10-K 1 v334953_10k.htm FORM 10-K

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

(Mark One)

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended                                       DECEMBER 31, 2012

Or

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________________________ to _________________________________

 

Commission file number 001-11252

Hallmark Financial Services, Inc.

(Exact name of registrant as specified in its charter)

 

Nevada   87-0447375
(State or Other Jurisdiction of Incorporation or Organization)   (I.R.S. Employer Identification No.)
     
777 Main Street, Suite 1000, Fort Worth, Texas   76102
(Address of Principal Executive Offices)   (Zip Code)

 

Registrant's Telephone Number, Including Area Code: (817) 348-1600

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of Each Class   Name of Each Exchange on Which Registered
Common Stock $.18 par value   Nasdaq Global Market

 

Securities registered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No  x 

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No  x 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not 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-K or any amendment to this Form 10-K. x

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “accelerated filer”, “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer ¨   Accelerated filer x   Non-accelerated filer ¨   Smaller reporting company ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).              Yes ¨ No x

 

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. $110,873,264

 

Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date. 19,263,457 shares of common stock, $.18 par value per share, outstanding as of March 14, 2013.

 

 
 

 

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.

 

Unless the context requires otherwise, in this Form 10-K the term “Hallmark” refers solely to Hallmark Financial Services, Inc. and the terms “we,” “our,” and “us” refer to Hallmark and its subsidiaries. The direct and indirect subsidiaries of Hallmark are referred to in this Form 10-K in the manner identified in the chart under “Item 1. Business – Operational Structure.”

 

Risks Associated with Forward-Looking Statements Included in this Form 10-K

 

This Form 10-K contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, which are intended to be covered by the safe harbors created thereby. Forward-looking statements include statements which are predictive in nature, which depend upon or refer to future events or conditions, or which include words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “estimate” or similar expressions. These statements include the plans and objectives of management for future operations, including plans and objectives relating to future growth of our business activities and availability of funds. Statements regarding the following subjects are forward-looking by their nature:

 

·our business and growth strategies;

 

·our performance goals;

 

·our projected financial condition and operating results;

 

·our understanding of our competition;

 

·industry and market trends;

 

·the impact of technology on our products, operations and business; and

 

·any other statements or assumptions that are not historical facts.

 

The forward-looking statements included in this Form 10-K are based on current expectations that involve numerous risks and uncertainties. Assumptions relating to these forward-looking statements involve judgments with respect to, among other things, future economic, competitive and market conditions, legislative initiatives, regulatory framework, weather-related events and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond our control. Although we believe that the assumptions underlying these 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-K will prove to be accurate. In light of the significant uncertainties inherent in these forward-looking statements, the inclusion of such information should not be regarded as a representation that our objectives and plans will be achieved.

 

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PART I

 

Item 1. Business.

 

Who We Are

 

We are a diversified property/casualty insurance group that serves businesses and individuals in specialty and niche markets. We offer standard commercial insurance, specialty commercial insurance and personal insurance in selected market subcategories that are characteristically low-severity and predominately short-tailed risks. We focus on marketing, distributing, underwriting and servicing property/casualty insurance products that require specialized underwriting expertise or market knowledge. We believe this approach provides us the best opportunity to achieve favorable policy terms and pricing. The insurance policies we produce are written by our six insurance company subsidiaries as well as unaffiliated insurers.

 

We market, distribute, underwrite and service our property/casualty insurance products primarily through six business units, each of which has a specific focus. Our Standard Commercial P&C business unit (formerly known as the Standard Commercial business unit) primarily handles standard commercial insurance, our Workers Compensation business unit specializes in small and middle market workers compensation business, our E&S Commercial business unit concentrates on excess and surplus lines commercial insurance, our General Aviation business unit specializes in general aviation insurance, our Excess & Umbrella business unit handles excess commercial automobile and commercial umbrella risks on both an admitted and non-admitted basis and our Personal Lines business unit focuses on non-standard personal automobile insurance and complementary personal insurance products and services. The subsidiaries comprising our Workers Compensation business unit were acquired July 1, 2011.

 

Each business unit has its own management team with significant experience in distributing products to its target markets and proven success in achieving underwriting profitability and providing efficient claims management. Each business unit is responsible for marketing, distribution, underwriting and claims management while we provide capital management, reinsurance, actuarial, investment, financial reporting, technology and legal services and other administrative support at the parent level. We believe this approach optimizes our operating results by allowing us to effectively penetrate our selected specialty and niche markets while maintaining operational controls, managing risks, controlling overhead and efficiently allocating our capital across business units. We expect future growth to be derived from organic growth in the premium production of our existing business units and selected opportunistic acquisitions that meet our criteria.

 

What We Do

 

We market commercial and personal lines of property/casualty insurance products which are tailored to the risks and coverages required by the insured. We believe that most of our target markets are underserved by larger property/casualty insurers because of the specialized nature of the underwriting required. We are able to offer these products profitably as a result of the expertise of our experienced underwriters. We also believe our long-standing relationships with independent general agencies and retail agents and the service we provide differentiate us from larger property/casualty insurers.

 

Our Standard Commercial P&C business unit primarily underwrites low-severity, short-tailed commercial property/casualty insurance products in the standard market. These products have historically produced stable loss results and include general liability, commercial automobile, commercial property and umbrella coverages. Our Standard Commercial P&C business unit currently markets its products through a network of 330 independent agents primarily serving businesses in the non-urban areas of Texas, New Mexico, Oregon, Idaho, Montana, Washington, Utah, Wyoming, Arkansas and Hawaii.

 

Our Workers Compensation business unit, which was acquired July 1, 2011, offers small and middle market workers compensation insurance products. Our Workers Compensation business unit currently markets its products through a network of 170 independent agents in Texas.

 

Our E&S Commercial business unit primarily offers commercial property/casualty insurance products in the excess and surplus lines market. Excess and surplus lines insurance provides coverage for difficult to place risks that do not fit the underwriting criteria of insurers operating in the standard market. Our E&S Commercial business unit focuses on middle market commercial risks and healthcare professionals that do not meet the underwriting requirements of standard insurers due to factors such as loss history, number of years in business, minimum premium size and types of business operation. Our E&S Commercial business unit primarily writes commercial automobile, general liability, commercial property and excess casualty. In addition, our E&S Commercial business unit markets medical professional liability insurance on an excess and surplus lines basis. Our E&S Commercial business unit markets its products in 42 states through 26 wholesale brokers and 76 general agency offices, as well as 203 independent retail agents in Texas and Oregon.

 

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Our General Aviation business unit offers general aviation property/casualty insurance primarily for private and small commercial aircraft and airports. The aircraft liability and hull insurance products underwritten by our General Aviation business unit are targeted to transitional or non-standard pilots who may have difficulty obtaining insurance from a standard carrier. Airport liability insurance is marketed to smaller, regional airports. Our General Aviation business unit markets these general aviation insurance products through 195 independent specialty brokers in 48 states.

 

Our Excess & Umbrella business unit offers small and middle market commercial excess liability, umbrella and general liability insurance on both an admitted and non-admitted basis focusing primarily on trucking, specialty automobile, and non-fleet automobile coverage. Typical risks range from one power unit to fleets of up to 200 power units. Our Excess & Umbrella business unit markets its products through 117 wholesale brokers in 49 states.

 

Our Personal Lines business unit offers non-standard personal automobile policies, which generally provide the minimum limits of liability coverage mandated by state law to drivers who find it difficult to obtain insurance from standard carriers due to various factors including age, driving record, claims history or limited financial resources. Our Personal Lines business unit also provides personal insurance products complementary to non-standard personal automobile insurance such as low value dwelling/homeowners, renters, manufactured homes, motorcycle and business auto coverage. Our Personal Lines business unit actively markets these policies through 8,133 independent retail agents in 22 states.

 

Our insurance company subsidiaries are American Hallmark Insurance Company of Texas (“AHIC”), Hallmark Insurance Company (“HIC”), Hallmark Specialty Insurance Company (“HSIC”), Hallmark County Mutual Insurance Company (“HCM”), Hallmark National Insurance Company (“HNIC”) and Texas Builders Insurance Company (“TBIC”). We acquired HNIC on December 31, 2010 and we acquired TBIC on July 1, 2011. AHIC, HIC, HSIC and HNIC have entered into a pooling arrangement, pursuant to which AHIC retains 30% of the net premiums written by any of them, HIC retains 27% of the net premiums written by any of them, HSIC retains 30% of the net premiums written by any of them and HNIC retains 13% of the net premiums written by any of them. A.M. Best Company (“A.M. Best”), a nationally recognized insurance industry rating service and publisher, has pooled its ratings of these four insurance company subsidiaries and assigned a financial strength rating of “A–” (Excellent) and an issuer credit rating of “a-” to each of these individual insurance company subsidiaries and to the pool formed by these four insurance company subsidiaries. Also, A.M. Best has assigned a financial strength rating of “A–” (Excellent) and an issuer credit rating of “a-” to HCM. A.M. Best does not assign a financial strength rating or an issuer credit rating to TBIC.

 

Our six business units are segregated into three reportable industry segments for financial accounting purposes. The Standard Commercial Segment consists of the Standard Commercial P&C business unit and the Workers Compensation business unit. The Specialty Commercial Segment includes our E&S Commercial business unit, General Aviation business unit and Excess & Umbrella business unit, as well as certain specialty risk programs (“Specialty Programs”) which are managed at the parent level. The Personal Segment presently consists solely of our Personal Lines business unit. The following table displays the gross premiums written and net premiums by these reportable segments for affiliated and unaffiliated insurers for the years ended December 31, 2012, 2011 and 2010.

 

   Year Ended December 31, 
   2012   2011   2010 
   (dollars in thousands) 
             
Gross Premiums Written:               
Standard Commercial Segment (1)  $77,091   $69,420   $67,832 
Specialty Commercial Segment   235,695    185,020    157,849 
Personal Segment (2)   77,056    100,441    95,292 
Total  $389,842   $354,881   $320,973 
                
Net Premiums Written:               
Standard Commercial Segment (1)  $70,091   $63,944   $63,572 
Specialty Commercial Segment   186,053    144,277    122,973 
Personal Segment (2)   76,345    95,655    95,096 
Total  $332,489   $303,876   $281,641 

 

(1) The Workers Compensation business unit included in the Standard Commercial Segment was acquired effective July 1, 2011.

 

(2) HNIC included in the Personal Segment was acquired effective December 31, 2010.

 

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Operational Structure

 

Our insurance company subsidiaries retain a portion of the premiums produced by our business units. The following chart reflects the operational structure of our organization, including the subsidiaries comprising our business units and the business units included in each reportable segment as of December 31, 2012.

 

 

Standard Commercial Segment

 

The Standard Commercial Segment of our business includes our Standard Commercial P&C business unit and our Workers Compensation business unit. During 2012, our Standard Commercial P&C business unit accounted for approximately 90% and our Workers Compensation business unit accounted for the remaining 10% of the aggregate premiums produced by the Standard Commercial Segment.

 

Standard Commercial P&C business unit. Our Standard Commercial P&C business unit markets, underwrites and services standard commercial lines insurance primarily in the non-urban areas of Texas, New Mexico, Idaho, Oregon, Montana, Washington, Utah, Wyoming, Arkansas and Hawaii. The subsidiaries comprising our Standard Commercial P&C business unit include American Hallmark Insurance Services, a regional managing general agency, and ECM, a claims administration company. American Hallmark Insurance Services targets customers that are in low-severity classifications in the standard commercial market, which as a group have relatively stable loss results. The typical customer is a small to midsize business with a policy that covers property, general liability and automobile exposures. Our Standard Commercial P&C business unit underwriting criteria exclude lines of business and classes of risks that are considered to be high-severity or volatile, or which involve significant latent injury potential or other long-tailed liability exposures. ECM administers the claims on the insurance policies produced by American Hallmark Insurance Services. Products offered by our Standard Commercial P&C business unit include the following:

 

·Commercial automobile. Commercial automobile insurance provides third-party bodily injury and property damage coverage and first-party property damage coverage against losses resulting from the ownership, maintenance or use of automobiles and trucks in connection with an insured’s business.

 

·General liability. General liability insurance provides coverage for third-party bodily injury and property damage claims arising from accidents occurring on the insured’s premises or from their general business operations.

 

·Umbrella. Umbrella insurance provides coverage for third-party liability claims where the loss amount exceeds coverage limits provided by the insured’s underlying general liability and commercial automobile policies.

 

·Commercial property. Commercial property insurance provides first-party coverage for the insured’s real property, business personal property, and business interruption losses caused by fire, wind, hail, water damage, theft, vandalism and other insured perils.

 

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·Commercial multi-peril. Commercial multi-peril insurance provides a combination of property and liability coverage that can include commercial automobile coverage on a single policy.

 

·Business owner’s. Business owner’s insurance provides a package of coverage designed for small to midsize businesses with homogeneous risk profiles. Coverage includes general liability, commercial property and commercial automobile.

 

Our Standard Commercial P&C business unit markets its property/casualty insurance products through 330 independent agencies operating in its target markets. Our Standard Commercial P&C business unit applies a strict agent selection process and seeks to provide its independent agents some degree of non-contractual geographic exclusivity. Our Standard Commercial P&C business unit also strives to provide its independent agents with convenient access to product information and personalized service. As a result, the Standard Commercial P&C business unit has historically maintained excellent relationships with its producing agents, as evidenced by the 25 year average tenure of the 14 agency groups that each produced more than $1.0 million in premium during the year ended December 31, 2012. During 2012, the top ten agency groups produced approximately 38%, and no individual agency group produced more than 9%, of the total premium volume of our Standard Commercial P&C business unit.

 

Our Standard Commercial P&C business unit writes most risks on a package basis using a commercial multi-peril policy or a business owner’s policy. Umbrella policies are written only when our Standard Commercial P&C business unit also writes the insured’s underlying general liability and commercial automobile coverage. Through December 31, 2005, our Standard Commercial P&C business unit marketed policies on behalf of Clarendon National Insurance Company (“Clarendon”), a third-party insurer. Our Standard Commercial P&C business unit earns a commission based on a percentage of the earned premium it produced for Clarendon. The commission percentage is determined by the underwriting results of the policies produced. Our Standard Commercial P&C business unit presently markets all new and renewal policies exclusively for AHIC.

 

All of the commercial policies written by our Standard Commercial P&C business unit are for a term of 12 months. If the insured is unable or unwilling to pay for the entire premium in advance, we provide an installment payment plan that requires the insured to pay 20% or 25% down and the remaining payments over eight months. We charge installment fees of up to $7.50 per payment for the installment payment plan.

 

Workers Compensation business unit. Our Workers Compensation business unit markets, underwrites and services workers compensation insurance in Texas. The subsidiaries comprising our Workers Compensation business unit include TBIC Holding which has two wholly-owned subsidiaries, TBIC, a Texas domiciled workers compensation insurance carrier and TBICRM, which provides risk management services to customers of TBIC. The subsidiaries comprising the Workers Compensation business unit were acquired July 1, 2011.

 

Our Workers Compensation business unit markets its products through approximately 170 independent agencies operating in Texas. During 2012, the top ten agency groups produced approximately 44%, and no individual agency group produced more than 7%, of the total premium volume of our Workers Compensation business unit.

 

Specialty Commercial Segment

 

The Specialty Commercial Segment of our business includes our E&S Commercial business unit, our General Aviation business unit and our Excess & Umbrella business unit, as well as certain Specialty Programs which are managed at the parent level. During 2012, our E&S Commercial business unit accounted for approximately 70% of the aggregate premiums produced by the Specialty Commercial Segment, with our Excess & Umbrella business unit, General Aviation business unit and Specialty Programs accounting for 17%, 8% and 5%, respectively.

 

E&S Commercial business unit. Our E&S Commercial business unit markets, underwrites, finances and services commercial lines insurance in 42 states with a particular emphasis on commercial automobile, general liability and commercial property risks produced on an excess and surplus lines basis. In addition, our E&S Commercial business unit markets medical professional liability insurance on an excess and surplus lines basis. Excess and surplus lines insurance provides coverage for difficult to place risks that do not fit the underwriting criteria of insurers operating in the standard market. The subsidiaries comprising our E&S Commercial business unit include HSU, which is a regional managing general underwriter, TGASRI which is a Texas managing general agency, and PAAC, which provides premium financing for policies marketed by HSU and certain unaffiliated general and retail agents. HSU accounts for approximately 98% of the premium volume financed by PAAC.

 

Our E&S Commercial business unit focuses on middle market commercial risks and healthcare professionals that do not meet the underwriting requirements of traditional standard insurers due to issues such as loss history, number of years in business, minimum premium size and types of business operation. During 2012, commercial automobile, general liability and medical professional liability approximated 81%, 14% and 3%, respectively, of the premiums produced by our E&S Commercial business unit. Target risks for commercial automobile insurance are business auto and trucking for hire fleets, excluding hazardous or flammable materials haulers. Target risks for general liability insurance are small business risk exposures including artisan contractors, sales and service organizations, and building and premises liability exposures. Target risks for commercial property insurance are low- to mid-value structures including office buildings, mercantile shops, restaurants and rental dwellings, in each case with aggregate property limits of less than $500,000. Target risks for medical professional liability insurance are medical entities and healthcare professionals, including physicians, surgeons and podiatrists. The commercial insurance products offered by our E&S Commercial business unit include the following:

 

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Commercial automobile. Commercial automobile insurance provides third-party bodily injury and property damage coverage and first-party property damage coverage against losses resulting from the ownership, maintenance or use of automobiles and trucks in connection with an insured’s business.

 

·General liability. General liability insurance provides coverage for third-party bodily injury and property damage claims arising from accidents occurring on the insured’s premises or from their general business operations.

 

·Commercial property. Commercial property insurance provides first-party coverage for the insured’s real property, business personal property, theft and business interruption losses caused by fire, wind, hail, water damage, vandalism and other insured perils. Windstorm, hurricane and hail are generally excluded in coastal areas.

 

·Medical professional liability. Medical professional liability insurance provides coverage for third-party bodily injury claims resulting from professional services provided by physicians, surgeons, podiatrists and medical entities.

 

·Commercial excess liability Commercial excess liability insurance is designed to provide an extra layer of protection for bodily injury, personal and advertising injury, or property damage losses above the primary layer of commercial automobile, general liability and employer’s liability insurance.  The excess insurance does not begin until the limits of liability in the primary layer have been exhausted.  The excess layer provides not only higher limits, but catastrophic protection from large losses.

 

·Commercial umbrella.  Commercial umbrella insurance protects businesses for bodily injury, personal and advertising injury, or property damage claims in excess of the limits of their primary commercial automobile, general liability and employers liability policies, and for some claims excluded by their primary policies (subject to a deductible).  Umbrella insurance provides not only higher limits, but catastrophic protection for large losses.

 

Our E&S Commercial business unit produces business in 42 states through 26 wholesale brokers, a program underwriter and a network of 76 general agency offices, as well as 203 independent retail agents in Texas and Oregon. Our E&S Commercial business unit strives to simplify the placement of its excess and surplus lines policies by providing our general agents with a web rating portal which allows for instantaneous quoting and signature-ready applications which can be emailed or faxed to its independent retail agents. During 2012, general agents produced 75%, the program underwriter produced 14%, retail agents produced 7% and wholesale brokers produced 4% of total premiums produced by our E&S Commercial business unit. During 2012, the top ten general agents produced approximately 39%, the top ten wholesale brokers produced approximately 4% and no general agent produced more than 7%, of the total premium volume of our E&S Commercial business unit. During the same period, the top ten retail agents produced approximately 4%, and no retail agent produced more than 1%, of the total premium volume of our E&S Commercial business unit.

 

Through 2008, all business of our E&S Commercial business unit was produced under a fronting agreement with member companies of the Republic Group (“Republic”), which granted our E&S Commercial business unit the authority to develop underwriting programs, set rates, appoint retail and general agents, underwrite risks, issue policies and adjust and pay claims. We assumed 70% of the risk under this arrangement in 2008. In 2009, our E&S Commercial business unit wrote a portion of its policies under a fronting arrangement with Republic pursuant to which we assumed 100% of the risk. Commission revenue was generated under the fronting agreement on the portion of premiums not assumed by AHIC. An additional commission may be earned if certain loss ratio targets are met. Additional revenue was generated from fully earned policy fees and installment billing fees charged on legacy personal lines products. Since 2010, in states where we were not yet licensed to offer a non-admitted product, we utilized a fronting arrangement with a third party pursuant to which we assumed all of the risk and then retroceded a portion of the risk to third party reinsurers. 

 

The majority of the commercial policies written by our E&S Commercial business unit are for a term of 12 months. Exceptions include certain commercial automobile policies that are written for a term that coincides with the annual harvest of crops and special event general liability policies that are written for the term of the event, which is generally one to two days. Commercial lines policies are paid in full up front or financed with various premium finance companies, including PAAC.

 

General Aviation business unit. Our General Aviation business unit markets, underwrites and services general aviation property/casualty insurance in 48 states. The subsidiaries comprising our General Aviation business unit include Aerospace Insurance Managers, which markets standard aviation coverages, ASRI, which markets excess and surplus lines aviation coverages, and ACMG, which handles claims management. Aerospace Insurance Managers is one of only a few similar entities in the U.S. and has focused on developing a well-defined niche centering on transitional pilots, older aircraft and small airports and aviation-related businesses. Products offered by our General Aviation business unit include the following:

 

·Aircraft. Aircraft insurance provides third-party bodily injury and property damage coverage and first-party hull damage coverage against losses resulting from the ownership, maintenance or use of aircraft.

 

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·Airport liability. Airport liability insurance provides coverage for third-party bodily injury and property damage claims arising from accidents occurring on airport premises or from their operations.

 

Our General Aviation business unit generates its business through 195 aviation specialty brokers. These specialty brokers submit to Aerospace Insurance Managers requests for aviation insurance quotations received from the states in which we operate and our General Aviation business unit selectively determines the risks fitting its target niche for which it will prepare a quote. During 2012, the top ten independent specialty brokers produced approximately 32%, and no broker produced more than 7%, of the total premium volume of our General Aviation business unit.

 

Our General Aviation business unit independently develops, underwrites and prices each coverage written. We target pilots who may lack experience in the type of aircraft they have acquired or are transitioning between types of aircraft. We also target pilots who may be over the age limits of other insurers. We do not accept aircraft that are used for hazardous purposes such as crop dusting or heli-skiing. Liability limits are controlled, with approximately 92% of the aircraft written in 2012 bearing per-occurrence limits of $1,000,000 and per-passenger limits of $100,000 or less. The average insured aircraft hull value for aircraft written in 2012 was approximately $165,700. All general aviation policies produced by our General Aviation business unit are written through our insurance company subsidiaries.

 

Excess & Umbrella business unit. Our Excess & Umbrella business unit markets, underwrites and services small and middle market commercial excess liability, umbrella and general liability insurance on both an admitted and non-admitted basis in 49 states.  Limits of liability offered are from $1,000,000 to $5,000,000 in coverage in excess of the primary carrier’s limits of liability. 

 

The principal focus of the Excess & Umbrella business unit is transportation, specifically trucking for hire, specialty automobile and non-fleet automobile coverage.  The Excess & Umbrella business unit also provides umbrella and excess liability coverage for small to midsize businesses in class categories such as contracting, manufacturing, hospitality and service. 

