UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
Quarterly report pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the quarterly period ended September 30, 2006
Commission file number 001-11252
Hallmark Financial Services, Inc.
---------------------------------
(Exact name of registrant as specified in its charter)
Nevada 87-0447375
------------------------------- -------------------
(State or other jurisdiction of (I.R.S. Employer
Incorporation or organization) Identification No.)
777 Main Street, Suite 1000, Fort Worth, Texas 76102
---------------------------------------------- ----------
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (817) 348-1600
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes X No ___
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes ___ No X
Indicate by check mark whether the registrant is a shell company (as defined
in Rule 12b-2 of the Exchange Act). Yes ___ No X
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date: Common Stock, par value
$.18 per share - 20,759,905 shares outstanding as of November 8, 2006.
PART I
FINANCIAL INFORMATION
Item 1. Financial Statements
INDEX TO FINANCIAL STATEMENTS
Page Number
-----------
Consolidated Balance Sheets at September 30, 2006 3
(unaudited) and December 31, 2005
Consolidated Statements of Operations (unaudited)
for the three months and nine months ended September 30,
2006 and September 30, 2005 4
Consolidated Statements of Stockholders' Equity and
Comprehensive Income (unaudited) for the three months and
nine months ended September 30, 2006 and September 30, 2005 5
Consolidated Statements of Cash Flows (unaudited) for the
nine months ended September 30, 2006 and September 30, 2005 6
Notes to Consolidated Financial Statements (unaudited) 7
Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Balance Sheets
($ in thousands)
September 30 December 31
ASSETS 2006 2005
------ ---------- ----------
(unaudited) (audited)
Investments:
Debt securities, available-for-sale,
at market value $ 125,800 $ 79,360
Equity securities, available-for-sale,
at market value 3,701 3,403
Short-term investments, available-for-sale,
at market value 40,169 12,281
---------- ----------
Total investments 169,670 95,044
Cash and cash equivalents 39,240 44,528
Restricted cash and investments 35,030 13,802
Premiums receivable 61,154 26,530
Accounts receivable 12,276 2,083
Prepaid reinsurance premium 1,575 767
Reinsurance balances receivable 777 -
Reinsurance recoverable 4,480 444
Deferred policy acquisition costs 14,742 9,164
Excess of cost over fair value
of net assets acquired 31,781 4,836
Intangible assets 26,647 459
Deferred federal income taxes - 3,992
Current federal income tax receivable 1,010 -
Other assets 9,034 7,257
---------- ----------
Total assets $ 407,416 $ 208,906
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Notes payable $ 48,529 $ 30,928
Note payable to related party 12,500 -
Structured settlements 24,326 -
Unpaid losses and loss adjustment expenses 65,604 26,321
Unearned premiums 82,085 36,027
Unearned revenue 7,079 4,055
Reinsurance balances payable - 116
Accrued agent profit sharing 1,854 2,173
Accrued ceding commission payable 11,534 11,430
Pension liability 2,766 2,932
Deferred federal income taxes 4,307 -
Current federal income tax payable - 300
Accounts payable and other accrued expenses 25,479 9,436
---------- ----------
Total liabilities 286,063 123,718
Commitments and Contingencies
Stockholders' equity:
Common stock, $.18 par value (authorized
33,333,333 shares in 2006 and 16,666,667
shares in 2005; issued 17,767,733 shares
in 2006 and 14,476,102 shares in 2005) 3,198 2,606
Additional paid in capital 93,712 62,907
Retained earnings 26,750 22,289
Accumulated other comprehensive loss (2,230) (2,597)
Treasury stock, at cost (7,828 shares in 2006
and 2,470 in 2005) (77) (17)
---------- ----------
Total stockholders' equity 121,353 85,188
---------- ----------
$ 407,416 $ 208,906
========== ==========
The accompanying notes are an integral part
of the consolidated financial statements
Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Statements of Operations
(Unaudited)
($ in thousands, except per share amounts)
Three Months Ended Nine Months Ended
September 30 September 30
--------------------- ----------------------
2006 2005 2006 2005
-------- -------- -------- --------
Gross premiums written $ 58,107 $ 43,512 $ 153,718 $ 62,985
Ceded premiums written (3,102) (552) (7,542) (552)
-------- -------- -------- --------
Net premiums written 55,005 42,960 146,176 62,433
Change in unearned premiums (12,811) (23,936) (41,289) (23,706)
-------- -------- -------- --------
Net premiums earned 42,194 19,024 104,887 38,727
Investment income, net of expenses 2,912 1,412 7,505 2,274
Realized gain (loss) (135) 93 (1,501) 52
Finance charges 1,037 487 2,940 1,536
Commission and fees 9,943 3,094 32,223 13,534
Processing and service fees 410 1,048 1,994 4,252
Other income 4 9 24 22
-------- -------- -------- --------
Total revenues 56,365 25,167 148,072 60,397
Losses and loss adjustment expenses 23,589 11,043 60,478 22,584
Other operating costs and expenses 23,044 9,897 64,097 27,752
Interest expense 1,527 559 4,774 664
Interest expense from amortization
of discount on convertible notes - - 9,625 -
Amortization of intangible asset 573 17 1,719 31
-------- -------- -------- --------
Total expenses 48,733 21,516 140,693 51,031
Income before tax 7,632 3,651 7,379 9,366
Income tax expense 2,755 1,178 2,918 3,074
-------- -------- -------- --------
Net income $ 4,877 $ 2,473 $ 4,461 $ 6,292
======== ======== ======== ========
Common stockholders net income
per share:
Basic $ 0.27 $ 0.17 $ 0.28 $ 0.58
======== ======== ======== ========
Diluted $ 0.27 $ 0.17 $ 0.28 $ 0.58
======== ======== ======== ========
The accompanying notes are an integral part
of the consolidated financial statements
Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Statements of Stockholders' Equity and Comprehensive Income
(Unaudited)
($ in thousands)
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------- ----------------------
2006 2005 2006 2005
-------- -------- -------- --------
Common Stock
Balance, beginning of period $ 3,198 $ 2,606 $ 2,606 $ 1,106
Conversion of note payable
to common stock - - 589 -
Issuance of common stock
in rights offering - - - 1,500
Issuance of common stock
upon option exercises - - 3 -
-------- -------- -------- --------
Balance, end of period 3,198 2,606 3,198 2,606
Additional Paid-In Capital
Balance, beginning of period 93,663 62,898 62,907 19,647
Discount on convertible notes,
net of tax - - 6,066 -
Conversion of note payable
to common stock - - 24,562 -
Issuance of common stock
in rights offering - (31) - 43,391
Equity based compensation 50 20 107 43
Exercise of stock options (1) - 70 (194)
-------- -------- -------- --------
Balance, end of period 93,712 62,887 93,712 62,887
Retained Earnings
Balance, beginning of period 21,873 16,922 22,289 13,103
Net income 4,877 2,473 4,461 6,292
-------- -------- -------- --------
Balance, end of period 26,750 19,395 26,750 19,395
Accumulated Other Comprehensive Loss
Balance, beginning of period (3,668) (964) (2,597) (759)
Additional minimum pension liability,
net of tax - - 32 30
Unrealized gains (losses) on
securities, net of tax 1,438 (832) 335 (1,067)
-------- -------- -------- --------
Balance, end of period (2,230) (1,796) (2,230) (1,796)
Treasury Stock
Balance, beginning of period (77) (17) (17) (441)
Acquisition of treasury shares - - (100) -
Exercise of stock options - - 40 424
-------- -------- -------- --------
Balance, end of period (77) (17) (77) (17)
-------- -------- -------- --------
Stockholders' Equity $ 121,353 $ 83,075 $ 121,353 $ 83,075
======== ======== ======== ========
Net income $ 4,877 $ 2,473 $ 4,461 $ 6,292
Additional minimum pension
liability, net of tax - - 32 30
Unrealized gains (losses)
on securities, net of tax 1,438 (832) 335 (1,067)
-------- -------- -------- --------
Comprehensive Income $ 6,315 $ 1,641 $ 4,828 $ 5,255
======== ======== ======== ========
The accompanying notes are an integral part
of the consolidated financial statements
Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Statement of Cash Flows
(Unaudited)
($ in thousands)
Nine Months Ended
September 30
------------------------
2006 2005
---------- ----------
Cash flows from operating activities:
Net income $ 4,461 $ 6,292
Adjustments to reconcile net income to cash
provided by operating activities:
Depreciation and amortization expense 3,202 289
Interest expense related to amortization
of discount on convertible notes 9,625 -
Deferred federal income tax (benefit) expense (4,062) 2,051
Realized (gain) loss on investments 1,501 (52)
Change in prepaid reinsurance premiums (808) (297)
Change in premiums receivable (10,118) (30,193)
Change in accounts receivable (8,725) 1,253
Change in deferred policy acquisition costs (5,578) (6,130)
Change in unpaid losses and loss adjustment
expenses 29,793 2,537
Change in unearned premiums 42,114 24,003
Change in unearned revenue (6,516) (1,685)
Change in accrued agent profit sharing (319) (496)
Change in reinsurance recoverable (3,396) 2,037
Change in reinsurance balances payable (1,542) -
Change in current federal income tax
payable/recoverable (2,197) (2,121)
Change in accrued ceding commission payable 104 9,678
Change in all other liabilities (3,556) 812
Change in all other assets 1,651 (2,354)
---------- ----------
Net cash provided by operating activities 45,634 5,624
---------- ----------
Cash flows from investing activities:
Purchases of property and equipment (487) (275)
Premium finance notes repaid,
net of finance notes originated (2,184) -
Acquisition of subsidiaries, net of cash acquired (25,964) -
Change in restricted cash and investments (24,089) (2,080)
Purchases of debt and equity securities (41,091) (57,901)
Maturities and redemptions of investment
securities 18,129 1,237
Net redemptions (purchases) of short-term
investments (27,776) 2
---------- ----------
Net cash used in investing activities (103,462) (59,017)
---------- ----------
Cash flows from financing activities:
Proceeds from exercise of employee stock options 40 230
Proceeds from stockholder rights offering - 44,891
Proceeds from issuance of trust preferred
securities - 30,928
Debt issuance costs - (907)
Proceeds from issuance of convertible debt 25,000 -
Proceeds from note payable to related party 12,500 -
Proceeds from revolving loan on credit facility 15,000 -
---------- ----------
Net cash provided by financing activities 52,540 75,142
---------- ----------
Increase (decrease) in cash and cash equivalents (5,288) 21,749
Cash and cash equivalents at beginning of period 44,528 12,901
---------- ----------
Cash and cash equivalents at end of period $ 39,240 $ 34,650
========== ==========
Supplemental Cash Flow Information:
Interest paid $ 3,698 $ 567
---------- ----------
Taxes paid $ 9,084 $ 3,144
---------- ----------
The accompanying notes are an integral part
of the consolidated financial statements
Hallmark Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
1. General
Hallmark Financial Services, Inc. ("Hallmark" and, together with
subsidiaries, "we", "us", "our") is a diversified property/casualty
insurance group that serves businesses and individuals in specialty and
niche markets. We market, distribute, underwrite and service our commercial
and personal property/casualty insurance products through four operating
units, each of which has a specific focus. Our HGA Operating Unit
primarily handles standard commercial insurance, our TGA Operating Unit
concentrates on excess and surplus lines commercial insurance, our Phoenix
Operating Unit focuses on non-standard personal automobile insurance and our
Aerospace Operating Unit specializes in general aviation insurance. The
subsidiaries comprising our TGA Operating Unit and our Aerospace Operating
Unit were acquired effective January 1, 2006. The insurance policies
produced by our four operating units are written by our three insurance
company subsidiaries as well as unaffiliated insurers. Our insurance
company subsidiaries are American Hallmark Insurance Company of Texas
("AHIC"), Phoenix Indemnity Insurance Company ("PIIC") and Gulf States
Insurance Company ("GSIC").
2. Basis of Presentation
Our unaudited consolidated financial statements included herein have
been prepared in accordance with U.S. generally accepted accounting
principles ("GAAP") and include our accounts and the accounts of our
subsidiaries. All significant intercompany accounts and transactions have
been eliminated in consolidation. Certain information and footnote
disclosures normally included in financial statements prepared in accordance
with GAAP have been condensed or omitted pursuant to rules and regulations
of the Securities and Exchange Commission ("SEC") for interim financial
reporting. These financial statements should be read in conjunction with
our audited financial statements for the year ended December 31, 2005
included in our Annual Report on Form 10-K filed with the SEC.
The interim financial data as of September 30, 2006 and 2005 is
unaudited. However, in the opinion of management, the interim data includes
all adjustments, consisting only of normal recurring adjustments, necessary
for a fair statement of the results for the interim periods. The results of
operations for the period ended September 30, 2006 are not necessarily
indicative of the operating results to be expected for the full year.
Reclassification
----------------
Certain previously reported amounts have been reclassified in order to
conform to current year presentation. Such reclassification had no effect
on net income or stockholders' equity.
Redesignation of Segments
-------------------------
Effective January 1, 2006, our Commercial Insurance Operation has been
redesignated as our HGA Operating Unit and our Personal Insurance Operation
has been redesignated as our Phoenix Operating Unit, in each case without
change in the composition of the reporting segment.
Reverse Stock Split
-------------------
All share and per share amounts have been adjusted to reflect a one-
for-six reverse split of all issued and unissued shares of our authorized
common stock effected July 31, 2006, and a corresponding increase in the par
value of our authorized common stock from $0.03 per share to $0.18 per
share.
Use of Estimates in the Preparation of the Financial Statements
---------------------------------------------------------------
Our preparation of financial statements in conformity with GAAP
requires us to make estimates and assumptions that affect our reported
amounts of assets and liabilities and our disclosure of contingent assets
and liabilities at the date of our financial statements, as well as our
reported amounts of revenues and expenses during the reporting period.
Actual results could differ materially from those estimates.
Recently Issued Accounting Standards
------------------------------------
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"). SFAS
148 amended FASB Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation" ("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 amended the disclosure requirements of SFAS 123 to
require prominent disclosures in both annual and interim financial
statements about the method of accounting for stock-based employee
compensation and the effect of the method used on reported results.
