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, 2002
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.)
14651 Dallas Parkway, Suite 900 Dallas, Texas 75240
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(Address of principal executive offices) (Zip Code)
Issuer's telephone number, including area code: (972) 404-1637
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 - 11,049,133 shares
outstanding as of October 31, 2002.
PART I
FINANCIAL INFORMATION
Item 1. Financial Statements
INDEX TO FINANCIAL STATEMENTS
Page Number
-----------
Consolidated Balance Sheets at September 30, 2002 3
(unaudited) and December 31, 2001
Consolidated Statements of Operations 4
(unaudited) for the three and nine months
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
(In thousands, except share amounts)
--------
September 30 December 31
ASSETS 2002 2001
----------- -----------
(Unaudited)
Investments:
Debt securities, held-to-maturity,
at amortized cost $ 8,280 $ 876
Equity securities, available-for-sale,
at market value 93 144
Short-term investments, at cost which
approximates market value 6,442 15,203
----------- -----------
Total investments 14,815 16,223
Cash and cash equivalents 6,361 5,533
Restricted cash 1,607 1,990
Prepaid reinsurance premiums 9,068 11,611
Premiums receivable from lender for financed
premiums (net of allowance for doubtful
Accounts of $172 in 2002 and $208 in 2001) 11,510 13,740
Premiums receivable 891 414
Reinsurance recoverable 13,272 16,871
Deferred policy acquisition costs 1,246 761
Excess of cost over net assets acquired 4,431 4,431
Current federal income taxes recoverable - 696
Deferred federal income taxes 279 425
Accrued investment income 69 6
Other assets 733 904
----------- -----------
$ 64,282 $ 73,605
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Notes payable $ 12,317 $ 13,933
Unpaid losses and loss adjustment expenses 17,202 20,089
Unearned premiums 15,367 16,793
Reinsurance balances payable 3,217 4,426
Drafts outstanding 610 890
Accrued ceding commission refund 2,217 4,598
Accounts payable and other accrued expenses 2,506 2,508
Current federal income taxes payable 67 -
----------- -----------
Total liabilities 53,503 63,237
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Stockholders' equity
Common stock, $.03 par value, authorized
100,000,000 shares Issued 11,855,610
in 2002 and 2001 356 356
Capital in excess of par value 10,875 10,875
Retained earnings 591 180
Treasury stock, 806,477 shares in 2002
and 2001, at cost (1,043) (1,043)
----------- -----------
Total stockholders' equity 10,779 10,368
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$ 64,282 $ 73,605
=========== ===========
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except earnings per share)
Three Months Ended Nine Months Ended
September 30 September 30
--------------------- ----------------------
2002 2001 2002 2001
-------- -------- -------- --------
Gross premiums written $ 12,123 $ 9,085 $ 37,542 $ 38,919
Ceded premiums written (7,001) (6,146) (22,131) (26,409)
-------- -------- -------- --------
Net premiums written $ 5,122 $ 2,939 $ 15,411 $ 12,510
======== ======== ======== ========
Revenues:
Gross premiums earned 13,193 12,087 38,682 37,580
Ceded premiums earned (7,986) (8,185) (24,388) (24,972)
-------- -------- -------- --------
Net premiums earned 5,207 3,902 14,294 12,608
Investment income, net of expenses 146 275 417 817
Finance charges 514 763 1,804 2,457
Processing and service fees 121 246 335 975
Other income 92 184 257 291
-------- -------- -------- --------
Total revenues 6,080 5,370 17,107 17,148
Benefits, losses and expenses:
Losses and loss adjustment expenses 9,316 10,223 26,584 34,392
Reinsurance recoveries (5,634) (6,486) (15,908) (22,017)
-------- -------- -------- --------
Net losses and loss adjustment expenses 3,682 3,737 10,676 12,375
Acquisition costs, net (36) (261) (486) (351)
Other acquisition and underwriting expenses
(net of year-to-date ceding commission of
$5,795 in 2002 and $7,176 in 2001) 1,626 902 4,001 2,724
