10-K 1 v404063_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, 2014

 

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. ¨

 

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. $151.0 million

 

Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date. 19,229,307 shares of common stock, $.18 par value per share, outstanding as of March 12, 2015.

 

 
 

  

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 five business units, each of which has a specific focus. Our Standard Commercial P&C business unit primarily handles standard commercial insurance and occupational accident insurance, our Workers Compensation business unit specializes in small and middle market workers compensation business, and our E&S Commercial business unit handles primarily commercial insurance products and services in the excess and surplus lines market. Our Hallmark Select business unit offers (i) general aviation insurance products and services, (ii) low and middle market commercial umbrella and excess liability insurance, (iii) medical professional liability insurance products and services and (iv) satellite launch insurance products. Our Personal Lines business unit focuses on non-standard personal automobile insurance and complementary personal insurance products and services.

 

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 358 independent agents primarily serving businesses in the non-urban areas of Texas, New Mexico, Oregon, Idaho, Montana, Washington, Utah, Wyoming, Arkansas, Hawaii and Missouri. In addition our Standard Commercial P&C business unit offers occupational accident coverage in Texas through an underwriting agency that specializes in the occupational accident insurance market.

 

Our Workers Compensation business unit offers small and middle market workers compensation insurance products. Our Workers Compensation business unit currently markets its products through a network of 108 independent agents in Texas and Montana, with a predominate portion of its distribution in Texas.

 

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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 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. Our E&S Commercial business unit markets its products in 26 states through 9 wholesale brokers, a program underwriter and 83 general agency offices, as well as 162 independent retail agents in Texas and Oregon.

 

Our Hallmark Select business unit offers small and middle market commercial excess liability, umbrella and general liability insurance on both an admitted and non-admitted basis; general aviation property/casualty insurance primarily for private and small commercial aircraft and airports; satellite launch property/casualty insurance products; and medical professional liability insurance on an excess and surplus lines basis. The small and middle market commercial excess liability, umbrella and general liability insurance underwritten by our Hallmark Select business unit focuses 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 Hallmark Select business unit markets these products through 113 wholesale brokers in 49 states. The aircraft liability and hull insurance products underwritten by our Hallmark Select 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 Hallmark Select business unit markets these general aviation insurance products through 182 independent specialty brokers in 48 states. The satellite launch property/casualty policies produced by our Hallmark Select business unit are 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. The medical professional liability insurance underwritten on an excess and surplus basis by our Hallmark Select business unit focuses on 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 Hallmark Select business unit markets these medical professional liability insurance products through 21 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 a renters insurance product that complements our non-standard auto offering and fits well in our distribution channel. During the fourth quarter of 2014, our Personal Lines business unit discontinued the low value dwelling/homeowner’s and manufactured homes insurance products it previously offered. Our Personal Lines business unit markets these policies through 3,302 independent retail agents in 14 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”). 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 five 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 and Hallmark Select business unit, as well as certain specialty risk programs (“Specialty Programs”) which are managed at the parent level. The Personal Segment 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, 2014, 2013 and 2012.

 

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   Year Ended December 31, 
   2014   2013   2012 
   (dollars in thousands) 
Gross Premiums Written:               
Standard Commercial Segment  $84,679   $87,147   $77,091 
Specialty Commercial Segment   324,547    296,108    235,695 
Personal Segment   63,992    76,772    77,056 
Total  $473,218   $460,027   $389,842 
                
Net Premiums Written:               
Standard Commercial Segment  $76,912   $79,466   $70,091 
Specialty Commercial Segment   230,638    235,655    186,053 
Personal Segment   16,802    45,644    76,345 
Total  $324,352   $360,765   $332,489 

 

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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, 2014.

 

 

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 2014, our Standard Commercial P&C business unit accounted for approximately 88% and our Workers Compensation business unit accounted for the remaining 12% 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, Hawaii and Missouri. 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. In addition our Standard Commercial P&C business unit offers occupational accident coverage in Texas through an underwriting agency that is a specialist in the occupational accident insurance market. Products offered by our Standard Commercial P&C 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.

 

  · 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.

 

  · 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.

 

  · Occupational accident.  Occupational accident insurance provides an alternative to statutory workers compensation insurance in Texas.  Coverage includes medical, short term disability and accidental death and dismemberment.

 

Our Standard Commercial P&C business unit markets its property/casualty insurance products through 358 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 22 year average tenure of the 15 agency groups that each produced more than $1.0 million in premium during the year ended December 31, 2014. During 2014, the top ten agency groups produced approximately 37%, 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 and Montana. 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. Our Workers Compensation business unit markets its products through 108 independent agencies operating in Texas and Montana, with a predominate portion of its distribution in Texas. During 2014, the top ten agency groups produced approximately 59%, and no individual agency group produced more than 20%, of the total premium volume of our Workers Compensation business unit.

 

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Specialty Commercial Segment

 

The Specialty Commercial Segment of our business includes our E&S Commercial business unit and our Hallmark Select business unit, as well as certain Specialty Programs which are managed at the parent level. During 2014, our E&S Commercial business unit accounted for approximately 73% of the aggregate premiums produced by the Specialty Commercial Segment, with our commercial umbrella and excess liability, general aviation, medical professional liability and satellite launch insurance products handled by our Hallmark Select business unit accounting for 18%, 5%, 2% and 1%, respectively. Our Specialty Programs accounted for the remaining 1% of the premium produced by the Specialty Commercial Segment during 2014.

 

E&S Commercial business unit. Our E&S Commercial business unit markets, underwrites, finances and services commercial lines insurance in 26 states with a particular emphasis on commercial automobile, general liability and commercial property risks produced 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 99% of the premium volume financed by PAAC.

 

Our E&S Commercial business unit focuses on middle market commercial risks 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 2014, commercial automobile, general liability and commercial property accounted for approximately 83%, 12% and 4%, 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. The commercial insurance products offered by our E&S Commercial 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.

 

  · 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.

 

  · 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.

  

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Our E&S Commercial business unit markets its products in 26 states through 9 wholesale brokers, a program underwriter and 83 general agency offices, as well as 162 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 2014, general agents produced 81%, the program underwriter produced 13%, retail agents produced 4% and wholesale brokers produced 2% of total premiums produced by our E&S Commercial business unit. During 2014, the top ten general agents produced approximately 46%, the top ten wholesale brokers produced approximately 2% and no general agent produced more than 9%, of the total premium volume of our E&S Commercial business unit. During the same period, the top ten retail agents produced approximately 3%, 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.

 

Hallmark Select business unit. Our Hallmark Select 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, general aviation property/casualty insurance primarily for private and small commercial aircraft and airports, satellite launch insurance products and medical professional liability insurance on an excess and surplus lines basis.

 

The small and middle market commercial excess liability, umbrella and general liability insurance underwritten by our Hallmark Select business unit is offered on 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 insurance products offered is transportation, specifically trucking for hire, specialty automobile and non-fleet automobile coverage. The Hallmark Select 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 the excess & umbrella and general liability insurance policies written by our Hallmark Select 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 insurance and general liability insurance products are offered through 113 wholesale brokers. During 2014, the top ten wholesale brokers accounted for 48% of our excess & umbrella and general liability premium volume, with no single wholesale broker accounting for more than 15%. During 2014, commercial excess liability risks accounted for 91% of the premiums, with the remaining 9% coming from commercial umbrella and general liability risks. The commercial excess & umbrella and general liability insurance products offered by our Hallmark Select 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.

 

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  · 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.

 

We presently cede 80% of the excess & umbrella and general liability risk on policies written by our Hallmark Select business unit.

 

Our Hallmark Select business unit markets, underwrites and services general aviation property/casualty insurance in 48 states. The subsidiaries marketing our general aviation insurance products 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. In addition, our Hallmark Select business unit offers satellite launch property/casualty policies marketed through underwriting agencies with technical knowledge of space insurance. The general aviation and satellite launch products offered by our Hallmark Select 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.

 

  · 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.
     
  · Satellite. We can retain up to $2.0 million per risk for satellite launches and in-orbit coverage for up to 12 months.

 

Our Hallmark Select business unit distributes its general aviation insurance products through 182 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 Hallmark Select business unit selectively determines the risks fitting its target niche for which it will prepare a quote. During 2014, the top ten independent specialty brokers produced approximately 30%, and no broker produced more than 6%, of the total general aviation premium volume of our Hallmark Select business unit. Our Hallmark Select business unit independently develops, underwrites and prices each general aviation 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 87% of the aircraft written in 2014 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 2014 was approximately $137,000. All general aviation policies produced by our Hallmark Select business unit are written through our insurance company subsidiaries.

 

Our Hallmark Select business unit markets medical professional liability insurance on an excess and surplus lines basis. Medical professional liability insurance provides coverage for third-party bodily injury claims resulting from professional services provided by physicians, surgeons, podiatrists and medical entities. Our Hallmark Select business unit distributes its medical professional liability insurance products through 21 wholesale brokers in 49 states.

 

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.

 

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Personal Segment / Personal Lines Business Unit

 

The Personal Segment of our business consists solely of our Personal Lines business unit. Our Personal Lines business unit markets and services non-standard personal automobile policies and renters insurance in 14 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.

 

  · 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.

 

During the fourth quarter of 2014, our Personal Lines business unit discontinued the low value dwelling/homeowner’s and manufactured homes insurance products it previously offered. Our Personal Lines business unit markets its products through 3,302 independent retail agents operating in its target geographic markets. Non-standard automobile represented 93% of the premiums produced during 2014. 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 2014, the top ten independent agency groups produced approximately 30%, and no individual agency group produced more than 8%, of the total premium volume of our Personal Lines business unit.

 

During 2014, personal automobile liability coverage accounted for approximately 82% and personal automobile physical damage coverage accounted for the remaining 18% 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 markets its products in 14 states directly for HIC, AHIC, HCM and HNIC.

 

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 and Hallmark Select 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.

 

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  · 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 strive 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.

 

  · 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.

 

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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 Hallmark Select business unit, the distribution of property/casualty insurance products by our business units is geographically concentrated. For the twelve months ended December 31, 2014, five states accounted for approximately 65% of the gross premiums written 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, 2014.

 

State  Standard
Commercial
Segment
   Specialty
Commercial
Segment
   Personal
Segment
   Total   Percent of
Total
 
   (dollars in thousands)     
                     
Texas  $33,864   $183,796   $17,745   $235,405    49.8%
Louisiana   -    24,347    -    24,347    5.1%
Arizona   -    1,125    17,506    18,631    3.9%
New Mexico   9,047    986    5,097    15,130    3.2%
Oregon   14,211    886    -    15,097    3.2%
All other states   27,557    113,407    23,644    164,608    34.8%
Total gross premiums written  $84,679   $324,547   $63,992   $473,218      
Percent of total   17.9%   68.6%   13.5%   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.

 

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.

 

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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, 
   2014   2013   2012 
Gross premiums written  $473,218   $460,027   $389,842 
                
Statutory loss & LAE ratio   64.8%   72.2%   72.0%
Statutory expense ratio   33.1%   34.7%   33.5%
Statutory combined ratio   97.9%   106.9%   105.5%

 

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, 2014, 2013 and 2012, our consolidated premium-to-surplus ratios were 154%, 184% and 188%, 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, 2014, our business units had a total of 91 claims managers, supervisors and adjusters with an average experience of approximately 16 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.

 

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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, 2014, 2013 and 2012, to the gross-of-reinsurance amounts reported in our balance sheets at December 31, 2014, 2013 and 2012.

