CONFORMED COPY
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
Quarterly report under Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the quarterly period ended March 31, 2003
Commission file number 0-16090
Hallmark Financial Services, Inc.
---------------------------------
(Exact name of small business issuer as specified in its charter)
Nevada 87-0447375
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(State or other jurisdiction of (I.R.S. Employer
Incorporation or organization) Identification No.)
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
Check whether the issuer (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities 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 X No
APPLICABLE ONLY TO CORPORATE ISSUERS
State the number of shares outstanding of each of the issuer's classes
of common equity, as of the latest practicable date: Common Stock, par
value $.03 per share - 11,170,800 shares outstanding as of May 12,
2003.
PART I
FINANCIAL INFORMATION
Item 1. Financial Statements
INDEX TO FINANCIAL STATEMENTS
Page Number
-----------
Consolidated Balance Sheets (unaudited) at 3
March 31, 2003 and December 31, 2002
Consolidated Statements of Operations (unaudited) for 4
the three months ended March 31, 2003 and March 31, 2002
Consolidated Statements of Cash Flows (unaudited) for 5
the three months ended March 31, 2003 and March 31, 2002
Notes to Consolidated Financial Statements 6
(unaudited)
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited)
(In thousands)
---------------------------
March 31 December 31
ASSETS 2003 2002
------ ---------- ----------
Investments:
Debt securities, available-for-sale,
at market value $ 16,001 $ 7,679
Equity securities, available-for-sale,
at market value 2,251 122
Short-term investments, available-for-sale,
at market value 4,831 8,927
---------- ----------
Total investments 23,083 16,728
Cash and cash equivalents 26,774 8,453
Restricted cash 1,088 1,072
Prepaid reinsurance premiums 8,764 8,550
Receivable from lender for financed premiums
(net of allowance for doubtful accounts of
$124 in 2003 and $115 in 2002) 12,564 11,593
Premiums receivable 2,765 1,012
Accounts receivable 2,869 2,129
Prepaid agent commission 4,243 3,899
Reinsurance recoverable 18,678 12,929
Deferred policy acquisition costs 2,192 1,367
Excess of cost over net assets acquired 4,883 5,171
Intangible assets 534 540
Note receivable - 6,500
Current federal income tax recoverable - 33
Deferred federal income taxes 4,386 1,021
Other assets 1,831 1,832
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$ 114,654 $ 82,829
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Liabilities:
Notes payable $ 1,565 $ 1,803
Note payable to related party 8,600 8,600
Net advances from lender for financed premiums 10,235 10,905
Unpaid losses and loss adjustment expenses 34,186 17,667
Unearned premiums 20,410 15,551
Reinsurance balances payable 4,041 3,764
Unearned revenue 7,715 6,872
Accrued agent profit sharing 174 450
Accrued ceding commission payable 2,412 2,536
Pension liability 604 604
Current federal income tax payable 483 -
Accounts payable and other accrued expenses 7,100 5,542
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97,525 74,294
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Stockholders' equity:
Common stock, $.03 par value, authorized
100,000,000 shares; issued 11,856,610
shares at March 31, 2003 and 11,855,610
shares at December 31, 2002 356 356
Capital in excess of par value 10,725 10,875
Retained (deficit) earnings 7,067 (1,491)
Accumulated other comprehensive loss (127) (162)
Treasury stock, 689,810 shares at
March 31, 2003 and 806,477 shares
at December 31, 2002, at cost (892) (1,043)
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Total stockholders' equity 17,129 8,535
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$ 114,654 $ 82,829
========== ==========
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except earnings per share)
----------------------------
Three Months Ended
March 31
------------------------
2003 2002
---------- ----------
Revenues:
Gross premiums earned $ 20,353 $ 12,312
Ceded premiums earned (8,015) (8,164)
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Net premiums earned 12,338 4,148
Investment income, net of expenses 194 126
Finance charges 1,253 655
Commission income 3,350 -
Processing and service fees 1,308 143
Other income 277 76
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Total revenues 18,720 5,148
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Losses and expenses:
Losses and loss adjustment expenses 14,060 8,033
Reinsurance recoveries (5,170) (4,784)
---------- ----------
Net losses and loss adjustment expenses 8,890 3,249
Acquisition costs, net (251) (419)
Other acquisition and underwriting expenses
(net of ceding commission of $2,206 in 2003
and $2,240 in 2002) 8,240 1,363
Operating expenses 781 451
Interest expense 443 205
Amortization of intangible assets 7 -
---------- ----------
Total benefits, losses and expenses 18,110 4,849
