CONFORMED COPY
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
Quarterly report under Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the quarterly period ended September 30, 2003
Commission file number 0-16090
Hallmark Financial Services, Inc.
---------------------------------
(Exact name of small business issuer 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
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(Address of principal executive offices) (Zip Code)
Issuer's telephone number, including area code: (817) 348-1600
Check whether the issuer (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act
during the past 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days.
Yes X No
APPLICABLE ONLY TO CORPORATE ISSUERS
State the number of shares outstanding of each of the issuer's
classes of common equity, as of the latest practicable date:
Common Stock, par value $.03 per share - 36,366,059 shares
outstanding as of September 30, 2003.
PART I
FINANCIAL INFORMATION
Item 1. Financial Statements
INDEX TO FINANCIAL STATEMENTS
Page Number
-----------
Consolidated Balance Sheets at September 30, 2003 3
(unaudited) and December 31, 2002
Consolidated Statements of Operations (unaudited) 4
for the three and nine months ended September 30, 2003
and September 30, 2002
Consolidated Statements of Cash Flows (unaudited) 5
for the nine months ended September 30, 2003 and
September 30, 2002
Notes to Consolidated Financial Statements (unaudited) 6
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands)
September 30 December 31
ASSETS 2003 2002
------ ----------- -----------
(unaudited) (audited)
Investments:
Debt securities, available-for-sale, at
market value in 2003 and held-to-maturity,
at amortized cost in 2002 $ 24,822 $ 7,679
Equity securities, available-for-sale,
at market value 4,193 122
Short-term investments, available-for-sale,
at market value 335 8,927
----------- -----------
Total investments 29,350 16,728
Cash and cash equivalents 9,209 8,453
Restricted cash 6,124 1,072
Prepaid reinsurance premiums 1,324 8,956
Premiums receivable encumbered by premium
financing activity (net of allowance for
doubtful accounts of $84 in 2003 and of
$115 in 2002) 2,117 11,593
Premiums receivable 3,980 1,012
Accounts receivable 2,903 2,129
Reinsurance recoverable 14,821 12,929
Deferred policy acquisition costs 7,578 5,266
Excess of cost over fair value
of net assets acquired 5,195 5,171
Intangible assets 520 540
Note receivable - 6,500
Current federal income tax recoverable - 33
Deferred federal income taxes 3,673 1,021
Other assets 2,520 2,358
----------- -----------
$ 89,314 $ 83,761
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Liabilities:
Notes payable $ 1,173 $ 1,803
Note payable to related party - 8,600
Net advances from lender for financed premiums 1,401 10,905
Unpaid losses and loss adjustment expenses 28,837 17,667
Unearned premiums 8,446 15,957
Reinsurance balances payable 53 3,764
Unearned revenue 10,078 6,872
Accrued agent profit sharing 885 450
Accrued ceding commission payable 942 2,536
Pension liability 604 604
Current federal income tax payable 47 -
Accounts payable and other accrued expenses 8,692 6,068
----------- -----------
61,158 75,226
Stockholders' equity:
Common stock, $.03 par value, authorized
100,000,000 shares issued 36,856,610
shares in 2003 and 11,855,610 in 2002 1,106 356
Capital in excess of par value 19,698 10,875
Retained earnings (deficit) 7,683 (1,491)
Accumulated other comprehensive income 244 (162)
Treasury stock, 490,551 shares in 2003
and 806,477 in 2002, at cost (575) (1,043)
----------- -----------
Total stockholders' equity 28,156 8,535
----------- -----------
$ 89,314 $ 83,761
=========== ===========
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)
Three Months Ended Nine Months Ended
September 30 September 30
--------------------- ----------------------
2003 2002 2003 2002
-------- -------- -------- --------
Gross premiums written $ 6,640 $ 12,122 $ 36,404 $ 37,541
Ceded premiums written 246 (7,001) (6,934) (22,130)
-------- -------- -------- --------
Net premiums written 6,886 5,121 29,470 15,411
Change in unearned premiums 2,509 87 3,855 (1,118)
-------- -------- -------- --------
Net premiums earned 9,395 5,208 33,325 14,293
Investment income, net of expenses 360 144 822 414
Realized gain (loss) (305) 2 (313) 2
Finance charges 856 514 2,936 1,804
Commission and fees 4,709 - 12,406 -
Processing and service fees 1,224 121 3,509 336
Other income 127 91 446 257
-------- -------- -------- --------
Total revenues 16,366 6,080 53,131 17,106
Losses and loss adjustment expenses 6,155 3,636 22,596 10,630
Other operating costs and expenses 9,559 2,128 27,724 5,223
Interest expense 359 205 1,234 631
Amortization of intangible asset 7 - 21 -
-------- -------- -------- --------
Total expenses 16,080 5,969 51,575 16,484
Income before income tax, cumulative
effect of change in accounting
principle and extraordinary gain (loss) 286 111 1,556 622
Income tax expense 66 38 498 212
-------- -------- -------- --------
Income before cumulative effect of
change in accounting principle
and extraordinary gain (loss) $ 220 $ 73 $ 1,058 $ 410
Cumulative effect of change
in accounting principle - - - (1,694)
Extraordinary gain (loss) - - 8,116 -
-------- -------- -------- --------
Net income (loss) $ 220 $ 73 $ 9,174 $ (1,284)
======== ======== ======== ========
Basic earnings (loss) per share:
Income before cumulative effect
of change in accounting principle
and extraordinary gain $ 0.01 $ 0.01 $ 0.08 $ 0.03
Cumulative effect of change
in accounting principle - - - (0.15)
Extraordinary gain - - 0.65 -
-------- -------- -------- --------
Net income (loss) $ 0.01 $ 0.01 $ 0.73 $ (0.12)
======== ======== ======== ========
Diluted earnings (loss) per share:
Income before cumulative effect
of change in accounting principle
and extraordinary gain $ 0.01 $ 0.01 $ 0.08 $ 0.03
Cumulative effect of change
in accounting principle - - - (0.15)
Extraordinary gain - - 0.63 -
-------- -------- -------- --------
