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, 2001
Commission file number 0-16090
Hallmark Financial Services, Inc.
---------------------------------
(Exact name of small business issuer as specified in its charter)
Nevada 87-0447375
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(State or other jurisdiction of (I.R.S. Employer
Incorporation or organization) Identification No.)
14651 Dallas Parkway, Suite 900
Dallas, Texas 75240
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(Address of principal executive offices) (Zip Code)
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
(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 - 11,049,133 shares outstanding as of November 10, 2001.
PART I
FINANCIAL INFORMATION
Item 1. Financial Statements
INDEX TO FINANCIAL STATEMENTS
Page Number
-----------
Consolidated Balance Sheets at September 30, 3
2001 (unaudited) and December 31, 2000
Consolidated Statements of Income (unaudited) 4
for the three and nine months ended September
Consolidated Statements of Cash Flows 5
(unaudited) for the nine months ended
Notes to Consolidated Financial Statements 6
(unaudited)
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
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September 30 December 31
ASSETS 2001 2000
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(Unaudited)
Investments:
Debt securities, held-to-maturity,
at amortized cost $ 2,292,806 $ 7,243,373
Equity securities, available-for-sale,
at market value 143,901 145,302
Short-term investments, at cost which
approximates market value 11,409,936 6,188,764
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Total investments 13,846,643 13,577,439
Cash and cash equivalents 6,270,295 6,830,712
Restricted cash 2,220,370 4,276,397
Prepaid reinsurance premiums 12,381,681 10,943,902
Premium receivable from lender (net of
allowance for doubtful accounts of
$234,358 in 2001 and $168,648 in 2000) 14,648,446 13,544,985
Premiums receivable 817,213 799,140
Reinsurance recoverable 19,311,091 19,212,172
Deferred policy acquisition costs 4,245,872 3,867,033
Excess of cost over net assets acquired (net
of accumulated amortization of $1,759,853
in 2001 and $1,642,093 in 2000) 4,470,361 4,588,121
Current federal income taxes recoverable 514,172 95,232
Deferred federal income taxes 515,582 572,112
Accrued investment income 25,648 108,364
Other assets 1,097,470 642,205
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$ 80,364,844 $ 79,057,814
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Notes payable $ 12,941,560 $ 13,032,999
Unpaid losses and loss adjustment expenses 21,817,148 22,297,816
Unearned premiums 18,050,030 16,710,581
Reinsurance balances payable 4,289,231 3,341,437
Deferred ceding commissions 3,533,345 3,505,421
Drafts outstanding 918,237 1,534,721
Accrued ceding commission refund 4,296,343 2,503,128
Accounts payable and other accrued expenses 3,934,096 3,258,475
Accrued litigation costs - 1,385,840
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Total liabilities 69,779,990 67,570,418
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Stockholders' equity
Common stock, $.03 par value, authorized
100,000,000 shares issued 11,855,610
in 2001 and 2000 355,668 355,668
Capital in excess of par value 10,875,432 10,875,432
Retained earnings 396,921 1,309,934
Accumulated other comprehensive income - (10,471)
Treasury stock, 806,477 shares at cost (1,043,167) (1,043,167)
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Total stockholders' equity 10,584,854 11,487,396
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$ 80,364,844 $ 79,057,814
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The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
Three Months Ended Nine Months Ended
September 30 September 30
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2001 2000 2001 2000
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Gross premiums written $ 9,085,179 $ 12,352,363 $ 38,919,448 $ 38,450,952
Ceded premiums written (6,146,413) (8,235,564) (26,409,333) (23,636,960)
------------ ------------ ------------ ------------
Net premiums written $ 2,938,766 $ 4,116,799 $ 12,510,115 $ 14,813,992
============ ============ ============ ============
Revenues:
Gross premiums earned 12,086,975 11,202,560 37,579,999 33,713,742
Ceded premiums earned (8,184,806) (7,390,701) (24,971,554) (20,323,870)
------------ ------------ ------------ ------------
Net premiums earned 3,902,169 3,811,859 12,608,445 13,389,872
Investment income, net of expenses 274,514 293,178 816,954 811,525
Finance charges 762,531 739,000 2,456,781 2,290,386
Processing and service fees 246,307 453,147 974,903 1,592,091
Other income 184,330 76,579 290,617 243,338
------------ ------------ ------------ ------------
Total revenues 5,369,851 5,373,763 17,147,700 18,327,212
------------ ------------ ------------ ------------
Benefits, losses and expenses:
Losses and loss adjustment expenses 10,223,098 10,616,960 34,391,745 31,735,103
