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Level 2 investment securities include corporate bonds, municipal bonds and U.S. Treasury 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 by the pricing service using observable market information such as quotes from less active markets and/or quoted prices of securities with similar characteristics, among other things. We have reviewed the processes used by the pricing service and have determined that they result in fair values consistent with the requirements of  ASC 820 for Level 2 investment securities.

In 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.

 

The following table presents for each of the fair value hierarchy levels, our assets that are measured at fair value on a recurring basis at September 30, 2010 (in thousands):

 

		Quoted Prices in				Other
		Active Markets for				Observable				Unobservable
		Identical Assets				Inputs				Inputs
		(Level 1)				(Level 2)				(Level 3)				Total
U.S. Treasury securities and obligations of U.S. Government		$	-			$	6,545			$	-			$	6,545
Corporate debt securities			-				198,402				-				198,402
Municipal bonds			-				134,419				20,024				154,443
Asset backed			-				848				-				848
Total debt securities			-				340,214				20,024				360,238
Financial services			21,356				-				-				21,356
All other			22,669				-				-				22,669
Total equity securities			44,025				-				-				44,025
Total debt and equity securities		$	44,025			$	340,214			$	20,024			$	404,263

 

Due to significant unobservable inputs into the valuation model for certain municipal bonds in illiquid markets, we classified these as Level 3 in the fair value hierarchy.  We used an income approach in order to derive an estimated fair value of such securities, which included inputs such as expected holding period, benchmark swap rate, benchmark discount rate and a discount rate premium for illiquidity.

The following table summarizes the changes in fair value for all financial assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the nine months ended September 30, 2010 (in thousands):

 

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Beginning balance as of January 1, 2010		$	25,272
Net purchases, issuances, sales and settlements			(5,125	)
Total realized/unrealized gains included in net income			-
Net losses included in other comprehensive income			(123	)
Transfers in and/or out of Level 3			-
Ending balance as of September 30, 2010		$	20,024

5. 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.

 

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Major categories of recognized gains and losses on investments are summarized as follows (in thousands):

 

		Three Months Ended								Nine Months Ended
		September 30								September 30
		2010				2009				2010				2009
U.S. Treasury securities and obligations of U.S. Government		$	-			$	-			$	-			$	-
Corporate debt securities			281				239				3,650				1,269
Municipal bonds			-				-				(74	)			(48	)
Equity securities-financial services			-				58				1,767				115
Equity securities-all other			30				300				414				318
Net realized gain before other-than-temporary impairments			311				597				5,757				1,654
Other-than-temporary impairments			-				-				-				(538	)
Net realized gain		$	311			$	597			$	5,757			$	1,116

 

We realized gross gains on investments of $0.3 million and $0.7 million during the three months ended September 30, 2010 and 2009, respectively, and $5.9 and $2.0 million for the nine months ended September 30, 2010 and 2009, respectively. We did not realize gross losses on investments for the three months ended September 30, 2010. We realized gross losses on investments of $0.1 million during the three months ended September 30, 2009 and $0.1 million and $0.9 million for the nine months ended September 30, 2010 and 2009, respectively. We recorded proceeds from the sale of investment securities of $26.3 million and $25.3 million during the three months ended September 30, 2010 and 2009, respectively, and $99.9 million and $66.2 million for the nine months ended September 30, 2010 and 2009, respectively. Realized investment gains and losses are recognized in operations on the specific identification method.

 

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The amortized cost and estimated fair value of investments in debt and equity securities by category is as follows (in thousands):

 

						Gross				Gross
		Amortized				Unrealized				Unrealized				Fair
As of September 30, 2010		Cost				Gains				Losses				Value
U.S. Treasury securities and
obligations of U.S. Government		$	6,509			$	36			$	-			$	6,545
Corporate debt securities			193,469				5,854				(921	)			198,402
Municipal bonds			152,877				3,621				(2,055	)			154,443
Asset backed			804				44				-				848
Total debt securities			353,659				9,555				(2,976	)			360,238
Financial services			16,834				4,727				(205	)			21,356
All other			17,532				5,465				(328	)			22,669
Total equity securities			34,366				10,192				(533	)			44,025
Total debt and equity securities		$	388,025			$	19,747			$	(3,509	)		$	404,263
As of December 31, 2009
U.S. Treasury securities and
obligations of U.S. Government		$	6,830			$	23			$	(17	)		$	6,836
Corporate debt securities			94,560				7,190				(2,201	)			99,549
Municipal bonds			185,036				2,543				(2,786	)			184,793
Asset backed			682				17				(1	)			698
Total debt securities			287,108				9,773				(5,005	)			291,876
Financial services			17,156				5,008				(232	)			21,932
All other			10,095				3,790				(16	)			13,869
Total equity securities			27,251				8,798				(248	)			35,801
Total debt and equity securities		$	314,359			$	18,571			$	(5,253	)		$	327,677

 

 

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The following schedules summarize the gross unrealized losses showing the length of time that investments have been continuously in an unrealized loss position as of September 30, 2010 and December 31, 2009 (in thousands):

		As of September 30, 2010
		12 months or less								Longer than 12 months								Total
						Unrealized								Unrealized								Unrealized
		Fair Value				Losses				Fair Value				Losses				Fair Value				Losses
U.S. Treasury securities and obligations of U.S. Government		$	-			$	-			$	-			$	-			$	-			$	-
Corporate debt securities			28,953				(229	)			4,774				(692	)			33,727				(921	)
Municipal bonds			7,356				(32	)			48,391				(2,023	)			55,747				(2,055	)
Total debt securities			36,309				(261	)			53,165				(2,715	)			89,474				(2,976	)
Financial services			1,259				(205	)			-				-				1,259				(205	)
All other			4,611				(328	)			-				-				4,611				(328	)
Total equity securities			5,870				(533	)			-				-				5,870				(533	)
Total debt and equity securities		$	42,179			$	(794	)		$	53,165			$	(2,715	)		$	95,344			$	(3,509	)

		As of December 31, 2009
		12 months or less								Longer than 12 months								Total
						Unrealized								Unrealized								Unrealized
		Fair Value				Losses				Fair Value				Losses				Fair Value				Losses
U.S. Treasury securities and obligations of U.S. Government		$	3,202			$	(17	)		$	-			$	-			$	3,202			$	(17	)
Corporate debt securities			18,924				(166	)			9,642				(2,035	)			28,566				(2,201	)
Municipal bonds			28,940				(1,524	)			42,183				(1,262	)			71,123				(2,786	)
Asset backed			51				(1	)			-				-				51				(1	)
Total debt securities			51,117				(1,708	)			51,825				(3,297	)			102,942				(5,005	)
Financial services			1,417				(232	)			-				-				1,417				(232	)
All other			658				(16	)			-				-				658				(16	)
Equity securities			2,075				(248	)			-				-				2,075				(248	)
Total debt and equity securities		$	53,192			$	(1,956	)		$	51,825			$	(3,297	)		$	105,017			$	(5,253	)

At September 30, 2010, the gross unrealized losses more than twelve months old were attributable to 35 bond positions.  At December 31, 2009, the gross unrealized losses more than twelve months old were attributable to 60 bond positions.  We consider these losses as a temporary decline in value as they are predominately on bonds that we do not intend to sell and do not believe we will be required to sell prior to recovery of our amortized cost basis.  We see no other indications that the decline in values of these securities is other-than-temporary.