Operating expenses 490 822 1,662 2,832
Interest expense 205 266 630 816
Amortization of intangible assets - 39 - 118
-------- -------- -------- --------
Total benefits, losses and expenses 5,967 5,505 16,483 18,514
-------- -------- -------- --------
Income (loss) from operations before
federal income taxes 113 (135) 624 (1,366)
Federal income tax expense (benefit) 38 (31) 213 (453)
-------- -------- -------- --------
Net income (loss) $ 75 $ (104) $ 411 $ (913)
======== ======== ======== ========
Basic and diluted earnings (loss) per share $ 0.01 $ (0.01) $ 0.04 $ (0.08)
======== ======== ======== ========
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 STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)
Nine Months Ended
September 30
-------------------------
2002 2001
----------- -----------
Cash flows from operating activities:
Net income (loss) $ 411 $ (913)
Adjustments to reconcile net income (loss) to
cash flows used in operating activities:
Depreciation and amortization expense 120 216
Change in deferred federal income taxes 146 57
Change in prepaid reinsurance premiums 2,543 (1,438)
Change in premiums receivable (477) (18)
Change in deferred policy acquisition costs (485) (351)
Change in unpaid losses and loss
adjustment expenses (2,887) (481)
Change in unearned premiums (1,426) 1,339
Change in reinsurance recoverable 3,599 (99)
Change in reinsurance balances payable (1,209) 948
Change in current federal income
tax payable/recoverable 763 (419)
Change in accrued ceding commission refund (2,381) 1,793
Change in litigation cost - (1,386)
Change in all other liabilities (282) 59
Change in all other assets 138 (265)
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Net cash used in operating activities (1,427) (958)
----------- -----------
Cash flows from investing activities:
Purchases of property and equipment (150) (205)
Premium finance notes originated (31,243) (39,337)
Premium finance notes repaid 33,473 38,234
Change in restricted cash 383 2,056
Purchase of debt securities (10,638) -
Maturities and redemptions
of investment securities 3,285 4,962
Purchase of short-term investments (20,961) (17,972)
Maturities of short-term investments 29,722 12,751
----------- -----------
Net cash provided by investing activities 3,871 489
----------- -----------
Cash flows from financing activities:
Net advances from lender (1,616) 455
Repayment of borrowings - (546)
----------- -----------
Net cash used in financing activities (1,616) (91)
----------- -----------
Increase (decrease) in cash and cash equivalents 828 (560)
Cash and cash equivalents at beginning of period 5,533 6,831
----------- -----------
Cash and cash equivalents at end of period $ 6,361 $ 6,271
=========== ===========
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, 2002 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, 2001 for a description of accounting
policies and certain other disclosures. Certain items in the 2001 interim
financial statements have been reclassified to conform to the 2002
presentation.
The results of operations for the period ended September 30, 2002 are
not necessarily indicative of the operating results to be expected for the
full year.
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, upon mutual agreement with
Dorinco, may elect on a quarterly basis to retain 30% to 45% of the risk.
The Company currently retains 40% of the risk and cedes 60% to Dorinco. For
the period of January 1, 2002 through March 31, 2002, the Company retained
35% of the risk and ceded 65% to Dorinco. Prior to January 1, 2002, the
Company retained 30% of the risk and ceded 70% to Dorinco.
Note 3 - Intangible Assets
When the Company's primary operating subsidiaries were purchased, the
excess cost over the fair value of the net assets acquired was recorded as
goodwill and was amortized on a straight-line basis over forty years. Other
intangible assets consist of a trade name, a managing general agent's
license and non-compete arrangements, all of which were fully amortized at
September 30, 2002.