Reinsurance recoveries (6,485,890) (7,038,221) (22,016,718) (21,082,332)
------------ ------------ ------------ ------------
Net losses and loss adjustment expenses 3,737,208 3,578,739 12,375,027 10,652,771
Acquisition costs, net (260,861) 146,195 (350,914) 163,727
Other acquisition and underwriting
expenses (net of ceding commission of
$7,175,891 in 2001 and $7,012,256 in 2000) 901,800 416,187 2,724,004 2,539,582
Operating expenses 821,661 998,525 2,832,121 3,280,700
Interest expense 265,998 300,225 815,519 804,972
Amortization of intangible assets 39,253 39,253 117,760 117,760
------------ ------------ ------------ ------------
Total benefits, losses and expenses 5,505,059 5,479,124 18,513,517 17,559,512
------------ ------------ ------------ ------------
Income (loss) from operations before
federal income taxes (135,208) (105,361) (1,365,817) 767,700
Federal income tax expense (benefit) (31,225) (23,154) (452,804) 300,934
------------ ------------ ------------ ------------
Net income (loss) $ (103,983) $ (82,207) $ (913,013) $ 466,766
============ ============ ============ ============
Basic and diluted earnings (loss) per share $ (0.01) $ (0.01) $ (0.08) $ 0.04
============ ============ ============ ============
Common stock shares outstanding 11,049,133 11,049,133 11,049,133 11,049,133
============ ============ ============ ============
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(Unaudited)
Nine Months Ended
September 30
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2001 2000
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Cash flows from operating activities:
Net income (loss) $ (913,013) $ 466,766
Adjustments to reconcile net income (loss) to cash
(used in) provided by operating activities:
Depreciation and amortization expense 216,163 234,517
Change in deferred federal income taxes 56,530 (149,331)
Change in prepaid reinsurance premiums (1,437,779) (2,608,617)
Change in premiums receivable (18,073) (205,693)
Change in deferred policy acquisition costs (378,839) (1,089,610)
Change in deferred ceding commissions 27,924 1,253,337
Change in unpaid losses and loss
adjustment expenses (480,668) 3,162,014
Change in unearned premiums 1,339,449 4,032,735
Change in reinsurance recoverable (98,919) (4,079,985)
Change in reinsurance balances payable 947,794 1,820,648
Change in current federal income
tax payable/recoverable (418,940) (17,406)
Change in accrued ceding commission refund 1,793,215 402,198
Change in litigation cost (1,385,840) -
Change in all other liabilities 59,137 1,733,482
Change in all other assets (265,482) (141,229)
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Net cash (used in) provided
by operating activities (957,341) 4,813,826
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Cash flows from investing activities:
Purchases of property and equipment (205,196) (169,662)
Premium finance notes originated (39,337,287) (29,426,827)
Premium finance notes repaid 38,233,826 25,103,207
Change in restricted cash 2,056,027 (27,000)
Purchase of debt securities - (3,601,030)
Maturities and redemptions
of investment securities 4,962,165 1,503,624
Purchase of short-term investments (17,972,172) (14,779,428)
Maturities of short-term investments 12,751,000 14,500,000
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Net cash provided by (used in)
investing activities 488,363 (6,897,116)
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Cash flows from financing activities:
Net advances from lender 454,560 3,621,469
Repayment of borrowings (545,999) (397,299)
Proceeds from common stock issued - 250
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Net cash (used in) provided by financing activities (91,439) 3,224,420
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Increase (decrease) in cash and cash equivalents (560,417) 1,141,130
Cash and cash equivalents at beginning of period 6,830,712 5,786,069
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Cash and cash equivalents at end of period $ 6,270,295 $ 6,927,199
========== ==========
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
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 primarily of normal recurring
adjustments, necessary to present fairly the financial position of Hallmark
Financial Services, Inc. and subsidiaries (the "Company") as of September
30, 2001 and the consolidated results of operations and cash flows for the
periods presented. 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 ("GAAP") have been condensed or omitted.
Reference is made to the Company's annual consolidated financial statements
for the year ended December 31, 2000 for a description of accounting
policies and certain other disclosures. Certain items in the 2000 interim
financial statements have been reclassified to conform to the 2001
presentation.
The results of operations for the period ended September 30, 2001 are
not necessarily indicative of the operating results to be expected for the
full year.
