CONFORMED COPY
U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-KSB
Annual Report under Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the fiscal year ended December 31, 2001
Commission file number 0-16090
HALLMARK FINANCIAL SERVICES, INC.
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(Name of Small Business Issuer in Its Charter)
Nevada 87-0447375
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(State or Other Jurisdiction (I.R.S. Employer I.D. No.)
of Incorporation Organization)
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
Securities registered under Section 12(b) of the Exchange Act:
Title of Each Class Name of Each Exchange on Which Registered
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Common Stock $.03 par value American Stock Exchange Emerging Company
Marketplace
Securities registered under Section 12(g) of the Exchange Act: None
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for
such shorter period that the registrant was required to file such reports)
and (2) has been subject to such filing requirements for the past 90 days
Yes [ XX ] No [ ]
Check if there is no disclosure of delinquent filers in response to Item
405 of Regulation S-B contained in this form, and no disclosure will be
contained, to the best of the registrant's knowledge, in definitive proxy
or information statements incorporated by reference in Part III of this
Form 10-KSB or any amendment to this Form 10-KSB.
Yes [ XX ] No [ ]
State issuer's revenues for its most recent fiscal year - $22,003,891.
State the aggregate market value of the voting stock held by non-affiliate
- $2,049,955 as of March 21, 2002.
State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date. Common Stock, $.03 par
value - 11,049,133 shares outstanding as of March 21, 2002.
DOCUMENTS INCORPORATED BY REFERENCE
The information required by Part III is incorporated by reference from the
Registrant's definitive proxy statement to be filed with the Commission
pursuant to Regulation 14A not later than 120 days after the end of the
fiscal year covered by this report.
Risks Associated with Forward-Looking Statements Included in this Form
10-KSB
This Form 10-KSB contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934, which are intended to be covered by the
safe harbors created thereby. These statements include the plans and
objectives of management for future operations, including plans and
objectives relating to future growth of the Company's business activities
and availability of funds. The forward-looking statements included herein
are based on current expectations that involve numerous risks and
uncertainties. Assumptions relating to the foregoing involve judgments with
respect to, among other things, future economic, competitive and market
conditions, regulatory framework, 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. Further, the Company's insurance
operations are inherently susceptible to unforeseeable catastrophic events,
such as weather-related disasters. Although the Company believes that the
assumptions underlying the forward-looking statements are reasonable, any
of the assumptions could be inaccurate and, therefore, there can be no
assurance that the forward-looking statements included in this Form 10-KSB
will prove to be accurate. In light of the significant uncertainties
inherent in the forward-looking statements included herein, the inclusion of
such information should not be regarded as a representation by the Company
or any other person that the objectives and plans of the Company will be
achieved.
Item 1. Description of Business.
Introduction
Hallmark Financial Services, Inc. ("HFS") and its wholly owned
subsidiaries (collectively, the "Company") engage in the sale of property
and casualty insurance products. The Company's business primarily involves
marketing, underwriting and premium financing of non-standard automobile
insurance, as well as claims adjusting and other insurance related services.
Overview
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 adjusting firm, Hallmark Claims Service, Inc. ("HCS"). The
Company operates only in Texas.
Hallmark writes non-standard automobile liability and physical damage
coverages. Hallmark provides insurance through a reinsurance arrangement
with an unaffiliated company, State & 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.
AHGA holds an appointment from State & County to manage the sale and
servicing of State & County policies. Hallmark reinsures 100% of the State
& County policies produced by AHGA under a related reinsurance agreement.
AHGA markets the policies produced by Hallmark through the Hallmark Agencies
and through approximately 400 independent agents operating under their
own names. Additionally, AHGA provides premium processing, underwriting,
reinsurance accounting, and cash management for unaffiliated managing
general agencies ("MGAs"). Hallmark assumes a portion of the business
produced by these unaffiliated MGA's.
HFC offers premium financing for policies sold by the Hallmark Agencies
and independent agents managed by AHGA.
HCS provides fee-based claims adjustment, salvage and subrogation
recovery, and litigation services to Hallmark and unaffiliated MGA's.
Insurance Group Operations
Formed in 1987, HFS commenced its current operations in 1990 when it
acquired, through several transactions, most of the companies now referred
to as the Insurance Group. HFS manages Hallmark, AHGA, the Hallmark
Agencies, HFC and HCS as an integrated Insurance Group that shares common
management, computer facilities and corporate offices.
The Company offers both liability and physical damage (comprehensive and
collision) coverages. Hallmark's bodily injury liability coverage is limited
to $20,000 per person and $40,000 per accident, and property damage
liability coverage is limited to $15,000 per accident. Physical damage
coverage is limited to $40,000 and $30,000 for vehicles insured under
annual/six-month and monthly policies, respectively. Hallmark also offers
optional bodily injury liability coverage of $25,000 per person and $50,000
per accident and optional physical damage liability coverage of $25,000 per
accident on annual and semi-annual policies. Additionally, late in 2001,
rental, towing and labor coverages were added.
Substantially all purchasers of Hallmark policies are individuals. No
single customer or group of related customers has accounted for more than 1%
of its net premiums written during any of the last three years.
The Company writes annual, monthly and six-month policies. The Company's
core net premium volume was composed of a policy mix of 64% annual, 35%
monthly and 1% six-month policies in 2001, and 57% annual, 42% monthly and
1% six-month policies in 2000. The Company's typical customer is unable or
unwilling to pay either a half- or full-year's premium in advance, and thus
a monthly policy, or an annual or six-month policy subject to financing,
suits his/her budgetary needs.
The Company finances annual and six-month policy premiums produced by AHGA
through a premium finance program offered by HFC. During 2001, 94% of
Hallmark's annual and six-month policyholders financed their premiums
through HFC's premium finance program. During 2000 and 1999 the percentages
were 93% and 92%, respectively.
HCS provides claims adjustment and related litigation services to both the
Company and unaffiliated MGAs. Fees are charged either on a per-file basis,
as a percentage of earned premiums or, in certain instances, a combination
of both methods. When the Company receives notice of a loss, HCS personnel
establish a claim file and an estimated loss reserve. HCS's adjusters
review, investigate and initiate claim payments. The Company has an in-
house legal department that closely manages its claims-related litigation.
Management believes that the Company achieves superior efficiency and cost
effectiveness by principally utilizing trained employee-adjusters and an in-
house litigation department.
Underwriting and Other Ratios
An insurance company's underwriting experience is traditionally measured
by its statutory "combined ratio". The combined ratio under statutory
accounting practices ("SAP") is the sum of (1) the ratio of net losses and
loss adjustment expenses ("LAE") incurred to net premiums earned (referred
to as the "statutory loss ratio"), and (2) the ratio of underwriting and
operating expenses to net premiums written (referred to as the "statutory
expense ratio"). During 2001, 2000 and 1999, Hallmark experienced statutory
loss ratios of 98.6%, 84.7% and 66.5%, respectively. During the same
periods, it experienced statutory expense ratios of 16.7 %, 16.4% and 29.1%,
respectively, and statutory combined ratios of 115%, 101% and 96%,
respectively. These statutory ratios do not reflect the deferral of policy
acquisition costs, investment income, premium finance revenues, or the
elimination of intercompany transactions required by accounting principles
generally accepted in the United States of America ("GAAP").
The most significant factor impacting the 2001 and 2000 statutory loss
ratio was various amendments to the Company's reinsurance treaties. As
discussed more fully below under Reinsurance Arrangements, Hallmark's
reinsurance treaties were changed effective July 1, 2000 to include policy
origination fees previously retained by the Company in the premiums subject
to ceding, thus directly impacting the Company's 2001 and 2000 statutory
loss ratios. Reinsurance terms were further amended effective April 1, 2001
to include a loss corridor provision, thus increasing losses retained by the
Company. If all of these reinsurance changes had not occurred, the
statutory loss ratios for 2001 and 2000 would have been 76.7% and 79.2%,
respectively.
The statutory loss ratio for 2001 was 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 statutory loss ratio for 2001 would have
been 74.5%. 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) adversely impacted the 2001statutory loss ratio.
The statutory expense ratio for 2001 increased only slightly over the 2000
statutory expense ratio despite a 5% decrease in the minimum ceding
commission rate effective April 1, 2001 and cession of 70% of policy
origination fees for all of 2001 as compared to half of 2000. These
decreases were partially offset by decreased commissions to AHGA and
decreased management fees to the Company, as discussed further under the
Financial Condition and Liquidity section below. The decrease in the 2001
and 2000 statutory expense ratios in relation to 1999 is primarily
attributable to the changes in the minimum ceding commission rate during
2000 and 2001.
Under Texas Department of Insurance ("TDI") guidelines, property and
casualty insurance companies are expected to maintain a premium-to-surplus
ratio of not more than 3 to 1. The premium-to-surplus ratio measures the
relationship between net premiums written in a given period (premiums
written, less returned premiums and reinsurance ceded to other carriers) to
surplus (admitted assets less liabilities), all determined on the basis of
SAP. For 2001, 2000, and 1999, Hallmark's premium-to-surplus ratios were
2.62 to 1, 2.98 to 1 and 2.57 to 1, respectively. The increase in the 2000
premium-to-surplus ratio was attributable primarily to increased core State
& County premium volume, expenditures on systems development and, to a
lesser extent, the increase in unaffiliated MGA premium volume assumed
during 2000.
Reinsurance Arrangements
Hallmark shares its claims risk with non-affiliated insurance companies.
Commencing March 1, 1992, Hallmark and AHGA entered into a reinsurance
arrangement with State & County. Effective July 1, 1996, this arrangement
was supplemented by separate risk-sharing agreements between Hallmark and
three unaffiliated companies, all of which are rated A- or better by A.M.
Best: GE Reinsurance Company ("GE RE"), Dorinco Reinsurance Company
("Dorinco"), and Odyssey Reinsurance Corporation ("Odyssey"). Effective
July 1, 1997, the treaty was renewed with GE RE and Dorinco under
substantially the same terms and conditions. Effective July 1, 2000, the
treaty was renewed solely with Dorinco under modified terms and conditions.
Under the Company's arrangement with State & County, AHGA is a managing
general agency appointed by State & County to issue State & County policies,
as well as to appoint producing agents to sell these policies. As
compensation for acting as the managing general agency, AHGA receives from
Hallmark commissions equal to a percentage of premiums written. It uses the
majority of these commissions to compensate its producing agents for selling
State & County policies. AHGA issues State & County policies in accordance
with Hallmark's underwriting standards and pursuant to rates approved by
State & County. Although State & County is required to file periodic rate
adjustments with the state, TDI approval is not required. Hallmark reinsures
100% of the State & County business produced by AHGA. Ceding fees paid by
Hallmark to State & County are equal to a percentage of premiums written
(including policy origination fees).
Effective July 1, 2000, the Company entered into a new reinsurance
agreement with Dorinco whereby the Company, upon mutual agreement with
Dorinco, may elect on a quarterly basis to retain 30% to 45% of the risk.
During the period of July 1, 2000 through December 31, 2001, the Company
elected to retain 30%, and Dorinco assumed 70% of the State & County
business produced by AHGA. In addition, Dorinco unconditionally guarantees
Hallmark's and AHGA's obligations to State & County. Under the current
reinsurance agreement, policy origination fees which were previously
retained by the Company are now included in the reinsurance treaty premium
base. Policy origination fees are fees that the Company is permitted by law
to charge in addition to premiums to cover or defray certain costs
associated with producing policies.
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 after April 1, 2001. As of July 1, 2001, this corridor
increased to 65% to 80% on policies effective after that date. The
provisional ceding commission rate was decreased to 34% from 41% on April 1,
2001 and further decreased to 31% on July 1, 2001. The provisional
commission is adjusted annually on a sliding scale based on annual loss
ratios. Further, Dorinco and the Company 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, 2001
to September 30, 2002.
As indicated above, because of our loss experience in 2001 our reinsurance
agreement terms were made significantly more restrictive in 2001 and could
change favorably or unfavorably in 2002. Additional restriction of our
reinsurance coverage, decreases in the provisional ceding commission and
increases in premium and policy amounts ceded increase the Company's
exposure to losses and could result in a failure of subsequent amended
treaties to qualify for reinsurance accounting. The availability of
reinsurance is an important factor in the Company's ability to continue
writing new business at the same levels it has historically maintained.
Limitations on the reinsurance coverage available to the Company would
increase the Company's exposure to losses and reductions in Hallmark's
statutory surplus.
From July 1, 1997 through June 30, 2000, GE RE and Dorinco, collectively,
assumed 75% of the State & County business produced by AHGA. From July 1,
1996 through June 30, 1997, GE RE, Dorinco and Odyssey, collectively,
assumed 75% of the State & County business. For the period of January 1,
1999 through June 30, 2000, Hallmark retained 100% of the policy origination
fees, paid premium taxes and ceding fees on 100% of the business produced,
and received a 30% provisional commission on the portion of the business
ceded. Prior to 1999, Hallmark retained 62.5% and ceded 37.5% of policy
origination fees to the reinsurers.
Marketing
Customers for non-standard automobile insurance typically fall into two
groups. The first are drivers who do not qualify for standard auto
insurance due to driving record, claims history, residency status, type of
vehicle or adverse credit history. The second group is drivers who live in
areas of Texas in which there is limited availability of standard rate
insurance.'
As the managing general agency, AHGA manages the marketing of the
Company's non-standard automobile insurance program through a retail network
of affiliated and independent agencies. At December 31, 2001, there were
four affiliated offices operating under the American Hallmark Agencies name
in Amarillo, Corpus Christi, Lubbock and the Dallas metropolitan area. In
addition, the Company is represented by approximately 400 independent agents
with offices located throughout the State of Texas.
