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 September 30, 2000
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 75240
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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
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 - 11,049,133 shares
outstanding as of November 10, 2000.
<PAGE>
PART I
FINANCIAL INFORMATION
Item 1. Financial Statements
INDEX TO FINANCIAL STATEMENTS
Page Number
-----------
Consolidated Balance Sheets at September 30, 3
2000 (unaudited) and December 31, 1999
Consolidated Statements of Income (unaudited) 4
for the three and nine months ended September
Consolidated Statements of Cash Flows 5
(unaudited) for the nine months ended
Notes to Consolidated Financial Statements 6
(unaudited)
<PAGE>
<TABLE>
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
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September 30 December 31
2000 1999
(Unaudited)
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<S> <C> <C>
Investments:
Debt securities, held-to-maturity, at
amortized cost $ 5,929,165 $ 3,831,657
Equity securities, available-for-sale, at
market value 142,800 142,901
Short-term investments, at cost which
approximates market value 6,652,919 6,373,491
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Total investments 12,724,884 10,348,049
Cash and cash equivalents 6,927,199 5,786,069
Restricted cash 3,449,297 3,422,297
Prepaid reinsurance premiums 10,281,813 7,673,196
Premium receivable from lender (net of
allowance for doubtful accounts of
$166,447 in 2000 and $78,326 in 1999) 13,382,577 9,058,958
Premiums receivable 947,306 741,613
Reinsurance recoverable 19,753,226 15,673,241
Deferred policy acquisition costs 3,830,686 2,741,076
Excess of cost over net assets acquired (net
of accumulated amortization of $1,602,841
in 2000 and $1,485,080 in 1999) 4,627,374 4,745,134
Deferred federal income taxes 361,390 212,059
Accrued investment income 96,108 52,721
Other assets 698,740 547,820
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$ 77,080,600 $ 61,002,233
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LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Notes payable $ 12,512,537 $ 9,288,366
Unpaid losses and loss adjustment expenses 20,966,268 17,804,254
Unearned premiums 15,794,458 11,761,723
Reinsurance balances payable 4,444,251 2,623,603
Deferred ceding commissions 3,395,434 2,142,097
Drafts outstanding 1,462,366 901,471
Accrued ceding commission refund 1,653,812 1,251,614
Current federal income taxes payable 28,718 46,124
Accounts payable and other accrued expenses 3,688,809 2,516,222
Accrued litigation costs 950,000 950,000
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Total liabilities 64,896,653 49,285,474
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Stockholders' equity
Common stock, $.03 par value, authorized
100,000,000 shares issued 11,855,610 in
2000 and 11,854,610 shares in 1999 355,668 355,638
Capital in excess of par value 10,875,432 10,875,212
Retained earnings 2,010,069 1,543,304
Accumulated other comprehensive income (14,055) (14,228)
Treasury stock, 806,477 shares, at cost (1,043,167) (1,043,167)
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Total stockholders' equity 12,183,947 11,716,759
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$ 77,080,600 $ 61,002,233
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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
Three Months Ended Nine Months Ended
September 30 September 30
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2000 1999 2000 1999
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<S> <C> <C> <C> <C>
Gross premiums written $ 12,352,362 $ 9,631,847 $ 38,450,952 $ 28,039,106
Ceded premiums written (8,235,564) (5,797,482) (23,636,960) (16,491,216)
----------- ----------- ----------- -----------
Net Premiums written $ 4,116,798 $ 3,834,365 $ 14,813,992 $ 11,547,890
=========== =========== =========== ===========
Revenues:
Gross premiums earned 11,202,560 8,628,631 33,713,742 24,647,840
Earned premiums ceded (7,390,701) (4,996,583) (20,323,870) (14,486,188)
----------- ----------- ----------- -----------
Net Premiums earned 3,811,859 3,632,048 13,389,872 10,161,652
Investment income, net of expenses 293,178 212,356 811,525 564,832
Finance charges - 521,974 - 1,488,262
Processing and service fee 1,191,435 499,973 3,881,764 1,506,597
Other income 76,577 93,784 243,338 287,116
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Total revenues 5,373,049 4,960,135 18,326,499 14,008,459
Benefits, losses and expenses