 

The majority of insurance policies written by our Excess & Umbrella business unit are on an annual basis. However, exceptions are common in an attempt to have policy effective dates coincide with those of the primary insurance policies.  Policy premiums are due in full 30 days from the inception date of the policy.

 

Our Excess & Umbrella business unit markets its products through 117 wholesale brokers.  During 2012, the top ten wholesale brokers accounted for 56% of our Excess & Umbrella business unit premium volume, with no single wholesale broker accounting for more than 17%.  During 2012, commercial excess liability risks accounted for 98% of the premiums produced by our Excess & Umbrella business unit, with the remaining 2% coming from commercial umbrella and general liability risks.  The commercial insurance products offered by our Excess & Umbrella business unit include the following:

 

·Commercial excess liability Commercial excess liability insurance is designed to provide an extra layer of protection for bodily injury, personal and advertising injury, or property damage losses above the primary layer of commercial automobile, general liability and employer’s liability insurance.  The excess insurance does not begin until the limits of liability in the primary layer have been exhausted.  The excess layer provides not only higher limits, but catastrophic protection from large losses.

 

·Commercial umbrella.  Commercial umbrella insurance protects businesses for bodily injury, personal and advertising injury, or property damage claims in excess of the limits of their primary commercial automobile, general liability and employers liability policies, and for some claims excluded by their primary policies (subject to a deductible).  Umbrella insurance provides not only higher limits, but catastrophic protection for large losses.

 

·Commercial general liability. General liability insurance provides coverage for third-party bodily injury and property damage claims arising from accidents occurring on the insured’s premises or from their general business operations.

 

In states where we are not admitted, our Excess & Umbrella business unit writes policies under a fronting arrangement pursuant to which we assume all of the risk and then retrocede a portion of the risk to third party reinsurers.  We presently reinsure or retrocede 79% of the risk on policies written by our Excess & Umbrella business unit.

 

Specialty Programs. Our Specialty Programs consist of fronting and agency arrangements which are managed at the parent level. The Specialty Programs business presently consists primarily of a fronting arrangement in Texas for a third party insurance company and satellite launch property/casualty policies marketed through underwriting agencies with technical knowledge of space insurance. We can retain up to $2.0 million per risk for satellite launches and in-orbit coverage for up to 12 months.

 

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Personal Segment / Personal Lines Business Unit

 

The Personal Segment of our business presently consists solely of our Personal Lines business unit. Our Personal Lines business unit markets and services non-standard personal automobile policies and low value dwelling/homeowners, renters, manufactured homes, motorcycle and business auto coverages in 22 states. We conduct this business under the name Hallmark Insurance Company. Hallmark Insurance Company provides management, policy and claims administration services to HIC and includes the operations of American Hallmark General Agency, Inc. and Hallmark Claims Services, Inc. Our non-standard personal automobile insurance generally provides for the minimum limits of liability coverage mandated by state laws to drivers who find it difficult to purchase automobile insurance from standard carriers as a result of various factors, including driving record, vehicle, age, claims history, or limited financial resources. Products offered by our Personal Lines business unit include the following:

 

·Personal automobile. Personal automobile insurance is the primary product offered by our Personal Lines business unit.  Our policies typically provide coverage to individuals for bodily injury and property damage at the minimum limits required by law, and for physical damage to an insured’s own vehicle from collision and various other perils. In addition, many states require policies to provide for first party personal injury protection, frequently referred to as no-fault coverage.

 

·Low value dwelling/homeowners. Low value dwelling/homeowners insurance provides coverage against insured’s property being destroyed or damaged by various perils and coverage for liability exposure of the insured.

 

·Renters. Renters insurance provides coverage for the contents of a renter’s home or apartment and for liability. Renter’s policies are similar to homeowners insurance, except they do not cover the structure.

 

·Manufactured homes. Manufactured home insurance covers mobile home owners against various perils and may include the liability exposure of the insured.

 

·Motorcycle. Motorcycle insurance provides coverage similar to the personal automobile products. A motorcycle policy is generally utilized for vehicles that do not qualify for a personal automobile policy because they have fewer than four wheels. Passenger liability may be included or excluded depending on customer choice or regulatory requirements.

 

·Business auto. Business auto insurance provides coverage to businesses for liability to others for bodily injury and property damage and for physical damage to vehicles from collision and various other perils.  The business auto coverage is offered by the Personal Lines business unit as an alternative to a personal automobile policy rated with business use for one or more vehicles included on the policy.

 

Our Personal Lines business unit markets its products through 8,133 independent retail agents operating in its target geographic markets. Non-standard automobile represented 76% of the premiums produced during 2012. Our Personal Lines business unit qualifies new agent appointments in order to establish an efficient network of independent agents to effectively penetrate its highly competitive markets. Our Personal Lines business unit periodically evaluates its independent agents and discontinues the appointment of agents whose production history does not satisfy certain standards. During 2012, the top ten independent agency groups produced approximately 16%, and no individual agency group produced more than 4%, of the total premium volume of our Personal Lines business unit.

 

During 2012, personal automobile liability coverage accounted for approximately 85% and personal automobile physical damage coverage accounted for the remaining 15% of the total non-standard automobile premiums produced by our Personal Lines business unit. Our most common policy term is a six month policy. We do offer additional terms of one-, two-, three and twelve-month policies in certain markets. Our typical non-standard personal automobile customer is unable or unwilling to pay a full or half year premium in advance. Accordingly, we currently offer a direct bill program where the premiums are directly billed to the insured on a monthly basis. We charge installment fees for each payment under the direct bill program.

 

Our Personal Lines business unit actively markets its products in 22 states directly for HIC, AHIC and HNIC. In Texas, our Personal Lines business unit also markets its policies through reinsurance arrangements with unaffiliated companies. We provide non-standard personal automobile coverage in Texas through a reinsurance arrangement with Old American County Mutual Fire Insurance Company (“OACM”) pursuant to which American Hallmark General Agency, Inc. holds a managing general agency appointment from OACM to manage the sale and servicing of OACM policies. HIC reinsures 100% of the OACM policies produced by American Hallmark General Agency, Inc. under these reinsurance arrangements. During the third quarter of 2009, HCM began fronting a portion of the business previously written through OACM.

 

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Our Competitive Strengths

 

We believe that we enjoy the following competitive strengths:

 

·Specialized market knowledge and underwriting expertise. All of our business units possess extensive knowledge of the specialty and niche markets in which they operate, which we believe allows them to effectively structure and market their property/casualty insurance products. Our Personal Lines business unit has a thorough understanding of the unique characteristics of the non-standard personal automobile market. Our Standard Commercial P&C business unit and Workers Compensation business unit have significant underwriting experience in their target markets for standard commercial property/casualty insurance products. In addition, our E&S Commercial business unit, General Aviation business unit, and Excess & Umbrella business unit have developed specialized underwriting expertise which enhances their ability to profitably underwrite non-standard property/casualty insurance coverages.

 

·Tailored market strategies. Each of our business units has developed its own customized strategy for penetrating the specialty or niche markets in which it operates. These strategies include distinctive product structuring, marketing, distribution, underwriting and servicing approaches by each business unit. As a result, we are able to structure our property/casualty insurance products to serve the unique risk and coverage needs of our insureds. We believe these market-specific strategies enable us to provide policies tailored to the target customer that are appropriately priced and fit our risk profile.

 

·Superior agent and customer service. We believe performing the underwriting, billing, customer service and claims management functions at the business unit level allows us to provide superior service to both our independent agents and insured customers. The easy-to-use interfaces and responsiveness of our business units enhance their relationships with the independent agents who sell our policies. We also believe our consistency in offering our insurance products through hard and soft markets helps to build and maintain the loyalty of our independent agents. Our customized products, flexible payment plans and prompt claims processing are similarly beneficial to our insureds.

 

·Market diversification. We believe operating in various specialty and niche segments of the property/casualty insurance market diversifies both our revenues and our risks. We also believe our business units generally operate on different market cycles, producing more earnings stability than if we focused entirely on one product. As a result of the pooling arrangement among four of our insurance company subsidiaries, we are able to efficiently allocate our capital among these various specialty and niche markets in response to market conditions and expansion opportunities. We believe this market diversification reduces our risk profile and enhances our profitability.

 

·Experienced management team. Our senior corporate management has an average of over 20 years of insurance experience. In addition, our business units have strong management teams, with an average of more than 20 years of insurance industry experience for the heads of our business units and an average of more than 15 years of underwriting experience for our underwriters. Our management has significant experience in all aspects of property/casualty insurance, including underwriting, claims management, actuarial analysis, reinsurance and regulatory compliance. In addition, Hallmark’s senior management has a strong track record of acquiring businesses that expand our product offerings and improve our profitability profile.

 

Our Strategy

 

We are striving to become a “Best in Class” specialty insurance company offering products in specialty and niche markets through the following strategies:

 

·Focusing on underwriting discipline and operational efficiency. We seek to consistently generate an underwriting profit on the business we write in hard and soft markets. Our business units have a strong track record of underwriting discipline and operational efficiency, which we seek to continue. We believe that in soft markets our competitors often offer policies at a low or negative underwriting profit in order to maintain or increase their premium volume and market share. In contrast, we seek to write business based on its profitability rather than focusing solely on premium production. To that end, we provide financial incentives to many of our underwriters and independent agents based on underwriting profitability.

 

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·Achieving organic growth in our existing business lines. We believe we can achieve organic growth in our existing business lines by consistently providing our insurance products through market cycles, expanding geographically, expanding our product offerings, expanding our agency relationships and further penetrating our existing customer base. We believe our extensive market knowledge and strong agency relationships position us to compete effectively in our various specialty and niche markets. We also believe there is a significant opportunity to expand some of our existing business lines into new geographical areas and through new agency relationships while maintaining our underwriting discipline and operational efficiency. In addition, we believe there is an opportunity for some of our business units to further penetrate their existing customer bases with additional products offered by other business units.

 

·Pursuing selected, opportunistic acquisitions. We seek to opportunistically acquire insurance organizations that operate in specialty or niche property/casualty insurance markets that are complementary to our existing operations. We seek to acquire companies with experienced management teams, stable loss results and strong track records of underwriting profitability and operational efficiency. Where appropriate, we intend to ultimately retain profitable business produced by the acquired companies that would otherwise be retained by unaffiliated insurers. Our management has significant experience in evaluating potential acquisition targets, structuring transactions to ensure continued success and integrating acquired companies into our operational structure.

 

·Maintaining a strong balance sheet. We seek to maintain a strong balance sheet by employing conservative investment, reinsurance and reserving practices and to measure our performance based on long-term growth in book value per share.

 

Distribution

 

We market our property/casualty insurance products predominately through independent general agents, retail agents and specialty brokers. Therefore, our relationships with independent agents and brokers are critical to our ability to identify, attract and retain profitable business. Each of our business units has developed its own tailored approach to establishing and maintaining its relationships with these independent distributors of our products. These strategies focus on providing excellent service to our agents and brokers, maintaining a consistent presence in our target niche and specialty markets through hard and soft market cycles and fairly compensating the agents and brokers who market our products. Our business units also regularly evaluate independent general and retail agents based on the underwriting profitability of the business they produce and their performance in relation to our objectives.

 

Except for the products of our General Aviation business unit, our Excess & Umbrella business unit, and our medical professional liability product, the distribution of property/casualty insurance products by our business segments is geographically concentrated. For the twelve months ended December 31, 2012, five states accounted for approximately 61% of the gross premiums retained by our insurance company subsidiaries. The following table reflects the geographic distribution of our insured risks, as represented by direct and assumed premiums written by our business segments for the twelve months ended December 31, 2012.

 

   Standard   Specialty             
   Commercial   Commercial   Personal       Percent of 
State  Segment   Segment   Segment   Total   Total 
   (dollars in thousands)     
                          
Texas  $31,598   $127,609   $18,699   $177,906    45.6%
Louisiana   -    17,907    114    18,021    4.6%
Oregon   14,882    887    541    16,310    4.2%
New Mexico   8,550    1,007    4,890    14,447    3.7%
Arizona   -    1,168    10,761    11,929    3.1%
All other states   22,061    87,117    42,051    151,229    38.8%
                          
Total gross premiums written  $77,091   $235,695   $77,056   $389,842      
Percent of total   19.8%   60.4%   19.8%   100.0%     

 

Underwriting

 

The underwriting process employed by our business units involves securing an adequate level of underwriting information, identifying and evaluating risk exposures and then pricing the risks we choose to accept. Each of our business units offering commercial, healthcare professional or aviation insurance products employs its own underwriters with in-depth knowledge of the specific niche and specialty markets targeted by that business unit. We employ a disciplined underwriting approach that seeks to provide policies appropriately tailored to the specified risks and to adopt price structures that will be supported in the applicable market. Our experienced commercial, healthcare professional and aviation underwriters have developed underwriting principles and processes appropriate to the coverages offered by their respective business units.

 

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We believe that managing the underwriting process through our business units capitalizes on the knowledge and expertise of their personnel in specific markets and results in better underwriting decisions. All of our underwriters have established limits of underwriting authority based on their level of experience. We also provide financial incentives to many of our underwriters based on underwriting profitability.

 

To better diversify our revenue sources and manage our risk, we seek to maintain an appropriate business mix among our business units. At the beginning of each year, we establish a target net loss ratio for each business unit. We then monitor the actual net loss ratio on a monthly basis. If any line of business fails to meet its target net loss ratio, we seek input from our underwriting, actuarial and claims management personnel to develop a corrective action plan. Depending on the particular circumstances, that plan may involve tightening underwriting guidelines, increasing rates, modifying product structure, re-evaluating independent agency relationships or discontinuing unprofitable coverages or classes of risk.

 

An insurance company’s underwriting performance is traditionally measured by its statutory loss and loss adjustment expense ratio, its statutory expense ratio and its statutory combined ratio. The statutory loss and loss adjustment expense ratio, which is calculated as the ratio of net losses and loss adjustment expenses (“LAE”) incurred to net premiums earned, helps to assess the adequacy of the insurer’s rates, the propriety of its underwriting guidelines and the performance of its claims department. The statutory expense ratio, which is calculated as the ratio of underwriting and operating expenses to net premiums written, assists in measuring the insurer’s cost of processing and managing the business. The statutory combined ratio, which is the sum of the statutory loss and LAE ratio and the statutory expense ratio, is indicative of the overall profitability of an insurer’s underwriting activities, with a combined ratio of less than 100% indicating profitable underwriting results.

 

The following table shows, for the periods indicated, (i) our gross premiums written (in thousands); and (ii) our underwriting results as measured by the net statutory loss and LAE ratio, the statutory expense ratio, and the statutory combined ratio.

 

   Year Ended December 31, 
   2012   2011   2010 
Gross premiums written  $389,842   $354,881   $320,973 
                
Statutory loss & LAE ratio   72.0%   82.8%   75.0%
Statutory expense ratio   33.5%   32.8%   33.3%
Statutory combined ratio   105.5%   115.6%   108.3%

 

These statutory ratios do not reflect the deferral of policy acquisition costs, investment income, premium finance revenues, or the elimination of inter-company transactions required by U.S. generally accepted accounting principles (“GAAP”).

 

The premium-to-surplus percentage measures the relationship between net premiums written in a given period (premiums written, less returned premiums and reinsurance ceded to other carriers) to policyholders surplus (admitted assets less liabilities), determined on the basis of statutory accounting practices prescribed or permitted by insurance regulatory authorities. State insurance department regulators expect insurance companies to maintain a premium-to-surplus percentage of not more than 300%. For the years ended December 31, 2012, 2011 and 2010, our consolidated premium-to-surplus ratios were 188%, 176% and 154%, respectively.

 

Claims Management and Administration

 

We believe that effective claims management is critical to our success and that our claims management process is cost-effective, delivers the appropriate level of claims service and produces superior claims results. Our claims management philosophy emphasizes the delivery of courteous, prompt and effective claims handling and embraces responsiveness to policyholders and agents. Our claims strategy focuses on thorough investigation, timely evaluation and fair settlement of covered claims while consistently maintaining appropriate case reserves. We seek to compress the cycle time of claim resolution in order to control both loss and claim handling cost. We also strive to control legal expenses by negotiating competitive rates with defense counsel and vendors, establishing litigation budgets and monitoring invoices.

 

Each of our business units maintains its own dedicated staff of specialized claims personnel to manage and administer claims arising under policies produced through their respective operations. The claims process is managed through a combination of experienced claims managers, seasoned claims supervisors, trained staff adjusters and independent adjustment or appraisal services, when appropriate. All adjusters are licensed in those jurisdictions for which they handle claims that require licensing. Limits on settlement authority are established for each claims supervisor and staff adjuster based on their level of experience. Certain independent adjusters have limited authority to settle claims. Claim exposures are periodically and systematically reviewed by claim supervisors and managers as a method of quality and loss control. Large loss exposures are reviewed at least quarterly with senior management of the business unit and monitored by Hallmark senior management.

 

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Claims personnel receive in-house training and are required to attend various continuing education courses pertaining to topics such as best practices, fraud awareness, legal environment, legislative changes and litigation management. Depending on the criteria of each business unit, our claims adjusters are assigned a variety of claims to enhance their knowledge and ensure their continued development in efficiently handling claims. As of December 31, 2012, our business units had a total of 79 claims managers, supervisors and adjusters with an average experience of approximately 14 years.

 

Analysis of Losses and LAE

 

Our consolidated financial statements include an estimated reserve for unpaid losses and LAE. We estimate our reserve for unpaid losses and LAE by using case-basis evaluations and statistical projections, which include inferences from both losses paid and losses incurred. We also use recent historical cost data and periodic reviews of underwriting standards and claims management practices to modify the statistical projections. We give consideration to the impact of inflation in determining our loss reserves, but do not discount reserve balances.

 

The amount of reserves represents our estimate of the ultimate cost of all unpaid losses and LAE incurred. These estimates are subject to the effect of trends in claim severity and frequency. We regularly review the estimates and adjust 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.

 

Changes in loss development patterns and claim payments can significantly affect the ability of insurers to estimate reserves for unpaid losses and related expenses. We seek to continually improve our loss estimation process by refining our ability to analyze loss development patterns, claim payments and other information within a legal and regulatory environment that affects development of ultimate liabilities. 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 reconciliation of our beginning and ending reserve balances on a net-of-reinsurance basis for the years ended December 31, 2012, 2011 and 2010, to the gross-of-reinsurance amounts reported in our balance sheets at December 31, 2012, 2011 and 2010.

 

   As of and for Year Ended December 31, 
   2012   2011   2010 
   (dollars in thousands) 
             
Reserve for unpaid losses and LAE, net of reinsurance recoverables, January 1  $254,901   $213,723   $176,250 
                
Acquisition of subsidiaries effective July 1   -    8,816    - 
                
Provision for losses and LAE for claims occurring in the current period   230,089    222,869    193,354 
                
(Decrease) increase in reserve for unpaid losses and LAE for claims occurring in prior periods   (3,675)   16,366    9,190 
                
Payments for losses and LAE, net of reinsurance:               
Current period   (107,945)   (101,025)   (91,424)
Prior periods   (109,538)   (105,848)   (73,647)
                
Reserve for unpaid losses and LAE at December 31, net of reinsurance recoverable   263,832    254,901    213,723 
                
Reinsurance recoverable on unpaid losses and LAE at December 31   49,584    42,044    37,954 
                
Reserve for unpaid losses and LAE at December 31, gross of reinsurance  $313,416   $296,945   $251,677 

 

The $3.7 million favorable development and $16.4 million and $9.2 million unfavorable development in prior accident years recognized in 2012, 2011, and 2010, respectively, represent normal changes in our loss reserve estimates. In 2012, the aggregate loss reserve estimates for prior years were decreased to reflect favorable loss development when the available information indicated a reasonable likelihood that the ultimate losses would be less than the previous estimates. In 2011 and 2010, the aggregate loss reserve estimates for prior years were increased to reflect unfavorable loss development when the available information indicated a reasonable likelihood that the ultimate losses would be more than the previous estimates. Generally, changes in reserves are caused by variations between actual experience and previous expectations and by reduced emphasis on the Bornhuetter-Ferguson method due to the aging of the accident years. (See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Estimates and Judgments - Reserves for unpaid losses and loss adjustment expenses.”)

 

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The $3.7 million decrease in reserves for unpaid losses and LAE recognized in 2012 was attributable to $0.4 million favorable development on claims incurred in the 2011 accident year, $0.8 million favorable development on claims incurred in the 2010 accident year and $2.5 million favorable development on claims incurred in the 2009 and prior accident years. Our Standard Commercial P&C business unit, General Aviation business unit and E&S Commercial business unit accounted for $3.7 million, $3.3 million and $0.3 million, respectively, of the decrease in reserves recognized during 2012. The decrease in reserves for our Standard Commercial P&C business unit was primarily related to commercial auto, commercial property and general liability lines of business. The decrease in reserves for our General Aviation business unit was primarily related to our liability lines of business. The decrease in reserves for our E&S Commercial business unit was primarily related to general liability. These favorable developments were partially offset by unfavorable prior years’ loss development of $3.6 million in our Personal Lines business unit related to auto liability claims spread throughout various states and our low value dwelling/homeowners line of business.

 

The $16.4 million increase in reserves for unpaid losses and LAE recognized in 2011 was attributable to $15.0 million unfavorable development on claims incurred in the 2010 accident year, $3.6 million unfavorable development on claims incurred in the 2009 accident year and $2.2 million favorable development on claims incurred in the 2008 and prior accident years. Our Personal Lines business unit and E&S Commercial business unit accounted for $19.6 million and $3.7 million, respectively, of the increase in reserves recognized during 2011. The $19.6 million increase in reserves during 2011 for our Personal Lines business unit includes $10.3 million which was attributable to Florida developing much worse than expected due primarily to rapid growth in the claim volume from Florida, the complexity related to Florida personal injury protection coverage claims and the high incidence of fraudulent claims in that market. The remaining unfavorable prior years’ loss development for our Personal Lines business unit was primarily due to rapid geographic expansion. The increase in reserves for our E&S Commercial business unit was primarily related to commercial auto and physical damage and general liability lines of business. These unfavorable developments were partially offset by favorable prior years’ loss development of $6.1 million in our General Aviation business unit related to our liability lines of business and $0.8 million in our Standard Commercial P&C business unit primarily related to our commercial property lines of business.

 

The $9.2 million increase in reserves for unpaid losses and LAE recognized in 2010 was attributable to $5.4 million unfavorable development on claims incurred in the 2009 accident year, $0.6 million unfavorable development on claims incurred in the 2008 accident year and $3.2 million unfavorable development on claims incurred in the 2007 and prior accident years. Our Standard Commercial P&C business unit, E&S Commercial business unit, Excess and Umbrella business unit and Personal Lines business unit accounted for $4.6 million, $1.6 million, $0.1 million and $3.1 million of the increase in reserves recognized during 2010, partially offset by a $0.2 million decrease in reserves for our General Aviation business unit. The increase in reserves for our Standard Commercial P&C business unit was largely driven by unfavorable claims development in the 2009 accident year due to late developing large property claims, including weather related claims. Further contributing to the increase in reserves for our Standard Commercial P&C business unit was unfavorable claims development in the 2007 and prior accident years driven by large loss development in property claims coupled with modest increases in general liability. The increase in reserves for our E&S Commercial business unit was primarily the result of unfavorable development due to modest increases in 2008 hurricane claims and strengthening in general liability case reserves in the 2007 and prior accident years. The increase in reserves for our Personal Lines business unit was primarily the result of unfavorable claims development in the 2009 and 2008 accident years mostly due to geographic expansion and the settlement of bad faith claims from the 2002 and 2001 accident years.