In March 2000, the Financial Accounting Standards Board ("FASB") issued
FASB Interpretation No. 44, "Accounting for Certain Transactions Involving
Stock Compensation - an interpretation of APB Opinion No. 25" ("FIN 44").
The Company adopted FIN 44 on a prospective basis effective July 1, 2000.
The adoption of FIN 44 did not have a material impact on the Company's
results of operations, liquidity or financial position.
In September 2000, the FASB issued Statement of Financial Accounting
Standards ("SFAS") No. 140, "Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities," which replaced SFAS
No. 125 of the same name. The Statement provides consistent standards for
distinguishing transfers of financial assets that are sales from transfers
that are secured borrowings. The Statement is effective for transfers and
servicing of financial assets and extinguishments of liabilities occurring
after March 31, 2001. The Statement is also effective for recognition and
reclassification of collateral and for disclosures relating to
securitization transactions and collateral for fiscal years ending after
December 15, 2000. Disclosures for prior years' comparative financial
statements are not required. The statement's requirements had no impact on
the Company's results of operation and financial position.
In June 2001, the FASB issued SFAS No. 141, "Business Combinations"
("SFAS 141"). This statement supercedes APB Opinion No. 16, "Business
Combinations" and FASB Statement No. 38, "Accounting for Preacquisition
Contingencies of Purchased Enterprises" and establishes accounting and
reporting standards for business combinations. Under the statement, all
business combinations in the scope of the statement are to be accounted for
using one method, the purchase method. The provisions of the statement
apply to all business combinations initiated after June 30, 2001. As the
Company has not been a part of any business combination initiated after the
effective date, the Company's financial statements are not affected by SFAS
141.
In June 2001, the FASB issued SFAS No. 142, "Goodwill and Other
Intangible Assets". SFAS No. 142 will be effective for fiscal years
beginning after December 15, 2001 and will require 1) intangible assets (as
defined in SFAS No. 141) to be reclassified into goodwill, 2) the ceasing of
amortization of goodwill, and 3) the testing of goodwill for impairment at
transition and on an annual basis (or more frequently if the occurrence of
an event or circumstance indicates an impairment). The Company will adopt
SFAS No. 142 on January 1, 2002. The Company has not yet determined what
the impact of SFAS No. 142 will be on the Company's results of operations
and financial position.
On August 15, 2001, the FASB issued SFAS No. 143, "Accounting for Asset
Retirement Obligations". SFAS No. 143 requires that the fair value of a
liability for an asset retirement obligation be recognized in the period in
which it is incurred if a reasonable estimate of fair value can be made.
The associated asset retirement costs are capitalized as part of the
carrying amount of the long-lived asset. SFAS No. 143 will be effective for
financial statements issued for fiscal years beginning after June 15, 2002.
An entity shall recognize the cumulative effect of adoption of SFAS No. 143
as a change in accounting principle. The Company has not determined whether
SFAS No. 1432 will have an impact on the Company's results of operations and
financial position.
On October 3, 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets". SFAS No. 144 supersedes SFAS
No. 121 by removing goodwill from its scope, by defining a probability-
weighted cash flow estimation approach and establishes a "primary-asset"
approach to determine the cash flow estimation period for a group of assets.
SFAS No. 144 will be effective for fiscal years beginning after 2001. The
Company has not determined whether SFAS No. 143 will have an impact on the
Company's results of operations and financial position.
Note 2 - Reinsurance
The Company is involved in the assumption and cession of reinsurance
from/to other companies. The Company remains obligated to its policyholders
in the event that reinsurers do not meet their obligations under the
reinsurance agreements.
Effective March 1, 1992, the Company entered into a reinsurance
arrangement with State & County Mutual Fire Insurance Company ("State &
County"), an unaffiliated company, to assume 100% of the nonstandard auto
business produced by the Company and underwritten by State & County. The
arrangement is supplemented by a separate retrocession agreement effective
July 1, 2000 between the Company and Dorinco Reinsurance Company
("Dorinco"). Under the agreement, the Company currently retains 30% and
cedes 70% of the risk to Dorinco.