 

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Based on evidence gathered through our normal credit evaluation process, we presently expect that all debt securities held in our investment portfolio will be paid in accordance with their contractual terms.  Nonetheless, it is at least reasonably possible that the performance of certain issuers of these debt securities will be worse than currently expected resulting in additional future write-downs within our portfolio of debt securities.

Also, as a result of the challenging market conditions, we expect the volatility in the valuation of our equity securities to continue in the foreseeable future. This volatility may lead to additional impairments on our equity securities portfolio or changes regarding retention strategies for certain equity securities.

The amortized cost and estimated fair value of debt securities at September 30, 2010 by contractual maturity are as follows. Expected maturities may differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties.

		Amortized				Fair
		Cost				Value
		(in thousands)
Due in one year or less		$	27,776			$	28,312
Due after one year through five years			184,429				190,046
Due after five years through ten years			96,305				97,434
Due after ten years			44,345				43,598
Asset backed			804				848
		$	353,659			$	360,238

Activity related to the credit component recognized in earnings for the nine months ended September 30, 2010, on debt securities held by us for which a portion of other-than-temporary impairment was previously recognized in other comprehensive income is as follows (in thousands):

Balance, January 1, 2010		$	1,168
Reductions for securities sold or matured during the period			(1,168	)
Balance, September 30, 2010		$	-

 

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6. Pledged Investments

We have certain of our securities pledged for the benefit of various state insurance departments and reinsurers.  These securities are included with our available-for-sale debt securities because we have the ability to trade these securities.  We retain the interest earned on these securities.  These securities had a carrying value of $26.8 million at September 30, 2010 and a carrying value of $29.7 million at December 31, 2009.

7. Share-Based Payment Arrangements

Our 2005 Long Term Incentive Plan (“2005 LTIP”) is a stock compensation plan for key employees and non-employee directors that was approved by the shareholders on May 26, 2005.  There are 2,000,000 shares authorized for issuance under the 2005 LTIP.  Our 1994 Key Employee Long Term Incentive Plan (the “1994 Employee Plan”) and 1994 Non-Employee Director Stock Option Plan (the “1994 Director Plan”) both expired in 2004 but have unexercised options outstanding.

As of September 30, 2010, there were incentive stock options to purchase 1,286,666 shares of our common stock outstanding and non-qualified stock options to purchase 320,000 shares of our common stock outstanding and there were 392,501 shares reserved for future issuance under the 2005 LTIP.  As of September 30, 2010, there were incentive stock options to purchase 2,500 shares outstanding under the 1994 Employee Plan and non-qualified stock options to purchase 20,834 shares outstanding under the 1994 Director Plan.  The exercise price of all such outstanding stock options is equal to the fair market value of our common stock on the date of grant.

Options granted under the 1994 Employee Plan prior to October 31, 2003, vest 40% six months from the date of grant and an additional 20% on each of the first three anniversary dates of the grant and terminate ten years from the date of grant.  Incentive stock options granted under the 2005 LTIP prior to 2009 and the 1994 Employee Plan after October 31, 2003, vest 10%, 20%, 30% and 40% on the first, second, third and fourth anniversary dates of the grant, respectively, and terminate five to ten years from the date of grant.  Incentive stock options granted in 2009 under the 2005 LTIP vest in equal annual increments on each of the first seven anniversary dates and terminate ten years from the date of grant.  There was one grant of 25,000 incentive stock options in 2010 under the 2005 LTIP that vest in equal annual increments on each of the first three anniversary dates and terminates ten years from the date of grant.  Non-qualified stock options granted under the 2005 LTIP generally vest 100% six months after the date of grant and terminate ten years from the date of grant.  There was one grant of 200,000 non-qualified stock options in 2009 under the 2005 LTIP that vest in equal annual increments on each of the first seven anniversary dates and terminate ten years from the date of grant.  All non-qualified stock options granted under the 1994 Director Plan vested 40% six months from the date of grant and an additional 10% on each of the first six anniversary dates of the grant and terminate ten years from the date of grant.

 

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A summary of the status of our stock options as of and changes during the nine months ended September 30, 2010 is presented below:

						Average				Contractual				Intrinsic
		Number of				Exercise				Term				Value
		Shares				Price				(Years)				$	(000	)
Outstanding at January 1, 2010			1,614,166			$	9.62
Granted			25,000			$	9.12
Exercised			(9,166	)		$	2.69
Forfeited or expired			-			$	-
Outstanding at September 30, 2010			1,630,000			$	9.65				7.3			$	1,515
Exercisable at September 30, 2010			779,427			$	10.34				6.6			$	538

The following table details the intrinsic value of options exercised, total cost of share-based payments charged against income before income tax benefit and the amount of related income tax benefit recognized in income for the periods indicated (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2010				2009				2010				2009
Intrinsic value of options exercised		$	-			$	-			$	47			$	107
Cost of share-based payments (non-cash)		$	263			$	612			$	852			$	1,488
Income tax benefit of share-based
payments recognized in income		$	8			$	118			$	23			$	231

As of September 30, 2010 there was $2.2 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under our plans, of which $0.3 million is expected to be recognized during the remainder of 2010, $0.8 million is expected to be recognized in 2011, $0.4 million is expected to be recognized in 2012, $0.2 million is expected to be recognized each year from 2013 through 2015 and $0.1 million is expected to be recognized in 2016.

The fair value of each stock option granted is estimated on the date of grant using the Black-Scholes option pricing model.  Expected volatilities are based on the historical volatility of the Company’s and similar companies’ common stock for a period equal to the expected term.  The risk- free interest rates for periods within the contractual term of the options are based on rates for U.S. Treasury Notes with maturity dates corresponding to the options’ expected lives on the dates of grant.  Expected term is determined based on the simplified method as the Company does not have sufficient historical exercise data to provide a basis for estimating the expected term.