Effective January 1, 2003, we adopted the prospective method provisions of
SFAS 148. Under the prospective method, we have applied the fair value
based method of accounting for our stock-based payments for option grants
after December 31, 2002.
In December 2004, FASB issued Statement of Financial Accounting
Standards No. 123R "Share-Based Payment" ("SFAS 123R"), which revises SFAS
123 and supersedes Accounting Principles Board ("APB") Opinion No. 25 ("APB
25"). SFAS 123R eliminates an entity's ability to account for share-based
payments using APB 25 and requires that all such transactions be accounted
for using a fair value based method. In April 2005, the SEC deferred the
effective date of SFAS 123R from the first interim or annual period
beginning after June 15, 2005 to the next fiscal year beginning after June
15, 2005. We adopted SFAS 123R on January 1, 2006 using the modified-
prospective transition method. Under the modified-prospective transition
method, compensation cost recognized during the period should include
compensation cost for all share-based payments granted to, but not yet
vested as of January 1, 2006, based on grant date fair value estimates in
accordance with the original provisions of SFAS 123 and compensation cost
for all share-based payments granted after January 1, 2006 in accordance
with SFAS 123R. Since we adopted the fair value method of SFAS 123 under
the prospective method provision of SFAS 148 beginning January 1, 2003, we
have a small amount of unvested share-based payments granted prior to
January 1, 2003. During the first nine months of 2006, we recognized
approximately $8 thousand of additional compensation expense under SFAS
123R. SFAS 123R also requires the benefits of tax deductions in excess of
recognized stock compensation cost to be reported as a financing cash flow,
rather than as an operating cash flow as previously required. (See Note 5,
"Share-Based Payment Arrangements.")
Had compensation cost for all of our stock option grants under our
stock compensation plans been determined based on fair value at the grant
date in accordance with the fair value provisions of SFAS 123, our net
income and earnings per share for the three and nine months ended September
30, 2005 would have been the pro forma amounts indicated below. Actual
results for the three and nine months ended September 30, 2006 have been
determined in accordance with the fair value provisions of SFAS 123R and,
therefore, pro forma results for such period are not necessary.
Three Months Nine Months
Ended Ended
September 30, September 30,
(in thousands) 2005 2005
---------------------
Net income as reported $ 2,473 $ 6,292
Add: Stock-based compensation expenses
included in reported net income, net of
related tax effects 13 28
Deduct: Total stock-based employee
compensation expense determined under
fair value based method for all awards,
net of related tax effects (16) (37)
--------------------
Pro forma net income $ 2,470 $ 6,283
====================
Earnings per share:
Basic-as reported $ 0.17 $ 0.58
====================
Basic-pro forma $ 0.17 $ 0.58
====================
Diluted-as reported $ 0.17 $ 0.58
====================
Diluted-pro forma $ 0.17 $ 0.57
====================
In May 2005, FASB issued Statement of Financial Accounting Standards
No. 154, "Accounting Changes and Error Corrections, a replacement of APB
Opinion No. 20 and FASB Statement No. 3" ("SFAS 154"). This Statement
requires retrospective application to prior periods' financial statements of
a change in accounting principle. It applies both to voluntary changes and
to changes required by an accounting pronouncement if the pronouncement does
not include specific transition provisions. APB 20 previously required that
most voluntary changes in accounting principles be recognized by recording
the cumulative effect of a change in accounting principle. SFAS 154 is
effective for fiscal years beginning after December 15, 2005. We do not
expect the adoption of SFAS 154 to have a material impact on our results of
operations or financial condition.
In November 2005, FASB issued Staff Position ("FSP") No. FAS 115-1 and
FAS 124-1, "The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments." This FSP addresses the determination
as to when an investment is considered impaired, whether the impairment is
other than temporary, and the measurement of an impaired loss. This FSP
also includes accounting considerations subsequent to the recognition of an
other-than-temporary impairment and requires certain disclosures about
unrealized losses that have not been recognized as other-than-temporary
impairments. FSP No. FAS 115-1 and FAS 124-1 is effective for reporting
periods beginning after December 15, 2005. The adoption of this FSP did not
have a material impact on our results of operations or financial condition.
In February 2006, FASB issued Statement of Financial Accounting
Standards No. 155, "Accounting for Certain Hybrid Financial Instruments"
("SFAS 155"). Under current GAAP, an entity that holds a financial
instrument with an embedded derivative must bifurcate the financial
instrument, resulting in the host and the embedded derivative being
accounted for separately. SFAS 155 permits, but does not require, entities
to account for financial instruments with an embedded derivative at fair
value thus negating the need to bifurcate the instrument between its host
and the embedded derivative. SFAS 155 is effective for fiscal periods
beginning after September 15, 2006. We do not expect that SFAS 155 will
have a material impact on our results of operations or financial condition.
In March 2006, FASB issued Statement of Financial Accounting Standards
No. 156, "Accounting for Servicing of Financial Assets" ("SFAS 156"). SFAS
156 amends FASB Statement of Financial Accounting Standards No. 140,
"Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities," to require that all separately recognized
servicing assets and servicing liabilities be initially measured at fair
value, if practicable. SFAS 156 permits, but does not require, the
subsequent measurement of separately recognized servicing assets and
servicing liabilities at fair value. An entity that uses derivative
instruments to mitigate the risks inherent in servicing assets and servicing
liabilities is required to account for those derivative instruments at fair
value. We do not expect that SFAS 156 will have a material impact on our
results of operations or financial condition.
In June 2006, FASB issued FASB Interpretation No. 48 "Accounting for
Uncertainty in Income Taxes" ("FIN 48"). This Interpretation clarifies the
accounting for uncertainty in income taxes recognized in a company's
financial statements in accordance with Statement of Financial Accounting
Standards No. 109, "Accounting for Income Taxes." FIN 48 prescribes a
recognition threshold and measurement attribute for the financial statements
recognition and measurement of a tax position taken or expected to be
taken in a tax return. FIN 48 also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure, and transition. FIN 48 requires that only income tax benefits
that meet the "more likely than not" recognition threshold be recognized or
continue to be recognized on the effective date. Initial derecognition
amounts would be reported as a cumulative effect of a change in accounting
principle, as an adjustment to the opening balance sheet of retained
earnings for the 2007 fiscal year. The provisions of FIN 48 are effective
for fiscal years ending after December 15, 2006. We do not contemplate any
adjustments and, accordingly, do not believe the adoption of this
Interpretation will have a material affect on our financial condition or
results of operations.
In September 2006, FASB issued Statement of Financial Accounting
Standards No. 157, "Fair Value Measurements" ("SFAS 157"). SFAS 157
establishes a separate framework for determining fair values of assets and
liabilities that are required by other authoritative GAAP pronouncements to
be measured at fair value. In addition, SFAS 157 incorporates and clarifies
the guidance in FASB Concepts Statement 7 regarding the use of present value
techniques in measuring fair value. SFAS 157 does not require any new fair
value measurements. SFAS 157 is effective for financial statements issued
for fiscal years beginning after November 15, 2007. We do not expect that
SFAS 157 will have a material impact on our results of operations or
financial condition.
In September 2006, FASB issued Statement of Financial Accounting
Standards No. 158, "Employers' Accounting for Defined Benefit Pension and
Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106,
and 132(R)" ("SFAS 158"). SFAS 158 requires (1) balance sheet recognition
of the funded status of defined benefit plans, (2) recognition in other
comprehensive income of various items before they are recognized in periodic
benefit cost, (3) the measurement date for plan assets and the benefit
obligation to be the balance sheet date, and (4) additional disclosure.
Requirements (1), (2), and (4) of SFAS 158 are effective as of the end of
the first fiscal year ending after December 15, 2006. Requirement (3) of
SFAS 158 is effective for fiscal years ending after December 15, 2008. We
currently recognize the funded status of our frozen defined benefit cash
balance plan in our balance sheet and, therefore, we do not expect that the
adoption of SFAS 158 will have a material impact on our results of
operations or financial condition.
In September 2006, the SEC staff issued Staff Accounting Bulletin Topic
1N, Financial Statements - Considering the Effects of Prior Year
Misstatements when Quantifying Misstatements in Current Year Financial
Statements ("SAB 108"). SAB 108 provides guidance on how prior year
misstatements should be evaluated when determining the materiality of
misstatements in the current year financial statements. SAB 108 requires
materiality to be determined by considering the effect of prior year
misstatements on both the current year balance sheet and income statement,
with consideration of their carryover and reversing effects. SAB 108 also
addresses how to correct material misstatements. The provisions of SAB 108
are effective for financial statements issued for fiscal years ending after
November 15, 2006. The effect of adopting SAB 108 has not been determined,
but it is not expected to have a significant effect on our reported
financial condition or results of operations.
3. Business Combinations
We account for business combinations using the purchase method of
accounting. The cost of an acquired entity is allocated to the assets
acquired (including identified intangible assets) and liabilities assumed
based on their estimated fair values. The excess of the cost of an acquired
entity over the net of the amounts assigned to assets acquired and
liabilities assumed is an asset referred to as "excess of cost over net
assets acquired" or "goodwill." Indirect and general expenses related to
business combinations are expensed as incurred.
Effective January 1, 2006, we acquired all of the issued and
outstanding capital stock of the subsidiaries now comprising the TGA
Operating Unit for an aggregate cash purchase price of up to $45.6 million,
consisting of unconditional consideration of $37.6 million and contingent
consideration of $8.0 million. Of the unconditional consideration, $13.9
million was paid at closing and $14.3 million will be paid on or before
January 1, 2007 and $9.5 million will be paid on or before January 1, 2008.
The payment of any contingent consideration is conditioned on the sellers
complying with certain restrictive covenants and the TGA Operating Unit
achieving certain operational objectives related to premium production and
loss ratios. The contingent consideration, if any, will be payable on or
before March 30, 2009, unless the sellers elect to defer payment until March
30 of any subsequent year in order to permit further development of the loss
ratios. In addition to the purchase price, we will pay $2.0 million to the
sellers in consideration of their compliance with certain restrictive
covenants, including a covenant not to compete for a period of five years
after closing. Of this additional amount, $750 thousand was paid at
closing, $750 thousand will be paid on or before January 1, 2007 and $500
thousand will be paid on or before January 1, 2008.
Texas General Agency, Inc. ("Texas General Agency") is a managing
general agency involved in the marketing, underwriting and servicing of
property and casualty insurance products, with a particular emphasis on
commercial automobile and general liability risks produced on an excess and
surplus lines basis. The other affiliated companies in the TGA Operating
Unit are Texas General Agency's wholly owned insurance subsidiary, GSIC,
which reinsures a portion of the business written by Texas General Agency;
TGA Special Risk, Inc. ("TGASRI"), which brokers mobile home insurance; and
Pan American Acceptance Corporation ("PAAC"), which finances premiums on
property and casualty insurance products marketed by Texas General Agency
and TGASRI. Interim GAAP financial statements for the subsidiaries now
comprising the TGA Operating Unit are not available for 2005 and, therefore,
quarterly supplemental pro forma disclosures are not included in this
report.
Effective January 1, 2006, we also acquired all of the issued and
outstanding membership interests in the subsidiaries now comprising the
Aerospace Operating Unit, for an aggregate consideration of up to $15.0
million, consisting of unconditional consideration of $12.5 million due in
cash at closing and contingent consideration of up to $2.5 million. The
unconditional consideration of $12.5 million is allocated $11.9 million to
the purchase price and $0.6 million to the seller's compliance with certain
restrictive covenants, including a covenant not to compete for a period of
five years after closing. The payment of contingent consideration is
conditioned on the seller complying with its restrictive covenants and the
Aerospace Operating Unit achieving certain operational objectives related to
premium production and loss ratios. The contingent consideration, if any,
will be payable in cash on or before March 30, 2009, unless the seller
elects to defer a portion of the payment in order to permit further
development of loss ratios.
Our Aerospace Operating Unit is involved in the marketing and servicing
of general aviation property and casualty insurance products with a
particular emphasis on private and small commercial aircraft. Interim GAAP
financial statements for the subsidiaries now comprising our Aerospace
Operating Unit are not available for 2005 and, therefore, quarterly
supplemental pro forma disclosures are not included in this report.
4. Supplemental Cash Flow Information
Effective January 1, 2006, we acquired the subsidiaries now comprising
our TGA Operating Unit and our Aerospace Operating Unit. (See Note 3,
"Business Combinations.") In conjunction with the acquisitions, cash and
cash equivalents were used in the acquisitions as follows (in thousands):
TGA Aerospace
Operating Operating
Unit Unit
--------------------
Fair value of tangible assets excluding
cash and cash equivalents $ 52,906 $ 8,391
Fair value of intangible assets acquired 31,585 12,575
Capitalized direct expenses 232 36
Structured settlement (23,542) -
Liabilities assumed (48,522) (7,697)
--------------------
Cash and cash equivalents used in acquisitions $ 12,659 $ 13,305
====================
5. Share-Based Payment Arrangements
Our 2005 Long Term Incentive Plan ("2005 LTIP") is a stock compensation
plan for key employees and non-employee directors that was approved by the
shareholders on May 26, 2005. There are 833,333 shares authorized for
issuance under the 2005 LTIP. Our 1994 Key Employee Long Term Incentive
Plan (the "Employee Plan") and 1994 Non-Employee Director Stock Option Plan
(the "Director Plan") both expired in 2004.
As of September 30, 2006, there were incentive stock options to
purchase 197,499 shares of our common stock outstanding under the 2005 LTIP,
leaving 635,834 shares reserved for future issuance. As of September 30,
2006, there were incentive stock options to purchase 101,918 shares
outstanding under the Employee Plan and non-qualified stock options to
purchase 25,001 shares outstanding under the Director Plan. In addition, as
of September 30, 2006, there were outstanding non-qualified stock options to
purchase 16,666 shares of our common stock granted to certain non-employee
directors outside the Director Plan in lieu of fees for service on our board
of directors in 1999. The exercise price of all such outstanding stock
options is equal to the fair market value of our common stock on the date of
grant.