Net income (loss) $ 0.01 $ 0.01 $ 0.71 $ (0.12)
======== ======== ======== ========
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
-------------------------
2003 2002
----------- -----------
Cash flows from operating activities:
Net income (loss) $ 9,174 $ (1,284)
Adjustments to reconcile net income (loss) to
cash provided by (used in) operating activities:
Cumulative effect of change
in accounting principle - 1,694
Depreciation and amortization expense 485 120
Change in deferred federal income taxes 166 146
Change in prepaid reinsurance premiums 7,264 2,543
Change in premiums receivable (1,223) (477)
Change in accounts receivable (774) -
Change in deferred policy acquisition costs (1,772) (485)
Change in unpaid losses and loss
adjustment expenses (4,716) (2,887)
Change in unearned premiums (10,201) (1,426)
Change in unearned revenue 3,159 -
Change in accrued agent profit sharing 318 -
Change in reinsurance recoverable 8,512 3,599
Change in reinsurance balances payable (3,029) (1,209)
Change in current federal income
tax payable/recoverable 385 763
Change in accrued ceding commission refund (1,594) (2,381)
Gain on acquisition of subsidiary (8,116) -
Change in all other liabilities 1,429 (282)
Change in all other assets 513 139
----------- -----------
Net cash used in operating activities (20) (1,427)
----------- -----------
Cash flows from investing activities:
Purchases of property and equipment (293) (150)
Acquisition of subsidiary 6,945 -
Premium finance notes originated (15,772) (31,243)
Premium finance notes repaid 25,248 33,473
Change in restricted cash (5,052) 383
Purchases of debt securities - (10,638)
Purchases of equity securities (16,854) -
Maturities and redemptions
of investment securities 6,384 3,285
Net redemptions of short-term investments 8,904 8,761
----------- -----------
Net cash provided by investing activities 9,510 3,871
----------- -----------
Cash flows from financing activities:
Proceeds from rights offering 10,000 -
Net advances from lender (9,504) (1,616)
Repayment of borrowings (9,230) -
----------- -----------
Net cash used in financing activities (8,734) (1,616)
----------- -----------
Increase in cash and cash equivalents 756 828
Cash and cash equivalents at beginning of period 8,453 5,533
----------- -----------
Cash and cash equivalents at end of period $ 9,209 $ 6,361
=========== ===========
The accompanying notes are an integral part
of the consolidated financial statements
Item 1. Notes to Consolidated Financial Statements (Unaudited)
Note 1 - Summary of Accounting Policies
In the opinion of management, the accompanying consolidated financial
statements contain all adjustments, consisting only of normal recurring
adjustments, necessary for a fair statement of the financial position of
Hallmark Financial Services, Inc. ("HFS") and subsidiaries (collectively,
the "Company") as of September 30, 2003 and the consolidated results of
operations and cash flows for the periods presented. The preparation of
financial statements requires the use of management's estimates. The
accompanying financial statements have been prepared by the Company without
audit.
Certain information and disclosures normally included in financial
statements prepared in accordance with accounting principles generally
accepted in the United States of America ("GAAP") have been condensed or
omitted. Reference is made to the Company's annual consolidated financial
statements for the year ended December 31, 2002 for a description of
accounting policies and certain other disclosures. Certain items in the
2002 financial statements have been reclassified to conform to the 2003
presentation.
The results of operations for the period ended September 30, 2003 are
not necessarily indicative of the operating results to be expected for the
full year.
On January 27, 2003, the Company received final approval from the
Arizona Department of Insurance ("AZDOI") for the acquisition of Phoenix
Indemnity Insurance Company ("Phoenix") from Millers American Group, Inc.
("Millers"), effective as of January 1, 2003. In consideration for Phoenix,
the Company retired $7.0 million of a $14.85 million balance on a note
receivable from Millers. The Company had valued the note receivable on its
balance sheet at its cost of $6.5 million. The acquisition of Phoenix
expanded the Company's geographic reach in non-standard automobile insurance
from its traditional base in Texas to the states of New Mexico and Arizona.
The results of operations of Phoenix are included in the Consolidated
Statement of Operations from the effective date of the acquisition (January
1, 2003). The pro forma results as if the Company had acquired Phoenix at
January 1, 2002 are as follows ($ in thousands, except per share amounts):
Three Months Nine Months
Ended Ended
September 30, 2002 September 30, 2002
------------------ ------------------
Revenues $ 10,417 $ 30,115
Loss before cumulative effect
of change in accounting principle $ (282) $ (655)
Net Loss $ (282) $ (2,349)
Basic loss per share $ (0.03) $ (0.21)
Diluted loss per share $ (0.03) $ (0.21)
The acquisition of Phoenix was accounted for in accordance with
Statement of Financial Accounting Standards No. 141, "Business Combinations"
("SFAS 141"). This statement requires that the Company estimate the fair
value of assets acquired and liabilities assumed by the Company as of the
date of the acquisition. In accordance with the application of SFAS 141,
the Company recognized an extraordinary gain of $8.1 million from the
acquisition of Phoenix in its Consolidated Statement of Operations for the
nine months ending September 30, 2003. The gain is calculated as the
difference between the fair value of the net assets of Phoenix of $14.6
million and the $6.5 million cost of the note receivable from Millers. The
allocation of values acquired in the acquisition of Phoenix was preliminary
as of the date of acquisition. Estimates involved in the application of
purchase accounting to the transaction may change over the next quarter.
