CONFORMED COPY
U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-KSB
Annual Report under Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the fiscal year ended December 31, 2002
Commission file number 0-16090
HALLMARK FINANCIAL SERVICES, INC.
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(Name of Small Business Issuer in Its Charter)
Nevada 87-0447375
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(State or Other Jurisdiction (I.R.S. Employer I.D. No.)
of Incorporation Organization)
14651 Dallas Parkway, Suite 900, Dallas, Texas 75254
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(Address of Principal Executive Offices) (Zip Code)
Issuer's Telephone Number, Including Area Code: (972) 404-1637
Securities registered under Section 12(b) of the Exchange Act:
Title of Each Class Name of Each Exchange on Which Registered
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Common Stock $.03 par value American Stock Exchange Emerging Company
Marketplace
Securities registered under Section 12(g) of the Exchange Act: None
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for
such shorter period that the registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90 days.
Yes [ XX ] No [ ]
Check if there is no disclosure of delinquent filers in response to Item 405
of Regulation S-B contained in this form, and no disclosure will be
contained, to the best of the registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form
10-KSB or any amendment to this Form 10-KSB.
Yes [ XX ] No [ ]
State issuer's revenues for its most recent fiscal year - $25,797,163.
State the aggregate market value of the voting and non-voting common equity
held by non-affiliates - $2,873,098 as of March 14, 2003.
State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date. Common Stock, $.03 par
value - 11,050,133 shares outstanding as of March 14, 2003.
DOCUMENTS INCORPORATED BY REFERENCE
The information required by Part III is incorporated by reference from the
Registrant's definitive proxy statement to be filed with the Commission
pursuant to Regulation 14A not later than 120 days after the end of the
fiscal year covered by this report.
Risks Associated with Forward-Looking Statements Included in this Form 10-KSB
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This Form 10-KSB contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934, which are intended to be covered by the
safe harbors created thereby. These statements include the plans and
objectives of management for future operations, including plans and
objectives relating to future growth of the Company's business activities
and availability of funds. The forward-looking statements included herein
are based on current expectations that involve numerous risks and
uncertainties. Assumptions relating to the foregoing involve judgments with
respect to, among other things, future economic, competitive and market
conditions, regulatory framework, weather-related events and future business
decisions, all of which are difficult or impossible to predict accurately
and many of which are beyond the control of the Company. Although the
Company believes that the assumptions underlying the forward-looking
statements are reasonable, any of the assumptions could be inaccurate and,
therefore, there can be no assurance that the forward-looking statements
included in this Form 10-KSB will prove to be accurate. In light of the
significant uncertainties inherent in the forward-looking statements
included herein, the inclusion of such information should not be regarded as
a representation by the Company or any other person that the objectives and
plans of the Company will be achieved.
Item 1. Description of Business.
Introduction
Hallmark Financial Services, Inc. ("HFS") and its wholly owned
subsidiaries (collectively, the "Company") engage in the sale of property
and casualty insurance products. The Company's business involves marketing,
underwriting and premium financing of non-standard personal automobile
insurance in Texas, commercial insurance in Texas, New Mexico, Idaho, Oregon
and Washington, third party claims administration and other insurance
related services.
Recent Developments
On January 27, 2003, the Company received final approval from the Arizona
Department of Insurance for the acquisition of Phoenix Indemnity Insurance
Company ("Phoenix), effective January 1, 2003. (See Note 17 to the
consolidated financial statements included in this report). The acquisition
of Phoenix expands the Company's geographic reach in non-standard automobile
insurance from its traditional base in Texas to the states of New Mexico and
Arizona.
Phoenix is an Arizona domiciled property casualty insurance company with
licenses in 24 states. Phoenix targets non-urban markets and underwrites
policies produced by approximately 250 independent agents that are licensed
to conduct business with the company. Customers of Phoenix are drivers who
do not qualify for standard auto insurance due to driving record, claims
history, residency status or type of vehicle. Policies are offered with six
month or monthly terms, principally on a direct bill basis. Policies are
written on a direct basis principally at minimum financial responsibility
limits and reinsurance is purchased on a treaty basis to protect Phoenix
from catastrophic losses.
Phoenix outsources the majority of its administrative functions and had six
full-time employees at the time of its acquisition. The offices of Phoenix
are located in Phoenix, Arizona, where it leases approximately 2,730 square
feet of space from an unaffiliated third party for rent of approximately
$4,350 per month. The lease expires in March 2003.
Overview
The Company pursues its business activities through integrated insurance
groups handling non-standard personal automobile insurance (the "Personal
Lines Group") and commercial insurance (the "Commercial Lines Group"). The
members of the Personal Lines group are an authorized Texas property and
casualty insurance company, American Hallmark Insurance Company of Texas
("Hallmark"); a managing general agency, American Hallmark General Agency,
Inc. ("AHGA"); a network of insurance agencies known as the American
Hallmark Agencies ("Hallmark Agencies"); a premium finance company, Hallmark
Finance Corporation ("HFC"); and an affiliated and third party claims
administrator, Hallmark Claims Service, Inc. ("HCS"). Effective December 1,
2002, the Company purchased the Commercial Lines Group. The members of the
Commercial Lines Group are a managing general agency, Millers General
Agency ("Millers GA"); a financial administrative service company, Financial
and Actuarial Resources, Inc. ("FAR"); and a third party claims
administrator, Effective Litigation Management, Inc. ("ELM"). Effective
February 28, 2003, the Company sold the four existing Hallmark Agencies
offices to three unaffiliated third parties.
Hallmark writes non-standard automobile liability and physical damage
coverages. Hallmark provides insurance through a reinsurance arrangement
with an unaffiliated company, State & County Mutual Fire Insurance Company
("State & County"). Through State & County, Hallmark provides insurance for
drivers who do not qualify for standard-rate insurance.
AHGA holds an appointment from State & County to manage the sale and
servicing of State & County policies ("core" program). Hallmark reinsures
100% of the State & County policies produced by AHGA under a related
reinsurance agreement. AHGA markets through the Hallmark Agencies and
approximately 350 independent agents operating under their own names.
Additionally, AHGA provides premium processing, underwriting, reinsurance
accounting, and cash management for four unaffiliated managing general
agencies ("MGAs") now in run-off.
HFC offers premium financing for policies sold by the Hallmark Agencies
and independent agents managed by AHGA.
HCS provides fee-based claims adjustment, salvage and subrogation
recovery, and litigation services to Hallmark and unaffiliated MGAs.
Millers GA, through approximately 150 independent agents operating under
their own names, markets commercial insurance policies primarily in the
rural areas of Texas, New Mexico, Idaho, Oregon and Washington. Millers GA
currently produces policies on behalf of Clarendon National Insurance
Company ("CNIC") and assumes none of the underwriting risk. Millers GA
earns a commission based on a percentage of the earned premium it produces
for CNIC.
FAR provides financial and administrative services to Millers GA and a
third party.
ELM provides fee-based claims adjustment, salvage and subrogation
recovery, and litigation services on behalf of CNIC and another third party.
Personal Lines Group Operations
Formed in 1987, HFS commenced its current operations in 1990 when it
acquired, through several transactions, most of the companies now referred
to as the Personal Lines Group. HFS manages Hallmark, AHGA, the Hallmark
Agencies, HFC and HCS as an integrated Personal Lines Group that shares
common management, computer facilities and office space.
Hallmark offers both liability and physical damage (comprehensive and
collision) coverages. Hallmark's bodily injury liability coverage is limited
to $20,000 per person and $40,000 per accident, and property damage
liability coverage is limited to $15,000 per accident. Physical damage
coverage is limited to $40,000 and $30,000 for vehicles insured under
annual/six-month and monthly policies, respectively. Hallmark also offers
optional bodily injury liability coverage of $25,000 per person and $50,000
per accident and optional physical damage liability coverage of $25,000 per
accident on annual and semi-annual policies. Late in 2001, rental and towing
coverages were added.
All purchasers of Hallmark policies are individuals. No single customer
or group of related customers has accounted for more than 1% of its net
premiums written during any of the last three years.
The Company writes annual, monthly and six-month policies. The Company's
core net premium volume was composed of a policy mix of 50.7% annual, 46.1%
monthly and 3.2% six-month policies in 2002, and 64.7% annual, 35.1% monthly
and 0.2% six-month policies in 2001. The Company's typical customer is
unable or unwilling to pay either a half or full year's premium in advance.
Accordingly, the Company offers monthly policies, six-month direct bill
policies and annual term policies subject to financing.
The Company finances annual policy premiums produced by AHGA through a
premium finance program offered by HFC. During 2002, 93.9% of Hallmark's
annual policyholders financed their premiums through HFC's premium finance
program. During 2001 and 2000, 93.9% and 93.4%, respectively, of annual
policyholders financed their premiums through HFC.
HCS provides claims adjustment and related litigation services to both the
Company and unaffiliated MGAs. Fees are charged on a per-file basis, as a
percentage of earned premiums or, in certain instances, a combination of
both methods. When HCS receives notice of a loss, a claim file and an
estimated loss reserve are established. HCS's adjusters review, investigate
and initiate claim payments. The Company has an in-house litigation
department that closely manages its claims-related litigation. Management
believes that the Company achieves superior efficiency and cost
effectiveness by principally utilizing its trained employee-adjusters and
in-house litigation department.
The following table shows, for each of the years in the three year period
ended December 31, 2002 (i) the amount of the Personal Lines Group gross
premiums written attributable to various coverages, and (ii) the
underwriting results attributable to each coverage as measured by the net
statutory loss and loss adjustment expense ("LAE") ratio for the calendar
year. The loss and LAE ratio is the ratio of incurred losses and LAE to net
premiums earned for a given period.
Gross Premiums Loss & LAE Ratio (Net,
Written Statutory)
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(in thousands) 2002 2001 2000 2002 2001 2000
------- ------- ------- ---- ---- ----
Auto Liability $ 32,523 $ 31,219 $ 32,641 79.4% 98.1% 83.2%
Auto Physical Damage 19,119 18,395 17,828 72.5% 99.4% 87.5%
------- ------- ------- ---- ---- ----
Total $ 51,643 $ 49,614 $ 50,469 76.8% 98.6% 84.7%
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Commercial Lines Group Operations
The Company's Commercial Lines Group consists of a regional managing
general agency, a third party claims administration company, and a financial
administrative services company which were acquired as of December 1, 2002.
Millers GA markets commercial insurance policies through an independent
agency force primarily in the rural areas of Texas, New Mexico, Idaho,
Oregon, and Washington. ELM administers the claims on insurance policies
produced by Millers GA. These insurance policies consist of small to medium
sized commercial risks, which as a group have relatively stable loss ratios.
The Commercial Lines Group's underwriting criteria exclude lines of
business and classes of risks that are considered to be high hazard or
volatile, or which involve latent injury potential or other long-tail
liability exposures. Selection criteria include specific classes of
businesses, occupancies, and operations with lower hazard ratings, which
present a relatively lower exposure to loss and are charged with a
correspondingly lower premium. The lines of business underwritten are
primarily commercial auto, commercial multi-peril, business owner's policy,
umbrella and other liability. Millers GA currently markets and underwrites
these policies on behalf of CNIC and assumes none of the underwriting risk.
Millers GA earns a commission based on a percentage of the earned premium
it produces for CNIC. ELM receives a claim servicing fee based on a
percentage of the earned premium it produces for CNIC with a portion
deferred for casualty claims. For the one month ended December 31, 2002,
the Commercial Lines Group recognized $1,221,096 of commission revenue and
$339,702 of claim servicing fee revenue.
Underwriting and Other Ratios
An insurance company's underwriting experience is traditionally measured
by its statutory "combined ratio". The combined ratio under statutory
accounting practices ("SAP") is the sum of (1) the ratio of net losses and
LAE incurred to net premiums earned (referred to as the "statutory loss and
LAE ratio"), and (2) the ratio of underwriting and operating expenses to net
premiums written (referred to as the "statutory expense ratio"). During
2002, 2001 and 2000, Hallmark experienced statutory loss and LAE ratios
of 76.8%, 98.6% and 84.7%, respectively. During the same periods, it
experienced statutory expense ratios of 19.5%, 16.7% and 16.4%,
respectively, and statutory combined ratios of 96.3%, 115.3% and 101.1%,
respectively. These statutory ratios do not reflect the deferral of policy
acquisition costs, investment income, premium finance revenues, or the
elimination of intercompany transactions required by accounting principles
generally accepted in the United States of America ("GAAP").
The most significant factor impacting the 2002 and 2001 statutory loss and
LAE ratios was the inclusion of a loss corridor provision in the Company's
reinsurance treaties effective April 1, 2001. The loss corridor provision
increased the losses retained by the Company. See further discussion of the
loss corridor under Reinsurance Arrangements below. Excluding the loss
corridor provision, the statutory loss and LAE ratios for 2002 and 2001
would have been 70.1% and 90.0%, respectively.
The statutory expense ratio for 2002 increased over the 2001 statutory
expense ratio primarily as a result of Hallmark's increase of retained
underwriting risk from 30% at December 31, 2001 to 45% at December 31, 2002.
This increased risk retention reduced ceding commission income which is an
offsetting component of statutory expenses.
Under Texas Department of Insurance ("TDI") guidelines, property and
casualty insurance companies are expected to maintain a premium-to-surplus
ratio of not more than 3 to 1. The premium-to-surplus ratio measures the
relationship between net premiums written in a given period (premiums
written, less returned premiums and reinsurance ceded to other carriers) to
surplus (admitted assets less liabilities), all determined on the basis of
SAP. For 2002, 2001, and 2000, Hallmark's premium-to-surplus ratios were
2.63, 2.62 and 2.98 to 1, respectively. The 2000 premium-to-surplus ratio
was unusually high as a result of increased core State & County premium
volume and to a lesser extent, the increase in unaffiliated MGA premium
volume assumed during 2000.
Reinsurance Arrangements
Hallmark is involved in the assumption and cession of reinsurance from/to
other companies. The Company remains obligated to its policyholders in the
event that the reinsurers do not meet their obligations under the
reinsurance agreements.
Effective March 1, 1992, Hallmark entered into a reinsurance arrangement
with State & County to assume 100% of the nonstandard auto business produced
by AHGA and underwritten by State & County. The earned premiums assumed
under this agreement in 2002 and 2001 were $51,142,856 and $47,430,645,
respectively. Certain funds generated from business produced under this
agreement are maintained in accounts for the benefit of State & County. At
December 31, 2002 and 2001, Hallmark held for the benefit of State & County,
cash and cash equivalents of $3,709,650 and $2,630,268, respectively, and
investment securities at amortized cost of $11,025,013 and $10,970,699,
respectively.
This arrangement is supplemented by a separate retrocession agreement
effective July 1, 2000 between Hallmark and Dorinco Reinsurance Company
("Dorinco"), under which Hallmark currently retains 45% and cedes 55% of the
underwriting risk to Dorinco. Prior to July 1, 2000, Hallmark retroceded
75% of the underwriting risk to its reinsurers (GE Reinsurance and Dorinco)
under a separate retrocession agreement effective January 1,1999 through
June 30, 2000. Under this agreement, Dorinco unconditionally guarantees
Hallmark's obligation to State & County.
Effective April 1, 2001, the Company's reinsurance agreements with Dorinco
were amended to include a loss corridor provision whereby the Company
retains 100% of losses between a loss ratio corridor of 65% to 77% on
policies effective after April 1, 2001. As of July 1, 2001, this corridor
increased to 65% to 80% on policies effective after that date. Further,
Dorinco and the Company executed an agreement effective July 1, 2001, that
among other things, imposes on the Company additional financial and
operational covenants under the Dorinco reinsurance agreements, provides
remedies for the breach of such covenants (including additional surplus
requirements, rate increases and cancellation provisions) and grants to
Dorinco certain options to maintain or increase the level of its reinsurance
of Hallmark policies. Effective October 1, 2002, Dorinco modified the
reinsurance agreement with improved terms, including raising the threshold
of the loss corridor to 65.5% and lowering the ceiling to 75.5%.
Under its reinsurance arrangements with Dorinco, the Company earns ceding
commissions based on Dorinco's loss ratio experience on the portion of
policies ceded to Dorinco. The Company receives a provisional commission as
policies are produced as an advance against the later determination of the
commission actually earned. The provisional commission is adjusted annually
on a sliding scale based on annual loss ratios. As of December 31, 2002 and
2001, the accrued ceding commission payable to Dorinco was $2,536,102 and
$4,598,089, respectively. This accrual represents the difference between
the provisional ceding commission received and the ceding commission earned
based on current loss ratios.
Hallmark assumes business from Dorinco on various unaffiliated MGA
programs. Three of the four programs were in run-off as of December 31,
2002. Subsequent to December 31, 2002, the fourth program was in run-off.
At December 31, 2002 and 2001, Dorinco held cash of $1,072,425 and
$1,990,458, respectively, to secure risks ceded to Hallmark. These amounts
are included in restricted cash in the consolidated balance sheets included
in this report.
The following table presents gross and net premiums written and earned for
each of the last three years:
(in thousands) 2002 2001 2000
-------- -------- --------
Gross premiums written $ 51,643 $ 49,614 $ 50,469
Ceded premiums written (29,611) (33,822) (31,396)
-------- -------- --------
Net premiums written $ 22,032 $ 15,792 $ 19,073
======== ======== ========
Gross premiums earned $ 52,486 $ 49,525 $ 45,520
Ceded premiums earned (32,273) (33,149) (28,125)
-------- -------- --------
Net premiums earned $ 20,213 $ 16,376 $ 17,395
======== ======== ========
Marketing
Hallmark's customers for non-standard automobile insurance typically fall
into two groups. The first are drivers who do not qualify for standard auto
insurance due to driving record, claims history, residency status, type of
vehicle or adverse credit history. The second group is drivers who live in
areas of Texas in which there is limited availability of standard rate
insurance.