Options granted under the Employee Plan prior to October 31, 2003, vest
40% six months from the date of grant and an additional 20% on each of the
first three anniversary dates of the grant and terminate ten years from the
date of grant. Options granted under the 2005 LTIP and the Employee Plan
after October 31, 2003, vest 10%, 20%, 30% and 40% on the first, second,
third and fourth anniversary dates of the grant, respectively, and terminate
five to ten years from the date of grant. All options granted under the
Director Plan vest 40% six months from the date of grant and an additional
10% on each of the first six anniversary dates of the grant and terminate
ten years from the date of grant. The options granted to non-employee
directors outside the Director Plan fully vested six months after the date
of grant and terminate ten years from the date of grant.
A summary of the status of our stock options as of and changes during
the year-to-date ended September 30, 2006 is presented below:
Weighted
Average
Weighted Remaining Aggregate
Average Contractual Intrinsic
Number of Exercise Term Value
Shares Price (Years) ($000)
--------------------------------------------
Outstanding at January 1, 2006 252,750 $ 4.92 - -
Granted 109,166 $ 11.34 - -
Exercised (20,832) $ 5.50 - -
Forfeited or expired - $ - - -
---------
Outstanding at
September 30, 2006 341,084 $ 6.93 6.6 $ 1,497
Exercisable at
September 30, 2006 90,834 $ 3.70 3.7 $ 691
The following table details the intrinsic value of options exercised,
total cost of share-based payments charged against income before income tax
benefit and the amount of related income tax benefit recognized in income
for the periods indicated (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
2006 2005 2006 2005
------ ------ ------- -------
Intrinsic value of options
exercised $ - $ - $ 103 $ 260
Cost of share-based payments $ 50 $ 20 $ 107 $ 43
Income tax benefit of
share-based payments
recognized in income $ 17 $ 7 $ 37 $ 15
As of September 30, 2006, there was $1.0 million of total unrecognized
compensation cost related to non-vested share-based compensation
arrangements granted under our plans, of which $47 thousand is expected to
be recognized in the remainder of 2006, $0.3 million is expected to be
recognized in each of 2007, 2008 and 2009 and $0.1 million is expected to be
recognized in 2010.
The fair value of each stock option granted is estimated on the date of
grant using the Black-Scholes option pricing model. Expected volatilities
are based on historical volatility of Hallmark's shares. The risk-free
interest rates for periods within the contractual term of the options are
based on rates for U.S. Treasury Notes with maturity dates corresponding to
the options expected lives on the dates of grant.
The following table details the grant date fair value and related
assumptions for the periods indicated (in thousands). There were no options
granted in either of the first or third quarters of 2006 or 2005.
Three Months Ended Nine Months Ended
September 30, September 30,
2006 2005 2006 2005
------ ------ ------- -------
Grant date fair value per share n/a n/a $ 6.26 $ 4.01
Expected term n/a n/a 5 5
Expected volatility n/a n/a 59.1% 62.5%
Risk free interest rate n/a n/a 4.9% 3.9%
For the nine months ended September 30, 2006 and 2005, we had non-cash
stock-based compensation expense of $107 thousand and $43 thousand,
respectively.
6. Segment Information
The following is business segment information for the three months and
nine months ended September 30, 2006 and 2005 (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
------------------- -------------------
2006 2005 2006 2005
------- ------- ------- -------
Revenues:
---------
HGA Operating Unit $ 20,964 $ 14,339 $ 57,768 $ 27,194
TGA Operating Unit 19,403 - 48,686 -
Phoenix Operating Unit 12,257 10,814 34,944 33,169
Aerospace Operating Unit 3,486 - 7,317 -
Corporate 255 14 (643) 34
------- ------- ------- -------
Consolidated $ 56,365 $ 25,167 $148,072 $ 60,397
======= ======= ======= =======
Pre-tax income (loss):
----------------------
HGA Operating Unit $ 5,112 $ 2,196 $ 11,245 $ 4,761
TGA Operating Unit 1,998 - 7,152 -
Phoenix Operating Unit 2,316 2,790 6,760 7,666
Aerospace Operating Unit 869 - 773 -
Corporate (2,663) (1,335) (18,551) (3,061)
------- ------- ------- -------
Consolidated $ 7,632 $ 3,651 $ 7,379 $ 9,366
======= ======= ======= =======
The following is additional business segment information as of the dates
indicated (in thousands):
Sept. 30, Dec. 31,
2006 2005
-------- --------
Assets
------
HGA Operating Unit $ 143,304 $ 136,220
TGA Operating Unit 121,695 -
Phoenix Operating Unit 80,767 68,264
Aerospace Operating Unit 29,424 -
Corporate 32,226 4,422
-------- --------
Consolidated $ 407,416 $ 208,906
======== ========
7. Reinsurance
We reinsure a portion of the risk we underwrite in order to control the
exposure to losses and to protect capital resources. We cede to reinsurers
a portion of these risks and pay premiums based upon the risk and exposure
of the policies subject to such reinsurance. Ceded reinsurance involves
credit risk and is generally subject to aggregate loss limits. Although the
reinsurer is liable to us to the extent of the reinsurance ceded, we are
ultimately liable as the direct insurer on all risks reinsured. Reinsurance
recoverables are reported after allowances for uncollectible amounts. We
monitor the financial condition of reinsurers on an ongoing basis and review
our reinsurance arrangements periodically. Reinsurers are selected based on
their financial condition, business practices and the price of their product
offerings. Refer to Note 6 of our Form 10-K for the year ended December 31,
2005 for more discussion of our reinsurance.
The following table shows earned premiums ceded and reinsurance loss
recoveries by period (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
------------------- -------------------
2006 2005 2006 2005
------- ------- ------- -------
Ceded earned premiums $ 3,099 $ 255 $ 6,696 $ 255
Reinsurance recoveries $ 3,130 $ (118) $ 4,024 $ (499)
8. Notes Payable
On June 21, 2005, our newly formed trust subsidiary completed a private
placement of $30.0 million of 30-year floating rate trust preferred
securities. Simultaneously, we borrowed $30.9 million from the trust
subsidiary and contributed $30.0 million to AHIC in order to increase
policyholder surplus. The note bears an initial interest rate of 7.725%
until June 15, 2015, at which time interest will adjust quarterly to the
three month LIBOR rate plus 3.25 percentage points. As of September 30,
2006, the note balance was $30.9 million.
On January 27, 2006, we borrowed $15.0 million under our revolving
credit facility to fund the cash required to close the acquisition of the
subsidiaries comprising our TGA Operating Unit. As of September 30, 2006,
the balance on the revolving note was $15.0 million. (See Note 3, "Business
Combinations" and Note 12, "Credit Facilities.") In October 2006, we repaid
$12.2 million of the principal balance of this note from the proceeds
received from our public equity offering. (See Note 16, "Subsequent Event.")
Also included in notes payable is $2.6 million outstanding under PAAC's
revolving credit facility, which currently bears 8.25% interest. (See Note
12, "Credit Facilities").
9. Note Payable to Related Party
On January 3, 2006, we executed a promissory note payable to Newcastle
Partners, L.P. in the amount of $12.5 million in order to obtain funding to
complete the acquisition of the subsidiaries comprising our Aerospace
Operating Unit. The promissory note bears interest at the rate of 10% per
annum. The principal of the promissory note, together with accrued and
unpaid interest, became due and payable on demand as of June 30, 2006. As
of September 30, 2006 the promissory note balance was $12.5 million. We
repaid this note in October 2006 from the proceeds received from our public
equity offering. (See Note 16, "Subsequent Event.")
10. Convertible Notes Payable
On January 27, 2006, we issued $25.0 million in subordinated
convertible promissory notes to Newcastle Special Opportunity Fund I, L.P.
and Newcastle Special Opportunity Fund II, L.P., which are investment
partnerships managed by an entity controlled by Mark E. Schwarz, our
Executive Chairman. Each convertible note bore interest at 4% per annum,
which rate increased to 10% per annum in the event of default. Interest was
payable quarterly in arrears commencing March 31, 2006. Principal and all
accrued but unpaid interest was due at maturity on July 27, 2007. The
principal and accrued interest on the convertible notes was converted to
approximately 3.3 million shares of our common stock during the second
quarter of 2006.
In accordance with the FASB Emerging Issues Task Force ("EITF") Issue
No. 98-5 "Accounting for Convertible Securities with Beneficial Conversion
Features or Contingently Adjustable Conversion Ratios" and EITF Issue No.
00-27 "Application of Issue No. 98-5 to Certain Convertible Instruments,"
the convertible notes contained a beneficial conversion feature requiring a
discount to the carrying amount of the notes equal to (i) the difference
between the stated conversion rate and the market price of our common stock
on the date of issuance, multiplied by (ii) the number of shares into which
the notes were convertible. Per EITF Issue No. 98-5 and EITF Issue No. 00-
27, upon issuance we recorded a $9.6 million discount to the convertible
notes which was amortized straight line as interest expense over the term of
the convertible notes, with the unamortized balance of the discount expensed
upon conversion of the notes in the second quarter of 2006. The discount to
the convertible notes was offset by increases to deferred federal income
taxes and additional paid in capital. The discount on the convertible notes
had no ultimate effect on our book value.
Interest expense resulting from amortization of the discount on the
convertible notes during the first nine months of 2006 was $9.6 million.
This interest expense had the effect of reducing our operating income for
the period, but had no effect on our cash flow.
11. Structured Settlements
In connection with the acquisition of the subsidiaries comprising our
TGA Operating Unit, we recorded a payable for the future guaranteed payments
of $25.0 million discounted at 4.4%, the rate of two-year U.S. Treasuries
(the only investment permitted on the trust account securing such future
payments and which is classified in restricted cash and investments on our
balance sheet). (See Note 3, "Business Combinations.") As of September 30,
2006, the balance of the structured settlements was $24.3 million.
12. Credit Facilities
On June 29, 2005, we entered into a credit facility with The Frost
National Bank. The credit facility was amended and restated on January 27,
2006 to a $20.0 million revolving credit facility, with a $5.0 million
letter of credit sub-facility. We borrowed $15.0 million under the
revolving credit facility to fund the cash required to close the acquisition
of the subsidiaries comprising our TGA Operating Unit. Principal
outstanding under the revolving credit facility generally bears interest at
the three month Eurodollar rate plus 2.00%, payable quarterly in arrears.
We pay letter of credit fees at the rate of 1.00% per annum. Our
obligations under the revolving credit facility are secured by a security
interest in the capital stock of all of our subsidiaries, guaranties of all
of our subsidiaries and the pledge of substantially all of our assets. The
revolving credit facility contains covenants which, among other things,
require us to maintain certain financial and operating ratios and restrict
certain distributions, transactions and organizational changes. The amended
and restated credit agreement terminates on January 27, 2008. As of
September 30, 2006, there was $15.0 million outstanding under our revolving
credit facility, and we were in compliance with all of our covenants. In
October 2006, we repaid $12.2 million of the outstanding principal balance
under our revolving credit facility with proceeds received from our public
equity offering. (See Note 16, "Subsequent Event.") In the third quarter of
2005, we issued a $4.0 million letter of credit under this facility to
collateralize certain obligations under the agency agreement between our HGA
Operating Unit and Clarendon National Insurance Company effective July 1,
2004.
PAAC has a $5.0 million revolving credit facility with JPMorgan Chase
Bank which terminates June 30, 2007. Principal outstanding under this
revolving credit facility generally bears interest at 1% above the prime
rate. PAAC's obligations under this revolving credit facility are secured
by its premium finance notes receivables. This revolving credit facility
contains various restrictive covenants which, among other things, require
PAAC to maintain minimum amounts of tangible net worth and working capital.
As of September 30, 2006, $2.6 million was outstanding under this revolving
credit facility and PAAC was in compliance with or had obtained waivers of
all of its covenants.
13. Deferred Policy Acquisition Costs
The following table shows total deferred and amortized policy
acquisition costs by period (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
------------------- -------------------
2006 2005 2006 2005
------- ------- ------- -------
Deferred $(10,709) $(14,252) $(28,299) $(25,877)
Amortized 8,531 8,751 22,721 19,747
------- ------- ------- -------
Net $ (2,178) $ (5,501) $ (5,578) $ (6,130)
======= ======= ======= =======
14. Earnings per Share
The following table sets forth basic and diluted weighted average
shares outstanding for the periods indicated (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
------------------- -------------------
2006 2005 2006 2005
------------------- -------------------
Weighted average shares - basic 17,760 14,474 16,019 10,841
Effect of dilutive securities 26 104 19 100
------------------- -------------------
Weighted average shares -
assuming dilution 17,786 14,578 16,038 10,941
=================== ===================
For the three and nine months ended September 30, 2006, 109,166 shares
attributable to outstanding stock options were excluded from the calculation
of diluted earnings per share because the exercise prices of the stock
options were greater than the average price of the common shares and,
therefore, their inclusion would have been anti-dilutive. For the three
months and nine months ended September 30, 2005, no shares attributable to
outstanding stock options were excluded from the calculation of diluted
earnings per share.
15. Net Periodic Pension Cost
The following table details the net periodic pension cost incurred by
period (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
------------------- -------------------
2006 2005 2006 2005
------------------- -------------------
Interest cost $ 172 $ 181 $ 515 $ 544
Amortization of net loss 40 19 121 57
Expected return on plan assets (157) (184) (472) (552)
------------------- -------------------
Net periodic pension cost $ 55 $ 16 $ 164 $ 49
=================== ===================
We contributed $0.2 million and $49 thousand to our frozen defined
benefit cash balance plan during the three months ended September 30, 2006
and 2005, respectively, and contributed $0.3 million and $0.1 million during
the nine months ended September 30, 2006 and 2005, respectively. Refer to
Note 13 of our Form 10-K for the year ended December 31, 2005 for more
discussion of our retirement plans.
16. Subsequent Event
In October 2006, we completed a public offering of 3.0 million shares
of our common stock for $9.00 per share. We have used all of the net
proceeds to (1) pay off the $12.5 million principal balance of the related
party note to Newcastle Partners, L.P., and (2) pay $12.2 million of the
outstanding principal balance of our revolving line of credit with Frost
Bank. (See Note 8, "Notes Payable," Note 9, "Notes Payable to Related Party"
and Note 12, "Credit Facilities.")
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.
