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, 1997
Commission file number 0-16090
Hallmark Financial Services, Inc.
(Exact name of small business issuer as specified in its charter)
Nevada 87-0447375
(State or other jurisdiction of (I.RS. Employer
corporation or organization) Identification No.)
14651 Dallas Parkway, Suite 900
Dallas, Texas 75240
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 - 10,662,277 shares outstanding as of May 9, 1997.
<PAGE>
PART I
FINANCIAL INFORMATION
Item 1. Financial Statements
INDEX TO FINANCIAL STATEMENTS
Sequential Page
Consolidated balance sheets at March 31, 1997
(unaudited) and December 31, 1996 3
Consolidated statements of income (unaudited)
for the three months ended March 31, 1997
and March 31, 1996 4
Consolidated statements of cash flows (unaudited)
for the three months ended March 31, 1997
and March 31, 1996 5
Notes to consolidated financial
statements (unaudited) 6
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<TABLE>
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
March 31 December 31
ASSETS 1997 1996
(Unaudited)
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Investments:
Debt securities, held-to-maturity $ 4,870,017 $ 5,160,137
Equity securities, available-for-sale 149,433 152,246
Short-term investments, at cost which
approximates market value 4,196,139 3,380,059
Total investments 9,215,589 8,692,442
Cash and cash equivalents 4,153,840 4,749,388
Prepaid reinsurance premiums 9,125,748 8,480,257
Premium receivable 3,360,435 2,524,938
Note receivable 6,174,144 -
Reinsurance recoverable 19,964,108 20,058,062
Deferred policy acquisition costs 2,911,841 2,536,564
Excess of cost over net assets acquired,
net of accumulated amortization 5,176,651 5,215,905
Deferred federal income taxes 296,841 330,718
Accrued investment income 64,469 46,606
Other assets 1,138,006 1,128,882
Total assets $61,581,672 $53,763,762
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Notes payable $ 7,578,014 $ 590,853
Unpaid losses and loss adjustment expenses 18,585,067 20,697,393
Unearned premiums 12,270,216 11,310,250
Reinsurance balances payable 3,828,792 2,946,034
Deferred ceding commissions 2,464,230 2,368,264
Drafts outstanding 1,164,885 838,007
Accounts payable and other accrued expenses 3,963,191 3,591,597
Total liabilities 49,854,395 42,342,398
Stockholders' equity:
Common stock, $.03 par value, authorized
100,000,000 shares;(issued 10,962,277 shares
in 1997 and 1996) 328,868 328,868
Capital in excess of par value 10,349,665 10,349,665
Retained earnings 1,648,744 1,342,831
Treasury stock (600,000) (600,000)
Total stockholders' equity 11,727,277 11,421,364
$61,581,672 $53,763,762
The accompanying notes are an integral part
of the consolidated financial statements.
</TABLE>
<PAGE>
<TABLE>
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months Ended
March 31
1997 1996
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Gross premiums written $11,140,479 $10,458,399
Ceded premiums written ( 7,846,463) ( 7,845,566)
Net premiums written $ 3,294,016 $ 2,612,833
Revenues:
Premiums earned $10,180,513 $12,076,910
Premiums ceded ( 7,200,971) ( 9,048,429)
Net premiums earned 2,979,542 3,028,481
Investment income, net of expenses 184,555 214,489
Interest income - note receivable 32,454 -
Processing fees 363,374 495,995
Service fees 50,332 29,502
Other income 65,822 30,445
Total revenues 3,676,079 3,798,912
Benefits, losses and expenses:
Losses and loss adjustment expenses 6,676,723 8,082,104
Reinsurance recoveries ( 5,038,874) ( 6,073,637)
Net losses and loss adjustment expenses 1,637,849 2,008,467
Acquisition costs, net ( 279,311) ( 105,321)
Other acquisition and underwriting expenses 1,344,755 957,392
Operating expenses 474,575 434,650
Interest expense 44,065 11,076
Amortization of intangible assets 43,370 41,399
Total benefits, losses and expenses 3,265,303 3,347,663
Income from operations before
federal income taxes 410,776 451,249
Federal income tax 104,863 148,660
Net income $ 305,913 $ 302,589
Net income per share of common stock $ .03 $ .03
Weighted average shares outstanding 11,640,734 11,533,131
The accompanying notes are an integral part
of the consolidated financial statements.