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Income from operations before federal income
taxes, cumulative effect of change in
accounting principle and extraordinary gain 610 299
Federal income tax expense 207 104
---------- ----------
Income before cumulative effect of change in
accounting principle and extraordinary gain $ 403 $ 195
Cumulative effect of change
in accounting principle - (1,694)
Extraordinary gain 8,152 -
---------- ----------
Net income (loss) $ 8,555 $ (1,499)
========== ==========
Basic earnings per share (11,166,800 shares
outstanding in 2003 and 11,049,133 shares
outstanding in 2002):
Income before cumulative effect of
change in accounting principle and
extraordinary gain $ 0.04 $ 0.02
Cumulative effect of change in
accounting principle - (0.16)
Extraordinary gain 0.73 -
---------- ----------
Net income (loss) $ 0.77 $ (0.14)
========== ==========
Diluted earnings per share (11,444,911 shares
in 2003 and 11,251,500 shares in 2002):
Income before cumulative effect of
change in accounting principle and
extraordinary gain $ 0.04 $ 0.02
Cumulative effect of change in
accounting principle - (0.15)
Extraordinary gain 0.71 -
---------- ----------
Net income (loss) $ 0.75 $ (0.13)
========== ==========
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)
----------------------------
Three Months Ended
March 31
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2003 2002
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Cash flows from operating activities:
Net income (loss) $ 8,555 $ (1,499)
Adjustments to reconcile net income (loss) to cash
provided by (used in) operating activities:
Cumulative effect of change
in accounting principle - 1,694
Extraordinary gain on acquisition of subsidiary (8,152) -
Depreciation and amortization expense 159 40
Change in deferred federal income taxes - 86
Change in prepaid reinsurance premiums (175) (345)
Change in premiums receivable (8) (402)
Change in accounts receivable (740) -
Change in deferred policy acquisition costs (825) (420)
Change in unpaid losses and loss
adjustment expenses 1,132 (1,987)
Change in unearned premiums 1,264 1,602
Change in unearned revenue 843 -
Change in accrued agent profit sharing (393) -
Change in reinsurance recoverable 4,655 2,201
Change in reinsurance balances payable 959 801
Change in excess of cost over
net assets acquired 288 -
Change in current federal income tax
payable/recoverable 516 19
Change in accrued ceding commission payable (124) (3,090)
Change in all other liabilities 642 429
Change in all other assets 331 167
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Net cash provided by (used in)
operating activities 8,927 (704)
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Cash flows from investing activities:
Purchases of property and equipment (203) (46)
Cash of acquired company 6,944 -
Premium finance notes originated (10,896) (13,090)
Premium finance notes repaid 9,925 12,166
Change in restricted cash (16) 297
Purchases of debt securities - (3,000)
Maturities and redemptions of
investment securities 114 77
Purchase of short-term investments (16) (7,996)
Maturities of short-term investments 4,450 14,242
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Net cash provided by investing activities 10,302 2,650
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Cash flows from financing activities:
Net advances from lender (670) 10
Repayment of borrowings (238) -
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Net cash (used in) provided
by financing activities (908) 10
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Increase in cash and cash equivalents 18,321 1,956
Cash and cash equivalents at beginning of period 8,453 5,533
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Cash and cash equivalents at end of period $ 26,774 $ 7,489
========== ==========
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
Item 1. Notes to Consolidated Financial Statements (Unaudited).
Note 1 - Summary of Accounting Policies
In the opinion of management, the accompanying consolidated financial
statements contain all adjustments, consisting only of normal recurring
adjustments, necessary for a fair statement of the financial position of
Hallmark Financial Services, Inc. ("HFS") and subsidiaries (the "Company")
as of March 31, 2003 and the consolidated results of operations and cash
flows for the periods presented. The accompanying financial statements have
been prepared by the Company without audit.
Certain information and disclosures normally included in financial
statements prepared in accordance with accounting principles generally
accepted in the United States of America ("GAAP") have been condensed or
omitted. Reference is made to the Company's annual consolidated financial
statements for the year ended December 31, 2002 for a description of
accounting policies and certain other disclosures. Certain items in the
2002 interim financial statements have been reclassified to conform to the
2003 presentation.