As the managing general agency, AHGA manages the marketing of Hallmark's
non-standard automobile insurance program through a retail network of
affiliated and 350 independent agencies located throughout the State of
Texas. At December 31, 2002, four affiliated offices operating under the
American Hallmark Agencies name were located in Amarillo, Corpus Christi,
Lubbock and Lancaster. Effective February 28, 2003, the Company sold the
four existing Hallmark Agencies offices to three unaffiliated third parties.
The Company intends to focus future marketing efforts on its independent
agent base.
The Hallmark Agencies' business was developed primarily through
advertising in regional and local publications, telephone solicitation,
referrals and existing customers. In addition, field marketing
representatives promote the Company's insurance programs to prospective
independent agents and service existing independent agents. The independent
agents represent other insurers and sell other insurance products in
addition to Hallmark policies. The Company's appointed independent agents
are located throughout Texas in major cities, as well as suburban and some
rural areas.
Millers GA markets commercial insurance policies through a force of
approximately 150 independent agencies primarily in the rural areas of
Texas, New Mexico, Idaho, Oregon, and Washington. Millers GA targets
customers that are in low hazard classifications in the standard commercial
market (typically referred to as "main street" accounts). The typical
customer is a small to medium sized business and will have a policy that
covers property, general liability and auto exposures. Millers GA has
historically maintained excellent relationships with its producing agents.
Competition
The property and casualty insurance market, the Company's primary source
of revenue, is highly competitive and, except for regulatory considerations,
has very few barriers to entry. The Company competes with large national
insurance carriers, smaller regional companies and managing general
agencies. The Company's competitors include entities which have, or are
affiliated with entities that have, greater financial and other resources
than the Company.
Generally, the Company competes based upon price, coverages offered,
claims handling, financial stability, customer service, agent commission,
customer recognition and geographic coverage. The Company competes with
companies using independent agents, captive agent networks, direct marketing
channels, or a combination thereof.
The current competitive environment in the personal non-standard auto
insurance market is driven largely by reinsurance capacity and terms.
Beginning in 2000, the capacity and terms offered or available were not
sufficient to continue to support programs with inadequate rates and poor
performance. The resulting effect has been a contraction of the marketplace
allowing remaining competitors to obtain additional rate and/or premium
growth. These conditions continued during 2002.
The current competitive environment in the commercial insurance market is
being impacted by a reduction in capacity as companies, following a
prolonged cyclical downturn in profitability, have reduced premium writing
capacity in areas that have been unprofitable. The Company's primary source
of revenue in this line of business has been the rural or non-urban markets
which have historically provided favorable underwriting results. As with
the personal non-standard auto industry, the commercial insurance
marketplace has contracted, allowing remaining competitors to obtain
additional rate and/or premium growth. Although these conditions continued
during 2002, there is currently more resistance to rate increases.
Insurance Regulation
The operations of Hallmark, AHGA and HFC are regulated by TDI. Hallmark
is required to file quarterly and annual statements of its financial
condition with TDI, prepared in accordance with SAP. Hallmark's financial
condition, including the adequacy of its surplus, loss reserves and
investments, is subject to review by TDI. Hallmark does not write its
insurance directly, but assumes business written directly through a county
mutual insurance company. Under Texas insurance regulation, premium rates
and underwriting guidelines of county mutuals are not subject to the same
degree of regulation imposed on standard insurance companies. AHGA and the
producing agents who staff the Hallmark Agencies offices are also subject to
TDI's licensing requirements. HFC is subject to licensing, financial
reporting and certain financial requirements required by TDI and is also
regulated by the Texas Office of Consumer Credit Commissioner.
TDI has broad authority to enforce its laws and regulations through
examinations, administrative orders, civil and criminal enforcement
proceedings, and suspension or revocation of an insurer's Certificate of
Authority or an agent's license. In extreme cases, including actual or
pending insolvency, TDI may take over, or appoint a receiver to take over,
the management or operations of an insurer or an agent's business or assets.
In addition, all insurance companies which write insurance in the State of
Texas are subject to assessments for a state administered fund which covers
the claims and expenses of insolvent or impaired insurers. The size of the
assessment is determined each year by the total claims on the fund that
year. Each insurer is assessed a pro-rata share based on its direct
premiums written. Payments to the fund may be recovered by the insurer
through deductions from its premium taxes at a rate of 10% per year over ten
years. While no assessments were received during 2002, Hallmark accrued
$50,000 in anticipation of possible assessments. On December 31, 2001, the
Company was assessed $72,692 for 2001.
HFS is also regulated as an insurance holding company under the Texas
Insurance Code. Financial transactions between HFS or any of its affiliates
and Hallmark are subject to regulation by TDI. Applicable regulations
require TDI's approval of management and expense sharing contracts,
intercompany loans and asset transactions, investments in the Company's
securities by Hallmark and similar transactions. Further, dividends and
distributions by Hallmark to HFS are restricted.
On September 20, 2002, TDI issued its formal report on the results of
TDI's regular, triennial examination of Hallmark's books and records as of
December 31, 2001. The report indicated that no significant items or
discrepancies were noted during the examination. On January 29, 2001, TDI
issued its formal report on the results of TDI's market conduct examination
of AHGA. The report indicated that AHGA was in compliance with TDI
regulations governing market conduct in all material respects.
Effective December 31, 1994, the National Association of Insurance
Commissioners ("NAIC") requested property/casualty insurers to file a risk-
based capital ("RBC") calculation according to a specified formula. The
purpose of the NAIC-designed formula is twofold: (1) to assess the adequacy
of an insurer's statutory capital and surplus based upon a variety of
factors such as potential risks related to investment portfolio, ceded
reinsurance and product mix; and (2) to assist state regulators under the
RBC for Insurers Model Act (the "Model Act") by providing thresholds at
which a state commissioner is authorized and expected to take regulatory
action. TDI adopted the Model Act during 1998. Hallmark's 2002 and 2001
adjusted capital under the RBC calculation exceeded the minimum TDI
requirement by 142.9% and 79.9%, respectively.
Millers GA is subject to and in compliance with the licensing requirements
of the department of insurance in each state in which it produces business.
Generally, each state requires one officer of Millers GA to maintain an
agent license. Claim adjusters employed by ELM are subject to the licensing
requirements of each state in which it conducts business. Each employed
claim adjuster either holds or has applied for the required licenses.
Analysis of Hallmark's Losses and LAE
The Company's consolidated financial statements include an estimated
reserve for unpaid losses and LAE of Hallmark. Hallmark estimates its
reserve for unpaid losses and LAE by using case-basis evaluations and
statistical projections, which include inferences from both losses paid and
losses incurred. Hallmark also uses recent historical cost data, periodic
reviews of underwriting standards and claims management to modify the
statistical projections. Hallmark gives consideration to the impact of
inflation in determining its loss reserves, but does not discount reserve
balances.
The amount of Hallmark's reserves represents management's estimates of the
ultimate net cost of all unpaid losses and LAE incurred through December of
each year. These estimates are subject to the effect of trends in claim
severity and frequency. Management continually reviews the estimates and
adjusts them as claims experience develops and new information becomes
known. Such adjustments are included in current operations, including
increases and decreases, net of reinsurance, in the estimate of ultimate
liabilities for insured events of prior years. (See Note 1 to the
consolidated financial statements included in this report.)
Changes in loss development patterns and claim payments can significantly
affect the ability of insurers to estimate reserves for unpaid losses and
related expenses. The Company seeks to continually improve its loss
estimation process by refining its ability to analyze loss development
patterns, claim payments and other information within a legal and regulatory
environment which affects development of ultimate liabilities. Future
changes in estimates of claim costs may adversely affect future period
operating results. However, such effects cannot be reasonably estimated
currently.
Reconciliation of Reserve for Unpaid Losses and LAE. The following table
provides a 2002 and 2001 reconciliation of the beginning and ending reserve
balances, on a gross-of-reinsurance basis, to the gross amounts reported in
the Company's balance sheet at December 31, 2002 and 2001 (in thousands):
2002 2001
------- -------
Reserve for unpaid losses and LAE, net $ 7,919 $ 7,451
of reinsurance recoverables, January 1
Provision for losses and LAE for claims 15,125 15,356
occurring in the current period
Increase in reserve for unpaid losses and 177 522
LAE for claims occurring in prior periods
Payments for losses and LAE, net of reinsurance:
Current period (9,119) (10,033)
Prior periods (5,691) (5,377)
Reserve for unpaid losses and LAE, net of $ 8,411 $ 7,919
reinsurance recoverable, December 31
Reinsurance recoverable on unpaid losses and 9,256 12,170
LAE at December 31
------- -------
Reserve for unpaid losses and LAE, gross of
reinsurance at December 31 $ 17,667 $ 20,089
======= =======
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SAP/GAAP Reserve Reconciliation. The differences between the reserves
for unpaid losses and LAE reported in the Company's consolidated financial
statements prepared in accordance with GAAP and those reported in the annual
statement filed with TDI in accordance with SAP for years 2002 and 2001 are
summarized below (in thousands):
December 31
2002 2001
----- -----
Reserve for unpaid losses and LAE on a SAP
basis (net of reinsurance recoverables on
unpaid losses) $8,296 $7,779
Estimated future unallocated LAE reserve for
HCS 115 140
----- -----
Reserve for unpaid losses and LAE on a GAAP
basis (net of reinsurance recoverables on
unpaid losses) $8,411 $7,919
===== =====
Analysis of Loss and LAE Reserve Development
The following table shows the development of Hallmark's loss reserves, net
of reinsurance, for 1992 through 2002. Section A of the table shows the
estimated liability for unpaid losses and LAE, net of reinsurance, recorded
at the balance sheet date for each of the indicated years. This liability
represents the estimated amount of losses and LAE for claims arising in
prior years that are unpaid at the balance sheet date, including losses that
have been incurred but not yet reported to Hallmark. Section B of the table
shows the re-estimated amount of the previously recorded liability, based on
experience as of the end of each succeeding year. The estimate is increased
or decreased as more information becomes known about the frequency and
severity of claims.
Cumulative Redundancy/Deficiency (Section C of the table) represents the
aggregate change in the estimates over all prior years. Thus, changes in
ultimate development estimates are included in operations over a number of
years, minimizing the significance of such changes in any one year. The
effects on income in the past two years of changes in estimates of the
liabilities for losses and LAE are shown in the table under reconciliation
of reserves for unpaid losses and LAE.
[This space left blank intentionally.]
ANALYSIS OF LOSS AND LAE DEVELOPMENT
(Thousands of dollars)
---------------------- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ----
Year Ended December 31 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02
A. Reserve for 4374 4321 4297 5923 5096 4668 4580 5409 7451 7919 8411
Unpaid Losses & LAE,
Net of Reinsurance
Recoverables
B. Net Reserve Re-
estimated as of :
One year later 3423 4626 5175 5910 6227 4985 4594 5506 7974 8096
Two years later 3285 4499 5076 6086 6162 4954 4464 5277 7863
Three years later 3147 4288 5029 6050 6117 4884 4225 5216
Four years later 3095 4251 5034 6024 6070 4757 4179
Five years later 3067 4238 5031 6099 5954 4732
Six years later 3065 4239 5038 6044 5928
Seven years later 3065 4234 5030 6038
Eight years later 3057 4234 5030
Nine years later 3057 4234
Ten years later 3057
C. Net Cumulative
Redundancy (Deficiency) 1317 87 (733) (115) (832) (64) 401 193 (412) (177)
D. Cumulative Amount
of Claim Paid, Net
of Reserve
Recoveries, through:
One year later 2109 3028 3313 3783 4326 3326 2791 3229 5377 5691
Two years later 2768 3883 4442 5447 5528 4287 3476 4436 7070
Three years later 2958 4147 4861 5856 5860 4387 3911 4909
Four years later 3027 4207 4975 5933 5699 4571 4002
Five years later 3054 4218 5005 6018 5818 4618
Six years later 3056 4223 5030 6018 5853
Seven years later 3056 4234 5030 6029
Eight years later 3057 4234 5030
Nine years later 3057 4234
Ten years later 3057
2001 2002
------ ------
Net Reserve-December 31 $ 7,919 $ 8,411
Reinsurance Recoverables 12,170 9,256
------ ------
Gross Reserve - December 31 $20,089 $17,667
====== ======
Net Re-estimated Reserve 7,829
Re-estimated Reinsurance Recoverable 12,680
------
Gross Re-estimated Reserve $20,509
======
Gross Cumulative Deficiency $ (420)
======
Investment Policy
Hallmark's investment objective is to maximize current yield while
maintaining safety of capital together with sufficient liquidity for ongoing
insurance operations. The investment portfolio is composed of fixed income
securities: U.S. Government and U.S. Government agency debentures and agency
mortgage-backed securities, municipal securities and U.S. Government bond
mutual funds. The average maturity of the portfolio (after taking into
account current assumptions regarding anticipated principal prepayments on
mortgage-backed securities and the call dates of certain securities held),
including short-term investments, is approximately three years, which
approximates Hallmark's claims payment patterns. Hallmark intends to hold
investments until maturity. Maturities, bond calls and prepayments of
mortgage-backed securities totaling approximately $5,858,000 represent the
securities liquidated in 2002.
In addition, as part of the Company's overall investment strategy, the
Company utilizes an integrated cash management system to maximize investment
earnings on all available cash. During 2002, the Company's investment
income totaled approximately $531,114 compared to approximately $1,043,231
for 2001. The decline in investment income from 2001 to 2002 was primarily
attributable to lower investment yields available in the marketplace.
Employees
On December 31, 2002, the Company employed 203 people on a full-time basis
as compared to 128 people at December 31, 2001. The increase in number of
employees from the prior year is the result of the acquisition of the
Commercial Lines Group effective December 1, 2002. None of the Company's
employees are represented by labor unions. The Company considers its
employee relations to be excellent.
Item 2. Description of Property.
The Company's corporate headquarters are located at 14651 Dallas Parkway,
Suite 900, Dallas, Texas. The suite is located in a high-rise office
building and contains approximately 25,570 square feet of space. Effective
June 7, 2000, the Company renegotiated its lease for a period of 71 months
to expire November 30, 2007. The rent is currently $42,617 per month.
The offices of the Commercial Lines Group are located in Fort Worth,
Texas. The Commercial Lines Group currently reimburses its former parent,
Millers American Group ("MAG") for rent under MAG's operating lease. The
suite is located in a high-rise office building and contains 27,808 square
feet of space. The lease expires in November 2009. The rent is currently
$38,236 per month. The Commercial Lines Group intends to either have this
lease assigned to it or to sublease this space from MAG at its current
terms.
Item 3. Legal Proceedings.
Except for routine litigation incidental to the business of the Company,
neither the Company nor any of its properties was subject to any material
pending or threatened legal proceedings as of the date of this report.
Item 4. Submission of Matters to a Vote of Security Holders.
During the fourth quarter of 2002, the Company did not submit any matter
to a vote of its security holders.
PART II
Item 5. Market for Common Equity and Related Stockholder Matters.
The Company's Common Stock has traded on the American Stock Exchange's
Emerging Company Marketplace under the symbol "HAF.EC" since January 6,
1994. The following table shows the Common Stock's high and low sales
prices on the AMEX Emerging Company Marketplace for each quarter since
January 1, 2001.
Period High Sale Low Sale
2001
----
First Quarter $ 0.69 $ 0.50
Second Quarter 0.65 0.50
Third Quarter 0.61 0.43
Fourth Quarter 0.60 0.40
2002
----
First Quarter $ 0.60 $ 0.40
Second Quarter 0.60 0.40
Third Quarter 0.54 0.35
Fourth Quarter 0.70 0.30
2003
----
First Quarter (thru March 14) $ 0.70 $ 0.50
On March 14, 2003 there were 157 record holders and approximately 560
beneficial shareholders of the Company's Common Stock.
The Company has never paid dividends on its Common Stock. The Board of
Directors intends to continue this policy for the foreseeable future in
order to retain earnings for development of the Company's business.
Item 6. Management's Discussion and Analysis or Plan of Operation.
The following discussion of the Company's financial condition and the
results of its operations should be read in conjunction with the
consolidated financial statements and related notes included in this report.
Plan of Operation
The Company recently made two acquisitions that have changed the scope of
its business beyond the non-standard automobile insurance market in the
State of Texas. On December 3, 2002 the Company completed the acquisition
of Millers GA, FAR and ELM. On January 27, 2003 the Company received final
approval from the Arizona Department of Insurance for the acquisition of
Phoenix. Management is focused on completing the assimilation of the two
acquisitions and enhancing its existing Texas non-standard automobile
insurance operations.
The acquisition of Millers GA expanded the lines of business offered by
the Company to include commercial lines of insurance. Millers GA markets and
underwrites small commercial insurance on behalf of CNIC in the states of
Texas, New Mexico, Oregon, Idaho and Washington. Management is not planning
to expand either the geographic or product scope of Millers GA during 2003.
The acquisition of Phoenix expands the Company's geographic reach in non-
standard automobile insurance from its traditional base in Texas to the
states of Arizona and New Mexico. Phoenix is an Arizona domiciled property
casualty insurance company with licenses in 24 states. Management is not
planning to expand the geographic scope of its non-standard auto insurance
operations beyond the states of Texas, New Mexico, and Arizona during 2003.
The acquisitions of Millers GA and Phoenix were financed by a bridge loan
from Newcastle Partners, L.P., an affiliate of the Company's Chairman of the
Board of Directors and Chief Executive Officer, Mark E. Schwarz. The Company
has previously announced its intention to retire this debt through a rights
offering of its common stock to its existing shareholders during 2003. If
the Company is unable to complete the rights offering or restructure the
payment schedule of the bridge loan, the Company may have difficulty meeting
its current liquidity requirements in 2003.