</TABLE>
<PAGE>
<TABLE>
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Three Months Ended
March 31
1997 1996
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Cash flows from operating activities:
Net income $ 305,913 $ 302,589
Adjustments to reconcile net income to
cash provided by operating activities:
Depreciation and amortization expense 72,146 63,055
Change in deferred federal income taxes 33,877 6,775
Change in prepaid reinsurance premiums ( 645,491) 1,202,864
Change in premium receivable ( 835,497) 1,787,569
Change in deferred policy acquisition
costs ( 375,277) 255,524
Change in deferred ceding commissions 95,966 ( 360,845)
Change in unpaid losses and loss
adjustment expenses (2,112,326) 1,707,719
Change in unearned premiums 959,966 (1,618,511)
Change in reinsurance recoverable 93,954 (1,659,929)
Change in reinsurance balances payable 882,758 301,519
Change in all other liabilities 698,472 ( 243,046)
Change in all other assets 59,502 ( 158,819)
Net cash provided by (used in)
operating activities ( 766,037) 1,586,464
Cash flows from investing activities:
Purchases of property and equipment ( 36,972) ( 129,651)
Purchase of note receivable (6,174,144) -
Maturities of debt securities - 121,374
Maturities, redemptions, and capital
distributions of investment securities 292,933 807
Purchase of short-term investments ( 816,080) (4,449,259)
Maturities of short-term investments - 3,139,554
Net cash used in investing activities (6,734,263) (1,317,175)
Cash flows from financing activities:
Proceeds from long-term borrowings 7,000,000 -
Payment of borrowing cost ( 82,409) -
Repayment of short-term borrowings ( 12,839) ( 11,622)
Cash provided by (used in) financing
activities 6,904,752 ( 11,622)
Increase (decrease) in cash and cash
equivalents ( 595,548) 257,667
Cash and cash equivalents at beginning
of period 4,749,388 4,257,755
Cash and cash equivalents at end
of period $4,153,840 $4,515,422
Supplemental cash flow information:
Cash paid during the period for
interest $ - $ 11,076
The accompanying notes are an integral part
of the consolidated financial statements.
</TABLE>
<PAGE>
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 primarily of normal
recurring adjustments, necessary to present fairly the financial
position of Hallmark Financial Services, Inc. and subsidiaries (the
"Company") as of March 31, 1997 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 generally accepted accounting
principles ("GAAP") have been condensed or omitted. Reference is made
to the Company's annual consolidated financial statements for the year
ended December 31, 1996 for a description of all other accounting
policies. Certain items in the 1996 interim financial statements have
been reclassified to conform to the 1997 presentation.
The results of operations for the period ended March 31, 1997 are not
necessarily indicative of the operating results to be expected for the
full year.
New Accounting Pronouncements
In February 1997, the FASB issued SFAS No. 128, "Earnings Per Share."
SFAS No. 128 is designed to improve the earnings per share information
provided in financial statements by simplifying the existing computation
guidelines provided for in APB Opinion No. 15 Earnings Per Share. SFAS
No. 128 is effective for financial statements for periods ending after
December 15, 1997. Management does not anticipate that SFAS No. 128
will have any effect on the Company's consolidated financial statements.
In February 1997, the FASB issued SFAS No. 129, "Disclosure of
Information about Capital Structure." SFAS 129 is applicable to all
entities and requires that disclosure about an entity's capital
structure include a brief discussion of rights and privileges for
securities outstanding. SFAS No. 129 is effective for financial
statements for periods ending after December 15, 1997.
Note 2 - Investments
Debt securities, held-to-maturity, for the three month period ended
March 31, 1997 include investments in U.S. Government securities
totaling $2,747,335, which includes special revenue bonds of $2,122,682.
Short-term investments consist of U.S. Government agency securities of
$4,196,139. Short-term investments mature within one year.
Realized investment gains and losses are recognized in operations on
the specific identification method. The Company has the ability and
intent to hold all investments to maturity. Provisions for possible
losses are recorded only on other-than-temporary declines in the value
of an investment.
<PAGE>
Note 3 - Notes Payable
A summary of the Company=s notes payable as of March 31, 1997 is as
follows:
Note payable to Dorinco $7,000,000
Note payable to unaffiliated finance
company 380,187
Note payable to individual 197,827
Total $7,578,014
Effective March 11, 1997, the Company entered into a loan agreement
with Dorinco Reinsurance Company ("Dorinco"), an unaffiliated company,
whereby the Company borrowed $7,000,000 to contribute to its premium
finance subsidiary, Hallmark Finance Corporation ("HFC"). Proceeds from
this loan are intended to be used by HFC to fund premium finance notes.
(See Notes 4 and 8.) The loan agreement provides for a seven-year term
at a fixed interest rate of 8.25%. Interest is payable monthly through
February 28, 1999, with principal and interest payments commencing March
31, 1999 through March 31, 2004. A penalty ranging from $80,000 to
$120,000 is charged for prepaying the loan prior to the fourth
anniversary date except that after the second anniversary date, up to
40% of the outstanding balance may be prepaid without penalty.
As long as certain financial covenants defined as "triggering events"
are maintained, collateral for the loan is limited to the stock of HFC
and a covenant by the Company not to use the stock of American Hallmark
Insurance Company of Texas ("Hallmark") and American Hallmark General
Agency, Inc. ("AHGA"). To avoid a triggering event, Hallmark must (1)
maintain a combined ratio and loss ratio which does not exceed 107% and
83%, respectively; (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; and (3) cause HFC to maintain a certain interest
coverage ratio and stockholders' equity levels as defined in the
agreement. 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. 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 incurring of
additional debt. For the period ending March 31, 1997, the Company is
in compliance with the covenants of the loan.