Effective April 1, 2001, the Company's reinsurance agreements with
Dorinco were amended to include a loss corridor provision whereby the
Company retains 100% of losses between a loss ratio corridor of 65% to 77%
on policies effective April 1, 2001. This corridor increased to 65% to 80%
effective July 1, 2001 on policies effective after that date. The
provisional ceding commission rate was decreased from 41% to 34% on April 1,
2001 and further decreased to 31% on July 1, 2001. Further, Dorinco and the
Company have executed a letter of agreement effective July 1, 2001, that
among other things, imposes on the Company additional financial and
operational covenants under the Dorinco reinsurance agreements, provides
remedies for the breach of such covenants (including additional surplus
requirements, rate increases and cancellation provisions) and grants to
Dorinco certain options to maintain or increase the level of its reinsurance
of Hallmark policies. Effective October 1, 2001, Dorinco extended the term
of the existing reinsurance agreement from June, 2001 to September 30, 2002.
Note 3 - Commitments and Contingencies
In March 1997, a jury returned a verdict against the Company and in
favor of a former director and officer of the Company in the amount of
approximately $517,000 on the basis of contractual and statutory
indemnification claims. The court subsequently granted the plaintiff's
motion for attorneys' fees of approximately $271,000, court costs of
approximately $39,000 and pre-judgment and post-judgment interest, and
rendered final judgment on the verdict. The Company believed the outcome in
this case was both legally and factually incorrect and appealed the
judgment. During the fourth quarter of 1997, the Company deposited
$1,248,758 into the registry of the court in order to stay execution on the
judgment pending the result of such appeals. The amount on deposit
(including interest) with the court of $1,457,311 as of December 31, 2000
was included as restricted cash in the accompanying balance sheet. During
February 2001, the court ruled against the Company in its appeal, and
$1,388,627 of the funds on deposit with the court was disbursed to the
plaintiff during March 2001. The remaining funds on deposit with the court
were refunded to the Company. There was no financial impact on the
Company's earnings in 2001.
Item 2. Management's Discussion and Analysis or Plan of Operation.
Introduction. Hallmark Financial Services, Inc. ("HFS") and its wholly
owned subsidiaries (collectively referred to herein as the "Company") engage
in the sale of property and casualty insurance products. The Company's
business primarily involves marketing, underwriting and premium financing of
non-standard automobile insurance, as well as claims adjusting and other
insurance related services.
The Company pursues its business activities through an integrated
insurance group (collectively, the "Insurance Group") the members of which
are an authorized Texas property and casualty insurance company, American
Hallmark Insurance Company of Texas ("Hallmark"); a managing general agency,
American Hallmark General Agency, Inc. ("AHGA"); a network of affiliated
insurance agencies known as the American Hallmark Agencies ("Hallmark
Agencies"); a premium finance company, Hallmark Finance Corporation ("HFC");
and a claims handling and adjustment firm, Hallmark Claims Service, Inc.
("HCS"). The Company operates only in Texas.
Hallmark provides non-standard automobile liability and physical damage
insurance through reinsurance arrangements with several unaffiliated
companies. Through arrangements with State & County Mutual Fire Insurance
Company ("State & County"), Hallmark provides insurance primarily for high-
risk drivers who do not qualify for standard-rate insurance. Under
supplementary quota-share reinsurance agreement, Hallmark, upon mutual
agreement with its current reinsurer, may elect on a quarterly basis to
retain 30% to 45% of the risk while ceding the remaining percentage to its
reinsurer. The Company's principal reinsurer, Dorinco Reinsurance Company
("Dorinco"), currently assumes 70% of Hallmark's risk. HFC finances annual
and six-month policy premiums through its premium finance program. AHGA
manages the marketing of Hallmark policies through a network of retail
insurance agencies which operate under the American Hallmark Agencies name,
and through independent agents operating under their own respective names.
Additionally, AHGA provides premium processing, underwriting, reinsurance
accounting and cash management for unaffiliated managing general agencies
("MGAs"). HCS provides fee-based claims adjustment, salvage, subrogation
recovery and litigation services to Hallmark and unaffiliated MGAs.
Reinsurance Term Changes
Effective April 1, 2001, the Company's reinsurance agreements with
Dorinco were amended to include a loss corridor provision whereby the
Company retains 100% of losses between a loss ratio corridor of 65% to 77%
on policies effective April 1, 2001. This corridor increased to 65% to 80%
effective July 1, 2001 on policies effective after that date. The
provisional ceding commission rate was decreased from 41% to 34% on April 1,
2001 and further decreased to 31% on July 1, 2001. Further, Dorinco and the
Company have executed a letter of agreement effective July 1, 2001, that
among other things, imposes on the Company additional financial and
operational covenants under the Dorinco reinsurance agreements, provides
remedies for the breach of such covenants (including additional surplus
requirements, rate increases and cancellation provisions) and grants to
Dorinco certain options to maintain or increase the level of its reinsurance
of Hallmark policies. Effective October 1, 2001, Dorinco extended the term
of the existing reinsurance agreement from June 30, 2002 to September 30,
2002.