 

   As of and for Year Ended December 31 
   2014   2013   2012 
   (dollars in thousands) 
Reserve for unpaid losses and LAE, net of reinsurance recoverables, January 1  $312,468   $263,832   $254,901 
Provision for losses and LAE for claims occurring in the current period   215,258    251,391    230,089 
(Decrease) increase in reserve for unpaid losses and LAE for claims occurring in prior periods   (5,203)   9,954    (3,675)
Payments for losses and LAE, net of reinsurance:               
Current period   (76,231)   (101,897)   (107,945)
Prior periods   (123,100)   (110,812)   (109,538)
Reserve for unpaid losses and LAE at December 31, net of reinsurance recoverable   323,192    312,468    263,832 
Reinsurance recoverable on unpaid losses and LAE at December 31   91,943    70,172    49,584 
Reserve for unpaid losses and LAE at December 31, gross of reinsurance  $415,135   $382,640   $313,416 

 

The $5.2 million favorable development, $10.0 million unfavorable development and $3.7 million favorable development in prior accident years recognized in 2014, 2013 and 2012, respectively, represent normal changes in our loss reserve estimates. In 2014 and 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 2013, 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.”)

 

The $5.2 million decrease in reserves for unpaid losses and LAE recognized in 2014 was attributable to $7.2 million favorable development on claims incurred in the 2013 accident year, $4.4 million unfavorable development on claims incurred in the 2012 accident year and $2.4 million favorable development on claims incurred in the 2011 and prior accident years. Our Standard Commercial P&C business unit, Personal Lines business unit, Workers Compensation business unit and Hallmark Select business unit accounted for $4.1 million, $2.9 million, $1.9 million and $1.0 million, respectively, of the decrease in reserves recognized during 2014. The decrease in reserves for our Standard Commercial P&C business unit was primarily related to our commercial auto and general liability lines of business. The decrease in reserves for our Personal Lines business unit was primarily attributable to the 2013 accident year. The decrease in reserves for our Workers Compensation business unit was attributable to the 2013, 2012 and 2011 and prior accident years. The decrease in reserves for our Hallmark Select business unit was primarily related to $0.9 million favorable development in our commercial excess liability line of business and $0.4 million favorable development in our medical professional liability products, partially offset by a $0.3 million unfavorable development in our general aviation line of business. These favorable developments were partially offset by unfavorable development of $4.7 million in our E&S Commercial business unit primarily related to our commercial auto liability and general liability lines of business.

 

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The $10.0 million increase in reserves for unpaid losses and LAE recognized in 2013 was attributable to $5.0 million unfavorable development on claims incurred in the 2012 accident year, $1.7 million unfavorable development on claims incurred in the 2011 accident year and $3.3 million unfavorable development on claims incurred in the 2010 and prior accident years. Our E&S Commercial business unit and Personal Lines business unit accounted for $16.0 million and $1.8 million of the increase in reserves recognized during 2013. The increase in reserves for our E&S Commercial business unit was primarily related to commercial auto liability line of business. The increase in reserves for our Personal Lines business unit was primarily related to personal auto in the 2012 accident year. These unfavorable developments were partially offset by favorable prior years’ loss development of $3.7 million in our Standard Commercial P&C business unit, $2.6 million in our Hallmark Select business unit and $1.5 million in our Workers Compensation business unit. The decrease in reserves for our Standard Commercial P&C business unit was primarily related to commercial auto and general liability line of business. The decrease in reserves for our Hallmark Select business unit was driven by $2.3 million of favorable claims development in the 2011 and prior accident years related to our aircraft liability lines of business, partially offset by $0.1 million unfavorable claims development in the 2012 accident year related to our aircraft hull coverage. Further contributing to the decrease in reserves for our Hallmark Select business unit was $0.4 million of favorable claims development in our excess & umbrella lines of business. The decrease in reserves for our Workers Compensation business unit was related to the 2012 and 2011 accident years.

 

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, Hallmark Select 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 Hallmark Select business unit was primarily related to our aircraft 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.

 

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, 2004 through 2014. 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

 

 

   2004   2005   2006   2007   2008   2009   2010   2011   2012   2013   2014 
A. Reserve for unpaid loss & LAE, net of reinsurance recoverables  $17,700   $25,997   $72,801   $120,849   $150,025   $176,250   $213,723   $254,901   $263,832   $312,468   $323,192 
                                                        
B. Net reserve re-estimated as of:                                                       
One year later   15,300    24,820    66,387    119,034    151,645    185,440    230,089    251,226    273,786    307,265      
Two years later   15,473    24,903    68,490    118,646    155,155    183,689    226,856    256,198    275,778           
Three years later   13,962    23,144    68,809    120,444    154,738    181,268    230,145    253,814                
Four years later   14,166    23,455    69,847    119,771    155,520    185,848    227,555                     
Five years later   13,163    24,425    71,879    123,949    158,842    184,995                          
Six years later   17,857    25,403    78,396    128,006    159,151                               
Seven years later   17,597    30,704    79,939    128,907                                    
Eight years later   17,605    32,395    80,439                                         
Nine years later   18,108    32,825                                              
Ten years later   18,005                                                   
                                                        
C. Net cumulative (deficiency) redundancy   (305)   (6,828)   (7,638)   (8,058)   (9,126)   (8,745)   (13,832)   1,087    (11,946)   5,203      
                                                        
D. Cumulative amount of claims paid, net of reserve recoveries through:                                                       
One year later   8,073    16,721    30,061    50,458    64,810    73,647    105,848    109,538    110,812    123,100      
Two years later   12,004    22,990    46,860    78,314    95,385    121,222    156,176    163,803    174,684           
Three years later   13,113    24,562    58,322    93,286    120,133    146,956    188,044    200,637                
Four years later   13,750    27,231    65,084    105,251    131,912    162,704    207,484                     
Five years later   13,102    28,833    71,082    112,029    140,618    172,330                          
Six years later   17,498    30,367    75,225    118,171    146,581                               
Seven years later   17,557    31,058    75,141    122,410                                    
Eight years later   17,551    33,171    83,865                                         
Nine years later   17,915    34,552                                              
Ten years later   18,158                                                   
                                                        
Net reserve-December 31   17,700    25,997    72,801    120,849    150,025    176,250    213,723    254,901    263,832    312,468    323,192 
Reinsurance recoverables   1,948    324    4,763    4,489    6,338    8,412    37,954    42,044    49,584    70,172    91,943 
Gross reserve-December 31   19,648    26,321    77,564    125,338    156,363    184,662    251,677    296,945    313,416    382,640    415,135 
                                                        
Net re-estimated reserve   18,005    32,825    80,439    128,907    159,151    184,995    227,555    253,814    275,778    307,265      
Re-estimated reinsurance recoverable   1,050    1,776    6,704    7,919    10,400    9,178    37,977    42,190    49,664    68,599      
Gross re-estimated reserve   19,055    34,601    87,143    136,826    169,551    194,173    265,532    296,004    325,442    375,864      
                                                        
Gross cumulative redundancy (deficiency)  $593   $(8,280)  $(9,579)  $(11,488)  $(13,188)  $(9,511)  $(13,855)  $941   $(12,026)  $6,776      

 

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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, 2014 was with reinsurers that had 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.

 

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 
   2014   2013   2012 
Gross premiums written  $473,218   $460,027   $389,842 
Ceded premiums written   (148,866)   (99,262)   (57,353)
Net premiums written  $324,352   $360,765   $332,489 
Gross premiums earned  $461,694   $437,226   $373,849 
Ceded premiums earned   (140,477)   (76,685)   (54,413)
Net premiums earned  $321,217   $360,541   $319,436 
Reinsurance recoveries  $99,911   $45,456   $29,014 

 

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.   Effective July 1, 2014 the terms of our property catastrophe reinsurance are:

 

  o We retain the first $3.0 million of property catastrophe losses; and

 

  o Our reinsurers reimburse us 100% for any loss occurrence in excess of our $3.0 million retention up to $32.0 million for each catastrophic occurrence, subject to an aggregate limit of $64.0 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:

 

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

 

  o Our 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

 

  o Individual 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:

 

  o We retain the first $1.0 million of any commercial liability risk; and
     
  o Our reinsurers reimburse us for the next $5.0 million for each commercial liability risk.

 

  · Aviation. We purchase proportional reinsurance where we currently cede 80% of the risk to reinsurers on the aviation risks produced in all states by our Hallmark Select business unit.  

 

  · Occupational Accident.  We purchase excess-of-loss reinsurance coverage for the occupational accident insurance product produced by our Standard Commercial P&C business unit.  The terms of our occupational accident reinsurance are:

 

  o We retain the first $1.0 million of any occupational accident risk; and
     
  o Our reinsurers reimburse us for the next $5.0 million for each occupational accident risk up to $10.0 million for each occurrence.

 

  · 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:

 

  o We retain the first $1.0 million of each workers compensation loss; and
     
  o Our 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.

 

  ·

Personal Property. Effective March 1, 2014, we purchased proportional reinsurance where we cede 80% of the risks to reinsurers on the low value dwelling/homeowners, renters and manufactured homes coverages produced in all states by our Personal Lines business unit. For policies written effective February 1, 2013 through February 28, 2014, we ceded 60% of these risks to reinsurers.

 

  ·

Personal Auto. Effective October 1, 2014 we purchased proportional reinsurance where we cede 50% of the risks to reinsurers on the nonstandard automobile risks produced in certain states by our Personal Lines business unit. For policies written effective October 1, 2013 through September 30, 2014, we ceded 90% of these risks to reinsurers.

 

  · Standard Commercial P&C. We purchase proportional reinsurance where we currently 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 currently retain 20% of each risk and cede the remaining 80% to reinsurers on the commercial umbrella and excess liability insurance produced by our Hallmark Select business unit.

 

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  · Professional Liability.  Effective June 1, 2014, we purchased excess of loss reinsurance on our medical professional liability risks produced by our Hallmark Select business unit. The terms of our professional liability reinsurance are as follows:

 

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

 

oOur reinsurers reimburse us for the next $2.0 million for each professional liability loss occurrence.

 

Prior to June 1, 2014, we purchased proportional reinsurance on our medical professional liability risks produced by our Hallmark Select business unit where we retained 60% of each risk and ceded the remaining 40% to the reinsurers.

 

  · E&S Commercial. We purchase facultative reinsurance on our commercial umbrella and excess liability risks produced by our E&S Commercial business unit where we currently retain 10% of the first $1.0 million of risk and cede the remaining 90% to reinsurers. We currently cede to reinsurers 100% of our commercial umbrella and excess liability risks in excess of $1.0 million. Effective May 1, 2014, we purchased proportional reinsurance on the commercial auto liability risks produced by a program underwriter in our E&S Commercial business unit where we retain 20% of each risk and cede the remaining 80% to reinsurers.
     
  · Hallmark County Mutual. HCM is used to front certain lines of business in our Specialty Commercial and Personal Segments in Texas. In addition, HCM is used to front business produced by unaffiliated third parties. HCM does not retain any business.

 

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, 2014, we had total invested assets of $507.2 million. If market rates were to increase by 1%, the fair value of our fixed-income securities as of December 31, 2014 would decrease by approximately $13.4 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, 2014 and 2013.

 

   As of December 31, 2014   As of December 31, 2013 
   Fair   Percent of       Fair   Percent of     
   Value   Total   Yield   Value   Total   Yield 
   (in thousands)   (in thousands) 
                         
Category:                              
Corporate bonds  $29,442    6.5%   3.5%  $43,875    10.7%   3.8%
Collateralized corporate bank loans   113,649    25.2%   4.0%   102,178    24.9%   4.0%
Municipal bonds   162,329    36.0%   4.5%   157,552    38.4%   5.0%
US Treasury securities and obligations of U.S. Government   93,305    20.7%   0.7%   78,753    19.2%   0.5%
Mortgage backed   52,060    11.6%   2.3%   27,737    6.8%   2.7%
                             
Total  $450,785    100.0%   3.3%  $410,095    100.0%   3.6%

 

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 A- at December 31, 2014. 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, 2014 and 2013:

 

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   As of   As of 
   December 31, 2014   December 31, 2013 
Rating:          
"AAA"   8.1%   0.9%
"AA"   43.7%   33.7%
"A"   8.1%   22.4%
"BBB"   15.3%   18.9%
"BB"   17.7%   18.6%
"B"   3.2%   4.5%
"CCC"   0.0%   0.7%
"NR"   3.9%   0.3%
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, 2014 and 2013.