 

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The following table details the weighted average grant date fair value and related assumptions for the periods indicated.  No options were granted in the third quarter of 2010 or 2009.

		Nine Months Ended
		September 30,
		2010				2009
Grant date fair value per share		$	3.62			$	2.84
Expected term (in years)			6.0				6.2
Expected volatility			35.0	%			40.0	%
Risk free interest rate			3.2	%			2.5	%

8. Segment Information

The following is business segment information for the three and nine months ended September 30, 2010 and 2009 (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2010				2009				2010				2009
Revenues:
Standard Commercial Segment		$	17,211			$	19,569			$	52,510			$	57,783
Specialty Commercial Segment			32,892				32,346				97,503				97,601
Personal Segment			25,418				18,735				71,386				54,971
Corporate			696				1,253				6,328				3,202
Consolidated		$	76,217			$	71,903			$	227,727			$	213,557
Pre-tax income (loss), net of non-controlling interest:
Standard Commercial Segment		$	(234	)		$	2,164			$	(3,043	)		$	5,987
Specialty Commercial Segment			2,515				3,588				9,829				14,280
Personal Segment			743				2,225				4,525				7,738
Corporate			(1,803	)			(2,178	)			(2,255	)			(6,960	)
Consolidated		$	1,221			$	5,799			$	9,056			$	21,045

 

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The following is additional business segment information as of the dates indicated (in thousands):

		September 30,				December 31,
		2010				2009
Assets
Standard Commercial Segment		$	130,916			$	136,745
Specialty Commercial Segment			316,040				280,970
Personal Segment			165,692				109,844
Corporate			80,722				101,310
		$	693,370			$	628,869

9. Reinsurance

We reinsure a portion of the risk we underwrite in order to control the exposure to losses and to protect 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.

The following table shows earned premiums ceded and reinsurance loss recoveries by period (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2010				2009				2010				2009
Ceded earned premiums		$	9,483			$	7,137			$	26,740			$	12,331
Reinsurance recoveries		$	6,247			$	4,166			$	16,825			$	7,388

 We currently reinsure the following exposures on business generated by our Standard Commercial, E&S Commercial, Excess & Umbrella, Personal Lines and General Aviation business units:

 

·

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

 

 

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o

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

 

o

Our reinsurers reimburse us 100% for any loss in excess of our $3.0 million retention up to $30.0 million for each catastrophic occurrence, subject to an aggregate limit of $54.0 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:

 

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

 

o

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

 

o

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

 

·

Excess & Umbrella.  Currently, we purchase proportional reinsurance where we retain 21% of each risk and cede the remaining 79% to reinsurers.  In states where we are not yet licensed to offer a non-admitted product, we utilize a fronting arrangement pursuant to which we assume all of the risk and then retrocede a portion of that risk under the same proportional reinsurance treaty.  Through June 30, 2009, our Excess & Umbrella business unit wrote policies pursuant to a general agency agreement with an unaffiliated carrier and we assumed 35% of the risk from that carrier.

·

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

 

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10. Note Payable

On January 27, 2006, we borrowed $15.0 million under our revolving credit facility to fund the cash required to close the acquisition of the subsidiaries comprising our E&S Commercial business unit.  As of September 30, 2010, the balance on the revolving note was $2.8 million, which currently bears interest at 2.79% per annum. (See Note 12, “Credit Facilities.”)

11.  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 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 uncollaterized and do not require maintenance of minimum financial covenants. As of September 30, 2010, 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 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 uncollaterized and do not require maintenance of minimum financial covenants. As of September 30, 2010, the balance of our Trust II subordinated debt was $25.8 million.

12. Credit Facilities

Our First Restated Credit Agreement with The Frost National Bank dated January 27, 2006 was most recently amended effective May 27, 2010 to extend the term of the facility until May 27, 2012, provide for the repayment of all amounts outstanding at termination on or before April 30, 2015, reduce the revolving commitment to $5.0 million from $25.0 million and eliminate the credit sub-facility for premium finance operations. This amendment further revised various affirmative and negative covenants and changed the interest rate, at our election, to either the prime rate or LIBOR plus 2.5%. We pay an annual average 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.  As of September 30, 2010, we were in compliance with or had obtained waivers of all of our covenants.  As of September 30, 2010, we had $2.8 million outstanding under this facility.

 

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13. Deferred Policy Acquisition Costs

The following table shows total deferred and amortized policy acquisition cost activity by period (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2010				2009				2010				2009
Deferred		$	(10,725	)		$	(7,454	)		$	(38,422	)		$	(38,539	)
Amortized			10,280				8,257				36,033				35,434
Net		$	(445	)		$	803			$	(2,389	)		$	(3,105	)

14. Earnings per Share

The following table sets forth basic and diluted weighted average shares outstanding for the periods indicated (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2010				2009				2010				2009
Weighted average shares - basic			20,124				20,652				20,122				20,790
Effect of dilutive securities			62				14				56				32
Weighted average shares - assuming dilution			20,186				20,666				20,178				20,822

For the three months and nine months ended September 30, 2010 and 2009, 899,166 shares of common stock potentially issuable upon the exercise of employee stock options were excluded from the weighted average number of shares outstanding on a diluted basis because the effect of such options would be anti-dilutive.

 

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15. Net Periodic Pension Cost

The following table details the net periodic pension cost incurred by period (in thousands):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2010				2009				2010				2009
Interest cost		$	163			$	160			$	488			$	482
Amortization of net loss			56				122				168				366
Expected return on plan assets			(136	)			(121	)			(409	)			(363	)
Net periodic pension cost		$	83			$	161			$	247			$	485

We contributed $246 thousand and $340 thousand to our frozen defined benefit cash balance plan (“Cash Balance Plan”) during the three months and nine months ended September 30, 2010, respectively.  We did not make any contributions to the Cash Balance Plan during the three months and nine months ended September 30, 2009.  Refer to Note 13 to the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2009 for more discussion of our retirement plans.

16.   Income Taxes

Our effective income tax rate for the nine months ended September 30, 2010 was 23.5%, which varied from the statutory income tax rate utilized primarily due to an increase in the proportion of tax exempt income relative to total pre-tax income and the recognition of a tax benefit related to the disposal of certain securities.  Our effective income tax rate for the nine months ended September 30, 2009 was 27.4%, which varied from the statutory income tax rate utilized primarily because of our investments in tax exempt securities and a reduction in the valuation allowance.