In June 2001, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 141 ("SFAS 141"), "Business
Combinations", and No. 142 ("SFAS 142"), "Goodwill and Other Intangible
Assets". SFAS 141 supersedes Accounting Principles Board Opinion ("APB")
No. 16, "Business Combinations". SFAS 141 (1) requires that the purchase
method of accounting be used for all business combinations initiated after
June 30, 2001, (2) provides specific criteria for the initial recognition
and measurement of intangible assets apart from goodwill, and (3) requires
that unamortized negative goodwill be written off immediately as an
extraordinary gain. SFAS 142 supersedes APB No. 17, "Intangible Assets,"
and is effective for fiscal years beginning after December 15, 2001. SFAS
142 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.
The Company adopted the provisions of SFAS 142 during the first quarter
of 2002 and immediately ceased recording amortization expense of its
goodwill. A reconciliation of net income and earnings per share as reported
to illustrate the impact of goodwill amortization for the nine months ended
September 30, 2002 and 2001 is as follows:
Three Months Ended Nine Months Ended
September 30 September 30
(In thousands except for earnings 2002 2001 2002 2001
per share amounts) ----- ----- ----- -----
Reported net income (loss) $ 75 $ (104) $ 411 $ (913)
Add back: Goodwill amortization - 39 - 118
----- ----- ----- -----
Adjusted net income (loss) $ 75 $ (65) $ 411 $ (795)
===== ===== ===== =====
Basic and diluted earnings per share:
Reported net income (loss) $ 0.01 $(0.01) $ 0.04 $(0.08)
Add back: Goodwill amortization - - - 0.01
----- ----- ----- -----
Adjusted net income (loss) $ 0.01 $(0.01) $ 0.04 $(0.07)
===== ===== ===== =====
SFAS 142 requires that goodwill be tested annually for impairment using
a two-step process. The first step is to determine reporting units and
compare the fair value of each reporting unit as of the beginning of the
fiscal year with its carrying amount (including goodwill) to identify any
potential impairment. The Company has completed this first step and
determined that an impairment of goodwill exists.
The second step of the goodwill impairment test under SFAS 142 is to
quantify the amount of any impairment loss as of the beginning of the fiscal
year. This process must be completed not later than the end of the fiscal
year. In accordance with SFAS 142, the Company presently expects to record
a significant charge to earnings resulting from the completion of this
transitional impairment test. Although the amount of such charge cannot
presently be reasonably estimated, the Company anticipates that the
implementation of this mandatory change in accounting principle will have a
material adverse impact on net income when recognized. The cumulative
effect of the change in accounting principle will be recognized as of
January 1, 2002.
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 four 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 a reinsurance arrangement with an unaffiliated company,
State and County Mutual Fire Insurance Company ("State & County"). Through
State & County, Hallmark provides insurance primarily for high-risk drivers
who do not qualify for standard-rate insurance. Under a supplementary quota-
share reinsurance agreement with Dorinco Reinsurance Company ("Dorinco"),
Hallmark, upon mutual agreement with its reinsurer, may elect on a quarterly
basis to retain 30% to 45% of the risk while ceding the remaining percentage
to its reinsurer. HFC finances annual and six-month policy premiums through
its premium finance program. AHGA manages the marketing of Hallmark
policies through the Hallmark Agencies and independent agents. Additionally,
AHGA provides premium processing, underwriting, reinsurance accounting and
cash management for unaffiliated managing general agents ("MGAs"). HCS
provides fee-based claims adjustment, salvage, subrogation recovery and
litigation services to Hallmark and unaffiliated MGAs.
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, and premium finance charges. Other sources of funds are from
financing and investment activities, as well as service fees.
At September 30, 2002 and December 31, 2001, the Company's consolidated
liquid assets consisting of cash, cash equivalents and investments
(excluding restricted cash) were $21.2 million and $21.8 million,
respectively. The Company's liquidity decreased 3% during the first nine
months of 2002 as compared to December 31, 2001 principally due to the
payment of an annual ceding commission adjustment with its reinsurer in the
amount of $3.4 million during the first quarter of 2002.