 

Analysis of loss and LAE reserve development. The following table shows the development of our loss reserves, net of reinsurance, for years ended December 31, 2002 through 2012. 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 us. 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.

 

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ANALYSIS OF LOSS AND LAE DEVELOPMENT

As of and for Year Ended December 31

 

   2002   2003   2004   2005   2006   2007   2008   2009   2010   2011   2012 
   (dollars in thousands) 
A. Reserve for unpaid loss & LAE, net of reinsurance recoverables  $8,411   $21,197   $17,700   $25,997   $72,801   $120,849   $150,025   $176,250   $213,723   $254,901   $263,832 
                                                        
B. Net reserve re-estimated as of:                                                       
One year later   8,875    20,003    15,300    24,820    66,387    119,034    151,645    185,440    230,089    251,226      
Two years later   8,881    19,065    15,473    24,903    68,490    118,646    155,155    183,689    226,856           
Three years later   8,508    19,698    13,962    23,144    68,809    120,444    154,738    181,268                
Four years later   8,446    18,551    14,166    23,455    69,847    119,771    155,520                     
Five years later   8,478    18,769    13,163    24,425    71,879    123,949                          
Six years later   8,461    17,784    17,857    25,403    78,396                               
Seven years later   7,949    18,521    17,597    30,704                                    
Eight years later   7,950    18,297    17,605                                         
Nine years later   7,947    18,312                                              
Ten years later   7,947                                                   
                                                        
C. Net cumulative redundancy (deficiency)   464    2,885    95    (4,707)   (5,595)   (3,100)   (5,495)   (5,018)   (13,133)   3,675      
                                                        
D. Cumulative amount of claims paid, net of reserve recoveries through:                                                       
One year later   5,845    12,217    8,073    16,721    30,061    50,458    64,810    73,647    105,848    109,538      
Two years later   7,663    15,814    12,004    22,990    46,860    78,314    95,385    121,222    156,176           
Three years later   8,228    18,162    13,113    24,562    58,322    93,286    120,133    146,956                
Four years later   8,374    17,997    13,750    27,231    65,084    105,251    131,912                     
Five years later   8,417    18,415    13,102    28,833    71,082    112,029                          
Six years later   8,439    17,735    17,498    30,367    75,225                               
Seven years later   7,949    18,083    17,557    31,058                                    
Eight years later   7,950    18,120    17,551                                         
Nine years later   7,947    18,115                                              
Ten years later   7,947                                                   
                                                        
                                                        
Net reserve-December 31   8,411    21,197    17,700    25,997    72,801    120,849    150,025    176,250    213,723    254,901    263,832 
Reinsurance recoverables   9,256    7,259    1,948    324    4,763    4,489    6,338    8,412    37,954    42,044    49,584 
Gross reserve-December 31   17,667    28,456    19,648    26,321    77,564    125,338    156,363    184,662    251,677    296,945    313,416 
                                                        
Net re-estimated reserve   7,947    18,312    17,605    30,704    78,396    123,949    155,520    181,268    226,856    251,226      
Re-estimated reinsurance recoverable   10,418    4,419    1,050    1,776    6,702    7,947    7,838    6,616    39,715    40,524      
Gross re-estimated reserve   18,365    22,731    18,655    32,480    85,098    131,896    163,358    187,884    266,571    291,750      
                                                        
Gross cumulative redundancy (deficiency)  $(698)  $5,725   $993   $(6,159)  $(7,534)  $(6,558)  $(6,995)  $(3,222)  $(14,894)  $5,195      

 

Reinsurance

 

We reinsure a portion of the risk we underwrite in order to control our exposure to losses and to protect our capital resources. We cede to reinsurers a portion of these risks and pay premiums based upon the risk and exposure of the policies subject to such reinsurance. Ceded reinsurance involves credit risk and is generally subject to aggregate loss limits. Although the reinsurer is liable to us to the extent of the reinsurance ceded, we are ultimately liable as the direct insurer on all risks reinsured. Reinsurance recoverables are reported after allowances for uncollectible amounts. We monitor the financial condition of reinsurers on an ongoing basis and review our reinsurance arrangements periodically. Reinsurers are selected based on their financial condition, business practices and the price of their product offerings. Our reinsurance facilities are subject to annual renewal. In order to mitigate credit risk to reinsurance companies, most of our reinsurance recoverable balance as of December 31, 2012 is with reinsurers that have an A.M. Best rating of “A-” or better. We also mitigate our credit risk for the remaining reinsurance recoverable by obtaining letters of credit.

 

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The following table presents our gross and net premiums written and earned and reinsurance recoveries for each of the last three years (in thousands).

 

   Year Ended December 31, 
   2012   2011   2010 
             
Gross premiums written  $389,842   $354,881   $320,973 
Ceded premiums written   (57,353)   (51,005)   (39,332)
Net premiums written  $332,489   $303,876   $281,641 
                
Gross premiums earned  $373,849   $350,080   $314,743 
Ceded premiums earned   (54,413)   (57,039)   (36,472)
Net premiums earned  $319,436   $293,041   $278,271 
                
Reinsurance recoveries  $29,014   $32,941   $22,172 

 

We currently reinsure the following exposures on business generated by our business units:

 

·Property catastrophe. Our property catastrophe reinsurance reduces the financial impact a catastrophe could have on our commercial and personal property insurance lines. Catastrophes might include multiple claims and policyholders. Catastrophes include hurricanes, windstorms, earthquakes, hailstorms, explosions, severe winter weather and fires. Our property catastrophe reinsurance is excess-of-loss reinsurance, which provides us reinsurance coverage for losses in excess of an agreed-upon amount. We utilize catastrophe models to assist in determining appropriate retention and limits to purchase. The terms of our property catastrophe reinsurance are:

 

oWe retain the first $6.0 million of property catastrophe losses in Texas and the first $15.0 million of property catastrophe losses in all other states;

 

oIn Texas, our reinsurers reimburse us 100% for any loss involving tropical depressions, tropical storms and/or hurricanes in excess of our $6.0 million retention and 87.5% for any other property catastrophe losses in excess of our $6.0 million retention, in each case up to $9.0 million for each catastrophic occurrence; and

 

oOur reinsurers reimburse us 100% for any loss occurrence in all states in excess of $15.0 million up to $25.0 million, subject to an aggregate limit of $50.0 million.

 

·Commercial property. Our commercial property reinsurance is excess-of-loss coverage intended to reduce the financial impact a single-event or catastrophic loss may have on our results. The terms of our commercial property reinsurance are:

 

oWe retain the first $1.0 million of loss for each commercial property risk;

 

oOur reinsurers reimburse us for the next $5.0 million for each commercial property risk, and $10.0 million for all commercial property risk involved in any one occurrence, in all cases subject to an aggregate limit of $30.0 million for all commercial property losses occurring during the treaty period; and

 

oIndividual risk facultative reinsurance is purchased on any commercial property with limits above $6.0 million.

 

·Commercial casualty. Our commercial casualty reinsurance is excess-of-loss coverage intended to reduce the financial impact a single-event loss may have on our results. The terms of our commercial casualty reinsurance are:

 

oWe retain the first $1.0 million of any commercial liability risk; and

 

oOur reinsurers reimburse us for the next $5.0 million for each commercial liability risk.

 

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·Aviation. We purchase reinsurance specific to the aviation risks underwritten by our General Aviation business unit. This reinsurance provides aircraft hull and liability coverage and airport liability coverage on a per occurrence basis on the following terms:

 

oWe retain the first $1.0 million of each aircraft hull or liability loss or airport liability loss; and

 

oOur reinsurers reimburse us for the next $5.5 million of each combined aircraft hull and liability loss and for the next $4.0 million of each airport liability loss.

 

·Workers Compensation. We purchase excess of loss reinsurance specific to the workers compensation risks underwritten by our Workers Compensation business unit. The terms of our workers compensation reinsurance are:

 

oWe retain the first $1.0 million of each workers compensation loss; and

 

oOur reinsurers reimburse us 100% for the next $14.0 million for each workers compensation loss, subject to a maximum limit of $10.0 million for any one person and an aggregate limit of $28.0 million for all workers compensation losses.

 

·Standard Commercial P&C. We purchase proportional reinsurance where we cede 100% of the risks to reinsurers on the equipment breakdown coverage on our commercial multi-peril property and business owner’s risks and on the employment practices liability coverage on certain commercial multi-peril, general liability and business owner’s risks.

 

·Excess & Umbrella. We purchase proportional reinsurance where we retain 20% of each risk and cede the remaining 80% to reinsurers.  In states where we are not yet licensed to offer a non-admitted product, we utilize a fronting arrangement pursuant to which we assume all of the risk and then retrocede a portion of that risk under the same proportional reinsurance treaty.  Through June 30, 2009, our Excess & Umbrella business unit wrote policies pursuant to a general agency agreement with an unaffiliated carrier and we assumed 35% of the risk from that carrier.

 

·E&S Commercial. Effective June 1, 2012 we purchase proportional reinsurance on our medical professional liability risks where we retain 50% of each risk and cede the remaining 50% to reinsurers. Prior to June 1, 2012 we retained 40% of each risk and ceded the remaining 60% to reinsurers. In states where we are not yet licensed to offer a non-admitted product, we utilize a fronting arrangement pursuant to which we assume all of the risk and then retrocede a portion of that risk under the same proportional reinsurance treaty. In addition, we purchase facultative reinsurance on our commercial umbrella and excess liability risks where we retain 10% of the first $1.0 million of risk and cede the remaining 90% to reinsurers. We cede 100% of our commercial umbrella and excess liability risks in excess of $1.0 million.

 

·Hallmark County Mutual. HCM is used to front certain lines of business in our Specialty Commercial and Personal Segments in Texas where we previously produced policies for third party county mutual insurance companies and reinsured 100% for a fronting fee. In addition, HCM is used to front business produced by unaffiliated third parties. HCM does not retain any business.

 

·Hallmark National Insurance Company. Simultaneous with the December 31, 2010 closing of our acquisition of HNIC, HNIC entered into reinsurance contracts with an affiliate of the seller pursuant to which such affiliate of the seller handles all claims and assumes all liabilities arising under policies issued by HNIC prior to closing or during a transition period following the closing.

 

Investment Portfolio

 

Our investment objective is to maximize current yield while maintaining safety of capital together with sufficient liquidity for ongoing insurance operations. Our investment portfolio is composed of fixed-income and equity securities. As of December 31, 2012, we had total invested assets of $445.4 million. If market rates were to increase by 1%, the fair value of our fixed-income securities as of December 31, 2012 would decrease by approximately $10.2 million. The following table shows the fair values of various categories of fixed-income securities, the percentage of the total fair value of our invested assets represented by each category and the tax equivalent book yield based on fair value of each category of invested assets as of December 31, 2012 and 2011.

 

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   As of December 31, 2012   As of December 31, 2011 
   Fair   Percent of       Fair   Percent of     
   Value   Total   Yield   Value   Total   Yield 
   (in thousands)           (in thousands)         
                         
Category:                              
Corporate bonds  $81,547    20.3%   4.6%  $93,922    24.7%   4.9%
Collateralized corporate bank loans   106,371    26.5%   4.8%   92,893    24.4%   4.9%
Municipal bonds   163,732    40.8%   5.1%   178,341    46.9%   5.5%
US Treasury securities and                              
obligations of U.S. Government   40,061    10.0%   0.3%   11,176    2.9%   0.4%
Mortgage backed   9,724    2.4%   2.9%   4,137    1.1%   3.9%
                               
Total  $401,435    100.0%   4.4%  $380,469    100.0%   5.1%

 

The weighted average credit rating for our fixed-income portfolio, using ratings assigned by Standard and Poor’s Rating Services (a division of the McGraw-Hill Companies, Inc.), was BBB at December 31, 2012. The following table shows the distribution of our fixed-income portfolio by Standard and Poor’s rating as a percentage of total fair value as of December 31, 2012 and 2011:

   As of   As of 
   December 31, 2012   December 31, 2011 
Rating:          
"AAA"   1.1%   1.3%
"AA"   17.9%   14.1%
"A"   18.1%   21.2%
"BBB"   37.1%   39.0%
"BB"   19.8%   18.4%
"B"   3.0%   3.3%
"CCC"   0.1%   0.5%
"NR"   2.9%   2.2%
Total   100.0%   100.0%

 

The following table shows the composition of our fixed-income portfolio by remaining time to maturity as of December 31, 2012 and 2011.

 

   As of December 31, 2012   As of December 31, 2011 
       Percentage of       Percentage of 
       Total       Total 
   Fair Value   Fair Value   Fair Value   Fair Value 
   (in thousands)       (in thousands)     
Remaining time to maturity:                    
Less than one year  $68,739    17.1%  $44,188    11.6%
One to five years   169,811    42.3%   162,921    42.8%
Five to ten years   102,770    25.6%   117,602    30.9%
More than ten years   50,391    12.6%   51,621    13.6%
Mortgage-backed   9,724    2.4%   4,137    1.1%
Total  $401,435    100.0%  $380,469    100.0%

 

Our investment strategy is to conservatively manage our investment portfolio by investing primarily in readily marketable, investment-grade fixed-income securities. As of December 31, 2012, 10% of our investment portfolio was invested in equity securities. Our investment portfolio is managed internally. We regularly review our portfolio for declines in value. For fixed maturity investments that are considered other-than-temporarily impaired and that we do not intend to sell and will not be required to sell, we separate the amount of the impairment into the amount that is credit related (credit loss component) and the amount due to all other factors.  The credit loss component is recognized in earnings and is the difference between the investment’s amortized cost basis and the present value of its expected future cash flows.  The remaining difference between the investment’s fair value and the present value of future expected cash flows is recognized in other comprehensive income. The following table details the net unrealized gain balance by invested asset category as of December 31, 2012.

 

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   Net Unrealized 
   Gain Balance 
Category  (in thousands) 
     
Corporate bonds  $2,031 
Collateralized corporate bank loans   278 
Municipal bonds   1,253 
Equity securities   12,423 
U.S. Treasury securities and obligations of U.S. Government   11 
Mortgage-backed   62 
Total  $16,058 

 

As part of our overall investment strategy, we also maintain an integrated cash management system utilizing on-line banking services and daily overnight investment accounts to maximize investment earnings on all available cash.

 

Technology

 

The majority of our technology systems are based on products licensed from insurance-specific technology vendors that have been substantially customized to meet the unique needs of our various business units. Our technology systems primarily consist of integrated central processing computers, a series of server-based computer networks and various communications systems that allow our branch offices to share systems solutions and communicate to the home office in a timely, secure and consistent manner. We maintain backup facilities and systems through a contract with a leading provider of computer disaster recovery services. Each business unit bears the information services expenses specific to its operations as well as a portion of the corporate services expenses. Increases to vendor license and service fees are capped per annum.

 

We believe the implementation of our various technology systems has increased our efficiency in the processing of our business, resulting in lower operating costs. Additionally, our systems enable us to provide a high level of service to our agents and policyholders by processing our business in a timely and efficient manner, communicating and sharing data with our agents and providing a variety of methods for the payment of premiums. We believe these systems have also improved the accumulation and analysis of information for our management.

 

Ratings

 

Many insurance buyers, agents and brokers use the ratings assigned by A.M. Best and other rating agencies to assist them in assessing the financial strength and overall quality of the companies from which they are considering purchasing insurance. A.M. Best has pooled its ratings of our AHIC, HIC, HSIC and HNIC subsidiaries and assigned a financial strength rating of “A-” (Excellent) and an issuer credit rating of “a-” to each of these individual insurance company subsidiaries and to the pool formed by the four insurance company subsidiaries. A.M. Best has also assigned a financial strength rating of “A-” (Excellent) and an issuer credit rating of “a-” to HCM. A.M. Best does not assign a financial strength rating or an issuer credit rating to TBIC. An “A–” rating is the fourth highest of 15 rating categories used by A.M. Best. In evaluating an insurer’s financial and operating performance, A.M. Best reviews the company’s profitability, indebtedness and liquidity, as well as its book of business, the adequacy and soundness of its reinsurance, the quality and estimated fair value of its assets, the adequacy of its loss reserves, the adequacy of its surplus, its capital structure, the experience and competence of its management and its market presence. A.M. Best’s ratings reflect its opinion of an insurer’s financial strength, operating performance and ability to meet its obligations to policyholders and are not an evaluation directed at investors or recommendations to buy, sell or hold an insurer’s stock.

 

Competition

 

The property/casualty insurance market, our primary source of revenue, is highly competitive and, except for regulatory considerations, has very few barriers to entry. According to A.M. Best, there were 3,235 property/casualty insurance companies and 2,197 property/casualty insurance groups operating in North America as of July 17, 2012. Our Standard Commercial P&C business unit competes with a variety of large national standard commercial lines carriers such as Liberty Mutual Group, Travelers Companies, Inc., Cincinnati Financial Corporation and The Hartford Financial Services Group, as well as numerous smaller regional companies. The primary competition for our Workers Compensation business unit includes such carriers as Texas Mutual Insurance Company, Service Lloyds Insurance Company, Employers Insurance Company, The Hartford Financial Services Group and FirstComp Insurance Company. The primary competition for our E&S Commercial business unit includes such carriers as American International Group, Inc., Atlantic Casualty Insurance Company, Canal Insurance Company, Carolina Casualty Insurance Company, Century Surety Insurance Group, Colony Insurance Company, Gramercy Insurance Company, Global Hawk Insurance Company, Great Western Insurance Company, Home State County Mutual Insurance Company, New York Marine & General Insurance Company, Praetorian Insurance Company, Progressive Insurance Company, Scottsdale Insurance Company, Southern County Mutual Insurance Company, Sparta Insurance Company, Stratford Insurance Company, Torus Insurance Holdings Limited and Zurich Insurance Group Limited. Our General Aviation business unit considers its primary competitors to be Phoenix Aviation Managers, Starr Aviation, Chartis, United States Specialty Insurance Company, W. Brown & Company, Meadowbrook Insurance Company, Global Aerospace and Allianz Aviation Managers. The primary competition for our Excess & Umbrella business unit includes such carriers as American International Group, Inc., First Mercury Insurance Company, Axis Insurance Company, W.R. Berkley Corporation and, to a lesser extent, a number of national standard lines carriers such as Travelers Companies, Inc. and Liberty Mutual Group. Although our Personal Lines business unit competes with large national insurers such as Allstate Corporation, GEICO Corporation and Progressive Insurance Company, as a participant in the non-standard personal automobile marketplace its competition is most directly associated with numerous regional companies and managing general agencies. Our competitors include entities that have, or are affiliated with entities that have, greater financial and other resources than we have.

 

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Generally, we compete on price, customer service, coverages offered, claims handling, financial stability, agent commission and support, customer recognition and geographic coverage. We compete with companies who use independent agents, captive agent networks, direct marketing channels or a combination thereof.

 

Insurance Regulation

 

AHIC, HCM and TBIC are domiciled in Texas, HIC is domiciled in Arizona, HSIC is domiciled in Oklahoma and HNIC is domiciled in Ohio. Therefore, our insurance operations are regulated by the Texas Department of Insurance, the Arizona Department of Insurance, the Oklahoma Insurance Department and the Ohio Department of Insurance, as well as the applicable insurance department of each state in which we issue policies. Our insurance company subsidiaries are required to file quarterly and annual statements of their financial condition prepared in accordance with statutory accounting practices with the insurance departments of their respective states of domicile and the applicable insurance department of each state in which they write business. The financial conditions of our insurance company subsidiaries, including the adequacy of surplus, loss reserves and investments, are subject to review by the insurance department of their respective states of domicile.

 

Periodic financial and market conduct examinations. The insurance departments of the states of domicile for our insurance company subsidiaries have broad authority to enforce insurance 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. The state insurance departments that have jurisdiction over our insurance company subsidiaries may conduct on-site visits and examinations of the insurance companies' affairs, especially as to their financial condition, ability to fulfill their obligations to policyholders, market conduct, claims practices and compliance with other laws and applicable regulations. Typically, these examinations are conducted every three to five years. In addition, if circumstances dictate, regulators are authorized to conduct special or target examinations of insurance companies to address particular concerns or issues. The results of these examinations can give rise to injunctive relief, regulatory orders requiring remedial or other corrective action on the part of the company that is the subject of the examination, assessment of fines, or other penalties against that company. In extreme cases, including actual or pending insolvency, the insurance department may take over, or appoint a receiver to take over, the management or operations of an insurer or an agent’s business or assets.

 

Guaranty funds. All insurance companies are subject to assessments for state-administered funds that cover 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 in that state. Payments to the fund may generally be recovered by the insurer through deductions from its premium taxes over a specified period of years.

 

Transactions between insurance companies and their affiliates. Hallmark is also regulated as an insurance holding company by the Texas Department of Insurance, the Arizona Department of Insurance, the Oklahoma Insurance Department and the Ohio Insurance Department. Financial transactions between Hallmark or any of its affiliates and our insurance company subsidiaries are subject to regulation. Transactions between our insurance company subsidiaries and their affiliates generally must be disclosed to state regulators, and prior regulatory approval generally is required before any material or extraordinary transaction may be consummated or any management agreement, services agreement, expense sharing arrangement or other contract providing for the rendering of services on a regular, systematic basis is implemented. State regulators may refuse to approve or may delay approval of such a transaction, which may impact our ability to innovate or operate efficiently.

 

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Dividends. Dividends and distributions to Hallmark by our insurance company subsidiaries are restricted by the insurance regulations of the respective state in which each insurance company subsidiary is domiciled. As property/casualty insurance company’s domiciled in the state of Texas, AHIC and TBIC may only pay dividends from unassigned surplus funds. In addition, AHIC and TBIC must obtain the approval of the Texas Department of Insurance before the payment of extraordinary dividends, which are defined as dividends or distributions of cash or other property the fair market value of which combined with the fair market value of each other dividend or distribution made in the preceding 12 months exceeds the greater of: (1) statutory net income as of the prior December 31st or (2) 10% of statutory policyholders’ surplus as of the prior December 31. HIC, domiciled in Arizona, may pay dividends out of that part of its available surplus funds that is derived from realized net profits on its business. Without prior written approval from the Arizona Department of Insurance, HIC may not pay extraordinary dividends, which are defined as dividends or distributions of cash or other property the fair market value of which combined with the fair market value of each other dividend or distribution made in the preceding 12 months exceeds the lesser of: (1) 10% of statutory policyholders’ surplus as of the prior December 31 or (2) net investment income as of the prior December 31. HSIC, domiciled in Oklahoma, may only pay dividends out of that part of its available surplus funds that is derived from realized net profits on its business. Without prior written approval from the Oklahoma Insurance Department, HSIC may not pay extraordinary dividends, which are defined as dividends or distributions of cash or other property the fair market value of which combined with the fair market value of each other dividend or distribution made in the preceding 12 months exceeds the greater of: (1) 10% of statutory policyholders’ surplus as of the prior December 31 or (2) statutory net income as of the prior December 31, not including realized capital gains. HNIC, domiciled in Ohio, may only pay dividends out of that part of its available surplus funds that is derived from earned surplus to shareholders. Without prior written approval from the Ohio Department of Insurance, HNIC may not pay extraordinary dividends, which are defined as dividends or distributions of cash or other property the fair market value of which combined with the fair market value of each other dividend or distribution made in the preceding 12 months exceeds the greater of: (1) 10% of statutory policyholders’ surplus as of the prior December 31 or (2) statutory net income as of the prior December 31. As a county mutual, dividends from HCM are payable to policyholders.