The results of operations for the period ended March 31, 2003 are not
necessarily indicative of the operating results to be expected for the full
year.
Recently Adopted Accounting Pronouncements
In December 2002, the Financial Accounting Standards Board ("FASB")
issued Statement of Financial Accounting Standards No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure" ("SFAS 148"). The
Statement amends SFAS 123 to provide alternative methods of transition for
voluntary change to the fair value based method of accounting for stock-
based employee compensation. In addition, SFAS 148 amends the disclosure
requirements of SFAS 123 to require prominent disclosures in both annual and
interim financial statements about the method of accounting for stock-based
employee compensation and the effect of the method used on reported results.
SFAS 148 is effective for financial statements for fiscal years ending
after December 15, 2002. Effective January 1, 2003, the Company adopted the
prospective method provisions of SFAS 148. See further discussion in Note 6.
Note 2 - Reinsurance
American Hallmark Insurance Company of Texas ("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 American Hallmark General Agency ("AHGA") and
underwritten by State & County. Under a separate retrocession agreement
effective July 1, 2000 between Hallmark and Dorinco Reinsurance Company
("Dorinco"), Hallmark may, with the consent of Dorinco, elect on a quarterly
basis to retain 30% to 45% of the underwriting risk. Hallmark currently
retains 45% of the premium and losses assumed from State and County,
retroceding 55% of the premium and losses to Dorinco. In addition, Dorinco
unconditionally guarantees Hallmark's obligation to State & County.
Effective April 1, 2001, the Company's reinsurance agreement with
Dorinco was amended to include a provision whereby the Company retains 100%
of losses in a loss ratio corridor of a threshold of 65% to a ceiling of 77%
on policies effective after April 1, 2001. As of July 1, 2001, the ceiling
of the loss ratio corridor was increased to 80% on policies effective on or
after that date. 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
(including additional surplus requirements, rate increases and cancellation
provisions), provides remedies for the breach of such covenants 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.
Note 3 - Intangible Assets
When Hallmark, AHGA, Hallmark Finance Corporation ("HFC") and Hallmark
Claim Service, Inc. ("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 agreements, all of which were 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 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 $1.7 million to reflect the adjustment to goodwill.
Since goodwill is a permanent difference, the charge to earnings has no
tax impact. This goodwill adjustment was made during the fourth quarter of
2002, but is required to be disclosed in the first quarter of 2002 for
comparative purposes.
Note 4 - Acquisitions
On January 27, 2003, the Company received final approval from the
Arizona Department of Insurance ("AZDOI") for the acquisition of Phoenix
Indemnity Insurance Company ("Phoenix"), effective as of January 1, 2003.
The acquisition of Phoenix expanded the Company's geographic reach in non-
standard automobile insurance from its traditional base in Texas to the
states of New Mexico and Arizona. The results of operations of Phoenix are
included in the Consolidated Statement of Operations from the effective date
of the acquisition (January 1, 2003). The pro forma information for the
corresponding prior period is not provided as it is not practicable to
obtain.
The acquisition of Phoenix was accounted for in accordance with
Statement of Financial Accounting Standards No. 141, "Business Combinations"
("SFAS 141"). This statement requires that the Company estimate the fair
value of assets acquired and liabilities assumed by the Company as of the
date of the acquisition. In accordance with the application of SFAS 141,
the Company recognized an extraordinary gain of $8.2 million from the
acquisition of Phoenix in its Consolidated Statement of Operations for the
three months ending March 31, 2003.
Note 5 - Segment Information
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, Hallmark; an authorized Arizona
property and casualty insurance company, Phoenix; a managing general agency,
AHGA; a premium finance company, HFC; and a claims administrator, 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, Inc. ("Millers GA"); a financial
administrative service company, Financial and Actuarial Resources, Inc.
("FAR"); and a third party claims administrator, Effective Claims
Management, Inc. ("ECM"), formerly known as Effective Litigation Management.