Introduction
Hallmark Financial Services, Inc. ("Hallmark" and, together with
subsidiaries, "we", "us", "our") is an insurance holding company which,
through its subsidiaries, engages in the sale of property/casualty insurance
products to businesses and individuals. Our business involves marketing,
distributing, underwriting and servicing commercial insurance in Texas, New
Mexico, Idaho, Oregon, Montana, Louisiana, Oklahoma and Washington;
marketing, distributing, underwriting and servicing non-standard personal
automobile insurance in Texas, New Mexico, Arizona, Oklahoma and Idaho;
marketing, distributing, underwriting and servicing general aviation
insurance in 48 states; and providing other insurance related services. We
pursue our business activities through subsidiaries whose operations are
organized into producing units and are supported by our insurance company
subsidiaries.
Our non-carrier insurance activities are organized by producing units
into the following operational segments:
* HGA Operating Unit. Our HGA Operating Unit includes the standard lines
commercial property/casualty insurance products and services handled by
our Hallmark General Agency, Inc. and Effective Claims Management, Inc.
subsidiaries.
* TGA Operating Unit. Our TGA Operating Unit includes the excess
and surplus lines commercial property/casualty insurance products
and services handled by our Texas General Agency, Inc., Pan
American Acceptance Corporation ("PAAC") and TGA Special Risk, Inc.
subsidiaries. Our TGA Operating Unit also includes a relatively small
amount of personal lines insurance handled by these subsidiaries. The
subsidiaries comprising our TGA Operating Unit were acquired effective
January 1, 2006.
* Phoenix Operating Unit. Our Phoenix Operating Unit includes the non-
standard personal automobile insurance products and services handled by
American Hallmark General Agency, Inc. and Hallmark Claims Services,
Inc., both of which do business as Phoenix General Agency.
* Aerospace Operating Unit. Our Aerospace Operating Unit includes
the general aviation insurance products and services handled by our
Aerospace Insurance Managers, Inc., Aerospace Special Risk, Inc. and
Aerospace Claims Management Group, Inc. subsidiaries. The subsidiaries
comprising our Aerospace Operating Unit were acquired effective January
1, 2006.
The retained premium produced by these producing units is supported by the
following insurance company subsidiaries:
* American Hallmark Insurance Company of Texas ("AHIC") presently retains
all of the risks on the commercial property/casualty policies marketed
by our HGA Operating Unit and assumes a portion of the risks on the
commercial property/casualty policies marketed by our TGA Operating
Unit.
* Gulf States Insurance Company ("GSIC"), which was acquired effective
January 1, 2006, presently assumes a portion of the risks on the
commercial property/casualty policies marketed by our TGA Operating
Unit.
* Phoenix Indemnity Insurance Company ("PIIC") presently assumes all of
the risks on the non-standard personal automobile policies marketed by
our Phoenix Operating Unit and assumes a portion of the risks on the
aviation property/casualty products marketed by our Aerospace Operating
Unit.
Effective January 1, 2006, our insurance company subsidiaries entered
into a pooling arrangement pursuant to which AHIC retains 59.9% of the total
net premiums written by all of our operating units, PIIC retains 34.1% of
our total net premiums written and GSIC retains 6.0% of our total net
premiums written.
Prior to January 1, 2006, our HGA Operating Unit was referred to as our
Commercial Insurance Operation and our Phoenix Operating Unit was referred
to as our Personal Insurance Operation. The retained premium produced by
our operating units was supported by our AHIC and PIIC insurance
subsidiaries. Discussions for periods prior to January 1, 2006 do not
include the operations of our TGA Operating Unit or our Aerospace Operating
Unit, each of which was acquired effective January 1, 2006. All share and
per share amounts have been adjusted to reflect a one-for-six reverse split
of all issued and unissued shares of our authorized common stock effected
July 31, 2006.
Results of Operations
Management Overview. During the three months and nine months ended
September 30, 2006, our total revenues were $56.4 million and $148.1
million, respectively, representing a 124.0% and 145.2% increase,
respectively, over the $25.2 million and $60.4 million in total revenues for
the comparable periods of 2005. The acquisitions of the TGA Operating Unit
and the Aerospace Operating Unit in the first quarter of 2006 contributed
$22.9 million and $56.0 million to the increase in total revenues for the
three months and nine months ended September 30, 2006, respectively, as
compared to the same periods in 2005. The following table provides
additional information concerning the increases in revenue contributed by
these acquisitions (in thousands):
Three Months Nine Months
Ended Ended
Sept. 30, 2006 Sept. 30, 2006
-------------- --------------
Third party commission revenue $ 9,737 $ 29,692
Earned premium on retained business 11,774 23,162
Investment income, finance charges
and other revenue items 1,378 3,149
--------- ---------
Revenue contributions from acquisitions $ 22,889 $ 56,003
========= =========
The retention of business produced by the HGA Operating Unit that was
previously retained by third parties also contributed $9.1 million and $40.3
million to the increase in revenue for the three months and nine months
ended September 30, 2006, respectively. Increased finance charge revenue of
$0.1 million also contributed to the increased revenues for the nine months
ended September 30, 2006. These increases were partially offset by lower
ceding commission revenue of $2.4 million and $10.0 million and lower
processing and services fees of $0.6 million and $2.1 million for the three
and nine months ended September 30, 2006, respectively, attributable to the
shift from a third-party agency structure to an insurance underwriting
structure. Earned premiums from our Phoenix Operating Unit contributed $2.3
million and $2.7 million to the increase in revenue for the three and nine
months ended September 30, 2006, respectively, as well as increased finance
charge revenue of $0.1 million and $0.2 million for the three and
nine months ended September 30, 2006, respectively. These increases were
partially offset by lower ceding commission revenue of $0.5 million and $1.0
million and lower processing and service fees of $0.1 million and $0.3
million for the three and nine months ended September 30, 2006,
respectively. The investment of funds derived from the implementation of
our 2005 capital plan contributed another $0.5 million and $3.4 million
to revenue for the three and nine months ended September 30, 2006,
respectively. These increases were partially offset by other-than-temporary
impairment charges on our equity investment portfolio of $1.2 million for
the nine months ended September 30, 2006 and increased net realized losses
on our investment portfolio of $0.1 million and $0.4 million for the three
and nine months ended September 30, 2006.
We reported net income of $4.9 million and $4.5 million for the three
months and nine months ended September 30, 2006, respectively, as compared
to net income of $2.5 million and $6.3 million in the same periods in the
prior year. On a diluted per share basis, net income was $0.27 and $0.28
for the three months and nine months ended September 30, 2006, respectively,
as compared to $0.17 and $0.58 for the same periods in 2005. During the
nine months ended September 30, 2006, we recorded $9.6 million of interest
expense from amortization attributable to the deemed discount on convertible
promissory notes issued in January, 2006 and converted to common stock
during the second quarter of 2006. (See Note 10, "Convertible Notes
Payable.") In the absence of this non-cash expense, our net income for the
nine months ended September 30, 2006 would have been $10.5 million,
representing a 67.3% increase over the similar period of 2005. The
following is a reconciliation of our net income without such interest
expense to our reported results (in thousands). Management believes this
reconciliation provides useful supplemental information in evaluating the
operating results of our business. This disclosure should not be viewed as
a substitute for net income determined in accordance with GAAP:
Three Months Nine Months
Ended Ended
Sept. 30, 2006 Sept. 30, 2006
-------------- --------------
Income excluding interest expense from
amortization of discount, net of tax $ 4,877 $ 10,527
------------- -------------
Interest expense from amortization
of discount - 9,625
Less related tax effect - (3,559)
------------- -------------
- 6,066
------------- -------------
Net income $ 4,877 $ 4,461
============= =============
Excluding the interest expense from amortization of discount, the
increase in net income for the three and nine months ended September 30,
2006 versus the same periods in 2005 was primarily attributable to the
results of our newly acquired TGA and Aerospace Operating Units, the
retention of business produced by our HGA Operating Unit beginning in the
third quarter of 2005, and additional investment income. These increases
were partially offset by additional income tax due to higher taxable income
and an increase in our federal statutory rate from 34% to 35% in 2006,
other-than-temporary impairments realized in the second quarter of 2006 on
our investment portfolio, additional interest expense on borrowings to
finance the acquisitions of our TGA Operating Unit and Aerospace Operating
Unit, lower results from our Phoenix Operating Unit due primarily to
favorable prior accident year loss development recognized in 2005 and the
runoff of third party revenue recognized in 2005 from assuming 100% of the
Texas non-standard auto business beginning in the fourth quarter of 2004,
and increased corporate operating expenses.
Our effective tax rates for the three months and nine months ended
September 30, 2006 were 36.1% and 39.5%, respectively, as compared to 32.3%
and 32.8% for the similar periods of 2005. The increase in our effective
tax rates was the combined result of the increase in our federal statutory
rate attributable to higher taxable income and an increase in the valuation
allowance on our deferred tax assets. During the third quarter of 2006, we
realized a $1.1 million loss from the sale of an equity investment for which
we had recognized an other-than-temporary impairment during the previous
quarter. We increased our deferred tax asset valuation allowance by $0.3
million to reflect the uncertainty of future capital gains which this
capital loss could be used to offset.
Third Quarter 2006 as Compared to Third Quarter 2005
The following is additional business segment information for the three
months ended September 30, 2006 and 2005 (in thousands):
Three Months Ended September 30, 2006
----------------------------------------------------------------------
HGA TGA Phoenix Aerospace Corporate Consolidated
-------- -------- -------- --------- --------- ------------
Produced premium $ 22,206 $ 34,825 $ 12,278 $ 6,495 $ - $ 75,804
-------- -------- -------- -------- -------- --------
Gross premiums written 21,967 17,269 12,278 6,593 - 58,107
Ceded premiums written (2,270) (747) - (85) - (3,102)
-------- -------- -------- -------- -------- --------
Net premiums written 19,697 16,522 12,278 6,508 - 55,005
Change in unearned premiums (497) (5,764) (1,058) (5,492) (12,811)
-------- -------- -------- -------- -------- --------
Net premiums earned 19,200 10,758 11,220 1,016 - 42,194
Total revenues 20,964 19,403 12,257 3,486 255 56,365
Loss and loss adjustment expenses 9,347 6,863 6,800 587 (8) 23,589
Pre-tax income $ 5,112 $ 1,998 $ 2,316 $ 869 $ (2,663) $ 7,632
-------- -------- -------- -------- -------- --------
Net loss ratio (1) 48.7% 63.8% 60.6% 57.8% 55.9%
Net expense ratio (1) 28.9% 29.1% 28.9% 35.1% 29.1%
-------- -------- -------- -------- --------
Net combined ratio 77.6% 92.9% 89.5% 92.9% 85.0%
======== ======== ======== ======== ========
Three Months Ended September 30, 2005
----------------------------------------------------------------------
HGA TGA Phoenix Aerospace Corporate Consolidated
-------- -------- -------- --------- --------- ------------
Produced premium $ 19,662 $ - $ 8,643 $ - $ - $ 28,305
-------- -------- -------- -------- -------- --------
Gross premiums written 34,869 - 8,643 - - 43,512
Ceded premiums written (552) - - - - (552)
-------- -------- -------- -------- -------- --------
Net premiums written 34,317 - 8,643 - - 42,960
Change in unearned premiums (24,250) - 314 - (23,936)
-------- -------- -------- -------- -------- --------
Net premiums earned 10,067 - 8,957 - - 19,024
Total revenues 14,339 - 10,814 - 14 25,167
Loss and loss adjustment expenses 5,630 - 5,429 - (16) 11,043
Pre-tax income $ 2,196 $ - $ 2,790 $ - $ (1,335) $ 3,651
-------- -------- -------- -------- -------- --------
Net loss ratio (1) 55.9% 60.6% 58.0%
Net expense ratio (1) 37.5% 33.5% 35.6%
-------- -------- --------
Net combined ratio 93.4% 94.1% 93.6%
======== ======== ========
(1) The net loss ratio is calculated as incurred loss and loss adjustment
expenses divided by net premiums earned, each determined in accordance with
GAAP. The net expense ratio is calculated as total underwriting expenses,
including allocated overhead expenses, of our insurance company subsidiaries
divided by net premiums earned, each determined in accordance with GAAP.
HGA Operating Unit
Beginning in the third quarter of 2005, our HGA Operating Unit began
retaining written premium through AHIC that was previously retained by third
parties. On July 1, 2005, our HGA Operating Unit assumed $20.1 million of
in-force policies it had previously produced for Clarendon National
Insurance Company which resulted in the written premium for third quarter
2005 being larger than third quarter 2006. This was partially offset by
increased retained written premium that was produced in the third quarter of
2006 over the retained written premium produced in the third quarter of
2005.
Total revenue for the HGA Operating Unit of $21.0 million for the third
quarter of 2006 was $6.6 million more than the $14.3 million reported in the
third quarter of 2005. This 46.2% increase in total revenue was primarily
due to increased net premiums earned of $9.1 million for the quarter.
Increased net investment income contributed an additional $0.4 million to
the increase in revenue for the quarter. These increases in revenue were
partially offset by lower ceding commission revenue of $2.4 million and
lower processing and service fees of $0.6 million, in both cases due to the
shift from a third party agency structure to an insurance underwriting
structure.
Pre-tax income for our HGA Operating Unit of $5.1 million for the third
quarter of 2006 increased $2.9 million, or 132.8%, over the $2.2 million
reported for the third quarter of 2005. Increased revenue, as discussed
above, was the primary reason for the increase in pre-tax income, partially
offset by increased loss and loss adjustment expenses of $3.7 million. The
HGA Operating Unit reported a net loss ratio of 48.7% for the third quarter
of 2006 as compared to a net loss ratio of 55.9% for the same period the
prior year. The loss ratios gross of reinsurance were 58.2% and 54.6% for
the third quarter of 2006 and 2005, respectively. The increase in the gross
loss ratio was due to four large property losses that penetrated our
reinsurance coverages. Partially offsetting the increase in the loss ratio
gross of reinsurance was $0.5 million of favorable reserve development on
prior accident years during the third quarter of 2006. There was no prior
year reserve development in 2005 as we began retaining this business during
the third quarter of 2005. The HGA Operating Unit reported net expense
ratios of 28.9% and 37.5% for the third quarters of 2006 and 2005,
respectively. The net expense ratio for the third quarter of 2005 was
higher due to costs to assume from Clarendon National Insurance Company the
unearned premium produced by our HGA Operating Unit.