 

Risk-based capital requirements. The National Association of Insurance Commissioners requires property/casualty insurers to file a risk-based capital calculation according to a specified formula. The purpose of the 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 by providing thresholds at which a state commissioner is authorized and expected to take regulatory action. As of December 31, 2012, the adjusted capital under the risk-based capital calculation of each of our insurance company subsidiaries substantially exceeded the minimum requirements.

 

Required licensing. Our non-insurance company subsidiaries are subject to and in compliance with the licensing requirements of the department of insurance in each state in which they produce business. These licenses govern, among other things, the types of insurance coverages, agency and claims services and products that we may offer consumers in these states. Such licenses typically are issued only after we file an appropriate application and satisfy prescribed criteria. Generally, each state requires one officer to maintain an agent license. Claims adjusters employed by us are also subject to the licensing requirements of each state in which they conduct business. Each employed claim adjuster either holds or has applied for the required licenses. Our premium finance subsidiaries are subject to licensing, financial reporting and certain financial requirements imposed by the Texas Department of Insurance, as well as regulations promulgated by the Texas Office of Consumer Credit Commissioner.

 

Regulation of insurance rates and approval of policy forms. The insurance laws of most states in which our subsidiaries operate require insurance companies to file insurance rate schedules and insurance policy forms for review and approval. State insurance regulators have broad discretion in judging whether our rates are adequate, not excessive and not unfairly discriminatory and whether our policy forms comply with law. The speed at which we can change our rates depends, in part, on the method by which the applicable state’s rating laws are administered. Generally, state insurance regulators have the authority to disapprove our rates or request changes in our rates.

 

Restrictions on cancellation, non-renewal or withdrawal. Many states have laws and regulations that limit an insurance company’s ability to exit a market. For example, certain states limit an automobile insurance company’s ability to cancel or not renew policies. Some states prohibit an insurance company from withdrawing from one or more lines of business in the state, except pursuant to a plan approved by the state insurance department. In some states, this applies to significant reductions in the amount of insurance written, not just to a complete withdrawal. State insurance departments may disapprove a plan that may lead to market disruption.

 

Investment restrictions. We are subject to state laws and regulations that require diversification of our investment portfolios and that limit the amount of investments in certain categories. Failure to comply with these laws and regulations would cause non-conforming investments to be treated as non-admitted assets for purposes of measuring statutory surplus and, in some instances, would require divestiture.

 

Trade practices. The manner in which we conduct the business of insurance is regulated by state statutes in an effort to prohibit practices that constitute unfair methods of competition or unfair or deceptive acts or practices. Prohibited practices include disseminating false information or advertising; defamation; boycotting, coercion and intimidation; false statements or entries; unfair discrimination; rebating; improper tie-ins with lenders and the extension of credit; failure to maintain proper records; failure to maintain proper complaint handling procedures; and making false statements in connection with insurance applications for the purpose of obtaining a fee, commission or other benefit.

 

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Unfair claims practices. Generally, insurance companies, adjusting companies and individual claims adjusters are prohibited by state statutes from engaging in unfair claims practices on a flagrant basis or with such frequency to indicate a general business practice. Examples of unfair claims practices include:

 

·misrepresenting pertinent facts or insurance policy provisions relating to coverages at issue;
·failing to acknowledge and act reasonably promptly upon communications with respect to claims arising under insurance policies;
·failing to adopt and implement reasonable standards for the prompt investigation and settlement of claims arising under insurance policies;
·failing to affirm or deny coverage of claims within a reasonable time after proof of loss statements have been completed;
·attempting to settle a claim for less than the amount to which a reasonable person would have believed such person was entitled;
·attempting to settle claims on the basis of an application that was altered without notice to, or knowledge and consent of, the insured;
·compelling insureds to institute suits to recover amounts due under policies by offering substantially less than the amounts ultimately recovered in suits brought by them;
·refusing to pay claims without conducting a reasonable investigation;
·making claim payments to an insured without indicating the coverage under which each payment is being made;
·delaying the investigation or payment of claims by requiring an insured, claimant or the physician of either to submit a preliminary claim report and then requiring the subsequent submission of formal proof of loss forms, both of which submissions contain substantially the same information;
·failing, in the case of claim denials or offers of compromise or settlement, to promptly provide a reasonable and accurate explanation of the basis for such actions; and
·not attempting in good faith to effectuate prompt, fair and equitable settlements of claims in which liability has become reasonably clear.

 

Employees

 

As of December 31, 2012, we employed 360 people on a full-time basis. None of our employees are represented by labor unions. We consider our employee relations to be good.

 

Available Information

 

The Company’s executive offices are located at 777 Main Street, Suite 1000 Fort Worth, Texas 76102. The Company’s mailing address is 777 Main Street, Suite 1000 Fort Worth, Texas 76102. Its telephone number is (817) 348-1600. The Company’s website address is www.hallmarkgrp.com. The Company files annual, quarterly and current reports, proxy statements and other information and documents with the U.S. Securities and Exchange Commission (the “SEC”), which are made available to read and copy at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by contacting the SEC at 1-800-SEC-0330. Reports filed with the SEC are also made available at www.sec.gov. The Company makes available free of charge on its website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed with or furnished to the SEC pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practical after it electronically files them with or furnishes them to the SEC.

 

Item 1A. Risk Factors.

 

Our success depends on our ability to price accurately the risks we underwrite.

 

Our results of operations and financial condition depend on our ability to underwrite and set premium rates accurately for a wide variety of risks. Adequate rates are necessary to generate premiums sufficient to pay losses, loss settlement expenses and underwriting expenses and to earn a profit. To price our products accurately, we must collect and properly analyze a substantial amount of data; develop, test and apply appropriate pricing techniques; closely monitor and timely recognize changes in trends; and project both severity and frequency of losses with reasonable accuracy. Our ability to undertake these efforts successfully, and as a result price our products accurately, is subject to a number of risks and uncertainties, some of which are outside our control, including:

 

·the availability of sufficient reliable data and our ability to properly analyze available data;

 

·the uncertainties that inherently characterize estimates and assumptions;

 

·our selection and application of appropriate pricing techniques; and

 

·changes in applicable legal liability standards and in the civil litigation system generally.

 

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Consequently, we could underprice risks, which would adversely affect our profit margins, or we could overprice risks, which could reduce our sales volume and competitiveness. In either case, our profitability could be materially and adversely affected.

 

Our results may fluctuate as a result of cyclical changes in the property/casualty insurance industry.

 

Our revenue is primarily attributable to property/casualty insurance, which as an industry is cyclical in nature and has historically been characterized by soft markets followed by hard markets. A soft market is a period of relatively high levels of price competition, less restrictive underwriting standards and generally low premium rates. A hard market is a period of capital shortages resulting in lack of insurance availability, relatively low levels of competition, more selective underwriting of risks and relatively high premium rates. If we find it necessary to reduce premiums or limit premium increases due to competitive pressures on pricing in a softening market, we may experience a reduction in our premiums written and in our profit margins and revenues, which could adversely affect our financial results.

 

Estimating reserves is inherently uncertain. If our loss reserves are not adequate, it will have an unfavorable impact on our results.

 

We maintain loss reserves to cover our estimated ultimate liability for unpaid losses and LAE for reported and unreported claims incurred as of the end of each accounting period. Reserves represent management’s estimates of what the ultimate settlement and administration of claims will cost and are not reviewed by an independent actuary. These estimates, which generally involve actuarial projections, are based on management’s assessment of facts and circumstances then known, as well as estimates of future trends in claim severity and frequency, judicial theories of liability, and other factors. These variables are affected by both internal and external events, such as changes in claims handling procedures, inflation, judicial trends and legislative changes. Many of these factors are not quantifiable. Additionally, there may be a significant lag between the occurrence of an event and the time it is reported to us. The inherent uncertainties of estimating reserves are greater for certain types of liabilities, particularly those in which the various considerations affecting the type of claim are subject to change and in which long periods of time may elapse before a definitive determination of liability is made. Reserve estimates are continually refined in a regular and ongoing process as experience develops and further claims are reported and settled. Adjustments to reserves are reflected in the results of the periods in which such estimates are changed. For example, a 1% change in December 31, 2012 unpaid losses and LAE would have produced a $3.1 million change to pretax earnings. Our gross loss and LAE reserves totaled $313.4 million at December 31, 2012. Our loss and LAE reserves, net of reinsurance recoverable on unpaid loss and LAE, were $263.8 million at that date. Because setting reserves is inherently uncertain, there can be no assurance that the current reserves will prove adequate.

 

Our failure to maintain favorable financial strength ratings could negatively impact our ability to compete successfully.

 

Third-party rating agencies assess and rate the claims-paying ability of insurers based upon criteria established by the agencies. AHIC, HIC, HSIC and HNIC have entered into a pooling arrangement, pursuant to which AHIC retains 30% of the net premiums written by any of them, HIC retains 27% of the net premiums written by any of them, HSIC retains 30% of the net premiums written by any of them and HNIC retains 13% of the net premiums written by any of them. A.M. Best has pooled its ratings of these four insurance company subsidiaries and assigned a financial strength rating of “A–” (Excellent) and an issuer credit rating of “a-” to each of these individual insurance company subsidiaries and to the pool formed by these four insurance company subsidiaries. Also, A.M. Best has assigned HCM a financial strength rating of “A–” (Excellent) and an issuer credit rating of “a-”. A.M. Best does not assign a financial strength rating or an issuer credit rating to TBIC.

 

These financial strength ratings are used by policyholders, insurers, reinsurers and insurance and reinsurance intermediaries as an important means of assessing the financial strength and quality of insurers. These ratings are not evaluations directed to potential purchasers of our common stock and are not recommendations to buy, sell or hold our common stock. Our ratings are subject to change at any time and could be revised downward or revoked at the sole discretion of the rating agencies. We believe that the ratings assigned by A.M. Best are an important factor in marketing our products. Our ability to retain our existing business and to attract new business in our insurance operations depends largely on these ratings. Our failure to maintain our ratings, or any other adverse development with respect to our ratings, could cause our current and future independent agents and insureds to choose to transact their business with more highly rated competitors. If A.M. Best downgrades our ratings or publicly indicates that our ratings are under review, it is likely that we would not be able to compete as effectively with our competitors, and our ability to sell insurance policies could decline. If that happens, our sales and earnings would decrease. For example, many of our agencies and insureds have guidelines that require us to have an A.M. Best financial strength rating of “A-” (Excellent) or higher. A reduction of our A.M. Best rating below “A-” would prevent us from issuing policies to insureds or potential insureds with such ratings requirements.

 

Lenders and reinsurers also use our A.M. Best ratings as a factor in deciding whether to transact business with us. The failure of our insurance company subsidiaries to maintain their current ratings could dissuade a lender or reinsurance company from conducting business with us or might increase our interest or reinsurance costs. In addition, a ratings downgrade by A.M. Best below “A-” would require us to post collateral in support of our obligations under certain of our reinsurance agreements pursuant to which we assume business.

 

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The loss of key executives could disrupt our business.

 

Our success will depend in part upon the continued service of certain key executives. Our success will also depend on our ability to attract and retain additional executives and personnel. We do not have employment agreements with our Chief Executive Officer or any of our other executive officers. The loss of key personnel, or our inability to recruit and retain additional qualified personnel, could cause disruption in our business and could prevent us from fully implementing our business strategies, which could materially and adversely affect our business, growth and profitability.

 

Our industry is very competitive, which may unfavorably impact our results of operations.

 

The property/casualty insurance market, our primary source of revenue, is highly competitive and, except for regulatory considerations, has very few barriers to entry. According to A.M. Best, there were 3,235 property/casualty insurance companies and 2,197 property/casualty insurance groups operating in North America as of July 17, 2012. Our competitors include entities that have, or are affiliated with entities that have, greater financial and other resources than we have. In addition, competitors may attempt to increase market share by lowering rates. In that case, we could experience reductions in our underwriting margins, or sales of our insurance policies could decline as customers purchase lower-priced products from our competitors. Losing business to competitors offering similar products at lower prices, or having other competitive advantages, could adversely affect our results of operations.

 

Our results may be unfavorably impacted if we are unable to obtain adequate reinsurance.

 

As part of our overall risk and capacity management strategy, we purchase reinsurance for significant amounts of risk, especially catastrophe risks that we and our insurance company subsidiaries underwrite. Our catastrophe and non-catastrophe reinsurance facilities are generally subject to annual renewal. We may be unable to maintain our current reinsurance facilities or to obtain other reinsurance facilities in adequate amounts and at favorable rates. The amount, availability and cost of reinsurance are subject to prevailing market conditions beyond our control, and may affect our ability to write additional premiums as well as our profitability. If we are unable to obtain adequate reinsurance protection for the risks we have underwritten, we will either be exposed to greater losses from these risks or we will reduce the level of business that we underwrite, which will reduce our revenue.

 

If the companies that provide our reinsurance do not pay our claims in a timely manner, we could incur severe losses.

 

We purchase reinsurance by transferring, or ceding, part of the risk we have assumed to a reinsurance company in exchange for part of the premium we receive in connection with the risk. Although reinsurance makes the reinsurer liable to us to the extent the risk is transferred or ceded to the reinsurer, it does not relieve us of our liability to our policyholders. Accordingly, we bear credit risk with respect to our reinsurers. We cannot assure that our reinsurers will pay all of our reinsurance claims, or that they will pay our claims on a timely basis. At December 31, 2012, we had a total of $74.4 million due us from reinsurers, including $52.0 million of recoverables from losses and $22.4 million in ceded unearned premiums. The largest amount due us from a single reinsurer as of December 31, 2012 was $9.4 million reinsurance and premium recoverable from Partner Reinsurance Company of the United States. If any of our reinsurers are unable or unwilling to pay amounts they owe us in a timely fashion, we could suffer a significant loss or a shortage of liquidity, which would have a material adverse effect on our business and results of operations.

 

Catastrophic losses are unpredictable and may adversely affect our results of operations, liquidity and financial condition.

 

Property/casualty insurance companies are subject to claims arising out of catastrophes that may have a significant effect on their results of operations, liquidity and financial condition. Catastrophes can be caused by various events, including hurricanes, windstorms, earthquakes, hail storms, explosions, severe winter weather and fires, and may include man-made events, such as terrorist attacks. The incidence, frequency, and severity of catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event.

 

Claims from catastrophic events could reduce our net income, cause substantial volatility in our financial results for any fiscal quarter or year or otherwise adversely affect our financial condition, liquidity or results of operations. Catastrophes may also negatively affect our ability to write new business. Increases in the value and geographic concentration of insured property and the effects of inflation could increase the severity of claims from catastrophic events in the future.

 

Catastrophe models may not accurately predict future losses.

 

Along with other insurers in the industry, we use models developed by third-party vendors in assessing our exposure to catastrophe losses that assume various conditions and probability scenarios. However, these models do not necessarily accurately predict future losses or accurately measure losses currently incurred. Catastrophe models, which have been evolving since the early 1990s, use historical information about various catastrophes and detailed information about our in-force business. While we use this information in connection with our pricing and risk management activities, there are limitations with respect to their usefulness in predicting losses in any reporting period. Examples of these limitations are significant variations in estimates between models and modelers and material increases and decreases in model results due to changes and refinements of the underlying data elements and assumptions. Such limitations lead to questionable predictive capability and post-event measurements that have not been well understood or proven to be sufficiently reliable. In addition, the models are not necessarily reflective of company or state-specific policy language, demand surge for labor and materials or loss settlement expenses, all of which are subject to wide variation by catastrophe. Because the occurrence and severity of catastrophes are inherently unpredictable and may vary significantly from year to year, historical results of operations may not be indicative of future results of operations.

 

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We are subject to comprehensive regulation, and our results may be unfavorably impacted by these regulations.

 

We are subject to comprehensive governmental regulation and supervision. Most insurance regulations are designed to protect the interests of policyholders rather than of the stockholders and other investors of the insurance companies. These regulations, generally administered by the department of insurance in each state in which we do business, relate to, among other things:

 

·approval of policy forms and rates;

 

·standards of solvency, including risk-based capital measurements, which are a measure developed by the National Association of Insurance Commissioners and used by the state insurance regulators to identify insurance companies that potentially are inadequately capitalized;

 

·licensing of insurers and their agents;

 

·restrictions on the nature, quality and concentration of investments;

 

·restrictions on the ability of insurance company subsidiaries to pay dividends;

 

·restrictions on transactions between insurance company subsidiaries and their affiliates;

 

·requiring certain methods of accounting;

 

·periodic examinations of operations and finances;

 

·the use of non-public consumer information and related privacy issues;

 

·the use of credit history in underwriting and rating;

 

·limitations on the ability to charge policy fees;

 

·the acquisition or disposition of an insurance company or of any company controlling an insurance company;

 

·involuntary assignments of high-risk policies, participation in reinsurance facilities and underwriting associations, assessments and other governmental charges;

 

·restrictions on the cancellation or non-renewal of policies and, in certain jurisdictions, withdrawal from writing certain lines of business;

 

·prescribing the form and content of records of financial condition to be filed;

 

·requiring reserves for unearned premium, losses and other purposes; and

 

·with respect to premium finance business, the federal Truth-in-Lending Act and similar state statutes. In states where specific statutes have not been enacted, premium finance is generally subject to state usury laws that are applicable to consumer loans.

 

State insurance departments also conduct periodic examinations of the affairs of insurance companies and require filing of annual and other reports relating to the financial condition of insurance companies, holding company issues and other matters. Our business depends on compliance with applicable laws and regulations and our ability to maintain valid licenses and approvals for our operations. Regulatory authorities may deny or revoke licenses for various reasons, including violations of regulations. Changes in the level of regulation of the insurance industry or changes in laws or regulations themselves or interpretations by regulatory authorities could have a material adverse affect on our operations. In addition, we could face individual, group and class-action lawsuits by our policyholders and others for alleged violations of certain state laws and regulations. Each of these regulatory risks could have an adverse effect on our profitability.

 

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State statutes limit the aggregate amount of dividends that our subsidiaries may pay Hallmark, thereby limiting its funds to pay expenses and dividends.

 

Hallmark is a holding company and a legal entity separate and distinct from its subsidiaries. As a holding company without significant operations of its own, Hallmark’s principal sources of funds are dividends and other sources of funds from its subsidiaries. State insurance laws limit the ability of Hallmark’s insurance company subsidiaries to pay dividends and require our insurance company subsidiaries to maintain specified minimum levels of statutory capital and surplus. The aggregate maximum amount of dividends permitted by law to be paid by an insurance company does not necessarily define an insurance company’s actual ability to pay dividends. The actual ability to pay dividends may be further constrained by business and regulatory considerations, such as the impact of dividends on surplus, by our competitive position and by the amount of premiums that we can write. Without regulatory approval, the aggregate maximum amount of dividends that could be paid to Hallmark in 2013 by our insurance company subsidiaries is $15.1 million. State insurance regulators have broad discretion to limit the payment of dividends by insurance companies and Hallmark’s right to participate in any distribution of assets of one of our insurance company subsidiaries is subject to prior claims of policyholders and creditors except to the extent that its rights, if any, as a creditor are recognized. Consequently, Hallmark’s ability to pay debts, expenses and cash dividends to our stockholders may be limited.

 

Our insurance company subsidiaries are subject to minimum capital and surplus requirements. Failure to meet these requirements could subject us to regulatory action.

 

Our insurance company subsidiaries are subject to minimum capital and surplus requirements imposed under the laws of their respective states of domicile and each state in which they issue policies. Any failure by one of our insurance company subsidiaries to meet minimum capital and surplus requirements imposed by applicable state law will subject it to corrective action, which may include requiring adoption of a comprehensive financial plan, revocation of its license to sell insurance products or placing the subsidiary under state regulatory control. Any new minimum capital and surplus requirements adopted in the future may require us to increase the capital and surplus of our insurance company subsidiaries, which we may not be able to do.

 

We are subject to assessments and other surcharges from state guaranty funds, mandatory reinsurance arrangements and state insurance facilities, which may reduce our profitability.

 

Virtually all states require insurers licensed to do business therein to bear a portion of the unfunded obligations of impaired or insolvent insurance companies. These obligations are funded by assessments, which are levied by guaranty associations within the state, up to prescribed limits, on all member insurers in the state on the basis of the proportionate share of the premiums written by member insurers in the lines of business in which the impaired, insolvent or failed insurer was engaged. Accordingly, the assessments levied on us by the states in which we are licensed to write insurance may increase as we increase our premiums written. In addition, as a condition to the ability to conduct business in certain states, insurance companies are required to participate in mandatory reinsurance funds. The effect of these assessments and mandatory reinsurance arrangements, or changes in them, could reduce our profitability in any given period or limit our ability to grow our business.

 

We monitor developments with respect to various state facilities, such as the Texas FAIR Plan and the Texas Windstorm Insurance Association. The impact of any catastrophe experience on these facilities could result in the facilities recognizing a financial deficit or a financial deficit greater than the level currently estimated. They may, in turn, have the ability to assess participating insurers when financial deficits occur, adversely affecting our results of operations. While these facilities are generally designed so that the ultimate cost is borne by policyholders, the exposure to assessments and the availability of recoupments or premium rate increases from these facilities may not offset each other in our financial statements. Moreover, even if they do offset each other, they may not offset each other in financial statements for the same fiscal period due to the ultimate timing of the assessments and recoupments or premium rate increases, as well as the possibility of policies not being renewed in subsequent years.

 

Adverse securities market conditions can have a significant and negative impact on our investment portfolio.

 

Our results of operations depend in part on the performance of our invested assets. As of December 31, 2012, 90% of our investment portfolio was invested in fixed-income securities. Certain risks are inherent in connection with fixed-income securities, including loss upon default and price volatility in reaction to changes in interest rates and general market factors. In general, the fair value of a portfolio of fixed-income securities increases or decreases inversely with changes in the market interest rates, while net investment income realized from future investments in fixed-income securities increases or decreases along with interest rates. In addition, 10% of our fixed-income securities have call or prepayment options. This subjects us to reinvestment risk should interest rates fall and issuers call their securities. Furthermore, actual net investment income and/or cash flows from investments that carry prepayment risk, such as mortgage-backed and other asset-backed securities, may differ from those anticipated at the time of investment as a result of interest rate fluctuations. An investment has prepayment risk when there is a risk that cash flows from the repayment of principal might occur earlier than anticipated because of declining interest rates or later than anticipated because of rising interest rates. The fair value of our fixed-income securities as of December 31, 2012 was $401.4 million. If market interest rates were to increase 1%, the fair value of our fixed-income securities would decrease by approximately $10.2 million as of December 31, 2012. The calculated change in fair value was determined using duration modeling assuming no prepayments.