The following is additional business segment information for the three
months ended March 31 (in thousands):
2003 2002
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Revenues
--------
Personal Lines Group $ 14,033 $ 5,148
Commercial Lines Group 4,687 -
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Consolidated $ 18,720 $ 5,148
======= =======
Pre-tax Income
--------------
Personal Lines Group $ 948 $ 274
Commercial Lines Group 300 -
Corporate (638) 25
------- -------
Consolidated $ 610 $ 299
======= =======
Note 6 - Stock-based Compensation
At March 31, 2003, the Company had two stock-based employee
compensation plans for employees and a non-qualified plan for non-employee
directors, which are described more fully in Note 11 to the Form 10KSB for
December 31, 2002. Prior to 2003, the Company accounted for those plans
under the recognition and measurement provisions of APB Opinion No. 25,
"Accounting for Stock Issued to Employees", and related Interpretations. No
stock-based employee compensation cost was reflected in 2002 net income.
Effective January 1, 2003, the Company adopted the fair value recognition
provisions of FASB Statement No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123"). Under the prospective method of adoption
selected by the Company under the provisions of SFAS 148, compensation cost
is recognized for all employee awards granted, modified, or settled after
the beginning of the fiscal year in which the recognition provisions are
first applied. Results for prior years have not been restated. The
following table illustrates the effect on net income and earnings per share
if the fair value based method had been applied to all outstanding and
unvested awards in each period.
3 Months Ended
March 31
(in thousands) 2003 2002
------- -------
Net income (loss) as reported $ 8,555 $ (1,499)
Add: Stock-based employee compensation
expenses included in reported net
income, net of related tax effects - -
Deduct: Total stock-based employee
compensation expense determined under
fair value based method for all
awards, net of related tax effects (9) (8)
------- -------
Pro forma net income (loss) $ 8,456 $ (1,507)
======= =======
Earnings per share:
Basic-as reported $ 0.77 $ (0.14)
======= =======
Basic-pro forma $ 0.77 $ (0.14)
======= =======
Diluted-as reported $ 0.75 $ (0.13)
======= =======
Diluted-pro forma $ 0.75 $ (0.13)
======= =======
Note 7 - 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 three months ended March 31, 2003:
Basic Earnings per Share
Income available to common stockholders:
Income before cumulative effect of
change in accounting principle $ 403 11,166,800 $ 0.04
Cumulative effect of change in
accounting Principle - 11,166,800 -
Extraordinary gain 8,152 11,166,800 0.73
------- ------
Net income $ 8,555 11,166,800 $ 0.77
======= ======
Diluted Earnings per Share
Income available to common stockholders:
Income before cumulative effect of
change in accounting principle $ 403 11,166,800 $ 0.04
Effect of Dilutive Securities:
Options and warrants - 278,111 -
------- ------
Income before cumulative effect of
change in accounting principle 403 11,444,911 0.04
Cumulative effect of change in
accounting Principle - 11,444,911 -
Extraordinary gain 8,152 11,444,911 0.71
------- ------
Net income $ 8,555 11,444,911 $ 0.75
======= ======
For the three months ended March 31, 2002:
Basic Earnings per Share
Income available to common stockholders:
Income before cumulative effect of
change in accounting principle $ 195 11,049,133 $ 0.02
Cumulative effect of change in
accounting principle (1,694) 11,049,133 (0.16)
Extraordinary gain - 11,049,133 -
------- ------
Net loss $ (1,499) 11,049,133 $ (0.14)
======= ======
Diluted Earnings per Share
Income available to common stockholders:
Income before cumulative effect of
change in accounting principle $ 195 11,049,133 $ 0.02
Effect of Dilutive Securities:
Options and warrants - 202,367 -
------- ------
Income before cumulative effect of
change in accounting principle 195 11,251,500 0.02
Cumulative effect of change in
accounting principle (1,694) 11,251,500 (0.15)
Extraordinary gain - 11,251,500 -
------- ------
Net loss $ (1,499) 11,251,500 $ (0.13)
======= ======
Options to purchase 771,000 shares of common stock at prices ranging from
$0.65 to $1.00 and options to purchase 477,550 shares of common stock at
prices ranging from $0.69 to $1.00 were outstanding at March 31, 2003 and
2002, respectively, but were not included in the computation of diluted
earnings per share because the inclusion would result in an antidilutive
effect in periods where the option exercise price exceeded the average
market price per share for the period.
Note 8 - Comprehensive Income
A reconciliation between net income and total comprehensive income for the
three months ended March 31, 2003 and 2002, respectively, is provided (in
thousands) in the table below:
March March
2003 2002
------- -------
Net income (loss) $ 8,555 $ (1,499)
Unrealized gains/losses on fixed
maturities available for sale 35 -
------- -------
Total comprehensive income (loss) $ 8,590 $ (1,499)
======= =======
A reconciliation of the change in accumulated other comprehensive loss as
of March 31, 2003 and December 31, 2002 is provided (in thousands) in the
table below:
March Dec.