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, processing fees, and premium finance service fees. Other
sources of funds are from financing and investment activities.
On a consolidated basis, the Company's liquidity remained relatively
the same during the first nine months of 2001 as compared to the same period
of 2000. The Company's total cash, cash equivalents and investments
(excluding restricted cash of $2.2 million) at September 30, 2001 and
December 31, 2000 were $20.1 million and $20.4 million, respectively.
Net cash used by operating activities was approximately $1.0 million
for the nine months ended September 30, 2001 compared to net cash provided
by operating activities of $4.8 million for the nine months ended September
30, 2000. This net change of approximately $5.8 million is primarily
attributable to several factors. During the first quarter of 2001, the
Company exhausted its appeals of a 1997 lawsuit and subsequently paid
approximately $1.4 million of restricted funds which had been held by the
court for several years (See Note 3 to the Consolidated Financial
Statements). The addition of a loss corridor provision in the Company's
reinsurance agreement effective April 1, 2001, increased the adverse
financial impact of the weather-related losses as well as a portion of other
second and third quarter losses. Further, during the second quarter of
2001, weather-related claims significantly impacted losses.
Cash provided by investing activities during the first nine months of
2001 increased approximately $7.4 million as compared to the first nine
months of 2000. Repayments of premium finance notes have exceeded the
origination of new premium finance notes by $3.2 million, thus increasing
cash available from investing activities. Additionally, the release of
funds during the first quarter of 2001 previously deposited in the registry
of the court and higher proceeds from maturities and calls of investments
account for the remainder of the increased funds generated by investing
activities.
Cash provided by financing activities decreased by $3.3 million during
the first nine months of 2001 as compared to the first nine months of 2000
primarily due to a decrease in net advances from the Company's premium
finance lender. As repayment of premium finance notes have exceeded new
premium finance note originations, the Company has not required as much
financing from the lender in 2001. Additionally, during 2001, the Company
began funding a portion of the premium finance notes internally.
A substantial portion of the Company's liquid assets is held by
Hallmark and is not available for general corporate purposes. Of the
Company's consolidated liquid assets of $20.1 million at September 30, 2001,
$1.6 million (as compared to $1.4 million at December 31, 2000) represents
non-restricted cash. Since state insurance regulations restrict financial
transactions between an insurance company and its affiliates, HFS is limited
in its ability to use Hallmark funds for its own working capital purposes.
Furthermore, dividends and loans by Hallmark to HFS are restricted and
subject to Texas Department of Insurance ("TDI") approval. Although TDI has
sanctioned the payment of management fees, commissions and claims handling
fees by Hallmark to HFS and affiliates, since the second half of 2000,
Hallmark has chosen not to pay all of the commissions allowed to AHGA.
Additionally, during the first nine months of 2001, Hallmark has not paid
any management fees to HFS. These steps were taken to preserve Hallmark's
surplus principally to accommodate increased premium volume during the first
half of 2001. During the first nine months of 2000, Hallmark paid $150,000
of management fees to HFS. Management anticipates that Hallmark may pay
nominal management fees during the fourth quarter of 2001. The Company has
never received a dividend from Hallmark, and there is no immediate plan to
pay a dividend.
During the first nine months of 2001, the amount of funding available
to fund premium finance notes under the secured financing arrangement with
the unaffiliated third party was increased to $12.5 million from $11.0
million. As of September 30, 2001, HFC had an outstanding balance on
advances under the financing arrangement of $12.1 million at an interest
rate of 6.5%. Under the financing arrangement, the maximum additional
advances available to HFC at September 30, 2001 were $0.4 million.
As of September 30, 2001, the Company had $1.9 million outstanding on
notes payable under a loan agreement with Dorinco. For the fiscal quarter
ended September 30, 2001, Dorinco waived compliance with certain financial
covenants of the loan agreement which were adversely impacted by changes
to the Dorinco reinsurance treaties and other factors affecting the loss
ratio of the Company. (See "Reinsurance Term Changes" and "Results of
Operations".)