 

In addition to the general risks described above, although 74% of our portfolio is investment-grade, our fixed-income securities are nonetheless subject to credit risk. If any of the issuers of our fixed-income securities suffer financial setbacks, the ratings on the fixed-income securities could fall (with a concurrent fall in market value) and, in a worst case scenario, the issuer could default on its obligations. As of December 31, 2012 Hallmark had $0.3 million exposed in its investment portfolio to sub-prime mortgages and $9.7 million total exposure in mortgage-backed securities. Future changes in the fair value of our available-for-sale securities will be reflected in other comprehensive income.

 

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Similar treatment is not available for liabilities. Therefore, interest rate fluctuations could adversely affect our stockholders’ equity, total comprehensive income and/or cash flows.

 

We rely on independent agents and specialty brokers to market our products and their failure to do so would have a material adverse effect on our results of operations.

 

We market and distribute our insurance programs exclusively through independent insurance agents and specialty insurance brokers. As a result, our business depends in large part on the marketing efforts of these agents and brokers and on our ability to offer insurance products and services that meet the requirements of the agents, the brokers and their customers. However, these agents and brokers are not obligated to sell or promote our products and many sell or promote competitors’ insurance products in addition to our products. Some of our competitors have higher financial strength ratings, offer a larger variety of products, set lower prices for insurance coverage and/or offer higher commissions than we do. Therefore, we may not be able to continue to attract and retain independent agents and brokers to sell our insurance products. The failure or inability of independent agents and brokers to market our insurance products successfully could have a material adverse impact on our business, financial condition and results of operations.

 

We may experience difficulty in integrating acquisitions into our operations.

 

The successful integration of any newly acquired businesses into our operations will require, among other things, the retention and assimilation of their key management, sales and other personnel; the coordination of their lines of insurance products and services; the adaptation of their technology, information systems and other processes; and the retention and transition of their customers. Unexpected difficulties in integrating any acquisition could result in increased expenses and the diversion of management time and resources. If we do not successfully integrate any acquired business into our operations, we may not realize the anticipated benefits of the acquisition, which could have a material adverse impact on our financial condition and results of operations. Further, any potential acquisitions may require significant capital outlays and, if we issue equity or convertible debt securities to pay for an acquisition, the issuance may be dilutive to our existing stockholders.

 

Our internal controls are not fail-safe.

 

We continually enhance our operating procedures and internal controls to effectively support our business and comply with our regulatory and financial reporting requirements. As a result of the inherent limitations in all control systems, no system of controls can provide absolute assurance that all control objectives have been or will be met, and that every instance of error or fraud has been or will be detected. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by individual acts or by collusion of two or more persons. The design of any system of controls is based in part upon assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Internal controls may also become inadequate because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate. Further, the design of a control system must reflect resource constraints, and the benefits of controls must be considered relative to their costs. As a result of the inherent limitations in a cost-effective control system, misstatement due to error or fraud may occur and not be detected. Accordingly, our internal controls and procedures are designed to provide reasonable, not absolute, assurance that the control objectives are met.

 

Our geographic concentration ties our performance to the business, economic and regulatory conditions of certain states.

 

The following states accounted for 61% of our gross written premiums for 2012: Texas (45%), Louisiana (5%), Oregon (4%), New Mexico (4%) and Arizona (3%). Our revenues and profitability are subject to the prevailing regulatory, legal, economic, political, demographic, competitive, weather and other conditions in the principal states in which we do business. Changes in any of these conditions could make it less attractive for us to do business in such states and would have a more pronounced effect on us compared to companies that are more geographically diversified. In addition, our exposure to severe losses from localized natural perils, such as windstorms or hailstorms, is increased in those areas where we have written significant numbers of property/casualty insurance policies.

 

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The exclusions and limitations in our policies may not be enforceable.

 

Many of the policies we issue include exclusions or other conditions that define and limit coverage, which exclusions and conditions are designed to manage our exposure to certain types of risks and expanding theories of legal liability. In addition, many of our policies limit the period during which a policyholder may bring a claim under the policy, which period in many cases is shorter than the statutory period under which these claims can be brought by our policyholders. While these exclusions and limitations help us assess and control our loss exposure, it is possible that a court or regulatory authority could nullify or void an exclusion or limitation, or legislation could be enacted modifying or barring the use of these exclusions and limitations. This could result in higher than anticipated losses and LAE by extending coverage beyond our underwriting intent or increasing the number or size of claims, which could have a material adverse effect on our operating results. In some instances, these changes may not become apparent until some time after we have issued the insurance policies that are affected by the changes. As a result, the full extent of liability under our insurance contracts may not be known for many years after a policy is issued.

 

We rely on our information technology and telecommunications systems and the failure or disruption of these systems could disrupt our operations and adversely affect our results of operations.

 

Our business is highly dependent upon the successful and uninterrupted functioning of our information technology and telecommunications systems. We rely on these systems to process new and renewal business, provide customer service, make claims payments and facilitate collections and cancellations, as well as to perform actuarial and other analytical functions necessary for pricing and product development. Our systems could fail of their own accord or might be disrupted by factors such as natural disasters, power disruptions or surges, computer hackers or terrorist attacks. Failure or disruption of these systems for any reason could interrupt our business and adversely affect our results of operations.

 

Cyber security risks in particular are evolving and include malicious software, unauthorized access to data and other electronic security breaches. We have not experienced cyber security attacks in the past and believe that we have adopted appropriate measures to mitigate potential risks to our information technology systems. However, the timing, nature and scope of cyber security attacks are difficult to predict and prevent. Therefore, we could be subject to operational delays, compromised confidential or proprietary information, destruction or corruption of data, manipulation or improper use of our systems and networks, financial losses from remedial actions and/or damage to our reputation from cyber security attacks. A cyber security attack on our information technology systems could disrupt our business and adversely affect our results of operations and financial position.

 

Global climate change may have an adverse effect on our financial statements.

 

Although uncertainty remains as to the nature and effect of greenhouse gas emissions, we could suffer losses if global climate change results in an increase in the frequency and severity of natural disasters. As with traditional natural disasters, claims arising from these incidents could increase our exposure to losses and have a material adverse impact on our business, results of operations, and/or financial condition.

 

Item 1B. Unresolved Staff Comments.

 

Not applicable

 

Item 2. Properties.

 

Our corporate headquarters and Standard Commercial P&C business unit are located at 777 Main Street, Suite 1000, Fort Worth, Texas. The suite is located in a high-rise office building and contains 27,808 square feet of space. The rent is currently $46,347 per month pursuant to a lease which expires June 30, 2022. 

 

Our Workers Compensation business unit is presently located at 11612 Bee Caves Road, Austin, Texas. The suite is located in a low-rise office building and contains 8,373 square feet of space of which 1,037 square feet is sub-leased. The gross rent is currently $16,718 per month pursuant to a lease which expires October 31, 2017.

 

Our E&S Commercial business unit is presently located at 7550 IH-10 West, San Antonio, Texas. These leased premises consist of a 16,599 square foot office suite and 800 square feet of storage space. The rent is currently $31,898 per month pursuant to a lease that expires November 30, 2020. Our E&S Commercial business unit also maintains a small office in Chicago, Illinois, the fixed rent on which is currently $8,063 per month under a lease that expires April 30, 2017.  

 

Our General Aviation business unit and Excess & Umbrella business unit are located at 15280 Addison Road, Suites 250 and 260, Addison, Texas. The suites are located in a low-rise office building and contain an aggregate of 12,277 square feet of space. The rent is currently $14,834 per month pursuant to a lease that expires July 31, 2018. Our General Aviation business unit also maintains a branch office in Glendale, California. Rent on the suite is currently $2,500 per month pursuant to a lease which expires July 31, 2015. Our Excess & Umbrella business unit also maintains a branch office in an executive suite in Los Angeles, California. The monthly rent is $1,354 per month pursuant to a lease which expires May 31, 2013.

 

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Our Personal Lines business unit is located at 6500 Pinecrest, Suite 100, Plano, Texas. The suite is located in a one story office building and contains 23,941 square feet of space. The rent is currently $28,729 per month pursuant to a lease that expires January 31, 2016.

 

Item 3. Legal Proceedings.

 

In December 2010, HSU was informed by the Texas Comptroller of Public Accounts that a surplus lines tax audit covering the period January 1, 2007 through December 31, 2009 was complete. HSU frequently acts as a managing general underwriter (“MGU”) authorized to underwrite policies on behalf of Republic Vanguard Insurance Company and HSIC, both Texas eligible surplus lines insurance carriers. In its role as the MGU, HSU underwrites policies on behalf of these carriers while other agencies located in Texas generally referred to as “producing agents” deliver the policies to the insureds and collect all premiums due from the insureds. During the period under audit, the producing agents also collected the surplus lines premium taxes due on the policies from the insureds, held them in trust, and timely remitted those taxes to the Comptroller. We believe this system for collecting and paying the required surplus lines premium taxes complies in all respects with the Texas Insurance Code and other regulations, which clearly require that the same party who delivers the policies and collects the premiums will also collect premium taxes, hold premium taxes in trust, and pay premium taxes to the Comptroller. It also complies with long standing industry practice. The Comptroller asserts that HSU is liable for the surplus lines premium taxes related to policy transactions and premiums collected from surplus lines insureds during the audit period and that HSU therefore owes $4.5 million in premium taxes, as well as $0.9 million in penalties and interest for the audit period.

 

We disagree with the Comptroller and intend to vigorously fight their assertion that HSU is liable for the surplus lines premium taxes. During the past year we have been engaged in conversations with the Comptroller’s counsel and are waiting on presentment of the Comptroller’s position paper. At this stage, we cannot predict the course of any proceedings, the timing of any rulings or other significant events relating to such surplus lines tax audit.  Given these limitations and the inherent difficulty of projecting the outcome of regulatory disputes, we are presently unable to reasonably estimate the possible loss or legal costs that are likely to arise out of the surplus lines tax audit or any future proceedings relating to this matter. Therefore we have not accrued any amount as of December 31, 2012 related to this matter.

 

We are engaged in various legal proceedings that are routine in nature and incidental to our business. None of these proceedings, either individually or in the aggregate, are believed, in our opinion, to have a material adverse effect on our consolidated financial position or our results of operations.

 

Item 4. Mine Safety Disclosures.

 

Not applicable.

 

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PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

 

Market for Common Stock

 

Our common stock is currently traded on the Nasdaq Global Market under the symbol “HALL.” The following table shows the high and low sales prices of our common stock on the Nasdaq Global Market for each quarter since January 1, 2011.

 

Period  High Sale   Low Sale 
         
Year Ended December 31, 2012:          
First quarter  $8.09   $6.57 
Second quarter   8.30    6.95 
Third quarter   8.32    7.29 
Fourth quarter   9.71    6.71 
           
Year Ended December 31, 2011:          
First quarter  $9.25   $8.00 
Second quarter   8.85    6.52 
Third quarter   8.26    6.32 
Fourth quarter   8.21    6.63 

 

Holders

 

As of March 1, 2013, there were 1,594 shareholders of record of our common stock.

 

Dividends

 

Hallmark has never paid dividends on its common stock. Our board of directors intends to continue this policy for the foreseeable future in order to retain earnings for development of our business.

 

Hallmark is a holding company and a legal entity separate and distinct from its subsidiaries. As a holding company, Hallmark is dependent on dividend payments and management fees from its subsidiaries to pay dividends and make other payments. State insurance laws limit the ability of our insurance company subsidiaries to pay dividends to Hallmark. As property/casualty insurance companies domiciled in the state of Texas, AHIC and TBIC are limited in the payment of dividends to Hallmark in any 12-month period, without the prior written consent of the Texas Department of Insurance, to the greater of statutory net income for the prior calendar year or 10% of statutory policyholders’ surplus as of the prior year end. Dividends may only be paid from unassigned surplus funds. HIC, domiciled in Arizona, is limited in the payment of dividends to the lesser of 10% of prior year policyholders surplus or prior year’s net investment income, without prior written approval from the Arizona Department of Insurance. HSIC, domiciled in Oklahoma, is limited in the payment of dividends to the greater of 10% of prior year policyholders’ surplus or prior year’s statutory net income, not including realized capital gains, without prior written approval from the Oklahoma Insurance Department. HNIC, domiciled in Ohio, is limited to the greater of 10% of statutory policyholders’ surplus as of the prior December 31 or statutory net income as of the prior December 31, without prior written approval from the Ohio Insurance Department. As a county mutual, dividends from HCM are payable to policyholders.

 

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Equity Compensation Plan Information

 

The following table sets forth information regarding shares of our common stock authorized for issuance under our equity compensation plans as of December 31, 2012.

 

           Number of securities 
   Number of securities       remaining available 
   to be issued upon   Weighted-average   for future issuance 
   exercise of outstanding   exercise price of   under equity compensation 
   options, warrants and   outstanding options,   plans [excluding securities 
Plan Category  rights   warrants and rights   reflected in column (a)] 
   (a)   (b)   (c) 
             
Equity compensation plans approved by security holders   1,404,989   $9.63    579,178 
                
Equity compensation plans not approved by security holders   -    -    - 
                
Total   1,404,989   $9.63    579,178 

 

Issuer Repurchases

 

We did not repurchase any shares of our common stock during the fourth quarter of 2012.

 

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Performance Graph

 

The following graph compares the cumulative 5-Year total return provided shareholders on Hallmark’s common stock relative to the cumulative total returns of the NASDAQ Composite index, the NASDAQ Insurance index, and the S&P Property & Casualty Insurance index. An investment of $100 (with reinvestment of all dividends) is assumed to have been made in our common stock and in each index on December 31, 2007 and its relative performance is tracked through December 31, 2012.

 

 

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Item 6. Selected Financial Data

 

   Year Ended December 31, 
   2012   2011   2010   2009   2008 
   (in thousands, except per share data) 
       (as adjusted)   (as adjusted)   (1)   (1) 
                     
Statement of Operations Data:                         
Gross premiums written  $389,842   $354,881   $320,973   $287,558   $243,849 
Ceded premiums written   (57,353)   (51,005)   (39,332)   (25,818)   (8,922)
Net premiums written   332,489    303,876    281,641    261,740    234,927 
Change in unearned premiums   (13,053)   (10,835)   (3,370)   (10,668)   1,393 
Net premiums earned   319,436    293,041    278,271    251,072    236,320 
                          
Investment income, net of expenses   15,293    15,880    14,849    14,947    16,049 
Realized gains (losses)   1,943    3,633    8,402    3,032    (11,261)
Finance charges   5,957    6,826    7,054    5,874    5,174 
Commission and fees   (1,145)   3,175    (1,575)   12,011    22,280 
Other income   316    216    59    103    128 
Total revenues   341,800    322,771    307,060    287,039    268,690 
                          
Loss and loss adjustment expenses   226,414    239,235    202,544    153,619    144,244 
Other operating costs and expenses   103,792    95,106    87,882    92,233    96,096 
Interest expense   4,634    4,631    4,598    4,602    4,745 
Amortization of intangible assets   3,586    3,586    3,665    3,328    2,481 
Total expenses   338,426    342,558    298,689    253,782    247,566 
                          
Income (loss) before tax   3,374    (19,787)   8,371    33,257    21,124 
Income tax (benefit) expense   (474)   (8,954)   863    8,630    8,175 
Net income (loss)   3,848    (10,833)   7,508    24,627    12,949 
Less: Net income attributable to non-controlling interest   324    58    105    52    50 
                          
Net income (loss) attributable to Hallmark Financial Services, Inc.   3,524    (10,891)   7,403    24,575    12,899 
                          
Net income (loss) per share attributable to                         
Hallmark Financial Services, Inc. common stockholders:                         
Basic  $0.18   $(0.55)  $0.37   $1.19   $0.62 
Diluted  $0.18   $(0.55)  $0.37   $1.19   $0.62 

 

   As of December 31, 2012 
Balance Sheet Items:  2012   2011   2010   2009   2008 
                     
       (as adjusted)   (as adjusted)   (1)   (1) 
                     
Total investments  $445,360   $424,628   $432,441   $327,677   $293,516 
Total assets  $790,468   $746,059   $736,557   $628,869   $538,398 
Unpaid loss and loss adjustment expenses  $313,416   $296,945   $251,677   $184,662   $156,363 
Unearned premiums  $162,502   $146,104   $140,965   $125,089   $102,192 
Total liabilities  $569,931   $529,203   $499,919   $401,228   $358,249 
Total stockholders' equity  $220,537   $215,572   $235,278   $226,517   $179,412 
                          
Book value per share  $11.45   $11.19   $11.69   $11.26   $8.61 

 

(1)Amounts prior to 2010 have not been adjusted for the adoption of a change in accounting principle related to deferred policy acquisition costs. (See, "Adoption of New Accounting Pronouncements" in Note 1 to the audited consolidated financial statements, included in this report.)

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

The following discussion should be read together with our consolidated financial statements and the notes thereto. This discussion contains forward-looking statements. Please see “Risks Associated with Forward-Looking Statements in this Form 10-K” for a discussion of some of the uncertainties, risks and assumptions associated with these statements.

 

Overview

 

Hallmark is an insurance holding company which, through its subsidiaries, engages in the sale of property/casualty insurance products to businesses and individuals. Our business involves marketing, distributing, underwriting and servicing our insurance products, as well as providing other insurance related services. We pursue our business activities primarily through subsidiaries whose operations are organized into business units and are supported by our insurance carrier subsidiaries.

 

Our insurance activities are organized by business units into the following reportable segments:

·Standard Commercial Segment. The Standard Commercial Segment includes the standard lines commercial property/casualty insurance products and services handled by our Standard Commercial P&C business unit and the workers compensation insurance products handled by our Workers Compensation business unit. Our Standard Commercial P&C business unit is comprised of our American Hallmark Insurance Services and ECM subsidiaries. Our Workers Compensation business unit is comprised of our TBIC Holdings, TBIC and TBICRM subsidiaries. The Workers Compensation business unit was acquired July 1, 2011.

 

·Specialty Commercial Segment. The Specialty Commercial Segment includes the excess and surplus lines commercial property/casualty and medical professional liability insurance products and services handled by our E&S Commercial business unit, the general aviation insurance products and services handled by our General Aviation business unit and the commercial excess liability and umbrella products handled by our Excess & Umbrella business unit, as well as certain Specialty Programs which are managed at the parent level. Our E&S Commercial business unit is comprised of our HSU, PAAC and TGASRI subsidiaries. Our General Aviation business unit is comprised of our Aerospace Insurance Managers, ASRI and ACMG subsidiaries. Our Excess & Umbrella business unit is comprised of our HXS and HDS subsidiaries.

 

·Personal Segment. The Personal Segment includes the non-standard personal automobile, low value dwelling/homeowners, renters, manufactured homes, motorcycle and business auto insurance products and services handled by our Personal Lines business unit that is comprised of American Hallmark General Agency, Inc. and Hallmark Claims Services, Inc., both of which do business as Hallmark Insurance Company.

 

The retained premium produced by these reportable segments is supported by the following insurance company subsidiaries:

 

·American Hallmark Insurance Company of Texas presently retains a portion of the risks on the commercial property/casualty and workers compensation policies marketed within the Standard Commercial Segment, retains a portion of the risks on personal policies marketed within the Personal Segment and retains a portion of the risks on the commercial, medical professional liability, aviation and satellite launch property/casualty policies marketed within the Specialty Commercial Segment.

 

·Hallmark Specialty Insurance Company presently retains a portion of the risks on the commercial property/casualty and medical professional liability policies marketed within the Specialty Commercial Segment and a portion of the commercial property/casualty policies marketed within the Standard Commercial Segment.

 

·Hallmark Insurance Company presently retains a portion of the risks on both the personal policies marketed within the Personal Segment and the commercial and aviation property/casualty products marketed within the Specialty Commercial Segment.

 

·Hallmark National Insurance Company was acquired on December 31, 2010. Simultaneous with the closing of the acquisition, HNIC entered into reinsurance contracts with an affiliate of the seller, pursuant to which such affiliate of the seller handles all claims and assumes all liabilities arising under policies issued by HNIC prior to the closing or during a transition period following the closing. Commencing January 1, 2011, HNIC retains a portion of the risks on the personal policies marketed within the Personal Segment.

 

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·Hallmark County Mutual Insurance Company control and management is maintained through our wholly owned subsidiary, CYR Insurance Management Company (“CYR”). CYR has as its primary asset a management agreement with HCM which provides for CYR to have management and control of HCM. HCM is used to front certain lines of business in our Specialty Commercial and Personal Segments in Texas. HCM does not retain any business.

 

·Texas Builders Insurance Company was acquired July 1, 2011 and retains a portion of the risks on the workers compensation policies marketed within our Standard Commercial Segment.

 

AHIC, HIC, HSIC and HNIC have entered into a pooling arrangement pursuant to which AHIC retains 30% of the net premiums written by any of them, HIC retains 27% of the net premiums written by any of them, HSIC retains 30% of the net premiums written by any of them and HNIC retains 13% of the net premiums written by any of them. Neither HCM nor TBIC is a party to the intercompany pooling arrangement.

 

Critical Accounting Estimates and Judgments

 

The significant accounting policies requiring our estimates and judgments are discussed below. Such estimates and judgments are based on historical experience, changes in laws and regulations, observance of industry trends and 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, we believe the estimates and judgments associated with the reported consolidated financial statement amounts are appropriate in the circumstances. For additional discussion of our accounting policies, see Note 1 to the audited consolidated financial statements included in this report.

 

Valuation of investments. We complete a detailed analysis each quarter to assess whether any decline in the fair value of any investment below cost is deemed other-than-temporary. All securities with an unrealized loss are reviewed. We recognize an impairment loss when an investment’s value declines below cost, adjusted for accretion, amortization and previous other-than-temporary impairments and it is determined that the decline is other-than-temporary.

 

Debt Investments: We assess whether we intend to sell, or it is more likely than not that we will be required to sell, a fixed maturity investment before recovery of its amortized cost basis less any current period credit losses. For fixed maturity investments that are considered other-than-temporarily impaired and that we do not intend to sell and will not be required to sell, we separate the amount of the impairment into the amount that is credit related (credit loss component) and the amount due to all other factors. The credit loss component is recognized in earnings and is the difference between the investment’s amortized cost basis and the present value of its expected future cash flows. The remaining difference between the investment’s fair value and the present value of future expected cash flows is recognized in other comprehensive income.

 

Equity Investments: Some of the factors considered in evaluating whether a decline in fair value for an equity investment is other-than-temporary include: (1) our ability and intent to retain the investment for a period of time sufficient to allow for an anticipated recovery in value; (2) the recoverability of cost; (3) the length of time and extent to which the fair value has been less than cost; and (4) the financial condition and near-term and long-term prospects for the issuer, including the relevant industry conditions and trends, and implications of rating agency actions and offering prices. When it is determined that an equity investment is other-than-temporarily impaired, the security is written down to fair value, and the amount of the impairment is included in earnings as a realized investment loss. The fair value then becomes the new cost basis of the investment, and any subsequent recoveries in fair value are recognized at disposition. We recognize a realized loss when impairment is deemed to be other-than-temporary even if a decision to sell an equity investment has not been made. When we decide to sell a temporarily impaired available-for-sale equity investment and we do not expect the fair value of the equity investment to fully recover prior to the expected time of sale, the investment is deemed to be other-than-temporarily impaired in the period in which the decision to sell is made.