Recently Adopted Accounting Pronouncements
In December 2002, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standards No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure" ("SFAS 148"). The
Statement amends SFAS 123 to provide alternative methods of transition for
voluntary change to the fair value based method of accounting for stock-
based employee compensation. In addition, SFAS 148 amends the disclosure
requirements of SFAS 123 to require prominent disclosures in both annual and
interim financial statements about the method of accounting for stock-based
employee compensation and the effect of the method used on reported results.
SFAS 148 is effective for financial statements for fiscal years ending
after December 15, 2002. Effective January 1, 2003, the Company adopted the
prospective method provisions of SFAS 148.
At September 30, 2003, the Company had two stock-based employee
compensation plans for employees and a non-qualified plan for non-employee
directors, which are described more fully in Note 11 to the Form 10-KSB for
December 31, 2002. Prior to 2003, the Company accounted for those plans
under the recognition and measurement provisions of APB Opinion No. 25,
"Accounting for Stock Issued to Employees", and related Interpretations. No
stock-based employee compensation cost was reflected in 2002 net income.
Effective January 1, 2003, the Company adopted the fair value recognition
provisions of FASB Statement No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123"). Under the prospective method of adoption
selected by the Company under the provisions of SFAS 148, compensation cost
is recognized for all employee awards granted, modified, or settled after
the beginning of the fiscal year in which the recognition provisions are
first applied. Results for prior years have not been restated.
The following table illustrates the effect on net income and earnings per
share if the fair value based method had been applied to all outstanding and
unvested awards in each period.
Nine Months Ended
September 30
(in thousands) 2003 2002
-------- --------
Net income (loss) as reported $ 9,174 $ (1,284)
Add: Stock-based employee compensation
expenses included in reported net income,
net of related tax effects 16 -
Deduct: Total stock-based employee
compensation expense determined under fair
value based method for all awards, net of
related tax effects (43) (24)
-------- --------
Pro forma net income (loss) $ 9,147 $ (1,308)
======== ========
Earnings (loss) per share:
Basic-as reported $ 0.73 $ (0.12)
======== ========
Basic-pro forma $ 0.73 $ (0.12)
======== ========
Diluted-as reported $ 0.71 $ (0.12)
======== ========
Diluted-pro forma $ 0.71 $ (0.12)
======== ========
Note 2 - Reinsurance
American Hallmark Insurance Company of Texas ("Hallmark"), a wholly
owned subsidiary of HFS, is involved in the assumption and cession of
reinsurance from/to other companies. The Company remains obligated to its
policyholders in the event that the reinsurers do not meet their obligations
under the reinsurance agreements.
Under its reinsurance arrangements, the Company earns ceding
commissions based on loss ratio experience on the portion of policies it
cedes. The Company receives a provisional commission as policies are
produced as an advance against the later determination of the commission
actually earned. The provisional commission is adjusted periodically on a
sliding scale based on expected loss ratios.
The following table shows earned premiums ceded and reinsurance loss
recoveries by period (in thousands):
Three Months Nine Months
Ended Ended
September 30, September 30,
2003 2002 2003 2002
------ ------ ------ ------
Ceded earned premiums $ 2,515 $ 7,986 $14,603 $ 24,388
Reinsurance recoveries $ 2,574 $ 5,634 $10,346 $ 15,909
Note 3 - Intangible Assets
When Hallmark, American Hallmark General Agency ("AHGA"), Hallmark
Finance Corporation ("HFC") and Hallmark Claim Service, Inc. ("HCS") were
purchased by HFS, the excess cost over the fair value of the net assets
acquired was recorded as goodwill. Prior to 2002, this goodwill was
amortized on a straight-line basis over forty years. Other intangible
assets consisted of a trade name, a managing general agent's license and
non-compete agreements, all of which were fully amortized.
On January 1, 2002, the Company adopted Statement of Financial
Accounting Standards No. 142 ("SFAS 142"), "Goodwill and Other Intangible
Assets". SFAS 142 supersedes APB 17, "Intangible Assets", and primarily
addresses the accounting for goodwill and intangible assets subsequent to
their initial recognition. SFAS 142 (1) prohibits the amortization of
goodwill and indefinite-lived intangible assets, (2) requires testing of
goodwill and indefinite-lived intangible assets on an annual basis for
impairment (and more frequently if the occurrence of an event or
circumstance indicates an impairment), (3) requires that reporting units be
identified for the purpose of assessing potential future impairments of
goodwill and (4) removes the forty-year limitation on the amortization
period of intangible assets that have finite lives.
Pursuant to SFAS 142, the Company identified two components of goodwill
and assigned the carrying value of these components into two reporting
units: the insurance company reporting unit and the finance company
reporting unit. During 2002, the Company completed the two step process
prescribed by SFAS 142 for testing for impairment and determining the
amount of impairment loss related to goodwill associated with these two
reporting units. Accordingly, during 2002, the Company recorded a charge
to earnings that is reported as a cumulative effect of the change in
accounting principle of $1.7 million to reflect the adjustment to goodwill.
Since goodwill is a permanent difference, the charge to earnings has no
tax impact. This goodwill adjustment was made during the fourth quarter of
2002, but is required to be reported in the first quarter of 2002 for
comparative purposes.
Note 4 - Segment Information
The Company pursues its business activities through integrated
insurance groups managing non-standard personal automobile insurance (the
"Personal Lines Group") and commercial insurance (the "Commercial Lines
Group"). The members of the Personal Lines Group are Hallmark, an
authorized Texas property and casualty insurance company; Phoenix, an
authorized Arizona property and casualty insurance company; AHGA, a managing
general agency; HFC, a premium finance company; and HCS, a claims
administrator. Effective December 1, 2002, the Company purchased the
Commercial Lines Group. The members of the Commercial Lines Group are a
managing general agency, Hallmark General Agency, Inc. ("HGA"), formerly
known as Millers General Agency, and a third party claims administrator,
Effective Claims Management, Inc. ("ECM"), formerly known as Effective
Litigation Management.