The Hallmark Agencies' business is developed primarily through
advertising in regional and local publications, direct-mail, telephone
solicitation, referrals and existing customers. In addition, field
marketing representatives promote the Company's insurance programs to
prospective independent agents and service existing agents. Both the
Hallmark Agencies and the independent agents represent other insurers and
sell other insurance products in addition to Hallmark policies. The
Company's appointed independent agents are located throughout Texas in major
cities, as well as suburban and some rural areas, with an emphasis in the
central and southern regions of Texas.
Competition
For several years through mid-2000, the Texas non-standard insurance
market was characterized by an acceleration in competition. A significant
number of companies, many of which were newly formed, entered the
marketplace by introducing programs with drastically reduced pricing. In
turn, existing competitors reduced pricing of existing programs and
introduced increasingly competitive new programs. This climate of intense
competition occurred principally as a by-product of the excess capital and
surplus of major insurance and reinsurance companies. However, beginning
approximately mid-2000, this trend started to abate. A number of companies
have withdrawn their non-standard automobile programs from Texas and others
are no longer writing business due to the inability to obtain reinsurance.
In this changing environment, Hallmark has implemented a number of rate
increases and strengthened its underwriting standards while continuing to
provide superior service to its agents and insureds.
Insurance Regulation
The operations of Hallmark, AHGA and HFC are regulated by TDI. Hallmark
is required to file quarterly and annual statements of its financial
condition with TDI, prepared in accordance with SAP. Hallmark's financial
condition, including the adequacy of its surplus, premium-to-surplus ratio,
loss reserves, deposits and investments, is subject to review by TDI. Since
Hallmark does not write its insurance directly, but rather writes through a
county mutual, its premium rates and underwriting guidelines are not subject
to the same degree of regulation imposed on standard insurance companies.
However, State & County must file rate changes with TDI. AHGA and the
producing agents who staff the Hallmark Agencies offices are also subject to
TDI's licensing requirements. In addition, HFC is subject to licensing,
financial reporting and certain financial requirements required by TDI.
HFC's interest rates, note forms and disclosures, among other things, are
also regulated by the Texas Office of Consumer Credit Commissioner.
TDI has broad authority to enforce its laws and regulations through
examinations, administrative orders, civil and criminal enforcement
proceedings, and suspension or revocation of an insurer's Certificate of
Authority or an agent's license. In extreme cases, including actual or
pending insolvency, TDI may take over, or appoint a receiver to take over,
the management or operations of an insurer or an agent's business or assets.
In addition, all insurance companies which write insurance in the State of
Texas are subject to assessments for a state administered fund which covers
the claims and expenses of insolvent or impaired insurers. The size of the
assessment is determined each year by the total claims on the fund that
year. Each insurer is assessed a pro-rata share based on its direct
premiums written. Payments to the fund may be recovered by the insurer
through deductions from its premium taxes at a rate of 10% per year over ten
years. On December 31, 2001, the Company was assessed $72,692 for 2001.
There were no assessments during 2000.
HFS is also regulated as an insurance holding company under the Texas
Insurance Code. Financial transactions between HFS or any of its affiliates
and Hallmark are subject to regulation by TDI. Applicable regulations
require TDI's approval of management and expense sharing contracts,
intercompany loans and asset transactions, investments in the Company's
securities by Hallmark and similar transactions. Further, dividends and
distributions by Hallmark to HFS are restricted.
On May 11, 2000, TDI issued its formal report on the results of TDI's
regular, triennial examination of Hallmark's books and records as of
December 31, 1998. The report indicated that no significant items or
discrepancies were noted during the examination. TDI has notified the
Company that it will perform a triennial examination of Hallmark as of
December 31, 2001 sometime during 2002. TDI has not yet set a date for the
commencement of this examination. On January 29, 2001, TDI issued its
formal report on the results of TDI's market conduct examination of AHGA.
The report indicated that AHGA was materially in compliance with TDI
regulations governing market conduct.
Effective December 31, 1994, the National Association of Insurance
Commissioners ("NAIC") requested property/casualty insurers to file a risk-
based capital ("RBC") calculation according to a specified formula. The
purpose of the NAIC-designed formula is twofold: (1) to assess the adequacy
of an insurer's statutory capital and surplus based upon a variety of
factors such as potential risks related to investment portfolio, ceded
reinsurance and product mix; and (2) to assist state regulators under the
RBC for Insurers Model Act (the "Model Act") by providing thresholds at
which a state commissioner is authorized and expected to take regulatory
action. TDI adopted the Model Act during 1998. Hallmark's 2001 and 2000
adjusted capital under the RBC calculation exceeded the minimum TDI
requirement by 80% and 79%, respectively.
Analysis of Hallmark's Losses and LAE
The Company's consolidated financial statements include an estimated
reserve for unpaid losses and LAE of Hallmark. Hallmark estimates its
reserve for unpaid losses and LAE by using case-basis evaluations and
statistical projections, which include inferences from both losses paid and
losses incurred. Hallmark also uses recent historical cost data, periodic
reviews of underwriting standards and claims management to modify the
statistical projections. Hallmark gives consideration to the impact of
inflation in determining its loss reserves, but does not discount reserve
balances.
The amount of Hallmark's reserves represents management's estimates of the
ultimate net cost of all unpaid losses and LAE incurred through December of
each year. These estimates are subject to the effect of trends in claim
severity and frequency. Management continually reviews the estimates and
adjusts them as claims experience develops and new information becomes
known. Such adjustments are included in current operations, including
increases and decreases, net of reinsurance, in the estimate of ultimate
liabilities for insured events of prior years. (See Note 1 to the
Consolidated Financial Statements.)
The Company seeks to continually improve its loss estimation process by
refining its ability to analyze loss development patterns, claim payments,
and other information within a legal and regulatory environment which
affects development of ultimate liabilities. During late-1997 and 1998, the
Company significantly accelerated its use of voluntary mediations (prior to
court-ordered mediations) and began to more aggressively participate in
"settlement weeks" sponsored by the courts in various counties throughout
the state. These actions have increased the timeliness in which litigation
claims settle and have favorably impacted ultimate settlements.
Changes in loss development patterns and claim payments can significantly
affect the ability of insurers to estimate reserves for unpaid losses and
related expenses. Future changes in estimates of claim costs may adversely
affect future period operating results; however, such effects cannot be
reasonably estimated currently.
Reconciliation of Reserve for Unpaid Losses and LAE. The following table
provides a 2001 and 2000 reconciliation of the beginning and ending reserve
balances, on a gross-of-reinsurance basis, to the gross amounts reported in
the Company's balance sheet at December 31, 2001 and 2000 (in thousands):
2001 2000
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Reserve for unpaid losses and LAE, net $ 7,451 $ 5,409
of reinsurance recoverables, January 1
Provision for losses and LAE for claims 15,356 14,460
occurring in the current period
Increase in reserve for unpaid losses and 522 97
LAE for claims occurring in prior periods
Payments for losses and LAE, net of reinsurance:
Current period (10,033) (9,286)
Prior periods (5,377) (3,229)
Reserve for unpaid losses and LAE, net of $ 7,919 $ 7,451
Reinsurance recoverable, December 31
Reinsurance recoverable on unpaid losses and 12,170 14,847
LAE at December 31
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Reserve for unpaid losses and LAE, gross of
reinsurance at December 31 $ 20,089 $ 22,298
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[This space left blank intentionally.]
SAP/GAAP Reserve Reconciliation. The differences between the reserves for
unpaid losses and LAE reported in the Company's consolidated financial
statements prepared in accordance with GAAP and those reported in the annual
statement filed with TDI in accordance with SAP for years 2001 and 2000 are
summarized below in thousands:
December 31
2001 2000
----- -----
Reserve for unpaid losses and LAE on a SAP
basis (net of reinsurance recoverables on
unpaid losses) $7,779 $7,213
Add estimated future unallocated LAE reserve
for which HCS is contractually liable 140 238
----- -----
Reserve for unpaid losses and LAE on a GAAP
basis (net of reinsurance recoverables on
unpaid losses) $7,919 $7,451
===== =====
Analysis of Loss and LAE Reserve Development
The following table shows the development of Hallmark's loss reserves, net
of reinsurance, for 1991 through 2001. Section A of the table shows the
estimated liability for unpaid losses and LAE, net of reinsurance, recorded
at the balance sheet date for each of the indicated years. This liability
represents the estimated amount of losses and LAE for claims arising in
prior years that are unpaid at the balance sheet date, including losses that
have been incurred but not yet reported to Hallmark. Section B of the table
shows the re-estimated amount of the previously recorded liability, based on
experience as of the end of each succeeding year. The estimate is increased
or decreased as more information becomes known about the frequency and
severity of claims.
Cumulative Redundancy/Deficiency (Section C of the table) represents the
aggregate change in the estimates over all prior years. Thus, changes in
ultimate development estimates are included in operations over a number of
years, minimizing the significance of such changes in any one year. The
effects on income in the past two years of changes in estimates of the
liabilities for losses and LAE are shown in the table under reconciliation
of reserves for unpaid losses and LAE.
[This space left blank intentionally.]
ANALYSIS OF LOSS AND LAE DEVELOPMENT
(Thousands of dollars)
Year Ended December 31 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01
---------------------- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ----
A. Reserve for 3353 4374 4321 4297 5923 5096 4668 4580 5409 7451 7919
Unpaid Losses & LAE,
Net of Reinsurance
Recoverables
B. Net Reserve Re-
estimated as of :
One year later 2815 3423 4626 5175 5910 6227 4985 4594 5506 7973
Two years later 2885 3285 4499 5076 6086 6162 4954 4464 5277
Three years later 2813 3147 4288 5029 6050 6117 4884 4225
Four years later 2700 3095 4251 5034 6024 6070 4757
Five years later 2699 3067 4238 5031 6099 5954
Six years later 2685 3065 4239 5038 6044
Seven years later 2686 3065 4234 5030
Eight years later 2686 3057 4234
Nine years later 2686 3057
Ten years later 2686
C. Net Cumulative 667 1317 87 (733) (121) (858) (89) 355 132 (522)
Redundancy (Deficiency)
D. Cumulative Amount
of Claims Paid, Net
of Reserve
Recoveries, through:
One year later 1958 2109 3028 3313 3783 4326 3326 2791 3229 5377
Two years later 2472 2768 3883 4442 5447 5528 4287 3476 4436
Three years later 2654 2958 4147 4861 5856 5860 4387 3911
Four years later 2668 3027 4207 4975 5933 5699 4571
Five years later 2669 3054 4218 5005 6018 5818
Six years later 2685 3056 4223 5030 6018
Seven years later 2686 3056 4234 5030
Eight years later 2686 3057 4234
Nine years later 2686 3057
Ten years later 2686
2000 2001
------ ------
Net Reserve-December 31 $ 7,451 $ 7,919
Reinsurance Recoverables 14,847 12,170
Gross Reserve - December 31 $22,298 $20,089
====== ======
Net Re-estimated Reserve 7,973
Re-estimated Reinsurance Recoverable 15,725
Gross Re-estimated Reserve $23,698
======
Gross Cumulative Deficiency $(1,400)
======
Investment Policy
Hallmark's investment objective is to maximize current yield while
maintaining safety of capital together with sufficient liquidity for ongoing
insurance operations. Accordingly, the investment portfolio is composed of
fixed income securities: U.S. Government and U.S. Government agency
debentures and agency mortgage-backed securities, municipal securities and
U.S. Government bond mutual funds. The average maturity of the portfolio
(after taking into account current assumptions regarding anticipated
principal prepayments on mortgage-backed securities and the call dates of
certain securities held), including short-term investments, is approximately
three years, which approximates Hallmark's claims payment patterns. It is
Hallmark's intent to hold investments until maturity. Maturities, bond
calls and prepayments of mortgage-backed securities totaling approximately
$6.4 million represent the securities liquidated in 2001. In addition, as
part of the Company's overall investment strategy, the Company utilizes an
integrated cash management system to maximize investment earnings on all
available cash. During 2001, the Company's investment income totaled
approximately $1.0 million compared to approximately $1.3 million for 2000.
Employees
On December 31, 2001, the Company employed 128 people on a full-time basis
as compared to 144 people at December 31, 2000. None of the
Company's employees are represented by labor unions. The Company considers
its employee relations to be excellent.
Item 2. Description of Property.
The Company's corporate headquarters are located at 14651 Dallas Parkway,
Suite 900, Dallas, Texas. The suite is located in a high-rise office
building and contains approximately 25,570 square feet of space. Effective
June 7, 2000, the Company renegotiated its lease for a period of 71 months
to expire November 30, 2007. The rent is currently $42,617 per month.
The Hallmark Agencies' offices are located in four Texas cities, including
Corpus Christi, Amarillo, Lubbock and the Dallas metropolitan area. These
offices are located in office buildings, shopping centers, store fronts and
similar commercial structures in low and middle income neighborhoods. They
contain an average of 900 square feet. All are leased, some on a month-to-
month basis and others for remaining terms ranging up to 36 months. The type
of space the Hallmark Agencies occupy is generally available at moderate
rentals. The Company does not consider the location of any particular
agency office to be material to its insurance marketing operations.
Item 3. Legal Proceedings.
Except for routine litigation incidental to the business of the Company
and as described in Note 10 to the Consolidated Financial Statements,
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 4. Submission of Matters to a Vote of Security Holders.