For the last two years, the Personal Lines Group has focused on
operational enhancements related to information technology. During the
summer of 2001, the Company rolled out its web-based information system
(named e-Integrity and referred to as the "Integrity System") which is
designed to enhance Company and agency relationships by improving content
and timeliness of information to support agents in servicing their
customers. The second phase of the Integrity System is composed of
two parts. Part One relates to electronic reporting and communication
capabilities, and Part Two encompasses, among other things, payment and new
business upload to support agents in more promptly and efficiently producing
new business, as well as to improve the quality and timeliness of service to
existing policyholders. Part One alleviates certain manual processes and
results in daily communication of time-sensitive information to agents, thus
decreasing labor, supplies and postage costs and increasing the agent's
likelihood of policyholder retention. This phase was completed during the
first quarter of 2002. Payment upload by the agents, which is included in
Part Two, was introduced during the third quarter of 2002. The remainder of
Part Two, which will further reduce processing costs, rolled out during the
first quarter of 2003 with anticipated cost savings to commence in 2003.
Management is continuing to evaluate opportunities to enhance and expand
the Company's operations. However, the raising of additional capital or
strategic alliances may be required to fund future expansion.
Critical Accounting Policies
The following discussion provides management's assessment of financial
results and material changes in financial position for the Company. This
discussion is based upon the Company's consolidated financial statements,
which have been prepared in accordance with accounting principles generally
accepted in the United States. The Company's significant accounting policies
requiring management estimates and judgments are discussed below. Such
estimates and judgments are based on historical experience, changes in laws
and regulations, observance of industry trends and various information
received from third parties. While the estimates and judgments associated
with the application of these accounting policies may be affected by
different assumptions or conditions, the Company believes the estimates and
judgments associated with the reported consolidated financial statement
amounts are appropriate in the circumstances.
Investments. Investment income is an important source of revenue, and the
Company's return on invested assets has a material effect on net income.
The Company's investment policy is subject to the requirements of regulatory
authorities. In addition, certain assets are held on deposit with the State
of Texas and invested in specified securities in order to comply with state
law. Although the Company closely monitors its investment portfolio,
available yields on newly-invested funds and gains or losses on existing
investments depend primarily on general market conditions. See Item 1 for
additional discussion of the Company's investment policy.
Investments in debt securities are reported at amortized cost. The
Company has the intent and ability to hold all investments in debt
securities to maturity. Provisions for possible losses are recorded only on
other-than-temporary declines in the value of an investment.
Investments in equity securities available-for-sale are reported at market
value. Unrealized gains and losses are recorded as a component of
stockholders' equity.
Short-term investments are carried at amortized cost which approximates
market. Short-term investments include U.S. Government securities maturing
within one year.
Realized investment gains and losses are recognized in operations on the
specific identification method.
Receivable from Lender for Financed Premiums. The majority of Hallmark's
insurance premiums on annual term policies are financed through the
Company's premium finance program offered by its wholly-owned subsidiary,
HFC. Finance charges on the premium finance notes are recorded as interest
earned. This interest is earned on the Rule of 78's method which
approximates the interest method for such short-term notes.
The Company routinely establishes a reserve for uncollectible premium
finance note balances based upon historical experience. As of December 31,
2002 and 2001, the Company's premium finance note receivables were
$11,593,373 and $13,739,622, respectively, net of allowances for
uncollectible amounts of $115,067 and $208,135, respectively.
Effective November 18, 1999, HFC entered into a secured financing
arrangement (the "Financing Arrangement") and a servicing agreement with an
unaffiliated third party in order to fund HFC's premium finance activities.
The Financing Arrangement provides that HFC sell to the third party all
eligible premium finance notes generated by HFC in connection with the
financing of insurance policies. The transaction is accounted for as a
secured financing transaction. Under the Financing Arrangement, HFC may
from time to time specify the amount to be advanced by the third party and
secured by the premium finance notes (up to a maximum of 94% of the face
amount of the premium finance notes).
Collections on the premium finance notes are remitted to HFC to the extent
they exceed the sum of (a) the aggregate amount of all prior advances, (b)
interest on the aggregate advance balance from time to time outstanding, and
(c) certain other fees and expenses payable to the third party. The
interest payable under the Financing Arrangement is at the prime rate plus a
spread ranging from one-half percent to one percent depending on the unpaid
balance of the advances. As of December 31, 2002 and 2001, HFC had an
outstanding balance on advances under the Financing Arrangement of
$10,904,994 and $12,213,205, respectively. The applicable interest rate was
5.75% for both years.
Deferred Policy Acquisition Costs. Policy acquisition costs (mainly
commissions, underwriting and marketing expenses) that vary with and are
primarily related to the production of new and renewal business are deferred
and charged to operations over periods in which the related premiums
are earned. 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. The Company routinely evaluates the realizability of
deferred policy acquisition costs. At December 31, 2002 and 2001, there was
no premium deficiency related to deferred policy acquisition costs.
At December 31, 2002 and 2001, the amount of deferred policy acquisition
costs, net of deferred ceding commissions, was $1,366,116 and $760,729,
respectively.
Business Combinations. The Company accounts for business combinations
using the purchase method of accounting. The cost of an acquired entity is
allocated to the assets acquired (including identified intangible assets)
and liabilities assumed based on their estimated fair values. The excess of
the cost of an acquired entity over the net of the amounts assigned to
assets acquired and liabilities assumed is an asset referred to as "excess
of cost over net assets acquired" or "goodwill". Indirect and general
expenses related to business combinations are expensed as incurred.
Retirement Plans. Certain employees of the Commercial Lines Group were
participants in a defined benefit cash balance plan covering all full-time
employees who had completed at least 1,000 hours of service. The plan was
frozen in March 2001 in anticipation of distribution of plan assets to
members upon plan termination. All participants were vested when the plan
was frozen. Management, in conjunction with its consulting actuaries,
determined the appropriate assumptions to be used in valuing the projected
benefit obligation of the plan at December 31, 2002. Assumptions used
considered the expected payout period for the liabilities and underlying
assets held to fund the obligation.
Intangible Assets. When Hallmark, AHGA, HFC and HCS were purchased by
HFS, the excess cost over the fair value of the net assets acquired was
recorded as goodwill. Prior to 2002, this goodwill was amortized on a
straight-line basis over forty years. Other intangible assets consisted of
a trade name, a managing general agent's license and non-compete
arrangements, all of which are fully amortized.
On January 1, 2002, the Company adopted Statement of Financial Accounting
Standards No. 142 ("SFAS 142"), Goodwill and Other Intangible Assets". SFAS
142 supersedes APB 17, "Intangible Assets", and primarily addresses the
accounting for goodwill and intangible assets subsequent to their initial
recognition. SFAS 142 (1) prohibits the amortization of goodwill and
indefinite-lived intangible assets, (2) requires testing of goodwill and
indefinite-lived intangible assets on an annual basis for impairment (and
more frequently if the occurrence of an event or circumstance indicates an
impairment), (3) requires that reporting units be identified for the purpose
of assessing potential future impairments of goodwill, and (4) removes the
forty-year limitation on the amortization period of intangible assets that
have finite lives.
Pursuant to SFAS 142, the Company has identified two components of
goodwill and assigned the carrying value of these components into two
reporting units: the insurance company reporting unit and the finance
company reporting unit. During 2002, the Company completed the two step
process prescribed by SFAS 142 for testing for impairment and determining
the amount of impairment loss related to goodwill associated with these two
reporting units. Accordingly, during 2002, the Company recorded a charge
to earnings that is reported as a cumulative effect of the change in
accounting principle of $1,694,025 to reflect the adjustment to goodwill.
Since goodwill is a permanent difference, the charge to earnings has no tax
impact. In accordance with SFAS 142 guidance, this adjustment was booked
as of January 1, 2002.
A reconciliation of net income and earnings per share as reported to
illustrate the impact of goodwill amortization for the year ended December
31, 2002 and 2001 is as follows:
(In thousands except for earnings per share
amounts) 2002 2001
-------- --------
Reported net income (loss) $ (1,671) $ (1,130)
Add back: Goodwill amortization - 157
-------- --------
Adjusted net income (loss) $ (1,671) $ (973)
======== ========
Basic and diluted earnings per share:
Reported net income (loss) $ (0.15) $ (0.10)
Add back: Goodwill amortization - 0.01
-------- --------
Adjusted net income (loss) $ (0.15) $ (0.09)
======== ========
On December 1, 2002, the Company acquired the assets of Millers GA, ELM
and FAR. The agency relationships were valued at $542,580 and are being
amortized over twenty years. The Company recognized $2,261 of amortization
expense for the one month ending December 31, 2002. As of December 31,
2002, the intangible assets related to this acquisition were composed of
$2,434,048 of goodwill and $540,319 for the Company's relationships with its
independent agents. The Company continually reevaluates the propriety of
the carrying amount of goodwill as well as the amortization period for
intangible assets to determine whether current events and circumstances
warrant adjustments to the carrying value and/or revised estimates of useful
lives of intangible assets. At this time, the Company believes that no
significant impairment of the goodwill has occurred and that no reduction of
the estimated useful life is warranted.
Deferred Tax Assets. The Company files a consolidated federal income tax
return. Deferred federal income taxes reflect the future tax consequences
of differences between the tax bases of assets and liabilities and their
financial reporting amounts at each year end. Deferred taxes are recognized
using the liability method, whereby tax rates are applied to cumulative
temporary differences based on when and how they are expected to affect the
tax return. Deferred tax assets and liabilities are adjusted for tax rate
changes. A valuation allowance is provided against the Company's deferred
tax asset to the extent that management does not believe it is more likely
than not that future taxable income will be adequate to realize these future
tax benefits. This allowance was $33,000 in 2002 and 2001. The Company's
deferred tax asset, net of the valuation allowance, was $1,021,000 and
$425,000 at December 31, 2002 and 2001, respectively.
Reserves for Unpaid Losses and Loss Adjustment Expenses. Reserves for
unpaid losses and loss adjustment expenses are established by the Company
for claims which have already been incurred by the policyholder but which
have not been paid by the Company. Losses and loss adjustment expenses
represent the estimated ultimate net cost of all reported and unreported
losses incurred through December 31, 2002 and 2001. The reserves for unpaid
losses and loss adjustment expenses are estimated using individual case-
basis valuations and statistical analyses. These estimates are subject to
the effects of trends in loss severity and frequency. Although considerable
variability is inherent in such estimates, management believes that the
reserves for unpaid losses and loss adjustment expenses are adequate. The
estimates are continually reviewed and adjusted as experience develops or
new information becomes known. Such adjustments are included in current
operations. The reserves for unpaid losses and loss adjustment expenses of
$17,667,255 and $20,088,885 at December 31, 2002 and 2001, respectively, are
reported net of recoverables for salvage and subrogation of $350,000 and
$320,000 for both 2002 and 2001, respectively.
The Company's reserve requirements are also interrelated with product
pricing and profitability. The Company must price its products at a level
sufficient to fund its policyholder benefits and still remain profitable.
Because the Company's claim expenses represent the single largest category
of its operating expenses, inaccuracies in the assumptions used to estimate
the amount of such benefits can result in the Company failing to price its
products appropriately and to generate sufficient premiums to fund its
operations.
Recognition of Premium Revenues. Insurance premiums and policy fees are
earned pro rata over the terms of the policies. Upon cancellation, any
unearned premium and policy fee is refunded to the insured. Insurance
premiums written include gross policy fees of $5,055,539 and $5,007,809 and
policy fees, net of reinsurance, of $2,051,356 and $1,481,718 for the years
ended December 31, 2002 and 2001, respectively.
Recognition of Commission Revenues and Expenses of the Commercial Lines
Group. Commission revenue and commission expense related to insurance
policies serviced by the Company are recognized during the period covered by
the policy. Profit sharing commission is recognized when the ratio of
ultimate losses and loss expenses incurred to earned premium ("loss ratio")
as determined by a qualified actuary fall below contractual thresholds. The
profit sharing commission is an estimate that varies with the estimated loss
ratio and is sensitive to changes in that estimate. For each 0.5% change in
the loss ratio, the profit sharing commission changes by approximately
$120,000.
Recognition of Claim Servicing Fees of the Commercial Lines Group. Claim
servicing fees are recognized during the period covered by the insurance
policy with a portion of the fees related to casualty claims deferred and
recognized over two years following the expiration of the policy.
Reinsurance. As is customary in the insurance industry, the Company
reinsures, or cedes, portions of the coverage provided to policyholders to
other insurance companies. Cession of reinsurance is utilized by an insurer
to limit its maximum loss, thereby providing a greater diversification of
risk and minimizing exposures on larger risks. Reinsurance does not
discharge the primary liability of the original insurer with respect to such
insurance. See Item 1 for further discussion of the Company's reinsurance
arrangements.
Statutory Accounting Practices. Hallmark is required to report its
results of operations and financial position to TDI based upon SAP. Under
SAP, unlike GAAP, Hallmark is required to expense all sales and other policy
acquisition costs as they are incurred rather than capitalizing and
amortizing them over the expected life of the policy. The immediate charge
off of sales and acquisition expenses and the sometimes conservative other
valuations under SAP generally cause a lag between the sale of a policy and
the emergence of reported earnings. Because this lag can reduce Hallmark's
gain from operations on a SAP basis, it can have the effect of reducing the
amount of funds available for dividend to HFS.
Financial Condition and Liquidity
The Company's sources of funds are principally derived from insurance
related operations. Major sources of funds from operations include premiums
collected (net of policy cancellations and premiums ceded), ceding
commissions, processing fees, premium finance service charges and service
fees. Other sources of funds are from financing and investment activities.
On a consolidated basis, the Company's liquidity increased approximately
15.7% as of December 31, 2002 as compared to December 31, 2001. The
Company's consolidated cash, cash equivalents and investments at December
31, 2002 and 2001 were $25,180,222 and $21,756,136, respectively, excluding
restricted cash of $1,072,425 and $1,990,458, respectively.
Net cash provided by the Company's consolidated operating activities was
approximately $1,949,000 for the year ended December 31, 2002, compared to
net cash used by operating activities of $1,386,000 for the year ended
December 31, 2001. During 2002, the Company increased its retention of its
core business from 30% at December 31, 2001 to 45% at December 31, 2002,
which accounted for approximately $1,839,000 of the increase in cash flow
from operations. The acquisition of Millers GA, ELM and FAR generated a one
month cash inflow of $852,000 to operations. During 2001, the Company paid
out $1,386,000 related to the settlement of a lawsuit which reduced
operations cashflow for 2001. The Company recovered $696,392 from the IRS
during 2002 for overpayment of previous years taxes. Partially offsetting
these increases in operating cash flow is the net change in the accrued
ceding commission payable to reinsurers of $2,062,000.
Cash used by investing activities during 2002 increased approximately
$5,482,000 as compared to 2002. During 2002, the Company purchased a note
receivable in the amount of $6,500,000 from a financial institution which
was secured by the stock of two companies. (See Note 5 to the consolidated
financial statements included in this report.) Additionally, in 2002 the
Company purchased the Commercial Lines Group for $2,100,000 plus assumption
of certain liabilities. These two transactions were partially offset by the
reduction in the premium finance note receivables as the volume of the
annual term insurance policies that are premium financed declined.
Cash provided by financing activities increased by approximately
$6,365,000 during 2002 as compared to 2001 primarily due to funds from a
related party promissory note of $8,600,000 which were used to purchase the
note receivable and Commercial Lines Group discussed above. (See Note 7
to the consolidated financial statements included in this report.) This
increase was partially offset by a decrease in net advances from the
Company's premium finance lender.
HFS is dependent on dividend payments and management fees from its
insurance company operations and free cash flow of its non-insurance
companies to meet operating expenses and debt obligations. As of December
31, 2002, cash and invested assets of HFS were $623,232. Cash and invested
assets of non-insurance subsidiaries were $917,286 as of December 31, 2002.
Property and casualty insurance companies domiciled in the State of Texas
are limited in the payment of dividends to their shareholders in any twelve-
month period, without the prior written consent of the Commissioner of
Insurance, to the greater of statutory net income for the prior calendar
year or 10% of its statutory policyholders' surplus as of the prior year
end. Dividends may only be paid from statutorily unassigned surplus funds.
During 2003, Hallmark's ordinary dividend capacity is $839,380. During 2002,
Hallmark paid dividends to HFS of $600,000.
TDI regulates financial transactions between Hallmark, HFS and affiliated
companies. Applicable regulations required TDI's approval of management and
expense sharing contracts and similar transactions. Although TDI has
approved Hallmark's payment of management fees to HFS and commissions to
AHGA, since the second half of 2000 management has elected not to pay all
the commissions or management fees. Hallmark paid management fees of
$242,500 to HFS during 2002, as compared to $50,000 in 2001. During 2003,
Hallmark is permitted to pay up to $600,000 in management fees to HFS under
the management fee agreement that is currently in place.
At December 31, 2002, Hallmark reported statutory capital and surplus of
$8,393,795, which reflects an increase of $2,376,264 from the $6,017,531
reported at December 31, 2001. During 2002, HFS contributed the common
stock of HFC to Hallmark as a capital contribution of $2,418,852. Hallmark
reported statutory net income of $436,135 during 2002 compared to statutory
net loss of $861,829 in 2001. Additionally, Hallmark increased its
deferred tax asset by $130,106 during 2002 which was a direct increase to
surplus. At December 31, 2002, Hallmark's premium-to-surplus ratio was 2.63
to 1 as compared to 2.62 to 1 for the year ended December 31, 2001.