Losses and loss adjustment expenses 10,616,960 7,355,814 31,735,103 18,894,337
Reinsurance recoveries (7,038,221) (4,911,209) (21,082,332) (12,362,513)
----------- ---------- ---------- -----------
Net losses and loss adjustment expenses 3,578,739 2,444,605 10,652,771 6,531,824
Acquisition costs, net 146,195 226,777 163,728 (161,766)
Other acquisition and underwriting
expenses 415,473 1,096,832 2,538,869 3,606,015
Operating expenses 998,526 809,345 3,280,698 2,443,980
Interest expense 300,225 149,275 804,972 444,299
Amortization of intangible assets 39,253 39,254 117,761 117,761
----------- ----------- ----------- -----------
Total benefits losses and expenses 5,478,411 4,766,088 17,558,799 12,982,113
----------- ----------- ----------- -----------
(Loss) income from operations
before federal income taxes (105,362) 194,047 767,700 1,026,346
Federal income tax (benefit) expense (23,154) 65,661 300,934 395,468
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Net (loss) income $ (82,208) $ 128,386 $ 466,766 $ 630,878
=========== =========== =========== ===========
Basic and diluted earnings per share $ (0.01) $ 0.01 $ 0.04 $ 0.06
=========== =========== =========== ===========
Common stock shares outstanding 11,049,133 11,048,133 11,049,133 11,048,133
=========== =========== =========== ===========
The accompanying notes are an integral part
of the consolidated financial statements
</TABLE>
<PAGE>
<TABLE>
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(Unaudited)
Nine Months Ended
September 30
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2000 1999
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<S> <C> <C>
Cash flows from operating activities:
Net income $ 466,766 $ 630,878
Adjustments to reconcile net loss to cash
Depreciation and amortization expense 234,517 214,558
Change in deferred Federal income taxes (149,331) (83,933)
Change in prepared reinsurance premiums (2,608,617) (2,005,028)
Change in premiums receivable (205,693) 72,313
Change in deferred policy acquisition costs (1,089,610) (724,946)
Change in deferred ceding commissions 1,253,337 563,181
Change in unpaid losses and loss adjustment
expenses 3,162,014 890,918
Change in unearned premiums 4,032,735 3,391,265
Change in reinsurance recoverable (4,079,985) (931,838)
Change in reinsurance balances payable 1,820,648 895,017
Change in current federal income payable (17,406) 304,021
Change in accrued ceding commission refund 402,198 485,183
Change in all other liabilities 1,733,482 788,664
Change in all other assets (141,229) 68,047
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Net cash provided by operating activities 4,813,826 4,558,300
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Cash flows from investing activities:
Purchases of property and equipment (169,662) (48,292)
Premium finance notes originated (29,426,827) (18,734,555)
Premium finance notes repaid 25,103,207 15,937,222
Change in restricted cash (27,000) (38,000)
Purchase of debt securities (3,601,030) (1,792,633)
Maturities and redemptions of
investment securities 1,503,624 1,906,491
Purchase of short-term investments (14,779,428) (12,301,156)
Maturities of short-term investments 14,500,000 9,221,201
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Net cash used in investing activities (6,897,116) (5,849,722)
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Cash flows from financing activities:
Net advances from lender 3,621,469 -
Repayment of borrowings (397,299) (48,201)
Proceeds from common stock issued 250 -
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Net cash provided by (used in) financing activities 3,224,420 (48,201)
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Increase (decrease) in cash and cash equivalents 1,141,130 (1,339,623)
Cash and cash equivalents at beginning of period 5,786,069 6,776,274
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Cash and cash equivalents at end of period $ 6,927,199 $ 5,436,651
========== ==========
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 September
30, 2000 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 ("GAAP") have been condensed or omitted.
Reference is made to the Company's annual consolidated financial statements
for the year ended December 31, 1999 for a description of accounting
policies and certain other disclosures. Certain items in the 1999 interim
financial statements have been reclassified to conform to the 2000
presentation.
The results of operations for the period ended September 30, 2000 are
not necessarily indicative of the operating results to be expected for the
full year.