Accrued ceding commission refund represents the difference between the
provisional commission allowed by the reinsurer and the actual commission
earned by Hallmark based upon contractually agreed upon loss ratios. The
$1.8 million increase in the balance since year-end 2000 is a result of the
provisional commission rate being significantly greater than the actual
commission rate currently earned by Hallmark. A substantial portion of this
refund will be paid during the first quarter of 2002 from Hallmark's cash
and/or cash equivalents.
Commissions from the Company's annual policy program for independent
agents represent a source of unrestricted liquidity when annual policy
production is level or increasing from the most recent previous quarters.
Under this program, AHGA offers independent agents the ability to write
annual policies and six-month policies, but commissions to substantially all
independent agents are paid monthly on an "earned" basis. However,
consistent with customary industry practice, Hallmark pays total commissions
up-front to AHGA based on the entire annual/six-months premiums written.
Independent agent production of annual policies was $22.1 million during the
first nine months of 2001 as compared to $18.7 million during the first nine
months of 2000. During the first nine months of 2001, AHGA received $3.3
million in commissions related to this program from Hallmark, and paid
earned commissions of approximately $3.2 million to independent agents.
During the first nine months of 2000, AHGA received $3.6 million in
commissions related to this program from Hallmark, and paid earned
commissions of $2.4 million to independent agents. As noted above, Hallmark
did not pay all of the commissions allowed to AHGA as evidenced by the
decreased commissions paid to AHGA by Hallmark during 2001 as compared to
commissions paid to AHGA during 2000 despite a $3.4 million increase in
annual policies during 2001. This was done to preserve Hallmark's surplus.
Ceding commission income represents a significant source of funds to
the Company. A portion of ceding commission income and policy acquisition
costs is deferred and recognized as income and expense, respectively, as
related net premiums are earned. Deferred ceding commission income
increased slightly from December 31, 2000 to September 30, 2001. Deferred
policy acquisition costs as of September 30, 2001 increased approximately
$0.4 million as compared to December 31, 2000. The increase in Hallmark's
core State & County annual premium volume contributed to the increase in
both deferred ceding commission income and deferred policy acquisition
costs. However, the decrease in the minimum ceding commission rate to 26%
from 31% more than offset the impact of increased annual premium volume in
relation to the deferred ceding commission income.
Premium receivable from lender increased $1.1 million during 2001 as a
result of increased annual policy production during the first nine months of
2001 as compared to the last nine months of 2000. Prepaid reinsurance
premiums and unearned premiums increased as expected in relation to
increased premium writings. Accounts payable and other accrued expenses
increased as a result of increased commissions due to independent agents
under the earned commission program.
At September 30, 2001, Hallmark's statutory capital and surplus was
$6.2 million, which reflects a slight decrease from the balance reported at
December 31, 2000. While Hallmark experienced a statutory net loss of $0.7
million during the first nine months of 2001, surplus did not decrease
accordingly. Effective January 1, 2001, TDI adopted the Codification of
Statutory Accounting Principles ("Codification") guidance, which replaces
the National Association of Insurance Commissioners primary guidance on
statutory accounting. As a result of the implementation of Codification,
Hallmark recognized a deferred tax asset in the amount of $0.5 million
during the first nine months of 2001. In accordance with Codification, the
deferred tax asset was established and a corresponding increase to surplus
was made. The deferred tax adjustment required by Codification is
recognized by TDI as an increase to surplus; however, certain rating
agencies, such as A.M. Best, do not recognize the adjustment as an increase
to surplus. Under Codification, Hallmark's premium to surplus ratio for the
twelve months ended September 30, 2001 was 2.71 to 1 as compared to 2.98 to
1 at December 31, 2000. Hallmark's premium to surplus ratio, without
Codification, for the twelve months ended September 30, 2001 was 2.93 to 1.
Management does not presently expect Hallmark to require additional capital
during 2001 to fund existing operations.
The Company provides on-going program administration and claims
handling services for one unaffiliated MGA and has three similar contracts
in run-off. The Company will continue to perform functions as defined in the
respective contracts during the run-off periods. For the one unaffiliated
MGA program which continues to produce new business, the Company, as program
administrator, performs certain administrative functions, including cash
management, underwriting and rate-setting reviews, underwriting, policy
processing and claims handling. Hallmark assumes a 20% pro-rata share of
the business produced under this unaffiliated MGA program, and Dorinco
assumes the remainder.
