Annual Report 2013
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777 Main Street, Suite 1000 I Fort Worth, Texas 76102 I P (817) 348-1600 I www.hallmarkgp.com
NASDAQ: HALL
Headquartered in Fort Worth, Texas,
Hallmark Financial Services, Inc. is a publicly traded
holding company with wholly owned subsidiaries
engaged in property and casualty insurance.
Hallmark'S BuSIneSS Plan
Our COrPOraTe STraTegy
is to operate as a diversified underwriter of niche property and casualty
insurance products. This plan is executed by five wholly owned business
units, each with separate specialty product focus. each business unit is
independent of each other and has their own senior management, under-
writing, and claims staff.
is to create a “Best-in-Class” Specialty Insurance Company focused on
under writing profitability and long-term growth of stockholders’ book
value per share. Our specialty product focus and niche market strategy
enable us to develop and retain in-house underwriting expertise and spe-
cialized market knowledge, which helps differentiate Hallmark from our
competitors. each business unit tailors its products and product distribu-
tion to the unique nature of the risk and coverages they provide.
Our FInanCIal gOal
is to earn a consistent underwriting profit and build long-term shareholder
value by focusing on profitability and operating efficiency versus topline
premium growth and market share.
PremIum BreakDOWn By Hallmark BuSIneSS unIT COmPOnenTS
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
$12
$10
$8
$6
$4
)
s
n
o
i
l
l
i
m
n
i
$
(
P
P
G
Book Value Per Share for “HALL”
Book Value Per Share for “HALL”
$12.36
Workers
Workers
Workers
Compensati on
Compensati on
Compensati on
$3,116
$3,116
$3,116
Workers
Workers
Workers
Compensati on
Compensati on
Compensati on
$7,977
$7,977
$7,977
Workers
Compensati on
$9,089
Other
Other
Other
Programs
Programs
$85
$85
excess &
umbrella
$12,679
e&S
Specialty
$108,145
general
general
Aviati on
$25,145
Other
Other
Programs
Programs
$247
$247
excess &
umbrella
$25,007
e&S
Specialty
$94,948
general
Aviati on
$24,029
Other
Other
Programs
Programs
$2,108
$2,108
excess &
umbrella
$33,762
e&S
e&S
Specialty
Specialty
$122,412
$122,412
general
general
Aviati on
$20,451
Other
Other
Programs
Programs
$11,473
$11,473
excess &
excess &
umbrella
umbrella
$40,687
$40,687
e&S
e&S
Specialty
Specialty
$159,223
$159,223
general
general
Aviati on
$18,690
Other
Programs
$8,773
excess &
umbrella
$51,847
e&S
Specialty
$212,255
general
Aviati on
$18,188
excess &
umbrella
$28,089
e&S
e&S
Specialty
Specialty
$101,094
$101,094
general
general
Aviati on
$22,538
e&S
e&S
Specialty
Specialty
$126,255
$126,255
general
general
Aviati on
$30,235
e&S
e&S
Specialty
Specialty
$121,390
$121,390
general
general
Aviati on
$29,607
Standard
Commercial
$68,519
Standard
Commercial
$75,808
Standard
Commercial
$81,721
Standard
Commercial
$91,679
Standard
Commercial
$90,988
Standard
Commercial
$80,193
Standard
Commercial
$72,511
Standard
Commercial
$67,844
Standard
Commercial
$66,304
Standard
Commercial
$69,113
Standard
Commercial
$78,057
Personal
lines
$51,643
Personal
lines
$55,745
Personal
lines
$43,497
Personal
lines
$36,345
Personal
lines
$45,135
Personal
lines
$55,919
Personal
lines
$60,834
Personal
lines
$71,708
Personal
lines
$95,292
Personal
lines
$96,226
Personal
lines
$77,068
Personal
lines
$76,772
$51,643
$124,264
$119,305
$118,066
$293,304
$297,904
$287,081
$288,450
$314,857
$344,379
$384,231
$454,981
Past performance is no guarantee of future performance.
HIGHLIGHTS
For the Years Ended December 31, ($ in thousands, except per share amounts)
Operati ng Results
Gross premiums writt en
net premiums earned
Net operati ng (loss) income
Net income (loss) att ributable to Hallmark
Weighted average shares outstanding—diluted
2013
2012
2011
2010
2009
$ 460,027
360,541
11,080
8,245
19,361
$ 389,842
319,436
3,374
3,524
19,269
$ 354,881
293,041
(19,787)
(10,891)
19,673
$ 320,973
278,271
8,371
7,403
20,175
$ 287,558
251,072
33,257
24,575
20,633
Per Share
net income—diluted
Book value
Selected Balance Sheet Items
Total cash and investments
Total assets
unpaid loss and loss adjustment expenses
unearned premiums
Total liabiliti es
Total stockholders’ equity
GAAP Rati os
Loss rati o
Expense rati o
Combined rati o
$ 0.43
$ 12.36
$ 0.18
$ 11.45
$ (0.55)
$ 11.19
$ 0.37
$ 11.69
$ 1.19
$ 11.26
$ 615,181
$ 909,023
$ 382,640
$ 185,303
$ 670,905
$ 238,118
$ 539,212
$ 790,468
$ 313,416
$ 162,502
$ 569,931
$ 220,537
$ 508,471
$ 746,059
$ 296,945
$ 146,104
$ 529,203
$ 215,572
$ 498,237
$ 736,557
$ 251,677
$ 140,965
$ 499,919
$ 235,278
$ 445,405
$ 628,869
$ 184,662
$ 125,089
$ 401,228
$ 226,517
72.5%
29.2%
101.7%
70.9%
30.8%
101.7%
81.6%
30.8%
112.4%
72.8%
29.6%
102.4%
61.2%
30.5%
91.7%
Letter from Our Executive Chairman
mark e. SCHWarz
In 2013, Hallmark’s book value per share increased 8% to $12.36,
its highest level ever. 2013 was a year marked by difficult credit
markets, a buoyant equity market and slowly improving economic
and industry conditions.