The following is additional business segment information for the three
and nine months ended September 30 (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
2003 2002 2003 2002
------- ------- ------- -------
Revenues
--------
Personal Lines Group $ 11,320 $ 6,061 $ 38,767 $ 17,087
Commercial Lines Group 5,046 - 14,364 -
Corporate - 19 - 19
------- ------- ------- -------
Consolidated $ 16,366 $ 6,080 $ 53,131 $ 17,106
======= ======= ======= =======
Pre-tax income
--------------
Personal Lines Group $ 526 $ 66 $ 2,609 $ 351
Commercial Lines Group 358 - 847 -
Corporate (598) 45 (1,900) 271
------- ------- ------- -------
Consolidated $ 286 $ 111 $ 1,556 $ 622
======= ======= ======= =======
The following is additional business segment information as of the
following dates (in thousands):
Sept. 30, 2003 Dec. 31, 2002
-------------- -------------
Assets
------
Personal Lines Group $ 74,331 $ 64,508
Commercial Lines Group 13,823 11,839
Corporate 1,160 7,414
--------- ---------
Consolidated $ 89,314 $ 83,761
========= =========
Note 5 - Acquisition Costs
Total amortized acquisition costs for the three months ending September 30,
2003 and 2002 (in thousands) was ($1,065) and ($36), respectively. Total
amortized acquisition costs for the nine months ending September 30, 2003
and 2002 (in thousands) was ($854) and ($486), respectively.
Note 6 - Earnings per Share
The Company has adopted the provisions of Statement of Financial Accounting
Standards No. 128 (" SFAS No. 128"), "Earnings Per Share," requiring
presentation of both basic and diluted earnings per share.
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,
2003 2002 2003 2002
------------------ ------------------
Weighted average shares - basic 15,166 11,049 12,501 11,049
Effect of dilutive securities 206 61 310 99
------------------ ------------------
Weighted average shares -
assuming dilution 15,372 11,110 12,811 11,148
Note 7 - Comprehensive Income
The following table sets forth comprehensive income for the periods
indicated (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
2003 2002 2003 2002
------- ------- ------- -------
Net Income $ 220 $ 73 $ 9,174 $ (1,284)
Additional pension liability,
net of tax (8) - (8) -
Unrealized gain/(loss) on
available for sale securities,
net of tax 355 - 414 -
------- ------- ------- -------
Other comprehensive income 347 - 406 -
------- ------- ------- -------
Comprehensive income $ 567 $ 73 $ 9,580 $ (1,284)
======= ======= ======= =======
Note 8 - Contingencies
On May 30, 2003, Phoenix was served with a suit from the Superior Court of
the State of Arizona in and for the County of Pima, alleging breach of
contract and bad faith in connection with Phoenix's denial of coverage in an
automobile accident. The plaintiffs have filed an offer of judgment in the
amount of $15 million. Phoenix believes the suit is without merit and has
filed an answer denying each and every allegation in the case. The suit is
still in pre-trial discovery stage. The Company intends to vigorously defend
Phoenix against all claims asserted by the plaintiffs in the case.
Note 9 - Treasury Stock
Shares issued under employee benefit plans reduced treasury stock by $0.5
million and reduced capital in excess of par value by the same amount in
2003.
Item 2. Management's Discussion and Analysis or Plan of Operation.
Introduction. HFS and its wholly owned subsidiaries (collectively, the
"Company") engage in the sale of property and casualty insurance products.
The Company's business involves marketing, underwriting and premium
financing of non-standard automobile insurance primarily in Texas, Arizona,
and New Mexico, marketing of commercial insurance in Texas, New Mexico,
Idaho, Oregon and Washington, and providing third party claims
administration and other insurance related services.
On January 27, 2003, the Company received final approval from the AZDOI
for the acquisition of Phoenix, effective as of January 1, 2003. The
acquisition of Phoenix expanded the Company's geographic reach in non-
standard automobile insurance from its traditional base in Texas to the
states of New Mexico and Arizona.
The Company pursues its business activities through integrated
insurance groups managing non-standard personal automobile insurance (the
"Personal Lines Group") and commercial insurance (the "Commercial Lines
Group").
The Personal Lines Group provides non-standard automobile liability and
physical damage insurance through Hallmark and Phoenix for drivers who do
not qualify for or cannot obtain standard-rate insurance. Prior to April 1,
2003, Hallmark assumed 100% of the premium and losses on business produced
by its affiliated managing general agency, AHGA, through a reinsurance
arrangement with an unaffiliated company, State & County Mutual Fire
Insurance Company ("State & County"). Under a separate retrocession
agreement, Hallmark retroceded 55% of the premium and losses to its
principal reinsurer, Dorinco Reinsurance Company ("Dorinco"). Effective
April, 1, 2003, Hallmark assumes and retains 45% of the premium and losses
on business produced by AHGA and underwritten by State & County. Dorinco
assumes its 55% share of the premiums and losses directly from State &
County. AHGA manages the marketing of policies through independent agents.
HFC finances annual and six-month policy premiums produced by AHGA through
its premium finance program. Effective July 1, 2003, the Company
discontinued the premium finance program and shifted the focus to a
six month direct bill program. HCS provides claims adjustment, salvage,
subrogation recovery and litigation services to Hallmark. Phoenix
underwrites non-standard auto insurance produced by independent agents and
retains 100% of the premium and losses for the business it writes.