 

Fair values of financial instruments. Accounting Standards Codification (“ASC”) 820 defines fair value, establishes a consistent framework for measuring fair value and expands disclosure requirements about fair value measurements. ASC 820, among other things, requires us to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. In addition, ASC 820 precludes the use of block discounts when measuring the fair value of instruments traded in an active market, which were previously applied to large holdings of publicly traded equity securities.

 

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We determine the fair value of our financial instruments based on the fair value hierarchy established in ASC 820. In accordance with ASC 820, we utilize the following fair value hierarchy:

 

·Level 1: quoted prices in active markets for identical assets;

 

·Level 2: inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, inputs of identical assets for less active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the instrument; and

 

·Level 3: inputs to the valuation methodology that are unobservable for the asset or liability.

 

This hierarchy requires the use of observable market data when available.

 

Under ASC 820, we determine fair value based on the price that would be received for an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date. It is our policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements, in accordance with the fair value hierarchy described above. Fair value measurements for assets and liabilities where there exists limited or no observable market data are calculated based upon our pricing policy, the economic and competitive environment, the characteristics of the asset or liability and other factors as appropriate. These estimated fair values may not be realized upon actual sale or immediate settlement of the asset or liability.

 

Where quoted prices are available on active exchanges for identical instruments, investment securities are classified within Level 1 of the valuation hierarchy. Level 1 investment securities include common stock and preferred stock.

 

Level 2 investment securities include corporate bonds, collateralized corporate bank loans, municipal bonds, U.S. Treasury securities, other obligations of the U.S. Government and mortgage-backed securities for which quoted prices are not available on active exchanges for identical instruments. We use a third party pricing service to determine fair values for each Level 2 investment security in all asset classes. Since quoted prices in active markets for identical assets are not available, these prices are determined using observable market information such as quotes from less active markets and/or quoted prices of securities with similar characteristics, among other things. We have reviewed the processes used by the pricing service and have determined that they result in fair values consistent with the requirements of ASC 820 for Level 2 investment securities. In addition, using the prices received for the securities from the third party pricing services, we compare a sample of the prices against additional sources. We have not adjusted any prices received from third-party pricing sources.

 

In cases where there is limited activity or less transparency around inputs to the valuation, investment securities are classified within Level 3 of the valuation hierarchy. Level 3 investments are valued based on the best available data in order to approximate fair value. This data may be internally developed and consider risk premiums that a market participant would require. Investment securities classified within Level 3 include other less liquid investment securities.

 

Deferred policy acquisition costs. Policy acquisition costs (mainly commission, underwriting and marketing expenses) that vary with and are primarily related to the successful acquisition of new and renewal insurance contracts are deferred and charged to operations over periods in which the related 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.

 

The method followed in computing deferred policy 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, unamortized acquisition costs, and maintenance costs exceeds related unearned premiums and expected investment income on those unearned premiums, as computed on a product line basis. We routinely evaluate the realizability of deferred policy acquisition costs. At December 31, 2012 and 2011, there was no premium deficiency related to deferred policy acquisition costs.

 

Goodwill. Our consolidated balance sheet as of December 31, 2012 includes goodwill of acquired businesses of $44.7 million that is assigned to our business units as follows: Standard Commercial P&C business unit - $2.1 million; E&S Commercial business unit - $19.9 million; General Aviation business unit - $9.7 million; Personal Lines business unit - $5.3 million; and Excess & Umbrella business unit - $7.7 million. This amount has been recorded as a result of prior business acquisitions accounted for under the purchase method of accounting. Under ASC 350, “Intangibles- Goodwill and Other,” goodwill is tested for impairment annually. We completed our last annual test for impairment on the first day of the fourth quarter of 2012 and determined that there was no impairment.

 

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A significant amount of judgment is required in performing goodwill impairment tests. Such tests include estimating the fair value of our reporting units. As required by ASC 350, we compare the estimated fair value of each reporting unit with its carrying amount, including goodwill. Under ASC 350, fair value refers to the amount for which the entire reporting unit may be bought or sold.

 

The determination of fair value was based on an income approach utilizing discounted cash flows. The valuation methodology utilized is subject to key judgments and assumptions. Estimates of fair value are inherently uncertain and represent management’s reasonable expectation regarding future developments. These estimates and the judgments and assumptions upon which the estimates are based will, in all likelihood, differ in some respects from actual future results. Declines in estimated fair value could result in goodwill impairments in future periods which could materially adversely affect our results of operations or financial position.

 

The income approach to determining fair value computed the projections of the cash flows that the reporting unit is expected to generate converted into a present value equivalent through discounting. Significant assumptions in the income approach model include income projections, discount rates and terminal growth values. The income projections reflect an improved premium pricing environment across most of our lines of business that began in 2012. The income projections also include loss and LAE assumptions which reflect recent historical claim trends and the movement towards a more favorable pricing environment. The income projections also include assumptions for expense growth and investment yields which are based on business plans for each of our business units. The discount rate was based on a risk free rate plus a beta adjusted equity risk premium and specific company risk premium. The assumptions were based on historical experience, expectations of future performance, expected market conditions and other factors requiring judgment and estimates. While we believe the assumptions used in these models were reasonable, the inherent uncertainty in predicting future performance and market conditions may change over time and influence the outcome of future testing.

 

The fair values of each of our business units were in excess of their respective carrying values, including goodwill, as a result of our annual test for impairment during the fourth quarter 2012. However, a 22% decline in the fair value of our Standard Commercial P&C business unit, a 17% decline in the fair value of our E&S Commercial business unit, a 7% decline in the fair value of our Personal Lines business unit, a 2% decline in the fair value of our General Aviation business unit, or a 52% decline in the fair value of our Excess & Umbrella business unit would have caused the carrying value of the respective business unit to be in excess of its fair value, resulting in the need to perform the second step of impairment testing prescribed by ASC 350, which could have resulted in an impairment to our goodwill.

 

The market capitalization of Hallmark’s common stock has been below book value during 2012. We consider our market capitalization in assessing the reasonableness of the fair values estimated for our business units in connection with our goodwill impairment testing. We believe the current market displacement caused by global financial market conditions, including the European sovereign credit crisis, as well as the limited daily trading volume of Hallmark shares has resulted in a decrease in our market capitalization that is not representative of a long-term decrease in value. The valuation analysis discussed above supports our view that goodwill was not impaired at October 1, 2012. Through December 31, 2012, there were no indicators of impairment.

 

While we believe the estimates and assumptions used in determining the fair value of our business units were reasonable, actual results could vary materially. If our actual results are not consistent with our estimates and assumptions used to calculate fair value, we may be required to perform the second step of impairment testing prescribed by ASC 350 in future periods and impairment of goodwill could result. We cannot predict future events that might impact the fair value of our business units and goodwill impairment. Such events include, but are not limited to, increased competition in insurance markets and global economic changes.

 

Deferred income tax assets and liabilities. We file 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 our deferred tax assets to the extent that we do not believe it is more likely than not that future taxable income will be adequate to realize these future tax benefits.

 

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Reserves for unpaid losses and LAE. Reserves for unpaid losses and LAE are established for claims that have already been incurred by the policyholder but which we have not yet paid. Unpaid losses and LAE represent the estimated ultimate net cost of all reported and unreported losses incurred through each balance sheet date. The reserves for unpaid losses and LAE are estimated using individual case-basis valuations and statistical analyses. These reserves are revised periodically and are subject to the effects of trends in loss severity and frequency. (See “Item 1. Business – Analysis of Losses and LAE” and “-Analysis of Loss and LAE Reserve Development.”)

 

Although considerable variability is inherent in such estimates, we believe that our reserves for unpaid losses and LAE are adequate. Due to the inherent uncertainty in estimating unpaid losses and LAE, the actual ultimate amounts may differ from the recorded amounts. A small percentage change could result in a material effect on reported earnings. For example, a 1% change in December 31, 2012 reserves for unpaid losses and LAE would have produced a $3.1 million change to pretax earnings. The estimates are continually reviewed and adjusted as experience develops or new information becomes known. Such adjustments are included in current operations.

 

An actuarial range of ultimate unpaid losses and LAE is developed independent of management’s best estimate and is only used to assess the reasonableness of that estimate. There is no exclusive method for determining this range, and judgment enters into the process. The primary actuarial technique utilized is a loss development analysis in which ultimate losses are projected based upon historical development patterns. The primary assumption underlying this loss development analysis is that the historical development patterns will be a reasonable predictor of the future development of losses for accident years which are less mature. An alternate actuarial technique, known as the Bornhuetter-Ferguson method, combines an analysis of loss development patterns with an initial estimate of expected losses or loss ratios. This approach is most useful for recent accident years. In addition to assuming the stability of loss development patterns, this technique is heavily dependent on the accuracy of the initial estimate of expected losses or loss ratios. Consequently, the Bornhuetter-Ferguson method is primarily used to confirm the results derived from the loss development analysis.

 

The range of unpaid losses and LAE estimated by our actuary as of December 31, 2012 was $266.7 million to $322.6 million. Our best estimate of unpaid losses and LAE as of December 31, 2012 is $313.4 million. Our carried reserve for unpaid losses and LAE as of December 31, 2012 is comprised of $163.2 million in case reserves and $150.2 million in incurred but not reported reserves. In setting this estimate of unpaid losses and LAE, we have assumed, among other things, that current trends in loss frequency and severity will continue and that the actuarial analysis was empirically valid. We have established a best estimate of unpaid losses and LAE, which is approximately $18.7 million higher than the midpoint or 97.1% of the high end of the actuarial range at December 31, 2012 as compared to $6.5 million above the midpoint or 92.2% of the high end of the actuarial range at December 31, 2011. We expect our best estimate to move within the actuarial range from year to year due to changes in our operations and changes within the marketplace. Due to the inherent uncertainty in reserve estimates, there can be no assurance that the actual losses ultimately experienced will fall within the actuarial range. However, because of the breadth of the actuarial range, we believe that it is reasonably likely that actual losses will fall within such range.

 

Our reserve requirements are also interrelated with product pricing and profitability. We must price our products at a level sufficient to fund our policyholder benefits and still remain profitable. Because claim expenses represent the single largest category of our expenses, inaccuracies in the assumptions used to estimate the amount of such benefits can result in our failing to price our products appropriately and to generate sufficient premiums to fund our operations.

 

Recognition of profit sharing commissions. Profit sharing commission is calculated and recognized when the loss ratio, as determined by a qualified actuary, deviates from contractual targets. We receive a provisional commission as policies are produced as an advance against the later determination of the profit sharing commission actually earned. The profit sharing commission is an estimate that varies with the estimated loss ratio and is sensitive to changes in that estimate.

 

The following table details the profit sharing commission revenue sensitivity of the Standard Commercial P&C business unit to the actual ultimate loss ratio for each effective quota share treaty at 5.0% above and below the current estimate, which we believe is a reasonably likely range of variance ($ in thousands).

 

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   Treaty Effective Dates 
   7/1/01   7/1/02   7/1/03   7/1/04 
Provisional loss ratio   60.0%   59.0%   59.0%   64.2%
Estimated ultimate loss ratio recorded at December 31, 2012   63.5%   64.5%   62.5%   61.8%
Effect of actual 5.0% above estimated loss ratio at December 31, 2012   -    -   $(3,024)  $(3,790)
Effect of actual 5.0% below estimated loss ratio at December 31, 2012  $1,850   $3,055   $3,025   $3,790 

 

The following table details the profit sharing commission revenue sensitivity of the E&S Commercial business unit for each effective quota share treaty at 5.0% above and below the current estimate, which we believe is a reasonably likely range of variance ($ in thousands).

 

   Treaty Effective Dates 
   1/1/06   1/1/07   1/1/08 
Provisional loss ratio   65.0%   65.0%   65.0%
Estimated ultimate loss ratio recorded at December 31, 2012   58.3%   62.4%   58.8%
Effect of actual 5.0% above estimated loss ratio at December 31, 2012  $(3,096)  $(1,223)  $(1,618)
Effect of actual 5.0% below estimated loss ratio at December 31, 2012  $2,663   $2,351   $1,554 

 

The Workers Compensation business unit earns a profit share commission on a quota share treaty effective July 1, 2001. The provisional loss ratio is 62.5% and we recorded an estimated ultimate loss ratio of 50.7% at December 31, 2012. The effect of a 5.0% movement in the loss ratio above or below the current estimated ultimate loss ratio would result in a $0.7 million adjustment to our pre-tax earnings.

 

Results of Operations

 

Comparison of Years ended December 31, 2012 and December 31, 2011

 

Management overview. During fiscal 2012, our total revenues were $341.8 million, representing an approximately 6% increase over the $322.8 million in total revenues for fiscal 2011. The growth in revenue was primarily attributable to increased premium production and resulting earned premium driven largely from our E&S Commercial business unit and from the acquisition of our Workers Compensation business unit during the third quarter of 2011. The increase in revenue was partially offset by an adverse profit share commission revenue adjustment in our Standard Commercial P&C business unit, combined with lower finance charges and earned premium in our Personal Segment due mostly to the impact of a reduction of premium written in underperforming states and products exited over the past twelve months. Further offsetting the increase in revenue was lower net realized gains for the period ended December 31, 2012.

 

We reported net income attributable to Hallmark of $3.5 million for the year ended December 31, 2012, as compared to a net loss of $10.9 million for the year ended December 31, 2011. On a diluted per share basis, net income attributable to Hallmark was $0.18 per share for fiscal 2012 as compared to a net loss of $0.55 per share for fiscal 2011.

 

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The increase in revenue for the year ended December 31, 2012 was complemented by decreased loss and LAE due primarily to improved current accident year loss trends in our Standard Commercial P&C business unit and Personal Lines business unit as well as $3.7 million of favorable prior year loss development for the year ended December 31, 2012 as compared to $16.4 million of adverse reserve development recognized during the prior year. Of the $16.4 million unfavorable development recognized for the year ended December 31, 2011, $10.3 million was a result of adverse prior year loss reserve development in our Personal Segment in Florida. In addition, the results for the years ended December 31, 2012 and 2011 included $11.7 million and $10.3 million, respectively, in current accident year net losses from weather related claims.

 

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Segment information. The following is additional business segment information for the years ended December 31, 2012 and 2011 (in thousands):

 

   Year Ended December 31, 2012 
   Standard   Specialty             
   Commercial   Commercial   Personal         
   Segment   Segment   Segment   Corporate   Consolidated 
     
Gross premiums written  $77,091   $235,695   $77,056   $-   $389,842 
Ceded premiums written   (7,000)   (49,642)   (711)   -    (57,353)
Net premiums written   70,091    186,053    76,345    -    332,489 
Change in unearned premiums   (936)   (17,223)   5,106    -    (13,053)
Net premiums earned   69,155    168,830    81,451    -    319,436 
                          
Total revenues   73,119    178,917    89,149    615    341,800 
                          
Losses and loss adjustment expenses   52,828    103,980    69,606    -    226,414 
                          
Pre-tax income (loss), net of non-controlling interest   (2,486)   25,932    (8,535)   (11,861)   3,050 
                          
Net loss ratio (1)   76.4%   61.6%   85.5%        70.9%
Net expense ratio (1)   33.2%   28.3%   28.5%        30.8%
Net combined ratio (1)   109.6%   89.9%   114.0%        101.7%

 

   Year Ended December 31, 2011 
   Standard   Specialty             
   Commercial   Commercial   Personal         
   Segment   Segment   Segment   Corporate   Consolidated 
     
Gross premiums written  $69,420   $185,020   $100,441   $-   $354,881 
Ceded premiums written   (5,476)   (40,743)   (4,786)   -    (51,005)
Net premiums written   63,944    144,277    95,655    -    303,876 
Change in unearned premiums   642    (8,784)   (2,693)   -    (10,835)
Net premiums earned   64,586    135,493    92,962    -    293,041 
                          
Total revenues   72,830    142,838    101,351    5,752    322,771 
                          
Losses and loss adjustment expenses   50,940    87,265    101,030    -    239,235 
                          
Pre-tax income (loss), net of non-controlling interest (2)   1,335    14,348    (29,647)   (5,881)   (19,845)
                          
Net loss ratio (1)   78.9%   64.4%   108.7%        81.6%
Net expense ratio (1)   32.3%   29.6%   25.8%        30.8%
Net combined ratio (1)   111.2%   94.0%   134.5%        112.4%

 

1The net loss ratio is calculated as incurred losses and LAE divided by net premiums earned, each determined in accordance with GAAP. The net expense ratio is calculated for our business units that retain 100% of produced premium as total operating expenses for the unit offset by agency fee income, divided by net premiums earned, each determined in accordance with GAAP. For the business units that do not retain 100% of the produced premium, the net expense ratio is calculated as underwriting expenses of the insurance company subsidiaries for the unit offset by agency fee income, divided by net premiums earned, each determined in accordance with GAAP. Net combined ratio is calculated as the sum of the net loss ratio and the net expense ratio.

 

2Amounts for 2011 have been adjusted for the adoption of a change in accounting principle related to deferred policy acquisition costs. (See, “Adoption of New Accounting Pronouncements” in Note 1 to the audited consolidated financial statements, included in this report.)

 

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Standard Commercial Segment. Gross premiums written for the Standard Commercial Segment were $77.1 million for the year ended December 31, 2012, which was $7.7 million, or approximately 11%, more than the $69.4 million reported for the same period in 2011. Net premiums written were $70.1 million for the year ended December 31, 2012 as compared to $63.9 million reported for the same period in 2011. The increase in gross premium volume was due predominately to the acquisition of our Workers Compensation business unit during the third quarter of 2011.

Total revenue for the Standard Commercial Segment of $73.1 million for the year ended December 31, 2012 was $0.3 million more than the $72.8 million reported during the year ended December 31, 2011. This increase in total revenue was the result of increased net earned premiums of $4.6 million due primarily to the acquisition of our Workers Compensation business unit during the third quarter of 2011 and higher net investment income of $0.9 million. This increase in revenue was partially offset by an adverse profit share commission revenue adjustment of $1.5 million during the year ended December 31, 2012 as compared to a favorable profit share commission revenue adjustment of $3.7 million during the same period of 2011.

 

Our Standard Commercial Segment reported a pre-tax loss of $2.5 million for the year ended December 31, 2012 as compared to pre-tax income of $1.3 million for the same period of 2011. Higher operating expenses of $2.2 million primarily due to the acquisition of our Workers Compensation business unit during the third quarter of 2011 and higher loss and LAE of $1.9 million contributed to this increase in pre-tax loss for the year ended December 31, 2012. Partially offsetting this increase in pre-tax loss was the increased revenue discussed above.

 

The net loss ratio for the year ended December 31, 2012 was 76.4% as compared to the 78.9% reported for 2011. The gross loss ratio before reinsurance was 74.8% for the year ended December 31, 2012 as compared to 77.4% for the prior year. The lower gross and net loss ratios for the year ended December 31, 2012 were aided by lower current accident year loss trends excluding catastrophe losses. The net loss ratios for the years ended December 31, 2012 and 2011 include $9.5 million and $7.7 million, respectively, of weather related losses. During the years ended December 31, 2012 and 2011 the Standard Commercial Segment reported $3.7 million and $0.8 million, respectively, of favorable prior years’ loss reserve development.

 

Specialty Commercial Segment. Gross premiums written for the Specialty Commercial Segment were $235.7 million for the year ended December 31, 2012, which was $50.7 million, or 27%, more than the $185.0 million reported for the same period in 2011. Net premiums written were $186.1 million for the year ended December 31, 2012 as compared to $144.3 million reported for the same period in 2011. The increase in premium volume was primarily due to increased premium production in our E&S Commercial business unit, Excess & Umbrella business unit and our space risk program partially offset by reduced premium volume in our General Aviation business unit.

 

The $178.9 million of total revenue for the year ended December 31, 2012 was $36.1 million higher than the $142.8 million reported for 2011. This 25% increase in revenue was due to higher net premiums earned of $33.3 million due predominately to increased production discussed above. Further contributing to this increased revenue was higher net investment income of $2.0 million and an adverse profit share commission revenue adjustment of $0.8 million for the year ended December 31, 2011.

 

Pre-tax income for the Specialty Commercial Segment of $25.9 million for the year ended December 31, 2012 was $11.6 million higher than the $14.3 million reported for the same period in 2011. The increase in pre-tax income was primarily due to the increased revenue discussed above partially offset by higher loss and LAE expenses of $16.7 million, higher operating expenses of $7.6 million and $0.3 million in expense related to the acquisition of the non-controlling interest in our Excess & Umbrella business unit during the third quarter of 2012. Our E&S Commercial business unit reported a $12.6 million increase in loss and LAE due primarily to increased premium volume partially offset by lower accident year loss trends, our Excess & Umbrella business unit reported a $0.8 million increase in loss and LAE due to increased premium production, our General Aviation business unit reported a $1.7 million increase in loss and LAE primarily due to increased current accident year loss trends and our space risk program reported a $1.6 million increase in loss and LAE due primarily to increased current accident year loss trends. The increased operating expenses during 2012 were primarily the result of increased production related expenses of $6.6 million, higher salary and related expense of $1.1 million and higher other operating expenses of $0.2 million, partially offset by lower professional service fees of $0.3 million.

 

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The Specialty Commercial Segment reported a net loss ratio of 61.6% for 2012 as compared to 64.4% for 2011. The lower net loss ratio was due primarily to overall lower current accident year loss trends and favorable prior year development for the year ended December 31, 2012 of $3.6 million as compared to $2.4 million favorable prior year development for the same period of 2011.

 

Personal Segment. Gross premiums written for the Personal Segment were $77.1 million for the year ended December 31, 2012, which was $23.3 million, or 23%, less than the $100.4 million reported for the same period in 2011. The decrease in premium was due mostly to exiting Florida and certain other underperforming states and programs.

 

Total revenue for the Personal Segment decreased 12% to $89.1 million for the year ended December 31, 2012 from $101.4 million the prior year. Lower earned premium of $11.5 million and lower finance charges of $0.7 million were the primary reason for the decrease in revenue for the period.

 

Our Personal Segment reported a pre-tax loss of $8.5 million for the year ended December 31, 2012 as compared to a pre-tax loss of $29.6 million for the same period of 2011. The lower pre-tax loss was the result of lower losses and LAE of $31.4 million and lower operating expenses of $1.8 million, primarily production related expenses. The decline in pre-tax loss was partially offset by lower revenue discussed above.