Hallmark’s 2013 net premiums written increased 9% to $361 mil-
lion, while policies in-force declined 5%. The increase in premiums
reflected modest rate increases across much of our business, with
the highest rate increases coming from Specialty Commercial, our
largest segment, where net premiums written increased $50 mil-
lion following a $42 million increase in the prior year. Hallmark’s
after-tax net income of $8 million improved compared to prior
year, but did not meet expectations due to a fourth consecutive
year with a greater than 100% combined ratio. While improvement
in reported underwriting results developed at a slower pace than
planned, meaningful improvement was achieved in current acci-
dent year results. With the turnaround in our Personal lines busi-
ness unit nearly complete and other underwriting initiatives taken,
we have reason to expect operating results will improve in 2014.
Hallmark’s 2013 total investment return was $35 million, or nearly
8% on beginning investments, an increase from $20 million in the
prior year. During the year bond prices fell, as the yield on 10-year
u.S. Treasuries nearly doubled to 3.0% from where it began at
1.8%. u.S. equity gauges rose to records, with the Standard &
Poor’s 500 Index posting a 32% advance, its greatest since 1997
and ending the year at an all-time high for the first time since
1999. against this backdrop, our fixed income portfolios, both tax-
able and tax-exempt, produced positive returns compared to
losses for nearly all bond benchmarks. The performance of our
equity portfolio exceeded that of the Standard & Poor’s 500 Index.
During 2013, total cash and investments increased $76 million or
14% to $615 million, or nearly $32 per share, another all-time high.
The increase in total cash and investments was due to investment
gains and cash flow from operations of $68 million, up from $34
million in the prior year. year-end cash balances totaled $154 mil-
lion. While punitive on returns in the short-term, our substantial
liquidity provides flexibility to take advantage of market opportu-
nities if and when they arise.
67%
Cash & Investments
Debt Securities
Cash & equivalents
equities
67%
25%
8%
It has been said that experience is what you get when you didn’t
get what you wanted. recent years have been a difficult period for
Hallmark. Clearly a lot of experience was gained during this time.
While we are disappointed to have fallen short of our targets, we
know what we want and believe we have become more capable
and “experienced” in our ability to achieve the results we expect
of ourselves.
Some years, or periods of years, are destined to be better than
others. Certain factors effecting performance will be determined
by things we control and others determined by market factors
beyond our control. regression to the mean does not apply to sit-
uations that are determined by skill. Therefore, we believe apply-
ing our skills and expertise to the factors we do control should
result in producing above average results over the longer term.
During the past year, our skills and expertise have been strength-
ened by increasing our investment in data analytics and related
human capital, helping to foster a more data driven culture
throughout the company.
It is reasonable to expect over the longer term that the price of
Hallmark stock will reflect the trend in book value growth. In the
short term these two can vary widely, as has been the case lately.
With the difference between market price and book value as great
$615
Cash & Investments
($ in millions)
$700
$600
$500
$400
$300
$200
$100
$0
2009
2010 2011 2012 2013
as it is now, it is fair to ask why the Company is not acquiring its
own shares. While true that the current discount represents
opportunity, it is only one of several factors that must be consid-
ered in making capital allocation decisions for the Company. as
such, present circumstances have dictated that priority be given to
growth in capital and surplus, rather than the reduction that would
result from share repurchases.
The Company’s capital and surplus position will undoubtedly
change in the future. Should the opportunity represented by the
market price for Hallmark shares still exist, we will likely seek to
again repurchase our shares. It should be noted that Hallmark is no
stranger to share repurchases. Since the September 2009 quarter,
Hallmark has repurchased 1.6 million, or 8.1%, of its outstanding
shares at an average price of $7.17, equivalent to 58% of today’s
book value per share. There remain approximately 2.4 million
shares authorized for repurchase under the Company’s stock buy-
back program.
Hallmark does some things differently than others in its industry,
owing to certain strongly held beliefs. First and foremost is our
owner-oriented culture, resulting from significant shareholder rep-
resentation on the board and the alignment of management and
shareholders’ interests evident in our investment decisions, capital
management practices and compensation and incentive struc-
tures. We believe these characteristics coupled with a true long-
term perspective will foster an above average record of long-term
value creation in the future.
During recent years many of Hallmark’s peer publicly-traded,
small-capitalization, property and casualty companies have disap-
peared. While arguments for the benefits of scale have merit, we
continue to consider our size an advantage. Simply put, it is easier
to find a great small opportunity, than a really great big opportu-
nity. as we go forward, we will seek great opportunities, both
small and large. We will emphasize underwriting profitability while
striving to increase the value of our existing businesses, finding
suitable acquisitions at sensible prices and identifying investment
opportunities in public securities that balance acceptable levels of
risk with the prospect for meaningful gains.
mark e. Schwarz
executive Chairman of the Board
april 15, 2014
Letter from Our President & CEO
mark j. mOrrISO n
a.m. Best reported that the u. S. property/casualty insurance
industry’s net premiums written increased nearly 5% in 2013 to
$484 billion, marking a fourth consecutive year of top-line growth.
lower catastrophe losses and strong prior-year reserve releases
produced the industry-wide combined ratio of 96% and the first
underwriting profit since 2009. The industry’s capital position
remains at historically high levels. Driven by modest underwriting
profit and strong gains in the investment portfolio, the property/
casualty insurers’ aggregate policyholder surplus increased in 2013
by over 11% to $674 billion. With interest rates likely to stay low
for some time, insurance companies will have to continue to focus
on improving their profitability through underwriting rather than
investments. However, the growing capacity in the market and
new entrants deploying capital across a variety of lines of busi-
ness, have already started to diminish the upward momentum on
premium rates.
For Hallmark, fiscal 2013 had a very similar story line as the previ-
ous year: increasing premium rates, improving underwriting mar-
gins and an extraordinarily high level of catastrophic losses from
weather events. While the industry enjoyed the benefit of a mild
catastrophe year, our fiscal 2013 was once again one of the most
costly catastrophic years in our history. even with proactive mea-
sures taken to reduce our exposure to large catastrophe-prone
property exposures, we incurred gross losses of $10 million and
$12 million, or nearly 3% and 4% to the consolidated loss ratio for
fiscal years 2013 and 2012, respectively. The catastrophe losses
incurred in the last two years represent more than twice the mod-
eled expected annual catastrophe losses. also dissimilar to the
industry as a whole, we incurred adverse development on prior
year loss reserves of $10 million during fiscal 2013, or nearly 3% of
our consolidated combined ratio of 101.7%.