HFC has entered into a secured financing arrangement and a servicing
agreement with an unaffiliated third party in order to fund HFC's premium
finance activities. The financing arrangement provides that HFC sell to the
third party all eligible premium finance notes generated by HFC in
connection with the financing of insurance policies. Under the financing
arrangement, HFC may from time to time specify the amount to be advanced by
the third party and secured by the premium finance notes (up to maximum of
94% of the face amount of the premium finance notes). Collections on the
premium finance notes are remitted to HFC to the extent they exceed the sum
of (a) the aggregate amount of all prior advances, (b) interest on the
aggregate advance balance from time to time outstanding, and (c) certain
other fees and expenses payable to the third party. The interest payable
under the financing arrangement is at the prime rate plus a spread ranging
from one-half percent to one percent depending on the unpaid balance of the
advances. As of December 31, 2002 and 2001, HFC had an outstanding balance
on advances under the financing arrangement of $10,904,994 and $12,213,205,
respectively, and the applicable interest rates were 5.75% for both years.
Under the financing arrangement, the maximum advances available to HFC were
$2,595,006 and $1,286,795 at December 31, 2002 and 2001, respectively. The
balance under the financing arrangement will be repaid during the coming
year as associated premium finance notes are repaid.
Results of Operations
Net income before the cumulative effect of a change in accounting
principle was $23,000 for the year ended December 31, 2002, compared to a
net loss of $1,130,000 for the year ended December 31, 2001. The
improvement in operating earnings for the full year of 2002, as compared to
2001, reflects improved loss ratios of the Personal Lines Group as a result
of increases in premium rates.
Gross premiums written (prior to reinsurance) of $51,642,679 for the year
ended December 31, 2002 increased 4.1% in relation to gross premiums written
in 2002. The increase in premiums written is principally attributable to
the impact of increased premium rates. Net premiums written (after
reinsurance) increased 39.5% during 2002 as compared to 2001. The
disproportionate change between the percentage increase in gross written
premiums and net written premiums is due to Hallmark's increased retention
of business during 2002 from 30% at December 31, 2001 to 45% at December 31,
2002.
Gross premiums earned (prior to reinsurance) of $52,485,558 increased 6.0%
during 2002 as compared to 2001, and net premiums earned (after reinsurance)
increased 23.4%. The disproportionate change between the percentage
increase in gross premiums earned and net premiums earned is due to
Hallmark's increased retention of business during 2002 as discussed in the
paragraph above.
Investment income, net of expenses, decreased $512,117 (49.1%) during 2002
as compared to 2001. The decline in investment income from 2001 to 2002 was
primarily attributable to lower investment yields available in the
marketplace.
Finance charges, which decreased $611,357 (19.8%) during 2002 as compared
to 2001, represent interest earned on premium notes issued by HFC. This
change is related to the decrease in annual term insurance policies and was
partially offset by increased premium rates.
Commission and fees represent commissions and claim servicing fees earned
by the Commercial Lines Group on insurance policies serviced by the Company
for CNIC and another unaffiliated third party. This was a new source of
revenue for the Company which commenced in December 2002.
Processing and service fees represent fees earned on processing and
servicing contracts with unaffiliated MGAs. Processing and service fees for
2002 decreased $663,127 (59.2%) as a result of cancellation of the service
contracts with three unaffiliated MGAs. These contracts are currently in
run-off.
Other income increased $182,415 (49.4%) during 2002 as compared to 2001.
During 2002, the Company received $218,213 of interest income on the
$6,500,000 note receivable acquired during 2002.
Incurred loss ratios (computed on premiums earned both prior to and after
reinsurance), on a GAAP basis, for the year ended December 31, 2002 were
approximately 69.5% and 75.7%, respectively, as compared to 88.3% prior to
and 97.0% after reinsurance for 2001. The most significant factor impacting
the net loss ratios after reinsurance was the inclusion of a loss corridor
provision in Hallmark's reinsurance treaties effective April 1, 2001. This
provision is discussed under Reinsurance Agreements in Item 1 above. The
improvement in the loss ratios for 2002 are due to management's focus on the
underwriting profitability through rate increases and more restrictive
underwriting guidelines beginning in 2001.
Acquisition costs, net represents the amortization over the past twelve
months of acquisition costs (and credits) previously deferred and the
deferral of acquisition costs (and credits) incurred in the current period.
The decrease in acquisition costs, net, is primarily due to the combined
effect of a decrease in ceding commission income due to changes in
Hallmark's retention and a slight increase in underwriting expenses related
to increased premium volume during 2002.
Other acquisition and underwriting expenses increased $3,794,900 as
compared to the prior year. The increase in other acquisition and
underwriting expenses is primarily attributable to (1) a $1,368,292 decrease
in ceding commission income as a result of Hallmark's increased retention of
business, (2) an approximate $1,555,085 of underwriting expenses of the
Commercial Lines Group for the one month activity during 2002, and (3)
increased variable expenses (commissions, front fees, premium taxes, etc.)
related to the increased premium volume during 2002. The expenses of the
Commercial Lines Group include commissions, salaries and benefits, and other
general and administrative expenses.
Operating expenses include expenses related to premium finance operations,
general corporate overhead, and third party administrative and claims
handling contracts. Related revenues are derived from finance charges and
processing and service fees. Operating expenses for 2002 decreased 22.0%
($735,122) in relation to the prior year. The majority of this decrease is
attributable to decreases in expenses related to the claims handling and
premium processing for the unaffiliated MGA programs (three of which were in
run-off at December 31, 2002) and to the decrease in annual term policies.
While interest expense only decreased 3.8% during 2002, as compared to
2001, the components of interest expense changed during 2002. Interest
expense related to the financing arrangement with an unaffiliated third
party decreased $165,266 during 2002, as compared to 2001. This decrease
was partially offset by the interest expense on the note payable to related
party of $148,597.
[This space left blank intentionally]
Item 7. Financial Statements
The following consolidated financial statements of the Company
and its subsidiaries are filed as part of this report.
Description Page Number
----------- -----------
Report of Independent Accountants F-2
Consolidated Balance Sheets at December 31, 2002 and 2001 F-3
Consolidated Statements of Operations for the Years Ended
December 31, 2002 and 2001 F-4
Consolidated Statements of Stockholders' Equity for the Years
Ended December 31, 2002 and 2001 F-5
Consolidated Statements of Cash Flows for the Years Ended
December 31, 2002 and 2001 F-6
Notes to Consolidated Financial Statements F-7
Item 8. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.
None
PART III
Item 9. Directors, Executive Officers, Promoters and Control Persons;
Compliance with Section 16(a) of the Exchange Act.
The information required by Part III, Item 9 is incorporated by reference
from the Registrant's definitive proxy statement to be filed with the
Commission pursuant to Regulation 14A not later than 120 days after the end
of the fiscal year covered by this report.
Item 10. Executive Compensation.
The information required by Part III, Item 10 is incorporated by reference
from the Registrant's definitive proxy statement to be filed with the
Commission pursuant to Regulation 14A not later than 120 days after the end
of the fiscal year covered by this report.
Item 11. Security Ownership of Certain Beneficial Owners and Management.
The information required by Item 403 of Regulation S-B 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.
The following table sets forth information regarding securities authorized
for issuance under the Company's equity compensation plans as of
December 31, 2002:
Number of securities Weighted-average Number of securities
to be issued upon exercise price remaining available for
exercise of of outstanding future issuance under
outstanding options, equity compensation plans
options, warrants warrants and (excluding securities
and rights rights reflected in column (a))
(a) (b) (c)
----------- ----- -----------
Equity compensation 2,379,000 $ 0.50 914,000 (2)
plans approved by
security holders(1)
Equity compensation - N/A -
plans not approved
by security
holders(3)
--------- ----- -------
Total 2,379,000 $ 0.50 914,000
========= ===== =======
(1)
Includes the 1991 Key Employee Stock Option Plan, the 1994 Key
Employee Long Term Incentive Plan, and a non-qualified plan for
non- employee directors.
(2)
Includes 914,000 shares available for future grant under the 1994
Key Employee Long Term Incentive Plan and non-qualified plan for
non- employee directors.
(3)
There are no equity compensation plans in place not approved by
shareholders.
Item 12. Certain Relationships and Related Transactions.
The information required by Part III, Item 12 is incorporated by reference
from the Registrant's definitive proxy statement to be filed with the
Commission pursuant to Regulation 14A not later than 120 days after the end
of the fiscal year covered by this report.
Item 13. Exhibits and Reports on Form 8-K.
(a) Exhibits. The exhibits listed in the Exhibit Index appearing at
page 24 of this report are filed with or incorporated by reference in this
report.
(b) Reports on Form 8-K. The registrant filed a current report on
Form 8-K on November 8, 2002, disclosing its acquisition of a secured
promissory note from an unaffiliated third party. The registrant filed a
current report on Form 8-K on December 4, 2002, disclosing its acquisition
of Millers GA, FAR, and ELM.
Item 14. Controls and Procedures.
The Chief Executive Officer and Chief Financial Officer of the Company
have evaluated the Company's disclosure controls and procedures as of a date
within 90 days of the filing date of this report and have concluded that
such controls and procedures are effective. There have been no significant
changes in the Company's internal controls or in other factors that could
significantly affect these controls subsequent to the date of their
evaluation.
[This space left blank intentionally.]
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.
HALLMARK FINANCIAL SERVICES, INC.
(Registrant)
Date: March 27, 2003 /s/ Mark E. Schwarz
---------------------------------------
Mark E. Schwarz, Chairman (Chief
Executive Officer)
Date: March 27, 2003 /s/ Timothy A. Bienek
---------------------------------------
Timothy A. Bienek, President (Chief
Operating Officer)
Date: March 27, 2003 /s/ Scott K. Billings
---------------------------------------
Scott K. Billings, Vice President
(Chief Financial Officer/Principal
Accounting Officer)
In accordance with the Exchange Act, this report has been signed below by
the following persons on behalf of the registrant and in the capacities an
on the dates indicated.
Date: March 27, 2003 /s/ Mark. E. Schwarz
---------------------------------------
Mark E. Schwarz, Director
Date: March 27, 2003 /s/ Timothy A. Bienek
---------------------------------------
Timothy A. Bienek, Director
Date: March 27, 2003 /s/ James H. Graves
---------------------------------------
James H. Graves, Director
Date: March 27, 2003 /s/ George R. Manser
---------------------------------------
George R. Manser, Director
Date: March 27, 2003 /s/ Scott T. Berlin
---------------------------------------
Scott T. Berlin, Director
CERTIFICATIONS
I, Mark E. Schwarz, Chief Executive Officer of Hallmark Financial
Services, Inc. (the "Company"), certify that:
1. I have reviewed this annual report on Form 10-KSB of the Company;
2. Based on my knowledge, this annual report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances under
which such statements were made, not misleading with respect to the period
covered by this annual report;
3. Based on my knowledge, the financial statements, and other
financial information included in this annual report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the Company as of, and for, the periods presented in this annual
report;
4. The Company's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the Company and have:
a) designed such disclosure controls and procedures to ensure
that material information relating to the Company, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this annual report is
being prepared;
b) evaluated the effectiveness of the Company's disclosure
controls and procedures as of a date within 90 days prior to the filing date
of this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The Company's other certifying officers and I have disclosed,
based on our most recent evaluation, to the Company's auditors and the audit
committee of the Company's board of directors (or persons performing the
equivalent functions):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the Company's ability to
record, process, summarize and report financial data and have identified for
the Company's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the registrant's internal
controls; and
6. The Company's other certifying officers and I have indicated in
this annual report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
Date: March 27, 2003
/s/ Mark E. Schwarz
________________________________________
Mark E. Schwarz, Chief Executive Officer
I, Scott K. Billings, Chief Financial Officer of Hallmark Financial
Services, Inc. (the "Company"), certify that:
1. I have reviewed this annual report on Form 10-KSB of the Company;
2. Based on my knowledge, this annual report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances under
which such statements were made, not misleading with respect to the period
covered by this annual report;
3. Based on my knowledge, the financial statements, and other
financial information included in this annual report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the Company as of, and for, the periods presented in this annual
report;
4. The Company's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the Company and have:
a) designed such disclosure controls and procedures to ensure
that material information relating to the Company, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this annual report is
being prepared;
b) evaluated the effectiveness of the Company's disclosure
controls and procedures as of a date within 90 days prior to the filing date
of this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The Company's other certifying officers and I have disclosed,
based on our most recent evaluation, to the Company's auditors and the audit
committee of the Company's board of directors (or persons performing the
equivalent functions):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the Company's ability to
record, process, summarize and report financial data and have identified for
the Company's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the registrant's internal
controls; and
6. The Company's other certifying officers and I have indicated in
this annual report whether there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
Date: March 27, 2003
/s/ Scott K. Billings
__________________________________________
Scott K. Billings, Chief Financial Officer
EXHIBIT INDEX
The following exhibits are either filed with this report or incorporated
by reference.
Exhibit
Number Description
------ -----------
2(a) Loan Purchase and Sale Agreement, between Hallmark Financial
Services, Inc and LaSalle Bank National Association dated
November 1, 2002 (incorporated by reference to Exhibit 2 to the
registrant's current report on Form 8-K filed November 8, 2002).
2(b) Promissory Note dated November 1, 2002, for $9,000,000 payable
by Hallmark Financial Services, Inc. to Newcastle Partners, L.P.
(incorporated by reference to Exhibit 4 to the registrant's
current report on Form 8-K filed November 8, 2002).
2(c) Purchase Agreement dated November 26, 2002 between Hallmark
Financial Services, Inc., Millers American Group, Inc. and The
Millers Insurance Company (incorporated by reference to Exhibit
2(a) to the registrant's current report on Form 8-K filed
December 4, 2002).
2(d) Assumption Agreement dated December 1, 2002 between Millers
Insurance Company, Millers General Agency, Inc. and Phoenix
Indemnity Insurance Company (incorporated by reference to Exhibit
2(b) to the registrant's current report on Form 8-K filed
December 4, 2002).
3(a) Articles of Incorporation of the registrant, as amended
(incorporated by reference to Exhibit 3(a) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended December
31, 1993).
3(b) By-Laws of the registrant, as amended (incorporated by reference
to Exhibit 3(b) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 1993).
3(c) Amendment of Article VII of the Amended and Restated Bylaws
of Hallmark Financial Services, Inc., adopted July 19, 2002
(incorporated by reference to Exhibit 10(b) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended September
30, 2002).
4 Specimen certificate for Common Stock, $.03 par value, of the
registrant (incorporated by reference to Exhibit 4 to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1991).
10(a) Office Lease for 14651 Dallas Parkway, Suite 900, dated January
1, 1995, between American Hallmark Insurance Company of Texas and
Fults Management Company, as agent for The Prudential Insurance
Company of America (incorporated by reference to Exhibit 10(a) to
the registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1994).
10(b) General Agency Agreement, effective March 1, 1992, between State
& County Mutual Fire Insurance Company and Brokers General, Inc.
(incorporated by reference to Exhibit 10(b) to Amendment No. 1 on
Form 8 to the registrant's Quarterly Report on Form 10-QSB for
the quarter ended September 30, 1992).
10(c) 1991 Key Employee Stock Option Plan of the registrant
(incorporated by reference to Exhibit C to the definitive
Proxy Statement relating to the registrant's Annual Meeting
of Shareholders held May 20, 1991).
10(d) 1994 Key Employee Long Term Incentive Plan (incorporated by
reference to Exhibit 10(f) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 1994).
10(e) 1994 Non-Employee Director Stock Option Plan (incorporated by
reference to Exhibit 10(g) to the registrant's Annual Report on
Form 10-KSB for the fiscal year ended December 31, 1994).
Exhibit
Number Description
------ -----------
10(f) Addendum No. 1 to the 100% Quota Share Reinsurance Agreement, as
restated between State & County Mutual Fire Insurance Company and
American Hallmark Insurance Company of Texas effective November
22, 1994 (incorporated by reference to Exhibit 10(q) to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1994).
10(g) Second, Third, Fourth and Fifth Amendments to Office Lease for
14651 Dallas Parkway, Suite 900, dated January 1, 1995, between
American Hallmark Insurance Company of Texas and Fults Management
Company, as agent for The Prudential Insurance Company of America
(incorporated by reference to Exhibit 10(t) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended December
31, 1995).
10(h) Quota Share Reinsurance Agreement between State & County Mutual
Fire Insurance Company and American Hallmark Insurance Company
of Texas effective July 1, 1996 (incorporated by reference to
Exhibit 10(a) to the registrant's Quarterly Report on Form
10-QSB for the quarter ended June 30, 1996).
10(i) Quota Share Retrocession Agreement between American Hallmark
Insurance Company of Texas and the Reinsurer (specifically
identified as follows: Dorinco, Kemper and Skandia), effective
July 1, 1996 (incorporated by reference to Exhibit 10(b) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended June 30, 1996).
10(j) Guaranty Agreement effective July 1, 1996 provided by Dorinco
Reinsurance Company in favor of State & County Mutual Fire
Insurance Company (incorporated by reference to Exhibit 10(c) to
the registrant's Quarterly Report on Form 10-QSB for the quarter
ended June 30, 1996).
10(k) Guaranty of Performance and Hold Harmless Agreement effective
July 1, 1996 between Hallmark Financial Services, Inc. and
Dorinco America Reinsurance Corporation (incorporated by
reference to Exhibit 10(f) to the registrant's Quarterly
Report on Form 10-QSB for the quarter ended June 30, 1996).
10(l) Addendum No. 3 - Termination to 100% Quota Share Reinsurance
Agreement between American Hallmark Insurance Company and State
& County Mutual Fire Insurance Company (incorporated by reference
to Exhibit 10(j) to the registrant's Quarterly Report on Form
10-QSB for the quarter ended June 30, 1996).
10(m) 100% Quota Share Reinsurance Agreement, effective January 1,
1997, between State & County Mutual Fire Insurance Company,
Vaughn General Agency, Inc. and American Hallmark General
Agency, Inc. (incorporated by reference to Exhibit 10(am) to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1996).