TGA Operating Unit
The subsidiaries comprising our TGA Operating Unit were all acquired
effective January 1, 2006. The $19.4 million of revenues was derived mostly
from third party commission revenue of $7.7 million on the portion of
business produced by the TGA Operating Unit that was retained by third
parties and from $10.8 million of earned premium on produced business that
was assumed by GSIC or AHIC. The remaining $0.9 million of revenue was
primarily derived from investment income and finance charges.
Pre-tax income for our TGA Operating Unit of $2.0 million was due
primarily to revenue as discussed above less (i) incurred loss and loss
adjustment expenses of $6.9 million on the portion of the business assumed
by GSIC or AHIC, (ii) $10.0 million in operating expenses, comprised mostly
of commission expense and salary related expenses, and (iii) $0.5 million of
amortization of intangible assets acquired in the acquisition of the
subsidiaries comprising our TGA Operating Unit. The TGA Operating Unit
reported a net loss ratio of 63.8% and a net expense ratio of 29.1% for the
third quarter of 2006. We do not have comparable loss or expense ratios for
the same period in 2005 as we acquired the subsidiaries comprising the TGA
Operating Unit effective January 1, 2006.
Phoenix Operating Unit
Net premium written for our Phoenix Operating Unit increased $3.6
million during the third quarter of 2006 to $12.3 million compared to $8.6
million in the third quarter of 2005. The increase in premium is due mostly
to premium from new states that our Phoenix Operating Unit expanded into
this year.
Total revenue for the Phoenix Operating Unit increased 13.3% to $12.3
million for the third quarter of 2006 from $10.8 million for the same period
in 2005. Higher earned premium of $2.3 million was partially offset by
lower third party commission revenue of $0.5 million and lower service fee
revenue of $0.1 million recognized in the third quarter of 2006 due to the
100% assumption of the Texas non-standard personal automobile premium
beginning late in 2004. Lower investment income of $0.3 million also
partially offset the increase in earned premium.
Pre-tax income for the Phoenix Operating Unit decreased $0.5 million,
or 17.0%, for the third quarter of 2006 compared to the third quarter of
2005. The primary reason for the decline in pre-tax income for the quarter
was the runoff of third party revenue recognized in 2005 from assuming 100%
of the Texas non-standard auto business beginning in the fourth quarter of
2004 of $0.6 million, as well as lower investment income of $0.3 million.
This was partially offset by additional underwriting margin of $0.4 million
realized on the increased earned premium. The Phoenix Operating Unit
reported net loss ratio of 60.6% for the third quarters of 2006 and 2005 and
net expense ratios of 28.9% and 33.5% for the third quarters of 2006
and 2005, respectively. The third quarter 2006 loss and loss adjustment
expenses included $0.7 million of favorable reserve development from prior
accident years as compared to $0.2 million of favorable development
recognized in the third quarter of 2005.
Aerospace Operating Unit
The subsidiaries comprising our Aerospace Operating Unit were all
acquired effective January 1, 2006. The $3.5 million of revenues was
derived primarily from third party commission revenue of $2.1 million on the
portion of business retained by third parties and from $1.0 million of
earned premium on produced business that was retained by Hallmark. We began
retaining 100% of this business beginning July 1, 2006. The remaining
revenue was derived primarily from investment income.
Pre-tax income for the Aerospace Operating Unit of $0.9 million for the
third quarter of 2006 was due to revenue discussed above less (i) incurred
loss and loss adjustment expenses of $0.6 million on the portion of the
business assumed by PIIC or AHIC, (ii) $1.9 million in operating expenses,
comprised mostly of commission expense and salary related expenses, and
(iii) $0.1 million of amortization of intangible assets acquired in the
acquisition of the subsidiaries comprising our Aerospace Operating Unit.
The Aerospace Operating Unit reported a net loss ratio of 57.8% and a net
expense ratio of 35.1% for the third quarter of 2006. The net expense ratio
includes $16 thousand of costs to license PIIC for aviation insurance in
various states where the Aerospace Operating Unit produces business. These
costs are not directly attributable to producing the premium that was earned
during the period. Excluding these costs, the net expense ratio was 33.6%.
We do not have comparable loss or expense ratios for the same period in
2005 as we acquired the subsidiaries comprising the Aerospace Operating Unit
effective January 1, 2006.
Corporate
Corporate revenue increased $0.2 million for the third quarter of 2006
as compared to the same period in 2005. The increase was primarily due to
$0.3 million in interest earned on a trust account established in the first
quarter of 2006 securing the guaranteed future payments to the sellers of
the subsidiaries now comprising our TGA Operating Unit. (See Note 3,
"Business Combinations" and Note 11, "Structured Settlements.")
Corporate pre-tax loss was $2.7 million for the third quarter of 2006
as compared to $1.3 million for the same period in 2005. The increased loss
was primarily due to additional interest expense of $0.9 million in the
third quarter of 2006 comprised of: (i) $0.3 million from the related party
promissory note issued in January 2006 (see Note 9, "Note Payable to Related
Party"); (ii) $0.3 million of amortization of the discount on the future
guaranteed payments to the sellers of the subsidiaries now comprising the
TGA Operating Unit (see Note 11, "Structured Settlements"); and (iii) $0.3
million from borrowings under our revolving credit facility in January 2006
(see Note 8, "Notes Payable" and Note 12, "Credit Facilities"). Also
contributing to the increase in pre-tax loss was increased salary and
related expenses of $0.4 million and travel expenses of $0.2 million. These
were partially offset by the increased investment income discussed above.
Year-to-Date 2006 as Compared to Year-to-Date 2005
The following is additional business segment information for the nine
months ended September 30, 2006 and 2005 (in thousands):
Nine Months Ended September 30, 2006
----------------------------------------------------------------------
HGA TGA Phoenix Aerospace Corporate Consolidated
-------- -------- -------- --------- --------- ------------
Produced premium $ 69,357 $ 93,254 $ 34,116 $ 22,356 $ - $ 219,083
-------- -------- -------- -------- -------- --------
Gross premiums written 68,884 43,773 34,116 6,945 - 153,718
Ceded premiums written (6,122) (1,309) - (111) - (7,542)
-------- -------- -------- -------- -------- --------
Net premiums written 62,762 42,464 34,116 6,834 - 146,176
Change in unearned premiums (12,396) (20,662) (2,757) (5,474) (41,289)
-------- -------- -------- -------- -------- --------
Net premiums earned 50,366 21,802 31,359 1,360 - 104,887
Total revenues 57,768 48,686 34,944 7,317 (643) 148,072
Loss and loss adjustment expenses 27,165 13,186 19,369 783 (25) 60,478
Pre-tax income $ 11,245 $ 7,152 $ 6,760 $ 773 $ (18,551) $ 7,379
-------- -------- -------- -------- -------- --------
Net loss ratio (1) 53.9% 60.5% 61.8% 57.6% 57.7%
Net expense ratio (1) 30.1% 30.6% 30.4% 38.1% 30.4%
-------- -------- -------- -------- --------
Net combined ratio 84.0% 91.1% 92.2% 95.7% 88.1%
======== ======== ======== ======== ========
Nine Months Ended September 30, 2005
----------------------------------------------------------------------
HGA TGA Phoenix Aerospace Corporate Consolidated
-------- -------- -------- --------- --------- ------------
Produced premium $ 62,209 $ - $ 28,008 $ - $ - $ 90,217
-------- -------- -------- -------- -------- --------
Gross premiums written 34,869 - 28,116 - - 62,985
Ceded premiums written (552) - - - - (552)
-------- -------- -------- -------- -------- --------
Net premiums written 34,317 - 28,116 - - 62,433
Change in unearned premiums (24,250) - 544 - - (23,706)
-------- -------- -------- -------- -------- --------
Net premiums earned 10,067 - 28,660 - - 38,727
Total revenues 27,194 - 33,169 - 34 60,397
Loss and loss adjustment expenses 5,631 - 17,002 - (49) 22,584
Pre-tax income $ 4,761 $ - $ 7,666 $ - $ (3,061) $ 9,366
-------- -------- -------- -------- -------- --------
Net loss ratio (1) 55.9% 59.3% 58.3%
Net expense ratio (1) 37.5% 32.8% 34.0%
-------- -------- --------
Net combined ratio 93.4% 92.1% 92.3%
======== ======== ========
(1) The net loss ratio is calculated as incurred loss and loss adjustment
expenses divided by net premiums earned, each determined in accordance with
GAAP. The net expense ratio is calculated as total underwriting expenses,
including allocated overhead expenses, of our insurance company subsidiaries
divided by net premiums earned, each determined in accordance with GAAP.
HGA Operating Unit
Beginning in the third quarter of 2005, our HGA Operating Unit began
retaining written premium through AHIC that was previously retained by third
parties. However, on July 1, 2005, our HGA Operating Unit assumed $20.1
million of in-force policies it had previously produced for Clarendon
National Insurance Company. The net effect of these changes was an in
increase in net written premium for the HGA Operating Unit of $28.4 million
for the nine months ended September 30, 2006 over the same period in 2005.
Total revenue for our HGA Operating Unit of $57.8 million for the first
nine months of 2006 was $30.6 million more than the $27.2 million reported
in the same period of 2005. This 112.4% increase in total revenue was
primarily due to an increase of $40.3 million in net premiums earned.
Increased net investment income contributed an additional $2.3 million to
the increase in revenue for the nine months ended September 30, 2006. These
increases in revenue were partially offset by lower ceding commission
revenue of $10.0 million and lower processing and service fees of $2.1
million, in both cases due to the shift from a third party agency structure
to an insurance underwriting structure.
Pre-tax income for our HGA Operating Unit of $11.2 million for the
first nine months of 2006 increased $6.5 million, or 136.2%, over the $4.8
million reported for the first nine months of 2005. Increased revenue, as
discussed above, was the primary reason for the increase in pre-tax income,
partially offset by increased loss and loss adjustment expenses of $21.5
million and additional operating expenses, mostly due to increased premium
production, of $2.6 million. The HGA Operating Unit reported a net loss
ratio of 53.9% for the first nine months of 2006 as compared to a net loss
ratio of 55.9% for the same period the prior year. The loss ratios gross of
reinsurance were 55.6% and 54.6% for the first nine months of 2006 and 2005,
respectively. The increase in the gross loss ratio was due to four large
property losses that penetrated our reinsurance coverages. Partially
offsetting the increase in the loss ratio gross of reinsurance was $0.8
million of favorable reserve development from prior accident years
recognized during the first nine months of 2006. There was no prior year
reserve development recognized during the first nine months of 2005 as we
began retaining this business during the third quarter of 2005. The HGA
Operating Unit reported net expense ratios of 30.1% and 37.5% for the nine
months ended September 30, 2006 and 2005, respectively. The net expense
ratio for the nine months ended September 30, 2005 is higher due to costs to
assume from Clarendon National Insurance Company the unearned premium
produced by our HGA Operating Unit.
TGA Operating Unit
The subsidiaries comprising our TGA Operating Unit were all acquired
effective January 1, 2006. The $48.7 million of revenues was derived mostly
from third party commission revenue of $24.3 million on the portion of
business produced by our TGA Operating Unit that was retained by third
parties and from $21.8 million of earned premium on produced business that
was assumed by GSIC or AHIC. The remaining $2.6 million of revenue was
primarily derived from investment income and finance charges.
Pre-tax income for the TGA Operating Unit of $7.2 million was primarily
due to revenue as discussed above less: (i) incurred loss and loss
adjustment expenses of $13.2 million on the portion of the business assumed
by GSIC or AHIC; (ii) $26.7 million in operating expenses, comprised mostly
of commission expense and salary related expenses; (iii) $0.2 million in
interest expense, and (iv) $1.4 million of amortization of intangible assets
acquired in the acquisition of the subsidiaries comprising our TGA Operating
Unit. The TGA Operating Unit reported a net loss ratio of 60.5% and a net
expense ratio of 30.6% for the nine months ended September 30, 2006. We do
not have comparable loss and expense ratios for the same period in 2005 as
we acquired the subsidiaries comprising the TGA Operating Unit effective
January 1, 2006.
Phoenix Operating Unit
Net premium written for our Phoenix Operating Unit increased $6.0
million during the first nine months of 2006 to $34.1 million compared to
$28.1 million in the first nine months of 2005. The increase in premium was
due mostly to premium from new states that our Phoenix Operating Unit
expanded into this year.
Revenue for the Phoenix Operating Unit increased 5.4% to $34.9 million
for the first nine months of 2006 from $33.2 million for the same period in
2005. Higher earned premium of $2.7 million and higher investment income of
$0.3 million was partially offset by lower ceding commission revenue of $1.0
million and lower processing and lower service fees of $0.3 million due to
the 100% assumption of the Texas non-standard automobile premium beginning
late in 2004.
Pre-tax income for the Phoenix Operating Unit decreased $0.9 million,
or 11.8%, for the first nine months of 2006 compared to the first nine
months of 2005. The primary reason for the decline in pre-tax income for
the first nine months of 2006 was increased losses and loss adjustment
expenses of $2.4 million as evidenced by an increase in the net loss ratio
to 61.8% versus 59.3% reported in the first nine months of 2005. A
competitive pricing environment with a bias towards decreasing rates, as
well as favorable reserve development of $1.2 million recognized during the
first nine months of 2005 as compared to $0.7 million recognized during the
first nine months of 2006, were the primary reasons for the increase in the
loss ratio. The increase in losses and loss adjustment expenses was
partially offset by the increase in revenue discussed above. The Phoenix
Operating Unit reported net expense ratios of 30.4% and 32.8% for the nine
months ended September 30, 2006 and 2005, respectively.
Aerospace Operating Unit
The subsidiaries comprising our Aerospace Operating Unit were all
acquired effective January 1, 2006. The $7.3 million of revenues was
derived primarily from third party commission revenue of $5.4 million on the
portion of business retained by third parties and from $1.4 million of
earned premium on produced business that was retained by Hallmark. We began
retaining 100% of this business beginning July 1, 2006. The remaining
revenue was derived $0.4 million from investment income and $0.1 million
from third party processing and service fees.