 

The Personal Segment reported a net loss ratio of 85.5% for the year ended December 31, 2012 as compared to 108.7% for 2011. The decrease in the net loss ratio was primarily due to normalizing claims experience during 2012 as compared to extremely adverse claims development during 2011 due to rapid growth in the Florida claim volume and the complexity related to Florida personal injury protection claims. The loss ratio for the year ended December 31, 2012 included improving current accident year loss trends in our non-standard auto line of business partially offset by increased weather and fire related losses in our low value dwelling/homeowners line of business. The loss and LAE during the year ended December 31, 2012 included $3.6 million of adverse prior year development as compared to $19.7 million of adverse prior year development for the same period during 2011. The Personal Segment reported a net expense ratio of 28.5% for the year ended December 31, 2012 as compared to 25.8% for the prior year. The increase in the expense ratio was due predominately to growth in staffing.

 

Corporate. Total revenue for corporate decreased by $5.1 million for the year ended December 31, 2012 as compared to the prior year. This decrease in total revenue was due primarily to gains of $1.9 million recognized on our investment portfolio for the year ended December 31, 2012 as compared to $3.7 million of gains recognized during the same period in 2011.  Further contributing to this decrease in revenue was lower net investment income of $3.4 million for the year ended December 31, 2012 as compared to the same period of the prior year.

 

Corporate pre-tax loss was $11.9 million for the year ended December 31, 2012 as compared to a $5.9 million pre-tax loss for the same period the prior year.   The increase in pre-tax loss was the result of the decreased revenue discussed above and higher operating expenses of $0.9 million due primarily to lower reductions recorded to the expected earn-out payable in conjunction with the acquisition of HNIC for the year ended December 31, 2012 as compared to the same period in 2011.

 

Comparison of Years ended December 31, 2011 and December 31, 2010

 

Management overview. During fiscal 2011, our total revenues were $322.8 million, representing an approximately 5% increase over the $307.1 million in total revenues for fiscal 2010. This increase in revenue was primarily attributable to increased earned premium due to increased production by our Personal Lines and E&S Commercial business unit, a new space risk Specialty Program entered into during the first quarter of 2011 and the acquisition of our Workers Compensation business unit during the third quarter of 2011.  Further contributing to the increased revenues were favorable profit sharing commission revenue adjustments and higher net investment income.  These increases in revenue were partially offset by lower earned premium in our Standard Commercial P&C business unit due to continued competition and continued soft market conditions and lower recognized gains on our investment portfolio.

 

We reported a net loss attributable to Hallmark of $10.9 million for the year ended December 31, 2011, compared to net income of $7.4 million for the year ended December 31, 2010. On a diluted per share basis, net loss attributable to Hallmark was $0.55 per share for fiscal 2011 as compared to net income of $0.37 per share for fiscal 2010.

 

The increase in revenue for the year ended December 31, 2011 was offset by increased loss and LAE due primarily to higher current accident year loss estimates, as well as unfavorable prior year loss development of $16.4 million for the year ended December 31, 2011 as compared to $9.2 million of unfavorable prior year development for the year ended December 31, 2010.  Of the $16.4 million unfavorable development recognized for the year ended December 31, 2011, $10.3 million was a result of adverse prior year loss reserve development in our Personal Lines Segment in Florida. In addition, the results for the year ended December 31, 2011 include $10.3 million in current accident year net losses from weather related claims.  The adverse prior year development and the losses from the weather related claims contributed 9.1% to the 81.6% consolidated net loss ratio for the year ended December 31, 2011.  

 

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Segment information. The following is additional business segment information for the years ended December 31, 2011 and 2010 (in thousands):

 

   Year Ended December 31, 2011 
   Standard   Specialty             
   Commercial   Commercial   Personal         
   Segment   Segment   Segment   Corporate   Consolidated 
     
Gross premiums written  $69,420   $185,020   $100,441   $-   $354,881 
Ceded premiums written   (5,476)   (40,743)   (4,786)   -    (51,005)
Net premiums written   63,944    144,277    95,655    -    303,876 
Change in unearned premiums   642    (8,784)   (2,693)   -    (10,835)
Net premiums earned   64,586    135,493    92,962    -    293,041 
                          
Total revenues   72,830    142,838    101,351    5,752    322,771 
                          
Losses and loss adjustment expenses   50,940    87,265    101,030    -    239,235 
                          
Pre-tax income (loss), net of non-controlling interest (2)   1,335    14,348    (29,647)   (5,881)   (19,845)
                          
Net loss ratio (1)   78.9%   64.4%   108.7%        81.6%
Net expense ratio (1)   32.3%   29.6%   25.8%        30.8%
Net combined ratio (1)   111.2%   94.0%   134.5%        112.4%

 

   Year Ended December 31, 2010 
   Standard   Specialty             
   Commercial   Commercial   Personal         
   Segment   Segment   Segment   Corporate   Consolidated 
     
Gross premiums written  $67,832   $157,849   $95,292   $-   $320,973 
Ceded premiums written   (4,260)   (34,876)   (196)   -    (39,332)
Net premiums written   63,572    122,973    95,096    -    281,641 
Change in unearned premiums   1,999    1,125    (6,494)   -    (3,370)
Net premiums earned   65,571    124,098    88,602    -    278,271 
                          
Total revenues   69,670    131,076    96,741    9,573    307,060 
                          
Losses and loss adjustment expenses   51,468    78,911    72,165    -    202,544 
                          
Pre-tax income (loss), net of non-controlling interest (2)   (2,301)   13,332    (630)   (2,135)   8,266 
                          
Net loss ratio (1)   78.5%   63.6%   81.4%        72.8%
Net expense ratio (1)   31.9%   29.4%   22.0%        29.6%
Net combined ratio (1)   110.4%   93.0%   103.4%        102.4%

 

1The net loss ratio is calculated as incurred losses and LAE divided by net premiums earned, each determined in accordance with GAAP. The net expense ratio is calculated for our business units that retain 100% of produced premium as total operating expenses for the unit offset by agency fee income, divided by net premiums earned, each determined in accordance with GAAP. For the business units that do not retain 100% of the produced premium, the net expense ratio is calculated as underwriting expenses of the insurance company subsidiaries for the unit offset by agency fee income, divided by net premiums earned, each determined in accordance with GAAP. Net combined ratio is calculated as the sum of the net loss ratio and the net expense ratio.

 

2Amounts for 2011 and 2010 have been adjusted for the adoption of a change in accounting principle related to deferred policy acquisition costs. (See, “Adoption of New Accounting Pronouncements” in Note 1 to the audited consolidated financial statements, included in this report.)

 

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Standard Commercial Segment. Gross premiums written for the Standard Commercial Segment were $69.4 million for the year ended December 31, 2011, which was $1.6 million, or approximately 2%, more than the $67.8 million reported for the same period in 2010. Net premiums written were $63.9 million for the year ended December 31, 2011 as compared to $63.6 million reported for the same period in 2010. The increase in gross premium volume was due to the acquisition of our Workers Compensation business unit during the third quarter of 2011, partially offset by a decline in premium for our Standard Commercial P&C business unit as a result of continued competition and soft market conditions.

 

Total revenue for the Standard Commercial Segment of $72.8 million for the year ended December 31, 2011 was $3.1 million more than the $69.7 million reported during the year ended December 31, 2010. This 5% increase in total revenue was primarily due to favorable profit share revenue adjustments of $3.6 million during the year ended December 31, 2011 as compared to an adverse adjustment of $0.9 million for the same period in 2010, partially offset by decreased net premiums earned of $1.0 million and lower investment income of $0.4 million.

 

Our Standard Commercial Segment reported pre-tax income of $1.3 million for the year ended December 31, 2011 as compared to pre-tax loss of $2.3 million for the same period of 2010. This improvement in pre-tax results was the result of lower loss and LAE of $0.5 million, primarily as a result of favorable prior year development in our Standard Commercial P&C business unit partially offset by the acquisition of our Workers Compensation business unit during the third quarter of 2011. Further contributing to the improved pre-tax results was the increased revenue discussed above.

 

The net loss ratio for the year ended December 31, 2011 was 78.9% as compared to the 78.5% reported for the same period of 2010. The gross loss ratio before reinsurance was 77.4% for the year ended December 31, 2011 as compared to 82.6% for the same period the prior year. The lower gross loss ratio for the year ended December 31, 2011 was primarily the result of favorable prior year development of $0.8 million as compared to $4.6 million of unfavorable development for the same period during the prior year, partially offset by higher current accident year claim activity due in large part to weather related losses of $7.7 million.

 

Specialty Commercial Segment. The $142.8 million of total revenue for the year ended December 31, 2011 was $11.7 million higher than the $131.1 million reported for 2010. This 9% increase in revenue was due to higher net premiums earned of $11.4 million due predominately to increased production in our E&S Commercial business unit and a new space risk Specialty Program entered into during the first quarter of 2011 in which we can retain up to $2.0 million per risk for satellite launches. Further contributing to this increased revenue was higher net investment income of $0.3 million and a lower adverse profit sharing commission adjustment of $0.8 million for the year ended December 31, 2011 as compared to an adverse $1.0 million profit share commission adjustment for the same period the prior year, partially offset by lower finance charges of $0.2 million.

 

Pre-tax income for the Specialty Commercial Segment of $14.3 million was $1.0 million higher than the $13.3 million reported in 2010. The increase in pre-tax income was primarily due to increased revenue discussed above and lower amortization of intangible assets of $0.5 million and lower non-controlling interest of $0.1 million. The increase in pre-tax income was offset by higher loss and LAE expenses of $8.4 million and higher operating expenses of $2.9 million. The increase in operating expense was the combined result of (i) increased production related expenses of $2.0 million , (ii) higher salary and related expenses of $0.6 million, and (iii) increased other operating expenses of $0.3 million, primarily comprised of professional services. 

 

The Specialty Commercial Segment reported a net loss ratio of 64.4% for 2011 as compared to 63.6% for 2010. The gross loss ratio before reinsurance was 63.1% for the year ended December 31, 2011 as compared to 61.9% for the same period the prior year. The higher gross and net loss ratio was impacted by higher current accident year loss trends predominately in our commercial auto and general liability lines of business. The gross loss results for the year ended December 31, 2011 included $2.4 million of favorable prior year development as compared to $1.5 million of unfavorable prior year development for the same period of 2010.

 

Personal Segment. Net premium written for our Personal Segment increased $0.6 million during the year ended December 31, 2011 to $95.7 million compared to $95.1 million in the year ended December 31, 2010. The increase in premium written was due mostly to the acquisition of HNIC partially offset by a reduction in premium written in Florida.

 

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Total revenue for the Personal Segment increased 5% to $101.3 million for the year ended December 31, 2011 from $96.7 million the prior year. Higher earned premium of $4.4 million was the primary reason for the increase in revenue for the period. Increased net investment income of $0.3 million further contributed to this increase in revenue, partially offset by lower finance charges and commissions and fees of $0.1 million.

 

Our Personal Segment reported pre-tax loss of $29.6 million for the year ended December 31, 2011 as compared to pre-tax loss of $0.6 million for the same period of 2010. The increased revenue, as discussed above, was offset by increased losses and LAE of $28.9 million and increased operating expenses of $4.2 million due mostly to increased production related expenses of $1.8 million, increased salary and related expense of $1.1 million, increased professional service fees of $0.3 million and increased other operating expenses of $1.0 million. Also contributing to the increase in pre-tax loss was increased amortization of intangible assets of $0.5 million related to the acquisition of HNIC.

 

The Personal Segment reported a net loss ratio of 108.7% for the year ended December 31, 2011 as compared to 81.4% for the same period of 2010.  The increase in the net loss ratio was primarily due to higher current accident year loss trends and claims developing much worse than anticipated due to rapid growth in the Florida claim volume and the complexity related to Florida personal injury protection claims. The net loss ratio for our Florida related business was 282.5% for the year ended December 31, 2011, which equates to approximately 20.6% of the net loss ratio reported as of December 31, 2011.   During late 2010 and into 2011, a number of actions were taken to address the issues in Florida. We increased prices, changed policy renewal terms, suspended new business production, significantly increased our personal lines claims department capabilities and made other increases in our claims staffing, including hiring experienced claims personnel in Florida. Also contributing to the increase in the net loss ratio were higher current accident year loss trends in our legacy and expansion states, outside of Florida. We implemented rate increases and changed policy down payment requirements in the underperforming states. We also exited certain underperforming states and closed unprofitable programs and products in order to focus on states and products where we can achieve desired returns. The loss and LAE during the year ended December 31, 2011 includes $19.7 million of adverse prior year development as compared to $3.1 million of adverse prior year development for the same period during 2010.   The Personal Segment reported a net expense ratio of 25.8% for the year ended December 31, 2011 as compared to 22.0% for the prior year. The increase in the expense ratio is due predominately to increased production expenses related to the renewal and appointment of agents from our acquisition of HNIC, increased salary and related expense and increased professional service fees.

 

Corporate. Total revenue for corporate decreased by $3.8 million for the year ended December 31, 2011 as compared to the prior year. This decrease in total revenue was due primarily to gains of $3.7 million recognized on our investment portfolio for the year ended December 31, 2011 as compared to $8.4 million of gains recognized during the same period in 2010.  This decrease in revenue was partially offset by higher net investment income of $0.7 million and a bargain purchase gain recorded on the acquisition of TBIC Holding of $0.2 million reported in other income during the third quarter of 2011.

 

Corporate pre-tax loss was $5.9 million for the year ended December 31, 2011 as compared to a $2.1 million pre-tax loss for the same period the prior year.   The increase in pre-tax loss was the result of the decreased revenue discussed above, higher salary and other related expenses of $0.6 million due primarily to recent hires, higher professional fees of $0.2 million and higher occupancy and related expenses of $0.1 million, partially offset by a $0.9 million adjustment to the expected earn-out payable in conjunction with the acquisition of HNIC.

 

Liquidity and Capital Resources

 

Sources and Uses of Funds

 

Our sources of funds are from insurance-related operations, financing activities and investing activities. Major sources of funds from operations include premiums collected (net of policy cancellations and premiums ceded), commissions and processing and service fees. As a holding company, Hallmark is dependent on dividend payments and management fees from its subsidiaries to meet operating expenses and debt obligations. As of December 31, 2012, Hallmark had $1.1 million in unrestricted cash and invested assets. Unrestricted cash and invested assets of our non-insurance subsidiaries were $5.6 million as of December 31, 2012. As of that date, our insurance subsidiaries held $78.4 million of cash and cash equivalents as well as $401.4 million in debt securities with an average modified duration of 2.5 years.  Accordingly, we do not anticipate selling long-term debt instruments to meet any liquidity needs.

 

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AHIC and TBIC, domiciled in Texas, are limited in the payment of dividends to their stockholders in any 12-month period, without the prior written consent of the Texas Department of Insurance, to the greater of statutory net income for the prior calendar year or 10% of statutory policyholders’ surplus as of the prior year end. Dividends may only be paid from unassigned surplus funds. HIC, domiciled in Arizona, is limited in the payment of dividends to the lesser of 10% of prior year policyholders’ surplus or prior year's net investment income, without prior written approval from the Arizona Department of Insurance. HSIC, domiciled in Oklahoma, is limited in the payment of dividends to the greater of 10% of prior year policyholders’ surplus or prior year’s statutory net income, not including realized capital gains, without prior written approval from the Oklahoma Insurance Department. HNIC, domiciled in Ohio, is limited in the payment of dividends to the greater of 10% of statutory policyholders’ surplus as of the prior December 31 or statutory net income as of the prior December 31 without prior written approval from the Ohio Insurance Department. During 2013, the aggregate ordinary dividend capacity of these subsidiaries is $21.0 million, of which $15.1 million is available to Hallmark. As a county mutual, dividends from HCM are payable to policyholders. None of our insurance company subsidiaries paid a dividend during the years ended December 31, 2012 or 2011.

 

The state insurance departments also regulate financial transactions between our insurance subsidiaries and their affiliated companies. Applicable regulations require approval of management fees, expense sharing contracts and similar transactions. The net amount paid in management fees by our insurance subsidiaries to Hallmark and our non-insurance company subsidiaries was $9.0 million, $6.0 million and $5.7 million during each of 2012, 2011 and 2010, respectively.

 

Statutory capital and surplus is calculated as statutory assets less statutory liabilities. The various state insurance departments that regulate our insurance company subsidiaries require us to maintain a minimum statutory capital and surplus. As of December 31, 2012, our insurance company subsidiaries reported statutory capital and surplus of $176.5 million, substantially greater than the minimum requirements for each state. Each of our insurance company subsidiaries is also required to satisfy certain risk-based capital requirements. (See, “Item 1. Business – Insurance Regulation – Risk-based Capital Requirements.”). As of December 31, 2012, the adjusted capital under the risk-based capital calculation of each of our insurance company subsidiaries substantially exceeded the minimum requirements. Our total statutory premium-to-surplus percentage for the years ended December 31, 2012 and 2011 was 188% and 176%, respectively.

 

Comparison of December 31, 2012 to December 31, 2011

 

On a consolidated basis, our cash and investments, excluding restricted cash and investments, at December 31, 2012 were $530.5 million compared to $499.1 million at December 31, 2011. Cash from operating activities was the primary reason for this increase.

 

Comparison of Years Ended December 31, 2012 and December 31, 2011

 

Net cash provided by our consolidated operating activities was $33.7 million for the year ended December 31, 2012 compared to $24.6 million for the year ended December 31, 2011. The increase in operating cash flow was primarily due to higher premiums collected during the year ended December 31, 2012 as compared to the same period in 2011 and a $6.5 million federal income tax refund during the second quarter of 2012.

 

Cash used in investing activities during the year ended December 31, 2012 was $18.1 million as compared to $3.8 million for the prior year. The increase in cash used in investing activities was primarily attributable to a $132.0 million decrease in maturities, sales and redemptions of investment securities, partially offset by a $98.1 million decrease in purchases of investment securities, a $1.5 million decrease in purchases of property and equipment and a $4.8 million increase in cash flow into restricted cash accounts. Further offsetting the increase in cash used by investing activities was a $13.3 million decrease in payments for acquisition of subsidiaries, net of cash received, which included a $14.0 million payment for the acquisition of HNIC during the first quarter 2011 partially offset by $0.7 million in net cash received in connection with the acquisition of TBIC Holdings during the third quarter 2011.

 

Cash used in financing activities during the year ended December 31, 2012 was $4.9 million as a result of a $2.6 million repayment on our revolving credit facility, a $0.3 million payment of holdback consideration for the acquisition of TBIC, $1.7 million paid during the fourth quarter of 2012 for the acquisition of the 20% non-controlling interest in the subsidiaries comprising our Excess & Umbrella business unit and a $0.3 million distribution to non-controlling interest for our Excess & Umbrella business unit. Cash used in financing activities during the year ended December 31, 2011 was $6.9 million primarily related to the repurchase of our common stock during the second quarter of 2011.  In addition, we borrowed $1.3 million under our revolving credit agreement and paid off $1.7 million in notes payable as part of the acquisition of TBIC Holdings during the year ended December 31, 2011.

 

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Credit Facilities

 

Our First Restated Credit Agreement with The Frost National Bank dated January 27, 2006, as amended to date, provides a revolving credit facility of $15.0 million. We pay interest on the outstanding balance at our election at a rate of the prime rate or LIBOR plus 2.5%.  We pay an annual fee of 0.25% of the average daily unused balance of the credit facility. We pay letter of credit fees at the rate of 1.00% per annum.  Our obligations under the revolving credit facility are secured by a security interest in the capital stock of all of our subsidiaries, guarantees of all of our subsidiaries and the pledge of all of our non-insurance company assets.  The revolving credit facility contains covenants that, among other things, require us to maintain certain financial and operating ratios and restrict certain distributions, transactions and organizational changes.  We are in compliance with all of our covenants.  As of December 31, 2012, the balance on the revolving note was $1.5 million. The revolving note currently bears interest at 2.81% per annum.

 

Subordinated Debt Securities

 

On June 21, 2005, we entered into a trust preferred securities transaction pursuant to which we issued $30.9 million aggregate principal amount of subordinated debt securities due in 2035.  To effect the transaction, we formed Hallmark Statutory Trust I (“Trust 1”) as a Delaware statutory trust.  Trust I issued $30.0 million of preferred securities to investors and $0.9 million of common securities to us.  Trust I used the proceeds from these issuances to purchase the subordinated debt securities.  Our Trust I subordinated debt securities bear an initial interest rate of 7.725% until June 15, 2015, at which time interest will adjust quarterly to the three-month LIBOR rate plus 3.25 percentage points.  Trust I pays dividends on its preferred securities at the same rate.  Under the terms of our Trust I subordinated debt securities, we pay interest only each quarter and the principal of the note at maturity.  The subordinated debt securities are uncollateralized and do not require maintenance of minimum financial covenants. As of December 31, 2012, the balance of our Trust I subordinated debt was $30.9 million.

 

On August 23, 2007, we entered into a trust preferred securities transaction pursuant to which we issued $25.8 million aggregate principal amount of subordinated debt securities due in 2037.  To effect the transaction, we formed Hallmark Statutory Trust II (“Trust II”) as a Delaware statutory trust.  Trust II issued $25.0 million of preferred securities to investors and $0.8 million of common securities to us.  Trust II used the proceeds from these issuances to purchase the subordinated debt securities.  Our Trust II subordinated debt securities bear an initial interest rate of 8.28% until September 15, 2017, at which time interest will adjust quarterly to the three-month LIBOR rate plus 2.90 percentage points.  Trust II pays dividends on its preferred securities at the same rate.  Under the terms of our Trust II subordinated debt securities, we pay interest only each quarter and the principal of the note at maturity.  The subordinated debt securities are uncollateralized and do not require maintenance of minimum financial covenants. As of December 31, 2012, the balance of our Trust II subordinated debt was $25.8 million.

 

Long-Term Contractual Obligations

 

Set forth below is a summary of long-term contractual obligations as of December 31, 2012. Amounts represent estimates of gross undiscounted amounts payable over time. In addition, certain unpaid losses and LAE are ceded to others under reinsurance contracts and are, therefore, recoverable. Such potential recoverables are not reflected in the table.

 

   Estimated Payments by Period (in thousands) 
   Total   2013   2014-2015   2016-2017   After 2017 
                     
Notes payable  $1,473   $-   $1,473   $-   $- 
Subordinated debt securities   56,702    -    -    -    56,702 
Interest on notes payable   96    41    55    -    - 
Interest on subordinated debt securities   83,103    4,388    8,775    8,210    61,730 
Unpaid losses and LAE (1)   313,416    120,619    107,216    45,744    39,837 
Operating leases   13,597    2,013    4,007    3,232    4,345 
Purchase obligations   3,063    1,522    1,541    -    - 

 

48
 

 

(1) The payout pattern for unpaid losses and LAE is based upon historical payment patterns and does not represent actual contractual obligations. The timing and amount ultimately paid will likely vary from these estimates.

 

Based on 2013 budgeted and year-to-date cash flow information, we believe that we have sufficient liquidity to meet our projected insurance obligations, operational expenses and capital expenditure requirements for the next 12 months.

 

Effects of Inflation

 

We do not believe that inflation has a material effect on our results of operations, except for the effect that inflation may have on interest rates and claim costs. The effects of inflation are considered in pricing and estimating reserves for unpaid losses and LAE. The actual effects of inflation on results of operations are not known until claims are ultimately settled. In addition to general price inflation, we are exposed to the upward trend in the judicial awards for damages. We attempt to mitigate the effects of inflation in the pricing of policies and establishing reserves for losses and LAE.