On June 10, 2003, the Governor of Texas signed legislation Senate Bill
14, which has been described as comprehensive insurance reform affecting
homeowners and personal automobile business. With respect to personal
automobile insurance, the most significant provisions provide for additional
rate regulation and limitations on the use of credit scoring. With the new
law, broadened rulemaking authority has been given to the Commissioner of
Insurance.
The Company currently writes all of its Texas personal automobile
business pursuant to a fronting arrangement with State & County, which is a
Texas county mutual insurance company. Although the new reforms are
significant, the primary rating regulation provisions do not apply directly
to the Company due to an exemption that applies to certain county mutual
insurance companies, including State & County. Additionally, the Company
does not currently use credit or insurance scoring models. Although we
currently do not believe the changes outlined in Senate Bill 14 will have a
material adverse affect on our operations, the Commissioner has been given
broad rulemaking authority and we cannot determine the ultimate outcome and
the impact it will have on our business until certain rules are developed by
the Commissioner. Any rule changes that would affect our ability to charge
adequate rates for the non-standard automobile line of business in the State
of Texas would have a material adverse effect on our operations.
The Commercial Lines Group, through HGA, markets commercial insurance
policies through independent agents. HGA produces policies on behalf of
Clarendon National Insurance Company ("CNIC") under a general agency
agreement where it receives a commission based on the premium written with
CNIC. ECM provides fee-based claims adjustment, salvage and subrogation
recovery, and litigation services on behalf of CNIC and another unaffiliated
third party.
Financial Condition and Liquidity
The Company's sources of funds are principally derived from insurance
related operations. Major sources of funds from operations include premiums
collected (net of policy cancellations and premiums ceded), ceding
commissions, premium finance service charges and service fees. Other
sources of funds are from financing and investment activities.
On a consolidated basis, the Company's total cash, cash equivalents and
investments (excluding restricted cash) at September 30, 2003 and December
31, 2002 were $38.6 million and $25.2 million, respectively. The Company's
liquidity increased during the first nine months of 2003 as compared to
December 31, 2002 principally as a result of the acquisition of Phoenix,
which increased cash and investments by $24.0 million. This is partially
offset by the deposit of $5.0 million in cash and investments into a trust
account to secure State & County's credit exposure from the quota share
reinsurance treaty with Hallmark effective April 1, 2003. The reduction in
Hallmark's net premium volume this year has also adversely impacted cash
flow.
Net cash used by the Company's consolidated operating activities was
$20,000 for the first nine months of 2003 compared to net cash used by
operating activities of $1.4 million for the first nine months of 2002. The
acquisition of Phoenix effective January 1, 2003 and the acquisition of the
Commercial Lines Group effective December 1, 2002 played a significant role
in the Company's improved cash flow from operations. Additionally, improved
underwriting results have further contributed to the Company's improved cash
flow from operations.
Cash provided by investing activities during the first nine months of
2003 increased $5.6 million as compared to the first nine months of 2002.
The acquisition of Phoenix produced a net cash increase of $6.9 million.
The increase was additionally attributable to purchases of debt securities
during the first nine months of 2002 of $10.6 million, an increase in
premium finance notes repaid over originated notes of $7.2 million in the
first nine months of 2003 compared to the same period of 2002 and increased
maturities and redemptions of short-term investments and bonds of $3.2
million in the first nine months of 2003 compared to the same period of
2002. These increases were partially offset by the purchase of equity
securities of $16.9 million in the first nine months of 2003 and an increase
in restricted cash of $5.4 million due to the trust account deposit
discussed above.
Cash used in financing activities increased by $7.1 million in the
first nine months of 2003 as compared to the same period of 2002 due to a
decrease in net advances from the Company's premium finance lender and the
repayment of notes payable to Dorinco during the first nine months of 2003.
The Company also used part of the $10.0 million of proceeds from its rights
offering to retire the $8.6 million note payable to Newcastle Partners, L.P.
("Newcastle") in September 2003.
HFS is dependent on dividend payments and management fees from its
insurance companies and free cash flow of its non-insurance companies to
meet operating expenses and debt obligations. As of September 30, 2003,
cash and invested assets of HFS were $0.7 million. Cash and invested assets
of non-insurance subsidiaries were $1.7 million as of September 30, 2003.
Property and casualty insurance companies domiciled in the State of Texas
are limited in the payment of dividends to their shareholders in any twelve-
month period, without the prior written consent of the Commission of
Insurance, to the greater of statutory net income for the prior calendar
year or 10% of its statutory policyholders' surplus as of the prior year
end. Dividends may only be paid from unassigned surplus funds. During 2003,
Hallmark's ordinary dividend capacity is $0.8 million. Hallmark paid $0.2
million of dividends to HFS during the first nine months of 2003. Phoenix,
domiciled in Arizona, is limited in the payment of dividends to the lesser
of 10% of prior year policyholder's surplus or prior year's net investment
income, without prior written approval from the AZDOI. During 2003,
Phoenix's ordinary dividend capacity is $0.6 million. Phoenix paid $0.3
million of dividends to HFS during the first nine months of 2003.
The Texas Department of Insurance ("TDI") regulates financial
transactions between Hallmark, HFS and affiliated companies. Applicable
regulations require TDI's approval of management and expense sharing
contracts and similar transactions. Although TDI has approved Hallmark's
payment of management fees to HFS and commissions to AHGA, since the second
half of 2000 management has elected not to pay all of the approved
commissions or management fees. Hallmark paid only nominal management fees
to HFS during the first nine months of 2002 and $0.5 million in management
fees to HFS during the first nine months of 2003.
The AZDOI regulates financial transactions between Phoenix and
affiliated companies. Applicable regulations require AZDOI's approval of
management and expense sharing contracts and similar transactions. Although
the AZDOI has approved payments of management fees to HFS, management has
elected to not pay a management fee to HFS in the first nine months of 2003
in order to strengthen Phoenix's statutory surplus.