Pre-tax income for our Aerospace Operating Unit of $0.8 million for the
first nine months of 2006 was due to revenue discussed above less: (i)
operating expenses of $5.5 million, comprised mostly of commission expense
and salary related expenses; (ii) loss and loss adjustment expenses of
$0.8 million; and (iii) $0.2 million of amortization of intangible assets
acquired in the acquisition of the subsidiaries now comprising our Aerospace
Operating Unit. The Aerospace Operating Unit reported a net loss ratio of
57.6% and a net expense ratio of 38.1% for the first nine months of 2006.
The net expense ratio includes $57 thousand of costs to license PIIC for
aviation insurance in various states where the Aerospace Operating Unit
produces business. These costs were not directly attributable to producing
the premium that was earned during the period. Excluding these costs, the
expense ratio was 34.0%. We do not have comparable loss or expense ratios
for the same period in 2005 as we acquired the subsidiaries comprising the
Aerospace Operating Unit effective January 1, 2006.
Corporate
Corporate revenue decreased $0.7 million for the first nine months of
2006 as compared to the same period in 2005. The decrease was primarily due
to $1.2 million in other-than-temporary impairment charges on our equity
investment portfolio. This was partially offset by $0.8 million in interest
earned on a trust account established in the first quarter of 2006 securing
the guaranteed future payments to the sellers of the subsidiaries now
comprising our TGA Operating Unit. (See Note 3, "Business Combinations" and
Note 11, "Structured Settlements.")
Corporate pre-tax loss was $18.6 million for the first nine months of
2006 as compared to $3.1 million for the same period in 2005. The increased
loss was primarily due to decreased revenue and $9.6 million in interest
expense from amortization attributable to the deemed discount on convertible
promissory notes issued in January, 2006. (See Note 10, "Convertible Notes
Payable.") This interest expense had no impact on our cash flow or our book
value. Also contributing to the increased corporate pre-tax loss was
additional interest expense of $3.9 million in the first nine months of 2006
comprised of: (i) $1.1 million from the trust preferred securities issued in
the second quarter of 2005 (see Note 8, "Notes Payable"); (ii) $0.9 million
from the related party promissory note issued in January 2006 (see Note 9,
"Note Payable to Related Party"); (iii) $0.8 million of amortization of the
discount on the future guaranteed payments to the sellers of the
subsidiaries now comprising our TGA Operating Unit (see Note 11, "Structured
Settlements"); (iv) $0.8 million from borrowings under our revolving credit
facility in January 2006 (see Note 8, "Notes Payable" and Note 12, "Credit
Facilities"); and (v) $0.3 million from the issuance of convertible notes
issued in January 2006 (see Note 10, "Convertible Notes Payable"). Also
contributing to the increase in pre-tax loss was increased salary and
related expenses of $0.7 million, travel expenses of $0.2 million,
professional services of $0.2 million, and director fees of $0.1 million.
Financial Condition and Liquidity
Sources and Uses of Funds
Our sources of funds are from insurance-related operations, financing
activities and investing activities. Major sources of funds from operations
include premiums collected (net of policy cancellations and premiums ceded),
commissions, and processing and service fees. As a holding company,
Hallmark is dependent on dividend payments and management fees from its
subsidiaries to meet operating expenses and debt obligations. As of
September 30, 2006, Hallmark had $2.2 million in cash and invested assets.
Cash and invested assets of our non-insurance subsidiaries were $5.7 million
as of September 30, 2006.
Property and casualty insurance companies domiciled in the State of
Texas are limited in the payment of dividends to their shareholders in any
12-month period, without the prior written consent of the Texas Department
of Insurance, to the greater of statutory net income for the prior calendar
year or 10% of statutory policyholders surplus as of the prior year end.
Dividends may only be paid from unassigned surplus funds. During 2006,
AHIC's ordinary dividend capacity is $6.4 million. PIIC, domiciled in
Arizona, is limited in the payment of dividends to the lesser of 10% of
prior year policyholders surplus or prior year's net investment income,
without prior written approval from the Arizona Department of Insurance.
During 2006, PIIC's ordinary dividend capacity is $1.6 million. GSIC,
domiciled in Oklahoma, is limited in the payment of dividends to the greater
of 10% of prior year policyholders surplus or prior year's statutory net
income, without prior written approval from the Oklahoma Insurance
Department. During 2006, GSIC's ordinary dividend capacity is $0.1 million.
None of AHIC, PIIC or GSIC paid a dividend to Hallmark during the first
nine months of 2006. Neither AHIC nor PIIC paid a dividend to Hallmark
during 2005.
The Texas Department of Insurance, the Arizona Department of Insurance
and the Oklahoma Insurance Department regulate financial transactions
between our insurance subsidiaries and their affiliated companies.
Applicable regulations require approval of management fees, expense sharing
contracts and similar transactions. Phoenix General Agency paid $0.8 million
in management fees to Hallmark during the first nine months of 2006 and paid
$0.3 million in management fees during the same period of 2005. PIIC paid
$0.9 million in management fees to Phoenix General Agency during the first
nine months of 2006 and 2005. AHIC did not pay any management fees during
the first nine months of 2006 or 2005. GSIC did not pay any management fees
during the first nine months of 2006.
Comparison of September 30, 2006 to December 31, 2005
On a consolidated basis, our cash and investments (excluding restricted
cash and investments) at September 30, 2006 were $208.9 million compared to
$139.6 million at December 31, 2005. The acquisitions of the subsidiaries
comprising our TGA Operating Unit and our Aerospace Operating Unit accounted
for $21.0 million of this increase, while the remainder of the increase was
primarily the result of the retention of business produced by our HGA
Operating Unit and our TGA Operating Unit.
Comparison of Nine Months Ended September 30, 2006 and September 30, 2005
Net cash provided by our consolidated operating activities was $45.6
million for the first nine months of 2006 compared to $5.6 million for the
first nine months of 2005. The increase in operating cash flow primarily
resulted from the retention of the HGA Operating Unit and a portion of the
TGA Operating Unit business in the first nine months of 2006 that was not
retained by us in the same period in 2005. The net effect on operating cash
flow was an increase of $63.1 million resulting from an increase in
collected premiums net of paid losses and loss adjustment expenses partially
offset by lower collected commission and claim fee revenue. Increased
collected commission revenue of $23.3 million from the acquisition of the
subsidiaries comprising our TGA Operating Unit and Aerospace Operating Unit,
increased collected investment income of $2.0 million and increased
collected finance charges of $1.4 million primarily for the acquisition of
PAAC were partially offset by an increase in paid operating expenses of
$40.8 million driven primarily from these acquisitions, additional interest
paid on debt financing these acquisitions of $3.1 million and increased tax
payments of $5.9 million due to higher taxable earnings.
Cash used in investing activities during the first nine months of 2006
was $103.5 million as compared to $59.0 million for the same period in 2005.
The increase in cash used in investing activities is mostly due to the
acquisitions of the subsidiaries comprising our TGA Operating Unit and our
Aerospace Operating Unit in the first quarter of 2006 which used $26.0
million, net of cash acquired. Also contributing to the increase in cash
used by investing activities was the funding of $25.0 million to a trust
account securing the future guaranteed payments to the sellers of the
subsidiaries comprising our TGA Operating Unit, additional net purchases of
short-term investments of $27.8 million as well as PAAC's $2.2 million
repayment of premium finance notes, net of premium finance notes originated.
Partially offsetting these uses was a $16.9 million increase in maturities
and redemptions, a $16.8 million decrease in purchases of debt and equity
securities and a net $2.9 million released from restricted cash and
investments accounts.
Cash provided by financing activities during the first nine months of
2006 was $52.5 million as compared to $75.1 million for the same period of
2005. The cash provided in 2006 was primarily from the issuance of three
debt instruments in January. The first was a promissory note payable to
Newcastle Partners, L.P. ("Newcastle Partners") in the amount of $12.5
million to fund the cash required to close the Aerospace acquisition. This
note bears interest at the rate of 10% per annum. The unpaid principal
balance of the promissory note, together with all accrued and unpaid
interest, became due and payable on demand as of June 30, 2006. The second
debt instrument was $25.0 million in subordinated convertible promissory
notes to the Newcastle Special Opportunity Fund I, L.P. and Newcastle
Special Opportunity Fund II, L.P, (the "Opportunity Funds"). The principal
and accrued interest on the convertible notes was converted to approximately
3.3 million shares of our common stock during the second quarter of 2006.
The $25.0 million raised with these notes was used to fund a trust account
securing future guaranteed payments to the sellers of the subsidiaries now
comprising our TGA Operating Unit. The third debt instrument was $15.0
million borrowed under our revolving credit facility to fund the cash
required to close the acquisition of the subsidiaries now comprising our TGA
Operating Unit. In October 2006, we repaid the promissory note to Newcastle
Partners and repaid $12.2 million of the outstanding principal balance of
our revolving credit facility, in each case with proceeds received from our
public equity offering. Newcastle Partners and the Opportunity Funds are
each an affiliate of our Executive Chairman, Mark E. Schwarz.
Credit Facilities
On June 29, 2005, we entered into a credit facility with The Frost
National Bank. The credit facility was amended and restated on January 27,
2006 to a $20.0 million revolving credit facility, with a $5.0 million
letter of credit sub-facility. We borrowed $15.0 million under the
revolving credit facility to fund the cash required to close the acquisition
of the subsidiaries now comprising our TGA Operating Unit. Principal
outstanding under the revolving credit facility generally bears interest at
the three month Eurodollar rate plus 2.00%, payable quarterly in arrears.
We pay letter of credit fees at the rate of 1.00% per annum. Our
obligations under the revolving credit facility are secured by a security
interest in the capital stock of all of our subsidiaries, guaranties of all
of our subsidiaries and the pledge of substantially all of our assets. The
revolving credit facility contains covenants which, among other things,
require us to maintain certain financial and operating ratios and restrict
certain distributions, transactions and organizational changes. The amended
and restated credit agreement terminates on January 27, 2008. As of
September 30, 2006, there was $15.0 million outstanding under our revolving
credit facility, and we were in compliance with all of our covenants. In
October 2006, we repaid $12.2 million of the outstanding principal balance
under our revolving credit facility with proceeds received from our public
equity offering. In the third quarter of 2005, we issued a $4.0 million
letter of credit under this facility to collateralize certain obligations
under the agency agreement between our HGA Operating Unit and Clarendon
National Insurance Company effective July 1, 2004.
PAAC has a $5.0 million revolving credit facility with JPMorgan Chase
Bank which terminates June 30, 2007. Principal outstanding under this
revolving credit facility generally bears interest at 1% above the prime
rate. PAAC's obligations under this revolving credit facility are secured
by its premium finance notes receivables. This revolving credit facility
contains various restrictive covenants which, among other things, require
PAAC to maintain minimum amounts of tangible net worth and working capital.
As of September 30, 2006, $2.6 million was outstanding under this revolving
credit facility and PAAC was in compliance with or had obtained waivers of
all of its covenants.
Trust Preferred Securities
On June 21, 2005, our newly formed trust entity completed a private
placement of $30.0 million of 30-year floating rate trust preferred
securities. Simultaneously, we borrowed $30.9 million from the trust
subsidiary and contributed $30.0 million to AHIC in order to increase
policyholder surplus. The note bears an initial interest rate of 7.725%
until June 15, 2015, at which time interest will adjust quarterly to the
three month LIBOR rate plus 3.25 percentage points. As of September 30,
2006, the note balance was $30.9 million.
Other Debt Obligations
On January 3, 2006, we executed a promissory note payable to Newcastle
Partners in the amount of $12.5 million in order to obtain funding to
complete the acquisition of the subsidiaries now comprising the Aerospace
Operating Unit. The promissory note bears interest at 10% per annum prior to
maturity and at the maximum rate allowed under applicable law upon default.
Interest is payable on the first business day of each month. The principal
of the promissory note, together with accrued but unpaid interest, became
due on demand as of June 30, 2006. We repaid this note in October 2006 from
proceeds received from our public equity offering.
On January 27, 2006, we issued an aggregate of $25.0 million in
subordinated convertible promissory notes to the Opportunity Funds. Each
convertible note bore interest at 4% per annum, which rate increased to 10%
per annum in the event of default. Interest was payable quarterly in arrears
commencing March 31, 2006. Principal and all accrued but unpaid interest was
due at maturity on July 27, 2007. The principal and accrued interest on the
convertible notes was converted to approximately 3.3 million shares of our
common stock during the second quarter of 2006.
Structured Settlements
In connection with our acquisition of the subsidiaries now comprising
our TGA Operating Unit, we issued to the sellers promissory notes in the
aggregate principal amount of $23.7 million payable $14.2 million on or
before January 1, 2007, and $9.5 million on or before January 1, 2008. We
are also obligated to pay to the sellers an additional $0.8 million on or
before January 1, 2007 and an additional $0.5 million on or before January
1, 2008 in consideration of the sellers' compliance with certain restrictive
covenants, including a covenant not to compete for a period of five years
after closing. We secured payment of these future installments of purchase
price and restrictive covenant consideration by depositing $25.0 million in
a trust account for the benefit of the sellers. We recorded a payable for
future guaranteed payments to the sellers of $25.0 million discounted at
4.4%, the rate of two-year U.S. Treasuries purchased as the only permitted
investment of the trust account. The trust account is classified in
restricted cash and investments on our balance sheet. As of September 30,
2006, the balance of the structured settlements was $24.3 million.
Conclusion
Based on budgeted and year-to-date cash flow information, we believe
that we have sufficient liquidity to meet our projected insurance
obligations, operational expenses and capital expenditure requirements for
the next 12 months.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
As of September 30, 2006, there had been no material changes in the
market risks described in the Company's Form 10-K for the year ended
December 31, 2005.
Item 4. Controls and Procedures.
