 Price
--------------- ----------- ----------- -------------- ----------- --------
$ .38 to $ .44 582,500 6.4 $ .41 537,500 $ .41
$ .45 to $ .69 555,000 6.1 $ .68 358,000 $ .68
$ .70 to $1.00 126,000 3.5 $ .97 111,000 $ .98
--------- ---------
$ .38 to $1.00 1,263,500 6.0 $ .58 1,006,500 $ .57
========= =========
14. Retirement Plans
----------------
Certain employees of the Commercial Lines Group were participants in a
defined benefit cash balance plan covering all full-time employees who
had completed at least 1,000 hours of service. This plan was frozen in
March 2001 in anticipation of distribution of plan assets to members
upon plan termination. All participants were vested when the plan was
frozen.
The following tables provide detail of the changes in benefit
obligations, components of benefit costs and weighted-average
assumptions, and plan assets for the Retirement Plan as of and for
the twelve months ending December 31, 2003 and for the one month
ending December 31, 2002 (in thousands) using a measurement date of
November 30:
12 Months 1 month
Ending Ending
12/31/03 12/31/02
-------- --------
Assumptions (end of period)
Discount rate used in determining
benefit obligation 6.00% 6.50%
Rate of compensation increase N/A N/A
Reconciliation of funded status
(end of period):
Vested benefit obligation $ (12,482) $ (11,756)
Accumulated benefit obligation (12,517) (11,758)
Projected benefit obligation (12,517) (11,758)
Fair value of plan assets 11,280 11,154
-------- --------
Funded status $ (1,237) $ (604)
Unrecognized net obligation - -
Unrecognized prior service cost - -
Unrecognized actuarial (gain)/loss 887 268
-------- --------
Prepaid/(accrued) pension cost $ (350) $ (336)
======== ========
Changes in projected benefit obligation:
Benefit obligation as of
beginning of period $ 11,758 $ 11,794
Service cost - -
Interest cost 762 64
Plan amendments - -
Actuarial liability (gain)/loss 1,085 (4)
Effect of curtailment (plan freeze) - -
Benefits paid (1,088) (96)
-------- --------
Benefit obligation as of end of period $ 12,517 $ 11,758
======== ========
12 Months 1 month
Ending Ending
12/31/03 12/31/02
-------- --------
Change in plan assets:
Fair value of plan assets as of
beginning of period $ 11,154 $ 11,446
Actual return on plan assets
(net of expenses) 1,214 (196)
Employer contributions - -
Benefits paid (1,088) (96)
-------- --------
Fair value of plan assets as
of end of period $ 11,280 $ 11,154
======== ========
Net periodic pension cost:
Service cost - benefits earned
during the period $ - $ -
Interest cost on projected
benefit obligation 762 64
Expected return on plan assets (749) (76)
Amortizations
Net obligation/(asset) - -
Unrecognized prior service cost - -
Unrecognized (gain)/loss - -
-------- --------
Net periodic pension cost (credit) $ 13 $ (12)
======== ========
Discount rate 6.00% 6.50%
Expected return on plan assets 8.00% 7.00%
Rate of compensation increase N/A N/A
As of December 31, 2003, the fair value of the plan assets was composed
of cash and cash equivalents of $0.4 million, bonds and notes of $5.2
million and equity securities of $5.7 million. As of December 31,
2002, the fair value of the plan assets was composed of cash and cash
equivalents of $0.7 million, bonds and notes of $5.7 million and equity
securities of $4.8 million. The Company recorded a $1.2 million
pension liability at December 31, 2003, of which, $0.9 million was
additional minimum pension liability.
The investment objectives of the Company are to preserve capital and to
achieve long-term growth through a favorable rate of return equal to or
greater than 5% over the long-term (60 yr.) average inflation rate as
measured by the consumers price index. The Company has prohibited all
investments in options, futures, precious metals, short sales and
purchase on margin. In 2003, management instructed an asset allocation
of 50% to 55% in equity securities to take a more conservative
investment strategy.
To develop the expected long-term rate of return on assets assumption,
the Company considered the historical returns and the future
expectations for returns for each asset class, as well as the target
asset allocation of the pension portfolio. This resulted in the
selection of the 8% long-term rate of return on assets assumption.
The Company estimates it will contribute $0.3 million to the defined
benefit cash balance plan during 2004.
The following table shows the weighted-average asset allocation for the
defined benefit cash balance plan held as of December 31, 2003 and
2002.
12/31/03 12/31/02
--------------------
Asset Category:
Debt securities 46% 50%
Equity securities 51% 43%
Other 3% 7%
--------------------
Total 100% 100%
The Company sponsors two defined contribution plans. Under these plans,
employees may contribute a portion of their compensation on a tax-
deferred basis, and the Company may contribute a discretionary amount
each year. The Company's contribution amounted to $0.1 million for each
of the years ended December 31, 2003 and 2002.