17. Commitments and Contingencies

We are engaged in legal proceedings in the ordinary course of business, none of which, either individually or in the aggregate, are believed likely to have a material adverse effect on our consolidated financial position or results of operations, in the opinion of management.  The various legal proceedings to which we are a party are routine in nature and incidental to our business.

 

On August 9, 2010 we announced the execution of an agreement for our wholly-owned subsidiary, HIC, to acquire State Auto National Insurance Company (“SAN”) from State Auto Financial Corporation.  SAN is an Ohio domiciled insurance company which writes  non-standard personal automobile policies through independent agents in 21 states.  Closing of the acquisition is subject to regulatory approval and other customary closing conditions.

 

The purchase price for the acquisition will be $14.0 million cash at closing plus an earn-out of up to $2.0 million.  We expect to fund the acquisition out of working capital.  The cash portion of the purchase price is subject to post-closing adjustment to the extent the statutory capital and surplus of SAN is greater or less than $10.0 million.  The earn-out is payable quarterly in an amount equal to 2% of gross collected premiums on new or renewal personal lines insurance policies written by SAN agents during the three years following closing.  In connection with the closing, SAN will enter into reinsurance agreements with an affiliate of the seller pursuant to which the affiliate will handle all claims and assume all liabilities arising under policies issued by SAN prior to the closing and during a transition period of up to six months following the closing.

 

 

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Item 2.  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-Q”  for a discussion of some of the uncertainties, risks and assumptions associated with these statements.

Introduction

Hallmark Financial Services, Inc. (“Hallmark” and, together with subsidiaries, “we,” “us” or “our”) is an insurance holding company that, through its subsidiaries, engages in the sale of property/casualty insurance products to businesses and individuals. Our business involves marketing, distributing, underwriting and servicing commercial insurance, personal insurance and general aviation insurance, as well as providing other insurance related services.  Our business is geographically concentrated in the south central and northwest regions of the United States, except for our General Aviation and Excess & Umbrella business, which is written on a national basis.  We pursue our business activities through subsidiaries whose operations are organized into five business units, which are supported by our four insurance company subsidiaries.

 

Our non-carrier insurance activities are segregated by business units into the following reportable segments:

 

·

Standard Commercial Segment.  Our Standard Commercial Segment includes the standard lines commercial property/casualty insurance products and services handled by our Standard Commercial business unit (formerly known as our AHIS Operating Unit).

·

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 (formerly known as our TGA Operating Unit), the general aviation insurance products and services handled by our General Aviation business unit (formerly known as our Aerospace Operating Unit), and the low and middle market commercial umbrella and excess liability insurance products handled by our Excess & Umbrella business unit (formerly known as our Heath XS Operating Unit).

·

Personal Segment.  Our Personal Segment includes the non-standard personal automobile insurance and complementary personal insurance products and services handled by our Personal Lines business unit (formerly known as our Personal Lines Operating Unit).

The retained premium produced by our business units is supported by the following insurance company subsidiaries:

·

American Hallmark Insurance Company of Texas (“AHIC”) presently retains all of the risks on the commercial property/casualty policies marketed within the Standard Commercial Segment, retains a portion of risks on the personal policies marketed within the Personal Segment and assumes a portion of the risks on the commercial and aviation property/casualty policies marketed within the Specialty Commercial Segment.

 

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·

Hallmark Specialty Insurance Company (“HSIC”)  presently retains a portion of the risks on the commercial property/casualty policies marketed within the Specialty Commercial Segment.

·

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

·

Hallmark County Mutual Insurance Company (“HCM”) control and management was acquired effective June 5, 2009 through the acquisition of all of the issued and outstanding shares of 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 where we previously produced policies for third party county mutual insurance companies and reinsured 100% for a fronting fee.  HCM does not retain any business.

AHIC, HSIC, and HIC have entered into a pooling arrangement pursuant to which AHIC retains 46% of the total net premiums written by all of our business units, HIC retains 34% of our total net premiums written and HSIC retains 20% of our total net premiums written.  This pooling arrangement has no impact on our consolidated financial statements reported in accordance with U.S. generally accepted accounting principles (“GAAP”).

Results of Operations

Management Overview.  During the three and nine months ended September 30, 2010, our total revenues were $76.2 million and $227.7 million, representing a 6% and 7% increase, respectively, from the $71.9 million and $213.6 million in total revenues for the same periods of 2009.  The increase in revenue for the three months ended September 30, 2010 was primarily attributable to increased production in our Personal Segment due to geographic expansion.  The increase in revenue for the nine months ended September 30, 2010 was primarily attributable to increased production in our Personal Segment due to geographic expansion, increased retention of business in our E&S Commercial business unit, increased earned premium in our Excess & Umbrella business unit and gains realized on our investment portfolio. These increases in revenue were partially offset by reduced earned premium in our Standard Commercial Segment due to the deterioration of the general economic environment in our major markets. 

We reported net income attributable to Hallmark of $1.0 million and $6.9 million for the three and nine months ended September 30, 2010, respectively, which was $3.2 million and $8.4 million lower than the $4.2 million and $15.3 million net income attributable to Hallmark reported for the same periods of 2009.  On a diluted basis per share, net income was $0.05 and $0.34 per share for the three and nine months ended September 30, 2010, respectively, as compared to net income of $0.20 and $0.73 per share for the same periods in 2009.    The decrease in net income for the three and nine months ending September 30, 2010 was primarily due to increased loss and loss adjustment expenses (“LAE”) due to higher current accident year loss estimates, as well as unfavorable prior year loss development of $0.5 million and $7.0 million recognized during the three and nine months ended September 30, 2010, respectively, as compared to $1.7 million and $3.5 million unfavorable development recognized for the three and nine months ended September 30, 2009.  Partially offsetting the increased loss and LAE was the increase in revenue for the three and nine months ending September 30, 2010, as well as lower operating expenses due to lower production related expenses in our Standard Commercial, E&S Commercial  and  General Aviation business units and lower general and administrative costs in our Standard Commercial Segment as a result of ongoing cost reduction initiatives.  The Company’s effective income tax rate for the nine months ending September 30, 2010 was 23.5% as compared to the 27.4% effective income tax rate for the same period during 2009.  The decrease in the effective tax rate was primarily due to an increase in the proportion of tax exempt income relative to total pre-tax income and the recognition of a tax benefit related to the disposal of certain securities.

 

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Third Quarter 2010 as Compared to Third Quarter 2009

The following is additional business segment information for the three months ended September 30, 2010 and 2009 (in thousands):

Hallmark Financial Services, Inc.