The note payable to unaffiliated finance company with interest at
prime plus one percent was due March 31, 1993. The Company has not made
payments on the note since November 1992, and is in technical default.
The note provides for an interest rate after maturity of the maximum
statutory interest rate. The Company believes it has the right to
offset $240,000 which is on deposit with a subsidiary of the
unaffiliated finance company. The total principal and interest in
arrears aggregates $776,959 at March 31, 1997. Both the lender and its
subsidiary are currently in bankruptcy proceedings. Upon final
settlement, management believes the cost, if any, to the Company will
not exceed amounts accrued in these financial statements.
The note payable to an individual is collateralized by most assets of
AHGA and requires monthly principal and interest payments of $6,000
through May 1, 2000, with interest at 10%.
<PAGE>
Note 4 - Note Receivable
Proceeds of $5,915,109 from the Dorinco loan (discussed in Note 3)
were used to repay external borrowing by Peregrine Premium Finance L.C.
("Peregrine") incurred to fund premium finance notes pursuant to the
financing and servicing arrangement between HFC and Peregrine. In
addition, $259,035 in internally generated funds were loaned to
Peregrine to fund new premium finance notes. As a result, at March 31,
1997, the Company had a $6,174,144 note receivable from Peregrine. The
Peregrine note principal varies in proportion to the amount used by
Peregrine to fund premium finance notes, but is not to exceed
$7,500,000. The note is collateralized by the premium finance notes and
bears interest at prime plus 1% ( 9.5% at March 31, 1997).
Note 5 - Federal Income Taxes
The composition of deferred tax assets and liabilities and the
related tax effects as of March 31, 1997 and December 31, 1996 is as
follows:
1997 1996
Deferred Tax Assets:
Property and equipment basis $ 21,873 $ 32,607
Unearned premiums 213,824 192,439
Loss reserve discounting 39,082 65,207
Deferred ceding commissions,
non-deductible for tax ( 152,188) ( 57,222)
Net operating loss carryforward 33,171 33,171
Other 174,250 97,694
Total gross deferred tax assets 330,012 363,896
Valuation allowance ( 33,171) ( 33,178)
Net deferred tax asset $ 296,841 $ 330,718
A reconciliation of the income tax provisions based on the prevailing
corporate tax rate of 34 percent to the provision reflected in the
consolidated financial statements for the period ended March 31, 1997
and 1996 is as follows:
1997 1996
Computed expected income tax expense
at statutory regulatory tax rate $ 139,664 $ 147,924
Amortization of excess cost 13,399 13,226
Tax-exempt interest ( 492) ( 328)
Change in valuation allowance - ( 16,098)
Other ( 47,708) 3,936
Income tax expense $ 104,863 $ 148,660
The Company has available, for federal income tax purposes, unused
net operating losses of $97,562 at March 31, 1997, which may be used to
offset future taxable income. The net operating losses will expire, if
unused, as follows:
Year
2002 $ 1,325
2003 96,237
$97,562
<PAGE>
Note 6 - Warrants Outstanding
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 1991
employee plan, the 1994 employee plan and the non-employee director plan
is 500,000, 1,500,000 and 1,350,000, 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 No. 25, the Company has
not recognized compensation expense for the stock options granted in
1996 and 1995.
In October 1992, the Company issued warrants to purchase 981,333
shares of its Common Stock ("Guaranty Warrants") to executive officers
and directors in consideration for the recipients' agreement to pledge
outstanding shares of the Company's common stock they owned as security
for a working capital line of credit the Company proposed to obtain from
a commercial bank. The Company subsequently abandoned its efforts to
obtain the working capital line of credit. Each Guaranty Warrant
covered the same number of shares the recipient agreed to pledge. No
value was assigned to these warrants. The Guaranty Warrants were fully
exercisable between October 2, 1992 and October 1, 1996, at which time
they would have expired to the extent not exercised. On March 28, 1996,
the Board of Directors extended the exercisability of the Guaranty
Warrants through October 1, 1998. This resulted in a new exercise
period from October 1, 1996 (new measurement date) to October 1, 1998.
The exercise price is $.50 per share, an amount equal to the last
reported sale price of the Common Stock on the American Stock Exchange's
Emerging Company Marketplace prior to October 2, 1992. The Guaranty
Warrants are not transferrable, but may be exercised only by their
recipients (or by a recipient's estate in the event of his/her death).
Note 7 - 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 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 written on State & County policies.
The arrangement was supplemented by a separate retrocession agreement
between Hallmark and Vesta Fire Insurance Corporation ("Vesta").
Hallmark and Vesta shared the risk on the State & County policies with
Hallmark retaining 25%. This retrocession agreement with Vesta was
terminated on a run-off basis effective June 30, 1996.
<PAGE>
Effective July 1, 1996, Hallmark renewed its reinsurance arrangement
with State & County and entered into a new retrocession agreement with
Kemper Reinsurance Company, Dorinco and Odyssey Reinsurance Corporation.