At September 30, 2003, Hallmark reported statutory capital and surplus
(calculated as statutory assets less statutory liabilities) of $9.5
million, as compared to $8.4 million at December 31, 2002. Hallmark
reported statutory net income of $1.5 million during the first nine months
of 2003, paid dividends of $0.2 million to HFS and reported a change in
deferred income taxes of ($0.2) million during the same period. Hallmark's
premium-to-surplus ratio as of September 30, 2003 was 2.01 to 1, as compared
to 2.63 to 1 for the twelve months ended December 31, 2002. The minimum
statutory capital and surplus required for Hallmark by the TDI is $2.0
million. Hallmark's statutory capital and surplus as of September 30, 2003
exceeded the minimum requirements by 373%.
At September 30, 2003, Phoenix reported statutory capital and surplus
of $11.0 million, up from $10.1 million at December 31, 2002. Phoenix
reported statutory net income of $0.6 million during the first nine months
of 2003, paid $0.3 million in dividends to HFS and reported other statutory
surplus adjustments of $0.6 million during the same period. The adjustments
to surplus consist of changes in unrealized capital gains and losses, non-
admitted assets and provision for reinsurance. Phoenix's premium-to-surplus
ratio as of September 30, 2003 was 2.07 to 1. The minimum statutory capital
and surplus required for Phoenix by the AZDOI is $1.5 million. Phoenix's
statutory capital and surplus as of September 30, 2003 exceeds the minimum
requirements by 633%.
The acquisitions of the Commercial Lines Group and Phoenix were
financed by a bridge loan from Newcastle, an affiliate of the Company's
Chairman of the Board of Directors and Chief Executive Officer, Mark E.
Schwarz. The Company has retired this debt with the proceeds from a rights
offering of its common stock to its shareholders in the third quarter of
2003.
Results of Operations
Three Months Ending September 30, 2003 as compared to Three Months Ending
September 30, 2002
Income before tax, cumulative effect of change in accounting principle
and extraordinary gain was $0.3 million for the quarter ended September 30,
2003, compared to $0.1 million for the same period in 2002. The effective
tax rate for the current year was reduced this quarter to 32% from 34%,
due primarily to tax exempt interest from municipal bonds held in Phoenix.
This true up reduced the effective tax rate for the quarter ended September
30, 2003 to 27% as compared to 34% for the same period in 2002. Net income
before cumulative effect of change in accounting principle and extraordinary
gain was $0.2 million for the quarter ended September 30, 2003, compared to
$0.1 million for the quarter ended September 30, 2002. The improvement in
operating earnings for the third quarter of 2003 compared to the third
quarter of 2002 reflects improved loss ratios of the Personal Lines Group
(including the acquisition of Phoenix) and the acquisition of the Commercial
Lines Group.
The following is additional business segment information for the three
months ended September 30 (in thousands):
2003 2002
-------- --------
Revenues
--------
Personal Lines Group $ 11,320 $ 6,061
Commercial Lines Group 5,046 -
Corporate - 19
-------- --------
Consolidated $ 16,366 $ 6,080
======== ========
Pre-tax Income
--------------
Personal Lines Group $ 526 $ 66
Commercial Lines Group 358 -
Corporate (598) 45
-------- --------
Consolidated $ 286 $ 111
======== ========
Personal Lines Group
Gross premiums written (prior to reinsurance) for the third quarter of
2003 decreased 45%, and net premiums written (after reinsurance) increased
34%, in relation to the same period in 2002. The decrease in gross premiums
written is principally due to the change in the reinsurance structure with
State & County and Dorinco. Effective April 1, 2003, the Company assumes a
45% share of the non-standard auto business produced by AHGA and
underwritten by State & County instead of the 100% share it assumed prior to
that date. Also, effective April 1, 2003, Dorinco assumes its 55% share of
this business directly from State & County, where prior to this date the
Company retroceded 55% of the business to Dorinco. The decrease in gross
premiums written is also impacted by the cancellation of unprofitable
agents, a shift in marketing focus from annual term premium financed
policies to six month term direct bill policies and reduction in policy
counts caused by increased rates. Partially offsetting the decrease in
gross premiums written is the acquisition of Phoenix effective January 1,
2003, which contributed $5.4 million of gross premiums written.
The increase in net premiums written is due primarily to the acquisition of
Phoenix in 2003, which contributed $4.8 million for the quarter. Partially
offsetting the net premium written generated by Phoenix is a $3.0 million
decrease in net premium written by Hallmark for the third quarter of 2003 as
compared to the same period in 2002, as discussed above.
Revenue for the Personal Lines Group increased 87% for the third
quarter of 2003 to $11.3 million from $6.1 million for the same period in
2002. The increase is primarily due to the acquisition of Phoenix effective
January 1, 2003 which contributed $5.3 million in revenue for the third
quarter of 2003. Revenue from Phoenix includes a $0.3 million impairment
charge of a portion of its investment portfolio. These investments were
purchased prior to Phoenix being acquired by the Company. Also contributing
to the increase is AHGA commission revenue of $0.9 million from State &
County on business ceded to Dorinco for policies effective after March 31,
2003 due to the new reinsurance structure. Prior to April 1, 2003, this
commission was classified as a ceding commission and a reduction to
commission expense. Partially offsetting these increases was a $0.8 million
decrease in net earned premium for Hallmark for the third quarter of 2003
over the same period in 2002, a $0.1 million decrease in Hallmark premium
finance charges and a $0.1 million decrease in other income as a result of
the absence of agency fees following the sale of all four captive insurance
offices of the Company in the first quarter of 2003.