10(n) General Agency Agreement, effective January 1, 1997, between
Dorinco Reinsurance Company, State & County Mutual Fire Insurance
Company and Vaughn General Agency, Inc. (incorporated by
reference to Exhibit 10(an) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 1996).
10(o) Administrative Services Agreement between State & County Mutual
Fire Insurance Company, Vaughn General Agency, Inc. and American
Hallmark General Agency, Inc. (incorporated by reference to
Exhibit 10(ao) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 1996).
10(p) Loan Agreement dated March 11, 1997, between Hallmark Financial
Services, Inc. and Dorinco Reinsurance Company (incorporated by
reference to Exhibit 10(ap) to the registrant's Annual Report on
Form 10-KSB for the fiscal year ended December 31, 1996).
10(q) Stock Pledge and Security Agreement dated March 11, 1997, between
ACO Holdings, Inc. and Dorinco Reinsurance Company (incorporated
by reference to Exhibit 10(ar) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 1996).
Exhibit
Number Description
------ -----------
10(r) Endorsement No. 1, effective July 1, 1996, to the 100% Quota
Share Reinsurance Agreement between State & County Mutual Fire
Insurance Company and American Hallmark Insurance Company of
Texas, effective July 1, 1996 (incorporated by reference to
Exhibit 10(a) to the registrant's Quarterly Report on Form
10-QSB for the quarter ended June 30, 1997).
10(s) Endorsement No. 1, effective July 1, 1997, to the Guaranty
Agreement provided by Dorinco Reinsurance Corporation in favor
of State & County Mutual Fire Insurance Company, effective
July 1, 1996 (incorporated by reference to Exhibit 10(d) to
the registrant's Quarterly Report on Form 10-QSB for the
quarter ended June 30, 1997).
10(t) Endorsement No. 1 - Termination, effective January 1, 1997,
to the Quota Share Retrocession Agreement between American
Hallmark Insurance Company of Texas and the Reinsurers (Dorinco
Reinsurance Company and Odyssey Reinsurance Corporation),
effective July 1, 1996 (incorporated by reference to Exhibit
10(e) to the registrant's Quarterly Report on Form 10-QSB for
the quarter ended June 30, 1997).
10(u) Endorsement No. 1, effective July 1, 1997, to the Quota Share
Retrocession Agreement between American Hallmark Insurance
Company of Texas and the Reinsurer (Dorinco Reinsurance
Company), effective July 1, 1996 (incorporated by reference
to Exhibit 10(h) to the registrant's Quarterly Report on Form
10-QSB for the quarter ended June 30, 1997).
10(v) Endorsement No. 2, effective January 1, 1997, to the Quota Share
Retrocession Agreement between American Hallmark Insurance
Company of Texas and Dorinco Reinsurance Company, effective
January 1, 1997 (incorporated by reference to Exhibit 10(bh) to
the registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1997).
10(w) Endorsement No. 1, effective January 1, 1997, to the 100% Quota
Share Reinsurance Agreement between State & County Mutual Fire
Insurance Company, Vaughn General Agency, Inc. and American
Hallmark General Agency, Inc (incorporated by reference to
Exhibit 10(bi) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 1997).
10(x) Endorsement No. 2, effective July 1, 1997, to the 100% Quota
Share Reinsurance Agreement between State & County Mutual Fire
Insurance Company, Vaughn General Agency, Inc., American Hallmark
General Agency, Inc. and the Reinsurers (Dorinco Reinsurance
Company and Kemper Reinsurance Company) effective July 1, 1997
(incorporated by reference to Exhibit 10(bj) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended December
31, 1997).
10(y) Amendment No. 1 to the Loan Agreement dated March 11, 1997,
between Hallmark Financial Services, Inc. and Dorinco Reinsurance
Company (incorporated by reference to Exhibit 10(bg) to the
registrant's annual Report on Form 10-KSB for the fiscal year
ended December 31, 1998).
10(z) Retrocession Agreement effective March 1, 1998, between American
Hallmark Insurance Company of Texas, Dorinco Reinsurance Company
and Associated General Agency, Inc. (incorporated by reference to
Exhibit 10(bh) to the registrant's annual Report on Form 10-KSB
for the fiscal year ended December 31, 1998).
10(aa) Quota Share Retrocession Agreement effective September 1, 1998,
between American Hallmark Insurance Company of Texas, Dorinco
Reinsurance Company and Van Wagoner Companies, Inc. (incorporated
by reference to Exhibit 10(bj) to the registrant's annual Report
on Form 10-KSB for the fiscal year ended December 31, 1998).
10(ab) Endorsement No. 5, effective January 1, 1999, to the Quota Share
Retrocession Agreement between American Hallmark Insurance
Company of Texas and the Reinsurer (Dorinco Reinsurance Company),
effective January 1, 1997 (incorporated by reference to Exhibit
10(a) to the registrant's Quarterly Report on Form 10-QSB for the
quarter ended June 30, 1999).
Exhibit
Number Description
------ -----------
10(ac) Endorsement No. 4, effective January 1, 1999, to the Quota Share
Retrocession Agreement between American Hallmark Insurance
Company of Texas and the Reinsurer (GE Reinsurance Company),
effective January 1, 1996 (incorporated by reference to Exhibit
10(b) to the registrant's Quarterly Report on Form 10-QSB for
the quarter ended June 30, 1999).
10(ad) Endorsement No. 2, effective July 1, 1997, to the 100% Quota
Share Reinsurance Agreement between State & County Mutual Fire
Insurance Company, Vaughn General Agency, Inc. and American
Hallmark General Agency, Inc. (incorporated by reference to
Exhibit 10(bg) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 1999).
10(ae) Amendment No. 3 to the Loan Agreement dated March 11, 1997,
between Hallmark Financial Services, Inc. and Dorinco Reinsurance
Company (incorporated by reference to Exhibit 10(bh) to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1999).
10(af) Endorsement No. 6, effective January 1, 1999, to the Quota Share
Retrocession Agreement between American Hallmark Insurance
Company of Texas and Dorinco Reinsurance Company, effective
January 1, 1997 (incorporated by reference to Exhibit 10(bi) to
the registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 1999).
10(ag) Sale and Assignment Agreement dated November 18, 1999,
with Hallmark Finance Corporation as Seller and FPF, Inc.
(incorporated by reference to Exhibit 10(bk) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended December
31, 1999).
10(ah) Premium Receivable Servicing Agreement dated November 18, 1999
between Hallmark Finance Corporation and FPF, Inc. (incorporated
by reference to Exhibit 10(bl) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 1999).
10(ai) Seventh Amendment to Office Lease for 14651 Dallas Parkway, Suite
900, dated January 1, 1995, between American Hallmark Insurance
Company of Texas and Fults Management Company, as agent for
The Prudential Insurance Company of America (incorporated by
reference to Exhibit 10(a) to the registrant's Quarterly Report
on Form 10-QSB for the quarter ended June 30, 2000).
10(aj) Quota Share Retrocession Agreement, effective July 1, 2000,
between American Hallmark Insurance Company of Texas and Dorinco
Reinsurance Company (incorporated by reference to Exhibit 10(a)
to the registrant's Quarterly Report on Form 10-QSB for the
quarter ended September 30, 2000).
10(ak) Addendum No. 2 to the Retrocession Contract, effective June 1,
1998, issued to Dorinco Reinsurance Company by American
Hallmark Insurance Company of Texas, effective October 1, 1999
(incorporated by reference to Exhibit 10(b) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended September
30, 2000).
10(al) Eighth Amendment to Office Lease for 14651 Dallas Parkway, Suite
900, dated January 1, 1995, between American Hallmark Insurance
Company of Texas and Fults Management Company, as agent for The
Prudential Insurance Company of America (incorporated by
reference to Exhibit 10(br) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 2000).
10(am) Quota Share Retrocession Contract between Dorinco Reinsurance
Company and American Hallmark Insurance Company of Texas,
effective September 1, 2000 (incorporated by reference to Exhibit
10(bs) to the registrant's Annual Report on Form 10-KSB for the
fiscal year ended December 31, 2000).
10(an) Endorsement No. 5, effective July 1, 2000, to the 100% Quota
Share Reinsurance Agreement issued to State and County Mutual
Fire Insurance Company, effective January 1, 1997 (incorporated
by reference to Exhibit 10(bt) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 2000).
Exhibit
Number Description
------ -----------
10(ao) Endorsement No. 4, effective July 1, 2000, to the 100% Quota
Share Reinsurance Agreement between State and County Mutual Fire
Insurance Company and American Hallmark Insurance Company of
Texas, effective July 1,1996 (incorporated by reference to
Exhibit 10(bu) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 2000).
10(ap) Termination Addendum to the Quota Share Retrocession Agreement,
effective May 28, 1999, issued to American Hallmark Insurance
Company of Texas by Kemper Reinsurance Company, effective July 1,
1996 (incorporated by reference to Exhibit 10(bv) to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 2000).
10(aq) Termination Addendum to the Quota Share Retrocession Agreement,
effective June 30, 2000, issued to Dorinco Reinsurance Company by
American Hallmark Insurance Company of Texas, effective January
1, 1997 (incorporated by reference to Exhibit 10(bw) to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 2000).
10(ar) Termination Addendum to the Quota Share Retrocession Contract,
effective September 1, 2000, issued to Dorinco Reinsurance
Company by American Hallmark Insurance Company of Texas,
effective September 1, 1998 (incorporated by reference to Exhibit
10(bx) to the registrant's Annual Report on Form 10-KSB for the
fiscal year ended December 31, 2000).
10(as) Termination Addendum to the Interests and Liability Agreement,
effective June 30, 2000, of GE Reinsurance Corporation with
respect to the 100% Quota Share Reinsurance Agreement, effective
January 1, 1997 (incorporated by reference to Exhibit 10(by) to
the registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 2001).
10(at) Termination Endorsement, effective July 1, 2000, to the Guaranty
of Performance and Hold Harmless Agreement between Hallmark
Financial Services, Inc. and GE Reinsurance Corporation (formerly
Kemper Reinsurance Company), effective July 1, 1996 (incorporated
by reference to Exhibit 10(cb) to the registrant's Annual Report
on Form 10-KSB for the fiscal year ended December 31, 2001).
10(au) Termination Endorsement, effective July 1, 2000, to the Guaranty
Agreement provided by GE Reinsurance Corporation (formerly Kemper
Reinsurance Company) in favor of State and County Mutual Fire
Insurance Company, effective July 1, 1996 (incorporated by
reference to Exhibit 10(cc) to the registrant's Annual Report on
Form 10-KSB for the fiscal year ended December 31, 2001).
10(av) Endorsement No. 2, effective July 1, 2000, to the Guaranty
Agreement provided by Dorinco Reinsurance Company in favor of
State and County Mutual Fire Insurance Company, effective
July 1, 1996 (incorporated by reference to Exhibit 10(a) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended March 31, 2001).
10(aw) Cut-Through Agreement, dated as of June 26, 2001, by and among
American Hallmark Insurance Company of Texas, American Hallmark
General Agency, Inc., Hallmark Finance Corporation and FPF, Inc.
(incorporated by reference to Exhibit 10(c) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended June 30,
2001).
10(ax) First Modification Agreement to the Cut-Through Agreement dated
as of June 26, 2001, by and among American Hallmark Insurance
Company of Texas, American Hallmark General Agency, Inc.,
Hallmark Finance Corporation and FPF, Inc., entered into June
27, 2001 (incorporated by reference to Exhibit 10(d) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended June 30, 2001).
10(ay) Letter of Agreement, dated August 3, 2001, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(f) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended June 30,
2001).
10(az) Letter of Agreement, dated August 6, 2001, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(g) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended June 30,
2001).
Exhibit
Number Description
------ -----------
10(ba) Addendum No. 1 to the Quota Share Retrocession Agreement,
effective July 1, 2000, between American Hallmark Insurance
Company of Texas and Dorinco Reinsurance Company, effective
January 1, 2001 (incorporated by reference to Exhibit 10(a) to
the registrant's Quarterly Report on Form 10-QSB for the quarter
ended September 30, 2001).
10(bb) Addendum No. 2 to the Quota Share Retrocession Agreement,
effective July 1, 2000, between American Hallmark Insurance
Company of Texas and Dorinco Reinsurance Company, effective July
1, 2001 (incorporated by reference to Exhibit 10(b) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended September 30, 2001).
10(bc) Endorsement No. 1 to the Guaranty of Performance and Hold
Harmless Agreement, effective July 1, 1996 between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company,
effective July 1, 2000 (incorporated by reference to Exhibit
10(c) to the registrant's Quarterly Report on Form 10-QSB for
the quarter ended September 30, 2001).
10(bd) Letter of Agreement, dated November 7, 2001 between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(d) to the registrant's
Quarterly Report on Form 10-QSB for the quarter ended September
30, 2001).
10(be) Second Amendment to Hallmark Financial Services, Inc. 1994 Non-
Employee Director Stock Option Plan (incorporated by reference to
Exhibit 10(e) to the registrant's Quarterly Report on Form 10-QSB
for the quarter ended September 30, 2001).
10(bf) Letter of Agreement, dated January 23, 2002, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company
(incorporated by reference to Exhibit 10(bl) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended December
31, 2001).
10(bg) Amendment No. 4 to the Loan Agreement dated March 10, 1997,
between Hallmark Financial Services, Inc. and Dorinco Reinsurance
Company (incorporated by reference to Exhibit 10(bm) to the
registrant's Annual Report on Form 10-KSB for the fiscal year
ended December 31, 2001).
10(bh) Second Modification Agreement, entered into December 11, 2001,
to the Sale and Assignment Agreement, dated November 18, 1999,
with Hallmark Finance Corporation as Seller and FPF, Inc.
(incorporated by reference to Exhibit 10(bn) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended December
31, 2001).
10(bi) Addendum No. 2, entered into January 9, 2001, to the General
Agency Agreement, effective March 1, 1992, between State &
County Mutual Fire Insurance Company and Brokers General, Inc.
(incorporated by reference to Exhibit 10(bo) to the registrant's
Annual Report on Form 10-KSB for the fiscal year ended December
31, 2001).
10(bj) Third Renewal Promissory Note, dated November 8, 2001, with
Hallmark Financial Services, Inc. as Maker and Dorinco
Reinsurance Company as Payee (incorporated by reference to
Exhibit 10(bp) to the registrant's Annual Report on Form 10-KSB
for the fiscal year ended December 31, 2001).
10(bk) Addendum No. 3 to the Quota Share Retrocession Agreement,
effective July 1, 2000, between American Hallmark Insurance
Company of Texas and Dorinco Reinsurance Company, effective June
30, 2001 (incorporated by reference to Exhibit 10(a) to the
registrant's Quarterly Report on Form 10-QSB for the quarter
ended September 30, 2002).
10(bl) 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(bm) * First Amendment to Hallmark Financial Services, Inc. 1994 Key
Employee Long Term Incentive Plan.
Exhibit
Number Description
------ -----------
10(bn) * First Amendment to Hallmark Financial Services, Inc. 1994 Non-
Employee Director Stock Option Plan.
10(bo) * Addendum No. 1 to the Quota Share Retrocession Contract between
Dorinco Reinsurance Company and American Hallmark Insurance
Company of Texas, effective September 1, 2000.
10(bp) * Letter of Agreement, dated October 31, 2002, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company.
10(bq) * Third Modification Agreement, entered into November 1, 2002, to
the Sale and Assignment Agreement, dated November 18, 1999, with
Hallmark Finance corporation as Seller and FPF, Inc.
10(br) * Letter of Agreement, dated December 30, 2002, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company.
10(bs) * Letter of Agreement, dated December 30, 2002, between Hallmark
Financial Services, Inc. and Dorinco Reinsurance Company.
10(bt) * Termination Agreement dated December 30, 2002, between Hallmark
Financial Services, Inc. and Linda H. Sleeper.
21 * List of subsidiaries of the registrant.
23 * Consent of Independent Accountants.
28 ** Schedule P of American Hallmark Insurance Company of Texas as
filed with the Texas Department of Insurance for the year ended
December 31, 2002.
99 * Certification Pursuant to 18 U.S.C. 1350 Enacted by Section 906
of the Sarbanes-Oxley Act of 2002.
* Filed herewith
** Filed herewith under cover of Form SE.
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Description Page Number
----------- -----------
Report of Independent Accountants F-2
Consolidated Balance Sheets at December 31, 2002 and 2001 F-3
Consolidated Statements of Operations for the Years Ended
December 31, 2002 and 2001 F-4
Consolidated Statements of Stockholders' Equity for the Years
Ended December 31, 2002 and 2001 F-5
Consolidated Statements of Cash Flows for the Years Ended
December 31, 2002 and 2001 F-6
Notes to Consolidated Financial Statements F-7
Report of Independent Accountants
---------------------------------
To the Board of Directors
Hallmark Financial Services, Inc.:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, stockholders' equity and cash flows,
present fairly, in all material respects, the financial position of Hallmark
Financial Services, Inc. and subsidiaries (the "Company") at December 31,
2002 and 2001, and the results of their operations and their cash flows for
the years then ended in conformity with accounting principles generally
accepted in the United States of America. These financial statements are the
responsibility of the Company's management; our responsibility is to express
an opinion on these financial statements based on our audits. We conducted
our audits of these statements in accordance with auditing standards
generally accepted in the United States of America, which require that we
plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures
in the financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
As discussed in Note 1, during 2002 the Company adopted Statement of
Financial Accounting Standards No. 142, "Goodwill and Other Intangible
Assets."