15. Income Taxes:
-------------
The composition of deferred tax assets and liabilities and the related
tax effects (in thousands) as of December 31, 2003 and 2002, are as
follows:
2003 2002
-------- --------
Deferred tax liabilities:
Deferred policy acquisition costs ( $ 2,429) ( $ 1,906)
Profit sharing commission ( 357) ( 320)
Agency relationship ( 188) ( 200)
Goodwill - ( 2)
Unrealized holding gains on investments ( 449) -
Guaranty assessment fund ( 39) -
Fixed asset depreciation ( 130) -
Loss reserve discount ( 53) -
Other ( 76) ( 25)
-------- --------
Total deferred tax liabilities ( $ 3,721) ( $ 2,453)
Deferred tax assets:
Unearned premiums $ 379 $ 476
Loss reserve discounting, net
of salvage and subrogation - 232
Deferred ceding commissions 2,839 2,304
Pension liability 421 223
Net operating loss carryforward 1,796 109
Allowance for bad debt 141 92
Unpaid loss and loss adjustment expense 489 -
Goodwill 1,782 -
Rent reserve 133 -
Investment impairments 207 -
Unearned revenue 81 -
Risk premium reserve 75 -
Other 223 71
-------- --------
Total deferred tax assets $ 8,566 $ 3,507
======== ========
Net deferred tax asset $ 4,845 $ 1,054
Valuation allowance 884 33
-------- --------
Net deferred tax asset $ 3,961 $ 1,021
======== ========
A valuation allowance is provided against the Company's deferred tax
asset to the extent that management does not believe it is more likely
than not that future taxable income will be adequate to realize these
future tax benefits. This allowance was $0.9 million and $33,000 at
December 31, 2003 and December 31, 2002, respectively. The valuation
allowance is provided against a net operating loss carryforward subject
to limitations on its utilization. Based on the evidence available as
of December 31, 2003, management believes that it is more likely than
not that the remaining net deferred tax assets will be realized.
However, this assessment may change during 2004 if the Company's
financial results do not meet management's current expectations.
A reconciliation of the income tax provisions (in thousands) based on
the prevailing corporate tax rate of 34% to the provision reflected in
the consolidated financial statements for the years ended December 31,
2003 and 2002, is as follows:
2003 2002
-------- --------
Computed expected income tax provision
(benefit) at statutory regulatory tax rate $ 233 $ 12
Meals and entertainment 5 1
Tax exempt interest ( 122) -
Dividends received deduction ( 28) -
State (net of federal benefit) ( 6) -
Other ( 57) -
-------- --------
Income tax provision (benefit) $ 25 $ 13
======== ========
Current income tax benefit ( $ 89) ( $ 32)
Deferred tax provision 114 45
-------- --------
Federal income tax provision (benefit) $ 25 $ 13
======== ========
The company has available, for federal income tax purposes, unused net
operating loss of approximately $5.3 million at December 31, 2003. The
losses were acquired as part of the Phoenix acquisition and may be used
to offset future taxable income. Utilization of the losses is limited
under Internal Revenue Code Section 382. Due to this limitation,
the company believes that $2.6 million of the net operating loss
carryforwards may expire unutilized. Therefore, a valuation allowance of
$2. 6 million has been established against these net operating loss
carryforwards. The Internal Revenue Code has provided that effective
with tax years beginning September 1997, the carryback and carryforward
periods are 2 years and 20 years, respectively, with respect to newly
generated operating losses. The net operating losses (in thousands)
will expire, if unused, as follows:
Year
----
2021 $ 2,600
2022 2,700
-------
$ 5,300
=======
16. Commitments and Contingencies:
------------------------------
The Company has several leases, primarily for office facilities and
computer equipment, which expire in various years through 2011.
Certain of these leases contain renewal options. Rental expense
amounted to $1.3 million and $0.8 million for the years ended
December 31, 2003 and 2002, respectively.
Future minimum lease payments (in thousands) under noncancellable
operating leases as of December 31, 2003 are as follows:
Year
----
2004 $ 1,085
2005 1,072
2006 1,020
2007 1,020
2008 956
2009 and thereafter 1,032
-------
Total minimum lease payments $ 6,185
=======
From time to time, assessments are levied on the Company by the
guaranty association of the State of Texas. Such assessments are made
primarily to cover the losses of policyholders of insolvent or
rehabilitated insurers. Since these assessments can be recovered
through a reduction in future premium taxes paid, the Company
capitalizes the assessments, as they are paid, and amortizes the
capitalized balance against its premium tax expense. There were no
assessments during 2003 or 2002.
17. Concentrations of Credit Risk:
------------------------------
The Company maintains cash equivalents in accounts with five financial
institutions in excess of the amount insured by the Federal Deposit
Insurance Corporation. The Company monitors the financial stability of
the depository institutions regularly, and management does not believe
excessive risk of depository institution failure exists at December 31,
2003.
The Company's reinsurance coverage has substantially been provided by
one company (Dorinco) since July 1, 2000.