For the past three years, the products and markets in which
Hallmark competes have allowed us to organically grow our books
of business in excess of the industry. Our gross written premium
has grown by 18% and 10% in fiscal years 2013 and 2012, respec-
tively, and has reached a new high watermark of $460 million in
fiscal 2013. There are two principal drivers of growth in the prop-
erty/casualty insurance industry: exposure growth and rate
increases. exposure growth is basically an increase in the number
and/or value of insurable interests fueled primarily by economic
Gross Premiums Written
($ in millions)
$500
$450
$400
$350
$300
$250
$200
$150
$100
$50
$0
$460
2009 2010 2011 2012 2013
201
201
201
expansion. growth from rate increases is simply applying a higher
price on the underlying exposure units insured. Our growth in
gross written premium over the past three years is primarily driven
by increased rate and, to a lesser extent, by exposure growth. We
feel our ability to aggressively raise rate over the last two years
will have a favorable effect on future underwriting margins as
earned price increases more than offset claim cost inflation. The
favorable impact of these rate increases on underwriting margin is
already evident from the significant improvement in our combined
ratio during fiscal 2013 from 105.6% in the first half of the year to
97.8% in the last half.
notwithstanding those elements that drove unexpected volatility
in our fiscal 2013 underwriting results, we feel that the strides we
have taken over recent years to better position our operating units
in their respective markets have significantly enhanced the long-
term competitiveness and financial strength of Hallmark, if not the
near-term results.
The accompanying annual report describes in detail the progress
we have made in realizing our vision for your Company. Please let
me summarize some of the highlights for you.
WHO We a re anD WHaT We DO
We are a diversified property/casualty insurance group serving
businesses and individuals in specialty and niche markets that
require specialized underwriting expertise or market knowledge.
We currently offer specialty commercial insurance, standard com-
mercial insurance and personal insurance in selected market sub-
low-severity and
categories that are characteristically
predominately short-tailed risks.
We market, distribute, underwrite and service our property/casu-
alty insurance products through the following business units, each
of which has a specific focus:
4 Our E&S Commercial business unit primarily offers commercial
automobile, general liability, commercial property and excess
casualty policies in the excess and surplus lines market. We offer
these products to middle market commercial businesses that often
do not meet the underwriting requirements of standard insurers.
The e&S Commercial business unit markets its products in 26
states through 11 wholesale brokers and 77 general agency offices,
as well as 188 independent retail agent offices throughout Texas
and Oregon.
4 Our Hallmark Select business unit offers small and middle mar-
ket commercial excess liability, umbrella and general liability insur-
ance on both an admitted and non-admitted basis; general aviation
property/casualty insurance primarily for private and small com-
mercial aircraft and airports; satellite launch property/casualty
insurance products; and medical professional liability insurance on
an excess and surplus lines basis.
The small and middle market commercial excess liability, umbrella
and general liability insurance underwritten by our Hallmark Select
business unit focuses primarily on trucking, specialty automobile,
and non-fleet automobile coverage. Typical risks range from one
power unit to fleets of up to 200 power units. Our Hallmark Select
business unit markets these products through 117 wholesale bro-
kers in 49 states.
Gross Premiums Produced
47%
e&S Commercial
17%
Standard Commercial
17%
Personal lines
11%
excess & umbrella
4%
general aviation
Workers Compensation 2%
2%
Other Programs
47%
per risk for satellite launches and in-orbit coverage for up to 12
months.
The medical professional liability insurance underwritten on an
excess and surplus basis by our Hallmark Select business unit
focuses on healthcare professionals that do not meet the under-
writing requirements of standard insurers due to factors such as
loss history, number of years in business, minimum premium size
and types of business operation. Our Hallmark Select business unit
markets these medical professional liability insurance products
through 18 wholesale brokers in 49 states.
4 Our Standard Commercial P&C business unit primarily under-
writes lower-severity, short-tailed commercial property/casualty
insurance products in the standard market. We distribute these
products through a network of 356 independent agents primarily
serving businesses in the non-urban areas of Texas, new mexico,
Oregon, Idaho, montana, Washington, utah, Wyoming, arkansas,
Hawaii and missouri.
4 Our Workers Compensation business unit offers small and mid-
dle market workers compensation insurance products. We distrib-
ute these products through a network of 154 independent agents
in Texas and montana with a predominate portion of the distribu-
tion in Texas.
4 Our Personal Lines business unit offers non-standard personal
automobile, low value dwelling/homeowners, renters and manu-
factured homes policies. We market these policies through a net-
work of over 3,300 independent retail agents in 15 states.
The aircraft liability and hull insurance products underwritten by
our Hallmark Select business unit are targeted to transitional or
non-standard pilots who may have difficulty obtaining insurance
from a standard carrier. airport liability insurance is marketed to
smaller, regional airports. Our Hallmark Select business unit mar-
kets these general aviation insurance products through 192 inde-
pendent specialty brokers in 48 states. The satellite launch
property/casualty policies produced by our Hallmark Select busi-
ness unit are marketed through underwriting agencies with techni-
cal knowledge of space insurance. We can retain up to $2.0 million
The insurance policies produced by our business units are written
by our insurance company subsidiaries, as well as unaffiliated
insurers. a.m. Best has assigned a financial strength rating of “a-”
VIII (Excellent) to each of our insurance company subsidiaries
except Texas Builders Insurance Company, which is not presently
rated. These insurance company subsidiaries are american
Hallmark Insurance Company of Texas, Hallmark Insurance
Company, Hallmark Specialty Insurance Company, Hallmark
national Insurance Company, Hallmark County mutual Insurance
Company and Texas Builders Insurance Company.