Under the new retrocession agreement, Hallmark continues to retain 25%.
Note 8 - Commitments and Contingencies
Effective March 17, 1997, HFC entered into a loan agreement (ABank
Credit Line@) with a bank whereby the bank committed to provide a
revolving credit facility of $8,000,000 for funding of up to 60% of
premium finance notes outstanding for State and County policies.
Beginning on or about June 15, 1997, upon completion of the 90-day
cancellation notification period to Peregrine, HFC will commence funding
all new notes issued by HFC with proceeds from both the Dorinco loan as
discussed in Note 3 and the Bank Credit Line.
The Bank Credit Line provides for an eighteen-month term which
expires September 17,1998. Fundings under this line are limited to a
60% advance rate against a borrowing base of eligible premium finance
notes receivable as defined in the agreement. The agreement provides
for monthly interest payments with interest rate options of prime plus
three-eighths floating or the London Interbank Offered Rate ("LIBOR")
plus two and eight-tenths with fixed rate tranches of three, six and/or
twelve months in $250,000-minimum increments up to a total of twelve
tranches. A one-fourth of one percent usage fee is payable on any
unused portion of the Bank Credit Line. To collateralize advances under
the line, HFC must grant the bank a security interest in the premium
finance notes and the Company must guarantee HFC's indebtedness. The
Bank Credit Line agreement also contains covenants which, among other
things, require the Company to satisfy the same financial ratios as in
the Dorinco loan agreement, and includes, but is not limited to,
restrictions on capital expenditures, payment of dividends, and
incurring of additional debt, and requires that the Company be in
compliance with all terms and covenants of the Dorinco loan agreement.
Item 2. Management's Discussion and Analysis or Plan of Operation.
Introduction. Hallmark Financial Services, Inc. ("HFS") and its
wholly owned subsidiaries (collectively referred to herein as the
"Company") engage in the sale of insurance products on credit terms,
primarily to lower and middle income customers. Its target market
encompasses the substantial number of Americans who either are denied
credit from banks, credit card companies and other conventional credit
sources, or have never established a bank account or credit history.
Currently, the Company's business primarily involves marketing,
underwriting and premium financing of non-standard automobile insurance.
Secondarily, the Company provides fee-based claims adjusting and
related services for affiliates and third parties.
<PAGE>
The Company conducts these activities through an integrated insurance
group, the dominant members of which are a property and casualty
insurance company, American Hallmark Insurance Company of Texas
("Hallmark"); a managing general agent, American Hallmark General
Agency, Inc. ("AHGA"); a network of affiliated insurance agencies known
as the American Hallmark Agencies ("Hallmark Agencies"); a commercial
excess and surplus lines affiliated managing general agency, Hallmark
Underwriters, Inc. ("HUI"); a premium finance company, Hallmark Finance
Corporation ("HFC"); and a claims handling and adjustment firm, Hallmark
Claims Service, Inc. ("HCS"). The Company operates only in Texas.
Hallmark provides non-standard automobile liability and physical
damage insurance through reinsurance arrangements with several
unaffiliated companies. Through arrangements with State & County Mutual
Fire Insurance Company ("State & County"), Hallmark provides insurance
primarily for high risk drivers who do not qualify for standard-rate
insurance. Under supplementary quota-share reinsurance agreements,
Hallmark cedes a substantial portion of its risk and retains the
balance. From March 1, 1992 through June 30, 1996, Hallmark ceded a
portion of its risk to Vesta Fire Insurance Corporation ("Vesta") (60%
between March 31, 1992 and July 31, 1993 and 75% between August 1, 1993
and June 30, 1996). Effective July 1, 1996, Hallmark entered into a new
reinsurance treaty with Kemper Reinsurance Company ("Kemper"), Dorinco
Reinsurance Company ("Dorinco"), and Odyssey Reinsurance Corporation
("Odyssey"), ceding a total of 75% of its risk. HFC offers premium
financing to Hallmark policyholders through a financing and servicing
arrangement with an unaffiliated premium finance company. Beginning in
June 1997, HFC will begin offering premium financing and issue its own
premium finance notes funded by $15 million in loan proceeds pursuant to
agreements executed in March 1997. (See Notes 3 and 8 to the
Consolidated Financial Statements.) AHGA manages the marketing of
Hallmark policies through a network of retail insurance agencies which
operate under the American Hallmark Agencies name, and through
independent agents operating under their own respective names.
HUI, formed to market and produce commercial excess and surplus lines
("E&S") insurance on behalf of unaffiliated E&S insurers, began
operations in late April 1996. HUI is expected to generate commission
income by producing E&S insurance business through the network of the
Company's fourteen retail agencies, certain agents from the Company's
current independent agent group, and other selected independent agents.