/s/ PricewaterhouseCoopers LLP
PricewaterhouseCoopers LLP
Dallas, Texas
March 16, 2003
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 2002 and 2001
(In thousands)
----------------------------
ASSETS 2002 2001
------ ---------- ----------
Investments:
Debt securities, held-to-maturity, at
amortized cost $ 7,679 $ 876
Equity securities, available-for-sale,
at market value 122 144
Short-term investments, at amortized
cost which approximates market value 8,927 15,203
---------- ----------
Total investments 16,728 16,223
Cash and cash equivalents 8,453 5,533
Restricted cash 1,072 1,990
Prepaid reinsurance premiums 8,550 11,611
Receivable from lender for financed premiums
(net of allowance for doubtful accounts of
$115 in 2002 and $208 in 2001) 11,593 13,740
Premiums receivable 1,012 414
Accounts receivable 2,129 -
Prepaid agent commission 3,899 -
Reinsurance recoverable 12,929 16,871
Deferred policy acquisition costs 1,367 761
Excess of cost over net assets acquired 5,171 4,431
Intangible assets 540 -
Note receivable 6,500 -
Current federal income tax recoverable 33 696
Deferred federal income taxes 1,021 425
Other assets 1,832 910
---------- ----------
$ 82,829 $ 73,605
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Liabilities:
Notes payable $ 1,803 $ 1,720
Note payable to related party 8,600 -
Net advances from lender for financed premiums 10,905 12,213
Unpaid losses and loss adjustment expenses 17,667 20,089
Unearned premiums 15,551 16,793
Reinsurance balances payable 3,764 4,426
Unearned revenue 6,872 -
Accrued agent profit sharing 450 -
Accrued ceding commission payable 2,536 4,598
Pension liability 604 -
Accounts payable and other accrued expenses 5,542 3,398
---------- ----------
74,294 63,237
---------- ----------
Stockholders' equity:
Common stock, $.03 par value, authorized
100,000,000 shares; issued 11,855,610
shares in 2002 and 2001 356 356
Capital in excess of par value 10,875 10,875
Retained (deficit) earnings (1,491) 180
Accumulated other comprehensive income (162) -
Treasury stock, 806,477 shares in 2002
and 2001, at cost (1,043) (1,043)
---------- ----------
Total stockholders' equity 8,535 10,368
---------- ----------
$ 82,829 $ 73,605
========== ==========
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
for the years ended December 31, 2002 and 2001
(In thousands, except earnings per share)
----------------------------
2002 2001
---------- ----------
Revenues:
Gross premiums earned $ 52,486 $ 49,525
Ceded premiums earned (32,273) (33,149)
---------- ----------
Net premiums earned 20,213 16,376
Investment income, net of expenses 531 1,043
Finance charges 2,484 3,095
Commissions and fees 1,561 -
Processing and service fees 457 1,120
Other income 551 368
---------- ----------
Total revenues 25,797 22,002
---------- ----------
Losses and expenses:
Losses and loss adjustment expenses 36,463 43,735
Reinsurance recoveries (21,161) (27,857)
---------- ----------
Net losses and loss adjustment expenses 15,302 15,878
Acquisition costs, net (605) (399)
Other acquisition and underwriting expenses
(net of ceding commission of $7,750 in
2002 and $9,118 in 2001) 7,468 3,673
Operating expenses 2,611 3,346
Interest expense 983 1,021
Amortization of intangible assets 2 157
---------- ----------
Total benefits, losses and expenses 25,761 23,676
---------- ----------
Income (loss) from operations before federal
income taxes and cumulative effect of
change in accounting principle 36 (1,674)
Federal income tax expense (benefit) 13 (544)
---------- ----------
Income (loss) before cumulative effect
of change in accounting principle $ 23 $ (1,130)
Cumulative effect of change
in accounting principle (1,694) -
---------- ----------
Net loss $ (1,671) $ (1,130)
========== ==========
Basic and diluted earnings per share
(11,049,133 shares outstanding):
Income (loss) before cumulative effect
of change in accounting principle $ - $ (0.10)
Cumulative effect of change
in accounting principle (0.15) -
---------- ----------
Net loss $ (0.15) $ (0.10)
========== ==========
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
for the years ended December 31, 2002 and 2001
(in thousands, except number of shares)
---------------------------------------
Capital Accumulated
Number In Other Total Comprehensive
of Par Excess of Retained Comprehensive Treasury Stockholders' Income
Shares Value Par Value Earnings Income Stock Equity (Loss)
---------- ------- --------- -------- ------ --------- ------- -------
Balance at December 31, 2000 11,855,610 $356 $10,875 $1,310 ($10) ($1,043) $11,488
Comprehensive loss:
Net loss (1,130) (1,130) $(1,130)
Other comprehensive income,
net of tax
Unrealized gains on
securities, net of
tax of $5 10 10 10
------
Comprehensive loss ($1,120)
---------- ------- --------- -------- ------ --------- ------- ======
Balance at December 31, 2001 11,855,610 $356 $10,875 $180 - ($1,043) $10,368
Comprehensive loss:
Net loss (1,671) (1,671) $(1,671)
Other comprehensive loss,
Additional minimum pension
liability, net of tax of $94 (162) (162) (162)
------
Comprehensive loss ($1,833)
---------- ------- --------- -------- ------ --------- ------- ======
Balance at December 31, 2002 11,855,610 $356 $10,875 ($1,491) ($162) ($1,043) $8,535
========== ======= ========= ======== ====== ========= =======
The accompanying notes are an integral
part of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
for the years ended December 31, 2002 and 2001
(In thousands)
----------------------------
2002 2001
-------- --------
Cash flows from operating activities:
Net loss $ (1,671) $ (1,130)
Adjustments to reconcile net loss to cash
provided by (used in) operating activities:
Depreciation and amortization expense 195 296
Change in deferred Federal income taxes 48 147
Change in prepaid reinsurance premiums 3,061 (667)
Change in premiums receivable (598) 385
Change in accounts receivable (170) -
Change in prepaid agent commission (36) -
Change in profit sharing commission receivable (64) -
Change in deferred policy acquisition costs (605) (399)
Change in unpaid losses and loss
adjustment expenses (2,422) (2,209)
Change in unearned premiums (1,242) 82
Change in unearned revenue 183 -
Change in accrued agent profit sharing 72 -
Change in reinsurance recoverable 3,942 2,341
Change in reinsurance balances payable (662) 1,085
Cumulative effect of change
in accounting principle 1,694 -
Change in current federal income
tax payable/recoverable 662 (601)
Change in accrued ceding commission payable (2,062) 2,095
Change in litigation costs - (1,386)
Change in all other liabilities 1,117 (1,395)
Change in all other assets 507 (30)
-------- --------
Net cash provided by (used in)
operating activities 1,949 (1,386)
-------- --------
Cash flows from investing activities:
Purchases of property and equipment (254) (268)
Purchase of note receivable (6,500) -
Acquisition of subsidiary (2,100) -
Premium finance notes originated (41,273) (50,655)
Premium finance notes repaid 43,420 50,461
Change in restricted cash 918 2,286
Purchases of debt securities (12,639) -
Maturities and redemptions of investment securities 5,858 6,378
Purchase of short-term investments (31,429) (27,515)
Maturities of short-term investments 37,705 18,501
-------- --------
Net cash used in investing activities (6,294) (812)
-------- --------
Cash flows from financing activities:
Proceeds from note payable 8,600 -
Net advances from lender (1,308) 1,628
Repayment of borrowings (27) (728)
-------- --------
Net cash provided by financing activities 7,265 900
-------- --------
Increase (decrease) in cash and cash equivalents 2,920 (1,298)
Cash and cash equivalents at beginning of year 5,533 6,831
-------- --------
Cash and cash equivalents at end of year $ 8,453 $ 5,533
======== ========
Supplemental cash flow information:
Interest paid $ (833) $ (1,036)
======== ========
Income taxes recovered/(paid) $ 696 $ 85
======== ========
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
__________
1. Accounting Policies:
-------------------
General
-------
Hallmark Financial Services, Inc. ("HFS") and its wholly owned
subsidiaries (collectively, the "Company") engage in the sale of
property and casualty insurance products. The Company's business
involves marketing, underwriting and premium financing of non-standard
personal automobile insurance in Texas, commercial insurance in Texas,
New Mexico, Idaho, Oregon and Washington, third party claims
administration and other insurance related services.
The Company pursues its business activities through integrated
insurance groups handling non-standard personal automobile insurance
(the "Personal Lines Group") and commercial insurance (the "Commercial
Lines Group"). The members of the Personal Lines group are an
authorized Texas property and casualty insurance company, American
Hallmark Insurance Company of Texas ("Hallmark"); a managing general
agency, American Hallmark General Agency, Inc. ("AHGA"); a network of
four insurance agencies known as the American Hallmark Agencies
("Hallmark Agencies"); a premium finance company, Hallmark Finance
Corporation ("HFC"); and an affiliated and third party claims
administrator, Hallmark Claims Service, Inc. ("HCS"). Effective
December 1, 2002, the Company purchased the Commercial Lines Group.
The members of the Commercial Lines Group are a managing
general agency, Millers General Agency ("Millers GA"); a financial
administrative service company, Financial and Actuarial Resources, Inc.
("FAR"); and a third party claims administrator, Effective Litigation
Management, Inc. ("ELM"). Effective February 28, 2003, the Company
sold the four existing Hallmark Agencies offices to three unaffiliated
third parties.
Principles of Consolidation
---------------------------
The accompanying consolidated financial statements include the accounts
and operations of HFS and its subsidiaries. Intercompany accounts and
transactions have been eliminated.
Basis of Presentation
---------------------
The accompanying consolidated financial statements have been prepared
in conformity with accounting principles generally accepted in the
United States of America ("GAAP") which, as to Hallmark, differ from
statutory accounting practices prescribed or permitted for insurance
companies by insurance regulatory authorities.
Investments
-----------
Debt securities are reported at amortized cost. The Company has the
intent and ability to hold all investments in debt securities to
maturity. Provisions for possible losses are recorded only on other-
than-temporary declines in the value of an investment.
Equity securities available-for-sale are reported at market value.
Unrealized gains and losses are recorded as a component of
stockholder's equity.
Short-term investments are carried at amortized cost which approximates
market. Short-term investments include U.S. Government securities
maturing within one year.
Realized investment gains and losses are recognized in operations on
the specific identification method.
Cash Equivalents
----------------
The Company considers all highly liquid investments with an original
maturity of three months or less to be cash equivalents.
Recognition of Premium Revenues
-------------------------------
Insurance premiums and policy fees are earned pro rata over the terms
of the policies. Upon cancellation, any unearned premium and policy fee
is refunded to the insured. Insurance premiums written include gross
policy fees of $5,055,539 and $5,007,809 and policy fees, net of
reinsurance, of $2,051,356 and $1,481,718 for the years ended December
31, 2002 and 2001, respectively.
Recognition of Commission Revenues and Expenses of the Commercial
-----------------------------------------------------------------
Lines Group
-----------
Commission revenue and commission expense related to insurance policies
serviced by the Company are recognized during the period covered by the
policy. Profit sharing commission is recognized when the ratio of
ultimate losses and loss expenses incurred to earned premium ("loss
ratio") as determined by a qualified actuary fall below contractual
thresholds. The profit sharing commission is an estimate that varies
with the estimated loss ratio and is sensitive to changes in that
estimate. For each 0.5% change in the loss ratio, the profit sharing
commission changes by approximately $120,000.
Recognition of Claim Servicing Fees of the Commercial Lines Group
-----------------------------------------------------------------
Claim servicing fees are recognized during the period covered by the
insurance policy with a portion of the fees related to casualty claims
deferred and recognized over two years following the expiration of the
policy.
Finance Charges
---------------
The majority of Hallmark's annual insurance premiums are financed
through the Company's premium finance program offered by its wholly-
owned subsidiary, HFC. Finance charges on the premium finance notes
are recorded as interest earned. This interest is earned on the Rule
of 78's method which approximates the interest method for such short-
term notes.
Property and Equipment
----------------------
Property and equipment (including leasehold improvements), aggregating
$3,245,000 and $1,954,000, at December 31, 2002 and 2001, 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
2002 and 2001 was $194,000 and $138,000, respectively. Accumulated
depreciation was $2,039,000 and $1,331,000 at December 31, 2002 and
2001, respectively.
Receivable from Lender for Financed Premiums
--------------------------------------------
Receivable from lender for financed premiums represents payments due to
HFC as a result of a secured financing agreement with an unaffiliated
third party which are carried at cost net of allowance for doubtful
accounts. (See Note 8.)
Premiums Receivable
-------------------
The majority of the balance in premiums receivable is premiums due to
Hallmark on unaffiliated MGA business assumed from Dorinco Reinsurance
Company ("Dorinco") which are carried at cost. (See Note 4.)
Deferred Policy Acquisition Costs
---------------------------------
Policy acquisition costs (mainly commissions, underwriting and
marketing expenses) that vary with and are primarily related to the
production of new and renewal business are deferred and charged to
operations over periods in which the related premiums are earned. The
method followed in computing deferred 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, related investment income, losses
and loss expenses and certain other costs expected to be incurred as
the premiums are earned. Ceding commissions from reinsurers, which
include expense allowances, are deferred and recognized over the period
premiums are earned for the underlying policies reinsured. Deferred
ceding commissions are netted against deferred policy acquisition costs
in the accompanying balance sheet. The change in deferred ceding
commission income is netted against the change in deferred policy
acquisition costs in the accompanying income statement.
Losses and Loss Adjustment Expenses
-----------------------------------
Losses and loss adjustment expenses represent the estimated ultimate
net cost of all reported and unreported losses incurred through
December 31, 2002 and 2001. The reserves for unpaid losses and loss
adjustment expenses are estimated using individual case-basis
valuations and statistical analyses.
These estimates are subject to the effects of trends in loss severity
and frequency. Although considerable variability is inherent in such
estimates, management believes that the reserves for unpaid losses and
loss adjustment expenses are adequate. The estimates are continually
reviewed and adjusted as experience develops or new information becomes
known. Such adjustments are included in current operations. The
reserves for unpaid losses and loss adjustment expenses at December
31, 2002 and 2001 are reported net of recoverables for salvage and
subrogation of approximately $350,000 and $320,000, respectively.
Agent Profit Sharing Commission
-------------------------------
The Company annually pays a profit sharing commission to it's
independent agency force based upon the results of the business
produced by each agent. The Company estimates and accrues this
liability to commission expense in the year the business is produced.
Reinsurance
-----------
Hallmark is routinely involved in reinsurance transactions with other
companies. Reinsurance premiums, losses, and loss adjustment expenses
are accounted for on bases consistent with those used in accounting for
the original policies issued and the terms of the reinsurance
contracts. (See Note 4.)
Income Taxes
------------
The Company files a consolidated federal income tax return. Deferred
federal income taxes reflect the future tax consequences of differences
between the tax bases of assets and liabilities and their financial
reporting amounts at each year end. Deferred taxes are recognized
using the liability method, whereby tax rates are applied to cumulative
temporary differences based on when and how they are expected to affect
the tax return. Deferred tax assets and liabilities are adjusted for
tax rate changes.
Net Income Per Share
--------------------
The computation of net income per share is based upon the weighted
average number of common shares outstanding during the period, plus (in
periods in which they have a dilutive effect) the effect of common
shares potentially issuable, primarily from stock options. (See Notes
6 and 8.)
Business Combinations
---------------------
The Company accounts for business combinations using the purchase
method of accounting. The cost of an acquired entity is allocated to
the assets acquired (including identified intangible assets) and
liabilities assumed based on their estimated fair values. The excess
of the cost of an acquired entity over the net of the amounts assigned
to assets acquired and liabilities assumed is an asset referred to
as "excess of cost over net assets acquired" or "goodwill". Indirect
and general expenses related to business combinations are expensed as
incurred.
Intangible Assets
-----------------
When Hallmark, AHGA, HFC and HCS were purchased by HFS, the excess cost
over the fair value of the net assets acquired was recorded as
goodwill. Prior to 2002, this goodwill was amortized on a straight-
line basis over forty years. Other intangible assets consisted of a
trade name, a managing general agent's license and non-compete
arrangements, all of which are fully amortized.
On January 1, 2002, the Company adopted Statement of Financial
Accounting Standards No. 142 ("SFAS 142"), Goodwill and Other
Intangible Assets". SFAS 142 supersedes APB 17, "Intangible Assets",
and primarily addresses the accounting for goodwill and intangible
assets subsequent to their initial recognition. SFAS 142 (1) prohibits
the amortization of goodwill and indefinite-lived intangible assets,
(2) requires testing of goodwill and indefinite-lived intangible assets
on an annual basis for impairment (and more frequently if the occurrence
of an event or circumstance indicates an impairment), (3) requires that
reporting units be identified for the purpose of assessing potential
future impairments of goodwill and (4) removes the forty-year limitation
on the amortization period of intangible assets that have finite lives.
Pursuant to SFAS 142, the Company has identified two components of
goodwill and assigned the carrying value of these components into two
reporting units: the insurance company reporting unit and the finance
company reporting unit. During 2002, the Company completed the two
step process prescribed by SFAS 142 for testing for impairment and
determining the amount of impairment loss related to goodwill associated
with these two reporting units. Accordingly, during 2002, the Company
recorded a charge to earnings that is reported as a cumulative effect
of the change in accounting principle of $1,694,025 to reflect the
adjustment to goodwill. Since goodwill is a permanent difference, the
charge to earnings has no tax impact.