Net cash used by operating activities was $1.4 million for the nine
months ended September 30, 2002 as compared to approximately $1.0 million
for the same period of 2001. The approximate $3.4 million ceding commission
adjustment paid to reinsurers during the first quarter of 2002 was partially
offset by an increase in the Company's retention of State & County business
to 40% (from 35% at January 1, 2002 and 30% prior to 2002) effective April
1, 2002 under the Company's quota share retrocession agreement with Dorinco
and by an increase in monthly policy production.
Cash provided by investing activities during the first nine months of
2002 increased approximately $3.4 million as compared to the first nine
months of 2001. This increase in cash provided by investing activities was
primarily the combined result of an increase in maturities of short-term
investments and an increase in repayments of premium finance notes when
netted against originations of premium finance notes during the first nine
months of 2002 as compared to the first nine months of 2001. This increase
was partially offset by reinvestment in both intermediate and short-term
investments during the first nine months of 2002.
Cash used by financing activities increased by $1.5 million during the
first nine months of 2002 as compared to the first nine months of 2001
primarily due to a decrease in net advances from the Company's premium
finance lender. The decrease in net advances was attributable to decreased
production of annual policies during 2002 as compared to 2001.
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 $21.2 million at September 30, 2002
and $21.8 million at December 31, 2001, $2.1 million and $1.9 million,
respectively, represented 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 the Company 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. These steps were taken to preserve
Hallmark's surplus. During the first nine months of 2002, Hallmark paid
$243,000 of management fees to HFS. Management anticipates that Hallmark
may pay management fees during the fourth quarter of 2002. The Company has
never received a dividend from Hallmark, and there is no immediate plan to
pay a dividend.
Ceding commission income represents a significant source of funds to
the Company. Ceding commission income for the first nine months of 2002
decreased $1.4 million (representing a 19% decrease) as compared to the
similar period of 2002. This decrease was the result of the combined effect
of (1) less favorable reinsurance terms during 2002 compared to 2001, (2) a
decrease in core State & County premium volume, and (3) an increase in
Hallmark's risk retention to 40% effective April 1, 2002 and to 35%
effective January 1, 2002 from 30% prior to January 1, 2002. In accordance
with GAAP, 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 policy acquisition costs (net of
deferred ceding commission) increased to $1.2 million at September 30, 2002
from $0.8 million at December 31, 2001. The increase in net deferred
acquisition costs was principally due to the decrease in ceding commission
partially offset by a decrease in underwriting expenses.
At September 30, 2002, Hallmark's statutory capital and surplus was
approximately $6.5 million, which reflects an increase of $0.5 million since
December 31, 2001. Hallmark's premium to surplus ratio for the twelve
months ended September 30, 2002 was 2.9 to 1 as compared to 2.62 for the
twelve months ended December 31, 2001. Effective January 1, 2001, TDI
adopted the Codification of Statutory Accounting Principles (the
"Codification"), which replaced the National Association of Insurance
Commissioners primary guidance on statutory accounting. As a result of the
implementation of the Codification, Hallmark recognized a deferred tax asset
which is recognized by TDI as an increase to surplus.
The Company provides on-going program administration and claims
handling for unaffiliated MGAs. The Company currently provides these
services for one unaffiliated MGA which continues to produce new business.
Hallmark assumes a pro-rata share of the business produced under this
unaffiliated MGA program, and Dorinco assumes the remainder. Three other
unaffiliated MGAs for whom the Company provided similar services have
discontinued writing new business due to the inability to obtain reinsurance
and are in run-off.
Management is continuing to investigate opportunities to enhance and
expand the Company's operations. While additional capital or strategic
alliances may be required to fund future expansion, operational enhancements
through increased information technology capabilities are in progress.