Management is continuing to investigate opportunities to enhance and
expand its operations. While additional capital or strategic alliances may
be required to fund future company expansion, operational enhancements
through increased information technology capabilities are in progress. The
first phase is designed to enhance Company and agency relationships by
improving content and timeliness of information to support agents in
servicing their customers. Full implementation of this web-based
information system (named e-Integrity and referred to as the "Integrity
System") was initiated and completed during the second quarter of 2001.
Additional enhancements not in the scope of the original first phase have
been developed and fully implemented during the second and third quarters of
2001. The second phase of the Integrity System is composed of two parts.
Part One relates to electronic reporting capabilities for agents and
enhanced endorsement processing, and Part Two encompasses point-of-sale
technology to support agents in more promptly and efficiently producing new
business, as well as to improve the quality and timeliness of servicing
existing policyholders. Part One will alleviate certain manual processes and
result in daily e-mailing of time-sensitive information to agents, thus
decreasing labor, supplies and postage costs and increasing the agent's
opportunity to increase policyholder retention. This phase is expected to
be completed during the first quarter of 2002. Part Two (point-of-sale
technology) is targeted to commence in Spring 2002 with full roll-out to be
completed by year-end 2002.
Results of Operations
Gross premiums written (prior to reinsurance) for the three months
ended September 30, 2001 decreased 26% as compared to the same period of
2000, while gross premium written for the nine months ended September 30,
2001 increased slightly over the same period of 2000. Net premiums written
(after reinsurance) for the three and nine months ended September 30, 2001
decreased approximately 29% and 16%, respectively, over the same periods in
2000. While gross core State & County premium volume increased approximately
7% for the nine months ended September 30, 2001, this volume increase was
offset by a decrease in premium volume from assumed business produced by
unaffiliated MGAs as compared to the prior year. Premium volume during the
third quarter of 2001 decreased as compared to the first two quarters of
2001 as well as the third quarter of 2000. This third quarter decrease was
principally due to (1) a one-third reduction in the agent base during the
last 12 months a significant portion of which ran-off early in the third
quarter of 2001 (2) successive rate increases in June and July 2001, and
(3) temporary disruption of insurance purchasing patterns as a result of the
terrorist attacks of September 11th. The disparity between gross premiums
written and net premiums written is due to the combined effect of a decrease
in policy fees retained by the Company (30% during the first nine months
of 2001 as compared to 100% during the first six months of 2000) and the
decrease in assumed business produced by the unaffiliated MGAs.
Premiums earned (prior to reinsurance) for the three and nine months
ended September 30, 2001 increased approximately 8% and 12%, respectively,
as compared to the same periods of 2000. For the three months ended
September 30, 2001, net premiums earned (after reinsurance) increased 2%,
while net premiums earned for the nine months ended September 30, 2001
decreased approximately 6% as compared to the same periods of 2000. Premiums
earned during the third quarter of 2001 increased despite the decrease in
premiums written for the same period as a result of the continued earning
of annual premiums written during previous higher volume quarters. The
disparate change in premiums earned prior to and after reinsurance is due
to the change in retention of policy fees and the decreased assumption of
premiums produced by the unaffiliated MGAs.
Net incurred loss ratios (computed on net premiums earned after
reinsurance) for the three and nine months ended September 30, 2001 were
approximately 96% and 98%, respectively, compared to 94% and 80% for the
same periods of 2000. The most significant factor impacting the 2001 loss
ratio was various amendments to Hallmark's reinsurance treaties. During the
second half of 2000, the reinsurance treaties were changed to include 100%
of policy fees in the reinsurance treaty base (i.e. Hallmark retained 30% of
policy fees during 2001 and 100% during the first six months of 2000), thus
reducing net earned premium in 2001. Reinsurance terms were further amended
effective April 1, 2001 to include a loss corridor provision, thus
increasing losses retained by the Company. If these changes to reinsurance
treaties had not occurred, the loss ratios for the three and nine months
ended September 30, 2001 would have been 70.5% and 76.6%, respectively as
compared to 85.4% and 77.4% for the respective periods of 2000.
Net incurred loss ratios (computed on net premiums earned after
reinsurance) for the three and nine months ended September 30, 2001 were
also adversely impacted by extraordinary weather-related losses principally
in connection with a catastrophic storm and flooding in the Houston area of
Texas in June 2001. These weather-related losses impacted both the number
and amount of claims filed which in turn magnified the impact of the loss
corridor. If neither the changes to the reinsurance treaties nor these
extraordinary weather-related losses had occurred, the loss ratios for the
three and nine months ended September 30, 2001 would have been 68.9% and
73.9%, respectively. Additionally, depressed premiums from 2000 (which do
not reflect the full impact of increasing rates) being earned in 2001 and
increasing claim costs (principally due to rising medical, labor and repair
costs) continue to adversely impact the 2001 loss ratio.