Consolidated Segment Data

		Three Months Ended September 30, 2010
		Standard				Specialty
		Commercial				Commercial				Personal
		Segment				Segment				Segment				Corporate				Consolidated
Produced premium (1)		$	15,586			$	39,653			$	25,188			$	-			$	80,427
Gross premiums written			15,586				41,425				25,188				-				82,199
Ceded premiums written			(1,147	)			(8,915	)			(90	)			-				(10,152	)
Net premiums written			14,439				32,510				25,098				-				72,047
Change in unearned premiums			1,626				(1,368	)			(1,899	)			-				(1,641	)
Net premiums earned			16,065				31,142				23,199				-				70,406
Total revenues			17,211				32,892				25,418				696				76,217
Losses and loss adjustment expenses			12,183				20,788				18,322				-				51,293
Pre-tax  income (loss), net of
non-controlling interest			(234	)			2,515				743				(1,803	)			1,221
Net loss ratio (2)			75.8	%			66.8	%			79.0	%							72.9	%
Net expense ratio (2)			32.2	%			30.1	%			21.0	%							29.4	%
Net combined ratio (2)			108.0	%			96.9	%			100.0	%							102.3	%
		Three Months Ended September 30, 2009
		Standard				Specialty
		Commercial				Commercial				Personal
		Segment				Segment				Segment				Corporate				Consolidated
Produced premium (1)		$	17,309			$	36,064			$	17,424			$	-			$	70,797
Gross premiums written			17,309				39,280				17,424				-				74,013
Ceded premiums written			(1,144	)			(10,078	)			-				-				(11,222	)
Net premiums written			16,165				29,202				17,424				-				62,791
Change in unearned premiums			1,627				92				(272	)			-				1,447
Net premiums earned			17,792				29,294				17,152				-				64,238
Total revenues			19,569				32,346				18,735				1,253				71,903
Losses and loss adjustment expenses			11,425				17,641				11,513				-				40,579
Pre-tax  income (loss), net of
non-controlling interest			2,164				3,588				2,225				(2,178	)			5,799
Net loss ratio (2)			64.2	%			60.2	%			67.1	%							63.2	%
Net expense ratio (2)			32.8	%			29.8	%			22.4	%							31.0	%
Net combined ratio (2)			97.0	%			90.0	%			89.5	%							94.2	%

(1)  Produced premium is a non-GAAP measurement that management uses to track total premium produced by our operations. Produced premium excludes unaffiliated third party premium fronted on our recently acquired HCM subsidiary. We believe this is a useful tool for users of our financial statements to measure our premium production whether retained by our insurance company subsidiaries or assumed by third party insurance carriers who pay us commission revenue.

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

 

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Standard Commercial Segment

Gross premiums written for the Standard Commercial Segment were $15.6 million for the three months ended September 30, 2010, which was $1.7 million, or 10%, less than the $17.3 million reported for the same period in 2009.  Net premiums written were $14.4 million for the three months ended September 30, 2010 as compared to $16.2 million reported for the same period in 2009.  The decrease in premium volume was predominately due to the deterioration of the general economic environment, particularly in the construction industry, reducing the available insured exposures.

Total revenue for the Standard Commercial Segment of $17.2 million for the three months ended September 30, 2010 was $2.4 million less than the $19.6 million reported during the same period in 2009.  This 12% decrease in total revenue was mostly due to decreased net premiums earned of $1.7 million and reduced profit sharing commissions of $0.7 million related to unfavorable loss development on prior treaty years.

Our Standard Commercial Segment reported a pre-tax loss of $0.2 million for the three months ended September 30, 2010 as compared to pre-tax income of $2.2 million for the same period of 2009. Higher loss and LAE of $0.8 million, primarily as a result of weather related losses and unfavorable prior year development, and decreased revenue were the primary drivers of the pre-tax loss for the three months ended September 30, 2010. Partially offsetting the decline in pre-tax results were lower operating expenses of $0.7 million driven by lower general and administrative costs and lower production related expenses.

The Standard Commercial Segment reported a net loss ratio of 75.8% for the three months ended September 30, 2010 as compared to 64.2% for 2009. The gross loss ratio before reinsurance for the three months ended September 30, 2010 was 80.1% as compared to the 66.2% reported for the same period of 2009.  The higher gross and net loss ratio for the three months ended September 30, 2010 was driven by development of weather related losses. The loss and LAE during the three months ended September 30, 2010 for the Standard Commercial Segment included unfavorable loss reserve development of $0.8 million as compared to unfavorable development of $0.4 million for the same period in 2009.  

Specialty Commercial Segment

 The $32.9 million of total revenue for the Specialty Commercial Segment during the three months ended September 30, 2010 was $0.6 million higher than the $32.3 million reported for the same period in 2009. This increase in revenue was primarily comprised of higher earned premiums of $1.8 million as a result of the increased earned premium in our E&S Commercial business unit as well as increased net investment income of $0.5 million. These increases in revenues were partially offset by lower commission and fee income of $1.7 million primarily related to the shift from a third party agency structure to an insurance underwriting structure.

Pre-tax income for the Specialty Commercial Segment of $2.5 million for the third quarter of 2010 was $1.1 million lower than the $3.6 million reported for the same period in 2009.  The decrease in pre-tax income was primarily due to higher loss and LAE expenses of $3.1 million primarily as a result of higher current accident year loss estimates.  This increase in loss and LAE was partially offset by lower operating expenses of $1.7 million.  The decrease in operating expense was the combined result of (i) lower production related expenses of $1.9 million due primarily to lower fronting fees in our E&S Commercial business unit as we began direct writing this business during 2009 and to increased quota share ceding commissions in our Excess & Umbrella business unit due to increased ceded premiums, (ii) lower salary and related expenses of $0.1 million, partially offset by (iii) increased other operating expenses of $0.3 million, primarily increased professional fees.  In addition increased amortization of intangible assets of $0.2 million related to our acquisition of CYR on June 5, 2009 further contributed to the decrease in pre-tax income.

 

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The Specialty Commercial Segment reported a net loss ratio of 66.8% for the three months ended September 30, 2010 as compared to 60.2% for the same period during 2009. The gross loss ratio before reinsurance was 64.6% for the three months ended September 30, 2010 as compared to 59.6% for the same period during 2009. The higher gross and net loss ratio was impacted by increased volatility in large general liability, commercial automobile and aircraft hull losses in the current accident year. During the three months ended September 30, 2010 the Specialty Commercial Segment reported $0.8 million of favorable prior year loss development as compared to $1.2 million of unfavorable prior loss development for the same period during 2009.