Note 2 - Reinsurance
The Company 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, the Company 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 the Company and underwritten by State & County. The
arrangement is supplemented by a separate retrocession agreement between the
Company and its reinsurer. Effective July 1, 2000, the Company entered into
a new reinsurance agreement with Dorinco Reinsurance Company ("Dorinco")
whereby the Company, upon mutual agreement with Dorinco, may elect on a
quarterly basis to retain 30% to 45% of the risk. Policy fees are 100%
included in the premium base. The minimum commission rate is 31% at a 64.5%
loss ratio or higher. The commission rate increases 1:1 to any percentage
decrease in the loss ratio to a provisional/maximum commission rate of 41%
at a loss ratio of 54.5% or lower. Prior to July 2000, the Company retained
25% of the risk and ceded 75% of the risk to two reinsurers, Dorinco and GE
Reinsurance Corporation.
During the third quarter of 2000, the Company commuted loss reserves
under its previous reinsurance agreement (effective March 1, 1992 through
June 30, 1996) with Vesta Fire Insurance Corporation. The reserves were
commuted at 100%. The Company received approximately $0.5 million in cash
which has subsequently been invested in government securities. It is
anticipated that related outstanding claims will be settled over the next
two years.
<PAGE>
Note 3 - Commitments and Contingencies
In March 1997, a jury returned a verdict against the Company and in
favor of a former director and officer of the Company in the amount of
approximately $517,000 on the basis of contractual and statutory
indemnification claims. The court subsequently granted the plaintiff's
motion for attorneys' fees of approximately $271,000, court costs of
approximately $39,000 and pre-judgment and post-judgment interest, and
rendered final judgment on the verdict. The Company believes the outcome in
this case was both legally and factually incorrect and has appealed the
judgment. During the fourth quarter of 1997, the Company deposited
$1,248,758 into the registry of the court in order to stay execution on the
judgment pending the result of such appeal. The amount on deposit
(including interest) with the court of $1,400,006 as of September 30, 2000
has been included as restricted cash in the accompanying balance sheet.
Although the Company intends to aggressively pursue its appeal, the
Company is presently unable to determine the likelihood of a favorable
result. Further, a favorable ruling on some portions of the appeal could
entail the necessity for a new trial. Therefore, the Company established a
reserve of $950,000 during the fourth quarter of 1997 for loss contingencies
related to this case. This reserve remains unchanged as of September 30,
2000. The possible range of loss in the event of an ultimately unfavorable
outcome to this case exceeds the amount presently reserved. Conversely, in
the event of a favorable resolution of the case, the expenses incurred could
be less than the reserve amount. Therefore, future adjustments to the
reserve may be required.
[This space left blank intentionally]
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 property and casualty insurance products. The Company's
business primarily involves marketing, underwriting and premium financing of
non-standard automobile insurance, as well as claims adjusting and other
insurance related services.
The Company pursues its business activities through an integrated
insurance group (collectively, the "Insurance Group") the members of which
are an authorized Texas 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 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.
<PAGE>
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. During the third
quarter of fiscal 2000, Dorinco Reinsurance Company ("Dorinco") assumed 70%
of the risk with Hallmark retaining the remaining 30%. Prior to July 1,
2000, the Company's principal reinsurers, GE Reinsurance Corporation and
Dorinco collectively assumed 75% of Hallmark's risk. HFC finances annual and
six-month policy premiums through its premium finance program. 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.
Additionally, AHGA provides premium processing, underwriting, reinsurance
accounting and cash management for unaffiliated managing general agents
("MGAs"). HCS provides fee-based claims adjustment, salvage, subrogation
recovery and litigation services to Hallmark and unaffiliated MGAs.
New Reinsurance Agreements
As a result of increased premium volume and funds expended by Hallmark
on systems development, the Company undertook several steps during the third
quarter to strengthen Hallmark's surplus. One such step was to
retroactively renegotiate certain terms of a new reinsurance agreement with
Dorinco previously executed to be effective July 1, 2000. Under the
renegotiated reinsurance agreement, Hallmark may elect on a quarterly basis
to retain between 30% and 45% of the risk (compared to 25% under the
previous arrangements) and Dorinco, as the sole reinsurer, has increased its
participation to assume the remainder. Policy fees are now included in the
treaty at 100% (compared to 0% previously). In addition, the new agreement
increases the provisional and maximum ceding commission from 30% to 41%,
increases the minimum ceding commission from 27.5% to 31%, and increases the
ratio for computing earned ceding commissions above the minimum from 0.7:1
to 1:1 (i.e. the number of percentage points by which the earned commission
is increased over the minimum is now equal to the number of percentage
points by which the reinsurance loss ratio decreases from an established
benchmark). Regarding the minimum commission, the rate of 31% is in force
through February 28, 2001 and decreases to 26% effective March 1, 2001.