2003 2002
------ ------
Accumulated other compr. loss at beginning of period: $ (162) $ -
Unrealized gains/losses on fixed maturities
available for sale 35 -
Change in additional minimum pension liability - (162)
------ ------
Accumulated other comprehensive loss $ (127) $ (162)
====== ======
Item 2. Management's Discussion and Analysis or Plan of Operation.
Introduction. 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 automobile insurance primarily in Texas, Arizona,
and New Mexico, marketing of commercial insurance in Texas, New Mexico,
Idaho, Oregon and Washington, and other insurance related services.
On January 27, 2003, the Company received final approval from the AZDOI
for the acquisition of Phoenix, effective as of January 1, 2003. The
acquisition of Phoenix expanded the Company's geographic reach in non-
standard automobile insurance from its traditional base in Texas to the
states of New Mexico and Arizona.
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 Personal Lines Group provides non-standard automobile liability and
physical damage insurance through Hallmark and Phoenix for drivers who do
not qualify for or cannot obtain standard-rate insurance. Hallmark assumes
100% of the premium and losses on business produced by its affiliated
managing general agency, AHGA through a reinsurance arrangement with
an unaffiliated company State & County. Under a separate retrocession
agreement, Hallmark retains 45% of the premium and losses assumed from State
and County and retrocedes 55% of the premium and losses to its principal
reinsurer, Dorinco. HFC finances Hallmark's annual and six-month policy
premiums through its premium finance program. AHGA manages the marketing
of Hallmark policies through independent agents. HCS provides claims
adjustment, salvage, subrogation recovery and litigation services to
Hallmark. Phoenix underwrites non-standard auto insurance produced by
independent agents appointed by the company and retains 100% of the premium
and losses for the business it writes.
The Commercial Lines Group, through Millers GA, markets commercial
insurance policies through independent agents. Millers GA produces policies
on behalf of Clarendon National Insurance Company ("CNIC") under a general
agency agreement where it receives a commission based on the premium written
with CNIC. FAR provides financial and administrative services to Millers GA
and an unaffiliated third party. ECM provides fee-based claims adjustment,
salvage and subrogation recovery, and litigation services on behalf of CNIC
and another unaffiliated third party.
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, premium finance service charges and service fees. Other
sources of funds are from financing and investment activities.
On a consolidated basis, the Company's total cash, cash equivalents and
investments (excluding restricted cash) at March 31, 2003 and December 31,
2002 were $49.9 million and $25.2 million, respectively. The Company's
liquidity increased during the first quarter of 2003 as compared to December
31, 2002 principally as a result of the acquisition of Phoenix which
increased cash and investments of $22.8 million. The remaining increase of
$1.9 million is attributable to Hallmark's increased level of retention of
business under its retrocession agreement with Dorinco coupled with improved
underwriting results driven by loss ratio improvements.
Net cash provided by the Company's consolidated operating activities
was $8.9 million for the first quarter of 2003 compared to net cash used by
operating activities of $0.7 million for the first quarter of 2002. The
acquisition of Phoenix effective January 1, 2003 and the acquisition of the
Commercial Lines Group effective December 1, 2002 played a significant role
in the Company's increased cash flow from operations. Additionally,
improved underwriting results have further contributed to the Company's cash
flow from operations.
Cash provided by investing activities during the first quarter of 2003
increased $7.7 million as compared to the first quarter of 2002. The
acquisition of Phoenix produced a net cash increase of $6.9 million. The
remaining increase was primarily attributable to maturities of short-term
investments during the first quarter of 2003.
Cash used in financing activities increased by $0.9 million in the
first quarter of 2003 as compared to the same period of 2002 due to a
decrease in net advances from the Company's premium finance lender and the
repayment of notes payable to Dorinco during the first quarter of 2003.