Personal Segment

Net premiums written for our Personal Segment increased $7.7 million during the third quarter of 2010 to $25.1 million as compared to $17.4 million for the third quarter of 2009.  The increase in premium was due mostly to continued geographic expansion.

Total revenue for the Personal Segment increased 36% to $25.4 million for the third quarter of 2010 from $18.7 million for the third quarter of 2009.  Higher earned premium of $6.0 million was the primary reason for the increase in revenue for the period.  Increased finance charges and net investment income of $0.4 million and $0.3 million, respectively, further contributed to the increase in revenue during the third quarter of 2010.

Pre-tax income for the Personal Segment was $0.7 million for the three months ended September 30, 2010 as compared to $2.2 million for the same period of 2009.  Increased revenue was offset by increased losses and LAE of $6.8 million and increased operating expenses of $1.3 million due primarily to increased production related expenses and salary and related expenses due to continued geographic expansion.

The Personal Segment reported a net loss ratio of 79.0% for the three months ended September 30, 2010 as compared to 67.1% for the third quarter of 2009.  The increase in the net loss ratio was due primarily to continued geographic expansion as the resulting growth has created a larger portion of new and maturing business as compared to our mature legacy business.  Our current accident year loss ratio reflects the near term loss ratio penalty associated with this change in mix of seasoned versus less seasoned business.  During the three months ended September 30, 2010, the Personal Segment reported $0.5 million of unfavorable prior loss development as compared to $0.1 million unfavorable prior year development reported for the same period in 2009.

Corporate

Total revenue for Corporate decreased by $0.6 million for the three months ended September 30, 2010 as compared to the same period the prior year.  This decrease in total revenue was due primarily to gains of $0.3 million recognized on our investment portfolio for the three months ended September 30, 2010 as compared to gains of $0.6 million recognized during the same period in 2009.  Further contributing to this decrease in revenue was lower net investment income of $0.3 million for the three months ended September 30, 2010 as compared to the same period of the prior year.

 

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Corporate pre-tax loss was $1.8 million for the three months ended September 30, 2010 as compared to a $2.2 million pre-tax loss for the same period the prior year.  The decrease in pre-tax loss was the result of a $0.7 million reduction in operating expenses during the third quarter of 2010 as compared to the same period during 2009.   The operating expense reduction for the quarter came primarily from lower professional fees of $0.4 million, lower expense related to stock options granted to employees and directors of $0.3 million, lower salary and related expenses of $0.2 million and lower travel expenses of $0.1 million.  These decreases in operating expenses were partially offset by a $0.4 million recovery of advances for a cancelled start-up program during the third quarter of 2009. In addition further contributing to the lower expenses during the third quarter of 2010 as compared to the same period during 2009 was decreased amortization of intangible assets of $0.2 million. Decreased revenue discussed above partially offset the decreased operating expenses.

 

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Nine Months Ended September 30, 2010 as Compared to Nine Months Ended September 30, 2009

The following is additional business segment information for the nine months ended September 30, 2010 and 2009 (in thousands):

Hallmark Financial Services, Inc.

Consolidated Segment Data

		Nine Months Ended September 30, 2010
		Standard				Specialty
		Commercial				Commercial				Personal
		Segment				Segment				Segment				Corporate				Consolidated
Produced premium (1)		$	52,487			$	115,286			$	74,932			$	-			$	242,705
Gross premiums written			52,475				119,831				74,932				-				247,238
Ceded premiums written			(3,092	)			(26,062	)			(109	)			-				(29,263	)
Net premiums written			49,383				93,769				74,823				-				217,975
Change in unearned premiums			200				(1,288	)			(9,518	)			-				(10,606	)
Net premiums earned			49,583				92,481				65,305				-				207,369
Total revenues			52,510				97,503				71,386				6,328				227,727
Losses and loss adjustment expenses			39,451				58,415				48,583				-				146,449
Pre-tax  income (loss), net of
non-controlling interest			(3,043	)			9,829				4,525				(2,255	)			9,056
Net loss ratio (2)			79.6	%			63.2	%			74.4	%							70.6	%
Net expense ratio (2)			31.9	%			29.2	%			21.7	%							29.5	%
Net combined ratio (2)			111.5	%			92.4	%			96.1	%							100.1	%
		Nine Months Ended September 30, 2009
		Standard				Specialty
		Commercial				Commercial				Personal
		Segment				Segment				Segment				Corporate				Consolidated
Produced premium (1)		$	56,881			$	110,598			$	54,968			$	-			$	222,447
Gross premiums written			56,881				108,696				54,968				-				220,545
Ceded premiums written			(3,331	)			(13,383	)			-				-				(16,714	)
Net premiums written			53,550				95,313				54,968				-				203,831
Change in unearned premiums			419				(13,692	)			(4,571	)			-				(17,844	)
Net premiums earned			53,969				81,621				50,397				-				185,987
Total revenues			57,783				97,601				54,971				3,202				213,557
Losses and loss adjustment expenses			33,890				48,422				33,240				-				115,552
Pre-tax  income (loss), net of
non-controlling interest			5,987				14,280				7,738				(6,960	)			21,045
Net loss ratio (2)			62.8	%			59.3	%			66.0	%							62.1	%
Net expense ratio (2)			32.4	%			30.0	%			21.4	%							30.8	%
Net combined ratio (2)			95.2	%			89.3	%			87.4	%							92.9	%

(1)  Produced premium is a non-GAAP measurement that management uses to track total premium produced by our operations. Produced premium excludes unaffiliated third party premium fronted on our recently acquired HCM subsidiary. We believe this is a useful tool for users of our financial statements to measure our premium production whether retained by our insurance company subsidiaries or assumed by third party insurance carriers who pay us commission revenue.

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

 

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Standard Commercial Segment

Gross premiums written for the Standard Commercial Segment were $52.5 million for the nine months ended September 30, 2010, which was $4.4 million, or 8%, less than the $56.9 million reported for the same period in 2009.  Net premiums written were $49.4 million for the nine months ended September 30, 2010 as compared to $53.6 million reported for the same period in 2009.  The decrease in premium volume was predominately due to the deterioration of the general economic environment, particularly in the construction industry, reducing the available insured exposures.

Total revenue for the Standard Commercial Segment of $52.5 million for the nine months ended September 30, 2010 was $5.3 million less than the $57.8 million reported during the same period in 2009.  This 9% decrease in total revenue was primarily due to lower net premiums earned of $4.4 million, decreased profit sharing commission of $0.5 million related to unfavorable loss development on prior treaty years and lower net investment income of $0.4 million.