During the fourth quarter of 2001, the Company did not submit any matter
to a vote of its security holders.
PART II
Item 5. Market for Common Equity and Related Stockholder Matters.
The Company's Common Stock has traded on the American Stock Exchange's
Emerging Company Marketplace under the symbol "HAF.EC" since January 6,
1994. The following table shows the Common Stock's high and low sales
prices on the AMEX Emerging Company Marketplace for each quarter since
January 1, 2000.
Period High Sale Low Sale
2000
----
First Quarter $ 0.44 $ 0.38
Second Quarter 0.50 0.38
Third Quarter 0.69 0.50
Fourth Quarter 0.69 0.44
2001
----
First Quarter $ 0.69 $ 0.50
Second Quarter 0.65 0.50
Third Quarter 0.61 0.43
Fourth Quarter 0.60 0.40
2002
----
First Quarter (thru March 21) $ 0.60 $ 0.43
On March 21, 2002 there were 157 record holders and approximately 557
beneficial shareholders of the Company's Common Stock.
The Company has never paid dividends on its Common Stock. The Board of
Directors intends to continue this policy for the foreseeable future in
order to retain earnings for development of the Company's business.
Item 6. Management's Discussion and Analysis or Plan of Operation.
The following discussion of the Company's financial condition and the
results of its operations should be read in conjunction with the
consolidated financial statements and related notes included in this report.
Critical Accounting Policies
The following discussion provides management's assessment of financial
results and material changes in financial position for the Company. This
discussion is based upon the Company's consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States. The Company's significant accounting
policies requiring management estimates and judgments relate to investments,
receivable from lender for financed premiums, deferred policy acquisition
costs, intangible assets, deferred tax assets, reserves for unpaid losses
and loss adjustment expenses, reinsurance and statutory accounting
practices. Such estimates and judgments are based on historical experience,
changes in laws and regulations, observance of industry trends and various
information received from third parties. While the estimates and judgments
associated with the application of these accounting policies may be
affected by different assumptions or conditions, the Company believes the
estimates and judgments associated with the reported consolidated
financial statement amounts are appropriate in the circumstances.
Investments. Investment income is an important source of revenue, and
the Company's return on invested assets has a material effect on net income.
The Company's investment policy is subject to the requirements of
regulatory authorities. In addition, certain assets are held on deposit with
the State of Texas and invested in specified securities in order to comply
with state law. Although the Company closely monitors its investment
portfolio, available yields on newly-invested funds and gains or losses
on existing investments depend primarily on general market conditions. See
Item 1 for additional discussion of the Company's investment policy.
Investments in debt securities are reported at amortized cost. The
Company has the intent and ability to hold all investments in debt
securities to maturity. Provisions for possible losses are recorded only on
other-than-temporary declines in the value of an investment.
Investments in equity securities available-for-sale are reported at market
value. Unrealized gains and losses are recorded as a component of
stockholders' equity.
Short-term investments are carried at amortized cost which approximates
market. Short-term investments include U.S. Government securities maturing
within one year.
Realized investment gains and losses are recognized in operations on the
specific identification method.
Receivable from Lender for Financed Premiums. The majority of Hallmark's
annual insurance premiums are financed through the Company's premium finance
program offered by its wholly-owned subsidiary, HFC. Finance charges on the
premium finance notes are recorded as interest earned. This interest is
earned on the Rule of 78's method which approximates the interest method for
such short-term notes.
The Company routinely establishes a reserve for uncollectible premium
finance note balances based upon historical experience. As of December 31,
2001 and 2000, the Company's premium finance note receivables were $13.7
million and $13.5 million, respectively, net of allowances for
uncollectible amounts of $0.2 million for both years.
Effective November 18, 1999, HFC entered into a secured financing
arrangement (the "Financing Arrangement") and a servicing agreement with an
unaffiliated third party in order to fund HFC's premium finance activities.
The Financing Arrangement provides that HFC sell to the third party all
eligible premium finance notes generated by HFC in connection with the
financing of insurance policies. The transaction is accounted for as a
secured financing transaction. Under the Financing Arrangement, HFC may
from time to time specify the amount to be advanced by the third party and
secured by the premium finance notes (up to a maximum of 94% of the face
amount of the premium finance notes).
Collections on the premium finance notes are remitted to HFC to the extent
they exceed the sum of (a) the aggregate amount of all prior advances, (b)
interest on the aggregate advance balance from time to time outstanding, and
(c) certain other fees and expenses payable to the third party. The
interest payable under the Financing Arrangement is at the prime rate plus a
spread ranging from one-half percent to one percent depending on the unpaid
balance of the advances. As of December 31, 2001 and 2000, HFC had an
outstanding balance on advances under the Financing Arrangement of $12.2
million and $10.6 million, respectively, and the applicable interest rates
were 5.75% and 10%, respectively.
Deferred Policy Acquisition Costs. Policy acquisition costs (mainly
commissions, underwriting and marketing expenses) that vary with and are
primarily related to the production of new and renewal business, are
deferred and charged to operations over periods in which the related
premiums are earned.
The method followed in computing deferred acquisition costs limits the
amount of such deferred costs to their estimated realizable value. A
premium deficiency exists if the sum of expected claim costs and claim
adjustment expenses, expected dividends to policyholders, unamortized
acquisition costs, and maintenance costs exceeds related unearned premiums
and expected investment income on those unearned premiums. The Company
routinely evaluates the realizability of deferred acquisition costs. At
December 31, 2001 and 2000, there was no premium deficiency related to
deferred acquisition costs.
Ceding commissions from reinsurers, which include expense allowances, are
deferred and recognized over the period premiums are earned for the
underlying policies reinsured. At December 31, 2001 and 2000, the amount of
deferred policy acquisition costs, net of deferred ceding commissions, was
$0.8 million and $0.4 million, respectively.
Intangible Assets. When Hallmark, AHGA, HFC and HCS were purchased by
HFS, the excess cost over the fair value of the net assets acquired was
recorded as goodwill and is being 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 December 31, 2001.
The Company continually reevaluates the propriety of the carrying amount
of goodwill as well as the amortization period to determine whether current
events and circumstances warrant adjustments to the carrying value and/or
revised estimates of useful lives. At this time, the Company believes that
no significant impairment of the goodwill has occurred and that no reduction
of the estimated useful life is warranted.
In June 2001, the FASB 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 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 will adopt the provisions of SFAS 142 in the first quarter of
2002. The Company is in the process of preparing for its adoption of SFAS
142 and is making the determinations as to what its reporting units are and
what amounts of goodwill, intangible assets, other assets, and liabilities
should be allocated to those reporting units. The Company expects that it
will no longer record approximately $157,000 of annual amortization relating
to its existing goodwill.
SFAS 142 requires that goodwill be tested annually for impairment using a
two-step process. The first step is to identify a potential impairment and,
in transition, this step must be measured as of the beginning of the fiscal
year. However, a company has six months from the date of adoption to
complete the first step. The Company expects to complete that first step of
the goodwill impairment test during the first or second quarter of 2002. The
second step of the goodwill impairment test measures the amount of the
impairment loss (measured as of the beginning of the year of adoption), if
any, and must be completed by the end of the Company's fiscal year 2002.
Any intangible assets deemed to have an indefinite life will be tested for
impairment using a one-step process which compares the fair value to the
carrying amount of the asset as of the beginning of the fiscal year, and
pursuant to the requirements of SFAS 142 will be completed during the first
or second quarter of 2002. Any impairment loss resulting from the
transitional impairment tests will be reflected as the cumulative effect of
a change in accounting principle in the first or second quarter of 2002.
The Company has not yet determined what effect these impairment tests will
have on the Company's earnings and financial position. However, an
impairment loss may be recognized.
Deferred Tax Assets. The Company files a consolidated federal income tax
return. Deferred federal income taxes reflect the future tax consequences
of differences between the tax bases of assets and liabilities and their
financial reporting amounts at each year end. Deferred taxes are recognized
using the liability method, whereby tax rates are applied to cumulative
temporary differences based on when and how they are expected to affect the
tax return. Deferred tax assets and liabilities are adjusted for tax rate
changes. A valuation allowance is provided against the Company's deferred
tax asset to the extent that management does not believe it is more likely
than not that future taxable income will be adequate to realize these future
tax benefits. This allowance was $33,000 in 2001 and 2000. The Company's
deferred tax asset, net of the above valuation allowance, was $0.4 million
and $0.6 million at December 31, 2001 and 2000, respectively.
Reserves for Unpaid Losses and Loss Adjustment Expenses. Reserves for
unpaid losses and loss adjustment expenses are established by the Company
for benefit payments which have already been incurred by the policyholder
but which have not been paid by the Company. Losses and loss adjustment
expenses represent the estimated ultimate net cost of all reported and
unreported losses incurred through December 31, 2001 and 2000. The
liabilities for unpaid losses and loss adjustment expenses are estimated
using individual case-basis valuations and statistical analyses. These
estimates are subject to the effects of trends in loss severity and
frequency. Although considerable variability is inherent in such estimates,
management believes that the liabilities for unpaid losses and loss
adjustment expenses are adequate. The estimates are continually reviewed
and adjusted as necessary as experience develops or new information becomes
known; such adjustments are included in current operations. The liabilities
for unpaid losses and loss adjustment expenses of $20.1 million and $22.3
million at December 31, 2001 and 2000, respectively, are reported net of
recoverables for salvage and subrogation of approximately $0.3 million for
both years.
The Company's reserve requirements are also interrelated with product
pricing and profitability. The Company must price its products at a level
sufficient to fund its policyholder benefits and still remain profitable.
Because the Company's claim expenses represent the single largest category
of its operating expenses, inaccuracies in the assumptions used to estimate
the amount of such benefits can result in the Company failing to price its
products appropriately and to generate sufficient premiums to fund the
payment thereof.
Reinsurance. As is customary in the insurance industry, the Company
reinsures, or cedes, portions of the coverage provided to policyholders to
other insurance companies. Cession of reinsurance is utilized by an insurer
to limit its maximum loss thereby providing a greater diversification of
risk and minimizing exposures on larger risks. Reinsurance does not
discharge the primary liability of the original insurer with respect to such
insurance. See Item 1 for further discussion of the Company's reinsurance
arrangements.
Statutory Accounting Practices. Hallmark is required to report its
results of operations and financial position to the Texas Department of
Insurance based upon "SAP". Under SAP, unlike GAAP, Hallmark is required
to expense all sales and other policy acquisition costs as they are
incurred rather than capitalizing and amortizing them over the expected
life of the policy. The immediate charge off of sales and acquisition
expenses and the sometimes conservative other valuation under SAP generally
cause a lag between the sale of a policy and the emergence of reported
earnings. Because this lag can reduce Hallmark's gain from operations on a
SAP basis, it can have the effect of reducing the amount of funds available
for dividend to HFS.
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, premium finance service charges and service
fees. Other sources of funds are from financing and investment activities.
On a consolidated basis, the Company's liquidity increased approximately
7% as of December 31, 2001 as compared to December 31, 2000. The Company's
consolidated cash, cash equivalents and investments at December 31, 2001 and
2000 were $21.8 million and $20.4 million, respectively, excluding
restricted cash of approximately $2.0 million and $4.3 million,
respectively.
Net cash used by the Company's consolidated operating activities was
approximately $1.4 million for the year ended December 31, 2001 compared to
net cash provided by operating activities of $6.1 million for the year ended
December 31, 2000. This net change of approximately $7.5 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 10 to the Consolidated Financial
Statements). Further, during the second quarter of 2001, weather-related
claims significantly impacted losses. 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 losses from April 1, 2001 through December 31, 2001.
Cash used by investing activities during 2001 decreased approximately $8.0
million as compared to 2000. Repayments of premium finance notes during
2001 were approximately equal to the origination of new premium finance
notes, thus reducing the use of cash for premium finance operations. The
release of funds previously deposited in the registry of the court and
higher proceeds from maturities and calls of investments account for the
remainder of the decrease in funds used by investing activities.
Cash provided by financing activities decreased by $2.8 million during
2001 as compared to 2000 primarily due to a decrease in net advances from
the Company's premium finance lender. As repayment of premium finance notes
have approximated net 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 consolidated liquid assets are held
by Hallmark and are not available for general corporate purposes. Of the
Company's consolidated liquid assets of $21.8 million at December 31, 2001,
approximately $1.9 million (as compared to approximately $1.4 million in
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 also restricted and, in certain instances, subject to TDI approval.
Based on surplus at December 31, 2001, Hallmark could pay a dividend of up
to $0.6 million to HFS during 2002 without 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, Hallmark only paid management fees of $50,000 to HFS during
2001 as compared to $150,000 in 2000. These steps were taken to preserve
Hallmark's surplus. Management anticipates that Hallmark may pay management
fees during 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 commissions for 2001 decreased $0.3 million
(representing a 3% decrease) as compared to 2000. This decrease is the
result of the decrease in the minimum ceding commission rate partially
offset by the increase in premium volume of the core State & County
business. In accordance with GAAP, a portion of ceding commissions 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
approximately $0.8 million at December 31, 2001 from $0.4 million at
December 31, 2000. The increase is principally due to the decrease in the
minimum ceding commission rate partially offset by an increase in the
Company's core State & County annual premium volume.
The accrued ceding commission refund represents the difference between the
ceding commission received based upon provisional commission and the ceding
commission earned based on current loss ratios. This accrued refund is
settled periodically with the reinsurers. Of the approximately $4.6 million
accrued refund at December 31, 2001, $3.4 million was refunded to Dorinco in
March 2002.