A reconciliation of net income and earnings per share as reported to
illustrate the impact of goodwill amortization for the year ended
December 31, 2002 and 2001 is as follows:
(In thousands except for earnings per share
amounts) 2002 2001
-------- --------
Reported net income (loss) $ (1,671) $ (1,130)
Add back: Goodwill amortization - 157
-------- --------
Adjusted net income (loss) $ (1,671) $ (973)
======== ========
Basic and diluted earnings per share:
Reported net income (loss) $ (0.15) $ (0.10)
Add back: Goodwill amortization - 0.01
-------- --------
Adjusted net income (loss) $ (0.15) $ (0.09)
======== ========
Effective December 1, 2002, the Company acquired the assets of Millers
GA, ELM and FAR. The intangible assets at December 31, 2002 related to
this acquisition are composed of $2,434,048 of goodwill and $540,319
for the Company's relationships with its independent agents. At
acquisition, the agency relationships were valued at $542,580 and are
being amortized over twenty years. The Company recognized $2,261 of
amortization expense for the one month ending December 31, 2002 and will
recognize $27,129 in amortization expense for each of the next five
years and $404,674 for the remainder of the asset's life. At this time,
the Company believes that no significant impairment of the goodwill
has occurred and that no reduction of the estimated useful life is
warranted.
Use of Estimates in the Preparation of Financial Statements
-----------------------------------------------------------
The preparation of financial statements in conformity with GAAP
requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities at the date(s) of the
financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates.
Fair Value of Financial Instruments
-----------------------------------
Cash and Short-term Investments: The carrying amounts reported in the
balance sheet for these instruments approximate their fair values.
Investment Securities: Fair values are obtained from an independent
pricing service. (See Note 2.)
Receivable from Lender for Financed Premiums: The carrying amount
reported in the balance sheet for this instrument approximates its fair
value as the term of the receivable is less than one year.
Notes Payable: The carrying amounts reported in the balance sheet for
these instruments approximate their fair values. (See Note 5.)
Stock-based Compensation
------------------------
SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"),
provides companies an alternative to accounting for stock-based
compensation as prescribed under Accounting Principles Board Opinion
No. 25 "Accounting for Stock Issued to Employees" ("APB 25"). SFAS 123
encourages, but does not require, companies to recognize expense for
stock-based awards based on their fair value at date of grant. SFAS 123
allows companies to follow existing accounting rules (intrinsic value
method under APB 25) provided that pro forma disclosures are made of
what net income and earnings per share would have been had the new fair
value method been used. The Company has elected to adopt the disclosure
requirements of SFAS 123, but will continue to account for stock-based
compensation under APB 25 and related interpretations.
At December 31, 2002, the Company had two stock-based employee
compensation plans, which are described more fully in Note 11. No
stock-based employee compensation cost has been charged to earnings for
options, as all options granted under those plans had an exercise price
equal to the market value of the underlying common stock on the date of
grant. Had compensation cost for the Company's stock option-based
compensation plans been determined based on the fair value at the grant
dates consistent with the method pursuant to SFAS 123, the Company's
net income and earnings per share would have been reduced to the pro
forma amounts indicated below:
2002 2001
-------- --------
Net loss $ (1,671) $ (1,130)
Deduct: Total stock-based employee
compensation expense determined
under fair value based method
for all awards net of related
tax effects 32 86
-------- --------
Pro Forma net income $ (1,703) $ (1,216)
======== ========
Net loss per share:
Basic and diluted - as reported $ (0.15) $ (0.10)
Basic and diluted - Pro Forma $ (0.15) $ (0.11)
The effects of applying SFAS No. 123 in this pro forma disclosure are
not indicative of future amounts. SFAS No. 123 does not apply to
awards prior to 1995, and the Company anticipates making awards in the
future under its stock-based compensation plan.
Codification of Statutory Accounting Principles
-----------------------------------------------
In 1998, the National Association of Insurance Commissioners (the
"NAIC") adopted the Codification of Statutory Accounting Principles
(the "Codification") guidance, which replaced the prior Accounting and
Practice Procedures manuals as the NAIC's primary guidance on statutory
accounting. The Codification provides guidance where statutory
accounting has been silent and changes current statutory accounting in
some areas (e.g. deferred income taxes are recorded). Effective
January 1, 2001, the Texas Department of Insurance (the "TDI") adopted,
in part, the Accounting Practices and Procedures Manual (the "Manual")
published by the NAIC. The Manual, previously known as Codification,
contains Statements of Statutory Accounting Principles. Effective
January 1, 2001 the Company implemented the Codification guidance in
the preparation of Hallmark's statutory financial statements. The
cumulative effect of the adoption of Codification was recorded as an
adjustment to Hallmark's statutory surplus as of January 1, 2001 in
accordance with Codification guidance regarding reporting of changes in
accounting principles. The adjustment increased Hallmark's statutory
surplus by approximately $464,373, primarily as a result of recording a
deferred tax asset.
Reclassification
----------------
Certain previously reported 2001 amounts have been reclassified to
conform to current year presentation. Such reclassification had no
effect on net loss or stockholders' equity.
2. Investments:
------------
Major categories of net investment income (in thousands) are summarized
as follows:
Years ended December 31,
------------------------
2002 2001
-------- --------
Debt securities $ 179 $ 194
Equity securities 5 7
Short-term investments 163 483
Cash equivalents 186 360
-------- --------
533 1,044
Investment expenses (2) (1)
-------- --------
Net investment income $ 531 $ 1,043
======== ========
No investment in any entity or its affiliates exceeded 10% of
stockholders' equity at December 31, 2002 or 2001.
The amortized cost and estimated market value of investments in debt
and equity securities (in thousands) by category is as follows:
Gross Gross
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
-------- ------ ------- ---------
At December 31, 2002
--------------------
U.S. Treasury securities
and obligations of U.S.
government corporations
and agencies $ 7,221 $ 38 $ - $ 7,259
Mortgage backed securities 458 - - 458
-------- ------ ------- ---------
Total debt securities 7,679 38 - 7,717
Equity securities 122 - - 122
-------- ------ ------- ---------
Total debt and equity
securities $ 7,801 $ 38 $ - $ 7,839
======== ====== ======= =========
At December 31, 2001
--------------------
U.S. Treasury securities
and obligations of U.S.
government corporations
and agencies $ 206 $ - $ (1) $ 205
Mortgage backed securities 670 - - 670
-------- ------ ------- ---------
Total debt securities 876 - (1) 875
Equity securities 144 - - 144
-------- ------ ------- ---------
Total debt and equity
securities $ 1,020 $ - $ (1) $ 1,019
======== ====== ======= =========
The amortized cost and estimated market value of debt securities at
December 31, 2002 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 Market
Maturity (in thousands): Cost Value
------------------------ ----- -----
Due in one year or less $ - $ -
Due after one year through five years 7,139 7,177
Due after five years through ten years 82 82
Mortgage backed securities 458 458
----- -----
$7,679 $7,717
===== =====
At December 31, 2002 and 2001, investments in debt securities with
an approximate carrying value of $100,000 were on deposit with the
Texas Department of Insurance (the "TDI") as required by insurance
regulations.
Proceeds from investment securities of $5,858,000 and $6,378,000 during
2002 and 2001, respectively, were from maturities, bond calls and
prepayments of mortgage-backed securities.
3. Reserves for Unpaid Losses and Loss Adjustment Expenses:
--------------------------------------------------------
Activity in the reserves for unpaid losses and loss adjustment expenses
(in thousands) is summarized as follows:
2002 2001
------- -------
Balance at January 1 $ 20,089 $ 22,298
Less reinsurance recoverables 12,170 14,847
------- -------
Net Balance at January 1 7,919 7,451
------- -------
Incurred related to:
Current year 15,125 15,356
Prior years 177 522
------- -------
Total incurred 15,302 15,878
------- -------
Paid related to:
Current year 9,119 10,033
Prior years 5,691 5,377
------- -------
Total paid 14,810 15,410
------- -------
Net Balance at December 31 8,411 7,919
Plus reinsurance recoverables 9,256 12,170
------- -------
Balance at December 31 $ 17,667 $ 20,089
======= =======
4. Reinsurance:
------------
Hallmark is involved in the assumption and cession of reinsurance
from/to other companies. The Company remains obligated to its
policyholders in the event that the reinsurers do not meet their
obligations under the reinsurance agreements.
Effective March 1, 1992, Hallmark entered into a reinsurance
arrangement with State & County Mutual Fire Insurance Company ("State &
County"), an unaffiliated company, to assume 100% of the nonstandard
auto business produced by AHGA and underwritten by State & County. The
earned premiums assumed under this agreement in 2002 and 2001 were
$51,142,856 and $47,430,645, respectively. Certain funds generated
from business produced under this agreement are maintained in accounts
for the benefit of State & County. At December 31, 2002 and 2001,
Hallmark held for the benefit of State & County, cash and cash
equivalents of $3,709,650 and $2,630,268, respectively, and investment
securities at amortized cost of $11,025,013 and $10,970,699,
respectively.
The arrangement is supplemented by a separate retrocession agreement
effective July 1, 2000 between Hallmark and Dorinco Reinsurance Company
("Dorinco"), under which Hallmark currently retains 45% and cedes 55%
of the underwriting risk to Dorinco. Prior to July 1, 2000, Hallmark
retroceded 75% of the underwriting risk to its reinsurers (GE
Reinsurance and Dorinco) under a separate retrocession agreement
effective January 1,1999 through June 30, 2000. In addition, Dorinco
unconditionally guarantees Hallmark's obligation to State & County.
Effective April 1, 2001, the Company's reinsurance agreements with
Dorinco were amended to include a loss corridor provision whereby the
Company retains 100% of losses between a loss ratio corridor of 65% to
77% on policies effective after April 1, 2001. As of July 1, 2001, this
corridor increased to 65% to 80% on policies effective after that date.
Further, Dorinco and the Company executed an agreement effective July
1, 2001, that among other things, imposes on the Company additional
financial and operational covenants under the Dorinco reinsurance
agreements, provides remedies for the breach of such covenants
(including additional surplus requirements, rate increases and
cancellation provisions) and grants to Dorinco certain options to
maintain or increase the level of its reinsurance of Hallmark policies.
Effective October 1, 2002, Dorinco modified the reinsurance agreement
with improved terms, including increasing the threshold of the loss
corridor to 65.5% and lowering the ceiling to 75.5%.
Under its reinsurance arrangements with Dorinco, the Company earns
ceding commissions based on Dorinco's loss ratio experience on the
portion of policies ceded to Dorinco. The Company receives a
provisional commission as policies are produced as an advance against
the later determination of the commission actually earned. The
provisional commission is adjusted annually on a sliding scale based on
annual loss ratios. As of December 31, 2002 and 2001, the accrued
ceding commission payable to Dorinco was $2,536,012 and $4,598,089,
respectively. This accrual represents the difference between the
provisional ceding commission received and the ceding commission earned
based on current loss ratios.
Hallmark assumes business from Dorinco on various unaffiliated MGA
programs. Three of the four programs are in run-off as of December 31,
2002. Subsequent to December 31, 2002, the fourth program was in run-
off. At December 31, 2002 and 2001, Dorinco held cash of $1,072,425
and $1,990,458, respectively, to secure balances ceded to Hallmark.
These amounts were included in restricted cash in the accompanying
Consolidated Balance Sheets.
5. Note Receivable:
----------------
On November 1, 2002, the Company purchased from a major bank all of the
right, title and interest in a promissory note (the "Millers Note")
payable to the bank by Millers American Group, Inc. ("Millers"),
together with all related loan documentation and collateral, for a cash
purchase price of $6,500,000. At the time of such acquisition, the
Millers Note was in default and had an outstanding balance of
approximately $15,070,000. The Millers Note is guaranteed by Trilogy
Holdings, Inc. ("Trilogy"), a wholly-owned subsidiary of Millers, and
is secured by all of the issued and outstanding capital stock of
Millers Insurance Company ("MIC"), a Texas-based property and casualty
insurance carrier, and Phoenix Indemnity Insurance Company ("Phoenix"),
an Arizona-based property and casualty insurance carrier, each of which
was a wholly-owned subsidiary of Trilogy at the time of the
acquisition. Effective January 1, 2003, the Company acquired all of
the outstanding capital stock of Phoenix in satisfaction of $7,000,000
of the outstanding balance of the Millers Note. (The acquisition of
Phoenix is discussed below in Note 16.)
Newcastle Partners, L.P. ("Newcastle"), an affiliate of Mark E.
Schwarz, Chairman of the Board of the Company, provided a $9,000,000
interim financing facility to the Company for the purchase of the
Millers Note and the consummation of certain proposed transactions
being negotiated with Millers. (The note to Newcastle is discussed in
Note 7.)
6. Notes Payable:
--------------
Effective March 11, 1997, the Company entered into a loan agreement
with Dorinco, whereby the Company borrowed $7,000,000 (the "Dorinco
Loan") to contribute to HFC. Proceeds from this loan were used by HFC
primarily to fund premium finance notes. The loan agreement provides
for a seven-year term at a fixed interest rate of 8.25%. In November
2001 the note was amended to provide for interest only payments from
December 2001 through and including December 2002 with a final principal
pay-off date of June 30, 2005.
As long as certain financial covenants defined as "triggering events"
are maintained, collateral for the Dorinco Loan is limited to the stock
of HFC and a covenant by the Company not to pledge the stock of Hallmark
or AHGA. To avoid a triggering event, Hallmark must (1) maintain a
combined ratio and loss ratio which do not exceed 107.0% and 83.0%,
respectively, and (2) maintain statutory surplus of $4,200,000 and
experience no decreases to surplus in any one year that exceeds 15% of
the prior year surplus. If a triggering event should occur, the Company
has ten days to pledge the stock of AHGA and Hallmark as additional
collateral for the Dorinco Loan. During 2001, Dorinco waived the maximum
loss ratio requirements and combined ratio requirement. There were
no triggering events during 2002. The loan agreement also contains
covenants which require the Company to satisfy certain financial ratios
which are less restrictive than the triggering event ratios and, among
other things, restrict capital expenditures, payment of dividends, and
incurrence of additional debt.
The Company's notes payable as of December 31, 2002 also include two
notes payable to Millers Insurance Company. Each of these notes carry
an interest rate of 9% and mature in March 2003.
A summary of the Company's notes payable (in thousands) is as follows:
December 31,
------------
2002 2001
------- -------
Note payable to Dorinco $ 1,720 $ 1,720
Note payable to Millers Insurance
Company 83 -
------- -------
$ 1,803 $ 1,720
======= =======
Scheduled annual principal payments on notes payable (in thousands) to
Dorinco and Millers Insurance Company are as follows at December 31,
2002
2003 $ 811
2004 728
2005 264
-------
Total $ 1,803
=======
7. Note Payable to Related Party:
-------------------------------
On November 1, 2002, the Company entered into a promissory note with
Newcastle (a related party) whereby the Company could borrow up to
$9,000,000. The Company borrowed $6,500,000 on November 1, 2002 to
purchase the Millers Note. (See further discussion of note receivable
in Note 5.) On December 3, 2002, the Company borrowed an additional
$2,100,000 to purchase the Commercial Lines Group from Millers
Insurance Company. The note agreement provides for a fixed interest
rate of 11.75%. The unpaid principal balance and accrued and unpaid
interest is due and payable on demand at any time after September 30,
2003. The Company has previously announced its intention to retire
this debt through a rights offering of its common stock during 2003.
If the Company is unable to complete the rights offering or restructure
the payment schedule of the promissory note, the Company may have
difficulty meeting its current liquidity requirements in 2003.
8. Net Advances from Lender for Financed Premiums:
-----------------------------------------------
Effective November 18, 1999, HFC entered into a secured financing
arrangement (the "Financing Arrangement") and a servicing agreement
with an unaffiliated third party in order to fund HFC's premium finance
activities. The Financing Arrangement provides that HFC sell to the
third party all eligible premium finance notes generated by HFC in
connection with the financing of insurance policies. The transaction
is accounted for as a secured financing transaction. Under the
Financing Arrangement, HFC may from time to time specify the amount to
be advanced by the third party and secured by the premium finance notes
(up to maximum of 94% of the face amount of the premium finance notes).
Collections on the premium finance notes are remitted to HFC to the
extent they exceed the sum of (a) the aggregate amount of all prior
advances, (b) interest on the aggregate advance balance from time to
time outstanding, and (c) certain other fees and expenses payable to
the third party. The interest payable under the Financing Arrangement
is at the prime rate plus a spread ranging from one-half percent to one
percent depending on the unpaid balance of the advances. As of
December 31, 2002 and 2001, HFC had an outstanding balance on advances
under the Financing Arrangement of $10,904,994 and $12,213,205,
respectively, and the applicable interest rates were 5.75% for both
years. Under the Financing Arrangement, the maximum advances available
to HFC were $2,595,006 and $1,286,795 at December 31, 2002 and 2001,
respectively. The balance under the Financing Arrangement will be
repaid during the coming year as associated premium finance notes are
repaid.