Our Standard Commercial Segment reported a pre-tax loss of $3.0 million for the nine months ended September 30, 2010 as compared to pre-tax income of $6.0 million for the same period of 2009. Higher loss and LAE of $5.6 million, primarily as a result of weather related losses and unfavorable prior year development, and decreased revenue contributed to this pre-tax loss reported for the nine months ended September 30, 2010. Partially offsetting the decline in results were lower operating expenses of $1.8 million driven by lower general and administrative costs and lower production related expenses.

The Standard Commercial Segment reported a net loss ratio of 79.6% for the nine months ended September 30, 2010 as compared to 62.8% for 2009. The gross loss ratio before reinsurance for the nine months ended September 30, 2010 was 83.2% as compared to the 62.7% reported for the same period of 2009.  The higher gross and net loss ratio for the nine months ended September 30, 2010 was impacted by an increased number of large property losses, including weather related losses.  Further contributing to the higher gross and net loss ratio during the nine months ended September 30, 2010 was unfavorable loss reserve development of $4.1 million, as compared to favorable development of $0.2 million for the same period during 2009.

Specialty Commercial Segment

 The $97.5 million of total revenue for the Specialty Commercial Segment during the nine months ended September 30, 2010 was $0.1 million lower than the $97.6 million reported for the same period in 2009. This decrease in revenue was primarily comprised of lower commission and fee income of $11.6 million primarily related to the shift from a third party agency structure to an insurance underwriting structure. Decreased finance charges of $0.2 million further contributed to this decrease in revenue. This decrease in revenue was partially offset by increased net premiums earned of $10.9 million as a result of the increased retention of business in our E&S Commercial business unit and increased earned premium in our Excess & Umbrella business unit and increased net investment income of $0.9 million.

 

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Pre-tax income for the Specialty Commercial Segment of $9.8 million for the first nine months of 2010 was $4.5 million lower than the $14.3 million reported for the same period in 2009.  The decrease in pre-tax income was primarily due to decreased revenue and higher loss and LAE expenses of $10.0 million.  The decrease in pre-tax income was partially offset by lower operating expenses of $6.1 million.  The decrease in operating expense was the combined result of (i)lower production related expenses of $6.2 million due primarily to lower commission expense and fronting fees in our E&S Commercial business unit as we began direct writing and retaining 100% of this business during 2009, and to increased quota share ceding commissions in our Excess & Umbrella business unit due to increased ceded premiums, (ii) lower salary and related expenses of $0.3 million, partially offset by (iii) increased other operating expenses of $0.4 million, primarily due to increased professional fees. In addition increased amortization of intangible assets of $0.5 million related to our acquisition of CYR on June 5, 2009 further contributed to the decrease in pre-tax income.

The Specialty Commercial Segment reported a net loss ratio of 63.2% for the nine months ended September 30, 2010 as compared to 59.3% for the same period during 2009.  The higher net loss ratio was impacted by (i) late emerging general liability claims and (ii) increased volatility in large general liability claims, aircraft hull losses and commercial automobile claims (partially weather related) in the current accident year. The Specialty Commercial Segment reported $1.7 million of unfavorable prior year development for the nine months ended September 30, 2010 as compared to $3.9 million of unfavorable development for the same period during 2009.

 

Personal Segment

Net premiums written for our Personal Segment increased $19.8 million during the first nine months of 2010 to $74.8 million as compared to $55.0 million for the first nine months of 2009.  The increase in premium was due mostly to continued geographic expansion.

Total revenue for the Personal Segment increased 30% to $71.4 million for the first nine months of 2010 from $55.0 million for the first nine months of 2009.  Higher earned premium of $14.9 million was the primary reason for the increase in revenue for the period.  Increased finance charges of $1.2 million and net investment income of $0.3 million further contributed to the increase in revenue during the first nine months of 2010.

Pre-tax income for the Personal Segment was $4.5 million for the nine months ended September 30, 2010 as compared to $7.7 million for the same period of 2009.  Increased revenue was offset by increased losses and LAE of $15.3 million and increased operating expenses of $4.2 million due mostly to increased production and salary expense related to continued geographic expansion.

The Personal Segment reported a net loss ratio of 74.4% for the nine months ended September 30, 2010 as compared to 66.0% for the same period of 2009.  The increase in the net loss ratio was due primarily to continued geographic expansion as the resulting growth has created a larger portion of new and maturing business as compared to our mature legacy business.  Our current accident year loss ratio reflects the near term loss ratio penalty associated with this change in mix of seasoned versus less seasoned business.  During the nine months ended September 30, 2010, the Personal Segment reported $1.2 million of unfavorable prior loss development driven in large part by legal expense related to a 2001 bad faith claim as compared to $0.2 million favorable prior year development reported for the same period in 2009.

Corporate

Total revenue for Corporate increased by $3.1 million for the nine months ended September 30, 2010 as compared to the same period the prior year.  This increase in total revenue was due primarily to gains of $5.8 million recognized on our investment portfolio for the nine months ended September 30, 2010 as compared to $1.1 million of gains recognized during the same period in 2009.  This increase in revenue was offset by lower net investment income of $1.5 million for the nine months ended September 30, 2010 as compared to the same period of the prior year.

 

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Corporate pre-tax loss was $2.3 million for the nine months ended September 30, 2010 as compared to a $7.0 million pre-tax loss for the same period the prior year.  The decrease in pre-tax loss was the result of increased revenue, as well as a $1.4 million reduction in operating expenses.  The reduction in operating expenses during the nine months ended September 30, 2010 as compared to the same period in the prior year came primarily from lower expense related to stock options granted to employees and directors of $0.6 million, lower professional fees of $0.5 million and lower salary and related expenses of $0.3 million.  In addition further contributing to the lower expenses was decreased amortization of intangible assets of $0.2 million.

Financial Condition and Liquidity

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 September 30, 2010, Hallmark had $12.9 million in unrestricted cash and invested assets at the holding company. Unrestricted cash and invested assets of our non-insurance subsidiaries were $4.0 million as of September 30, 2010.  As of that date, our insurance subsidiaries held $65.1 million of cash and cash equivalents as well as $360.2 million in debt securities with an average modified duration of 2.7 years.  Accordingly, we do not anticipate selling long-term debt instruments to meet any liquidity needs.

AHIC, domiciled in Texas, is limited in the payment of dividends 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 surplus as of the prior year end. Dividends may only be paid from unassigned surplus funds.  HIC, domiciled in Arizona, is limited in the payment of dividends to the lesser of 10% of prior year 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 surplus or prior year’s statutory net income, not including realized capital gains, without prior written approval from the Oklahoma Insurance Department.  During 2010, our insurance company subsidiaries’ ordinary dividend capacity is $19.4 million, of which $15.9 million is available to Hallmark.  As a county mutual, dividends from HCM are payable to policyholders. None of our insurance company subsidiaries paid a dividend to Hallmark during the first nine months of 2010 or the 2009 fiscal year.