Our OPeraTIOnal STruCTure
Hallmark Select
E&S Commercial
Standard
Commercial P&C
Workers
Compensation
Personal Lines
General
Aviation
Excess &
Umbrella
Professional
Liability
We SegregaTe Our FIVe BuSIneSS unITS I nTO THree rePOrTIng SegmenTS FOr FInanCIal aCCOunTIng
PurPOSeS. Our InSur anCe COmP any SuBSIDIarIeS reTaIn a POrTIOn OF THe PremIumS PrODuCeD By Our
BuSIneSS unITS. TH e aBOVe CHar T reFleC TS THe OPer aTIOnal STruC Ture OF Our OrganIz aTIOn anD THe
BuSIneSS unITS I nCluDeD In eaCH rePOrTIng SegmenT.
Our PHIl OSOPHy, STrengTHS anD STraTegIeS
Our goal is to create a “Best-in-Class” specialty property/casualty
insurance company focused on underwriting profitability and
long-term growth of shareholders’ equity. We also seek to build a
strong balance sheet based on conservative investment, reinsur-
ance and reserving practices. In pursuing these objectives, we
have certain competitive strengths, including:
• Specialized market knowledge and underwriting expertise in the
market subcategories served by our business units;
• Tailored marketing strategies developed by each business unit
to penetrate the specialty or niche market in which it operates;
• Superior agent and customer service from performing the
underwriting, billing, customer service and claims management
functions at the business unit level;
• market diversification that spreads both our revenue and our
risks among various specialty and niche markets that generally
operate on different market cycles; and
• an experienced management team comprised of executive offi-
cers with an average of over 20 years of insurance industry experi-
ence, as well as strong management and underwriting teams
within each of our business units.
Our strategies for exploiting these competitive strengths to
achieve our goal of becoming a “Best in Class” specialty property/
casualty insurance company include:
• Focusing on underwriting discipline and operational efficiency
to consistently generate an underwriting profit in both hard and
soft markets;
• achieving organic growth in our existing business lines by con-
sistently providing our insurance products through market cycles,
expanding geographically, expanding our agency relationships and
further penetrating our existing customer base;
• Pursuing selected, opportunistic acquisitions of insurance orga-
nizations operating in specialty and niche property/casualty insur-
ance markets that are complementary to our existing operations;
• maintaining a strong balance sheet by employing conservative
investment, reinsurance and reserving practices;
• achieving above average long-term investment returns; and
• measuring our performance based on long-term growth in book
value per share.
Our 2013 PerFOrman Ce
Our total revenues for 2013 were $389 million, net income was $8
million, or $0.43 per diluted share, and operating cash flows were
$68 million. The year-over-year increase in revenue continues to
be largely driven by organic growth from our Specialty Commercial
Segment, which now represents approximately two-thirds of our
total gross written premium. nearly all of our commercial lines of
business have seen an increase in premium production generated
from multiple years of favorable rate trends, as well as from
growth in insured exposure units that suggests improving eco-
nomic conditions in the markets in which we operate.
The following are highlights of the 2013 results and our plans for
2014 for our reporting segments:
4 gross written premium for our Specialty Commercial Segment
grew $60 million, or 26%, during fiscal 2013 to $296 million. most
of the premium growth came from our primary and excess
commercial automobile lines of business, which now represent
46% of company-wide premium writings. Pricing trends in com-
mercial automobile continued to be favorable in 2013, as we have
now compounded three years of premium rate increases. Our pri-
mary commercial automobile business achieved premium rate
increases of over 12% on policies written in 2013, while our excess
commercial automobile business achieved premium rate increases
of 5%. The state of Texas, which comprises approximately 80% of
our commercial automobile business, experienced a hardening
rate environment as several competing carriers discontinued writ-
ing business in the state, while demand increased as a result of
economic expansion in the energy related trucking business.
Fiscal 2013 proved to be yet another active hail season in our geo-
graphic territories. However, year-over-year, our net catastrophe
losses decreased from $10 million incurred during 2012 to $6 mil-
lion in 2013. The improvement in catastrophe-related losses is
partly attributed to underwriting actions taken to reduce exposure
in the geographic areas that have experienced increased frequency
of storm activity in recent years. In addition to implementing
aggressive premium rate increases in catastrophe prone areas, we
reduced property risks with underwriting characteristics making
them more susceptible to hail damage. For remaining property
risks, renewal policies included increases in wind/hail deductibles
and certain coverage restrictions on cosmetic damages.
Our general aviation and medical professional liability lines of busi-
ness saw flat year-over-year gross premium writing for 2013 as
they continue to operate in highly competitive markets. We
expect the premium writings for these lines of business to remain
flat to slightly down in 2014 as we strive to maintain premium rate
adequacy and underwriting discipline as the current competitive
market cycle persists.
Our Specialty Commercial Segment net loss ratio was 69.8% in
2013 which increased from the 61.6% reported in 2012. This
increase was due primarily to adverse loss reserve development
from prior years when soft market conditions prevailed and pre-
mium rates were not as strong. The net expense ratio improved to
26.6% in 2013 from the 28.3% in 2012. The improvement in the
net expense ratio was largely due to operational efficiencies
gained from the increase in premium writings.
We continue to have a positive outlook for 2014 in our the com-
mercial specialty business as the rate increases achieved during
2013 are earned into the 2014 underwriting results and we are
able to take additional premium rate increases in 2014 in our com-
mercial automobile lines of business.
4 gross written premium for our Standard Commercial Segment
of $87 million during fiscal 2013 grew 13.0% from the $77.1 million
produced in 2012. as was true for nearly all of our commercial
lines of business, growth was achieved through increases in pre-
mium rates. Our Standard Commercial P&C business unit achieved
a premium rate increase of 9% on policies written during 2013.
This increase is in addition to a rate increase of 7% on policies writ-
ten in 2012. Our Workers Compensation business unit also
achieved premium rate increases of nearly 9% for policies initiated
in 2013.