Under the renegotiated agreement, Hallmark retains the provisional/maximum
commission from July 1, 2000, through the third quarter of 2002, at which
time the earned ceding commission will be determined based on the developed
reinsurance loss ratio as of June 30, 2002.
Financial Condition and Liquidity
The Company's sources of funds are principally derived from insurance
related operations. Major sources of funds from operations include premiums
collected (net of policy cancellations and premiums ceded), ceding
commissions, processing fees, and premium finance service fees. Other
sources of funds are from financing and investment activities.
<PAGE>
Net cash provided by the Company's consolidated operating activities
was approximately $0.3 million greater during the first nine months of 2000
than during the first nine months of 1999. This increase is principally due
to increased annual policy premium volume and the increase in the
provisional ceding commission rate effective July 1, 2000. Additionally,
the Company commuted one of its reinsurance treaties during the third
quarter (as discussed below), thus generating additional cash flow from
operations. Cash used by investing activities increased approximately $1.0
million. As a result of increased annual policy premium volume, HFC
originated more premium finance notes than it received in premium finance
payments. Cash provided by financing activities increased approximately $3.3
million as a result of net advances under HFC's secured financing
arrangement with an unaffiliated third party.
On a consolidated basis, the Company's liquidity increased $3.6 million
during the first nine months of 2000. The Company's total cash, cash
equivalents and investments (excluding restricted cash of $3.5 million) at
September 30, 2000 and December 31, 1999 were $19.7 million and $16.1
million, respectively. This increased liquidity is primarily due to
increased policy production during fiscal 2000 and the increase in the
provisional ceding commission rate to 41% from 30%. To a lesser extent, the
commutation of the reinsurance treaty discussed below was also a
contributing factor to the Company's increased liquidity.
A substantial portion of the Company's liquid assets is held by
Hallmark and is not available for general corporate purposes. Of the
Company's consolidated liquid assets of $19.7 million at September 30, 2000,
$1.7 million (as compared to $0.9 million at December 31, 1999) represents
non-restricted cash. Since state insurance regulations restrict financial
transactions between an insurance company and its affiliates, HFS 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. Although TDI
has sanctioned the payment of management fees, commissions and claims
handling fees by Hallmark to HFS and affiliates, during the third quarter
Hallmark did not pay the commissions allowed to AHGA. Additionally, HFS made
a capital contribution of $250,000 to Hallmark. These steps were taken in
order to bolster Hallmark's surplus to accommodate increased premium volume
and systems development expenditures. During the first nine months of 2000
and 1999, Hallmark paid or accrued management fees of $150,000 and $425,000,
respectively. Management anticipates that Hallmark will continue to pay
management fees periodically during the remainder of 2000, and this should
continue to be a moderate source of unrestricted liquidity.
During the third quarter of 2000, the Company commuted loss reserves
under its previous reinsurance agreement (effective March 1, 1992 through
June 30, 1996) with Vesta Fire Insurance Corporation. The reserves were
commuted at 100%. The Company received approximately $0.5 million in cash
which has subsequently been invested in government securities. It is
anticipated that related outstanding claims will be settled over the next
two years.
<PAGE>
During the first nine months of 2000, the amount of funding available
to fund premium finance notes under the secured financing arrangement with
the unaffiliated third party was increased to $11.0 million from $8.0
million. As of September 30, 2000, HFC had an outstanding balance on
advances under the financing arrangement of $10.4 million at an interest
rate of 10%. Under the financing arrangement, the maximum additional
advances available to HFC at September 30, 2000 were $0.6 million.
Commissions from the Company's annual policy program for independent
agents represent a source of unrestricted liquidity when annual policy
production is level or increasing from the most recent previous quarters.
Under this program, AHGA offers independent agents the ability to write
annual policies and six-month policies, but commissions to substantially all
independent agents are paid monthly on an "earned" basis. However,
consistent with customary industry practice, Hallmark pays total commissions
up-front to AHGA based on the entire annual/six-months premiums written.