Finance charges, which increased approximately $0.2 million (7%) during
the first nine months of 2001 as compared to the same period of 2000,
represent interest earned on premium notes issued by HFC. This increase is
directly correlated to the increase in annual premium volume.
Processing and service fees represent fees earned on third party
processing and servicing contracts with unaffiliated MGAs. Processing and
service fees for the first nine months of 2001 decreased $0.6 million (39%)
as a result of cancellation of the service contracts with three unaffiliated
MGAs (which are currently in run-off).
During the third quarter of 2001, Hallmark received a refund of
approximately $0.1 million from the Texas Property and Casualty Insurance
Guaranty Association for assessments paid prior to 1991 which is reflected
in other income. No such refund was received during the third quarter of
2000.
Acquisition costs, net, represents the amortization of acquisition
costs (and credits) deferred over the past twelve months and the deferral of
acquisition costs (and credits) incurred in the current period. The
decrease in acquisition costs, net, is primarily due to the deferral of a
larger increase in acquisition costs than ceding commission income. The
increase in acquisition costs, net is primarily due to an increase in annual
premium volume which in turn increased the deferral rate. The decrease in
ceding commission income is principally due to the decrease in the minimum
ceding commission rate to 26% from 31% and to a lesser extent the decrease
in core State and County premium volume for the third quarter of 2001.
Other acquisition and underwriting expenses for the three and nine
months ended September 30, 2001 increased approximately 117% ($0.5 million)
and 7%, respectively, as compared to the same periods of 2000. The
significant increase noted in the third quarter of 2001 is attributable to a
$1.0 million decrease in ceding commission income as a result of 5% decrease
in the minimum ceding commission rate and a third quarter decrease in core
State & County premium volume. Partially offsetting the decrease in ceding
commission are decreases in commission expenses, front fees, premium taxes
and other variable expenses associated with the decreased premium volume.
Operating expenses include expenses related to premium finance
operations, general corporate overhead, and third party administrative and
claims handling contracts. Related revenues are derived from finance
charges and processing and service fees. Operating expenses decreased 18%
and 14%, respectively, during the three and nine months ended September 30,
2001 as compared to the same periods of 2000. The majority of this decrease
is attributable to the variable expenses related to the processing of third
party contracts. As three of the unaffiliated MGA programs are in run-off,
staffing and operational costs related to the run-off of this business have
decreased, particularly in the second and third quarters of 2001. These
decreases are partially offset by increased costs related to premium finance
operations, corporate office space and health-care.
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, 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.
Except for routine litigation incidental to the
business of the Company and as described in Note 3
to the Consolidated Financial Statements of the
Company, neither the Company, nor any of the
properties of the Company was subject to any
material pending or threatened legal proceedings
as of the date of this report.
Item 2. Changes in Securities.
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 and Reports on Form 8-K.
(a) The exhibits listed in the Exhibit Index following
the signature page are filed herewith.
(b) The Company did not file any Form 8-K Current Reports
during the third quarter of 2001.
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, 2001 /s/ Linda H. Sleeper
---------------------------
Linda H. Sleeper, President
(Chief Executive Officer
Date: November 13, 2001 /s/ John J. DePuma
---------------------------
John J. DePuma,
Chief Financial Officer
Exhibit Index
-------------
Exhibit Description
------- -----------
10 ( a ) Addendum No. 1 to the Quota Share Retrocession Agreement,
effective July 1, 2000, between American Hallmark Insurance
Company of Texas and Dorinco Reinsurance Company, effective
January 1, 2001.
10 ( b ) Addendum No. 2 to the Quota Share Retrocession Agreement,
effective July 1, 2000, between American Hallmark Insurance
Company of Texas and Dorinco Reinsurance Company, effective
July 1, 2000.
10 ( c ) Endorsement No. 1 to the Guaranty of Performance and Hold
Harmless Agreement, effective July 1, 1996 between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company,
effective July 1, 2000.
10 ( d ) Letter of Agreement, dated November 7, 2001 between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company.
10 ( e ) Second Amendment to Hallmark Financial Services, Inc. 1994
Non-Employee Director Stock Option Plan.