During December 2001, the amount of funding available to fund premium
finance notes under a secured financing arrangement with an unaffiliated
third party was increased to $13.5 million from $12.0 million. As of
December 31, 2001, HFC had an outstanding balance on advances under the
financing arrangement of $12.2 million at an interest rate of 5.75%. Under
the financing arrangement, the maximum additional advances available to HFC
at December 31, 2001 were $1.3 million. At December 31, 2000, HFC had an
outstanding balance on advances under the financing arrangement of $10.6
million at an interest rate of 10%.
At December 31, 2001, Hallmark reported statutory capital and surplus of
approximately $6.0 million, which reflects a decrease of approximately $0.4
million from the approximately $6.4 million reported at December 31, 2000.
Hallmark reported a statutory net loss of approximately $0.9 million during
2001 compared to statutory net income of $0.1 million in 2000. At December
31, 2001, Hallmark showed a premium-to-surplus ratio of 2.62 to 1, as
compared to 2.98 to 1 for the year ended December 31, 2000. Effective
January 1, 2001, the Company implemented new Codification of Statutory
Accounting Principles (the "Codification") guidance in the preparation of
Hallmark's statutory financial statements. The cumulative effect of the
adoption of Codification was recorded as an adjustment to Hallmark's
statutory surplus as of January 1, 2001 in accordance with Codification
guidance regarding reporting of changes in accounting principles. The
adjustment increased Hallmark's statutory surplus by $0.5 million primarily
as a result of recording a deferred tax asset.
The Company provides 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 provides 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. 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 Phase One enhancements were 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 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 servicing 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 has been completed during the first quarter of 2002.
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
Gross premiums written (prior to reinsurance) of $49.6 million for the
year ended December 31, 2001 decreased approximately 2% in relation to gross
premiums written in 2000. This decrease in 2001 was due to a decrease in
assumed business produced by unaffiliated MGAs (three of which programs are
in run-off) partially offset by an increase in core State & County premium
volume. The increase in core premiums written is principally attributable to
the impact of increased premium rates. Net premiums written (after
reinsurance) decreased 17% during 2001 as compared to 2000. The
disproportionate change between the percentage decrease in gross written
premiums and net written premiums is due to the combined effect of the
decrease in assumed business produced by the unaffiliated MGAs and the
decrease in policy fees retained by the Company (30% during 2001 as compared
to 100% during the first six months of 2000).
Gross premiums earned (prior to reinsurance) of $49.5 million increased
9% during 2001 as compared to 2000, and net premiums earned (after
reinsurance) decreased 6%. 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.
Incurred loss ratios (computed on premiums earned both prior to and after
reinsurance), on a GAAP basis, for the year ended December 31, 2001, were
approximately 88% and 97%, respectively, as compared to 95% prior to and 84%
after reinsurance for 2000. The most significant factor impacting the 2001
net loss ratio (after reinsurance) was various amendments to Hallmark's
reinsurance treaties. During the second half of 2000, the reinsurance
treaties were changed to include 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 net loss ratios
would have been 75.3% for 2001 and 78.2% for 2000.
Incurred loss ratios for 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 net loss ratio for 2001 would have been
73.1%. The gross incurred loss ratio was only impacted by the weather-
related losses and not the changes in reinsurance terms. The gross loss
ratio excluding the impact of the weather-related losses was 85.5% for 2001.
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. Management has implemented rate
increases and increased the restrictiveness of underwriting guidelines in
2001 in an effort to improve the Company's loss exposure in 2002.
The Company's insurance operations are inherently susceptible to
unforeseeable catastrophic events, such as weather-related disasters. If
excessive claims from any such catastrophic event caused the Company to
exceed its anticipated range of loss ratios in 2002, the Company's financial
position could be adversely impacted.
Finance charges, which increased approximately $0.2 million (6%) during
2001 as compared to 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 processing and
servicing contracts with unaffiliated MGAs. Processing and service fees for
2001 decreased $0.8 million (43%) 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
decrease in acquisition costs, net, is primarily due to the combined effect
of a larger increase in acquisition costs than ceding commission income, and
the increase in the deferral rate due to higher annual premium volume in
2001 than in 2000. The decrease in ceding commission income is due to the
decrease in the minimum ceding commission rate as a result of amendments to
the Company's reinsurance agreements.
Other acquisition and underwriting expenses increased 12% ($0.4 million)
as compared to the prior year. The increase in other acquisition and
underwriting expenses is primarily attributable to decreased ceding
commission income as a result of amendments to the Company's reinsurance
terms. Secondarily, acquisition and underwriting expenses, gross of ceding
commission, increased 1% during 2001 as compared to the prior year. These
expenses include supervisory and management expenses, reflected as operating
expenses during 2000 as they related to oversight of the premium processing
of the unaffiliated MGA's business. The combined effect of the increase in
supervisory and management expenses and a significant increase in corporate
office lease costs during 2001 account for the increased acquisition and
underwriting expenses. The increase in these expenses is partially offset
by decreases in various other expenses which are principally due to the
introduction and usage of the Integrity system by both independents and the
Company.
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 for 2001 decreased 23%
($1.0 million) in relation to the prior year. The majority of this decrease
is attributable to decreases in expenses related to the premium processing
for the unaffiliated MGA programs (three of which are in run-off).
Litigation costs during 2000 represented an accrual for additional post-
judgment interest and legal fees associated with the appeal of a 1997
verdict. During 2000, the court ruled against the Company in its appeal of
a 1997 verdict in favor of a former director and officer of Hallmark. The
judgment was paid out of restricted funds during March 2001. There was no
financial impact on the Company's earnings in 2001.
Item 7. Financial Statements
The following consolidated financial statements of the Company
and its subsidiaries are filed as part of this report.
Description Page Number
----------- -----------
Report of Independent Accountants F-2
Consolidated Balance Sheets at December 31, 2001 and 2000 F-3
Consolidated Statements of Operations for the
Years Ended December 31, 2001 and 2000 F-4
Consolidated Statements of Stockholders' Equity
for the Years Ended December 31, 2001 and 2000 F-5
Consolidated Statements of Cash Flows for the
Years Ended December 31, 2001 and 2000 F-6
Notes to Consolidated Financial Statements F-7
Item 8. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.
None
PART III
Item 9. Directors, Executive Officers, Promoters and Control Persons;
Compliance with Section 16(a) of the Exchange Act.
The information required by Part III, Item 9 is incorporated by reference
from the Registrant's definitive proxy statement to be filed with the
Commission pursuant to Regulation 14A not later than 120 days after the end
of the fiscal year covered by this report.
Item 10. Executive Compensation.
The information required by Part III, Item 10 is incorporated by
reference from the Registrant's definitive proxy statement to be filed with
the Commission pursuant to Regulation 14A not later than 120 days after the
end of the fiscal year covered by this report.
Item 11. Security Ownership of Certain Beneficial Owners and Management.
The information required by Part III, Item 11 is incorporated by reference
from the Registrant's definitive proxy statement to be filed with the
Commission pursuant to Regulation 14A not later than 120 days after the end
of the fiscal year covered by this report.
Item 12. Certain Relationships and Related Transactions.
The information required by Part III, Item 12 is incorporated by reference
from the Registrant's definitive proxy statement to be filed with the
Commission pursuant to Regulation 14A not later than 120 days after the end
of the fiscal year covered by this report.
Item 13. Exhibits and Reports on Form 8-K.
(a) Exhibits. The exhibits listed in the Exhibit Index appearing at
page 19 of this report are filed with or incorporated by reference in this
Report.
(b) Reports on Form 8-K. The Company did not file any Form 8-K
Current Reports during the fourth quarter of 2001.
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
HALLMARK FINANCIAL SERVICES, INC.
(Registrant)
Date: March 27, 2002 /s/ Linda H. Sleeper
----------------------------------
Linda H. Sleeper, President
(Chief Executive Officer)
Date: March 27, 2002 /s/ Johnny J. DePuma
----------------------------------
Johnny J. DePuma, Vice President
(Chief Financial Officer/Principal
Accounting Officer)
In accordance with the Exchange Act, this report has been signed below by
the following persons on behalf of the registrant and in the capacities and
on the dates indicated.
Date: March 27, 2002 /s/ Linda H. Sleeper
----------------------------------
Linda H. Sleeper, Director
Date: March 27, 2002 /s/ James H. Graves
----------------------------------
James H. Graves, Director
Date: March 27, 2002 /s/ George R. Manser
----------------------------------
George R. Manser, Director
Date: March 27, 2002 /s/ Scott T. Berlin
----------------------------------
Scott T. Berlin, Director
Date: March 27, 2002 /s/ Mark E. Schwarz
----------------------------------
Mark E. Schwarz, Director
EXHIBIT INDEX
The following exhibits are either filed with this report or incorporated
by reference.
Exhibit
Number Description
------ -----------
3(a) Articles of Incorporation of the registrant, as amended
(incorporated by reference to Exhibit 3(a) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended December
31, 1993).
3(b) By-Laws of the registrant, as amended (incorporated by
reference to Exhibit 3(b) to the registrant's Annual Report on
Form 10-KSB for the fiscal year ended December 31, 1993).
4 Specimen certificate for Common Stock, $.03 par value, of the
registrant (incorporated by reference to Exhibit 4 to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1991).
10(a) Office Lease for 14651 Dallas Parkway, Suite 900, dated January
1, 1995, between American Hallmark Insurance Company of Texas
and Fults Management Company, as agent for The Prudential
Insurance Company of America (incorporated by reference to
Exhibit 10(a) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 1994).
10(b) General Agency Agreement, effective March 1, 1992, between
State & County Mutual Fire Insurance Company and Brokers
General, Inc. (incorporated by reference to Exhibit 10(b) to
Amendment No. 1 on Form 8 to the registrant's Quarterly Report
on Form 10-QSB for the quarter ended September 30, 1992).
10(c) 1991 Key Employee Stock Option Plan of the registrant
(incorporated by reference to Exhibit C to the definitive Proxy
Statement relating to the registrant's Annual Meeting of
Shareholders held May 20, 1991).
10(d) 1994 Key Employee Long Term Incentive Plan (incorporated by
reference to Exhibit 10(f) to the registrant's Annual Report on
Form 10-KSB for the fiscal year ended December 31, 1994).
10(e) 1994 Non-employee Director Stock Option Plan (incorporated by
reference to Exhibit 10(g) to the registrant's Annual Report on
Form 10-KSB for the fiscal year ended December 31, 1994).
10(f) Form of Executive Compensation Agreement representing
respective agreements dated August 23, 1994, between registrant
and Ramon D. Phillips, Raymond A. Kilgore, Linda H. Sleeper,
and Johnny J. DePuma (incorporated by reference to Exhibit
10(p) to the registrant's Annual Report on Form 10-KSB for the
fiscal year ended December 31, 1994).
10(g) Addendum No. 1 to the 100% Quota Share Reinsurance Agreement,
as restated between State & County Mutual Fire Insurance
Company and American Hallmark Insurance Company of Texas
effective November 22, 1994 (incorporated by reference to
Exhibit 10(q) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 1994).
10(h) Second, Third, Fourth and Fifth Amendments to Office Lease for
14651 Dallas Parkway, Suite 900, dated January 1, 1995, between
American Hallmark Insurance Company of Texas and Fults
Management Company, as agent for The Prudential Insurance
Company of America (incorporated by reference to Exhibit 10(t)
to the registrant's Annual Report on Form 10-KSB for the fiscal
year ended December 31, 1995).
10(i) Form of 100% Quota Share Reinsurance Agreement between State &
County Mutual Fire Insurance Company and American Hallmark
Insurance Company of Texas effective July 1, 1996 (incorporated
by reference to Exhibit 10(a) to the registrant's Quarterly
Report on Form 10-QSB for the quarter ended June 30, 1996).
Exhibit
Number Description
------ -----------
10(j) Form of Quota Share Retrocession Agreement between American
Hallmark Insurance Company of Texas and the Reinsurer
(specifically identified as follows: Dorinco, Kemper and
Skandia), effective July 1, 1996 (incorporated by reference to
Exhibit 10(b) to the registrant's Quarterly Report on Form 10-
QSB for the quarter ended June 30, 1996).
10(k) Form of Quota Share Retrocession Agreement between American
Hallmark Insurance Company of Texas and the Reinsurer
(specifically identified as follows: Dorinco, Kemper and
Skandia), effective July 1, 1996 (incorporated by reference to
Exhibit 10(b) to the registrant's Quarterly Report on Form 10-
QSB for the quarter ended June 30, 1996).
10(l) Guaranty Agreement effective July 1, 1996 provided by Dorinco
Reinsurance Company in favor of State & County Mutual Fire
Insurance Company (incorporated by reference to Exhibit 10(c)
to the registrant's Quarterly Report on Form 10-QSB for the
quarter ended June 30, 1996).
10(m) Form of Guaranty of Performance and Hold Harmless Agreement
effective July 1, 1996 between Hallmark Financial Services,
Inc. and Dorinco America Reinsurance Corporation (incorporated
by reference to Exhibit 10(f) to the registrant's Quarterly
Report on Form 10-QSB for the quarter ended June 30, 1996).
10(n) Form of Addendum No. 3 - Termination to 100% Quota Share
Reinsurance Agreement between American Hallmark Insurance
Company and State & County Mutual Fire Insurance Company
(incorporated by reference to Exhibit 10(j) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended June 30,
1996).