Independent agent production of annual policies was $18.7 million during the
first nine months of 2000 as compared to $11.9 million during the first nine
months of 1999. During the first nine months of 2000, AHGA received $3.6
million in commissions related to this program from Hallmark, and paid
earned commissions of approximately $2.4 million to independent agents.
This has resulted in increased unrestricted liquidity for the Company.
During the first nine months of 1999, AHGA received $2.5 million in
commissions related to this program from Hallmark, and paid earned
commissions of $1.4 million to independent agents.
Ceding commission income represents a significant source of funds to
the Company. A portion of ceding commission income and policy acquisition
costs is deferred and recognized as income and expense, respectively, as
related net premiums are earned. Deferred ceding commission income
increased to approximately $3.4 million at September 30, 2000 from $2.1
million at December 31, 1999. Deferred policy acquisition costs as of
September 30, 2000 increased approximately $1.1 million as compared to
December 31, 1999. The increase in Hallmark's core State & County annual
premium volume contributed to the increase in both deferred ceding
commission income and deferred policy acquisition costs. Additionally, the
increase in deferred ceding commission income was impacted by the increase
in the minimum ceding commission rate to 31% from 27.5%.
Premium receivable from lender increased $4.3 million during 2000 as a
result of increased annual policy production during the first nine months of
2000 as compared to the last nine months of 1999. Prepaid reinsurance
premiums, unpaid losses and LAE, reinsurance recoverable and unearned
premiums increased as expected in relation to increased premium writings.
Accounts payable and other accrued expenses increased as a result of
increased commissions due to independent agents under the earned commission
program.
<PAGE>
At September 30, 2000, Hallmark's statutory capital and surplus was
$6.3 million, which reflects a 5% increase over the balance reported at
December 31, 1999. On a rolling-twelve months premium basis, Hallmark's
premium-to-surplus ratio for the twelve months ended September 30, 2000 was
2.96 to 1 as compared to 2.57 to 1 for the year ended December 31, 1999 and
2.81 to 1 at September 30, 1999. As noted previously, during the third
quarter of 2000, HFS contributed $250,000 to Hallmark. The increase in
Hallmark's premium to surplus ratio from December 31, 1999 to September 30,
2000 is a result of increased core State & County premium volume as well as
funds expended by Hallmark on systems development. For statutory purposes,
systems development is treated as a non-admitted asset and thus reduces
statutory surplus. For GAAP purposes, the systems development qualifies as
an asset.
The Company provides program administration and claims handling
services for unaffiliated MGAs. The Company provides these services for two
unaffiliated MGA programs which are currently producing new business. Under
these contracts, the Company, as program administrator, performs certain
administrative functions, including cash management, underwriting and rate-
setting reviews, underwriting and policy processing (on two of the programs)
and claims handling. Hallmark assumes a 20% pro-rata share of the business
produced under each of the unaffiliated MGAs programs with the remaining
percentage of the business assumed by Hallmark's principal reinsurer.
Effective July 1, 2000, two other unaffiliated MGA programs discontinued
writing new business due to non-renewal of their reinsurance treaties. The
Company will continue to perform functions as defined in the respective
contracts during the run-off period.
Management is continuing to investigate opportunities for future growth
and expansion. Additional capital or strategic alliances may be required to
fund future expansion of the Company.
Results of Operations
Gross premiums written (prior to reinsurance) for the three and nine
months ended September 30, 2000 increased 28% and 37%, respectively, in
relation to gross premiums written during the same periods in 1999. Net
premiums written (after reinsurance) for the three and nine months ended
September 30, 2000 increased 7% and 28%, respectively, over the same periods
in 1999. The increase in premiums written for the three and nine months of
2000 was due to the increase in the core State & County premium volume.
Additionally, increased premium volume from assumed business produced by
unaffiliated MGAs contributed to the increase for the nine months of 2000.
As a result of a new reinsurance agreement effective July 1, 2000, 100% of
policy fees are now included as reinsurance premium compared to 0%
previously (i.e. Hallmark retained 30% during the third quarter of 2000
compared to 100% previously). This change in reinsurance has impacted net
premiums written during the third quarter of 2000 thus explaining the
disproportionate increase between gross and net premiums written.