During the summer of 2001, the Company rolled out its web-based information
system (named e-Integrity and referred to as the "Integrity System") which
is designed to enhance Company and agency relationships by improving content
and timeliness of information to support agents in servicing their
customers. The second phase of the Integrity System is composed of two
parts. Part One relates to electronic reporting and communication
capabilities, and Part Two encompasses, among other things, payment and new
business upload to support agents in more promptly and efficiently producing
new business, as well as to improve the quality and timeliness of service to
existing policyholders. Part One alleviates certain manual processes and
results in daily communication of time-sensitive information to agents, thus
decreasing labor, supplies and postage costs and increasing the agent's
likelihood of policyholder retention. This phase was completed during the
first quarter of 2002. Payment upload by the agents, which is included in
Part Two, was introduced during August 2002. The remainder of Part Two,
which will further reduce processing costs, is targeted to be completed by
year-end 2002 with related cost savings to commence in 2003.
Results of Operations
Overview
The Company had profitable results for the first nine months of 2002
principally due to its focus on rate adequacy, underwriting discipline and
agent management. For the first nine months ended September 30, 2002, net
income was $0.4 million compared to a net loss of $0.9 million for the same
period of 2001. Gross premiums written for the first nine months of 2002
decreased approximately 4% as compared to 2001, while net premiums written
for the first nine months of 2002 increased by 23% to $15.4 million for 2002
compared to $12.5 million in 2001. Net premiums earned of $14.3 million for
the first nine months of 2002 increased 13% in relation to net premiums
earned of $12.6 million for the comparable period of 2001.
The Company's net incurred loss ratios declined to 74.7% for the first
nine months of 2002 from 98.2% for the first nine months of 2001. Certain
key financial operational ratios follow:
Qtr Qtr YTD YTD
ended ended ended ended
9/30/02 9/30/01 9/30/02 9/30/01
------ ------ ------ ------
GAAP Incurred Loss Ratio
(excluding storm and loss corridor) 68.4% 83.7% 67.0% 88.5%
GAAP Loss Corridor Incurred
Loss Ratio (1) 1.7% 10.2% 6.2% 6.5%
GAAP Storm\Flood Incurred
Loss Ratio (2) 0.6% 1.9% 1.5% 3.2%
------ ------ ------ ------
GAAP Incurred Loss Ratio 70.7% 95.8% 74.7% 98.2%
GAAP Expense Ratio (3) 29.6% 21.2% 23.8% 18.6%
------ ------ ------ ------
GAAP Combined Ratio 100.3% 117.0% 98.5% 116.8%
====== ====== ====== ======
(1) Effective April 1, 2001, the Company's reinsurance agreement
was amended to include a loss corridor provision. Losses incurred
within the loss corridor range are retained 100% by the Company.
Losses incurred within the loss corridors for the three months
ended September 30, 2002 and 2001 were $0.1 million and $0.4
million, respectively. Losses incurred within the loss corridors
for the nine months ended September 30, 2002 and 2001 were $0.9
million and $0.8 million, respectively.
(2) Net storm losses retained by the Company were approximately
$0.03 million and $0.1 million for the three months ended
September 30, 2002 and 2001, respectively. Net storm losses
retained by the Company were approximately $0.2 million and $0.4
million for the nine months ended September 30, 2002 and 2001,
respectively.
(3) The GAAP expense ratio represents underwriting expenses and
other income less certain expenses as a percentage of net premiums
written. The principal reason for the increased GAAP expense
ratio is the decrease in ceding commission income. As a percentage
of net premiums written, ceding commission income for the three
months ended September 30, 2002 declined 21.8%. As a percentage
of net premiums written, ceding commission income for the nine
months ended September 30, 2002 declined 19.8%, as discussed in
the Financial Condition and Liquidity section.
Analysis
Gross premiums written (prior to reinsurance) for the three months
ended September 30, 2002 increased 33% as compared to the same period of
2001, while gross premium written for the nine months ended September 30,
2002 decreased approximately 4% over the same period of 2001. The 33%
increase in gross premiums written during the third quarter of 2002 compared
to the same period in 2001 is principally due to unusually low premium
volume in 2001 as a result of (1) a one-third reduction in the agent base
during the last 12 months, a significant portion of the business of the
terminated agents 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 11, 2001. The overall year to date decrease in gross premiums
written from 2001 to 2002 was principally due to the Company's strategic
focus on underwriting profitability rather than market share. This focus
included increased attention to rate adequacy, agent performance and
underwriting discipline. Net premiums written (after reinsurance) for the
three and nine months ended September 30, 2002 increased 74% and 23%,
respectively, over the same periods in 2001. The disparity between gross
premiums written and net premiums written is primarily due to the increase
in the Company's retention of premiums from 30% to 35% effective January 1,
2002 and further to 40% effective April 1, 2002.