10(o) Form of 100% Quota Share Reinsurance Agreement, effective
January 1, 1997, between State & County Mutual Fire Insurance
Company, Vaughn General Agency, Inc. and American Hallmark
General Agency, Inc. (incorporated by reference to Exhibit
10(am) to the registrant's Annual Report on Form 10-KSB for the
fiscal year ended December 31, 1996).
10(p) Form of General Agency Agreement, effective January 1, 1997,
between Dorinco Reinsurance Company, State & County Mutual Fire
Insurance Company and Vaughn General Agency, Inc. (incorporated
by reference to Exhibit 10(an) to the registrant's Annual
Report on Form 10-KSB for the fiscal year ended December 31,
1996).
10(q) Form of Administrative Services Agreement between State &
County Mutual Fire Insurance Company, Vaughn General Agency,
Inc. and American Hallmark General Agency, Inc. (incorporated
by reference to Exhibit 10(ao) to the registrant's Annual
Report on Form 10-KSB for the fiscal year ended December 31,
1996).
10(r) Form of Loan Agreement dated March 11, 1997, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company.
(incorporated by reference to Exhibit 10(ap) to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1996).
10(s) Form of Promissory Note dated March 11, 1997, with Hallmark
Financial Services, Inc. as Maker and Dorinco Reinsurance
Company as Payee. (incorporated by reference to Exhibit 10(aq)
to the registrant's Annual Report on Form 10-KSB for the year
ended December 31, 1996).
10(t) Stock Pledge and Security Agreement dated March 11, 1997,
between ACO Holdings, Inc. and Dorinco Reinsurance Company.
(incorporated by reference to Exhibit 10(ar) to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1996).
10(u) Form of Endorsement No. 1, effective July 1, 1996, to the 100%
Quota Share Reinsurance Agreement between State & County Mutual
Fire Insurance Company and American Hallmark Insurance Company
of Texas, effective July 1, 1996. (incorporated by reference to
Exhibit 10(a) to the registrant's Quarterly Report on Form 10-
QSB for the quarter ended June 30, 1997).
Exhibit
Number Description
------ -----------
10(v) Form of Endorsement No. 1, effective July 1, 1997, to the
Guaranty Agreement provided by Dorinco Reinsurance Corporation
in favor of State & County Mutual Fire Insurance Company,
effective July 1, 1996. (incorporated by reference to Exhibit
10(d) to the registrant's Quarterly Report on Form 10-QSB for
the quarter ended June 30, 1997).
10(w) Form of Endorsement No. 1 - Termination, effective January 1,
1997, to the Quota Share Retrocession Agreement between
American Hallmark Insurance Company of Texas and the Reinsurers
(Dorinco Reinsurance Company and Odyssey Reinsurance
Corporation), effective July 1, 1996. (incorporated by
reference to Exhibit 10(e) to the registrant's Quarterly Report
on Form 10-QSB for the quarter ended June 30, 1997).
10(x) Form of Endorsement No. 1, effective July 1, 1997, to the Quota
Share Retrocession Agreement between American Hallmark
Insurance Company of Texas and the Reinsurer (Dorinco
Reinsurance Company), effective July 1, 1996. (incorporated by
reference to Exhibit 10(h) to the registrant's Quarterly
Report on Form 10-QSB for the quarter ended June 30, 1997).
10(y) Endorsement No. 2, effective January 1, 1997, to the Quota
Share Retrocession Agreement between American Hallmark
Insurance Company of Texas and Dorinco Reinsurance Company,
effective January 1, 1997. (incorporated by reference to
Exhibit 10(bh) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 1997).
10(z) Endorsement No. 1, effective January 1, 1997, to the 100% Quota
Share Reinsurance Agreement between State & County Mutual Fire
Insurance Company, Vaughn General Agency, Inc. and American
Hallmark General Agency, Inc. (incorporated by reference to
Exhibit 10(bi) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 1997).
10(aa) Form of Endorsement No. 2, effective July 1, 1997, to the 100%
Quota Share Reinsurance Agreement between State & County Mutual
Fire Insurance Company, Vaughn General Agency, Inc., American
Hallmark General Agency, Inc. and the Reinsurers (Dorinco
Reinsurance Company and Kemper Reinsurance Company) effective
July 1, 1997. (incorporated by reference to Exhibit 10(bj) to
the registrant's Annual Report on Form 10-KSB for the fiscal
year ended December 31, 1997).
10(ab) Form of Amendment No. 1 to the Loan Agreement dated March 11,
1997, between Hallmark Financial Services, Inc. and Dorinco
Reinsurance Company. (Incorporated by reference to Exhibit
10(bg) to the registrant's annual Report on Form 10KSB for the
fiscal year ended December 31, 1998.)
10(ac) Form of Retrocession Agreement effective March 1, 1998, between
American Hallmark Insurance Company of Texas, Dorinco
Reinsurance Company and Associated General Agency, Inc.
(Incorporated by reference to Exhibit 10(bh) to the
registrant's annual Report on Form 10KSB for the fiscal year
ended December 31, 1998.)
10(ad) Form of Quota Share Retrocession Agreement effective September
1, 1998, between American Hallmark Insurance Company of Texas,
Dorinco Reinsurance Company and Van Wagoner Companies, Inc.
(Incorporated by reference to Exhibit 10(bj) to the
registrant's annual Report on Form 10KSB for the fiscal year
ended December 31, 1998.)
10(ae) Endorsement No. 5, effective January 1, 1999, to the Quota
Share Retrocession Agreement between American Hallmark
Insurance Company of Texas and the Reinsurer (Dorinco
Reinsurance Company), effective January 1, 1997. (incorporated
by reference to Exhibit 10(a) to the registrant's Quarterly
Report on Form 10-QSB for the quarter ended June 30, 1999).
10(af) Endorsement No. 4, effective January 1, 1999, to the Quota
Share Retrocession Agreement between American Hallmark
Insurance Company of Texas and the Reinsurer (GE Re Reinsurance
Company), effective January 1, 1996.(incorporated by reference
to Exhibit 10(b) to the registrant's Quarterly Report on Form
10-QSB for the quarter ended June 30, 1999).
Exhibit
Number Description
------ -----------
10(ag) Form of Endorsement No. 2, effective July 1, 1997, to the 100%
Quota Share Reinsurance Agreement between State & County Mutual
Fire Insurance Company, Vaughn General Agency, Inc. and
American Hallmark General Agency, Inc. (incorporated by
reference to Exhibit 10(bg) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 1999)
10(ah) Form of Amendment No. 3 to the Loan Agreement dated March 11,
1997, between Hallmark Financial Services, Inc. and Dorinco
Reinsurance Company. (incorporated by reference to Exhibit
10(bh) to the registrant's Annual Report on Form 10-KSB for the
fiscal year ended December 31, 1999)
10(ai) Form of Endorsement No. 6, effective January 1, 1999, to the
Quota Share Retrocession Agreement between American Hallmark
Insurance Company of Texas and Dorinco Reinsurance Company,
effective January 1, 1997. (incorporated by reference to
Exhibit 10(bi) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 1999)
10(aj) Form of the Second Renewal Promissory Note dated November 19,
1999, with Hallmark Financial Services, Inc. as Maker and
Dorinco Reinsurance Company as Payee. (incorporated by
reference to Exhibit 10(bj) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 1999)
10(ak) Form of Sale and Assignment Agreement dated November 18, 1999,
with Hallmark Finance Corporation as Seller and FPF, Inc.
(incorporated by reference to Exhibit 10(bk) to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1999)
10(al) Form of Premium Receivable Servicing Agreement dated November
18, 1999 between Hallmark Finance Corporation and FPF, Inc.
(incorporated by reference to Exhibit 10(bl) to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1999)
10(am) Seventh Amendment to Office Lease for 14651 Dallas Parkway,
Suite 900, dated January 1, 1995, between American Hallmark
Insurance Company of Texas and Fults Management Company, as
agent for The Prudential Insurance Company of America
(incorporated by reference to Exhibit 10(a) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended June 30,
2000).
10(an) Quota Share Retrocession Agreement, effective July 1, 2000,
between American Hallmark Insurance Company of Texas and
Dorinco Reinsurance Company (incorporated by reference to
Exhibit 10(a) to the registrant's Quarterly Report on Form 10-
QSB for the quarter ended September 30, 2000).
10(ao) Addendum No. 2 to the Retrocession Contract, effective June 1,
1998, issued to Dorinco Reinsurance Company by American
Hallmark Insurance Company of Texas, effective October 1, 1999
(incorporated by reference to Exhibit 10(b) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended September
30, 2000).
10(ap) Form of Eighth Amendment to Office Lease for 14651 Dallas
Parkway, Suite 900, dated January 1, 1995, between American
Hallmark Insurance Company of Texas and Fults Management
Company, as agent for The Prudential Insurance Company of
America.
10(aq) Form of Quota Share Retrocession Contract between Dorinco
Reinsurance Company and American Hallmark Insurance Company of
Texas, effective September 1, 2000.
10(ar) Form of Endorsement No. 5, effective July 1, 2000, to the 100%
Quota Share Reinsurance Agreement issued to State and County
Mutual Fire Insurance Company, effective January 1, 1997.
10(as) Form of Endorsement No. 4, effective July 1, 2000, to the 100%
Quota Share Reinsurance Agreement between State and County
Mutual Fire Insurance Company and American Hallmark Insurance
Company of Texas, effective July 1,1996.
Exhibit
Number Description
------ -----------
10(at) Form of Termination Addendum to the Quota Share Retrocession
Agreement, effective June 30, 2000, issued to Dorinco
Reinsurance Company by American Hallmark Insurance Company of
Texas, effective January 1, 1997.
10(au) Form of Termination Addendum to the Quota Share Retrocession
Contract, effective September 1, 2000, issued to Dorinco
Reinsurance Company by American Hallmark Insurance Company of
Texas, effective September 1, 1998.
10(av) Form of Termination Addendum to the Interests and Liability
Agreement, effective June 30, 2000, of GE Reinsurance
Corporation with respect to the 100% Quota Share Reinsurance
Agreement, effective January 1, 1997.
10(aw) Form of Third Amendment to Executive Compensation Agreement,
effective November 26, 2000, between Ramon D. Phillips and
Hallmark Financial Services Inc., dated August 24, 1994.
10(ax) Form of Third Amendment to Executive Compensation Agreement,
effective November 26, 2000, between Linda H. Sleeper and
Hallmark Financial Services Inc., dated August 24, 1994.
10(ay) Form of Termination Endorsement, effective July 1, 2000, to the
Guaranty of Performance and Hold Harmless Agreement between
Hallmark Financial Services, Inc. and GE Reinsurance
Corporation (formerly Kemper Reinsurance Company), effective
July 1, 1996.
10(az) Form of Termination Endorsement, effective July 1, 2000, to the
Guaranty Agreement provided by GE Reinsurance Corporation
(formerly Kemper Reinsurance Company) in favor of State and
County Mutual Fire Insurance Company, effective July 1, 1996.
10(ba) Form of Endorsement No. 2, effective July 1, 2000, to the
Guarantee Agreement provided by Dorinco Reinsurance Company in
favor of State and County Mutual Fire Insurance Company,
effective July 1, 1996. (incorporated by reference to Exhibit
10(a) to the registrant's Quarterly Report on Form 10-QSB for
the quarter ended March 31, 2001).
10(bb) Cut-Through Agreement, dated as of June 26, 2001, by and among
American Hallmark Insurance Company of Texas, American Hallmark
General Agency, Inc., Hallmark Finance Corporation and FPF,
Inc. (incorporated by reference to Exhibit 10(c) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended June 30, 2001).
10(bc) First Modification Agreement to the Cut-Through Agreement dated
as of June 26, 2001, by and among American Hallmark Insurance
Company of Texas, American Hallmark General Agency, Inc.,
Hallmark Finance Corporation and FPF, Inc., entered into June
27, 2001 (incorporated by reference to Exhibit 10(d) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended June 30, 2001).
10(bd) Form of Fourth Amendment to Executive Compensation Agreement
effective June 1, 2001, between Ramon D. Phillips and Hallmark
Financial Services Inc., dated August 24, 1994. (incorporated
by reference to Exhibit 10(e) to the registrant's Quarterly
Report on Form 10-QSB for the quarter ended June 30, 2001).
10(be) Letter of Agreement, dated August 3, 2001, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(f) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended June 30,
2001).
Exhibit
Number Description
------ -----------
10(bf) Letter of Agreement, dated August 6, 2001, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(g) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended June 30,
2001).
10(bg) Addendum No. 1 to the Quota Share Retrocession Agreement,
effective July 1, 2000, between American Hallmark Insurance
Company of Texas and Dorinco Reinsurance Company, effective
January 1, 2001 (incorporated by reference to Exhibit 10(a) to
the registrant's Quarterly Report on Form 10-QSB for the
quarter ended September 30, 2001).
10(bh) Addendum No. 2 to the Quota Share Retrocession Agreement,
effective July 1, 2000, between American Hallmark Insurance
Company of Texas and Dorinco Reinsurance Company, effective
July 1, 2001 (incorporated by reference to Exhibit 10(b) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended September 30, 2001).
10(bi) Endorsement No. 1 to the Guaranty of Performance and Hold
Harmless Agreement, effective July 1, 1996 between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company,
effective July 1, 2000 (incorporated by reference to Exhibit
10(c) to the registrant's Quarterly Report on Form 10-QSB for
the quarter ended September 30, 2001).
10(bj) Letter of Agreement, dated November 7, 2001 between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(d) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended September
30, 2001).