The fiscal 2013 net loss ratio of 71.8% for our Standard Commercial
Segment reflected an improvement of 4.6 percentage points from
76.4% in 2012. The net expense ratio improved by 1.0 percentage
point as well during fiscal 2013 decreasing to 32.2%. much of this
improvement was due to efficiencies gained from the increase in
premium volumes.
We expect the positive momentum gained in fiscal 2013 will con-
tinue into 2014 as the premium rate and underwriting actions fully
earn into our underwriting results and additional rate increases
are achieved.
4 Operating results in our Personal Segment improved for a sec-
ond year with a net loss ratio of 82.5% in 2013 as compared to
85.5% in 2012. gross written premium was $77 million in 2013,
which is in line with 2012. The net expense ratio for 2013 also
improved 1.8 percentage points to 26.7%.
although in 2013 the loss ratio improved across the segment, we
did not achieve our targeted underwriting goal for the year. These
improving loss ratio trends throughout the year signal a continued
reduction of the adverse impact of decisions made by the prior
personal lines management team—specifically, the rapid expan-
sion of states and products, punctuated by the decision to enter
the Florida personal automobile market.
The corrective actions taken by the current management team
have improved results and trends indicate improvement will con-
tinue in 2014. earned premium associated with the states and
products that were exited has now fallen below $2 million and will
completely runoff by the end of 2014, thus eliminating the busi-
ness that has generated the unacceptable results for more than
the last three years. In addition to managing runoff of this busi-
ness, the management team has focused resources on improving
profitability in our core remaining products and states. aggressive
rate activity in personal automobile and property resulted in aver-
age increases of 5% and 10%, respectively, on policies written in
2013. as these increases earn into the underwriting results in
2014, we expect to see continued improvement in loss ratio
trends. additionally, this rate activity is being supplemented by
improvements in our risk selection and agency management pro-
cesses to ensure we maintain positive momentum and continue to
see overall improvement in profitability.
We remain confident that we have taken the proper corrective
actions and expect the business produced by the Personal Segment
will positively contribute to profitable results going forward.
geOgraPHIC SPreaD OF PremIumS PrODuCeD In 2013
1% to 2.99%
3% to 4.99%
5% to 9.99%
10% and higher
(All other states are <1.00% of total premium)
1%
3%
2%
2%
1%
1%
1%
1%
1%
1%
4%
3%
3%
51%
1%
2%
1%
2%
1%
2%
5%
1%
1%
1%
1%
1%
WHere We gO FrOm Here
Overall, the property/casualty insurance industry looks to be doing
quite well. The economy and interest rate trends appear stable, if
not improving; catastrophe experience has been modest; and cap-
ital continues to grow each year to record levels. While conditions
for the insurance industry have clearly improved over the recent
years, we believe as long as the industry remains overcapitalized,
competition for premium volume will once again take priority over
underwriting margin, and a true hard market will remain elusive.
For Hallmark, the greatest opportunity in 2014 will be our ability to
improve underwriting margins through our continued focus on
organic growth within our current books of business. a reduction
of underwriting capacity due to competitors pulling out of our
markets has allowed us to achieve meaningful rate increases in
2013 and 2012. robust economic conditions in our core states
have resulted in growth in insured exposure units. We expect
these trends to generally continue throughout 2014 as we monitor
and pursue price increases across most of our lines of business.
as we move beyond 2014, we believe the most successful compa-
nies will be those that differentiate themselves in the marketplace
other than by the price they charge. This will require innovation
and improved service, especially when it comes to integrating
technology and developing better data analytics and risk model-
ing. We continue to make investments in technology and people,
with the intent to increase access to data and information across
operational platforms, drive down operating costs, and enhance
analytic capabilities across all of our businesses.
Finally, the first quarter of 2014 marks my 10th anniversary at
Hallmark. I am very fortunate to have worked with a dedicated and
capable team over this timeframe, and I am proud of the 10-year
track record we have achieved together. Our strategy has been to
transform Hallmark into a “Best-In-Class” specialty insurance com-
pany. Since the start of 2004, we have been able to successfully
diversify Hallmark’s premium base and grow book value per share
at a compounded annual growth rate of 16% and 10%, respec-
tively. This achievement spans a 10-year period that included a
prolonged soft market, worldwide financial crisis and severe eco-
nomic recession. although this outcome was less than what we
had targeted, our results have consistently exceeded that of the
overall property/casualty insurance industry. recent years have
been a challenge in many ways. However, we remain confident
that over the long-term, Hallmark will achieve the greater perfor-
mance goals we set for ourselves and our stakeholders have grown
to expect.
I greatly appreciate your support of our vision and continue to be
optimistic that the best is yet to come.
mark j. morrison
President and Chief executive Officer
april 15, 2014
10-K Financial Report
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended DECEMBER 31, 2013
Or
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _________________________ to _________________________________
Commission file number 001-11252
Hallmark Financial Services, Inc.
(Exact name of registrant as specified in its charter)
Nevada
(State or Other Jurisdiction of Incorporation or Organization)
777 Main Street, Suite 1000, Fort Worth, Texas
(Address of Principal Executive Offices)
Registrant's Telephone Number, Including Area Code: (817) 348-1600
Securities registered pursuant to Section 12(b) of the Act:
87-0447375
(I.R.S. Employer Identification No.)
76102
(Zip Code)
Title of Each Class
Common Stock $.18 par value
Name of Each Exchange on Which Registered
Nasdaq Global Market
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes No
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 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 No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every
Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter)
during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will
not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by
reference in Part III of this Form 10-K or any amendment to this Form 10-K.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a
smaller reporting company. See definition of “accelerated filer”, “large accelerated filer” and “smaller reporting company” in
Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer
Smaller reporting company
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No
Non-accelerated filer
Accelerated filer
State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to
the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last
business day of the registrant’s most recently completed second fiscal quarter. $129.9 million
Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of the latest practicable date.
19,263,457 shares of common stock, $.18 par value per share, outstanding as of March 12, 2014.
1
DOCUMENTS INCORPORATED BY REFERENCE
The information required by Part III is incorporated by reference from the Registrant's definitive proxy statement to be filed
with the Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this report.