HFS is dependent on dividend payments and management fees from its
insurance companies and free cash flow of its non-insurance companies to
meet operating expenses and debt obligations. As of March 31, 2003, cash
and invested assets of HFS were $0.3 million. Cash and invested assets of
non-insurance subsidiaries were $0.9 million as of March 31, 2003. 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 Commission 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 unassigned surplus funds. During 2003, Hallmark's
ordinary dividend capacity is $0.8 million. Hallmark paid $0.2 million of
dividends to HFS during the first quarter of 2003. Phoenix, domiciled in
Arizona, is limited in the payment of dividends to the lesser of 10% of
prior year policyholder's surplus or prior year's net investment income,
without prior written approval from the AZDOI. During 2003, Phoenix's
ordinary dividend capacity is $0.6 million. Phoenix paid $0.15 million of
dividends to HFS during the first quarter of 2003.
The Texas Department of Insurance ("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 only nominal management fees to HFS during
the first quarter of 2002 and did not pay any management fees to HFS during
the first quarter of 2003.
The AZDOI regulates financial transactions between Phoenix and
affiliated companies. Applicable regulations required AZDOI's approval of
management and expense sharing contracts and similar transactions. Although
the AZDOI has approved payments of management fees to HFS, management has
elected to not pay a management fee to HFS in the first quarter of 2003.
At March 31, 2003, Hallmark reported statutory capital and surplus of
$8.4 million, unchanged as compared to December 31, 2002. Hallmark reported
a statutory net income of $0.3 million during the first quarter of 2003 and
paid dividends of $0.2 million to HFS during the same quarter. Hallmark's
premium-to-surplus ratio for the twelve months ended March 31, 2003 was
increased to 2.78 to 1, as compared to 2.63 for the twelve months ended
December 31, 2002, primarily as a result of increases in its retention of
underwriting risk in the second and fourth quarters of 2002. The minimum
statutory capital and surplus required for Hallmark by the TDI is
$2,000,000. Hallmark's statutory capital and surplus as of March 31, 2003
exceeds the minimum requirements by 322%.
At March 31, 2003, Phoenix reported statutory capital and surplus of
$10.3 million, up from $10.1 million at December 31, 2002. Phoenix reported
a de minimis statutory net loss during the first quarter of 2003, paid $0.15
million in dividends to HFS during the first quarter of 2003 and reversed
certain previously non-admitted receivables. Phoenix's premium-to-surplus
ratio for the twelve months ended March 31, 2003 was 2.52 to 1. The minimum
statutory capital and surplus required for Phoenix by the AZDOI is $1.5
million. Phoenix's statutory capital and surplus as of March 31, 2003
exceeds the minimum requirements by 587%.
The Company believes that it has sufficient liquidity to meet its
ongoing insurance, operational and capital expenditure needs for the
foreseeable future. However, management is continuing to investigate
opportunities for future growth and additional capital may be required to
fund expansion of the Company. Further, the acquisitions of the Commercial
Lines Group and Phoenix were financed by a bridge loan from Newcastle
Partners, L.P. ("Newcastle"), 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, reschedule payment of
the bridge loan from Newcastle, or find alternative methods to reduce the
bridge loan debt, the Company may be unable to repay the bridge loan when it
matures in the fourth quarter of 2003.
Results of Operations
Net income before cumulative effect of change in accounting principle
and extraordinary gain was $0.4 million for the quarter ended March 31,
2003, compared to $0.2 million for the quarter ended March 31, 2002. The
improvement in operating earnings for the first quarter of 2003 compared to
the first quarter of 2002 reflects improved loss ratios of the Personal
Lines Group (including the acquisition of Phoenix) and the acquisition of
the Commercial Lines Group.
The following is additional business segment information for the three
months ended March 31 (in thousands):
2003 2002
------- -------
Revenues
--------
Personal Lines Group $ 14,033 $ 5,148
Commercial Lines Group 4,687 -
------- -------
Consolidated $ 18,720 $ 5,148
======= =======
Pre-tax Income
--------------
Personal Lines Group $ 948 $ 274
Commercial Lines Group 300 -
Corporate (638) 25
------- -------
Consolidated $ 610 $ 299
======= =======
A.M. Best is a rating agency which offers comprehensive data to
insurance professionals and is the world's oldest and most authoritative
source of insurance company ratings and information. Its Best's Ratings are
the industry's standard measure of insurer financial performance. In April
2003, A. M. Best upgraded Hallmark's rating from C+ to B- and upgraded
Phoenix from D to B-.