 

   As of December 31, 2014   As of December 31, 2013 
       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  $50,329    11.2%  $71,969    17.6%
One to five years   185,525    41.2%   163,006    39.7%
Five to ten years   109,925    24.4%   108,761    26.5%
More than ten years   52,946    11.7%   38,622    9.4%
Mortgage-backed   52,060    11.5%   27,737    6.8%
Total  $450,785    100.0%  $410,095    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, 2014, 11% 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.

 

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The following table details the net unrealized gain balance by invested asset category as of December 31, 2014.

 

   Net Unrealized Gain Balance 
Category  (in thousands) 
Corporate bonds  $799 
Collateralized corporate bank loans   (1,709)
Municipal bonds   783 
Equity securities   31,084 
U.S. Treasury securities and obligations of U.S. Government   25 
Mortgage-backed   117 
Total  $31,099 

 

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 various operations to share systems solutions and communicate to the corporate 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.

 

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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 3,087 property/casualty insurance companies and 2,134 property/casualty insurance groups operating in North America as of July 14, 2014. 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 the occupational accident insurance product offered by our Standard Commercial P&C unit includes such carriers as Great American Insurance Group, One Beacon Insurance Company, North American Insurance Company and Service Lloyds. 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 Atlantic Casualty Insurance Company, Colony Insurance Company, National Casualty Company, National Liability & Fire Insurance Company, Northland Insurance Company, Scottsdale Insurance Company and Progressive County Mutual. Our Hallmark Select business unit considers its primary competition for our excess & umbrella and general liability insurance products to include such carriers as American International Group, Inc., First Mercury Insurance Company, Axis Insurance Company, XL Specialty Insurance, 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. The primary competitors for our general aviation insurance products produced by our Hallmark Select business unit are Phoenix Aviation Managers, Starr Aviation, Chartis, United States Specialty Insurance Company, W. Brown & Company, United States Aircraft Insurance Group, Global Aerospace and Allianz Aviation Managers. The primary competition for the medical professional liability insurance products produced by our Hallmark Select business unit are Admiral Insurance Company, Catlin Insurance Company, CNA Financial Corporation, Evanston Insurance Company, Kinsale Insurance Company, Lexington Insurance Company, ProAssurance Corporation, RSUI Group and TDC Companies. 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.

 

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 and HNIC are domiciled in Arizona and HSIC is domiciled in Oklahoma. Therefore, our insurance operations are regulated by the Texas Department of Insurance, the Arizona Department of Insurance and the Oklahoma Insurance Department, 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.

 

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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 and the Oklahoma 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.

 

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 companies 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 and HNIC, both 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 and 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 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. 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, 2014, 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.

 

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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.

 

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;

 

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  · 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, 2014, we employed 393 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.

 

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.

 

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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, 2014 unpaid losses and LAE would have produced a $4.2 million change to pretax earnings. Our gross loss and LAE reserves totaled $415.1 million at December 31, 2014. Our loss and LAE reserves, net of reinsurance recoverable on unpaid loss and LAE, were $323.2 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 happened, 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 3,087 property/casualty insurance companies and 2,134 property/casualty insurance groups operating in North America as of July 14, 2014. 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, 2014, we had a total of $163.1 million due us from reinsurers, including $109.7 million of recoverables from losses and $53.4 million in ceded unearned premiums. The largest amount due us from a single reinsurer as of December 31, 2014 was $20.4 million reinsurance and premium recoverable from Swiss Reinsurance America Corporation. 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.

 

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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.

 

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;

 

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  · 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.

 

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 2015 by our insurance company subsidiaries is $16.2 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.

 

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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, 2014, 89% 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, 35% 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, 2014 was $450.8 million. If market interest rates were to increase 1%, the fair value of our fixed-income securities would decrease by approximately $13.4 million as of December 31, 2014. The calculated change in fair value was determined using duration modeling assuming no prepayments.

 

In addition to the general risks described above, although 75% 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, 2014, Hallmark had $0.3 million exposed in its investment portfolio to sub-prime mortgages and $52.1 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.

 

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.

 

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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 65% of our gross written premiums for 2014: Texas (50%), Louisiana (5%), Arizona (4%), New Mexico (3%) and Oregon (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.

 

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 sometime 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.

 

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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 $48,664 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 $17,269 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 $32,632 per month pursuant to a lease that expires November 30, 2020.

 

Our Hallmark Select business unit is located at 15280 Addison Road, Suite 250, Addison, Texas. The suite is located in a low-rise office building and contains an aggregate of 8,219 square feet of space. The rent is currently $9,564 per month pursuant to a lease that expires July 31, 2018. Our Hallmark Select business unit also maintains branch offices in the following locations:

 

Location  Monthly Rent   Lease Expiration
        
Atlanta, Georgia  $1,200   May 31, 2015
         
Glendale, California  $2,500   July 31, 2015
         
Chicago, Illinois  $8,472   April 30, 2017

 

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 $27,931 per month pursuant to a lease that expires December 31, 2020.

 

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Item 3. Legal Proceedings.

 

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, likely 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, 2013.

 

Period  High Sale   Low Sale 
Year Ended December 31, 2014:          
First quarter  $9.25   $8.15 
Second quarter   11.06    8.05 
Third quarter   11.05    8.66 
Fourth quarter   12.43    9.96 
           
Year Ended December 31, 2013:          
First quarter  $9.67   $8.36 
Second quarter   9.40    8.03 
Third quarter   10.03    8.18 
Fourth quarter   9.52    8.05 

 

Holders

 

As of March 2, 2015, there were 1,855 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. HIC and HNIC, both domiciled in Arizona, are 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. 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, 2014.

 

Plan Category  Number of securities to be
issued upon exercise of
outstanding options, warrants
and rights
   Weighted-average
exercise price of
outstanding options,
warrants and rights
   Number of securities
remaining available for future
issuance under equity
compensation plans
[excluding securities reflected
in column (a)](1)
 
   (a)   (b)   (c) 
             
Equity compensation plans approved by security holders   1,062,134   $9.51    358,850 
Equity compensation plans not approved by security holders   -    -    - 
Total   1,062,134   $9.51    358,850 

 

(1) Securities remaining available for future issuance are net of a maximum of 427,824 shares of common stock issuable pursuant to outstanding restricted stock units, subject to applicable vesting requirements and performance criteria.  See Note 13 to the audited consolidated financial statements included in this report.

 

Issuer Repurchases

 

Our stock buyback program initially announced on April 18, 2008, authorized the repurchase of up to 1,000,000 shares of our common stock in the open market or in privately negotiated transactions (the “Stock Repurchase Plan”). On January 24, 2011, we announced an increased authorization to repurchase up to an additional 3,000,000 shares. The Stock Repurchase Plan does not have an expiration date.

 

The following table furnishes information for purchases made pursuant to the Stock Repurchase Plan during the quarter ended December 31, 2014:

 

   Total Number of
Shares  Purchased
   Average Price
Paid Per Share
   Cumulative Number of
Shares Purchased as
Part of Publicly
Announced Plan
   Maximum
Number  of
Shares that May
Yet Be
Purchased
Under the Plan
 
   (a)   (b)   (c)   (d) 
                 
October 1st - October 31st   39,683   $10.35    1,807,003    2,192,997 
November 1st – November 30th   -   $-    1,807,003    2,192,997 
December 1st – December 31st   -   $-    1,807,003    2,192,997 

  

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Performance Graph

 

The following graph compares the five year cumulative 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, 2009 and its relative performance is tracked through December 31, 2014.

 

 

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Item 6. Selected Financial Data

 

   Year Ended December 31 
   2014   2013   2012   2011   2010 
   (in thousands, except per share data) 
Statement of Operations Data:                         
Gross premiums written  $473,218   $460,027   $389,842   $354,881   $320,973 
Ceded premiums written   (148,866)   (99,262)   (57,353)   (51,005)   (39,332)
Net premiums written   324,352    360,765    332,489    303,876    281,641 
Change in unearned premiums   (3,135)   (224)   (13,053)   (10,835)   (3,370)
Net premiums earned   321,217    360,541    319,436    293,041    278,271 
                          
Investment income, net of expenses   12,383    12,884    15,293    15,880    14,849 
Net realized gains   134    10,540    1,943    3,633    8,402 
Finance charges   5,279    5,830    5,957    6,826    7,054 
Commission and fees   (1,694)   (487)   (1,145)   3,175    (1,575)
Other income   47    120    316    216    59 
Total revenues   337,366    389,428    341,800    322,771    307,060 
                          
Loss and loss adjustment expenses   210,055    261,345    226,414    239,235    202,544 
Operating expenses   101,427    109,289    103,792    95,106    87,882 
Interest expense   4,576    4,599    4,634    4,631    4,598 
Amortization of intangible assets   2,526    3,115    3,586    3,586    3,665 
Total expenses   318,584    378,348    338,426    342,558    298,689 
                          
Income (loss) before tax   18,782    11,080    3,374    (19,787)   8,371 
Income tax expense (benefit)   5,353    2,835    (474)   (8,954)   863 
Net income (loss)   13,429    8,245    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.   13,429    8,245    3,524    (10,891)   7,403 
                          
Net income (loss) per share attributable to Hallmark Financial Services, Inc. common stockholders:                         
Basic  $0.70   $0.43   $0.18   $(0.55)  $0.37 
Diluted  $0.69   $0.43   $0.18   $(0.55)  $0.37 

 

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   As of December 31, 2014 
Balance Sheet Items:  2014   2013   2012   2011   2010 
Total investments  $507,229   $461,325   $445,360   $424,628   $432,441 
Total assets  $980,869   $909,023   $790,468   $746,059   $736,557 
Reserves for unpaid loss and loss adjustment expenses  $415,135   $382,640   $313,416   $296,945   $251,677 
Unearned premiums  $196,826   $185,303   $162,502   $146,104   $140,965 
Total liabilities  $728,832   $670,905   $569,931   $529,203   $499,919 
Total stockholders' equity  $252,037   $238,118   $220,537   $215,572   $235,278 
                          
Book value per share  $13.11   $12.36   $11.45   $11.19   $11.69 

 

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 and occupational accident 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.

 

  · Specialty Commercial Segment. Our Specialty Commercial Segment includes the excess and surplus lines commercial property/casualty insurance products and services handled by our E&S Commercial business unit and the general aviation, satellite launch, commercial umbrella and excess liability and medical professional liability insurance products and services handled by our Hallmark Select 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 Hallmark Select business unit is comprised of our Aerospace Insurance Managers, ASRI, ACMG, HXS and HDS subsidiaries.

 

  · Personal Segment. The Personal Segment includes the non-standard personal automobile, low value dwelling/homeowners, renters and manufactured homes, 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.

 

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The retained premium produced by these reportable segments is supported by our American Hallmark Insurance Company of Texas, Hallmark Specialty Insurance Company, Hallmark Insurance Company, Hallmark National Insurance Company and Texas Builders Insurance Company insurance subsidiaries. In addition, control and management of Hallmark County Mutual 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.

 

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.

 

Impairment 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. 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, 2014 and 2013, there was no premium deficiency related to deferred policy acquisition costs.