Unless the context requires otherwise, in this Form 10-K the term “Hallmark” refers solely to Hallmark Financial Services, Inc.
and the terms “we,” “our,” and “us” refer to Hallmark and its subsidiaries. The direct and indirect subsidiaries of Hallmark are
referred to in this Form 10-K in the manner identified in the chart under “Item 1. Business – Operational Structure.”
Risks Associated with Forward-Looking Statements Included in this Form 10-K
This Form 10-K contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act
of 1995, which are intended to be covered by the safe harbors created thereby. Forward-looking statements include
statements which are predictive in nature, which depend upon or refer to future events or conditions, or which include words
such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “estimate” or similar expressions. These statements include the
plans and objectives of management for future operations, including plans and objectives relating to future growth of our
business activities and availability of funds. Statements regarding the following subjects are forward-looking by their nature:
•
•
•
•
•
•
•
our business and growth strategies;
our performance goals;
our projected financial condition and operating results;
our understanding of our competition;
industry and market trends;
the impact of technology on our products, operations and business; and
any other statements or assumptions that are not historical facts.
The forward-looking statements included in this Form 10-K are based on current expectations that involve numerous risks and
uncertainties. Assumptions relating to these forward-looking statements involve judgments with respect to, among other
things, future economic, competitive and market conditions, legislative initiatives, regulatory framework, weather-related
events and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond
our control. Although we believe that the assumptions underlying these 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-K will prove to be accurate. In light of the significant uncertainties inherent in these forward-looking statements,
the inclusion of such information should not be regarded as a representation that our objectives and plans will be achieved.
2
Item 1. Business.
Who We Are
PART I
We are a diversified property/casualty insurance group that serves businesses and individuals in specialty and niche markets.
We offer standard commercial insurance, specialty commercial insurance and personal insurance in selected market
subcategories that are characteristically low-severity and predominately short-tailed risks. We focus on marketing, distributing,
underwriting and servicing property/casualty insurance products that require specialized underwriting expertise or market
knowledge. We believe this approach provides us the best opportunity to achieve favorable policy terms and pricing. The
insurance policies we produce are written by our six insurance company subsidiaries as well as unaffiliated insurers.
We market, distribute, underwrite and service our property/casualty insurance products primarily through five business units,
each of which has a specific focus. Our Standard Commercial P&C business unit primarily handles standard commercial
insurance and occupational accident insurance, our Workers Compensation business unit specializes in small and middle market
workers compensation business, and our E&S Commercial business unit handles primarily commercial insurance products and
services in the excess and surplus lines market. Our Hallmark Select business unit offers (i) general aviation insurance products
and services, (ii) low and middle market commercial umbrella and excess liability insurance, (iii) medical professional liability
insurance products and services and (iv) satellite launch insurance products. Our Hallmark Select business unit is the
combination of our operations previously known as our General Aviation business unit, our Excess & Umbrella business unit,
the medical professional liability business previously handled by our E&S Commercial business unit and the satellite launch
insurance products previously managed at the parent level. Our Personal Lines business unit focuses on non-standard personal
automobile insurance and complementary personal insurance products and services. The subsidiaries comprising our Workers
Compensation business unit were acquired July 1, 2011.
Each business unit has its own management team with significant experience in distributing products to its target markets and
proven success in achieving underwriting profitability and providing efficient claims management. Each business unit is
responsible for marketing, distribution, underwriting and claims management while we provide capital management,
reinsurance, actuarial, investment, financial reporting, technology and legal services and other administrative support at the
parent level. We believe this approach optimizes our operating results by allowing us to effectively penetrate our selected
specialty and niche markets while maintaining operational controls, managing risks, controlling overhead and efficiently
allocating our capital across business units. We expect future growth to be derived from organic growth in the premium
production of our existing business units and selected opportunistic acquisitions that meet our criteria.
What We Do
We market commercial and personal lines of property/casualty insurance products which are tailored to the risks and
coverages required by the insured. We believe that most of our target markets are underserved by larger property/casualty
insurers because of the specialized nature of the underwriting required. We are able to offer these products profitably as a
result of the expertise of our experienced underwriters. We also believe our long-standing relationships with independent
general agencies and retail agents and the service we provide differentiate us from larger property/casualty insurers.
Our Standard Commercial P&C business unit primarily underwrites low-severity, short-tailed commercial property/casualty
insurance products in the standard market. These products have historically produced stable loss results and include general
liability, commercial automobile, commercial property and umbrella coverages. Our Standard Commercial P&C business unit
currently markets its products through a network of 356 independent agents primarily serving businesses in the non-urban
areas of Texas, New Mexico, Oregon, Idaho, Montana, Washington, Utah, Wyoming, Arkansas, Hawaii and Missouri. In addition
our Standard Commercial P&C business unit offers occupational accident coverage in Texas through an underwriting agency
that specializes in the occupational accident insurance market.
Our Workers Compensation business unit, which was acquired July 1, 2011, offers small and middle market workers
compensation insurance products. Our Workers Compensation business unit currently markets its products through a network
of 154 independent agents in Texas and Montana, with a predominate portion of its distribution in Texas.
Our E&S Commercial business unit primarily offers commercial property/casualty insurance products in the excess and surplus
lines market. Excess and surplus lines insurance provides coverage for difficult to place risks that do not fit the underwriting
criteria of insurers operating in the standard market. Our E&S Commercial business unit focuses on middle market commercial
3
risks that do not meet the underwriting requirements of standard insurers due to factors such as loss history, number of years
in business, minimum premium size and types of business operation. Our E&S Commercial business unit primarily writes
commercial automobile, general liability, commercial property and excess casualty. Our E&S Commercial business unit markets
its products in 26 states through 11 wholesale brokers, a program underwriter and 77 general agency offices, as well as 188
independent retail agents in Texas and Oregon.
Our Hallmark Select business unit offers small and middle market commercial excess liability, umbrella and general liability
insurance on both an admitted and non-admitted basis ; general aviation property/casualty insurance primarily for private and
small commercial aircraft and airports; satellite launch property/casualty insurance products; and medical professional liability
insurance on an excess and surplus lines basis.