Personal Lines Group
Gross premiums written (prior to reinsurance) for the first quarter of
2003 increased 56%, and net premiums written (after reinsurance) increased
147%, in relation to the same period in 2002. The increase in gross
premiums written and net premiums written is principally due to the
acquisition of Phoenix effective January 1, 2003, which contributed $6.6
million to gross and net premiums written. The disproportionate increase
between gross premiums written and net premiums written is attributable to
(i) Hallmark's increased retention of underwriting risk from 35% during the
first quarter of 2002 to 45% during the first quarter of 2003, and (ii) the
acquisition of Phoenix, which does not cede any current portion of its
written premiums. Hallmark's ability to increase its risk retention during
the past twelve months is directly related to its improved underwriting
results which have generated increased statutory surplus and a capital
contribution made by HFS to Hallmark in the fourth quarter of 2002. Under
its current reinsurance agreement with Dorinco, Hallmark is at its maximum
risk retention of 45%.
Gross premiums earned (prior to reinsurance) for the first quarter of
2003 increased 65%, and net premiums earned (after reinsurance) increased
197%. The increase in gross premiums earned and net premiums earned is
principally due to the acquisition of Phoenix effective January 1, 2003
which contributed $6.1 million to gross and net premiums earned. The
disproportionate increase between gross premiums earned and net premiums
earned is attributable to Hallmark's increased retention of underwriting
risk and the acquisition of Phoenix..
Finance charges of $1.2 million for the first quarter of 2003 increased
85% ($0.6 million) from the same quarter of 2002. Finance charges are
composed of two components: premium finance note interest and direct bill
fee income. The increase in finance charges is principally due to $0.5
million in direct bill fee income from Phoenix for the first quarter of
2003.
Processing and service fees represent fees earned on processing and
servicing contracts with unaffiliated managing general agencies ("MGAs").
Processing and service fees declined 77% as a result of the discontinuation
of all unaffiliated MGA programs.
Other income increased $0.2 million as a result of the sale of all four
retail captive insurance offices of the Company effective February 28, 2003.
The four offices were sold for a total purchase price of $0.2 million.
Incurred loss ratios prior to and after reinsurance, for the quarter
ended March 31, 2003 were approximately 69.1% and 72.1%, respectively, as
compared to 65.2% prior to and 78.3% after reinsurance for the same period
of 2002. The converse movements of the loss ratios prior to and after
reinsurance are the result of the acquisition of Phoenix, which does not
reinsure any of its current primary underwriting risk. Phoenix's loss
ratios prior to and after reinsurance were 69.1% and 69.5%, respectively for
the first quarter of 2003. Hallmark's incurred loss ratios prior to and
after reinsurance for the first quarter of 2003 were 69.1% and 74.5%,
respectively. Hallmark's improvement in its loss ratio after reinsurance
is primarily the result of increases in net premiums earned due to the
Company's increased retention from 35% to 45%, which lessens the impact of
loss corridor amounts (as discussed in Note 2).
Acquisition costs, net represents the amortization of acquisition costs
(and credits) deferred over the past twelve months and the deferral of
acquisition costs (and credits) incurred in the current period. The $0.2
million decrease in acquisition costs, net is primarily due to the combined
effect of a (i) decrease in ceding commission income as Hallmark retains
more underwriting risk and (ii) the acquisition of Phoenix which deferred a
percentage of its net acquisition costs during the first quarter of 2003.
Other acquisition and underwriting expenses increased $2.5 million
during the first quarter of 2003 as compared to the same period of 2002.
Expenses increased approximately $2.2 million due to the acquisition of
Phoenix. Approximately $0.3 million of the increase is attributable to
increased variable costs such as commissions, front fees and premium taxes
as a result of increased premium volume of Hallmark.
Commercial Lines Group
Commission income represents net commissions earned by the Commercial
Lines Group on insurance policies serviced by Millers GA for CNIC. This
$3.4 million was a new source of revenue for the Company as a result of the
acquisition of the companies in the Commercial Lines Group in December 2002.
Processing and service fees represent fees earned by FAR and ECM for
claims and accounting administration for CNIC and another unaffiliated third
party. This $1.3 million was a new source of revenue as a result of the
acquisition of the companies in the Commercial Lines Group in December 2002.
Other acquisition and underwriting expenses of $4.4 million represent
the expenses associated with the production and servicing of insurance
policies for CNIC, the largest component of which is independent agent
commissions.