10(bk) Second Amendment to Hallmark Financial Services, Inc. 1994 Non-
Employee Director Stock Option Plan (incorporated by reference
to Exhibit 10(e) to the registrant's Quarterly Report on Form
10-QSB for the quarter ended September 30, 2001).
10(bl) Letter of Agreement, dated January 23, 2002, between Hallmark *
Financial Services, Inc. and Dorinco Reinsurance Company.
10(bm) Amendment No. 4 to the Loan Agreement dated March 10, 1997, *
between Hallmark Financial Services, Inc. and Dorinco
Reinsurance Company.
10(bn) Second Modification Agreement, entered into December 11, 2001, *
to the Sale and Assignment Agreement, dated November 18, 1999,
with Hallmark Finance Corporation as Seller and FFP, Inc.
10(bo) Addendum No. 2, entered into January 9, 2001, to the General *
Agency Agreement, effective March 1, 1992, between State &
County Mutual Fire Insurance Company and Brokers General, Inc.
10(bp) Third Renewal Promissory Note, dated November 8, 2001, with *
Hallmark Financial Services, Inc. as Maker and Dorinco
Reinsurance Company as Payee.
22 List of subsidiaries of the registrant (incorporated by
reference to Exhibit 22 to the registrant's Annual Report on
Form 10-KSB for the fiscal year ended December 31, 1991).
23 Consent of Independent Accountants. *
28 Schedule P of American Hallmark Insurance Company of Texas as
filed with the Texas Department of Insurance for the year ended
December 31, 2001.
* Filed herewith
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Description Page Number
----------- -----------
Report of Independent Accountants F-2
Consolidated Balance Sheets at December 31, 2001 and 2000 F-3
Consolidated Statements of Operations for the
Years Ended December 31, 2001 and 2000 F-4
Consolidated Statements of Stockholders' Equity
for the Years Ended December 31, 2001 and 2000 F-5
Consolidated Statements of Cash Flows for the
Years Ended December 31, 2001 and 2000 F-6
Notes to Consolidated Financial Statements F-7
Report of Independent Accountants
---------------------------------
To the Board of Directors
Hallmark Financial Services, Inc.:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, stockholders' equity and cash flows,
present fairly, in all material respects, the financial position of Hallmark
Financial Services, Inc. and Subsidiaries (the "Company") at December 31,
2001 and 2000, and the results of their operations and their cash flows for
the years then ended in conformity with accounting principles generally
accepted in the United States of America. These financial statements are the
responsibility of the Company's management; our responsibility is to express
an opinion on these financial statements based on our audits. We conducted
our audits of these statements in accordance with auditing standards
generally accepted in the United States of America, which require that we
plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures
in the financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
PricewaterhouseCoopers LLP
Dallas, Texas
March 21, 2002
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 2001 and 2000
(In thousands)
----------------------------
ASSETS 2001 2000
------ --------- ---------
Investments:
Debt securities, held-to-maturity, at
amortized cost $ 876 $ 7,243
Equity securities, available-for-sale, at
market value 144 145
Short-term investments, at amortized cost
which approximates market value 15,203 6,189
--------- ---------
Total investments 16,223 13,577
Cash and cash equivalents 5,533 6,831
Restricted cash 1,990 4,276
Prepaid reinsurance premiums 11,611 10,944
Receivable from lender for financed premiums
(net of allowance for doubtful accounts
of $208 in 2001 and $169 in 2000) 13,740 13,545
Premiums receivable 414 799
Reinsurance recoverable 16,871 19,212
Deferred policy acquisition costs 761 362
Excess of cost over net assets acquired
(net of accumulated amortization
of $2,305 in 2001 and $2,148 in 2000) 4,431 4,588
Current federal income tax recoverable 696 95
Deferred federal income taxes 425 572
Accrued investment income 6 108
Other assets 904 644
--------- ---------
$ 73,605 $ 75,553
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Liabilities:
Notes payable $ 13,933 $ 13,033
Unpaid losses and loss adjustment expenses 20,089 22,298
Unearned premiums 16,793 16,711
Reinsurance balances payable 4,426 3,341
Drafts outstanding 890 1,535
Accrued ceding commission refund 4,598 2,503
Accounts payable and other accrued expense 2,508 3,258
Accrued litigation costs - 1,386
--------- ---------
63,237 64,065
--------- ---------
Stockholders' equity:
Common stock, $.03 par value, authorized
100,000,000 shares issued 11,855,610
shares in 2001 and 2000 356 356
Capital in excess of par value 10,875 10,875
Retained earnings 180 1,310
Accumulated other comprehensive income - (10)
Treasury stock, 806,477 shares in 2001
and 2000, at cost (1,043) (1,043)
--------- ---------
Total stockholders' equity 10,368 11,488
--------- ---------
$ 73,605 $ 75,553
========= =========
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
for the years ended December 31, 2001 and 2000
(In thousands, except earnings per share)
----------------------------
2001 2000
---------- -----------
Gross premiums written $ 49,614 $ 50,469
Ceded premiums written (33,822) (31,396)
---------- -----------
Net premiums written $ 15,792 $ 19,073
========== ===========
Revenues
Gross premiums earned $ 49,525 $ 45,520
Ceded premiums earned (33,149) (28,125)
---------- -----------
Net premiums earned 16,376 17,395
Investment income, net of expenses 1,043 1,264
Finance charges 3,095 2,926
Processing and service fees 1,120 1,952
Other income 368 348
---------- -----------
Total revenues 22,002 23,885
---------- -----------
Benefits, losses and expenses:
Losses and loss adjustment expenses 43,735 43,185
Reinsurance recoveries (27,857) (28,627)
---------- -----------
Net losses and loss adjustment expenses 15,878 14,558
Acquisition costs, net (399) 237
Other acquisition and underwriting expenses
(net of ceding commission of $9,118 in
2001 and $9,414 in 2000) 3,673 3,274
Operating expenses 3,346 4,347
Interest expense 1,021 1,138
Amortization of intangible assets 157 157
Litigation costs - 435
---------- -----------
Total benefits, losses and expenses 23,676 24,146
---------- -----------
Loss from operations before federal income (1,674) (261)
Federal income tax benefit (544) (28)
---------- -----------
Net loss $ (1,130) $ (233)
========== ===========
Basic and diluted earnings per share
(11,049,133 shares outstanding):
Net loss $ (0.10) $ (0.02)
========== ===========
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
for the years ended December 31, 2001 and 2000
(in thousands, except number of shares)
---------------------------------------
Capital Accumulated
Number In Other Total Comprehensive
of Par Excess of Retained Comprehensive Treasury Stockholders' Income
Shares Value Par Value Earnings Income Stock Equity (Loss)
---------- ------- --------- -------- ------ --------- ------- -------
Balance at December 31, 1999 11,854,610 $356 $10,875 $1,543 ($14) ($1,043) $11,717
Comprehensive loss:
Net loss (233) (233) $ (233)
Other comprehensive
income, net of tax
Unrealized gains on
securities, net of tax
of $2 4 4 4
-------
Comprehensive loss ($229)
=======
Issuance of common stock 1,000
---------- ------- --------- -------- ------ --------- -------
Balance at December 31, 2000 11,855,610 $356 $10,875 $1,310 ($10) ($1,043) $11,488
Comprehensive loss:
Net loss (1,130) (1,130) $ (1,130)
Other comprehensive
income, net of tax
Unrealized gains on
securities, net of
tax of $5 10 10 10
-------
Comprehensive loss ($1,120)
=======
Issuance of common stock
---------- ------- --------- -------- ------ --------- -------
Balance at December 31, 2001 11,855,610 $356 $10,875 $ 180 $ - ($1,043) $10,368
========== ======= ========= ======== ====== ========= =======
The accompanying notes are an integral
part of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
for the years ended December 31, 2001 and 2000
(In thousands)
----------------------------
2001 2000
-------- --------
Cash flows from operating activities:
Net loss $ (1,130) $ (233)
Adjustments to reconcile net loss to cash
(used in) provided by operating activities:
Depreciation and amortization expense 296 305
Change in deferred Federal income taxes 147 (360)
Change in prepaid reinsurance premiums (667) (3,271)
Change in premiums receivable 385 (58)
Change in deferred policy acquisition expenses (399) (237)
Change in unpaid losses and loss
adjustment expenses (2,209) 4,494
Change in unearned premiums 82 4,949
Change in reinsurance recoverable 2,341 (3,539)
Change in reinsurance balances payable 1,085 718
Change in current federal income tax recoverable (601) (95)
Change in current federal income tax payable - (46)
Change in accrued ceding commission refund 2,095 1,252
Change in litigation costs (1,386) 436
Change in all other liabilities (1,395) 1,376
Change in all other assets (30) (62)
-------- --------
Net cash (used in) provided by
operating activities (1,386) 6,103
-------- --------
Cash flows from investing activities:
Purchases of property and equipment (268) (237)
Premium finance notes originated (50,655) (40,608)
Premium finance notes repaid 50,461 36,122
Change in restricted cash 2,286 (854)
Purchases of debt securities - (6,803)
Maturities and redemptions of investment securities 6,378 3,393
Purchase of short-term investments (27,515) (22,604)
Maturities of short-term investments 18,501 22,789
-------- --------
Net cash used in investing activities (812) (8,802)
-------- --------
Cash flows from financing activities:
Net advances from lender 1,628 4,324
Repayment of borrowings (728) (580)
-------- --------
Net cash provided by financing activities 900 3,744
-------- --------
(Decrease) increase in cash and cash equivalents (1,298) 1,045
Cash and cash equivalents at beginning of year 6,831 5,786
-------- --------
Cash and cash equivalents at end of year $ 5,533 $ 6,831
======== ========
Supplemental cash flow information:
Interest paid $ (1,036) $ (1,107)
======== ========
Income taxes recovered/(paid) $ 85 $ (429)
======== ========
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
__________
1. Accounting Policies:
General
Hallmark Financial Services, Inc. ("HFS") and its subsidiaries
(collectively, the "Company"), are engaged primarily in the 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 insurance agencies known as the
American Hallmark Agencies ("Hallmark Agencies"); a premium finance
company, Hallmark Finance Corporation ("HFC"); and a claims handling
and adjusting firm, Hallmark Claims Service, Inc. ("HCS"). The Company
operates only in Texas.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts
and operations of HFS and its subsidiaries. Intercompany accounts and
transactions have been eliminated.
Basis of Presentation
The accompanying consolidated financial statements have been prepared
in conformity with accounting principles generally accepted in the
United States of America ("GAAP") which, as to Hallmark, differ from
statutory accounting practices prescribed or permitted for insurance
companies by insurance regulatory authorities.
Investments
Debt securities are reported at amortized cost. The Company has the
intent and ability to hold all investments in debt securities to
maturity. Provisions for possible losses are recorded only on other-
than-temporary declines in the value of an investment.
Equity securities available-for-sale are reported at market value.
Unrealized gains and losses are recorded as a component of
stockholder's equity.
Short-term investments are carried at amortized cost which approximates
market. Short-term investments include U.S. Government securities
maturing within one year.
Realized investment gains and losses are recognized in operations on
the specific identification method.
Cash Equivalents
The Company considers all highly liquid investments with an original
maturity of three months or less to be cash equivalents.
Recognition of Premium Revenues
Insurance premiums and policy fees are earned pro rata over the terms
of the policies. Upon cancellation, any unearned premium and policy fee
is refunded to the insured. Insurance premiums written include gross
policy fees of $5.0 million and $5.7 million and policy fees, net of
reinsurance, of $1.5 million and $3.7 million for the years ended
December 31, 2001 and 2000, respectively.
Finance Charges
The majority of Hallmark's annual insurance premiums are financed
through the Company's premium finance program offered by its wholly-
owned subsidiary, HFC. Finance charges on the premium finance notes
are recorded as interest earned. This interest is earned on the Rule
of 78's method which approximates the interest method for such short-
term notes.
Property and Equipment
Property and equipment, aggregating $2.0 million and $1.6 million, at
December 31, 2001 and 2000, respectively, which is included in other
assets, is recorded at cost and is depreciated using the straight-line
method over the estimated useful lives of the assets (three to five
years). Depreciation expense for 2001 and 2000 was $0.1 million for
both years. Accumulated depreciation was $1.3 million and $1.2 million
at December 31, 2001 and 2000, respectively.
Receivable from Lender for Financed Premiums
Receivable from lender for financed premiums represents premiums
due to HFC as a result of a secured financing agreement with an
unaffiliated third party. (See Note 5.)
Premiums Receivable
The majority of the balance in premiums receivable is premiums due to
Hallmark on unaffiliated MGA business assumed from Dorinco. (See Note
4.)
Deferred Policy Acquisition Costs
Policy acquisition costs (mainly commissions, underwriting and
marketing expenses) that vary with and are primarily related to the
production of new and renewal business, are deferred and charged to
operations over periods in which the related premiums are earned. The
method followed in computing deferred acquisition costs limits the
amount of such deferred costs to their estimated realizable value. In
determining estimated realizable value, the computation gives effect to
the premium to be earned, related investment income, losses and loss
expenses and certain other costs expected to be incurred as the
premiums are earned. Ceding commissions from reinsurers, which include
expense allowances, are deferred and recognized over the period
premiums are earned for the underlying policies reinsured. Deferred
ceding commissions are netted against deferred policy acquisition costs
in the accompanying balance sheet. The change in deferred ceding
commission income is netted against the change in deferred policy
acquisition costs in the accompanying income statement.