 

Goodwill. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (October 1) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. For purposes of evaluating goodwill for impairment, we have determined that our reporting units are the same as our business units except for the Hallmark Select business unit for which reporting units are at the component level (“one level below”). Our consolidated balance sheet as of December 31, 2014 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 - $19.8 million; Hallmark Select business unit- $17.4 million (comprised of $7.7 million for the excess & umbrella component and $9.7 million for the general aviation and satellite component); and Personal Lines business unit - $5.4 million. This amount has been recorded as a result of prior business acquisitions accounted for under the acquisition 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 2014 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 rate environment across most of our lines of business that continued throughout 2014. 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 2014. However, a 7% decline in the fair value of our Standard Commercial P&C business unit, a 13% decline in the fair value of our E&S Commercial business unit, a 28% decline in the fair value of our Personal Lines business unit, a 52% decline in the fair value of our excess & umbrella component or a 12% decline in the fair value of our general aviation and satellite component would have caused the carrying value of the respective reporting 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 2014. 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 financial market conditions, 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, 2014. Through December 31, 2014, 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 basis 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, 2014 reserves for unpaid losses and LAE would have produced a $4.2 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, 2014 was $356.1 million to $438.1 million. Our best estimate of unpaid losses and LAE as of December 31, 2014 is $415.1 million. Our carried reserve for unpaid losses and LAE as of December 31, 2014 is comprised of $223.1 million in case reserves and $192.0 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 $18.0 million higher than the midpoint or 94.8% of the high end of the actuarial range at December 31, 2014 as compared to $19.5 million above the midpoint or 98.5% of the high end of the actuarial range at December 31, 2013. 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 
   7/1/2001   7/1/2002   7/1/2003   7/1/2004 
Provisional loss ratio   60.0%   59.0%   59.0%   64.2%
                     
Estimated ultimate loss ratio recorded at December 31, 2014   63.5%   64.5%   61.2%   66.0%
                     
Effect of actual 5.0% above estimated loss ratio at December 31, 2014   -    -   $(3,360)  $(3,790)
                     
Effect of actual 5.0% below estimated loss ratio at December 31, 2014  $1,850   $3,055   $2,734   $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 
   1/1/2006   1/1/2007   1/1/2008 
Provisional loss ratio   65.0%   65.0%   65.0%
                
Estimated ultimate loss ratio recorded at December 31, 2014   58.7%   63.6%   59.5%
                
Effect of actual 5.0% above estimated loss ratio at December 31, 2014  $(3,096)  $(658)  $(1,618)
                
Effect of actual 5.0% below estimated loss ratio at December 31, 2014  $2,911   $2,351   $1,618 

 

Results of Operations

 

Comparison of Years ended December 31, 2014 and December 31, 2013

 

Management overview. During fiscal 2014, our total revenues were $337.4 million, representing an approximately 13% decrease over the $389.4 million in total revenues for fiscal 2013. The decrease in revenue was primarily attributable to lower net earned premiums in our Personal Segment due to a new quota share reinsurance contract entered into during the fourth quarter of 2013 on our non-standard automobile risk produced in certain states. Further contributing to the decrease in revenue were significant realized gains recognized in our investment portfolio for the year ended December 31, 2013, lower net investment income and adverse profit share commission revenue adjustments in our Standard Commercial Segment for the year ended December 31, 2014.

 

The decrease in revenue for the year ended December 31, 2014 was offset by decreased loss and LAE of $51.3 million as compared to the same period of 2013. During the twelve months ended December 31, 2014 we recorded $5.2 million of favorable prior year loss development. During the twelve months ended December 31, 2013 we recorded $10.0 million of unfavorable prior year loss development. The decrease in loss and LAE occurred despite a $4.8 million increase in net catastrophe losses to $15.0 million during the year ended December 31, 2014 from $10.2 million reported for the same period of 2013. Other operating expenses also decreased due mostly to decreased production related expenses in our Specialty Commercial Segment and Personal Segment, partially offset by $3.0 million of costs related to higher salary and related expenses due mostly to increased incentive compensation accruals compared to the prior period, $0.7 million of CEO transition costs and $0.2 million of costs related to a previously announced public debt offering.

 

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We reported net income of $13.4 million for the year ended December 31, 2014, as compared to net income of $8.2 million for the year ended December 31, 2013. On a diluted per share basis, net income was $0.69 per share for fiscal 2014 as compared to net income of $0.43 per share for fiscal 2013.

 

Segment information

 

The following is additional business segment information for the years ended December 31, 2014 and 2013 (in thousands):

 

   Year Ended December 31, 2014 
   Standard
Commercial Segment
   Specialty Commercial
Segment
   Personal Segment   Corporate   Consolidated 
   2014   2013   2014   2013   2014   2013   2014   2013   2014   2013 
Gross premiums written  $84,679   $87,147   $324,547   $296,108   $63,992   $76,772   $-   $-   $473,218   $460,027 
Ceded premiums written   (7,767)   (7,681)   (93,909)   (60,453)   (47,190)   (31,128)   -    -    (148,866)   (99,262)
Net premiums written   76,912    79,466    230,638    235,655    16,802    45,644    -    -    324,352    360,765 
Change in unearned premiums   1,399    (1,290)   (1,815)   (17,090)   (2,719)   18,156    -    -    (3,135)   (224)
Net premiums earned   78,311    78,176    228,823    218,565    14,083    63,800    -    -    321,217    360,541 
                                                   
Total revenues   81,464    83,306    241,920    229,734    20,404    71,081    (6,422)   5,307    337,366    389,428 
                                                   
Losses and loss adjustment expenses   51,130    56,143    149,961    152,546    8,964    52,656    -    -    210,055    261,345 
                                                   
Pre-tax income (loss)   4,595    1,980    34,237    19,527    1,226    (3,416)   (21,276)   (7,011)   18,782    11,080 
                                                   
Net loss ratio (1)   65.3%   71.8%   65.5%   69.8%   63.7%   82.5%             65.4%   72.5%
Net expense ratio (1)   33.3%   32.2%   25.6%   26.6%   43.3%   26.7%             30.5%   29.2%
Net combined ratio (1)   98.6%   104.0%   91.1%   96.4%   107.0%   109.2%             95.9%   101.7%
                                                   
Favorable (Unfavorable) Prior Year Development   6,033    5,235    (3,721)   (13,381)   2,891    (1,808)             5,203    (9,954)

 

1 The 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 as total underwriting expenses 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.

 

Standard Commercial Segment.

 

Gross premiums written for the Standard Commercial Segment were $84.7 million for the year ended December 31, 2014, which was $2.4 million, or approximately 3%, less than the $87.1 million reported for the same period in 2013. Net premiums written were $76.9 million for the year ended December 31, 2014 as compared to $79.5 million reported for the same period in 2013. The decrease in premium volume was primarily due to decreased premium production in our Standard Commercial P&C business unit.

 

Total revenue for the Standard Commercial Segment of $81.5 million for the year ended December 31, 2014 was $1.8 million less than the $83.3 million reported during the year ended December 31, 2013. This 2% decrease in total revenue was mostly due to an increased adverse profit share commission revenue adjustment of $1.6 million and lower net investment income of $0.3 million, partially offset by higher net earned premiums of $0.1 million.

 

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Our Standard Commercial Segment reported pre-tax income of $4.6 million for the year ended December 31, 2014 which was $2.6 million higher than the $2.0 million reported for the same period of 2013. The increase in pre-tax income for the Standard Commercial Segment was the result of lower loss and LAE of $5.0 million, partially offset by higher operating expenses of $0.6 million primarily consisting of higher professional services and higher salary and related expenses. The increase in pre-tax income for the Standard Commercial Segment was further partially offset by the decreased revenue discussed above.

 

The net loss ratio for the year ended December 31, 2014 was 65.3% as compared to the 71.8% reported for the year ended December 31, 2013. The gross loss ratio before reinsurance was 71.7% for the year ended December 31, 2014 as compared to 67.8% for the prior year. The increase in the gross loss ratio was primarily due to $16.9 million of gross catastrophe losses for the year ended December 31, 2014 as compared to $6.0 million for the same period during 2013. The net loss ratio improved primarily due to $10.7 million of ceded loss recoveries during the year ended December 31, 2014 as compared to $2.1 million reported for the same period in 2013. The Standard Commercial Segment reported $13.4 million of net catastrophe losses for the year ended December 31, 2014 as compared to $6.0 million for the same period during 2013.

 

Specialty Commercial Segment.

 

Gross premiums written for the Specialty Commercial Segment were $324.5 million for the year ended December 31, 2014, which was $28.4 million, or approximately 10%, more than the $296.1 million reported for the same period in 2013. Net premiums written were $230.6 million for the year ended December 31, 2014 as compared to $235.7 million reported for the same period in 2013. The lower net premiums written was primarily due to a quota share reinsurance agreement entered into during the third quarter of 2013 in our Hallmark Select business unit on our general aviation line of business and a quota share agreement entered into during the second quarter of 2014 on business produced by a program underwriter in our E&S Commercial business unit.

 

The $241.9 million of total revenue for the year ended December 31, 2014 was $12.2 million higher than the $229.7 million reported for 2013. This 5% increase in revenue was due to higher net premiums earned of $10.3 million due predominately to increased production discussed above. Further contributing to this increased revenue was higher net investment income of $1.6 million and higher commissions and fees revenue of $0.3 million.

 

Pre-tax income for the Specialty Commercial Segment of $34.2 million for the year ended December 31, 2014 was $14.7 million higher than the $19.5 million reported for the same period in 2013. The increase in pre-tax income was primarily due to the increased revenue discussed above, lower loss and LAE expenses of $2.6 million and lower amortization of intangible assets of $0.3 million, partially offset by higher operating expenses of $0.4 million. Our E&S Commercial business unit reported a $0.2 million decrease in loss and LAE for the year ended December 31, 2014 as compared to the same period of 2013. In addition, our Hallmark Select business unit reported a $2.3 million decrease in loss and LAE which consisted of (a) a $7.1 million decrease in loss and LAE primarily due to increased reinsurance recoveries on the general aviation quota share agreement entered into during the third quarter of 2013, (b) a $2.1 million increase in loss and LAE due to increased premium production in our commercial umbrella and excess liability line of business, (c) a $0.8 million increase in loss and LAE attributable to our medical professional liability insurance products and (d) a $1.9 million increase in loss and LAE in our satellite insurance products due primarily to the increased occurrence of insured satellite losses during the year. The increase in operating expense was the combined result of higher salary and related expenses of $1.5 million due primarily to increased incentive compensation accruals and higher other operating expenses of $0.4 million partially offset by lower production related expenses of $1.3 million due to increased ceding commissions on the quota share reinsurance agreements discussed above and lower professional services of $0.2 million.

 

The Specialty Commercial Segment reported a net loss ratio of 65.5% for the year ended December 31, 2014 as compared to 69.8% for the same period during 2013. The gross loss ratio before reinsurance was 65.7% for the year ended December 31, 2014 as compared to 68.5% for the same period in 2013. The lower gross and net loss ratio included $3.7 million of unfavorable prior year loss reserve development for the year ended December 31, 2014 as compared to $13.4 million of unfavorable prior year loss reserve development for the same period during 2013. The Specialty Commercial Segment reported $1.0 million in net catastrophe losses for the year ended December 31, 2014 as compared to $1.6 million for the same period of 2013. The Specialty Commercial Segment reported a net expense ratio of 25.6% for the year ended December 31, 2014 as compared to 26.6% reported for the same period the prior year. The decrease in the net expense ratio is due primarily to the effect of increased net earned premium on fixed operating expenses and the increased ceding commission on quota share reinsurance agreements discussed above.

 

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Personal Segment.

 

Gross premiums written for the Personal Segment were $64.0 million for the year ended December 31, 2014, which was $12.8 million less than the $76.8 million reported for the same period in 2013. Net premiums written for our Personal Segment were $16.8 million for the year ended December 31, 2014, which was a decrease of $28.8 million, or 63%, from the $45.6 million reported for the same period of 2013. The decrease in gross premiums written was due mostly to reduced business in our discontinued states and programs to focus on our ongoing core profitable business. The decrease in net premium written was due mostly to a new quota share reinsurance contract entered into during the fourth quarter of 2013 on our non-standard automobile risks produced in certain states.

 

Total revenue for the Personal Segment decreased 71% to $20.4 million for the year ended December 31, 2014 from $71.1 million the prior year. Lower net premiums earned of $49.7 million, lower net investment income of $0.4 million, decreased finance charges of $0.5 million and decreased other income of $0.1 million were the primary reasons for the decrease in revenue for the period.

 

Our Personal Segment reported pre-tax income of $1.2 million for the year ended December 31, 2014 as compared to a pre-tax loss of $3.4 million for the same period of 2013. The pre-tax income was the result of decreased losses and LAE of $43.7 million and lower operating expenses of $11.3 million, primarily due to lower production related expenses driven by increased ceding commission on the quota share agreements entered into during 2013, as well as lower amortization of intangible assets of $0.3 million. These increases in pre-tax income were partially offset by the decreased revenue discussed above.