<PAGE>
Premiums earned (prior to reinsurance) for the three and nine months
ended September 30, 2000 increased approximately 30% and 37%, respectively,
as compared to the same periods of 1999. For the three and nine months
ended September 30, 2000, net premiums earned (after reinsurance) increased
5% and 32%, respectively, as compared to the same periods of 1999. As noted
above, changes in the Company's reinsurance have impacted the retention of
policy fees. The disproportionate change in premiums earned prior to and
after reinsurance is due to policy fees and the assumption of increased
premiums produced by the unaffiliated MGAs, both of which are fully retained
by the Company and thus have a greater impact on net premiums earned.
Net incurred loss ratios (computed on net premiums earned after
reinsurance) for the three and nine months ended September 30, 2000 were
approximately 94% and 80%, respectively, compared to 67% and 64% for the
same periods of 1999. As noted above, Hallmark's reinsurance treaties were
changed effective July 1, 2000 to include 100% of policy fees in the premium
base. If policy fees had not been ceded during the third quarter of 2000,
then the loss ratios for the three and nine months would have been 85% and
77%, respectively. The increase in loss ratios is attributable to increased
loss ratios on the unaffiliated MGA business as well as the core State &
County business. Two of the unaffiliated MGA programs, which are still in
run-off and thus continue to impact the Company's loss ratio, were cancelled
effective July 1, 2000. The loss ratios on these two programs exceeded 110%
for the nine months ended September 30, 2000. The increased loss ratio on
the core State & County business is a result of depressed premium rates
during 1999 and the first part of 2000. Additionally, hail related losses
incurred during the spring of 2000 also impacted the loss ratio for the nine
months ended September 2000. As a result of a tightening of underwriting
guidelines, raising of agent performance criteria, and a recent rate
increase, the indicated loss ratio on the Company's new treaty year
effective July 1, 2000 is significantly lower. However, claims costs are
increasing principally due to rising medical, labor and repair costs.
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 acquisition costs, net, is primarily due to an increase in
annual policy premium volume which directly impacts the deferral rate and an
increased ceding commission rate as a result of changes in the Company's
reinsurance terms.
Other acquisition and underwriting expenses for the three and nine
months ended September 30, 2000 decreased approximately 62% and 30%,
respectively, as compared to the same periods of 1999. The decrease in
expenses is primarily attributable to increased ceding commission income as
a result of increased core State & County premium volume and increased
minimum commission rate due to changes in the Company's reinsurance terms
during the third quarter of 2000 to 31% from 27.5%. These decreases are
partially offset by an increase in commission expenses and other variable
expenses associated with increased premium volume.
<PAGE>
Operating expenses include expenses related to premium finance
operations, general corporate overhead, and third party administrative and
claims handling contracts. Related revenues are derived from
service/consulting fees. Operating expenses increased 23% and 34%,
respectively, during the three and nine months ended September 30, 2000 as
compared to the same periods of 1999. The majority of this increase is
attributable to the variable expenses related to increased volume in the
Company's premium finance operations, the deployment of management and staff
resources to the administration and processing of third party contracts and
the development of technological improvements in information systems.
During 1999, the Company earned finance charges (interest) on premium
notes issued by HFC. The Company has not earned finance charges during 2000
as the result of a secured financing and servicing arrangement with an
unaffiliated third party to fund HFC's premium finance activities. This
arrangement was initiated during the fourth quarter of 1999. As HFC
services the premium finance notes for the unaffiliated third party, income
derived from the premium finance notes is reflected in processing and
service fees.
Investment income increased 38% and 44%, respectively, during the three
and nine months ended September 30, 2000 compared to the same periods of
1999. The increase is attributable to the combined effect of an increase in
funds available for investment resulting from increased premium volume and
an overall increase in the effective yield of the Company's investment
portfolio.
Processing and service fees represent income earned on the premium
finance servicing arrangement with an unaffiliated third party and third
party processing and servicing contracts with unaffiliated MGAs. Processing
and service fees for the three and nine months of 2000 increased $0.7
million and $2.4 million, respectively, as compared to 1999 principally as a
result of the Company's premium finance servicing arrangement with the
unaffiliated third party.