Losses and Loss Adjustment Expenses
Losses and loss adjustment expenses represent the estimated ultimate
net cost of all reported and unreported losses incurred through
December 31, 2001 and 2000. The liabilities for unpaid losses and loss
adjustment expenses are estimated using individual case-basis
valuations and statistical analyses.
These estimates are subject to the effects of trends in loss severity
and frequency. Although considerable variability is inherent in such
estimates, management believes that the liabilities for unpaid losses
and loss adjustment expenses are adequate. The estimates are
continually reviewed and adjusted as necessary as experience develops
or new information becomes known; such adjustments are included in
current operations. The liabilities for unpaid losses and loss
adjustment expenses at December 31, 2001 and 2000 are reported net of
recoverables for salvage and subrogation of approximately $0.3 million
for both years.
Reinsurance
Hallmark is routinely involved in reinsurance transactions with other
companies. Reinsurance premiums, losses, and loss adjustment expenses
are accounted for on bases consistent with those used in accounting for
the original policies issued and the terms of the reinsurance
contracts. (See Note 4.)
Income Taxes
The Company files a consolidated federal income tax return. Deferred
federal income taxes reflect the future tax consequences of differences
between the tax bases of assets and liabilities and their financial
reporting amounts at each year end. Deferred taxes are recognized
using the liability method, whereby tax rates are applied to cumulative
temporary differences based on when and how they are expected to affect
the tax return. Deferred tax assets and liabilities are adjusted for
tax rate changes.
Net Income Per Share
The computation of net income per share is based upon the weighted
average number of common shares outstanding during the period, plus (in
periods in which they have a dilutive effect) the effect of common
shares potentially issuable, primarily from stock options. (See Notes
6 and 8.)
Intangible Assets
When Hallmark, AHGA, HFC and HCS were purchased by HFS, the excess cost
over the fair value of the net assets acquired was recorded as goodwill
and is being 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 December 31, 2001.
The Company continually reevaluates the propriety of the carrying
amount of goodwill as well as the amortization period to determine
whether current events and circumstances warrant adjustments to the
carrying value and/or revised estimates of useful lives. At this time,
the Company believes that no significant impairment of the goodwill has
occurred and that no reduction of the estimated useful life is
warranted.
In June 2001, the FASB issued Statement of Financial Accounting
Standards No. 141 ("SFAS 141"), "Business Combinations", and No. 142
("SFAS 142"), "Goodwill and Other Intangible Assets", collectively
referred to as the "Standards". 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 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 will adopt the provisions of SFAS 142 in the first quarter
of 2002. The Company is in the process of preparing for its adoption of
SFAS 142 and is making the determinations as to what its reporting
units are and what amounts of goodwill, intangible assets, other
assets, and liabilities should be allocated to those reporting units.
The Company expects that it will no longer record approximately
$157,000 of annual amortization relating to its existing goodwill.
SFAS 142 requires that goodwill be tested annually for impairment using
a two-step process. The first step is to identify a potential
impairment and, in transition, this step must be measured as of the
beginning of the fiscal year. However, a company has six months from
the date of adoption to complete the first step. The Company expects to
complete that first step of the goodwill impairment test during the
first or second quarter of 2002. The second step of the goodwill
impairment test measures the amount of the impairment loss (measured as
of the beginning of the year of adoption), if any, and must be
completed by the end of the Company's fiscal year 2002. Any intangible
assets deemed to have an indefinite life will be tested for impairment
using a one-step process which compares the fair value to the carrying
amount of the asset as of the beginning of the fiscal year, and
pursuant to the requirements of SFAS 142 will be completed during the
first or second quarter of 2002. Any impairment loss resulting from the
transitional impairment tests will be reflected as the cumulative
effect of a change in accounting principle in the first or second
quarter of 2002. The Company has not yet determined what effect these
impairment tests will have on the Company's earnings and financial
position. However, an impairment loss may be recognized.
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with GAAP
requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities at the date(s) of the
financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates.
Fair Value of Financial Instruments
Cash and Short-term Investments: The carrying amounts reported in the
balance sheet for these instruments approximate their fair values.
Investment Securities: Fair values are obtained from an independent
pricing service. (See Note 2.)
Receivable from Lender for Financed Premiums: The carrying amount
reported in the balance sheet for this instrument approximates its fair
value as the term of the receivable is less than one year.
Notes Payable: The carrying amounts reported in the balance sheet for
these instruments approximate their fair values. (See Note 5.)
Stock-based Compensation
The Company recognizes its compensation expense for grants of stock,
stock options, and other equity instruments in accordance with
Accounting Principles Board Opinion No. 25, Accounting for Stock Issued
to Employees ("APB 25"). (See Note 8.)
Codification of Statutory Accounting Principles
In 1998, the National Association of Insurance Commissioners (the
"NAIC") adopted the Codification of Statutory Accounting Principles
(the "Codification") guidance, which replaced the prior Accounting and
Practice Procedures manuals as the NAIC's primary guidance on statutory
accounting. The Codification provides guidance where statutory
accounting has been silent and changes current statutory accounting in
some areas (e.g. deferred income taxes are recorded). Effective
January 1, 2001, the Texas Department of Insurance (the "TDI") adopted,
in part, the Accounting Practices and Procedures Manual (the "Manual")
published by the NAIC. The Manual, previously known as Codification,
contains Statements of Statutory Accounting Principles. Effective
January 1, 2001 the Company implemented the Codification guidance in
the preparation of Hallmark's statutory financial statements. The
cumulative effect of the adoption of Codification was recorded as an
adjustment to Hallmark's statutory surplus as of January 1, 2001 in
accordance with Codification guidance regarding reporting of changes in
accounting principles. The adjustment increased Hallmark's statutory
surplus by approximately $0.5 million, primarily as a result of
recording a deferred tax asset.
Reclassification
Certain previously reported 2000 amounts have been reclassified to
conform to current year presentation. Such reclassification had no
effect on net loss or stockholders' equity.
2. Investments:
Major categories of net investment income (in thousands) are
summarized as follows:
Years ended December 31,
------------------------
2001 2000
-------- --------
Debt securities $ 194 $ 293
Equity securities 7 9
Short-term investments 483 525
Cash equivalents 357 319
Other 3 125
-------- --------
1,044 1,271
Investment expenses (1) (7)
-------- --------
Net investment income $ 1,043 $ 1,264
======== ========
No investment in any entity or its affiliates exceeded 10% of
stockholders' equity at December 31, 2001 or 2000.
The amortized cost and estimated market value of investments in debt
and equity securities (in thousands) by category is as follows:
Gross Gross
Amortized Unrealized Unrealized
Cost Gains Losses Market
-------- ------ ------- ---------
At December 31, 2001
--------------------
U.S. Treasury securities
and obligations of U.S.
government corporations
and agencies $ 206 $ - $ (1) $ 205
Mortgage backed securities 670 - - 670
-------- ------ ------- ---------
Total debt securities 876 - (1) 875
Equity securities 144 - - 144
-------- ------ ------- ---------
Total debt and equity
securities $ 1,020 $ - $ (1) $ 1,019
======== ====== ======= =========
At December 31, 2000
--------------------
U.S. Treasury securities
and obligations of U.S.
government corporations
and agencies $ 6,421 $ 14 $ (10) $ 6,425
Mortgage backed securities 822 4 (6) 820
-------- ------ ------- ---------
Total debt securities 7,243 19 (17) 7,245
Equity securities 161 2 (18) 145
-------- ------ ------- ---------
Total debt and equity
securities $ 7,404 $ 21 $ (35) $ 7,390
======== ====== ======= =========
The amortized cost and estimated market value of debt securities at
December 31, 2001, by contractual maturity, are as follows. Expected
maturities may differ from contractual maturities because certain
borrowers may have the right to call or prepay obligations with or
without penalities.
Amortized Market
Maturity (in thousands): Cost Value
------------------------ ---- ----
Due in one year or less $100 $100
Due after one year through five years - -
Due after five years through ten years 106 105
Mortgage backed securities 670 670
---- ----
$876 $875
==== ====
At December 31, 2001 and 2000, investments in debt securities with
an approximate carrying value of $0.1 million were on deposit with
the Texas Department of Insurance (the "TDI") as required by insurance
regulations.
Proceeds from investment securities of $6.4 million and $3.4 million
during 2001 and 2000, respectively, were primarily from maturities,
bond calls and prepayments of mortgage-backed securities.
3. Liability for Unpaid Losses and Loss Adjustment Expenses:
Activity in the liability for unpaid losses and loss adjustment
expenses (in thousands) is summarized as follows:
2001 2000
------- -------
Balance at January 1 $ 22,298 $ 17,804
Less reinsurance recoverables 14,847 12,395
------- -------
Net Balance at January 1 7,451 5,409
------- -------
Incurred related to:
Current year 15,356 14,460
Prior years 522 97
------- -------
Total incurred 15,878 14,557
------- -------
Paid related to:
Current year 10,033 9,286
Prior years 5,377 3,229
------- -------
Total paid 15,410 12,515
------- -------
Net Balance at December 31 7,919 7,451
Plus reinsurance recoverables 12,170 14,847
------- -------
Balance at December 31 $ 20,089 $ 22,298
======= =======
The Company's loss experience for the year ended December 31, 2001
was 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 amounts of claims filed. The Company's
insurance operations are inherently susceptible to unforeseeable
catastrophic events, such as weather-related disasters. If excessive
claims from any such catastrophic event caused the Company to exceed
its anticipated range of loss ratios in 2002, the Company's financial
position could be adversely impacted. Requirements for compliance with
covenants associated with the Company's reinsurance and debt agreements
are discussed in notes 4 and 5, respectively.
4. Reinsurance:
Hallmark 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.
Effective March 1, 1992, Hallmark 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 AHGA and underwritten by State & County. The
earned premiums assumed under this agreement in 2001 and 2000 were
$47.4 million and $41.6 million, respectively. Funds generated from
business produced under this agreement are maintained in accounts for
the benefit of State & County. At December 31, 2001 and 2000,
Hallmark, held for the benefit of State & County, cash and cash
equivalents of $2.6 million and $4.3 million, respectively, and
investment securities at amortized cost of $11.0 million and $8.4
million, respectively.
The arrangement is supplemented by a separate retrocession agreement
effective July 1, 2000 between Hallmark and Dorinco Reinsurance Company
("Dorinco"), under which Hallmark currently retains 30% and cedes 70%
of the risk to Dorinco. Prior to July 1, 2000, Hallmark retroceded 75%
to its reinsurers (GE Reinsurance and Dorinco) under a separate
retrocession agreement effective January 1,1999 through June 30, 2000.
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 after 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 to 34% from
41% on April 1, 2001 and further decreased to 31% on July 1, 2001. The
provisional commission is adjusted annually on a sliding scale based on
annual loss ratios. Based upon its loss experience, Hallmark can earn
a maximum commission of 31% and is guaranteed a minimum commission of
26% regardless of loss experience on business reinsured by Dorinco. As
of December 31, 2001 and 2000, the accrued ceding commission refund was
$4.6 million and $2.5 million, respectively. This accrual represents
the difference between the ceding commission received and the ceding
commission earned based on current loss ratios.
Dorinco and the Company 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, 2001 to September 30, 2002.
Hallmark assumes business from Dorinco on various unaffiliated MGA
programs. Three of the four programs are in run-off. Under these
programs, HCS also provides claims processing, and AHGA provides
premium processing. At December 31, 2001 and 2000, Dorinco held cash
of $2.0 million and $2.8 million, respectively, to secure balances
ceded to Hallmark. These amounts were included in restricted cash in
the accompanying Consolidated Balance Sheets.
During 2000, the Company commuted loss reserves under its previous
reinsurance arrangement (effective March 1, 1992 through June 30, 1996)
with Vesta Fire Insurance Corporation. The reserves were commuted at
100%. The Company commuted outstanding loss and LAE reserves of $0.5
million as of the date of commutation.
5. Notes Payable:
A summary of the Company's notes payable
December 31,
2001 2000
------ ------
Note payable to Dorinco $ 1,720 $ 2,447
Balance under Financing Arrangement 12,213 10,586
------ ------
$13,933 $13,033
====== ======
Scheduled annual principal payments on note payable (in thousands)
to Dorinco are as follows at December 31, 2001:
2002 $ -
2003 728
2004 728
2005 264
------
Total $ 1,720
======
The balance under the Financing Arrangement will be repaid during the
coming year as associated premium finance notes are repaid (See below).
Effective March 11, 1997, the Company entered into a loan agreement with
Dorinco, whereby the Company borrowed $7.0 million (the "Dorinco Loan") to
contribute to HFC. Proceeds from this loan were used by HFC primarily to
fund premium finance notes. The loan agreement provides for a seven-year
term at a fixed interest rate of 8.25%. In November 2001 the note was
amended to provide for interest only payments from December 2001 through
and including December 2002 with a final principal pay-off date of June 30,
2005.
As long as certain financial covenants defined as "triggering events" are
maintained, collateral for the Dorinco Loan is limited to the stock of HFC
and a covenant by the Company not to pledge the stock of Hallmark or AHGA.
To avoid a triggering event, Hallmark must (1) maintain a combined ratio
and loss ratio which do not exceed 107% and 83%, respectively, and (2)
maintain statutory surplus of $4.2 million and experience no decreases to
surplus in any one year that exceeds 15% of the prior year surplus. If a
triggering event should occur, the Company has ten days to pledge the stock
of AHGA and Hallmark as additional collateral for the Dorinco Loan.
Dorinco waived the maximum loss ratio requirements for 2001 and 2000 and
the combined ratio requirement for 2001. The loan agreement also contains
covenants which require the Company to satisfy certain financial ratios
which are less restrictive than the triggering event ratios and, among
other things, restrict capital expenditures, payment of dividends, and
incurrence of additional debt.