The principal executive officer and principal financial officer of the
Company have evaluated the Company's disclosure controls and procedures and
have concluded that, as of the end of the period covered by this report,
such disclosure controls and procedures were effective in ensuring that
information required to be disclosed by the Company in the reports that it
files or submits under the Securities Exchange Act of 1934 is timely
recorded, processed, summarized and reported. The principal executive
officer and principal financial officer also concluded that such disclosure
controls and procedures were effective in ensuring that information required
to be disclosed by the Company in the reports that it files or submits under
such Act is accumulated and communicated to the Company's management,
including its principal executive officer and principal financial officer,
as appropriate, to allow timely decisions regarding required disclosure.
During the most recent fiscal quarter, there have been no changes in 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.
Risks Associated with Forward-Looking Statements Included in this Form 10-Q
This Form 10-Q contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934, which are intended to be covered by the
safe harbors created thereby. These statements include the plans and
objectives of management for future operations, including plans and
objectives relating to future growth of 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-Q will prove to be accurate. In light of the
significant uncertainties inherent in the forward-looking statements
included herein, the inclusion of such information should not be regarded as
a representation by the Company or any other person that the objectives and
plans of the Company will be achieved.
PART II
OTHER INFORMATION
Item 1. Legal Proceedings.
The Company is engaged in legal proceedings in the ordinary course of
business, none of which, either individually or in the aggregate, are
believed likely to have a material adverse effect on the consolidated
financial position of the Company or the results of operations, in the
opinion of management. The various legal proceedings to which the Company
is a party are routine in nature and incidental to the Company's business.
Item 1A. Risk Factors.
In addition to the other information set forth in this report, you
should carefully consider the following risk factors:
Our success depends on our ability to price accurately the risks we
underwrite.
Our results of operations and financial condition depend on our ability to
underwrite and set premium rates accurately for a wide variety of risks.
Adequate rates are necessary to generate premiums sufficient to pay losses,
loss settlement expenses and underwriting expenses and to earn a profit. To
price our products accurately, we must collect and properly analyze a
substantial amount of data; develop, test and apply appropriate pricing
techniques; closely monitor and timely recognize changes in trends; and
project both severity and frequency of losses with reasonable accuracy. Our
ability to undertake these efforts successfully, and as a result price our
products accurately, is subject to a number of risks and uncertainties, some
of which are outside our control, including:
* the availability of sufficient reliable data and our ability to properly
analyze available data;
* the uncertainties that inherently characterize estimates and
assumptions;
* our selection and application of appropriate pricing techniques; and
* changes in applicable legal liability standards and in the civil
litigation system generally.
Consequently, we could underprice risks, which would adversely affect our
profit margins, or we could overprice risks, which could reduce our sales
volume and competitiveness. In either case, our profitability could be
materially and adversely affected.
Our results may fluctuate as a result of cyclical changes in the
property/casualty insurance industry.
All of our revenue is attributable to property/casualty insurance, which as
an industry is cyclical in nature and has historically been characterized by
soft markets followed by hard markets. A soft market is a period of
relatively high levels of price competition, less restrictive underwriting
standards and generally low premium rates. A hard market is a period of
capital shortages resulting in lack of insurance availability, relatively
low levels of competition, more selective underwriting of risks and
relatively high premium rates. If we find it necessary to reduce premiums or
limit premium increases due to competitive pressures on pricing in a
softening market, we may experience a reduction in our premiums written and
in our profit margins and revenues, which could adversely affect our
financial results.
Estimating reserves is inherently uncertain. If our loss reserves are not
adequate, it will have an unfavorable impact on our results.
We maintain loss reserves to cover our estimated ultimate liability for
unpaid losses and loss adjustment expenses for reported and unreported
claims incurred as of the end of each accounting period. Reserves represent
management's estimates of what the ultimate settlement and administration of
claims will cost and are not reviewed by an independent actuary. These
estimates, which generally involve actuarial projections, are based on
management's assessment of facts and circumstances then known, as well as
estimates of future trends in claim severity and frequency, judicial
theories of liability, and other factors. These variables are affected by
both internal and external events, such as changes in claims handling
procedures, inflation, judicial trends and legislative changes. Many of
these factors are not quantifiable. Additionally, there may be a significant
reporting lag between the occurrence of an event and the time it is reported
to us. The inherent uncertainties of estimating reserves are greater for
certain types of liabilities, particularly those in which the various
considerations affecting the type of claim are subject to change and in
which long periods of time may elapse before a definitive determination of
liability is made. Reserve estimates are continually refined in a regular
and ongoing process as experience develops and further claims are reported
and settled. Adjustments to reserves are reflected in the results of the
periods in which such estimates are changed. For example, a 1% change in
September 30, 2006 unpaid losses and loss adjustment expenses would have
produced a $0.7 million change to pretax earnings. Our gross loss and loss
adjustment expense reserves totaled $65.6 million at September 30, 2006. Our
loss and loss adjustment expense reserves, net of reinsurance recoverables,
were $61.1 million at that date. Because setting reserves is inherently
uncertain, there can be no assurance that the current reserves will prove
adequate.
Our failure to maintain favorable financial strength ratings could
negatively impact our ability to compete successfully.
Third-party rating agencies assess and rate the claims-paying ability of
insurers based upon criteria established by the agencies. During 2005, A.M.
Best, a nationally recognized insurance industry rating service and
publisher, upgraded the financial strength rating of PIIC, from "B" (Fair)
to "B+" (Very Good), and upgraded the financial strength rating of AHIC,
from "B" (Fair) to "A-" (Excellent). Our insurance company subsidiaries have
historically been rated on an individual basis. However, effective January
1, 2006, our insurance company subsidiaries entered into a pooling
arrangement whereby AHIC would retain 59.9% of the net premiums written,
PIIC would retain 34.1% of the net premiums written and GSIC would retain
6.0% of the net premiums written. As a result, in June 2006, A.M. Best
notified us that our insurance company subsidiaries would be rated on a
pooled basis and assigned a rating of "A-" (Excellent) to each of our
individual insurance company subsidiaries and to the pool formed by our
insurance company subsidiaries.
These financial strength ratings are used by policyholders, insurers,
reinsurers and insurance and reinsurance intermediaries as an important
means of assessing the financial strength and quality of insurers. These
ratings are not evaluations directed to potential purchasers of our common
stock and are not recommendations to buy, sell or hold our common stock. Our
ratings are subject to change at any time and could be revised downward or
revoked at the sole discretion of the rating agencies. We believe that the
ratings assigned by A.M. Best are an important factor in marketing our
products. Our ability to retain our existing business and to attract new
business in our insurance operations depends largely on these ratings. Our
failure to maintain our ratings, or any other adverse development with
respect to our ratings, could cause our current and future independent
agents and insureds to choose to transact their business with more highly
rated competitors. If A.M. Best downgrades our ratings or publicly indicates
that our ratings are under review, it is likely that we would not be able to
compete as effectively with our competitors, and our ability to sell
insurance policies could decline. If that happens, our sales and earnings
would decrease. For example, many of our agencies and insureds have
guidelines that require us to have an A.M. Best financial strength rating of
"A-" or higher. A reduction of our A.M. Best rating below "A-" would prevent
us from issuing policies to insureds or potential insureds with such ratings
requirements. Because lenders and reinsurers will use our A.M. Best ratings
as a factor in deciding whether to transact business with us, the failure of
our insurance company subsidiaries to maintain their current ratings could
dissuade a lender or reinsurance company from conducting business with us or
might increase our interest or reinsurance costs. In addition, a ratings
downgrade by A.M. Best below "A-" would require us to post collateral in
support of our obligations under certain of our reinsurance agreements
pursuant to which we assume business.
The loss of key executives could disrupt our business.
Our success will depend in part upon the continued service of certain key
executives. Our success will also depend on our ability to attract and
retain additional executives and personnel. We do not have employment
agreements with our Chief Executive Officer or any other of our executive
officers other than employment agreements entered into in connection with
the acquisitions of the subsidiaries now comprising our TGA Operating Unit
and our Aerospace Operating Unit. The loss of key personnel, or our
inability to recruit and retain additional qualified personnel, could cause
disruption in our business and could prevent us from fully implementing our
business strategies, which could materially and adversely affect our
business, growth and profitability.
Our industry is very competitive, which may unfavorably impact our results
of operations.
The property/casualty insurance market, our primary source of revenue, is
highly competitive and, except for regulatory considerations, has very
few barriers to entry. According to A.M. Best, there were 3,173
property/casualty insurance companies and 2,065 property/casualty insurance
groups operating in North America as of July 24, 2006. Our HGA Operating
Unit and TGA Operating Unit compete with a variety of large national
commercial lines carriers such as Hartford, Zurich, St. Paul Travelers and
Safeco, as well as numerous smaller regional companies. Although our Phoenix
Operating Unit competes with large national insurers such as Allstate, State
Farm and Progressive, as a participant in the non-standard personal
automobile marketplace, its primary competition consists of numerous
regional companies and managing general agencies. Our Aerospace Operating
Unit competes primarily with several other companies specializing in general
aviation insurance, including Houston Casualty Corp., Phoenix Aviation, W.
Brown & Company and London Aviation Underwriters. Our competitors include
entities which have, or are affiliated with entities which have, greater
financial and other resources than we have. In addition, competitors may
attempt to increase market share by lowering rates. In that case, we could
experience reductions in our underwriting margins, or sales of our insurance
policies could decline as customers purchase lower-priced products from our
competitors. Losing business to competitors offering similar products at
lower prices, or having other competitive advantages, could adversely affect
our results of operations.
Our results may be unfavorably impacted if we are unable to obtain adequate
reinsurance.
As part of our overall risk and capacity management strategy, we purchase
reinsurance for significant amounts of risk, especially catastrophe risks
that we and our insurance company subsidiaries underwrite. Our catastrophe
and non-catastrophe reinsurance facilities are subject to annual renewal. We
may be unable to maintain our current reinsurance facilities or to obtain
other reinsurance facilities in adequate amounts and at favorable rates. The
amount, availability and cost of reinsurance are subject to prevailing
market conditions beyond our control and may affect our ability to write
additional premiums as well as our profitability. If we are unable to obtain
adequate reinsurance protection for the risks we have underwritten, we will
either be exposed to greater losses from these risks or we will reduce the
level of business that we underwrite, which will reduce our revenue.
If the companies that provide our reinsurance do not pay our claims in a
timely manner, we could incur severe losses.
We purchase reinsurance by transferring, or ceding, part of the risk we have
assumed to a reinsurance company in exchange for part of the premium we
receive in connection with the risk. Although reinsurance makes the
reinsurer liable to us to the extent the risk is transferred or ceded to the
reinsurer, it does not relieve us of our liability to our policyholders.
Accordingly, we bear credit risk with respect to our reinsurers. We cannot
assure that our reinsurers will pay all of our reinsurance claims, or that
they will pay our claims on a timely basis. At September 30, 2006, we had a
total of $6.1 million due us from reinsurers, including $4.5 million of
recoverables from losses and $1.6 million in prepaid reinsurance premiums.
The largest amount due us from a single reinsurer as of September 30, 2006
was $1.9 million reinsurance and premium recoverable from GE Reinsurance
Corp. If any of our reinsurers are unable or unwilling to pay amounts they
owe us in a timely fashion, we could suffer a significant loss or a shortage
of liquidity, which would have a material adverse effect on our business and
results of operations.
Catastrophic losses are unpredictable and may adversely affect our results
of operations, liquidity and financial condition.
Property/casualty insurance companies are subject to claims arising out of
catastrophes that may have a significant effect on their results of
operations, liquidity and financial condition. Catastrophes can be caused by
various events, including hurricanes, windstorms, earthquakes, hail storms,
explosions, severe winter weather and fires, and may include man-made
events, such as the September 11, 2001 terrorist attacks on the World Trade
Center. The incidence, frequency, and severity of catastrophes are
inherently unpredictable. The extent of losses from a catastrophe is a
function of both the total amount of insured exposure in the area affected
by the event and the severity of the event. Claims from catastrophic events
could reduce our net income, cause substantial volatility in our financial
results for any fiscal quarter or year or otherwise adversely affect our
financial condition, liquidity or results of operations. Catastrophes may
also negatively affect our ability to write new business. Increases in the
value and geographic concentration of insured property and the effects of
inflation could increase the severity of claims from catastrophic events in
the future.
Catastrophe models may not accurately predict future losses.
Along with other insurers in the industry, we use models developed by third-
party vendors in assessing our exposure to catastrophe losses that assume
various conditions and probability scenarios. However, these models do not
necessarily accurately predict future losses or accurately measure losses
currently incurred. Catastrophe models, which have been evolving since the
early 1990s, use historical information about various catastrophes and
detailed information about our in-force business. While we use this
information in connection with our pricing and risk management activities,
there are limitations with respect to their usefulness in predicting losses
in any reporting period. Examples of these limitations are significant
variations in estimates between models and modelers and material increases
and decreases in model results due to changes and refinements of the
underlying data elements and assumptions. Such limitations lead to
questionable predictive capability and post-event measurements that have not
been well understood or proven to be sufficiently reliable. In addition, the
models are not necessarily reflective of company or state-specific policy
language, demand surge for labor and materials or loss settlement expenses,
all of which are subject to wide variation by catastrophe. Because the
occurrence and severity of catastrophes are inherently unpredictable and may
vary significantly from year to year, historical results of operations may
not be indicative of future results of operations.
We are subject to comprehensive regulation, and our results may be
unfavorably impacted by these regulations.
We are subject to comprehensive governmental regulation and supervision.
Most insurance regulations are designed to protect the interests of
policyholders rather than of the stockholders and other investors of the
insurance companies. These regulations, generally administered by the
department of insurance in each state in which we do business, relate to,
among other things:
* approval of policy forms and rates;
* standards of solvency, including risk-based capital measurements,
which are a measure developed by the National Association of Insurance
Commissioners and used by the state insurance regulators to identify
insurance companies that potentially are inadequately capitalized;
* licensing of insurers and their agents;
* restrictions on the nature, quality and concentration of investments;
* restrictions on the ability of insurance company subsidiaries to pay
dividends;
* restrictions on transactions between insurance company subsidiaries and
their affiliates;
* requiring certain methods of accounting;
* periodic examinations of operations and finances;
* the use of non-public consumer information and related privacy issues;
* the use of credit history in underwriting and rating;
* limitations on the ability to charge policy fees;
* the acquisition or disposition of an insurance company or of any company
controlling an insurance company;
* involuntary assignments of high-risk policies, participation in
reinsurance facilities and underwriting associations, assessments
and other governmental charges;
* restrictions on the cancellation or non-renewal of policies and, in
certain jurisdictions, withdrawal from writing certain lines of business;
* prescribing the form and content of records of financial condition to be
filed;
* requiring reserves for unearned premium, losses and other purposes; and
* with respect to premium finance business, the federal Truth-in-Lending
Act and similar state statutes. In states where specific statutes have
not been enacted, premium finance is generally subject to state usury
laws that are applicable to consumer loans.