 

The Personal Segment reported a net loss ratio of 63.7% for the year ended December 31, 2014 as compared to 82.5% for 2013. The gross loss ratio before reinsurance was 70.1% for the year ended December 31, 2014 as compared to 80.6% for the same period in 2013. The lower gross and net loss ratios were primarily the result of favorable prior year net loss reserve development. The loss and LAE for the year ended December 31, 2014 included $2.9 million of favorable prior years’ net loss reserve development as compared to $1.8 million of unfavorable prior years’ net loss reserve development for the same period of 2013. The Personal Segment reported $0.6 million of net catastrophe losses for the year ended December 31, 2014 as compared to $2.6 million for the same period in 2013. The Personal Segment reported a net expense ratio of 43.3% for the year ended December 31, 2014 as compared to 26.7% for the same period of 2013. The increase in the expense ratio was due predominately to the impact of the quota share reinsurance agreement entered into during the fourth quarter of 2013.

 

Corporate.

 

Total revenue for Corporate decreased by $11.7 million for the year ended December 31, 2014 as compared to the same period the prior year. This decrease in total revenue was due primarily to lower net realized gains on our investment portfolio of $10.4 million as compared to the same period of the prior year and lower net investment income of $1.3 million for the year ended December 31, 2014 as compared to the same period of the prior year.

 

Corporate pre-tax loss was $21.3 million for the year ended December 31, 2014 as compared to a $7.0 million pre-tax loss for the same period the prior year. The increase in pre-tax loss was the result of decreased revenue and higher operating expenses of $2.6 million during the year ended December 31, 2014 as compared to the same period the prior year due primarily to $0.8 million higher salary and related costs due mostly to increased incentive compensation accruals compared to the prior period, $0.7 million of CEO transition costs, $0.2 million of costs related to a previously announced public debt offering, $0.4 million of professional service fee expense and $0.5 million due primarily to increases recorded to the expected earn-out payable in conjunction with the previous acquisition of TBIC.

 

Comparison of Years ended December 31, 2013 and December 31, 2012

 

Management overview. During fiscal 2013, our total revenues were $389.4 million, representing an approximately 14% increase over the $341.8 million in total revenues for fiscal 2012. The growth in revenue was primarily attributable to increased premium production and resulting earned premium driven largely from our Specialty Commercial Segment and our Standard Commercial Segment. Further contributing to the increase in revenue were higher net realized gains on our investment portfolio and a lower adverse profit share commission revenue adjustment in our Standard Commercial Segment. These increases in revenue were partially offset by lower net investment income and lower year to date earned premium in our Personal Segment due mostly to the impact of discontinued products and a reduction of premium written in underperforming states.

 

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The increase in revenue for the year ended December 31, 2013 was accompanied by increased loss and LAE of $34.9 million as compared to the same period of 2012. During the twelve months ended December 31, 2013 we recorded $10.0 million of unfavorable prior year loss development. During the twelve months ended December 31, 2012 we recorded $3.7 million of favorable prior year loss development. The increase in loss and LAE occurred despite a $1.5 million decrease in catastrophe losses to $10.2 million during the year ended December 31, 2013 from $11.7 million reported for the same period of 2012. Other operating expenses also increased due mostly to increased production related expenses in our E&S Commercial business unit.

 

We reported net income of $8.2 million for the year ended December 31, 2013, as compared to net income of $3.5 million for the year ended December 31, 2012. On a diluted per share basis, net income attributable to Hallmark was $0.43 per share for fiscal 2013 as compared to net income of $0.18 per share for fiscal 2012.

 

Segment information.

 

The following is additional business segment information for the years ended December 31, 2013 and 2012 (in thousands):

 

   Year Ended December 31, 2013 
   Standard Commercial
Segment
   Specialty Commercial
Segment
   Personal Segment   Corporate   Consolidated 
   2013   2012   2013   2012   2013   2012   2013   2012   2013   2012 
Gross premiums written  $87,147   $77,091   $296,108   $235,695   $76,772   $77,056   $-   $-   $460,027   $389,842 
Ceded premiums written   (7,681)   (7,000)   (60,453)   (49,642)   (31,128)   (711)   -    -    (99,262)   (57,353)
Net premiums written   79,466    70,091    235,655    186,053    45,644    76,345    -    -    360,765    332,489 
Change in unearned premiums   (1,290)   (936)   (17,090)   (17,223)   18,156    5,106    -    -    (224)   (13,053)
Net premiums earned   78,176    69,155    218,565    168,830    63,800    81,451    -    -    360,541    319,436 
                                                   
Total revenues   83,306    73,119    229,734    178,917    71,081    89,149    5,307    615    389,428    341,800 
                                                   
Losses and loss adjustment expenses   56,143    52,828    152,546    103,980    52,656    69,606    -    -    261,345    226,414 
                                                   
Pre-tax income (loss), net of non-controlling interest   1,980    (2,486)   19,527    25,932    (3,416)   (8,535)   (7,011)   (11,861)   11,080    3,050 
                                                   
Net loss ratio (1)   71.8%   76.4%   69.8%   61.6%   82.5%   85.5%             72.5%   70.9%
Net expense ratio (1)   32.2%   33.2%   26.6%   28.3%   26.7%   28.5%             29.2%   30.8%
Net combined ratio (1)   104.0%   109.6%   96.4%   89.9%   109.2%   114.0%             101.7%   101.7%
                                                   
Favorable (Unfavorable) Prior Year Development   5,235    3,744    (13,381)   3,577    (1,808)   (3,646)             (9,954)   3,675 

 

1 The 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 as total underwriting expenses 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.

 

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Standard Commercial Segment.

 

Gross premiums written for the Standard Commercial Segment were $87.1 million for the year ended December 31, 2013, which was $10.0 million, or approximately 13%, more than the $77.1 million reported for the same period in 2012. Net premiums written were $79.5 million for the year ended December 31, 2013 as compared to $70.1 million reported for the same period in 2012. The increase in premium volume was primarily due to increased premium production in both our Standard Commercial P&C and Workers Compensation business units.

 

Total revenue for the Standard Commercial Segment of $83.3 million for the year ended December 31, 2013 was $10.2 million more than the $73.1 million reported during the year ended December 31, 2012. This increase in total revenue was the result of increased net earned premiums of $9.0 million, higher net investment income of $0.1 million and a $1.1 million lower adverse profit share commission revenue adjustment during the year ended December 31, 2013 as compared to the same period during 2012.

 

Our Standard Commercial Segment reported pre-tax income was $2.0 million for the year ended December 31, 2013 as compared to a pre-tax loss of $2.5 million for the same period of 2012. The increased revenue discussed above was the primary driver of the increased pre-tax income for the year ended December 31, 2013, partially offset by higher loss and LAE of $3.3 million and higher operating expenses of $2.4 million consisting primarily of higher production related expenses due to increased premium production.

 

The net loss ratio for the year ended December 31, 2013 was 71.8% as compared to the 76.4% reported for 2012. The gross loss ratio before reinsurance was 67.8% for the year ended December 31, 2013 as compared to 74.8% for the prior year. The lower gross and net loss ratios for the year ended December 31, 2013 were aided by lower catastrophe losses coupled with increased favorable prior year loss reserve development. The net loss ratios for the years ended December 31, 2013 and 2012 included catastrophe losses of $6.0 million and $9.5 million, respectively. During the years ended December 31, 2013 and 2012, the Standard Commercial Segment reported favorable loss reserve development of $5.2 million and $3.7 million, respectively. The Standard Commercial Segment reported a net expense ratio of 32.2% for the year ended December 31, 2013 as compared to 33.2% reported for the same period the prior year. The decrease in net expense ratio was due primarily to the increased premium volume.

 

Specialty Commercial Segment.

 

Gross premiums written for the Specialty Commercial Segment were $296.1 million for the year ended December 31, 2013, which was $60.4 million, or 26%, more than the $235.7 million reported for the same period in 2012. Net premiums written were $235.7 million for the year ended December 31, 2013 as compared to $186.1 million reported for the same period in 2012. The increase in premium volume was due to increased premium production in both our E&S Commercial and Hallmark Select business units.

 

The $229.7 million of total revenue for the year ended December 31, 2013 was $50.8 million higher than the $178.9 million reported for 2012. This 28% increase in revenue was due to higher net premiums earned of $49.7 million due predominately to increased production discussed above. Further contributing to this increased revenue was higher net investment income of $1.6 million partially offset by lower profit share commission revenue adjustment of $0.5 million for the year ended December 31, 2013 as compared to the same period of 2012.

 

Pre-tax income for the Specialty Commercial Segment of $19.5 million for the year ended December 31, 2013 was $6.4 million lower than the $25.9 million reported for the same period in 2012. The decrease in pre-tax income was primarily due to higher loss and LAE expenses of $48.6 million and higher operating expenses of $9.4 million, partially offset by lower amortization of intangible assets of $0.5 million, lower non-controlling interest of $0.3 million and the increased revenue discussed above. Our E&S Commercial business unit reported a $45.7 million increase in loss and LAE due primarily to increased premium volume and $16.0 million of unfavorable prior year loss reserve development as compared to $0.3 million of favorable development during the same period of 2012. In addition, our Hallmark Select business unit reported a $2.9 million increase in loss and LAE which consisted of (a) a $1.4 million increase in loss and LAE due to increased premium production in our commercial umbrella and excess liability line of business, (b) a $2.5 million increase in loss and LAE primarily due to large loss volatility in our aircraft hull coverage during fiscal 2013, (c) a $0.3 million increase in loss and LAE attributable to our medical professional liability insurance products and (d) a $1.3 million decrease in loss and LAE in our satellite insurance products due primarily to decreased premium volume as well as lower current accident year loss trends. The increase in operating expense was the combined result of increased production related expenses of $8.7 million, higher salary and related expenses of $0.4 million, higher professional service fees of $0.5 million partially offset by lower other operating expenses of $0.2 million.

 

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The Specialty Commercial Segment reported a net loss ratio of 69.8% for the year ended December 31, 2013 as compared to 61.6% for the same period during 2012. The gross loss ratio before reinsurance was 68.5% for the year ended December 31, 2013 as compared to 61.1% for the same period in 2012. The higher gross and net loss ratios included $13.4 million of unfavorable prior year loss reserve development for the year ended December 31, 2013 as compared to $3.6 million of favorable prior year loss reserve development for the same period during 2012. The Specialty Commercial Segment reported a net expense ratio of 26.6% for the year ended December 31, 2013 as compared to 28.3% reported for the same period the prior year. The decrease in the net expense ratio was due primarily to increased net premium volume.

 

Personal Segment.

 

Gross premiums written for the Personal Segment were $76.8 million for the year ended December 31, 2013, which was $0.3 million less than the $77.1 million reported for the same period in 2012. Net premiums written for our Personal Segment were $45.6 million in the year ended December 31, 2013, which was a decrease of $30.7 million, or 40%, from the $76.3 million reported for the same period of 2012. The decrease in net premium written was due mostly to exiting certain underperforming states and programs and quota share reinsurance contracts entered into during the first quarter of 2013 on our low value dwelling/homeowners, renters, and manufactured homes lines of business and during the fourth quarter of 2013 on our non- standard automobile risks produced in certain states.

 

Total revenue for the Personal Segment decreased 20% to $71.1 million for the year ended December 31, 2013 from $89.1 million the prior year. Lower net premiums earned of $17.7 million and lower net investment income of $0.4 million, partially offset by higher other income of $0.1 million, were the primary reason for the decrease in revenue for the period.

 

Our Personal Segment reported a pre-tax loss of $3.4 million for the year ended December 31, 2013 as compared to a pre-tax loss of $8.5 million for the same period of 2012. The lower pre-tax loss was the result of lower losses and LAE of $16.9 million and lower operating expenses of $6.2 million, primarily due to lower production related expenses driven by increased ceding commission on the quota share agreements entered into during 2013. The decline in pre-tax loss was partially offset by lower revenue discussed above.