9. Earnings per Share:
-------------------
The Company has adopted the provisions of Statement of Financial
Accounting Standards No. 128 (" SFAS No. 128"), "Earnings Per Share,"
requiring presentation of both basic and diluted earnings per share. A
reconciliation of the numerators and denominators of the basic and
diluted per-share computations (in thousands, except number of shares)
as required by SFAS No. 128 is presented below:
Income Shares Per-Share
(Numerator) (Denominator) Amount
----------- ------------- ------
For the year ended December 31, 2002:
Basic Earnings per Share
Income available to common
stockholders:
Income before cumulative
effect of change in
accounting principle $ 23 11,049,133 $ -
Cumulative effect of change
in accounting principle (1,694) 11,049,133 (.15)
------- ---------- ------
Net loss ($1,671) 11,049,133 $ (.15)
======= ========== ======
Diluted Earnings per Share
Income available to common
stockholders:
Income before cumulative
effect of change in
accounting principle $ 23 11,049,133 $ -
Effect of Dilutive Securities:
Options and warrants - 77,689 -
------- ---------- ------
Income before cumulative effect
of change in accounting
principle 23 11,126,822 -
Cumulative effect of change
in accounting principle (1,694) 11,126,822 (.15 )
------- ---------- ------
Net loss ($1,671) 11,126,822 $ (.15 )
======= ========== ======
For the year ended December 31, 2001:
Basic Earnings per Share
Income available to common
stockholders:
Income before cumulative
effect of change in
accounting principle ($1,130) 11,049,133 $ (.10)
Cumulative effect of change
in accounting principle - 11,049,133 -
------- ---------- ------
Net loss ($1,130) 11,049,133 $ (.10)
======= ========== ======
Diluted Earnings per Share
Income available to common
stockholders:
Income before cumulative
effect of change in
accounting principle ($1,130) 11,049,133 $ (.10)
Effect of Dilutive Securities:
Options and warrants - - -
------- ---------- ------
Income before cumulative effect
of change in accounting
principle (1,130) 11,049,133 (.10)
Cumulative effect of change
in accounting principle - 11,049,133 -
------- ---------- ------
Net loss ($1,130) 11,049,133 $ (.10)
======= ========== ======
Options to purchase 1,532,000 shares of common stock at prices ranging
from $0.44 to $1.00 were outstanding at December 31, 2002 but were not
included in the computation of diluted earnings per share because the
inclusion would result in an antidilutive effect in periods where the
option exercise price exceeded the average market price per share for
the period. Options to purchase 2,679,000 shares of common stock at
prices ranging from $0.25 to $1.00 were outstanding at December 31,
2001 but were not included in the computation of diluted earnings per
share because the inclusion would result in an antidilutive effect in
periods where a loss from continuing operations was incurred.
10. Regulatory Capital Restrictions:
--------------------------------
Hallmark's 2002 and 2001 net income (loss) and stockholders' equity
(capital and surplus), as determined in accordance with statutory
accounting practices, were $436,135 and ($861,829), and $8,393,795 and
$6,017,531, respectively. The minimum statutory capital and surplus
required for Hallmark by the TDI is $2,000,000. Texas state law limits
the payment of dividends to stockholders by property and casualty
insurance companies. The maximum dividend that may be paid without
prior approval of the Commissioner of Insurance is limited to the
greater of 10% of statutory surplus as regards policyholders as of the
preceding calendar year end or the statutory net income of the
preceding calendar year. During 2002, Hallmark paid dividends to HFS
of $600,000. Based on surplus at December 31, 2002, Hallmark could pay
a dividend of up to $839,380 to HFS during 2003 without TDI approval.
Although TDI has approved the payment of management fees, commissions
and claims handling fees by Hallmark to HFS and affiliates, since the
second half of 2000 Hallmark has chosen not to pay all of the
commissions allowed to AHGA. Hallmark paid management fees of $242,500
to HFS during 2002 as compared to $50,000 in 2001.
Effective December 31,1994, the NAIC requested property/casualty
insurers to file a risk-based capital ("RBC") calculation according to
a specified formula. The purpose of the NAIC-designed formula is
twofold: (1) to assess the adequacy of an insurer's statutory capital
and surplus based upon a variety of factors such as potential risks
related to investment portfolio, ceded reinsurance and product mix; and
(2) to assist state regulators under the RBC for Insurers Model Act
(the "Model Act") by providing thresholds at which a state commissioner
is authorized and expected to take regulatory action. The TDI adopted
the Model Act during 1998. The Company's 2002 and 2001 adjusted
capital under the RBC calculation exceeded the minimum TDI requirement
by 142.9% and 79.9%, respectively.
11. Stock Option Plans:
-------------------
The Company has two stock option plans for key employees, the 1991 Key
Employee Stock Option Plan and the 1994 Key Employee Long Term
Incentive Plan, and a non-qualified plan for non-employee directors.
The number of shares reserved for future issuance under the 1994
employee plan and the non-employee director plan is 239,000 and
675,000, respectively. The option prices under the plans are not to be
less than the closing price of the common stock on the day preceding
the grant date. Pursuant to the stock option plans, the Company has
granted incentive stock options under Section 422 of the Internal
Revenue Code of 1986. The stock options granted to employees vest over
a 3 year period on a graded schedule, 40% in the first 6 months and 20%
on each anniversary date of the grant date. The stock options granted
to the directors vest over a 6 year period on a graded schedule, 40% in
the first 6 months and 10% on each anniversary date of the grant date.
In accordance with APB 25, the Company has not recognized compensation
expense for the stock options granted in 2001.
Pursuant to Statement of Financial Accounting Standards No. 123 ("SFAS
No. 123"), "Accounting for Stock-based Compensation," a company may
elect to continue expense recognition under APB 25, or to recognize
compensation expense for grants of stock, stock options, and other
equity instruments to employees based on fair value methodology
outlined in SFAS No. 123. The Company has elected to continue expense
recognition pursuant to APB 25.
A summary of the status of the Company's stock options as of December 31,
2002 and December 31, 2001 and the changes during the years ended on those
dates is presented below:
__________2002_________ _________2001_________
Number Weighted Number Weighted
of Shares of Average of Shares of Average
Underlying Exercise Underlying Exercise
Options Prices Options Prices
------- ------ ------- ------
Outstanding at beginning
of the year 2,679,000 $ 0.49 2,431,500 $ 0.47
Granted 200,000 $ 0.43 250,000 $ 0.69
Exercised - $ - - $ -
Forfeited (500,000) $ 0.41 (2,500) $ 0.44
Expired - $ - - $ -
Outstanding at end of year 2,379,000 $ 0.50 2,679,000 $ 0.49
Exercisable at end of year 1,913,000 $ 0.50 2,052,000 $ 0.48
Weighted-average fair value
of all options granted $ 0.22 $ 0.43
The fair value of each stock option granted is estimated on the date of
grant using the Black-Scholes option-pricing model with the following
weighted-average assumptions:
2002 2001
---- ----
Expected Term 5.00 7.00
Expected Volatility 53.37% 56.11%
Risk-Free Interest Rate 4.91% 5.11%
The following table summarizes information about stock options
outstanding at December 31, 2002:
Options Outstanding Options Exercisable
------------------- -------------------
Number Weighted Avg. Number
Range of Outstanding Remaining Weighted Avg. Exercisable Weighted Avg.
Exercise Prices at 12/31/02 Contr. Actual Life Exercise Price at 12/31/02 Exercise Price
--------------- ----------- ------------------ -------------- ----------- --------------
$ .25 to $ .70 2,228,000 5.3 $ .47 1,762,000 $ .46
$ .71 to $1.00 151,000 3.0 $ 1.00 151,000 $ 1.00
$ .25 to $1.00 2,379,000 5.2 $ .50 1,913,000 $ .50
12. Retirement Plans
----------------
Certain employees of the Commercial Lines Group were participants in a
defined benefit cash balance plan covering all full-time employees who
had completed at least 1,000 hours of service. This plan was frozen in
March 2001 in anticipation of distribution of plan assets to members
upon plan termination. All participants were vested when the plan was
frozen.
The following tables provide detail of the changes in benefit
obligations, components of benefit costs and weighted-average
assumptions, and plan assets for the Retirement Plan as of and for the
one month ending December 31, 2002 (in thousands):
1 month Ending
12/31/02
--------
Assumptions (end of period)
Discount rate used in determining benefit obligation 6.50%
Rate of compensation increase N/A
Reconciliation of funded status (end of period):
Vested benefit obligation $ (11,756)
Accumulated benefit obligation (11,758)
Projected benefit obligation (11,758)
Fair value of plan assets 11,154
--------
Funded status $ (604)
Unrecognized net obligation/(asset) -
Unrecognized prior service cost -
Unrecognized actuarial (gain)/loss 268
--------
Prepaid/(accrued) pension cost $ (336)
Changes in projected benefit obligation:
Benefit obligation as of beginning of period $ 11,794
Service cost -
Interest cost 64
Plan amendments -
Actuarial liability (gain)/loss (4)
Effect of curtailment (plan freeze) -
Benefits paid (96)
--------
Benefit obligation as of end of period $ 11,758
1 month Ending
12/31/02
--------
Change in plan assets:
Fair value of plan assets as of beginning of period $ 11,446
Actual return on plan assets (net of expenses) (196)
Employer contributions -
Benefits paid (96)
--------
Fair value of plan assets as of end of period $ 11,154
--------
Net periodic pension cost:
Service cost - benefits earned during the period $ -
Interest cost on projected benefit obligation 64
Expected return on plan assets (76)
Amortizations
Net obligation/(asset) -
Unrecognized prior service cost -
Unrecognized (gain)/loss -
--------
Net periodic pension cost (credit) $ (12)
Discount rate (beginning of year) 6.50%
Expected return on plan assets 8.00%
Rate of compensation increase N/A
As of December 31, 2002, the fair value of the plan assets was composed
of cash and cash equivalents of $740,031, bonds and notes of $5,661,985
and equity securities of $4,752,031.
The Company sponsors two defined contribution plans. Under these
plans, employees may contribute a portion of their compensation on a
tax-deferred basis, and the Company may contribute a discretionary
amount each year. The Company's contribution for 2002 was $86,157.
The Company did not make a contribution for 2001.
13. Income Taxes:
-------------
The composition of deferred tax assets and liabilities and the
related tax effects (in thousands) as of December 31, 2002 and
2001, are as follows:
2002 2001
-------- ---------
Deferred tax liabilities:
Prepaid commission ( $ 1,442) $ -
Deferred policy acquisition costs ( 464) ( 1,343)
Profit sharing commission ( 320) -
Agency relationship ( 200) -
Goodwill ( 2) -
Other ( 25) ( 37)
-------- ---------
Total deferred tax liabilities ( $ 2,453) ( $ 1,380)
======== =========
Deferred tax assets:
Unearned premiums $ 476 $ 352
Loss reserve discounting, net of
salvage and subrogation 232 171
Deferred ceding commissions 2,304 1,084
Pension liability 223 -
Net operating loss carryforward 109 33
Allowance for bad debt 92 147
Other 71 51
-------- ---------
Total deferred tax assets $ 3,507 $ 1,838
======== =========
Net deferred tax asset $ 1,054 $ 458
Valuation allowance 33 33
-------- ---------
Net deferred tax asset $ 1,021 $ 425
======== =========
A valuation allowance is provided against the Company's deferred tax asset
to the extent that management does not believe it is more likely than not
that future taxable income will be adequate to realize these future tax
benefits. This allowance was $33,000 at December 31, 2002 and December 31,
2001. The valuation allowance is provided against a net operating loss
carryforward subject to limitations on its utilization. Based on the
evidence available as of December 31, 2002, management believes that it is
more likely than not that the remaining net deferred tax assets will be
realized. However, this assessment may change during 2003 if the Company's
financial results do not meet management's current expectations.
The deferred tax asset at December 31, 2002 includes $642,130 of net
deferred tax asset in relation to the purchase of Millers GA, FAR and ELM
where an election under Internal Revenue Code Section 338(h)(10) is
considered that would, if made, cause the tax basis of the assets acquired
to increase from historical carrying value to fair market value, resulting
in some amount of tax deductible goodwill. The balance of the deferred tax
asset as of the date of acquisition would be reduced to zero with a
corresponding increase to goodwill.
A reconciliation of the income tax provisions (in thousands) based on the
prevailing corporate tax rate of 34% to the provision reflected in the
consolidated financial statements for the years ended December 31, 2002 and
2001, is as follows:
2002 2001
-------- ---------
Computed expected income tax provision
(benefit) at statutory regulatory tax rate $ 12 ( $ 569)
Amortization of excess cost over
net assets acquired - 54
Meals and entertainment 1 2
Other - ( 31)
-------- ---------
Income tax provision (benefit) $ 13 ( $ 544)
======== =========
Current income tax benefit ( $ 32) ( $ 688)
Deferred tax provision 45 144
-------- ---------
Federal income tax provision (benefit) $ 13 ( $ 544)
======== =========
The Company has available, for federal income tax purposes, unused net
operating losses of $96,000 at December 31, 2002, which may be used to
offset future taxable income. The Internal Revenue Code generally has
provided for a three-year carryback and a 15-year carryforward of operating
losses. Effective with tax years beginning September 1997, the carryback and
carryforward periods are 2 years and 20 years, respectively, with respect to
newly generated operating losses. In March 2002, a change in federal tax law
was passed that allows for net operating losses generated in 2001 and 2002
to be carried back five years, rather than two. The net operating losses
(in thousands) will expire, if unused, as follows:
Year
----
2003 96
-------
$ 96
=======
14. Commitments and Contingencies:
------------------------------
The Company has several leases, primarily for office facilities and computer
equipment, which expire in various years through 2008. Certain of these
leases contain renewal options. Rental expense amounted to $758,474 and
$605,912 for the years ended December 31, 2002 and 2001, respectively.
Future minimum lease payments (in thousands) under noncancellable operating
leases as of December 31, 2002 are as follows:
Year
----
2003 $ 1,124
2004 1,152
2005 1,153
2006 1,110
2007 1,047
2008 and thereafter 947
-------
Total minimum lease payments $ 6,533
=======
The Company is involved in various other claims and legal actions
arising in the ordinary course of business. In the opinion of
management, the ultimate disposition of these matters will not have a
material adverse effect on the Company's financial position or results
of operations.
From time to time, assessments are levied on the Company by the
guaranty association of the State of Texas. Such assessments are made
primarily to cover the losses of policyholders of insolvent or
rehabilitated insurers. Since these assessments can be recovered
through a reduction in future premium taxes paid, the Company
capitalizes the assessments, as they are paid, and amortizes the
capitalized balance against its premium tax expense. There were no
assessments during 2002. However the Company has accrued $50,000 in
anticipation of an assessment for 2002. On December 31, 2001, the
Company was assessed $72,692 for 2001.
15. Concentrations of Credit Risk:
------------------------------
The Company maintains cash equivalents in accounts with two financial
institutions in excess of the amount insured by the Federal Deposit
Insurance Corporation. The Company monitors the financial stability of
the depository institutions regularly, and management does not believe
excessive risk of depository institution failure exists at December 31,
2002.
The Company's reinsurance coverage has been provided by one company
(Dorinco) since July 1, 2000.
Funding for the majority of HFC's premium finance activities is
provided by one unaffiliated third party.
16. Acquisition of Millers GA, ELM and FAR:
---------------------------------------
On December 3, 2002, the Company acquired from Millers all of the
outstanding stock of two inactive subsidiaries, ELM and FAR. The
Company simultaneously acquired from MIC, an indirect subsidiary of
Millers, all of the outstanding stock of Millers GA, an active Texas
managing general agency, as well as certain contracts and fixed assets.
The effective date of the transactions was December 1, 2002. The
results of Millers GA, ELM and FAR are included in the Company's
consolidated results of operations for the period December 1, 2002
through December 31, 2002.
The aggregate purchase price for the acquired subsidiaries and assets
was $2,580,000, consisting of $2,100,000 in cash and Millers GA
assumption of $480,000 in debt owed by MIC to Phoenix, another indirect
subsidiary of Millers. The purchase price was determined through arms-
length negotiations between the Company and Millers. The Company
funded the cash portion of the purchase price from an interim financing
facility previously provided by Newcastle Partners, L.P., an affiliate
of Mark E. Schwarz, Chairman of the Board of the Company.
The following table summarizes the estimated fair values of the assets
acquired and liabilities assumed at the date of acquisition.
At December 1, 2002
(In Thousands)
Current assets $ 5,234
Furniture, fixtures and equipment 522
Deferred tax asset, net 547
Other non-current assets 803
Intangible assets 543
Goodwill 2,434
-------
Total assets acquired 10,083
-------
Current liabilities 7,635
Additional minimum pension liability 348
-------
Total liabilities assumed 7,983
-------
Net assets acquired $ 2,100
=======
The acquired intangible assets of $542,580 represent the estimated fair
value of Millers GA relationship with its independent agents. These
assets are being amortized over twenty years.
The Company is considering an election under Internal Revenue Code
section 338 (h) (10) that would, if made, cause the tax basis of the
assets acquired to increase from historic carrying value to fair market
value, resulting in some amount of tax deductible goodwill. The balance
of the deferred tax asset as of the date of acquisition would be reduced
to zero with a corresponding increase to goodwill.
The unaudited pro forma consolidated historical results, as if Millers
GA, ELM and FAR had been acquired at the beginning of 2002 and 2001,
respectively, are estimated to be:
(In thousands, except per share data) 2002 2001
-------- ---------
Revenues $36,674 $31,432
Income (loss) before cumulative effect
of change in accounting principle $253 ($1,253)
Net income ($ 1,441) ($1,253)
Earnings per share-
Basic and Diluted ($0.13) ($0.11)
The pro forma results include amortization of the intangibles presented
above and interest expense on debt assumed to finance the purchase. The
pro forma results are not necessarily indicative of what actually would
have occurred if the acquisition had been completed as of the beginning
of each fiscal period presented, nor are they necessarily indicative of
future consolidated results.
17. Subsequent Event:
-----------------
As discussed in Note 5, the Company purchased the Millers Note on
November 1, 2002. In lieu of immediate foreclosure of the collateral
securing the Millers Note, the Company agreed to accept all of the
outstanding capital stock of Phoenix in satisfaction of $7,000,000 of
the outstanding balance of the Millers Note. The transaction was
approved by the Arizona Department of Insurance on January 27, 2003 to
be effective January 1, 2003. As a result, Phoenix became a wholly-
owned subsidiary of the Company as of January 1, 2003. As of the
filing date of this report, the Company has not finalized Phoenix's
purchase price allocation, and the audit of Phoenix's 2002 financial
statements has not been completed.
Effective February 28, 2003, the Company sold its four Hallmark
Agencies offices (Amarillo, Corpus Christi, Lubbock and Lancaster) for
a total purchase price of $231,356 to three unaffiliated third parties.
The Company received cash of $166,178 and is due the remaining $65,178
during 2003.