Although total revenues for the three and nine months ended September
30, 2000 increased approximately 8% and 31%, respectively, compared to the
same periods of 1999, net income for both periods decreased. Market
fragmentation and capital over-capacity in the insurance industry over the
last several years have depressed premium rates. The cumulative effect of
inadequate rates, coupled with hailstorm claims in the first half of the
year and less favorable reinsurance terms in the third quarter mitigated the
impact of increased revenues on profitability.
Recent Developments
Management believes that recent trends emerging in the Texas insurance
industry may provide the foundation for increasing future profitability of
the Company. Initial indicators reflect a marketplace characterized by
higher premium rates and a decrease in active competitors. The Company has
been strategically increasing premium rates since November 1999, and intends
to systematically implement additional rate increases to optimize
underwriting profits. As part of the continual management of its
independent agents, the Company is actively working to increase the
profitability of the business produced by its agent base through targeted
rate increases, more stringent underwriting guidelines and heightened agent
performance requirements (including agency underwriting performance,
operational quality standards and premium production commitments).
<PAGE>
Additionally, management is in the process of implementing a phased
program to strengthen its information technology capabilities in several
areas. The thrust of the first phase is to enhance Company and agency
relationships by improving content and timeliness of information to support
its agents in servicing their customers. The Company is currently testing
the first phase internally. The Company expects to commence testing by
selected agents during the fourth quarter of fiscal 2000, with a full
implementation beginning thereafter. The emphasis of the second phase will
be to implement point-of-sale technology to support agents in more promptly
and efficiently producing new business, as well as to improve the quality
and timeliness of service to existing policyholders. When fully
implemented, these information technology enhancements should result in cost
savings for both the Company and its participating agents. The Company
anticipates implementation of phase one and the majority of phase two during
2001.
The expectation of increased premium rates in the Texas marketplace is
largely the result of recent tightening in the availability of reinsurance
on acceptable terms. Partially as a result of this development, effective
July 1, 2000, Hallmark entered into a new reinsurance agreement with
Dorinco, one of the two primary reinsurers under the prior arrangement (as
more fully discussed under New Reinsurance Arrangements).
Management believes that Hallmark's new reinsurance agreement is
advantageous to the Company in light of the current reinsurance market.
Although the increase in the minimum ceding commission rate favorably
impacts underwriting expenses through February 28, 2001, the reduction in
retained policy fees may negatively impact loss ratios in the short-term.
Further, the decrease in the minimum ceding commission rate effective March
1, 2001 could adversely impact underwriting margins if improvement in the
loss ratio has not occurred. The increase in both the provisional ceding
commission and the ratio for computing earned ceding commissions provides
the potential for enhancing future profits. In addition, short-term
liquidity will be favorably impacted by the increase in the provisional
ceding commissions.
Principally as a result of the inability of many MGA's to secure
acceptable reinsurance terms, the Company has curtailed active pursuit of
full service third party program administration contracts. For the
foreseeable future, the Company plans to limits its marketing of third party
services primarily to claims handling contracts.
<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 a 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 3
to the Consolidated Financial Statements 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 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) The exhibits listed in the Exhibit Index following
the signature page are filed herewith.
(b) The Company did not file any Form 8-K Current Reports
during the third quarter of 2000.
<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
duly authorized.
HALLMARK FINANCIAL SERVICES, INC.
(Registrant)
Date: November 13, 2000 /s/ Linda H. Sleeper
---------------------------
Linda H. Sleeper, President
Date: November 13, 2000 /s/ John J. DePuma
---------------------
John J. DePuma, Chief
Financial Officer
<PAGE>
Exhibit Index
Exhibit Description
------- -----------
10 ( a ) Quota Share Retrocession Agreement, effective July 1,
2000, between American Hallmark Insurance Company of
Texas and Dorinco Reinsurance Company.
10 ( b ) Addendum No. 2 to the Retrocession Contract, effective
June 1, 1998, issued to Dorinco Reinsurance Company by
American Hallmark Insurance Company of Texas, effective
October 1, 1999.
10 ( c ) Commutation Agreement, effective April 30, 2000, between
Vesta Fire Insurance Corporation and American Hallmark
Insurance Company of Texas.