The small and middle market commercial excess liability, umbrella and general liability insurance underwritten by our Hallmark
Select business unit focuses primarily on trucking, specialty automobile, and non-fleet automobile coverage. Typical risks range
from one power unit to fleets of up to 200 power units. Our Hallmark Select business unit markets these products through 117
wholesale brokers in 49 states.
The aircraft liability and hull insurance products underwritten by our Hallmark Select business unit are targeted to transitional
or non-standard pilots who may have difficulty obtaining insurance from a standard carrier. Airport liability insurance is
marketed to smaller, regional airports. Our Hallmark Select business unit markets these general aviation insurance products
through 192 independent specialty brokers in 48 states. The satellite launch property/casualty policies produced by our
Hallmark Select business unit are marketed through underwriting agencies with technical knowledge of space insurance. We
can retain up to $2.0 million per risk for satellite launches and in-orbit coverage for up to 12 months.
The medical professional liability insurance underwritten on an excess and surplus basis by our Hallmark Select business unit
focuses on healthcare professionals that do not meet the underwriting requirements of standard insurers due to factors such as
loss history, number of years in business, minimum premium size and types of business operation. Our Hallmark Select
business unit markets these medical professional liability insurance products through 18 wholesale brokers in 49 states.
Our Personal Lines business unit offers non-standard personal automobile policies, which generally provide the minimum limits
of liability coverage mandated by state law to drivers who find it difficult to obtain insurance from standard carriers due to
various factors including age, driving record, claims history or limited financial resources. Our Personal Lines business unit also
provides personal insurance products complementary to non-standard personal automobile insurance such as policies covering
low value dwelling/homeowners, renters and manufactured homes. Our Personal Lines business unit markets these policies
through 3,335 independent retail agents in 15 states.
Our insurance company subsidiaries are American Hallmark Insurance Company of Texas (“AHIC”), Hallmark Insurance
Company (“HIC”), Hallmark Specialty Insurance Company (“HSIC”), Hallmark County Mutual Insurance Company (“HCM”),
Hallmark National Insurance Company (“HNIC”) and Texas Builders Insurance Company (“TBIC”). We acquired TBIC on July 1,
2011. AHIC, HIC, HSIC and HNIC have entered into a pooling arrangement, pursuant to which AHIC retains 30% of the net
premiums written by any of them, HIC retains 27% of the net premiums written by any of them, HSIC retains 30% of the net
premiums written by any of them and HNIC retains 13% of the net premiums written by any of them. A.M. Best Company
(“A.M. Best”), a nationally recognized insurance industry rating service and publisher, has pooled its ratings of these four
insurance company subsidiaries and assigned a financial strength rating of “A–” (Excellent) and an issuer credit rating of “a-” to
each of these individual insurance company subsidiaries and to the pool formed by these four insurance company subsidiaries.
Also, A.M. Best has assigned a financial strength rating of “A–” (Excellent) and an issuer credit rating of “a-” to HCM. A.M. Best
does not assign a financial strength rating or an issuer credit rating to TBIC.
Our five business units are segregated into three reportable industry segments for financial accounting purposes. The Standard
Commercial Segment consists of the Standard Commercial P&C business unit and the Workers Compensation business unit. The
Specialty Commercial Segment includes our E&S Commercial business unit and Hallmark Select business unit, as well as certain
specialty risk programs (“Specialty Programs”) which are managed at the parent level. The Personal Segment presently consists
solely of our Personal Lines business unit. The following table displays the gross premiums written and net premiums by these
reportable segments for affiliated and unaffiliated insurers for the years ended December 31, 2013, 2012 and 2011.
4
Gross Premiums Written:
Standard Commercial Segment (1)
Specialty Commercial Segment
Personal Segment
Total
Net Premiums Written:
Standard Commercial Segment (1)
Specialty Commercial Segment
Personal Segment
Total
2013
Year Ended December 31,
2012
(dollars in thousands)
2011
$
$
$
$
87,147
296,108
76,772
460,027
79,466
235,655
45,644
360,765
$
$
$
$
77,091
235,695
77,056
389,842
70,091
186,053
76,345
332,489
$
$
$
$
69,420
185,020
100,441
354,881
63,944
144,277
95,655
303,876
(1) The Workers Compensation business unit included in the Standard Commercial Segment was
acquired effective July 1, 2011.
5
Operational Structure
Our insurance company subsidiaries retain a portion of the premiums produced by our business units. The following chart
reflects the operational structure of our organization, including the subsidiaries comprising our business units and the business
units included in each reportable segment as of December 31, 2013.
Hallmark Financial Services, Inc.
(“Hallmark”)
Standard Commercial Segment
Personal Segment
Specialty Commercial Segment
Standard Commercial
P&C
§
American Hallmark
Insurance Services, Inc.
(“American Hallmark
Insurance Services”)
§
TBIC Holding
Corporation
(“TBIC Holding”)
TBIC Risk Management,
Inc. (“TBICRM”)
Effective Claims
Management, Inc.
(“ECM”)
§
Texas Builders
Insurance Company
§
§
Workers Compensation
Personal Lines
E&S Commercial
Hallmark Select
§
§
American Hallmark
General Agency Inc.
(d/b/a Hallmark
Insurance Company)
Hallmark Claims
Services, Inc. (d/b/a
Hallmark Insurance
Company)
§
§
§
Hallmark Specialty
Underwriters, Inc.
(”HSU”)
TGA Special Risk, Inc.
(“TGASRI”)
Pan American
Acceptance Corporation
(“PAAC”)
§
§
§
§
§
Aerospace Insurance
Managers, Inc.
(“Aerospace Insurance
Managers”)
Aerospace Special Risk,
Inc. (“ASRI”)
Aerospace Claims
Management Group,
Inc. (“ACMG”)
Heath XS, LLC
(“HXS”)
Hardscrabble Data
Solutions, LLC
(“HDS”)
American Hallmark Insurance
Company of Texas
Hallmark Insurance Company
Hallmark County Mutual
Insurance Company
Texas Builders
Insurance Company
Hallmark Specialty
Insurance Company
Hallmark National
Insurance Company
Standard Commercial Segment
The Standard Commercial Segment of our business includes our Standard Commercial P&C business unit and our Workers
Compensation business unit. During 2013, our Standard Commercial P&C business unit accounted for approximately 90% and
our Workers Compensation business unit accounted for the remaining 10% of the aggregate premiums produced by the
Standard Commercial Segment.