Pre-tax income for the Personal Lines Group increased $0.5 million for
the third quarter of 2003 from $0.1 million for the same period in 2002.
The increase is derived partially from the acquisition of Phoenix,
which contributed $0.1 million in pre-tax income for the quarter. Also
contributing is an improvement in Hallmark's ratio of loss and loss
adjustment expenses over net premiums earned ("loss ratio") to 57.1% for the
third quarter of 2003 as compared to 69.8% for the same period in 2002.
Improved pricing in 2003 and the termination of unprofitable agents in the
first quarter of 2003 caused the loss ratio improvement. Underwriting
income (net premiums earned less loss and loss adjustment expenses)
increased by $0.3 million for the third quarter of 2003 as compared to the
same period in 2002.
Commercial Lines Group
Total revenue for the Commercial Lines Group of $5.0 million for the
third quarter of 2003 is primarily comprised of $3.8 million of commissions
earned on policies produced by HGA for CNIC and $1.1 million of processing
and service fees earned by ECM for claims processing for CNIC. These were
new sources of income for the Company in 2003 as a result of the acquisition
of the Commercial Lines Group in December 2002.
Pre-tax income for the Commercial Lines Group of $0.4 million for the
third quarter of 2003 is primarily comprised of $5.0 million in revenue as
discussed above and $4.6 million in other operating costs and expenses.
These costs represent expenses associated with the production and servicing
of insurance policies for CNIC, the largest component of which is
independent retail agent commissions.
Corporate
Corporate pre-tax loss was $0.6 million for the third quarter of 2003
as compared to a nominal amount for the same period in 2002. Other
operating costs and expenses increased $0.4 million as a result of the shift
in management structure from 2002 to 2003 that has increased salary related
expenses and other overhead during the third quarter of 2003, as well as
lower management fees charged to Hallmark than in the same period in 2002.
Interest expense increased by $0.3 million for the third quarter 2003 as
compared to the same period in 2002. The increase is related to the
interest expense on the note payable to Newcastle, which was retired from
the proceeds of the Company's rights offering in September 2003. Proceeds
from this note payable were used to acquire the Commercial Lines Group and
Phoenix.
Nine Months Ending September 30, 2003 as compared to Nine Months Ending
September 30, 2002
Income before tax, cumulative effect of change in accounting principle
and extraordinary gain was $1.6 million for the nine months ended September
30, 2003, compared to $0.6 million for the same period in 2002. The
effective tax rate for the current year was reduced to 32% from the 34%
reported last year, due primarily to tax exempt interest from municipal
bonds held in Phoenix. Net income before cumulative effect of change in
accounting principle and extraordinary gain was $1.1 million for the nine
months ended September 30, 2003, compared to $0.4 million for the same
period in 2002. The improvement in operating earnings for the first nine
months of 2003 compared to 2002 reflects improved loss ratios of the
Personal Lines Group (including the acquisition of Phoenix) and the
acquisition of the Commercial Lines Group.
The following is additional business segment information for the nine
months ended September 30 (in thousands):
2003 2002
-------- --------
Revenues
--------
Personal Lines Group $ 38,767 $ 17,087
Commercial Lines Group 14,364 -
Corporate - 19
-------- --------
Consolidated $ 53,131 $ 17,106
======== ========
Pre-tax Income
--------------
Personal Lines Group $ 2,609 $ 351
Commercial Lines Group 847 -
Corporate (1,900) 271
-------- --------
Consolidated $ 1,556 $ 622
======== ========
Personal Lines Group
Gross premiums written (prior to reinsurance) for the first nine months
of 2003 decreased 3%, and net premiums written (after reinsurance) increased
91%, in relation to the same period in 2002. The decrease in gross premiums
written is principally due to the change in the reinsurance structure with
State & County and Dorinco. Effective April 1, 2003, the Company assumes
a 45% share of the non-standard auto business produced by AHGA and
underwritten by State & County instead of the 100% share it assumed prior to
that date. Also, effective April 1, 2003, Dorinco assumes its 55% share of
this business directly from State & County, where prior to this date the
Company retroceded 55% of the business to Dorinco. The decrease in gross
premiums written is also impacted by the cancellation of unprofitable
agents, a shift in marketing focus from annual term premium financed
policies to six month term direct bill policies and reduction in policy
counts caused by increased rates. Partially offsetting the decrease in
gross premiums written is the acquisition of Phoenix effective January 1,
2003, which contributed $17.8 million of gross premiums written. The
increase in net premiums written is due primarily to the acquisition of
Phoenix in 2003, which contributed $17.0 million for the first nine months
of 2003. Partially offsetting the net premium written generated by Phoenix
is a $3.0 million decrease in net premium written by Hallmark for the first
nine months of 2003 as compared to the same period in 2002, as discussed
above.
Total revenue for the Personal Lines Group increased 127% for the first
nine months of 2003 to $38.8 million from $17.1 million for the same period
in 2002. The increase is due primarily to the acquisition of Phoenix
effective January 1, 2003, which contributed $18.4 million in revenue for
the first nine months of 2003. Revenue from Phoenix includes a $0.3
million impairment charge of a portion of its investment portfolio. These
investments were purchased prior to Phoenix being acquired by the Company.
Also contributing to the increase is AHGA commission revenue of $1.6 million
from State & County on business ceded to Dorinco for policies effective
after March 31, 2003 due to the new reinsurance structure. Prior to April
1, 2003, this commission was classified as ceding commission and a reduction
to commission expense. Also contributing is a $1.9 million increase in net
earned premium for Hallmark for the first nine months of 2003 over the same
period in 2002. The increase in net earned premiums is due to Hallmark's
net written premium trending upwards in 2002 through the first quarter of
2003. The increase in net earned premium is partially offset by a $0.2
million decrease in processing and service fees for the first nine months
of 2003 as compared to the same period in 2002. This is due to the
discontinuation of an unaffiliated managing general agency program in
January 2003.