<PAGE>
Financial Condition and Liquidity
The Company's sources of funds are principally derived from insurance
related operations. Major sources of funds are from premiums collected
(net of policy cancellations and premiums ceded), external funding of
premium notes, ceding commissions, processing fees, premium finance
service charges and investment activities. Net cash flow utilized from
the Company's consolidated operations for the three months ended March
31, 1997 was $766,037 and net cash flow provided for the three months
ended March 31, 1996 was $1,586,464. While premiums receivable at March
31, 1997 and 1996 are approximately the same, the year-end premiums
receivable balances preceding each respective quarter varied
significantly. Premiums receivable at December 31, 1996 were almost 50%
lower than at December 31, 1995 principally due to unusually high annual
premium volume during 1995. As a result, cash received under the
Company's premium finance program during the first quarter of 1997 was
considerably less than cash received during the same period of 1996.
On a consolidated basis, the Company=s liquidity remained relatively
unchanged as of March 31, 1997 as compared to December 31, 1996. The
Company's total cash and investments were $13,369,429 and $13,441,830 as
of March 31, 1997 and December 31, 1996, respectively. Although cash
flow from operations decreased during the first quarter of 1997 compared
to the same quarter in 1996 (as discussed above), the unusually high
1995 premium volume moderated during 1996 and thus, did not continue to
affect subsequent quarters.
Under HFC's premium finance program, premiums for annual policies due
Hallmark are funded-in-full in approximately 30 days and immediately
invested. Any unfunded premium balances are recorded as premiums
receivable. Premiums receivable of $3,360,435 and $2,524,938 at March
31, 1997 and December 31, 1996, respectively, include unfunded premium
balances due of $3,252,023 and $2,437,024 at March 31, 1997 and December
31, 1996, respectively. Premiums receivable increased at March 31, 1997
compared to December 31, 1996 principally due to the combined effect of
a 7% increase in gross premiums written during the first quarter of 1997
as compared to the prior year, and a change in the 1997 policy mix to
55% annual policies compared to 47% annual policies in 1996. During the
first quarter of 1997 and 1996, respectively, the Company received
external funds, net of cancellations, of $3,090,451 and $3,814,277 to
fund premiums generated by the Company.
<PAGE>
At March 31, 1997, the Company reported $7,578,014 in notes payable
as compared to $590,853 at December 31, 1996. Effective March 11, 1997,
the Company entered into a loan agreement with Dorinco (ADorinco Loan
Agreement@), an unaffiliated company and principal reinsurer of
Hallmark, whereby the Company borrowed $7,000,000 to contribute to HFC.
(See Note 3 to the Consolidated Financial Statements.) Proceeds from
the Dorinco Loan Agreement were used to pay $5,915,109 outstanding and
to fund February premium notes under HFC=s financing and servicing
arrangement with an unaffiliated premium finance company. As a result,
the Company recorded notes receivable in the amount of $6,174,144 as of
March 31, 1997. (See Note 4 to the Consolidated Financial Statements.)
Of the outstanding notes payable balance, $420,679 is due before
December 31, 1997. The Company expects to repay these notes with cash
from operations. However, the amount to be paid in 1997 may be less
than the $420,679 reflected in the notes payable balance. Included in
this amount is a disputed obligation of $380,000 in connection with a
financing transaction which occurred prior to the Company's acquisition
of the insurance group. Further, if any portion of the approximately
$380,000 is ultimately deemed owing, the Company believes that it has
the right to offset $240,000 which is on deposit with a subsidiary of
the unaffiliated finance company.
A substantial portion of the Company's liquid assets are held by
Hallmark and are not available for general corporate purposes. Of the
Company's consolidated liquid assets at March 31, 1997, $1,785,792
represents non-restricted cash (compared to $991,095 at December 31,
1996 and $1,233,481 at March 31, 1996). Since state insurance
regulations restrict financial transactions between an insurance company
and its affiliates, the Company is limited in its ability to use
Hallmark funds for its own working capital purposes. Furthermore,
dividends and loans by Hallmark to the Company are restricted and
subject to Texas Department of Insurance ("TDI") approval. However, TDI
has sanctioned the payment of management fees, commissions and claims
handling fees by Hallmark to the Company and affiliates. During the
first quarter of 1997, Hallmark paid or accrued $200,000 in management
fees as compared to $250,000 for the first quarter of 1996. For the
year ended December 31, 1996, Hallmark paid or accrued $1,050,000 in
management fees. While management fees for 1997 may be higher than the
fees paid or accrued in 1996, they should be less than the amounts
authorized by TDI. Management fees from Hallmark should continue to be
a moderate source of unrestricted liquidity. However, management
intends to continue to restrict payment of management fees, as
necessary, to insure the surplus strength of Hallmark.
<PAGE>
Commissions from the Company's annual policy program for independent
agents represent a source of unrestricted liquidity. Under this
program, AHGA offers independent agents the ability to write annual
policies, but commissions to independent agents are paid monthly on an
"earned" basis. However, consistent with customary industry practice,
Hallmark is paying total commissions up-front to AHGA based on the
entire annual premiums written. Independent agent production of annual
policies was approximately $4.7 million for the three months ended March
31, 1997. During the first quarter of 1997, AHGA received $2.0 million
in commissions related to this program from Hallmark, and will pay
earned commissions of $1.2 million to independent agents. During 1996,
AHGA received approximately $6.3 million in commissions related to this
annual policy program from Hallmark, of which approximately $5.2 million
was paid to independent agents in 1996 and approximately $1.1 million is
being paid to independent agents during 1997 as earned.