 

The Personal Segment reported a net loss ratio of 82.5% for the year ended December 31, 2013 as compared to 85.5% for 2012. The gross loss ratio before reinsurance was 80.6% for the year ended December 31, 2013 as compared to 85.6% for the same period in 2012. The lower gross and net loss ratio were primarily the result of lower current accident year loss trends as well as lower unfavorable prior year loss reserve development for the year ended December 31, 2013 as compared to the same period of 2012. Loss and LAE during the years ended December 31, 2013 and 2012 included unfavorable prior years’ loss reserve development of $1.8 million and $3.6 million, respectively. The Personal Segment reported a net expense ratio of 26.7% for the year ended December 31, 2013 as compared to 28.5% for the same period of 2012. The decrease in the expense ratio was due predominately to lower production related expenses.

 

Corporate.

 

Total revenue for Corporate was $5.3 million for the year ended December 31, 2013 as compared to $0.6 million for the same period of 2012. Net realized gains recognized on our investment portfolio were $10.5 million for the year ended December 31, 2013 as compared to $1.9 million during the same period during 2012. Net investment income decreased $3.7 million for the year ended December 31, 2013 as compared to the same period during 2012. Other income decreased $0.2 million for the year ended December 31, 2013 as compared to the same period during 2012.

 

Corporate pre-tax loss was $7.0 million for the year ended December 31, 2013 as compared to a $11.9 million pre-tax loss for the same period the prior year. The decrease in pre-tax loss was the result of the increased revenue discussed above and lower operating expenses of $0.2 million due primarily to lower salary and related expenses during the year ended December 31, 2013 as compared to the same period the prior year.

 

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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, 2014, Hallmark had $11.8 million in unrestricted cash and cash equivalents. Unrestricted cash and cash equivalents of our non-insurance subsidiaries were $5.3 million as of December 31, 2014. As of that date, our insurance subsidiaries held $113.9 million of cash and cash equivalents as well as $450.8 million in debt securities with an average modified duration of 3.0 years. Accordingly, we do not anticipate selling long-term debt instruments to meet any liquidity needs.

 

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. HIC and HNIC, both domiciled in Arizona, are 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. For all our insurance companies, dividends may only be paid from unassigned surplus funds. During 2015, the aggregate ordinary dividend capacity of these subsidiaries is $24.3 million, of which $16.2 million is available to Hallmark. As a county mutual, dividends from HCM are payable to policyholders. During the year ended December 31, 2014, our insurance company subsidiaries paid $8.0 million in dividends to Hallmark. None of our insurance company subsidiaries paid a dividend during the year ended December 31, 2013.

 

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 $1.1 million, $8.2 million and $9.0 million during each of 2014, 2013 and 2012, 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, 2014, our insurance company subsidiaries reported statutory capital and surplus of $210.0 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, 2014, 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, 2014 and 2013 was 154% and 184%, respectively.

 

Comparison of December 31, 2014 to December 31, 2013

 

On a consolidated basis, our cash and investments, excluding restricted cash and investments, at December 31, 2014 were $638.2 million compared to $603.0 million at December 31, 2013. Cash flow from operations and an increase in investment fair values were the primary reasons for this increase.

 

Comparison of Years Ended December 31, 2014 and December 31, 2013

 

Net cash provided by our consolidated operating activities was $33.7 million for the year ended December 31, 2014 compared to $68.3 million for the year ended December 31, 2013. The decrease in operating cash flow was primarily due to increased ceded premium payments, partially offset by lower net paid losses and increased collected provisional ceding commission.

 

Cash used in investing activities during the year ended December 31, 2014 was $42.2 million as compared to $11.8 million for the prior year. The increase in cash used in investing activities was primarily attributable to a $68.0 million decrease in maturities, sales and redemptions of investment securities, partially offset by a $33.7 million decrease in purchases of investment securities, a $0.1 million decrease in purchases of property and equipment and a $3.8 million decrease in cash flow into restricted cash accounts.

 

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Cash used in financing activities during the year ended December 31, 2014 was $2.1 million as a result of a $1.5 million repayment on our revolving credit facility and $1.8 million related to the repurchase of our common stock, partially offset by $1.2 million related to proceeds from the exercise of employee stock options. There were no financing cash flow activities during the year ended December 31, 2013.

 

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, 2014, we had no outstanding borrowings under this revolving credit facility.

 

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 I”) 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, 2014, 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, 2014, 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, 2014. 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.

 

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   Estimated Payments by Period (in thousands) 
   Total   2015   2016-2017   2018-2019   After 2019 
                          
Subordinated debt securities  $56,702   $-   $-   $-   $56,702 
                          
Interest on subordinated debt securities   75,409    4,388    7,761    6,477    56,783 
                          
Unpaid losses and LAE (1)   415,135    169,468    145,310    43,512    56,845 
                          
Operating leases   10,940    1,922    3,659    2,927    2,432 
                          
Purchase obligations   3,083    2,154    929    -    - 

 

(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 2015 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.

 

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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, 2014 was $450.8 million. The effective duration of our portfolio as of December 31, 2014 was 3.0 years. Should interest rates increase 1.0%, our fixed-income investment portfolio would be expected to decline in market value by 3.0%, or $13.4 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 3.0%, or $13.4 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, 2014, our fixed-income investments were in the following: U.S. Treasury bonds – 20.7%; municipal bonds – 36.0%; collateralized corporate bank loans – 25.2%; corporate bonds – 6.5%; and asset-backed – 11.6%. As of December 31, 2014, 75.2% 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, 2014 was with reinsurers having 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 11.1% of our portfolio as of December 31, 2014. 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, 2014 was $56.4 million. The fair value of our equity securities would increase or decrease by $16.9 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 4.4%. The selected hypothetical change does not reflect what should be considered the best or worsed case scenario.

 

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, 2014 and 2013   F-3
Consolidated Statements of Operations for the Years Ended December 31, 2014, 2013 and 2012   F-4
Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2014, 2013 and 2012   F-5
Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2014, 2013 and 2012   F-6
Consolidated Statements of Cash Flows for the Years Ended December 31, 2014, 2013 and 2012   F-7
Notes to Consolidated Financial Statements   F-8
Financial Statement Schedules   F-43

 

55
 

  

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, 2014, 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 (2013 Framework). Based upon that evaluation, management has concluded that our internal control over financial reporting was effective as of December 31, 2014.

 

Ernst & Young LLP, the independent registered public accounting firm that audited our consolidated financial statements as of December 31, 2014 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, 2014. 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, 2014, is included in this Item under the heading “ Report of Independent Registered Public Accounting Firm.”

 

56
 

  

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, 2014, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 Framework) (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, 2014, 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, 2014 and 2013, and the related consolidated statements of operations, comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2014 of Hallmark Financial Services, Inc. and subsidiaries and our report dated March 12, 2015 expressed an unqualified opinion thereon.

 

  /s/ Ernst & Young LLP
Fort Worth, Texas  
March 12, 2015  

 

57
 

  

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.

 

58
 

  

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, 2014 and 2013

Consolidated Statements of Operations for the Years Ended December 31, 2014, 2013 and 2012

Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2014, 2013 and 2012

Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2014, 2013 and 2012

Consolidated Statements of Cash Flows for the Years Ended December 31, 2014, 2013 and 2012

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).
     
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).

 

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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).
     
4.17   Eleventh Amendment to First Restated Credit Agreement among Hallmark Financial Services, Inc. and its subsidiaries and Frost Bank dated July 26, 2013 (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed July 30, 2013).
     
4.18   Twelfth Amendment to First Restated Credit Agreement among Hallmark Financial Services, Inc. and its subsidiaries and Frost Bank dated August 8, 2014 (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed August 12, 2014).
     
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).
     
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).

 

60
 

  

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*   Hallmark Financial Services, Inc. Amended and Restated 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, 2013).
     
10.13*   Form of Restricted Stock Unit Award Agreement(incorporated by reference to Exhibit 10.13 to the registrant’s Form 10-K filed March 12, 2014).
     
10.14   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).
     
10.15   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).
     
10.16*  

Letter agreement dated August 13, 2014, between Hallmark Financial Services, Inc. and Naveen Anand (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed August 15, 2014).

 

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.
     
101 INS+   XBRL Instance Document.

 

61
 

  

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.

 

62
 

  

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 12, 2015 By: /s/ Naveen Anand
      Naveen Anand, Chief Executive Officer and
      President
       
Date: March 12, 2015 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 12, 2015   /s/ Naveen Anand
      Naveen Anand, Chief Executive Officer and
      President (Principal Executive Officer)
       
Date: March 12, 2015   /s/ Jeffrey R. Passmore
      Jeffrey R. Passmore, Chief Accounting Officer and Senior
      Vice President (Principal Financial Officer and Principal
      Accounting Officer)
       
Date: March 12, 2015   /s/ Mark E. Schwarz
      Mark E. Schwarz, Executive Chairman
       
Date: March 12, 2015   /s/ James H. Graves
      James H. Graves, Director
       
Date: March 12, 2015   /s/ Jim W. Henderson
      Jim W. Henderson, Director
       
Date: March 12, 2015   /s/ Scott T. Berlin
      Scott T. Berlin, Director

 

63
 

   

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, 2014 and 2013   F-3
     
Consolidated Statements of Operations for the Years Ended December 31, 2014, 2013 and 2012   F-4
     
Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2014, 2013 and 2012   F-5
     
Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2014, 2013 and 2012   F-6
     
Consolidated Statements of Cash Flows for the Years Ended December 31, 2014, 2013 and 2012   F-7
     
Notes to Consolidated Financial Statements   F-8
     
Financial Statement Schedules   F-43

 

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, 2014 and 2013, and the related consolidated statements of operations, comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2014. Our audits also included the financial statement schedules listed in Item 15(a)(2). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these 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 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, 2014 and 2013, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2014, 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 financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.

 

We also have audited in accordance with the standards of the Public Company Accounting Oversight Board (United States), Hallmark Financial Services, Inc. and subsidiaries internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 Framework) and our report dated March 12, 2015 expressed an unqualified opinion thereon.

 

  /s/ Ernst & Young LLP
   

Fort Worth, Texas

March 12, 2015

 

F-2
 

 

HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

December 31, 2014 and 2013

($ in thousands)

  

   2014   2013 
ASSETS          
Investments:          
Debt securities, available-for-sale, at fair value (cost; $450,770 in 2014 and $408,627 in 2013)  $450,785   $410,095 
Equity securities, available-for-sale, at fair value (cost; $25,360 in 2014 and $24,902 in 2013)   56,444    51,230 
Total investments   507,229    461,325 
Cash and cash equivalents   130,985    141,666 
Restricted cash   11,914    12,190 
Ceded unearned premiums   53,376    44,988 
Premiums receivable   71,003    71,157 
Accounts receivable   3,141    2,382 
Receivable for securities   932    1,320 
Reinsurance recoverable   109,719    76,818 
Deferred policy acquisition costs   20,746    22,586 
Goodwill   44,695    44,695 
Intangible assets, net   17,427    19,953 
Prepaid expenses   1,823    1,531 
Other assets   7,879    8,412 
Total assets  $980,869   $909,023 
LIABILITIES AND STOCKHOLDERS’ EQUITY          
Liabilities:          
Revolving credit facility payable  $-   $1,473 
Subordinated debt securities   56,702    56,702 
Reserves for unpaid losses and loss adjustment expenses   415,135    382,640 
Unearned premiums   196,826    185,303 
Reinsurance balances payable   26,403    20,598 
Pension liability   2,619    1,433 
Payable for securities   1,321    206 
Federal income tax payable   968    719 
Deferred federal income taxes, net   3,092    2,825 
Accounts payable and other accrued expenses   25,766    19,006 
Total liabilities   728,832    670,905 
Commitments and contingencies (Note 16)          
           
Stockholders’ equity:          
Common stock, $.18 par value, authorized 33,333,333 shares; issued 20,872,831 shares in 2014 and 2013   3,757    3,757 
Additional paid-in capital   123,194    122,827 
Retained earnings   119,638    106,209 
Accumulated other comprehensive income   17,801    16,883 
Treasury stock (1,655,306 shares in 2014 and 1,609,374 in 2013), at cost   (12,353)   (11,558)
           