 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

We believe that interest rate risk, credit risk and equity risk are the types of market risk to which we are principally exposed.

 

Interest rate risk. Our investment portfolio consists largely of investment-grade, fixed-income securities, all of which are classified as available-for-sale. Accordingly, the primary market risk exposure to these securities is interest rate risk. In general, the fair value of a portfolio of fixed-income securities increases or decreases inversely with changes in market interest rates, while net investment income realized from future investments in fixed-income securities increases or decreases along with interest rates. The fair value of our fixed-income securities as of December 31, 2012 was $401.4 million. The effective duration of our portfolio as of December 31, 2012 was 2.5 years. Should interest rates increase 1.0%, our fixed-income investment portfolio would be expected to decline in market value by 2.5%, or $10.2 million, representing the effective duration multiplied by the change in market interest rates. Conversely, a 1.0% decline in interest rates would be expected to result in a 2.5%, or $10.2 million, increase in the fair value of our fixed-income investment portfolio.

 

Credit risk. An additional exposure to our fixed-income securities portfolio is credit risk. We attempt to manage the credit risk by investing primarily in investment-grade securities and limiting our exposure to a single issuer. As of December 31, 2012, our fixed-income investments were in the following: U.S. Treasury bonds – 10.0%; municipal bonds – 40.8%; collateralized corporate bank loans – 26.5%; corporate bonds – 20.3%; and asset-backed – 2.4%. As of December 31, 2012, 74.2% of our fixed-income securities were rated investment-grade by nationally recognized statistical rating organizations.

 

We are also subject to credit risk with respect to reinsurers to whom we have ceded underwriting risk. Although a reinsurer is liable for losses to the extent of the coverage it assumes, we remain obligated to our policyholders in the event that the reinsurers do not meet their obligations under the reinsurance agreements. In order to mitigate credit risk to reinsurance companies, most of our reinsurance recoverable balance as of December 31, 2012 is with reinsurers that have an A.M. Best rating of “A-” or better.

 

Equity price risk. Investments in equity securities that are subject to equity price risk made up 9.9% of our portfolio as of December 31, 2012. The carrying values of equity securities are based on quoted market prices as of the balance sheet date. Market prices are subject to fluctuation and, consequently, the amount realized in the subsequent sale of an investment may significantly differ from the reported fair value. Fluctuation in the market price of a security may result from perceived changes in the underlying economic characteristics of the issuer, the relative price of alternative investments and general market conditions. Furthermore, amounts realized in the sale of a particular security may be affected by the relative quantity of the security being sold.

 

The fair value of our equity securities as of December 31, 2012 was $43.9 million. The fair value of our equity securities would increase or decrease by $13.2 million assuming a hypothetical 30% increase or decrease in market prices as of the balance sheet date. This would increase or decrease stockholders’ equity by 3.9%. The selected hypothetical change does not reflect what should be considered the best or worse case scenario.

 

49
 

 

Item 8. Financial Statements and Supplementary Data.

 

The following consolidated financial statements of Hallmark and its subsidiaries are filed as part of this report.

 

Description   Page Number
     
Report of Independent Registered Public Accounting Firm   F-2
     
Consolidated Balance Sheets at December 31, 2012 and 2011   F-3
     
Consolidated Statements of Operations for the Years Ended December 31, 2012, 2011 and 2010   F-4
     
Consolidated Statements of Comprehensive Income (Loss) for the Years Ended December 31, 2012, 2011 and 2010   F-5
     
Consolidated Statements of Stockholders’ Equity for the Years Ended  
December 31, 2012, 2011 and 2010   F-6
     
Consolidated Statements of Cash Flows for the Years Ended  
December 31, 2012, 2011 and 2010   F-7
     
Notes to Consolidated Financial Statements   F-8
     
Financial Statement Schedules   F-42

 

50
 

 

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

 

None.

 

Item 9A. Controls and Procedures.

 

Evaluation of Disclosure Controls and Procedures

 

The principal executive officer and principal financial officer of Hallmark have evaluated our disclosure controls and procedures and have concluded that, as of the end of the period covered by this report, such disclosure controls and procedures were effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is timely recorded, processed, summarized and reported. The principal executive officer and principal financial officer also concluded that such disclosure controls and procedures were effective in ensuring that information required to be disclosed by us in the reports that we file or submit under such Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure.

 

During the three month period ended December 31, 2012, there were no changes in internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

Management’s Report on Internal Control over Financial Reporting

 

Management is responsible for establishing and maintaining adequate “internal control over financial reporting,” as such phrase is defined in Exchange Act Rule 13a-15(f). Under the supervision and with the participation of management, including our Chief Executive Officer and Chief Accounting Officer, an evaluation of the effectiveness of our internal control over financial reporting was conducted based upon the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based upon that evaluation, management has concluded that our internal control over financial reporting was effective as of December 31, 2012.

 

Ernst & Young LLP, the independent registered public accounting firm that audited our consolidated financial statements as of December 31, 2012 included in this Annual Report on Form 10-K, has issued an attestation report on our internal control over financial reporting as of December 31, 2012. The Ernst & Young LLP attestation report, which expresses an unqualified opinion on the effectiveness of our internal control over financial reporting as of December 31, 2012, is included in this Item under the heading “Attestation Report of Independent Registered Public Accounting Firm.”

 

51
 

 

Attestation Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Stockholders of

Hallmark Financial Services, Inc. and subsidiaries:

 

We have audited Hallmark Financial Services, Inc. and subsidiaries’ (the Company) internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, Hallmark Financial Services, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on the COSO criteria.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Hallmark Financial Services, Inc. and subsidiaries as of December 31, 2012 and 2011, and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2012 of Hallmark Financial Services, Inc. and subsidiaries and our report dated March 14, 2013 expressed an unqualified opinion thereon.

 

  /s/ ERNST & YOUNG LLP
   
Fort Worth, Texas  
March 14, 2013  

 

52
 

 

Item 9B. Other Information.

 

None.

 

PART III

 

Item 10. Directors, Executive Officers and Corporate Governance.

 

The information required by Item 10 is incorporated by reference from the Registrant’s definitive proxy statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this report.

 

Item 11. Executive Compensation.

 

The information required by Item 11 is incorporated by reference from the Registrant’s definitive proxy statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this report.

 

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

 

The information required by Item 12 is incorporated by reference from the Registrant’s definitive proxy statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this report.

 

Item 13. Certain Relationships and Related Transactions, and Director Independence.

 

The information required by Item 13 is incorporated by reference from the Registrant’s definitive proxy statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this report.

 

Item 14. Principal Accounting Fees and Services.

 

The information required by Item 14 is incorporated by reference from the Registrant's definitive proxy statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this report.

 

53
 

 

PART IV

 

Item 15. Exhibits, Financial Statement Schedules.

 

(a)(1)Financial Statements

 

The following consolidated financial statements, notes thereto and related information are included in Item 8 of this report:

 

Report of Independent Registered Public Accounting Firm

Consolidated Balance Sheets at December 31, 2012 and 2011

Consolidated Statements of Operations for the Years Ended December 31, 2012, 2011 and 2010

Consolidated Statements of Comprehensive Income (Loss) for the Years Ended December 31, 2012, 2011 and 2010

Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2012, 2011 and 2010

Consolidated Statements of Cash Flows for the Years Ended December 31, 2012, 2011 and 2010

Notes to Consolidated Financial Statements

   

(a)(2)Financial Statement Schedules

 

The following financial statement schedules are included in this report:

 

Schedule II – Condensed Financial Information of Registrant (Parent Company Only)

Schedule III – Supplemental Insurance Information

Schedule IV – Reinsurance

Schedule VI – Supplemental Information Concerning Property-Casualty Insurance Operations

 

(a)(3)Exhibit Index

 

The following exhibits are either filed with this report or incorporated by reference:

 

Exhibit

Number

  Description
     
3.1   Restated Articles of Incorporation of the registrant (incorporated by reference to Exhibit 3.1 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1 [Registration No. 333-136414] filed September 8, 2006).
     
3.2   Amended and Restated By-Laws of the registrant (incorporated by reference to Exhibit 3.1 to the registrant’s Current Report on Form 8-K filed October 1, 2007).
     
4.1   Specimen certificate for common stock, $0.18 par value, of the registrant (incorporated by reference to Exhibit 4.1 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1 [Registration No. 333-136414] filed September 8, 2006).
     
4.2   Indenture dated June 21, 2005, between Hallmark Financial Services, Inc. and JPMorgan Chase Bank, National Association (incorporated by reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed June 27, 2005).
     
4.3   Amended   and   Restated  Declaration   of  Trust  of  Hallmark Statutory Trust I dated  as  of  June 21, 2005,  among Hallmark Financial Services, Inc.,  as sponsor, Chase Bank USA, National Association,  as Delaware  trustee,  and  JPMorgan  Chase Bank, National  Association,  as  institutional  trustee,  and   Mark Schwarz and Mark Morrison, as administrators (incorporated by reference to Exhibit 4.2 to the registrant’s Current Report on Form 8-K filed June 27, 2005).
4.4   Form of Junior Subordinated Debt Security Due 2035 (included in Exhibit 4.2 above).
     
4.5   Form of Capital Security Certificate (included in Exhibit 4.3 above).

 

54
 

 

4.6   First Restated Credit Agreement dated January 27, 2006, between Hallmark Financial Services, Inc. and The Frost National Bank (incorporated by reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed February 2, 2006).
     
4.7   Indenture dated as of August 23, 2007, between Hallmark Financial Services, Inc. and The Bank of New York Trust Company, National Association (incorporated by reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed August 24, 2007).
     
4.8   Amended and Restated Declaration of Trust of Hallmark Statutory Trust II dated as of August 23, 2007, among Hallmark Financial Services, Inc., as sponsor, The Bank of New York (Delaware), as Delaware trustee, and The Bank of New York Trust Company, National Association, as institutional trustee, and Mark Schwarz and Mark Morrison, as administrators (incorporated by reference to Exhibit 4.2 to the registrant’s Current Report on Form 8-K filed August 24, 2007).
     
4.9   Form of Junior Subordinated Debt Security Due 2037 (included in Exhibit 4.7 above).
     
4.10   Form of Capital Security Certificate (included in Exhibit 4.8 above).
     
4.11  

Fifth Amendment to First Restated Credit Agreement among Hallmark Financial Services, Inc. and its subsidiaries and The Frost National Bank dated February 20, 2008 (incorporated by reference to Exhibit 99.1 to the registrant’s Current Report on Form 8-K filed February 25, 2008). 

     
4.12   Sixth Amendment to First Restated Credit Agreement among Hallmark Financial Services, Inc. and its subsidiaries and The Frost National Bank dated January 21, 2010 (incorporated by reference to Exhibit 99.1 to the registrant’s Current Report on Form 8-K filed January 25, 2010).
     
4.13   Seventh Amendment to First Restated Credit Agreement among Hallmark Financial Services, Inc. and its subsidiaries and The Frost National Bank dated May 27, 2010 (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed June 17, 2010).
     
4.14   Eighth Amendment to First Restated Credit Agreement among Hallmark Financial Services, Inc. and its subsidiaries and The Frost National Bank dated March 21, 2011 (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed March 21, 2011).
     
4.15   Ninth Amendment to First Restated Credit Agreement among Hallmark Financial Services, Inc. and its subsidiaries and Frost Bank dated July 10, 2012 (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed July 12, 2012).
     
4.16   Tenth Amendment to First Restated Credit Agreement among Hallmark Financial Services, Inc. and its subsidiaries and Frost Bank dated September 30, 2012 (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed October 1, 2012).
     
10.1   Office Lease for 6500 Pinecrest, Plano, Texas, dated July 22, 2008, between Hallmark Financial Services, Inc. and Legacy Tech IV Associates, Limited Partnership (incorporated by reference to Exhibit 99.1 to the registrant’s Current Report on Form 8-K filed July 29, 2008).
     
10.2   Lease Agreement for 777 Main Street, Fort Worth, Texas, dated June 12, 2003 between Hallmark Financial Services, Inc. and Crescent Real Estate Funding I, L.P. (incorporated by reference to Exhibit 10(a) to the registrant’s Quarterly Report on Form 10-QSB for the quarter ended June 30, 2003).

 

55
 

  

 

10.3   Office Lease by and between SAOP Northwest Center, L.P. and Hallmark Specialty Underwriters, Inc. dated January 29, 2010 (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed February 2, 2010).
     
10.4   Office Lease by and between Minol Center, L.P. and Aerospace Insurance Managers, Inc. dated August 9, 2010 (incorporated by reference to Exhibit 99.1 to the registrant’s Current Report on Form 8-K filed August 17, 2010).
     
10.5  

Office Lease by and between Civic Opera, L.P. and Hallmark Specialty Underwriters, Inc. dated December 27, 2010 (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed January 4, 2011).

 

10.6   First Amendment to Office Lease between MS Crescent One SPV, LLC and Hallmark Financial Services, Inc., dated February 28, 2011 (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed March 1, 2011).
     
10.7*   Form of Indemnification Agreement between Hallmark Financial Services, Inc. and its officers and directors, adopted July 19, 2002 (incorporated by reference to Exhibit 10(c) to the registrant’s Quarterly Report on Form 10-QSB for the quarter ended September 30, 2002).
     
10.8*   Hallmark Financial Services, Inc. 2005 Long Term Incentive Plan (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed June 3, 2005).
     
10.9*   Form of Incentive Stock Option Grant Agreement (incorporated by reference to Exhibit 10.2 to the registrant’s Current Report on Form 8-K filed June 3, 2005).
     
10.10*   Form of Non-Qualified Stock Option Agreement (incorporated by reference to Exhibit 10.3 to the registrant’s Current Report on Form 8-K filed June 3, 2005).
     
10.11   Guarantee Agreement dated as of June 21, 2005, by Hallmark Financial Services, Inc. for the benefit of the holders of trust preferred securities (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed June 27, 2005).
     
10.12   Guarantee Agreement dated as of August 23, 2007, by Hallmark Financial Services, Inc. for the benefit of the holders of trust preferred securities (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed August 24, 2007).
     
10.13   Stock Purchase Agreement dated August 9, 2010, between Hallmark Insurance Company and State Auto Financial Corporation (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed August 9, 2010).
     
10.14   Stock Purchase Agreement dated March 25, 2011, between American Hallmark Insurance Company of Texas and Robert C. Siddons, Stephen W. Gurasich, Andrew J. Reynolds, Paul W. Keller, Kerry A. Keller and Austin Engineering Co., Inc. (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K dated March 25, 2011).
     
21+   List of subsidiaries of the registrant.
     
23 (a)+   Consent of Independent Registered Public Accounting Firm. 
     
31(a)+   Certification of principal executive officer required by Rule 13a-14(a) or Rule 15d-14(b).
     
31(b)+   Certification of principal financial officer required by Rule 13a-14(a) or Rule 15d-14(b).
     
32(a)+   Certification of principal executive officer pursuant to 18 U.S.C. 1350.
     
32(b)+   Certification of principal financial officer pursuant to 18 U.S.C. 1350.

 

56
 

 

101 INS+   XBRL Instance Document.
     
101 SCH+   XBRL Taxonomy Extension Schema Document.
     
101 CAL+   XBRL Taxonomy Extension Calculation Linkbase Document.
     
101 LAB+   XBRL Taxonomy Extension Label Linkbase Document.
     
101 PRE+   XBRL Taxonomy Extension Presentation Linkbase Document.
     
101 DEF+   XBRL Taxonomy Extension Definition Linkbase Document.
     
*   Management contract or compensatory plan or arrangement.
     
+   Filed herewith.

 

57
 

 

SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

      HALLMARK FINANCIAL SERVICES, INC.
      (Registrant)
       
Date: March 14, 2013 By: /s/ Mark J. Morrison
      Mark J. Morrison, Chief Executive Officer and
      President
       
Date: March 14, 2013 By: /s/ Jeffrey R. Passmore
      Jeffrey R. Passmore, Chief Accounting Officer and Senior
      Vice President

 

Pursuant to the requirements of the Securities Exchange Act of 1934, 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 14, 2013   /s/ Mark J. Morrison
      Mark J. Morrison, Chief Executive Officer and
      President (Principal Executive Officer)
       
Date: March 14, 2013   /s/ Jeffrey R. Passmore
      Jeffrey R. Passmore, Chief Accounting Officer and Senior
      Vice President (Principal Financial Officer and Principal
      Accounting Officer)
       
Date: March 14, 2013   /s/ Mark E. Schwarz
      Mark E. Schwarz, Executive Chairman
       
Date: March 14, 2013   /s/ James H. Graves
      James H. Graves, Director
       
Date: March 14, 2013   /s/ Jim W. Henderson
      Jim W. Henderson, Director
       
Date: March 14, 2013   /s/ Scott T. Berlin
      Scott T. Berlin, Director

 

58
 

 

HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
 
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

Description   Page Number
     
Report of Independent Registered Public Accounting Firm   F-2
     
Consolidated Balance Sheets at December 31, 2012 and 2011   F-3
     
Consolidated Statements of Operations for the Years Ended December 31, 2012, 2011 and 2010   F-4
     
Consolidated Statements of Comprehensive Income (Loss) for the Years Ended December 31, 2012, 2011 and 2010   F-5
     
Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2012, 2011 and 2010   F-6
     
Consolidated Statements of Cash Flows for the Years Ended December 31, 2012, 2011 and 2010   F-7
     
Notes to Consolidated Financial Statements   F-8
     
Financial Statement Schedules   F-42

  

F-1
 

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directors and Stockholders of
Hallmark Financial Services, Inc. and subsidiaries:

 

We have audited the accompanying consolidated balance sheets of Hallmark Financial Services, Inc. and subsidiaries (the Company) as of December 31, 2012 and 2011, and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2012. Our audits also included the financial statement schedules listed in Item 15(a)(2). These consolidated financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and schedules based on our audits.

 

We conducted our audits in accordance with the auditing standards of the Public Company Accounting Oversight Board (United States). Those standards 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Hallmark Financial Services, Inc. and subsidiaries at December 31, 2012 and 2011, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2012, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.

 

As discussed in Note 1 to the consolidated financial statements, in 2012 the Company retrospectively changed its method of accounting for costs associated with issuing or renewing insurance contracts.

 

We have also audited in accordance with the Standards of the Public Company Oversight Board (United States), Hallmark Financial Services, Inc. and subsidiaries internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 14, 2013 expressed an unqualified opinion thereon.

 

  /s/ ERNST & YOUNG LLP
   

Fort Worth, Texas

March 14, 2013

 

F-2
 

  

HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

December 31, 2012 and 2011

($ in thousands)

 

  2012   2011 
       (as adjusted) 
ASSETS          
           
Investments:          
Debt securities, available-for-sale, at fair value (cost; $397,800 in 2012 and $380,578 in 2011)  $401,435   $380,469 
Equity securities, available-for-sale, at fair value (cost; $31,502 in 2012 and $30,465 in 2011)   43,925    44,159 
           
Total investments   445,360    424,628 
           
Cash and cash equivalents   85,145    74,471 
Restricted cash   8,707    9,372 
Ceded unearned premiums   22,411    19,470 
Premiums receivable   66,683    53,513 
Accounts receivable   3,110    3,946 
Receivable for securities   3    2,617 
Reinsurance recoverable   51,970    42,734 
Deferred policy acquisition costs   24,911    22,554 
Goodwill   44,695    44,695 
Intangible assets, net   23,068    26,654 
Deferred federal income taxes, net   1,940    - 
Federal income tax recoverable   -    6,738 
Prepaid expenses   1,480    1,458 
Other assets   10,985    13,209 
           
Total assets  $790,468   $746,059 
           
LIABILITIES AND STOCKHOLDERS’ EQUITY          
Liabilities:          
Revolving credit facility payable  $1,473   $4,050 
Subordinated debt securities   56,702    56,702 
Reserves for unpaid losses and loss adjustment expenses   313,416    296,945 
Unearned premiums   162,502    146,104 
Reinsurance balances payable   7,330    3,139 
Pension liability   3,685    3,971 
Payable for securities   -    203 
Federal income tax payable   1,518    - 
Deferred federal income taxes, net   -    135 
Accounts payable and other accrued expenses   23,305    17,954 
           
Total liabilities   569,931    529,203 
Commitments and contingencies (Note 16)          
           
Redeemable non-controlling interest   -    1,284 
           
Stockholders’ equity:          
Common stock, $.18 par value, authorized 33,333,333 shares ; issued 20,872,831 shares in 2012 and 2011   3,757    3,757 
Additional paid-in capital   122,475    122,487 
Retained earnings   97,964    94,440 
Accumulated other comprehensive income   7,899    6,446 
Treasury stock (1,609,374 shares in 2012 and 2011), at cost   (11,558)   (11,558)
           
Total stockholders’ equity   220,537    215,572 
           
   $790,468   $746,059 

 

The accompanying notes are an integral

part of the consolidated financial statements

 

F-3
 

 

HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

For the years ended December 31, 2012, 2011 and 2010

($ in thousands, except per share amounts)

 

   2012   2011   2010 
       (as adjusted)   (as adjusted) 
             
Gross premiums written  $389,842   $354,881   $320,973 
Ceded premiums written   (57,353)   (51,005)   (39,332)
Net premiums written   332,489    303,876    281,641 
Change in unearned premiums   (13,053)   (10,835)   (3,370)
Net premiums earned   319,436    293,041    278,271 
                
Investment income, net of expenses   15,293    15,880    14,849 
Net realized gains   1,943    3,633    8,402 
Finance charges   5,957    6,826    7,054 
Commission and fees   (1,145)   3,175    (1,575)
Other income   316    216    59 
                
Total revenues   341,800    322,771    307,060 
                
Losses and loss adjustment expenses   226,414    239,235    202,544 
Operating expenses   103,792    95,106    87,882 
Interest expense   4,634    4,631    4,598 
Amortization of intangible assets   3,586    3,586    3,665 
                
Total expenses   338,426    342,558    298,689 
                
Income (loss) before tax   3,374    (19,787)   8,371 
Income tax (benefit) expense   (474)   (8,954)   863 
Net income (loss)   3,848    (10,833)   7,508 
Less: Net income attributable to non-controlling interest   324    58    105 
                
Net income (loss) attributable to Hallmark Financial Services, Inc.  $3,524   $(10,891)  $7,403 
                
Net income (loss) per share attributable to               
Hallmark Financial Services, Inc. common stockholders:               
Basic  $0.18   $(0.55)  $0.37 
Diluted  $0.18   $(0.55)  $0.37 

 

The accompanying notes are an integral part

of the consolidated financial statements

 

F-4
 

 

HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

For the years ended December 31, 2012, 2011 and 2010

(In thousands)

 

   2012   2011   2010 
       (as adjusted)   (as adjusted) 
             
Net income (loss)  $3,848   $(10,833)  $7,508 
Other comprehensive income (loss):               
                
Change in net actuarial gain (loss)   37    (1,468)   (309)
                
Tax effect on change in net actuarial gain (loss)   (13)   514    108 
                
Unrealized holding gains arising during the period   4,388    191    10,324 
                
Tax effect on unrealized holding gains arising during the period