Effective November 18, 1999, HFC entered into a secured financing
arrangement (the "Financing Arrangement") and a servicing agreement with an
unaffiliated third party in order to fund HFC's premium finance activities.
The Financing Arrangement provides that HFC sell to the third party all
eligible premium finance notes generated by HFC in connection with the
financing of insurance policies. The transaction is accounted for as a
secured financing transaction. Under the Financing Arrangement, HFC may
from time to time specify the amount to be advanced by the third party and
secured by the premium finance notes (up to maximum of 94% of the face
amount of the premium finance notes). Collections on the premium finance
notes are remitted to HFC to the extent they exceed the sum of (a) the
aggregate amount of all prior advances, (b) interest on the aggregate
advance balance from time to time outstanding, and (c) certain other fees
and expenses payable to the third party. The interest payable under the
Financing Arrangement is at the prime rate plus a spread ranging from
one-half percent to one percent depending on the unpaid balance of the
advances. As of December 31, 2001 and 2000, HFC had an outstanding balance
on advances under the Financing Arrangement of $12.2 million and $10.6
million, respectively, and the applicable interest rates were 5.75% and
10%, respectively. Under the Financing Arrangement, the maximum advances
available to HFC were $1.3 million and $0.6 million at December 31, 2001
and 2000, respectively.
[This space left blank intentionally.]
6. Earnings per Share:
The Company has adopted the provisions of SFAS No. 128, Earnings Per
Share, requiring presentation of both basic and diluted earnings per
share. A reconciliation of the numerators and denominators of the basic
and diluted per-share computations (in thousands, except number of
shares) as required by SFAS No. 128 is presented below:
Income Shares Per-Share
(Numerator) (Denominator) Amount
----------- ------------- ------
For the year ended December 31, 2001:
Basic Earnings per Share
Income available to
common stockholders:
Net loss ($1,130) 11,049,133 $ (.10)
======= ======
Effect of Dilutive Securities:
Options and warrants - - -
Diluted Earnings per Share
Income available to
common stockholders
+ assumed conversions:
Net loss ($1,130) 11,049,133 $ (.10)
======= ======
For the year ended December 31, 2000:
Basic Earnings per Share
Income available to
common stockholders:
Net loss ($233) 11,049,133 $ (.02)
======= ======
Effect of Dilutive Securities:
Options and warrants - - -
Diluted Earnings per Share
Income available to
common stockholders
+ assumed conversions:
Net loss ($233) 11,049,133 $ (.02)
======= ======
Options to purchase 2,679,000 and 2,431,500 shares of common stock at
prices ranging from $0.25 to $1.00 were outstanding at December 31,
2001 and 2000 respectively, but were not included in the computation of
diluted earnings per share because the inclusion would result in an
antidilutive effect in periods where a loss from continuing operations
was incurred.
7. Regulatory Capital Restrictions:
Hallmark's 2001 and 2000 net income (loss) and stockholders' equity
(capital and surplus), as determined in accordance with statutory
accounting practices, were ($0.9) million and $0.1 million, and $6.0
million and $6.4 million, respectively. The minimum statutory capital
and surplus required for Hallmark by the TDI is $2.0 million. Texas
state law limits the payment of dividends to stockholders by property
and casualty insurance companies. The maximum dividend that may be
paid without prior approval of the Commissioner of Insurance is limited
to the greater of 10% of statutory surplus as regards policyholders as
of the preceding calendar year end or the statutory net income of the
preceding calendar year. No dividends were declared or paid by
Hallmark in 2001 or 2000. Based on surplus at December 31, 2001,
Hallmark could pay a dividend of up to $0.6 million to HFS during 2002
without 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,
Hallmark only paid management fees of $50,000 to HFS during 2001 as
compared to $150,000 in 2000. These steps were taken to preserve
Hallmark's surplus. Management anticipates that Hallmark may pay
management fees during 2002.
Effective December 31, 1994, the NAIC requested property/casualty
insurers to file a risk-based capital ("RBC") calculation according to
a specified formula. The purpose of the NAIC-designed formula is
twofold: (1) to assess the adequacy of an insurer's statutory capital
and surplus based upon a variety of factors such as potential risks
related to investment portfolio, ceded reinsurance and product mix; and
(2) to assist state regulators under the RBC for Insurers Model Act
(the "Model Act") by providing thresholds at which a state commissioner
is authorized and expected to take regulatory action. The TDI adopted
the Model Act during 1998. The Company's 2001 and 2000 adjusted
capital under the RBC calculation exceeded the minimum TDI requirement
by 80% and 79%, respectively.
8. Stock Option Plans:
The Company has two stock option plans for key employees, the 1991 Key
Employee Stock Option Plan and the 1994 Key Employee Long Term
Incentive Plan, and a non-qualified plan for non-employee directors.
The number of shares reserved for future issuance under the 1991
employee plan, the 1994 employee plan and the non-employee director
plan is 500,000, 1,500,000 and 1,375,000, respectively. The option
prices under the plans are not to be less than the closing price of the
common stock on the day preceding the grant date. Pursuant to the
stock option plans, the Company has granted incentive stock options
under Section 422 of the Internal Revenue Code of 1986. The stock
options granted to employees vest over a 3 year period on a graded
schedule, 40% in the first 6 months and 20% on each anniversary date of
the grant date. The stock options granted to the directors vest over a
6 year period on a graded schedule, 40% in the first 6 months and 10%
on each anniversary date of the grant date. In accordance with APB 25,
the Company has not recognized compensation expense for the stock
options granted in 2001.
Pursuant to SFAS No. 123, Accounting for Stock-based Compensation, a
company may elect to continue expense recognition under APB 25, or to
recognize compensation expense for grants of stock, stock options, and
other equity instruments to employees based on fair value methodology
outlined in SFAS No. 123. The Company has elected to continue expense
recognition pursuant to APB 25.
[This space left blank intentionally]
A summary of the status of the Company's stock options as of December 31,
2001 and December 31, 2000 and the changes during the years ended on
those dates is presented below:
__________2001_________ _________2000_________
Number Weighted Number Weighted
of Shares of Average of Shares of Average
Underlying Exercise Underlying Exercise
Options Prices Options Prices
------- ------ ------- ------
Outstanding at beginning
of the year 2,431,500 $ 0.47 1,275,000 $ 0.47
Granted 250,000 $ 0.69 1,157,500 $ 0.43
Exercised - $ - (1,000) $ 0.25
Forfeited (2,500) $ 0.44 - $ -
Expired - $ - - $ -
Outstanding at end of year 2,679,000 $ 0.49 2,431,500 $ 0.47
Exercisable at end of year 2,052,000 $ 0.48 1,774,500 $ 0.47
Weighted-average fair value
of all options granted $ 0.43 $ 0.22
The fair value of each stock option granted is estimated on the date
of grant using the Black-Scholes option-pricing model with the following
weighted-average assumptions:
2001 2000
----- -----
Expected Term 7.00 5.00
Expected Volatility 56.11% 51.48%
Risk-Free Interest Rate 5.11% 6.37%
The following table summarizes information about stock options outstanding
at December 31, 2001:
Options Outstanding Options Exercisable
------------------- -------------------
Number Weighted Avg. Number
Range of Outstanding Remaining Weighted Avg. Exercisable Weighted Avg.
Exercise Prices at 12/31/01 Contr. Actual Life Exercise Price at 12/31/00 Exercise Price
--------------- ----------- ------------------ -------------- ----------- --------------
$ .25 to $ .70 2,528,000 5.9 $ .46 1,916,000 $ .45
$ .71 to $1.00 151,000 4.0 $ 1.00 136,000 $ 1.00
--------- ---------
$ .25 to $1.00 2,679,000 5.8 $ .49 2,052,000 $ .48
========= =========
The pro forma effects on net income (in thousands) and earnings per share
for 2001 and 2000 from compensation expense computed pursuant to SFAS No.
123 is as follows:
December 31, 2001 December 31, 2000
As Reported Pro Forma As Reported Pro Forma
------- ------- -------- -------
SFAS No. 123 Charge $ - $ 130 $ - $ 188
Net loss $ (1,130) $ (1,216) $ ( 233) $ ( 357)
Net loss per common share $ ( .10) $ ( 0.11) $ ( 0.02) $ (0.03)
The effects of applying SFAS No. 123 in this pro forma disclosure
are not indicative of future amounts. SFAS No. 123 does not apply to
awards prior to 1995, and the Company anticipates making awards in the
future under its stock-based compensation plan.
9. Income Taxes:
The composition of deferred tax assets and liabilities and the related
tax effects in thousands as of December 31, 2001 and 2000, are as
follows:
2001 2000
-------- ---------
Deferred tax liabilities:
Deferred policy acquisition costs ( $ 1,343) ( $ 1,315)
Other ( 37) ( 42)
-------- ---------
Total deferred tax liabilities ( 1,380) ( 1,357)
-------- ---------
Deferred tax assets:
Unearned premiums 352 392
Loss reserve discounting, net of 171 216
salvage and subrogation
Deferred ceding commissions 1,084 1,192
Unrealized gains (losses) on securities - 4
Net operating loss carry forward 33 33
Allowance for bad debt 147 -
Other 51 125
-------- ---------
Total deferred tax assets 1,838 1,962
-------- ---------
Net deferred tax asset 458 605
Valuation allowance 33 33
-------- ---------
Net deferred tax asset $ 425 $ 572
======== =========
A valuation allowance is provided against the Company's deferred tax
asset to the extent that management does not believe it is more likely
than not that future taxable income will be adequate to realize these
future tax benefits. This allowance was $33,000 in 2001 and 2000.
A reconciliation of the income tax provisions in thousands based on the
prevailing corporate tax rate of 34 percent to the provision reflected
in the consolidated financial statements for the years ended December
31, 2001 and 2000, is as follows:
2001 2000
------- -------
Computed expected income tax expense
(benefit) at statutory regulatory
tax rate ( $ 569) ( $ 89)
Amortization of excess cost over 54 54
net assets acquired
Meals and entertainment 2 3
Other ( 31) 4
------- -------
Income tax expense (benefit) ( $ 544) ( $ 28)
======= =======
2001 2000
------- -------
Currrent income tax (benefit)/provision ( $ 688) $ 334
Deferred tax provision/(benefit) 144 ( 362)
------- -------
Federal income tax benefit ( $ 544) ( $ 28)
======= =======
The Company has available, for federal income tax purposes, unused
net operating losses of approximately $0.1 million at
December 31, 2001, which may be used to offset future taxable
income. The Internal Revenue Code generally has provided for a
three-year carryback and a 15-year carryforward of operating losses.
Effective with tax years beginning September 1997, the carryback and
carryforward periods are 2 years and 20 years, respectively, with
respect to newly generated operating losses. In March 2002, a change
in federal tax law was passed that allows for net operating losses
generated in 2001 and 2002 to be carried back five years, rather than
two. The net operating losses will expire, if unused, as follows:
Year
----
2002 $ 2
2003 96
-------
$ 98
=======
10 Commitments and Contingencies:
The Company has several leases, primarily for office facilities and
computer equipment, which expire in various years through 2007.
Certain of these leases contain renewal options. Rental expense
amounted to $0.6 million for both of the years ended December 31, 2001
and 2000.
Future minimum lease payments (in thousands) under noncancellable
operating leases as of December 31, 2001 are as follows:
Year
----
2002 $ 663
2003 617
2004 666
2005 643
2006 607
2007 and thereafter 551
-----------
Total minimum lease payments $ 3,747
===========
The Company has a 401(K) savings plan. Employees who have completed
three months of service are eligible to participate. Under this plan
employees may contribute a portion of their compensation, and the
Company may contribute a discretionary amount each year. The Company
did not make a contribution for 2001. The Company's contribution for
2000 paid in 2001 was $0.1 million.
In March 1997, a jury returned a verdict against the Company and in
favor of a former director and officer of Hallmark in the amount of
$0.5 million on the basis of contractual and statutory indemnification
claims. The court subsequently granted the plaintiff's motion for
attorneys' fees of approximately $0.3 million, court costs 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 $1.3 million into the
registry of the court in order to stay execution on the judgment
pending the result of appeals. The amount on deposit with the court of
$1.5 million 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 $1.4 million 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.
The Company is involved in various other claims and legal actions
arising in the ordinary course of business. In the opinion of
management, the ultimate disposition of these matters will not have a
material adverse effect on the Company's financial position or results
of operations.
From time to time, assessments are levied on the Company by the
guaranty association of the State of Texas. Such assessments are made
primarily to cover the losses of policyholders of insolvent or
rehabilitated insurers. Since these assessments can be recovered
through a reduction in future premium taxes paid, the Company
capitalizes the assessments, as they are paid, and amortizes the
capitalized balance against its premium tax expense. On December 31,
2001, the Company was assessed $0.1 million for 2001. There were no
assessments during 2000.
11. Concentrations of Credit Risk:
The Company maintains cash equivalents in accounts with two financial
institutions in excess of the amount insured by the Federal Deposit
Insurance Corporation. The Company monitors the financial stability of
the depository institutions regularly, and management does not believe
excessive risk of depository institution failure exists at December 31,
2001.
All of the Company's business activity is with customers and
independent agents located within the State of Texas.
The Company's reinsurance coverage has been provided by one company
(Dorinco Reinsurance Company) since July 1, 2000.
Funding for the majority of HFC's premium finance activities is provided
by one unaffiliated third party.