Total stockholders’ equity   252,037    238,118 
           
Total liabilities and stockholders’ equity  $980,869   $909,023 

 

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, 2014, 2013 and 2012

($ in thousands, except per share amounts)

 

   2014   2013   2012 
Gross premiums written  $473,218   $460,027   $389,842 
Ceded premiums written   (148,866)   (99,262)   (57,353)
Net premiums written   324,352    360,765    332,489 
Change in unearned premiums   (3,135)   (224)   (13,053)
Net premiums earned   321,217    360,541    319,436 
                
Investment income, net of expenses   12,383    12,884    15,293 
Net realized gains   134    10,540    1,943 
Finance charges   5,279    5,830    5,957 
Commission and fees   (1,694)   (487)   (1,145)
Other income   47    120    316 
                
Total revenues   337,366    389,428    341,800 
                
Losses and loss adjustment expenses   210,055    261,345    226,414 
Operating expenses   101,427    109,289    103,792 
Interest expense   4,576    4,599    4,634 
Amortization of intangible assets   2,526    3,115    3,586 
                
Total expenses   318,584    378,348    338,426 
                
Income before tax   18,782    11,080    3,374 
Income tax expense (benefit)   5,353    2,835    (474)
Net income   13,429    8,245    3,848 
Less: Net income attributable to non-controlling interest   -    -    324 
                
Net income attributable to Hallmark Financial Services, Inc.  $13,429   $8,245   $3,524 
                
Net income per share attributable to Hallmark Financial Services, Inc. common stockholders:               
Basic  $0.70   $0.43   $0.18 
Diluted  $0.69   $0.43   $0.18 

 

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

For the years ended December 31, 2014, 2013 and 2012

($ In thousands)

 

   2014   2013   2012 
Net income  $13,429   $8,245   $3,848 
Other comprehensive income:               
Change in net actuarial (loss) gain   (1,723)   2,268    37 
Tax effect on change in net actuarial (loss) gain   603    (794)   (13)
Unrealized holding gains arising during the period   3,543    22,094    4,388 
Tax effect on unrealized holding gains arising during the period   (1,240)   (7,733)   (1,536)
Reclassification adjustment for gains included in net income   (408)   (10,540)   (2,189)
Tax effect on reclassification adjustment for gains included in net income   143    3,689    766 
                
Other comprehensive income, net of tax   918    8,984    1,453 
Comprehensive income  $14,347   $17,229   $5,301 
Less: comprehensive income attributable to non-controlling interest   -    -    324 
Comprehensive income attributable to Hallmark Financial Services, Inc.  $14,347   $17,229   $4,977 

 

The accompanying notes are an integral part of the consolidated financial statements

 

F-5
 

 

HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

For the years ended December 31, 2014, 2013 and 2012

($ In thousands)

  

   Number
of Shares
   Par Value   Additional
Paid-In
Capital
   Retained
Earnings
   Accumulated
Other
Comprehensive
Income
   Treasury
Stock
   Number
of
 Shares
   Total
Stockholders'
Equity
 
Balance at January 1, 2012   20,873   $3,757   $122,487   $94,440   $6,446   $(11,558)   1,609   $215,572 
Equity incentive plan activity   -    -    380    -    -    -    -    380 
Accretion of redeemable non-controlling interest   -    -    (392)   -    -    -    -    (392)
Net income   -    -    -    3,524    -    -    -    3,524 
Other comprehensive income, net of tax   -    -    -    -    1,453    -    -    1,453 
                                         
Balance at December 31, 2012   20,873   $3,757   $122,475   $97,964   $7,899   $(11,558)   1,609   $220,537 
Equity incentive plan activity   -    -    352    -    -    -    -    352 
Net income   -    -    -    8,245    -    -    -    8,245 
Other comprehensive income, net of tax   -    -    -    -    8,984    -    -    8,984 
                                         
Balance at December 31, 2013   20,873   $3,757   $122,827   $106,209   $16,883   $(11,558)   1,609   $238,118 
Acquisition of treasury stock   -    -    -    -    -    (1,805)   181    (1,805)
Equity incentive plan activity   -    -    222    -    -    -    -    222 
Stock options exercised   -    -    145    -    -    1,010    (135)   1,155 
Net income   -    -    -    13,429    -    -    -    13,429 
Other comprehensive income, net of tax   -    -    -    -    918    -    -    918 
                                         
Balance at December 31, 2014   20,873   $3,757   $123,194   $119,638   $17,801   $(12,353)   1,655   $252,037 

 

The accompanying notes are an integral part of the consolidated financial statements

 

F-6
 

  

HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the years ended December 31, 2014, 2013 and 2012

($ in thousands)

 

   2014   2013   2012 
Cash flows from operating activities:               
Net income  $13,429   $8,245   $3,848 
Adjustments to reconcile net income to cash provided by operating activities:               
Depreciation and amortization expense   3,224    4,300    4,421 
Deferred federal income taxes   (393)   (257)   (2,851)
Net realized gains   (134)   (10,540)   (1,943)
Share-based payments expense   222    352    380 
Change in ceded unearned premiums   (8,388)   (22,577)   (2,941)
Change in premiums receivable   154    (4,474)   (13,170)
Change in accounts receivable   (759)   728    836 
Change in deferred policy acquisition costs   1,840    2,325    (2,357)
Change in unpaid losses and loss adjustment expenses   32,495    69,224    16,471 
Change in unearned premiums   11,523    22,801    16,398 
Change in reinsurance recoverable   (32,901)   (24,848)   (9,236)
Change in reinsurance balances payable   5,805    13,268    4,191 
Change in current federal income tax payable   249    (799)   8,256 
Change in all other liabilities   7,946    (6,551)   5,396 
Change in all other assets   (628)   17,141    5,983 
Net cash provided by operating activities   33,684    68,338    33,682 
Cash flows from investing activities:               
Purchases of property and equipment, net   (546)   (673)   (107)
Net transfers from (into) restricted cash   276    (3,483)   665 
Purchases of investment securities   (188,749)   (222,399)   (167,626)
Maturities, sales and redemptions of investment securities   146,777    214,738    148,968 
Net cash used in investing activities   (42,242)   (11,817)   (18,100)
Cash flows from financing activities:               
Activity under revolving credit facility, net   (1,473)   -    (2,577)
Redemption of non-controlling interest   -    -    (1,700)
Distribution to non-controlling interest   -    -    (281)
Payment of contingent consideration   -    -    (350)
Proceeds from exercise of employee stock options   1,155    -    - 
Purchase of treasury shares   (1,805)   -    - 
Net cash used in financing activities   (2,123)   -    (4,908)
(Decrease) Increase in cash and cash equivalents   (10,681)   56,521    10,674 
Cash and cash equivalents at beginning of year   141,666    85,145    74,471 
Cash and cash equivalents at end of year  $130,985   $141,666   $85,145 
Supplemental cash flow information:               
Interest paid  $(4,576)  $(4,599)  $(4,656)
Income taxes (paid) recovered  $(5,497)  $(3,891)  $5,879 
Supplemental schedule of non-cash activities:               
Change in receivable for securities related to investment disposals that settled after the balance sheet date  $388   $(1,317)  $2,614 
Change in payable for securities related to investment purchases that settled after the balance sheet date  $1,115   $206   $(203)

 

The accompanying notes are an integral part of the consolidated financial statements

 

F-7
 

 

HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years ended December 31, 2014, 2013, and 2012

 

1.Accounting Policies:

 

General

 

Hallmark Financial Services, Inc. (“Hallmark” and, together with subsidiaries, the “Company”, “we,” “us” or “our”) is an insurance holding company engaged 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 five business units that are supported by our insurance company subsidiaries. Our Standard Commercial P&C business unit handles commercial insurance products and services and is comprised of American Hallmark Insurance Services, Inc. (“American Hallmark Insurance Services”) and Effective Claims Management, Inc. (“ECM”). Our Workers Compensation business unit specializes in small and middle market workers compensation business and is comprised of TBIC Holding Corporation, Inc. (“TBIC Holding”), Texas Builders Insurance Company (“TBIC”) and TBIC Risk Management (“TBICRM”). Our E&S Commercial business unit handles primarily commercial insurance products and services and is comprised of Hallmark Specialty Underwriters, Inc. (“HSU”), Pan American Acceptance Corporation (“PAAC”) and TGA Special Risk, Inc. (“TGASRI”). Our Hallmark Select business unit offers (i) general aviation insurance products and services, (ii) low and middle market commercial umbrella and excess liability insurance, (iii) medical professional liability insurance products and services, and (iv) satellite launch insurance products. Our Hallmark Select business unit is comprised of Aerospace Insurance Managers, Inc. (“Aerospace Insurance Managers”), Aerospace Special Risk, Inc. (“ASRI”), Aerospace Claims Management Group, Inc. (“ACMG”), Heath XS, LLC (“HXS”) and Hardscrabble Data Solutions, LLC (“HDS”). Our Personal Lines business unit handles personal insurance products and services and is comprised of American Hallmark General Agency, Inc. and Hallmark Claims Services, Inc. (both of which do business as Hallmark Insurance Company). Our insurance company subsidiaries supporting these business units 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 TBIC.

 

These five business units are segregated into three reportable industry segments for financial accounting purposes. The Standard Commercial Segment includes our Standard Commercial P&C business unit and our Workers Compensation business unit. The Specialty Commercial Segment includes our E&S Commercial business unit and our Hallmark Select business unit, as well as certain specialty risk programs (“Specialty Programs”) which are managed by Hallmark. The Personal Segment consists solely of our Personal Lines business unit.

 

Basis of Presentation

 

The accompanying consolidated financial statements include the accounts and operations of Hallmark and its subsidiaries. Intercompany accounts and transactions have been eliminated. The accompanying consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles (“GAAP”) which, as to our insurance company subsidiaries, differ from statutory accounting practices prescribed or permitted for insurance companies by insurance regulatory authorities.

 

Use of Estimates in the Preparation of Financial Statements

 

Our preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect our reported amounts of assets and liabilities at the dates of the financial statements and our reported amounts of revenues and expenses during the reporting periods. Management evaluates its estimates and assumptions on an ongoing basis using historical experience and other factors, including the current economic environment, which management believes to be reasonable under the circumstances. We adjust such estimates and assumptions when facts and circumstances dictate. Since future events and their effects cannot be determined with precision, actual results could differ significantly from these estimates. Changes in estimates resulting from continuing changes in the economic environment may be reflected in the financial statements in future periods.

 

F-8
 

 

HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years ended December 31, 2014, 2013, and 2012

 

Fair Value of Financial Instruments

 

Fair value estimates are made at a point in time, based on relevant market data as well as the best information available about the financial instruments. Fair value estimates for financial instruments for which no or limited observable market data is available are based on judgments regarding current economic conditions, credit and interest rate risk. These estimates involve significant uncertainties and judgments and cannot be determined with precision. As a result, such calculated fair value estimates may not be realizable in a current sale or immediate settlement of the instrument. In addition, changes in the underlying assumptions used in the fair value measurement technique, including discount rate and estimates of future cash flows, could significantly affect these fair value estimates.

 

Cash and Cash Equivalents: The carrying amounts reported in the balance sheet for these instruments approximate their fair values.

 

Restricted Cash: The carrying amount for restricted cash reported in the balance sheet approximates the fair value.

 

Revolving Credit Facility Payable: The carrying value of our bank revolving credit facility approximates the fair value based on the current interest rate.

 

Subordinated debt securities: Our trust preferred securities are reported at carry value of $56.7 million and $56.7 million, and have a fair value of $47.6 million and $53.2 million, as of December 31, 2014 and 2013, respectively. The fair value of our trust preferred securities is based on discounted cash flows using current yields to maturity of 8.0% and 8.0% as of December 31, 2014 and 2013, respectively, which are based on similar issues to discount future cash flows and would be included in Level 3 of the fair value hierarchy if they were reported at fair value.