Ceding commission income represents a significant source of funds to
the Company. In accordance with GAAP, a portion of ceding commission
income and policy acquisition costs is deferred and recognized as income
and expense, respectively, as related net annual premiums are earned.
Deferred ceding commission income increased to $2,464,230 at March 31,
1997 from $2,368,264 at December 31, 1996. This increase is principally
attributable to the combined effect of increased premium volume during
the first quarter of 1997, and an increase in the annual policy mix to
55% in 1997 from 47% in 1996. Partially offsetting this increase is an
approximate 8% decrease in ceding commission income during the first
quarter of 1997 as compared to the same quarter of 1996 primarily due to
a change in reinsurance treaty terms effective July 1, 1996. Deferred
policy acquisition costs of $2,911,841 as of March 31, 1997 were
$375,276 greater than at December 31, 1996 as a result of the first
quarter increase in 1997 premium volume as well as the change in
reinsurance terms with regard to front fees and premium taxes.
At March 31, 1997, Hallmark reported statutory capital and surplus of
$5,349,871, which shows an increase of $171,877 over the $5,177,994
reported at December 31, 1996. On an annualized-premium basis,
Hallmark's premium-to-surplus ratio at March 31, 1997 was 2.46 to 1 as
compared to 2.21 to 1 at December 31, 1996, and 2.12 to 1 at March 31,
1996. Management does not presently expect Hallmark to require
additional capital during 1997. Management anticipates that Hallmark is
positioned to maintain and strengthen statutory surplus through
increased earnings from insurance operations. For the three months
ended March 31, 1997, the statutory loss ratio was approximately 61.3%
compared to 64.1% and 81.8% for the twelve months ended December 31,
1996 and 1995, respectively. See Results of Operations for discussion
of loss ratio improvement.
<PAGE>
As previously mentioned, effective July 1, 1996, Hallmark entered
into new reinsurance treaties with Kemper, Dorinco, and Odyssey.
Certain provisions of the reinsurance treaties could impact the
Company's liquidity. Under the new reinsurance agreement between
Hallmark and the reinsurers, Hallmark retains 62.5% and cedes only 37.5%
of the policy fees (rather than ceding 75% of the policy fees as under
the Vesta treaty), pays premium taxes and front fees on 100% of the
business produced (rather than premium taxes and front fees on only its
retained business under the Vesta treaty), and receives a 30%
provisional commission on the portion of the business ceded (rather than
a guaranteed 30% ceding commission under the Vesta treaty). Policy fees
are up-front, fully earned fees that the Company is permitted by law to
charge in addition to premiums to cover or defray certain costs
associated with producing policies. The provisional commission paid
under the new treaty will be adjusted annually over a three-year rating
period on a sliding scale based on annual loss ratios. Based upon its
loss experience, Hallmark can earn a maximum commission of 33.5% and is
guaranteed a minimum commission of 26% regardless of loss experience.
Currently, the Company is recognizing a commission of 27.5% based on
current loss experience. Pursuant to the loan agreement dated March 11,
1997 between the Company and Dorinco (as discussed above), effective
January 1, 1997, the commission structure of Dorinco=s pro-rata share
of the July 1, 1996 reinsurance treaty was amended to include terms that
allows Hallmark to earn an additional 1% commission at a higher loss
ratio than under the previous structure and also increases the maximum
ceding commission that Hallmark may earn by 1% up to 34.5%, but reduces
the minimum ceding commission from 26% to 23%. In addition, the Dorinco
Loan Agreement requires that effective July 1, 1997, Hallmark increase
future volume of business ceded to Dorinco under the July 1, 1996
reinsurance treaty and satisfy certain annual volume levels ceded over
the seven year term of the loan agreement.
Unearned premiums increased approximately 9% as of March 31, 1997
compared to December 31, 1996. This increase was principally due to an
approximate 7% increase in gross premiums written (prior to reinsurance)
for the quarter ended March 31, 1997 compared to the same quarter in
1996 and a shift in the annual policy mix to 55% for the respective
quarter in 1997 from 47% for the first quarter of 1996. As expected,
prepaid reinsurance premiums increased proportionately.
Unpaid losses and loss adjustment expenses ("LAE") decreased
approximately 10% due to the combined effect of a continued decrease in
average claim payments during the first quarter of 1997 as compared to
the first quarter of 1996 as well as a decrease in the number of days to
process and pay a claim. Accordingly, reinsurance recoverable
decreased proportionately.