Corporate
Operating expenses include expenses related to general corporate
overhead. Operating expenses increased $0.3 million during the first
quarter of 2003 as compared to the same period of 2002. The majority of
this increase is related to legal and consulting fees associated with
acquisitions and other corporate matters. Additionally, the shift in
management structure from 2002 to 2003 has increased salaries and other
overhead during the first quarter of 2003.
Interest expense increased $0.2 million during the first quarter of
2003 as compared to 2002. This increase is related to the interest expense
on the note payable to Newcastle. This note payable was used to finance the
acquisition of the Commercial Lines Group and Phoenix.
Item 3. 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.
Risks Associated with Forward-Looking Statements Included in this Form
10-QSB
This Form 10-QSB 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-QSB 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.
PART II
OTHER INFORMATION
Item 1. Legal Proceedings.
Except for routine litigation incidental to the
business of the Company, neither the Company, nor
any of the properties of the Company was subject to
any material pending or threatened legal proceedings
as of the date of this report.
Item 2. Changes in Securities.
None.
Item 3. Defaults on Senior Securities.
None.
Item 4. Submission of Matters to a Vote of Security-Holders.
None
Item 5. Other Information.
None.
Item 6. Exhibits and Reports on Form 8-K.
(a) The exhibits listed in the Exhibit Index following
the signature page are filed herewith.
(b) Reports on Form 8-K. The registrant filed a current
report on Form 8-K on January 27, 2002, disclosing
its acquisition of Phoenix Indemnity Insurance
Company. The registrant filed an amended current
report on Form 8-K/A on February 14, 2003, providing
financial statements required in connection with its
acquisition of Millers GA, FAR, and ECM, formerly
known as Effective Litigation Management. The
registrant filed a current report on March 14, 2003,
disclosing its fourth quarter and year ended
earnings for December 31, 2002.
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant has
caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.
HALLMARK FINANCIAL SERVICES, INC.
(Registrant)
Date: May 15, 2003 /s/ Mark E. Schwarz
-------------------
Mark E. Schwarz, Chairman (Chief Executive Officer)
Date: May 15, 2003 /s/ Timothy A. Bienek
---------------------
Timothy A. Bienek, President (Chief Operating Officer)
Date: May 15, 2003 /s/ Scott K. Billings
---------------------
Scott K. Billings, Vice President
(Chief Financial Officer/Principal Accounting Officer)
CERTIFICATIONS
I, Mark E. Schwarz, Chief Executive Officer of Hallmark Financial Services,
Inc. (the "Company"), certify that:
1. I have reviewed this quarterly report on Form 10-QSB of the
Company;
2. Based on my knowledge, this quarterly 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 quarterly report;
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly 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
quarterly 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 quarterly 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
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly 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 quarterly 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: May 15, 2003
/s/ Mark E. Schwarz
-------------------
Mark E. Schwarz, Chief Executive Officer
CERTIFICATIONS
I, Scott K. Billings, Chief Financial Officer of Hallmark Financial
Services, Inc. (the "Company"), certify that:
1. I have reviewed this quarterly report on Form 10-QSB of the
Company;
2. Based on my knowledge, this quarterly 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 quarterly report;
3. Based on my knowledge, the financial statements, and other
financial information included in this quarterly 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
quarterly 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 quarterly 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
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly 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 quarterly 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: May 15, 2003
/s/ Scott K. Billings
---------------------
Scott K. Billings, Chief Financial Officer
Exhibit Index
Exhibit Description
------- -----------
10 ( a ) Tenth Amendment to Office Lease for 14651 Dallas Parkway,
Suite 900, dated May 5th, 2003, between American Hallmark
Insurance Company of Texas and Fults Management Company, as
agent for The Prudential Insurance Company of America.
10 ( b ) General Agency Agreement between Millers General Agency, Inc
and Clarendon National Insurance Company, effective August 15,
2001.
10 ( c ) Claims Administration Agreement between Millers General
Agency, Inc. and Clarendon National Insurance Company,
effective August 15, 2001.
10 ( d ) Claims Services Agreement between Millers General Agency, Inc.
and Effective Claims Management, Inc., effective March 25,
2003.
99.1 Certification of Chief Executive Officer Pursuant to 18 U.S.C.
1350 Enacted by Section 906 of the Sarbanes-Oxley Act of 2002.
99.2 Certification of Chief Financial Officer Pursuant to 18 U.S.C.
1350 Enacted by Section 906 of the Sarbanes-Oxley Act of 2002.