Pre-tax income for the Personal Lines Group increased $2.2 million for
the first nine months of 2003 to $2.6 million as compared to $0.4 million
for the same period in 2002. The increase is derived partially from the
acquisition of Phoenix, which contributed $0.9 million for the first nine
months of 2003. Also contributing is an improvement in Hallmark's loss
ratio to 66.5% for the first nine months of 2003 as compared to 74.4% the
same period in 2002. Improved pricing in 2003 and the termination of
unprofitable agents in the first quarter of 2003 caused the loss ratio
improvement. Underwriting income increased by $1.8 million for the first
nine months of 2003 as compared to the same period in 2002. Partially
offsetting these increases to pre-tax income is increased other operating
costs and expenses of $1.9 million for the first nine months of 2003 as
compared to the same period in 2002. This is due to $1.6 million of ceding
commission classified as revenue due to the new reinsurance structure
effective April 1, 2003 where this commission was classified as a reduction
to commission expense under prior agreements.
Commercial Lines Group
Total revenue for the Commercial Lines Group of $14.3 million for the
first nine months of 2003 is mostly comprised of $10.8 million of
commissions earned on policies serviced by HGA for CNIC and $3.2 million of
processing and service fees earned by ECM for claims processing for CNIC.
These were new sources of income for the Company in 2003 as a result of the
acquisition of the Commercial Lines Group in December 2002.
Pre-tax income for the Commercial Lines Group of $0.8 million for the
first nine months of 2003 is comprised of $14.3 million in revenue as
discussed above and $13.5 million in other operating costs and expenses.
These costs represent expenses associated with the production and servicing
of insurance policies for CNIC, the largest component of which is
independent retail agent commissions.
Corporate
Corporate pre-tax loss was $1.9 million for the first nine months of
2003 as compared to pre-tax income of $0.3 million for the same period in
2002. Other operating costs and expenses increased $1.6 million primarily
as a result of legal and consulting fees associated with acquisitions and
other corporate matters. Additionally, the shift in management structure
from 2002 to 2003 increased salary related expenses and other overhead
during the first nine months of 2003. Interest expense increased by $0.8
million for the first nine months of 2003 as compared to the same period in
2002. This increase is related to the interest expense on the note payable
to Newcastle, which was retired from the proceeds of the Company's rights
offering in September 2003. Proceeds from this note payable were used to
acquire the Commercial Lines Group and Phoenix.
Item 3. Controls and Procedures.
The Chief Executive Officer and Chief Financial Officer of the Company
have evaluated the Company's disclosure controls and procedures and have
concluded that such controls and procedures are effective as of the end of
the period covered by this report. During the most recent fiscal quarter,
there have been no changes in the Company's internal controls over financial
reporting that have materially affected, or are reasonably likely to
materially affect, the Company's internal control over financial reporting.
Risks Associated with Forward-Looking Statements Included in this Form
10-QSB
This Form 10-QSB 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-QSB 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, with the exception of the following:
On May 30, 2003, Phoenix was served with a suit from the
Superior Court of the State of Arizona in and for the
County of Pima, alleging breach of contract and bad faith
in connection with Phoenix's denial of coverage in an
automobile accident. The plaintiffs have filed an offer of
judgment in the amount of $15 million. Phoenix believes
the suit is without merit and has filed an answer denying
each and every allegation in the case. The suit is still
in pre-trial discovery stage. The Company intends to
vigorously defend Phoenix against all claims asserted by
the plaintiffs in the case.
Item 2. Changes in Securities.
None.
Item 3. Defaults on Senior Securities.
None.
Item 4. Submission of Matters to a Vote of Security-Holders.
None.
Item 5. Other Information.
None.
Item 6. Exhibits and Reports on Form 8-K.
(a) The exhibit listed in the Exhibit Index appearing on page 21 is
filed herewith.
(b) The Company filed the following 8-K reports during the third
quarter of 2003:
Form 8-K filed August 8, 2003 containing a press release
announcing financial results for the second quarter ended June
30, 2003.
Form 8-K filed September 5, 2003 containing a press release
announcing the completion of the Company's rights offering.
Exhibit Index
-------------
Exhibit
Number Description
------- -----------
10(a) Technology Processing Services Agreement, effective
December 1, 2003 between Phoenix Indemnity Insurance
Company and CGI Information Systems & Management
Consultants, Inc.
10(b) Policy and Claims Processing Services Agreement,
effective September 1, 2003 between Phoenix Indemnity
Insurance Company and CGI Information Systems &
Management Consultants, Inc.
10(c) Processing Services Agreement, effective July 1, 2003
between Hallmark General Agency, Inc., Effective Claims
Management, Inc. and CGI Information Systems &
Management Consultants, Inc.
31(a) Certification of Chief Executive Officer required by
Rule 13a-14(a) or Rule 15d-14(a).
31(b) Certification of Chief Financial Officer required by
Rule 13a-14(a) or Rule 15d-14(a).
32(a) Certification of Chief Executive Officer Pursuant to 18
U.S.C. 1350 Enacted by Section 906 of the Sarbanes-Oxley
Act of 2002.
32(b) Certification of Chief Financial Officer Pursuant to 18
U.S.C. 1350 Enacted by Section 906 of the Sarbanes-Oxley
Act of 2002.
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 14, 2003 /s/ Mark E. Schwarz
---------------------------------------------
Mark E. Schwarz, Chairman (Chief
Executive Officer)
Date: November 14, 2003 /s/ Scott K. Billings
---------------------------------------------
Scott K. Billings, Executive Vice President
(Chief Financial Officer/Principal
Accounting Officer)