<PAGE>
During 1997, management expects that the Company's liquidity will
continue to be favorably impacted by a continued focus on the
performance of the Company's core State & County business with emphasis
on claims operations. The Company has increased its claims staff and
hired additional experienced claims adjusters and supervisory personnel
that, in turn, have contributed to lower loss and LAE payments and
favorably impacted the Company=s profitability. This focus, along with
the Company's ongoing ability to identify and retain quality independent
agents and to respond on a timely basis to rate-change indications
arising from both loss experience and competitive market considerations,
is expected to enhance earnings and liquidity during 1997.
Additionally, revised reinsurance terms related to the Dorinco
financing, as well as reduced borrowing costs for the Company's premium
finance program from both the Dorinco financing and bank credit line,
should positively impact liquidity and earnings beginning late-1997.
Management also anticipates that an integrated cash management system
implemented in late-1995 will continue to positively impact 1997
liquidity.
The Company continues to pursue third party claims handling and
administrative contracts. Effective January 1, 1997, the Company entered
into a new agreement with an unaffiliated managing general agency
(AMGA@). Under this three-year contract, the Company, as program
administrator, performs certain administrative functions, including but
not limited to, cash management, underwriting and rate-setting reviews,
and claims handling. In addition, Hallmark assumes a 10% pro-rata share
of the business produced under this MGA=s program. It is anticipated
that fees under this contract could positively impact liquidity
increasingly throughout the year.
Beginning late-April 1996, the Company began marketing E&S insurance
through HUI. This business is produced by the Hallmark Agencies and a
select group of independent agents, and some portion of the premiums are
financed by HFC. No entity within the Company bears any underwriting
risk. The E&S policies are written on behalf of A-rated (A.M. Best
rating) unaffiliated insurance companies. HFC offers premium financing
for E&S business produced by HUI, and is currently financing E&S premium
notes with internally generated funds. As anticipated, the growth of
this business has been gradual due, in part, to increased competition
from the standard insurance market. Management remains committed to the
development of its E&S program, and HUI is increasing its appointments
of qualified independent agents. In addition, HUI recently entered into
a relationship with a London broker and may begin producing business
effective May 1, 1997 on behalf of two London-based carriers. HCS will
perform claims handling functions on a fee basis. Nonetheless, it is
not anticipated that the E&S program will significantly impact liquidity
during 1997.
Management intends to continue to investigate opportunities for
future growth and expansion. However, the Company currently has no
growth plans which would require significant external funding during
1997.
<PAGE>
Results of Operations
Gross premiums written (prior to reinsurance) and net premiums
written (after reinsurance) of $11,140,479 and $3,294,016, respectively,
for the quarter ended March 31, 1997 increased approximately 7% and 26%,
respectively, in relation to gross premiums written and net premiums
written of $10,458,399 and $2,612,833, respectively, for the same period
last year. The disproportionate increase in gross and net premiums
written pertains to Hallmark=s retention of 62.5% of policy origination
fees during the quarter ended March 31, 1997 as compared to 25% during
the quarter ended March 31, 1996. As previously discussed, this change
in the policy fee retention-percentage is due to a change in reinsurance
terms effective July 1, 1996.
Premiums earned (prior to reinsurance) of $10,180,513 were $1,896,397
lower than in 1996 representing a 16% decrease for the period ended
March 31, 1997 over the same period in 1996. Net premiums earned (after
reinsurance) of $2,979,542 for 1997 remained relatively the same as the
1996 quarter. During the first quarter of 1996, premiums earned (prior
to reinsurance) were high due to the 1996 earning of premiums written
during high-volume months of late 1995 as well as the increase in
monthly policy production during 1996 from 39% in 1995 to 52% in 1996.
Hallmark did not experience any high-volume months during 1996 and
additionally, annual policy production has been on the rise during the
first three months of 1997 (55% for 1997 as compared to 47% for the same
period of 1996). The disproportionate decrease between premiums earned
(prior to and after reinsurance) resulted from the change discussed in
the paragraph above.
Net incurred loss ratios (computed on net premiums earned after
reinsurance) for the three months ended March 31, 1997 and 1996 were
approximately 55% and 66%, respectively. The decrease in the loss ratio
between the first quarter of 1997 and 1996, was primarily attributable
to a continued emphasis on effective claims handling procedures,
adequate rates, responsive rate-setting procedures and an increase in
retention of policy fees to 62.5%. Reinsurance recoveries decreased
accordingly.
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 increase in the credit balance of acquisition costs, net is
primarily due to the deferral of increased premium taxes and front fees
during the first quarter of 1997 as compared to the same period in 1996.
Other acquisition and underwriting expenses increased $387,363 during
the first quarter of 1997 as compared to the same quarter of 1996. This
increase is primarily due to an increase in the Company=s share of
premium taxes and front fees paid under the July 1, 1996 reinsurance
treaty as previously discussed, and a decrease in ceding commission
income for the first quarter due to the change in treaty terms effective
July 1, 1996. Partially offsetting these fluctuations are the
cumulative affect of decreases in a number of underwriting expenses with
no single amount accounting for a significant fluctuation.