State insurance departments also conduct periodic examinations of the
affairs of insurance companies and require filing of annual and other
reports relating to the financial condition of insurance companies, holding
company issues and other matters. Our business depends on compliance with
applicable laws and regulations and our ability to maintain valid licenses
and approvals for our operations. Regulatory authorities may deny or revoke
licenses for various reasons, including violations of regulations. Changes
in the level of regulation of the insurance industry or changes in laws or
regulations themselves or interpretations by regulatory authorities could
have a material adverse affect on our operations. In addition, we could face
individual, group and class-action lawsuits by our policyholders and others
for alleged violations of certain state laws and regulations. Each of these
regulatory risks could have an adverse effect on our profitability.
State statutes limit the aggregate amount of dividends that our subsidiaries
may pay Hallmark, thereby limiting its funds to pay expenses and dividends.
Hallmark is a holding company and a legal entity separate and distinct from
its subsidiaries. As a holding company without significant operations of its
own, Hallmark's principal sources of funds are dividends and other sources
of funds from its subsidiaries. State insurance laws limit the ability of
Hallmark's insurance company subsidiaries to pay dividends and require our
insurance company subsidiaries to maintain specified minimum levels of
statutory capital and surplus. The aggregate maximum amount of dividends
permitted by law to be paid by an insurance company does not necessarily
define an insurance company's actual ability to pay dividends. The actual
ability to pay dividends may be further constrained by business and
regulatory considerations, such as the impact of dividends on surplus, by
our competitive position and by the amount of premiums that we can write.
Without regulatory approval, the aggregate maximum amount of dividends that
could be paid to Hallmark in 2006 by our insurance company subsidiaries is
$8.1 million. State insurance regulators have broad discretion to limit the
payment of dividends by insurance companies and Hallmark's right to
participate in any distribution of assets of one of our insurance company
subsidiaries is subject to prior claims of policyholders and creditors
except to the extent that its rights, if any, as a creditor are recognized.
Consequently, Hallmark's ability to pay debts, expenses and cash dividends
to our stockholders may be limited.
Our insurance company subsidiaries are subject to minimum capital and
surplus requirements. Failure to meet these requirements could subject us to
regulatory action.
Our insurance company subsidiaries are subject to minimum capital and
surplus requirements imposed under the laws of Texas, Arizona and Oklahoma.
Any failure by one of our insurance company subsidiaries to meet minimum
capital and surplus requirements imposed by applicable state law will
subject it to corrective action, which may include requiring adoption of a
comprehensive financial plan, revocation of its license to sell insurance
products or placing the subsidiary under state regulatory control. Any new
minimum capital and surplus requirements adopted in the future may require
us to increase the capital and surplus of our insurance company
subsidiaries, which we may not be able to do.
We are subject to assessments and other surcharges from state guaranty
funds, mandatory reinsurance arrangements and state insurance facilities,
which may reduce our profitability.
Virtually all states require insurers licensed to do business therein to
bear a portion of the unfunded obligations of impaired or insolvent
insurance companies. These obligations are funded by assessments, which are
levied by guaranty associations within the state, up to prescribed limits,
on all member insurers in the state on the basis of the proportionate share
of the premiums written by member insurers in the lines of business in which
the impaired, insolvent or failed insurer was engaged. Accordingly, the
assessments levied on us by the states in which we are licensed to write
insurance may increase as we increase our premiums written. In addition, as
a condition to the ability to conduct business in certain states, insurance
companies are required to participate in mandatory reinsurance funds. The
effect of these assessments and mandatory reinsurance arrangements, or
changes in them, could reduce our profitability in any given period or limit
our ability to grow our business.
We are currently monitoring developments with respect to various state
facilities, such as the Texas FAIR Plan and the Texas Windstorm Insurance
Association, and the various guaranty funds in which we participate. The
ultimate impact of recent catastrophe experience on these facilities is
currently uncertain but could result in the facilities recognizing a
financial deficit or a financial deficit greater than the level currently
estimated. They may, in turn, have the ability to assess participating
insurers when financial deficits occur, adversely affecting our results of
operations. While these facilities are generally designed so that the
ultimate cost is borne by policyholders, the exposure to assessments and the
availability of recoupments or premium rate increases from these facilities
may not offset each other in our financial statements. Moreover, even if
they do offset each other, they may not offset each other in financial
statements for the same fiscal period due to the ultimate timing of the
assessments and recoupments or premium rate increases, as well as the
possibility of policies not being renewed in subsequent years.
Adverse securities market conditions can have a significant and negative
impact on our investment portfolio.
Our results of operations depend in part on the performance of our invested
assets. As of September 30, 2006, 77.7% of our investment portfolio was
invested in fixed-income securities. Certain risks are inherent in
connection with fixed-income securities, including loss upon default and
price volatility in reaction to changes in interest rates and general market
factors. In general, the fair market value of a portfolio of fixed-income
securities increases or decreases inversely with changes in the market
interest rates, while net investment income realized from future investments
in fixed-income securities increases or decreases along with interest rates.
In addition, 8.5% of our fixed-income securities have call or prepayment
options. This subjects us to reinvestment risk should interest rates fall
and issuers call their securities. Furthermore, actual net investment income
and/or cash flows from investments that carry prepayment risk, such as
mortgage-backed and other asset-backed securities, may differ from those
anticipated at the time of investment as a result of interest rate
fluctuations. An investment has prepayment risk when there is a risk that
cash flows from the repayment of principal might occur earlier than
anticipated because of declining interest rates or later than anticipated
because of rising interest rates.
In addition to the general risks described above, although we maintain an
investment-grade portfolio, our fixed-income securities are also subject to
credit risk. If any of the issuers of our fixed-income securities suffer
financial setbacks, the ratings on the fixed-income securities could fall
(with a concurrent fall in market value) and, in a worst case scenario, the
issuer could default on its obligations. Future changes in the fair market
value of our available-for-sale securities will be reflected in other
comprehensive income. Similar treatment is not available for liabilities.
Therefore, interest rate fluctuations could adversely affect our
stockholders' equity, total comprehensive income and/or our cash flows.
We rely on independent agents and specialty brokers to market our products
and their failure to do so would have a material adverse effect on our
results of operations.
We market and distribute our insurance programs exclusively through
independent insurance agents and specialty insurance brokers. As a result,
our business depends in large part on the marketing efforts of these agents
and brokers and on our ability to offer insurance products and services that
meet the requirements of the agents, the brokers and their customers.
However, these agents and brokers are not obligated to sell or promote our
products and many sell or promote competitors' insurance products in
addition to our products. Some of our competitors have higher financial
strength ratings, offer a larger variety of products, set lower prices for
insurance coverage and/or offer higher commissions than we do. Therefore, we
may not be able to continue to attract and retain independent agents and
brokers to sell our insurance products. The failure or inability of
independent agents and brokers to market our insurance products successfully
could have a material adverse impact on our business, financial condition
and results of operations.
We may experience difficulty in integrating recent or future acquisitions
into our operations.
We completed the acquisitions of the subsidiaries now comprising both our
TGA Operating Unit and our Aerospace Operating Unit during January 2006. We
may pursue additional acquisitions in the future. The successful integration
of newly acquired businesses into our operations will require, among other
things, the retention and assimilation of their key management, sales and
other personnel; the coordination of their lines of insurance products and
services; the adaptation of their technology, information systems and other
processes; and the retention and transition of their customers. Unexpected
difficulties in integrating any acquisition could result in increased
expenses and the diversion of management time and resources. If we do not
successfully integrate any acquired business into our operations, we may not
realize the anticipated benefits of the acquisition, which could have a
material adverse impact on our financial condition and results of
operations. Further, any potential acquisitions may require significant
capital outlays and, if we issue equity or convertible debt securities to
pay for an acquisition, the issuance may be dilutive to our existing
stockholders.
Our geographic concentration ties our performance to the business, weather,
economic and regulatory conditions of certain states.
The following five states account for 91.0% of our gross written premiums
for the nine months ended September 30, 2006: Texas (48.8%), Oregon (17.0%),
New Mexico (11.6%), Idaho (7.8%) and Arizona (5.8%). Our revenues and
profitability are subject to the prevailing regulatory, legal, economic,
political, demographic, competitive, weather and other conditions in the
principal states in which we do business. Changes in any of these conditions
could make it less attractive for us to do business in such states and would
have a more pronounced effect on us compared to companies that are more
geographically diversified. In addition, our exposure to severe losses from
localized natural perils, such as windstorms or hailstorms, is increased in
those areas where we have written significant numbers of property/casualty
insurance policies.
The exclusions and limitations in our policies may not be enforceable.
Many of the policies we issue include exclusions or other conditions that
define and limit coverage, which exclusions and conditions are designed to
manage our exposure to certain types of risks and expanding theories of
legal liability. In addition, many of our policies limit the period during
which a policyholder may bring a claim under the policy, which period in
many cases is shorter than the statutory period under which these claims can
be brought by our policyholders. While these exclusions and limitations help
us assess and control our loss exposure, it is possible that a court or
regulatory authority could nullify or void an exclusion or limitation, or
legislation could be enacted modifying or barring the use of these
exclusions and limitations. This could result in higher than anticipated
losses and loss adjustment expenses by extending coverage beyond our
underwriting intent or increasing the number or size of claims, which could
have a material adverse effect on our operating results. In some instances,
these changes may not become apparent until some time after we have issued
the insurance policies that are affected by the changes. As a result, the
full extent of liability under our insurance contracts may not be known for
many years after a policy is issued.
We rely on our information technology and telecommunications systems and the
failure or disruption of these systems could disrupt our operations and
adversely affect our results of operations.
Our business is highly dependent upon the successful and uninterrupted
functioning of our information technology and telecommunications systems. We
rely on these systems to process new and renewal business, provide customer
service, make claims payments and facilitate collections and cancellations,
as well as to perform actuarial and other analytical functions necessary for
pricing and product development. Our systems could fail of their own accord
or might be disrupted by factors such as natural disasters, power
disruptions or surges, computer hackers or terrorist attacks. Failure or
disruption of these systems for any reason could interrupt our business and
adversely affect our results of operations.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
None.
Item 3. Defaults Upon Senior Securities.
None.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
Item 5. Other Information.
None.
Item 6. Exhibits.
The following exhibits are filed herewith or incorporated herein by
reference:
Exhibit
Number Description
------ -----------
3(a) 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) Restated By-Laws of the registrant, as amended (incorporated
by reference to Exhibit 3.2 to the registrant's Registration
Statement on Form S-1 filed August 8, 2006).
4(a) Specimen certificate for Common Stock, $0.18 par value per
share, of the registrant (incorporated by reference to Exhibit
4.1 to the registrant's Post-Effective Amendment No. 1 to
Registration Statement on Form S-1 filed October 3, 2006).
4(b) Indenture dated as of June 21, 2005, between Hallmark
Financial Services, Inc. and JPMorgan Chase Bank, National
Association (incorporated by reference to Exhibit 4.1 to the
registrant's Current Report on Form 8-K filed June 27, 2005).
4(c) Amended and Restated Declaration of Trust of Hallmark
Statutory Trust I dated as of June 21, 2005, among Hallmark
Financial Services, Inc., as sponsor, Chase Bank USA, National
Association, as Delaware trustee, and JPMorgan Chase Bank,
National Association, as institutional trustee, and Mark
Schwarz and Mark Morrison, as administrators (incorporated by
reference to Exhibit 4.2 to the registrant's Current Report on
Form 8-K filed June 27, 2005).
4(d) Form of Junior Subordinated Debt Security Due 2035
(incorporated by reference to Exhibit 4.1 to the registrant's
Current Report on Form 8-K filed June 27, 2005).
4(e) Form of Capital Security Certificate (incorporated by
reference to Exhibit 4.2 to the registrant's Current Report
on Form 8-K filed June 27, 2005).
4(f) Promissory Note dated January 3, 2006, between Hallmark
Financial Services, Inc. and Newcastle Partners, L.P.
(incorporated by reference to Exhibit 4.1 to the registrant's
Current Report on Form 8-K filed January 5, 2006).
4(g) First Restated Credit Agreement dated January 27, 2006,
between Hallmark Financial Services, Inc. and The Frost
National Bank (incorporated by reference to Exhibit 4.1 to
the registrant's Current Report on Form 8-K filed February 2,
2006).
4(h) Form of Registration Rights Agreement dated January 27, 2006,
between Hallmark Financial Services, Inc. and Newcastle
Special Opportunity Fund I, L.P. and Newcastle Special
Opportunity Fund II, L.P. (incorporated by reference to
Exhibit 4.1 to the registrant's Current Report on Form 8-K
filed February 2, 2006).
31(a) Certification of principal executive officer required by Rule
13a-14(a) or Rule 15d-14(a).
31(b) Certification of principal financial officer required by Rule
13a-14(a) or Rule 15d-14(a).
32(a) Certification of principal executive officer Pursuant to 18
U.S.C. 1350.
32(b) Certification of principal financial officer Pursuant to 18
U.S.C. 1350.
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant has
caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.
HALLMARK FINANCIAL SERVICES, INC.
(Registrant)
Date: November 13, 2006 /s/ Mark J. Morrison
---------------------------------------------
Mark J. Morrison, Chief Executive Officer
and President
(Principal Executive Officer)
Date: November 13, 2006 /s/ Jeffrey R. Passmore
---------------------------------------------
Jeffrey R. Passmore, Chief Accounting Officer
and Senior Vice President
(Principal Financial Officer)