Comparison of September 30, 2010 to December 31, 2009

On a consolidated basis, our cash and investments (excluding restricted cash) at September 30, 2010 were $486.2 million compared to $439.9 million at December 31, 2009.  An increase in the fair market value of our investment portfolio for the period and cash from operating activities were the primary reasons for this increase.

 

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Comparison of Nine Months Ended September 30, 2010 and September 30, 2009

Net cash provided by our consolidated operating activities was $28.9 million for the first nine months of 2010 compared to $45.7 million for the first nine months of 2009.  The decrease in operating cash flow was primarily due to higher paid losses and lower collected ceding commissions, partially offset by more collected premiums.

Net cash used in investing activities during the first nine months of 2010 was $59.1 million as compared to $13.8 million for the same period in 2009.  Contributing to the increase in cash used in investing activities were an increase of $82.9 million in purchases of debt and equity securities, partially offset by a $34.6 million increase in maturities, sales and redemptions of investment securities during 2010.

Cash used in financing activities during the first nine months of 2010 was $0.1 million as compared to $6.6 million for the same period of 2009.  The cash used during the first nine months of 2009 was primarily for the payment of a note payable by our premium finance operation and for the repurchase of the Company’s common stock.

Credit Facilities

           Our First Restated Credit Agreement with The Frost National Bank was most recently amended effective May 27, 2010 to extend the term of the facility until May 27, 2012, provide for the repayment of all amounts outstanding at termination on or before April 30, 2015, reduce the revolving commitment to $5.0 million from $25.0 million and eliminate the credit sub-facility for premium finance operations. This amendment further revised various affirmative and negative covenants and changed the interest rate, at our election, to either the prime rate or LIBOR plus 2.5%. We pay an annual average 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.  As of September 30, 2010, we were in compliance with or had obtained waivers of all of our covenants.  As of September 30, 2010, we had $2.8 million outstanding under this facility.

Trust Preferred 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 a Delaware statutory trust, Hallmark Statutory Trust I (“Trust I”).  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 uncollaterized and do not require maintenance of minimum financial covenants. As of September 30, 2010, the balance of our Trust I subordinated debt was $30.9 million.

 

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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 a Delaware statutory trust, Hallmark Statutory Trust II (“Trust II”).  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 uncollaterized and do not require maintenance of minimum financial covenants. As of September 30, 2010, the balance of our Trust II subordinated debt was $25.8 million.

Item 3.  Quantitative and Qualitative Disclosures About Market Risk.

This Item is omitted as permitted for a “smaller reporting company” (as defined by the SEC).

Item 4.  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 most recent fiscal quarter, there have been no changes in our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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

This Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created thereby.  These statements include the plans and objectives of management for future operations, including plans and objectives relating to future growth of our business activities and availability of funds.  The forward-looking statements included herein are based on current expectations that involve numerous risks and uncertainties.  Assumptions relating to the foregoing involve judgments with respect to, among other things, future economic, competitive and market conditions, regulatory framework, 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 the forward-looking statements are reasonable, any of the assumptions could be inaccurate and, therefore, there can be no assurance that the forward-looking statements included in this Form 10-Q will prove to be accurate.  In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and plans will be achieved.

 

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PART II

OTHER INFORMATION

Item 1.          Legal Proceedings.

We are engaged in legal proceedings in the ordinary course of business, none of which, either individually or in the aggregate, are believed likely to have a material adverse effect on our consolidated financial position or results of operations, in the opinion of management.  The various legal proceedings to which we are a party are routine in nature and incidental to our business.

Item 1A.       Risk Factors.

This Item is omitted as permitted for a “smaller reporting company” (as defined by the SEC).

Item 2.          Unregistered Sales of Equity Securities and Use of Proceeds.

None.

Item 3.          Defaults Upon Senior Securities.

None.

Item 4.          (Removed and Reserved.)

Item 5.          Other Information.

None.

Item 6.          Exhibits.

The following exhibits are filed herewith or incorporated herein by reference:

Exhibit Number		Description
3(a)		Restated Articles of Incorporation of the registrant, as amended (incorporated by reference to Exhibit 3.1 to the registrant’s Registration Statement on Form S-1 [Registration No. 333-136414] filed September 8, 2006).
3(b)		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(a)		Specimen certificate for Common Stock, $0.18 par value per share, 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).

 

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Exhibit Number		Description
4(b)		Indenture dated as of 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(c)		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(d)		Form of Junior Subordinated Debt Security Due 2035 (incorporated by reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed June 27, 2005).
4(e)		Form of Capital Security Certificate (incorporated by reference to Exhibit 4.2 to the registrant’s Current Report on Form 8-K filed June 27, 2005).
4(f)		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(g)		Form of Registration Rights Agreement dated January 27, 2006, between Hallmark Financial Services, Inc. and Newcastle Special Opportunity Fund I, L.P. and Newcastle Special Opportunity Fund II, L.P. (incorporated by reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed February 2, 2006).
4(h)		Indenture dated as of August 23, 2007, between Hallmark Financial Services, Inc. and The Bank of New York Trust Company, National Association (incorporated by reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed August 24, 2007).
4(i)		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(j)		Form of Junior Subordinated Debt Security Due 2037 (incorporated by reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed August 24, 2007).
4(k)		Form of Capital Security Certificate (incorporated by reference to Exhibit 4.2 to the registrant’s Current Report on Form 8-K filed August 24, 2007).
4(l)		Seventh Amendment to First Restated Credit Agreement dated May 27, 2010, between Hallmark Financial Services, Inc. and The Frost National Bank (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed June 17, 2010).
31(a)		Certification of principal executive officer required by Rule 13a-14(a) or Rule 15d-14(a).
31(b)		Certification of principal financial officer required by Rule 13a-14(a) or Rule 15d-14(a).

 

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Exhibit Number		Description
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.

SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

HALLMARK FINANCIAL SERVICES, INC.

(Registrant)

Date:  November 10, 2010		/s/ Mark J. Morrison
		Mark J. Morrison, Chief Executive Officer and President
		(Principal Executive Officer)
Date:  November 10, 2010		/s/ Jeffrey R. Passmore
		Jeffrey R. Passmore, Chief Accounting Officer and
		Senior Vice President
		(Principal Financial Officer)

 

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