Despite the decrease in gross premiums written compared to 2001, gross
premiums earned (prior to reinsurance) for the three and nine months ended
September 30, 2002 increased 9% and 3%, respectively, as compared to the
same periods of 2001. This was principally due to the combined effect of a
shift in policy mix from annual to monthly policies and the continued
earnings of annual premiums written at a higher volume level during 2001.
For the three and nine months ended September 30, 2002, net premiums earned
(after reinsurance) increased 33% and 13%, respectively, as compared to the
same periods of 2001. The disproportionate change in premiums earned prior
to and after reinsurance is due to the impact of the increased retention of
core State & County premium volume which has reduced ceded premiums and
ultimately increased net premiums written and earned.
Net incurred loss ratios (computed on net premiums earned after
reinsurance) for the three and nine months ended September 30, 2002 were
approximately 70.7% and 74.7%, respectively, compared to 95.8% and 98.2% for
the same periods of 2001. During the second quarter of 2001, the Company's
reinsurance agreement was amended to include a loss corridor provision which
increases net losses incurred by the Company between certain loss ratio
levels. If the loss corridor had not been in place during the first nine
months of 2002 and the second and third quarters of 2001, the year to date
net incurred loss ratios would have been 68.5% and 91.7%, respectively.
Additionally, severe storms occurring in the spring of 2002 and the Houston
flood of May 2001 impacted the 2002 and 2001 loss ratios. Excluding the
impact of storms and the loss corridor, the year to date loss ratios
for 2002 and 2001 would have been 67.0% and 88.5%, respectively. The
significant improvement in the loss ratio in 2002 compared to 2001 is
principally the result of the Company's increasing focus on underwriting
profitability during 2001 which is now reflected in 2002 results. Specific
strategies implemented in late 2000 and 2001 to improve the Company's loss
ratio included multiple rate increases, more restrictive underwriting
guidelines, reductions in agency force and emphasis on faster payment of
claims.
Investment income decreased 47% and 49% during the first three and nine
months of 2002, respectively, compared to the same periods of 2001. The
decrease is attributable to the combined effect of the decreased yield
currently available in the marketplace and maturities/calls of higher yield
investments.
Finance charges, which decreased approximately $0.2 million (33%) and
$0.7 million (27%) during the first three and nine months of 2002,
respectively, as compared to the same periods of 2001, represent interest
earned on premium notes issued by HFC. This decrease is directly correlated
to the decrease in annual policy 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 three and nine months ended September 30, 2002
decreased $0.1 million (51%) and $0.6 million (66%), respectively, compared
to the same periods of 2001, as a result of cancellation of the service
contracts with three unaffiliated MGAs (which are currently in run-off).
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 $0.1
million decrease in acquisition costs, net, is primarily due to the combined
effect of a decrease in ceding commission income due to changes in the
Company's reinsurance terms and an increase in the deferral rate as a result
of the Company increasing its retention of State & County business under its
quota share retrocession agreement.
Other acquisition and underwriting expenses for the three and nine
months ended September 30, 2002 increased 80% and 47%, respectively, as
compared to the same periods of 2001. The increase in expenses is primarily
attributable to decreased ceding commission income as a result of increases
in the Company's retention of its core business since year end 2001, less
favorable reinsurance terms, and decreased core State & County annual
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 during the
three and nine months ended September 30, 2002, decreased 40% and 41%,
respectively, as compared to the same periods of 2001. The majority of this
decrease in operating expenses is attributable to decreased operating costs
related to third party processing and claims handling, and to a lesser
extent, decreased operating costs related to premium finance.