<PAGE>
Operating expenses increased during the three months ended March 31,
1997 as compared to the same period in 1996, due to an increase in the
expenditures of management time and financial resources to premium
finance, the managing general agency, and the surplus lines programs.
Interest expense for the first quarter of 1997 increased in relation
to the same period in 1996 as a result of the Dorinco loan which closed
early-March to fund premium finance operations. Previous premium
financing was through an unaffiliated premium finance company and thus
did not result in interest expense on the Company's financial
statements. (See Note 3 to the Consolidated Financial Statements.)
Investment income of $184,555 for the quarter ended March 31, 1997
decreased by approximately 14% over the comparable 1996 quarter as a
result of a decrease in funds available for investment and the maturity
of some higher-yielding long-term investments. Long-term invested funds
have decreased principally due to recent maturities and to changing
market conditions whereby long-term rates were less favorable for 1997
as compared to 1996.
Processing fees of $363,374 for the 1997 quarter decreased $132,621
in relation to the same quarter in 1996. These fees represent income
earned by HFC pursuant to the commencement of its premium finance
program January 1, 1995. The decrease in processing fees is directly
related to a decrease in the outstanding premium notes at March 31, 1997
as compared to the outstanding premium notes at March 31, 1996. The
lower premium note balances in 1997 compared to 1996 is due to the large
volume of notes generated in connection with unusually high premium
volumes during the third quarter of 1995. At March 31, 1997, there were
28,828 premium notes totaling approximately $10,085,053, and at March
31, 1996, there were 31,501 notes totaling $12,224,662.
Service and consulting fees for the quarter ended March 31, 1997,
increased by $20,830 over the same period of 1996 primarily as a result
of the Company's contract to act as program administrator for an
unaffiliated MGA.
Other income for the three months ended March 31, 1997, increased by
$35,377 as compared to the same period of 1996 principally as a result
of additional outside commissions earned by the captive agencies and
HUI, the Company=s excess and surplus lines agency.
<PAGE>
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, 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 as representation by the Company
or any other person that the objectives and plans of the Company will be
achieved.
<PAGE>
PART II
OTHER INFORMATION
Item 1.Legal Proceedings.
Except for routine litigation incidental to the business of the
Company and as described in Note 9 to the Consolidated Financial
Statements of the Company contained in its Form 10-KSB as of December
31, 1996, 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 upon Security 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) No exhibits are filed herewith.
(b) The Company did not file a Current Report on Form 8-K to report
any events which occurred during the quarter ended March 31, 1997.
<PAGE>
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 duty authorized.
HALLMARK FINANCIAL SERVICES, INC.
(Registrant)
Date: May 13, 1997 /s/ Ramon D. Phillips
Ramon D. Phillips, President (Chief
Executive Officer)
Date: May 13, 1997 /s/ John J. DePuma
John J. DePuma,
Chief Financial Officer
<TABLE> <S> <C>
<ARTICLE> 7
<LEGEND>
Due to format constraints of this Financial Data Schedule (FDS) certain
Balance Sheet items where omitted: i.e. Prepaid reinsurance premiums,
Premium notes receivable, Installment premiums receivable, Excess of cost
over net assets acquired & Other assets. Refer to actual 10KSB submission.
</LEGEND>
<MULTIPLIER> 1
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-END> MAR-31-1997
<DEBT-HELD-FOR-SALE> 0
<DEBT-CARRYING-VALUE> 9,066,156
<DEBT-MARKET-VALUE> 9,076,614
<EQUITIES> 149,433
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 9,215,589
<CASH> 4,153,840
<RECOVER-REINSURE> 19,964,108
<DEFERRED-ACQUISITION> 447,611
<TOTAL-ASSETS> 61,581,672
<POLICY-LOSSES> 0
<UNEARNED-PREMIUMS> 12,270,216
<POLICY-OTHER> 3,828,792
<POLICY-HOLDER-FUNDS> 5,128,076
<NOTES-PAYABLE> 7,578,014
0
0
<COMMON> 328,868
<OTHER-SE> 11,398,409
<TOTAL-LIABILITY-AND-EQUITY> 61,581,672
2,979,542
<INVESTMENT-INCOME> 184,555
<INVESTMENT-GAINS> 0
<OTHER-INCOME> 511,982
<BENEFITS> 1,637,849
<UNDERWRITING-AMORTIZATION> (279,311)
<UNDERWRITING-OTHER> 1,906,765
<INCOME-PRETAX> 410,776
<INCOME-TAX> 104,863
<INCOME-CONTINUING> 305,913
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 305,913
<EPS-PRIMARY> 0.03
<EPS-DILUTED> 0.03
<RESERVE-OPEN> 20,697,393
<PROVISION-CURRENT> 5,694,780
<PROVISION-PRIOR> 698,492
<PAYMENTS-CURRENT> (1,968,256)
<PAYMENTS-PRIOR> (6,537,342)
<RESERVE-CLOSE> 18,585,067
<CUMULATIVE-DEFICIENCY> 0
</TABLE>