 

For reinsurance balances, premiums receivable, federal income tax payable, other assets and other liabilities, the carrying amounts approximate fair value because of the short maturity of such financial instruments.

 

Investments

 

Debt and equity securities available for sale are reported at fair value. Unrealized gains and losses are recorded as a component of stockholders’ equity, net of related tax effects. Equity securities that are determined to have other-than-temporary impairment are recognized as a loss on investments in the consolidated statements of operations. Debt securities that are determined to have other-than-temporary impairment are recognized as a loss on investments in the consolidated statements of operations for the portion that is related to credit deterioration with the remaining portion recognized in other comprehensive income. Debt security premiums and discounts are amortized into earnings using the effective interest method. Maturities of debt securities and sales of equity securities are recorded in receivable for securities until the cash is settled. Purchases of debt and equity securities are recorded in payable for securities until the cash is settled.

 

Realized investment gains and losses are recognized in operations on the specific identification method.

 

Cash and Cash Equivalents

 

We consider all highly liquid investments with an original maturity of three months or less to be cash equivalents.

 

Restricted Cash

 

We collect premiums from customers and, after deducting authorized commissions, remit these premiums to the Company’s consolidated insurance subsidiaries. Unremitted insurance premiums are held in a fiduciary capacity until disbursed to the Company’s consolidated insurance subsidiaries.

 

Premiums Receivable

 

Premiums receivable represent amounts due from policyholders or independent agents for premiums written and uncollected. These balances are carried at net realizable value.

 

Reinsurance

 

We are routinely involved in reinsurance transactions with other companies. Reinsurance premiums, losses and loss adjustment expenses (“LAE”) are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. (See Note 7.)

 

F-9
 

 

HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years ended December 31, 2014, 2013, and 2012

 

Deferred Policy Acquisition Costs

 

Policy acquisition costs (mainly commission, underwriting and marketing expenses) that are directly 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. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. In determining estimated realizable value, the computation gives effect to the premium to be earned, expected investment income, losses and LAE and certain other costs expected to be incurred as the premiums are earned. If the computation results in an estimated net realizable value less than zero, a liability will be accrued for the premium deficiency. During 2014, 2013 and 2012, we deferred $39.1 million, $55.0 million and $62.2 million of policy acquisition costs and amortized $40.9 million, $57.3 million and $59.8 million of deferred policy acquisition costs, respectively. Therefore, the net (amortization) deferrals of policy acquisition costs were ($1.8) million, ($2.3) million and $2.4 million for 2014, 2013 and 2012, respectively.

 

Business Combinations

 

We account for business combinations using the acquisition method of accounting pursuant to Accounting Standards Codification (“ASC”) 805, “Business Combinations.” The base cash purchase price plus the estimated fair value of any non-cash or contingent consideration given for an acquired business is allocated to the assets acquired (including identified intangible assets) and liabilities assumed based on the estimated fair values of such assets and liabilities. The excess of the fair value of the total consideration given for an acquired business over the aggregate net fair values assigned to the assets acquired and liabilities assumed is recorded as goodwill. Contingent consideration is recognized as a liability at fair value as of the acquisition date with subsequent fair value adjustments recorded in the consolidated statements of operations. The valuation of contingent consideration requires assumptions regarding anticipated cash flows, probabilities of cash flows, discount rates and other factors. Significant judgment is employed in determining the propriety of these assumptions as of the acquisition date and for each subsequent period. Accordingly, future business and economic conditions, as well as changes in any of the assumptions, can materially impact the amount of contingent consideration expense we record in any given period. Indirect and general expenses related to business combinations are expensed as incurred.

 

Goodwill and Intangible Assets, net

 

We account for our goodwill and intangible assets according to ASC 350, “Intangibles – Goodwill and Other.” ASC 350 (1) prohibits the amortization of goodwill and indefinite-lived intangible assets, (2) requires testing of goodwill and indefinite-lived intangible assets on an annual basis for impairment (and more frequently if the occurrence of an event or circumstance indicates an impairment), (3) requires testing of definite-lived intangible assets if the occurrence of an event or circumstances indicates an impairment, (4) requires that reporting units be identified for the purpose of assessing potential future impairments of goodwill, and (5) removes the forty-year limitation on the amortization period of intangible assets that have finite lives. We have elected to perform our goodwill impairment test on the first day of the fourth quarter, October 1, of each year.

 

Leases

 

We have several leases, primarily for office facilities and computer equipment, which expire in various years through 2022. Some of these leases include rent escalation provisions throughout the term of the lease. We expense the average annual cost of the lease with the difference to the actual rent invoices recorded as deferred rent which is classified in accounts payable and other accrued expenses on our consolidated balance sheets.

 

F-10
 

 

HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years ended December 31, 2014, 2013, and 2012

 

Property and Equipment

 

Property and equipment (including leasehold improvements), aggregating $14.8 million and $14.3 million, at December 31, 2014 and 2013, respectively, which is included in other assets, is recorded at cost and is depreciated using the straight-line method over the estimated useful lives of the assets (three to ten years). Depreciation expense for 2014, 2013 and 2012 was $0.7 million, $1.2 million and $1.2 million, respectively. Accumulated depreciation was $13.2 million and $12.5 million at December 31, 2014 and 2013, respectively.

 

Variable Interest Entities

 

On June 21, 2005, we formed Hallmark Statutory Trust I (“Trust I”), an unconsolidated trust subsidiary, for the sole purpose of issuing $30.0 million in trust preferred securities. Trust I used the proceeds from the sale of these securities and our initial capital contribution to purchase $30.9 million of subordinated debt securities from Hallmark. The debt securities are the sole assets of Trust I, and the payments under the debt securities are the sole revenues of Trust I.

 

On August 23, 2007, we formed Hallmark Statutory Trust II (“Trust II”), an unconsolidated trust subsidiary, for the sole purpose of issuing $25.0 million in trust preferred securities. Trust II used the proceeds from the sale of these securities and our initial capital contribution to purchase $25.8 million of subordinated debt securities from Hallmark. The debt securities are the sole assets of Trust II, and the payments under the debt securities are the sole revenues of Trust II.

 

We evaluate on an ongoing basis our investments in Trust I and Trust II (collectively, (the “Trusts”)) and we do not have variable interests in the Trusts. Therefore, the Trusts are not consolidated in our consolidated financial statements.

 

We are also involved in the normal course of business with variable interest entities primarily as a passive investor in mortgage-backed securities and certain collateralized corporate bank loans issued by third party variable interest entities. The maximum exposure to loss with respect to these investments is limited to the investment carrying values included in the consolidated balance sheets.

 

Losses and Loss Adjustment Expenses

 

Losses and LAE represent the estimated ultimate net cost of all reported and unreported losses incurred through December 31, 2014, 2013 and 2012. The reserves for unpaid losses and LAE are estimated using individual case-basis valuations and statistical analyses. These estimates are subject to the effects of trends in loss severity and frequency. Although considerable variability is inherent in such estimates, we believe that the reserves for unpaid losses and LAE are adequate. The estimates are continually reviewed and adjusted as experience develops or new information becomes known. Such adjustments are included in current operations.

 

Redeemable Non-Controlling Interest

 

We accreted the redeemable non-controlling interest to its redemption value from the date of issuance to the redemption date using the interest method. Changes in redemption value were considered a change in accounting estimate. We follow the two class method of computing earnings per share. We treat only the portion of the periodic adjustment to the redeemable non-controlling interest carrying amount that reflects a redemption in excess of fair value as being akin to an actual dividend. Effective September 30, 2012, we exercised our call option and acquired the remaining 20% membership interests in the subsidiaries for $1.7 million.

 

Recognition of Premium Revenues

 

Insurance premiums are earned pro rata over the terms of the policies. Insurance policy fees are earned as of the effective date of the policy. Upon cancellation, any unearned premium is refunded to the insured. Insurance premiums written include gross policy fees of $11.5 million, $13.2 million and $11.8 million for the years ended December 31, 2014, 2013, and 2012, respectively. Insurance premiums on monthly reporting workers’ compensation policies are earned on the conclusion of the monthly coverage period. Deposit premiums for workers’ compensation policies are earned upon the expiration of the policy.

 

F-11
 

  

HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years ended December 31, 2014, 2013, and 2012

 

Finance Charges

 

We receive premium installment fees for each direct bill payment from policyholders. Installment fee income is classified as finance charges on the consolidated statement of operations and is recognized as the fee is invoiced.

 

Relationship with Third Party Insurers

 

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. Through December 31, 2008, all business of our E&S Commercial business unit was produced under a fronting agreement with member companies of the Republic Group (“Republic”), a third-party insurer. These insurance contracts on third party paper are accounted for under agency accounting. Ceding commissions and other fees received under these arrangements were classified as unearned commission revenue until earned pro rata over the terms of the policies.

 

Profit sharing commission is calculated and recognized when the loss ratio, as determined by a qualified actuary, deviates from contractual targets. We received a provisional commission as policies were 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. Profit share commission is classified as commissions and fees on the consolidated statement of operations

 

The following table details the profit sharing commission provisional loss ratio compared to the estimated ultimate loss ratio for each effective quota share treaty between the Standard Commercial P&C business unit and Clarendon.

 

   Treaty Effective Dates 
   7/1/2001   7/1/2002   7/1/2003   7/1/2004 
Provisional loss ratio   60.0%   59.0%   59.0%   64.2%
Estimated ultimate loss ratio recorded at December 31, 2014   63.5%   64.5%   61.2%   66.0%

 

As of December 31, 2014, we had a payable of $1.3 million on these profit share treaties. The payable or receivable is the difference between the cash received to date and the recognized commission revenue based on the estimated ultimate loss ratio.

 

The following table details the profit sharing commission revenue provisional loss ratio compared to the estimated ultimate loss ratio for the effective quota share treaty between the E&S Commercial business unit and Republic.

 

   Treaty Effective Dates 
   1/1/2006   1/1/2007   1/1/2008 
Provisional loss ratio   65.0%   65.0%   65.0%
Estimated ultimate loss ratio recorded at December 31, 2014   58.7%   63.6%   59.5%

 

As of December 31, 2014, we had a net payable of $0.7 million on these profit share treaties. The payable or receivable is the difference between the cash received to date and the recognized commission revenue based on the estimated ultimate loss ratio.

 

F-12
 

  

HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years ended December 31, 2014, 2013, and 2012

 

Agent Commissions

 

We pay monthly commissions to agents based on written premium produced, but generally recognize the expense pro rata over the term of the policy. If the policy is cancelled prior to its expiration, the unearned portion of the agent commission is refundable to us. The unearned portion of commissions paid to agents is included in deferred policy acquisition costs.

We annually pay a profit sharing commission to our independent agency force based upon the results of the business produced by each agent. We estimate and accrue this liability to commission expense in the year the business is produced.

 

Commission expense is classified as other operating expenses in the consolidated statement of operations.

 

Income Taxes

 

We file a consolidated federal income tax return. Deferred federal income taxes reflect the future tax consequences of differences between the tax basis 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 in effect for the year in which these temporary differences are expected to be recovered or settled.

 

Earnings Per Share

 

The computation of earnings per share is based upon the weighted average number of common shares outstanding during the period plus the effect of common shares potentially issuable (in periods in which they have a dilutive effect), primarily from stock options. (See Notes 11 and 13.)

 

Adoption of New Accounting Pronouncements

 

In May 2014, the FASB issued guidance which revises the criteria for revenue recognition. Insurance contracts are excluded from the scope of the new guidance. Under the guidance, the transaction price is attributed to underlying performance obligations in the contract and revenue is recognized as the entity satisfies the performance obligations and transfers control of a good or service to the customer. Incremental costs of obtaining a contract may be capitalized to the extent the entity expects to recover those costs. The guidance is effective for reporting periods beginning after December 15, 2016 and is to be applied retrospectively. The Company is in the process of evaluating the impact of adoption, which is not expected to be material to the Company’s results of operations and financial position.

 

F-13
 

 

 

HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years ended December 31, 2014, 2013, and 2012

 

2.