Interest expense during the three and nine months ended September 30,
2002, decreased approximately $0.1 million and $0.2 million respectively, as
compared to 2001. This decrease is principally the result of a decrease in
the effective interest rate related to the premium finance line of credit
and to lower premium note volume as a result of lower annual premium volume.
Recent Developments
The Company's retrocession reinsurance agreement with Dorinco has been
modified effective October 1, 2002 with modestly improved terms. The
threshold of the loss corridor has been raised to a loss ratio of 65.5% from
a loss ratio of 65.01%. In addition, the ceiling of the loss corridor has
been lowered to a loss ratio of 75.5%, resulting in a narrowing of the
corridor from 15 percentage points to 10 percentage points. The minimum
ceding commission has been increased by 0.5%, and the loss ratio threshold
for minimum commissions has been raised by 0.5%. Further, Dorinco has
waived any deficit loss carryforward. A deficit loss carryforward results
when the loss ratio exceeds an established benchmark and the deficit is
carried forward into subsequent ceding commission adjustments. As a result
of the wavier of the deficit loss carryforward effective October 1, 2002,
the Company will be able to recognize additional ceding commission above the
minimum commission at established loss ratios below 65.5%. If the deficit
loss carryforward had not been waived, any potential additional commission
would have been applied to the deficit loss carryforward accumulated through
September 30, 2002.
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.
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 as of a date
within 90 days of the filing date of this report and have concluded that
such controls and procedures are effective. There have been no significant
changes in the Company's internal controls or in other factors that could
significantly affect these controls subsequent to the date of their
evaluation.
PART II
OTHER INFORMATION
Item 1. Legal Proceedings.
Except for routine litigation incidental to the business
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 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: October 31, 2002 /s/ Linda H. Sleeper
---------------------------
Linda H. Sleeper, President
(Chief Executive Officer)
Date: October 31, 2002 /s/ John J. DePuma
---------------------------
John J. DePuma,
Chief Financial Officer
CERTIFICATIONS
I, Linda H. Sleeper, Chief Executive Officer of Hallmark Financial Services,
Inc. (the "Company"), certify that:
1. I have reviewed this quarterly report on Form 10-QSB of the
Company;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances under
which such statements were made, not misleading with respect to the period
covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report, fairly present in
all material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible
for establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
have:
a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the filing
date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons performing
the equivalent functions):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's ability
to record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant deficiencies and
material weaknesses.
Date: October 31, 2002
/s/ Linda H. Sleeper
-----------------------------------------
Linda H. Sleeper, Chief Executive Officer
I, John J. DePuma, Chief Financial Officer of Hallmark Financial Services,
Inc. (the "Company"), certify that:
1. I have reviewed this quarterly report on Form 10-QSB of the
Company;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances under
which such statements were made, not misleading with respect to the period
covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly report, fairly present in
all material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible
for establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
have:
a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to the filing
date of this quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons performing
the equivalent functions):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrant's ability
to record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the registrant's
internal controls; and
6. The registrant's other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant deficiencies and
material weaknesses.
Date: October 31, 2002
/s/ John J. DePuma
-----------------------------------------
John J. DePuma, Chief Financial Officer
Exhibit Index
-------------
Exhibit Description
------- -----------
10 ( a ) Addendum No. 3 to the Quota Share Retrocession
Agreement, effective July 1, 2000, between American
Hallmark Insurance Company of Texas and Dorinco
Reinsurance Company, effective June 30, 2001.
10 ( b ) Amendment of Article VII of the Amended and Restated
Bylaws of Hallmark Financial Services, Inc., adopted
July 19, 2002.
10 ( c ) Form of Indemnification Agreement between Hallmark
Financial Services, Inc. and its officers and directors,
adopted July 19, 2002.
99 Certification Pursuant to 18 U.S.C. 1350 Enacted by
Section 906 of the Sarbanes-Oxley Act of 2002.