Standard Commercial P&C business unit. Our Standard Commercial P&C business unit markets, underwrites and services
standard commercial lines insurance primarily in the non-urban areas of Texas, New Mexico, Idaho, Oregon, Montana,
Washington, Utah, Wyoming, Arkansas, Hawaii and Missouri. The subsidiaries comprising our Standard Commercial P&C
business unit include American Hallmark Insurance Services, a regional managing general agency, and ECM, a claims
administration company. American Hallmark Insurance Services targets customers that are in low-severity classifications in the
standard commercial market, which as a group have relatively stable loss results. The typical customer is a small to midsize
business with a policy that covers property, general liability and automobile exposures. Our Standard Commercial P&C business
unit underwriting criteria exclude lines of business and classes of risks that are considered to be high-severity or volatile, or
which involve significant latent injury potential or other long-tailed liability exposures. ECM administers the claims on the
insurance policies produced by American Hallmark Insurance Services. In addition our Standard Commercial P&C business unit
6
offers occupational accident coverage in Texas through an underwriting agency that is a specialist in the occupational accident
insurance market. Products offered by our Standard Commercial P&C business unit include the following:
•
Commercial automobile. Commercial automobile insurance provides third-party bodily injury and property damage
coverage and first-party property damage coverage against losses resulting from the ownership, maintenance or
use of automobiles and trucks in connection with an insured’s business.
• General liability. General liability insurance provides coverage for third-party bodily injury and property damage
claims arising from accidents occurring on the insured’s premises or from their general business operations.
• Umbrella. Umbrella insurance provides coverage for third-party liability claims where the loss amount exceeds
coverage limits provided by the insured’s underlying general liability and commercial automobile policies.
•
•
•
Commercial property. Commercial property insurance provides first-party coverage for the insured’s real property,
business personal property, and business interruption losses caused by fire, wind, hail, water damage, theft,
vandalism and other insured perils.
Commercial multi-peril. Commercial multi-peril insurance provides a combination of property and liability coverage
that can include commercial automobile coverage on a single policy.
Business owner’s. Business owner’s insurance provides a package of coverage designed for small to midsize
businesses with homogeneous risk profiles. Coverage includes general liability, commercial property and
commercial automobile.
• Occupational accident.
insurance provides an alternative to statutory workers
compensation insurance in Texas. Coverage includes medical, short term disability and accidental death and
dismemberment.
Occupational accident
Our Standard Commercial P&C business unit markets its property/casualty insurance products through 356 independent
agencies operating in its target markets. Our Standard Commercial P&C business unit applies a strict agent selection process
and seeks to provide its independent agents some degree of non-contractual geographic exclusivity. Our Standard Commercial
P&C business unit also strives to provide its independent agents with convenient access to product information and
personalized service. As a result, the Standard Commercial P&C business unit has historically maintained excellent relationships
with its producing agents, as evidenced by the 22 year average tenure of the 14 agency groups that each produced more than
$1.0 million in premium during the year ended December 31, 2013. During 2013, the top ten agency groups produced
approximately 37%, and no individual agency group produced more than 9%, of the total premium volume of our Standard
Commercial P&C business unit.
Our Standard Commercial P&C business unit writes most risks on a package basis using a commercial multi-peril policy or a
business owner’s policy. Umbrella policies are written only when our Standard Commercial P&C business unit also writes the
insured’s underlying general liability and commercial automobile coverage. Through December 31, 2005, our Standard
Commercial P&C business unit marketed policies on behalf of Clarendon National Insurance Company (“Clarendon”), a third-
party insurer. Our Standard Commercial P&C business unit earns a commission based on a percentage of the earned premium it
produced for Clarendon. The commission percentage is determined by the underwriting results of the policies produced. Our
Standard Commercial P&C business unit presently markets all new and renewal policies exclusively for AHIC.
All of the commercial policies written by our Standard Commercial P&C business unit are for a term of 12 months. If the insured
is unable or unwilling to pay for the entire premium in advance, we provide an installment payment plan that requires the
insured to pay 20% or 25% down and the remaining payments over eight months. We charge installment fees of up to $7.50 per
payment for the installment payment plan.
Workers Compensation business unit. Our Workers Compensation business unit markets, underwrites and services workers
compensation insurance in Texas and Montana. The subsidiaries comprising our Workers Compensation business unit include
TBIC Holding which has two wholly-owned subsidiaries, TBIC, a Texas domiciled workers compensation insurance carrier and
TBICRM, which provides risk management services to customers of TBIC. The subsidiaries comprising the Workers
Compensation business unit were acquired July 1, 2011.
7
Our Workers Compensation business unit markets its products through 154 independent agencies operating in Texas and
Montana, with a predominate portion of its distribution in Texas. During 2013, the top ten agency groups produced
approximately 45%, and no individual agency group produced more than 9%, of the total premium volume of our Workers
Compensation business unit.
Specialty Commercial Segment
The Specialty Commercial Segment of our business includes our E&S Commercial business unit and our Hallmark Select business
unit, as well as certain Specialty Programs which are managed at the parent level. During 2013, our E&S Commercial business
unit accounted for approximately 72% of the aggregate premiums produced by the Specialty Commercial Segment, with our
commercial umbrella and excess liability, general aviation, medical professional liability and satellite launch insurance products
handled by our Hallmark Select business unit accounting for 17%, 6%, 2% and 1%, respectively. Our Specialty Programs
accounted for the remaining 2% of the premium produced by the Specialty Commercial Segment during 2013.
E&S Commercial business unit. Our E&S Commercial business unit markets, underwrites, finances and services commercial
lines insurance in 26 states with a particular emphasis on commercial automobile, general liability and commercial property
risks produced on an excess and surplus lines basis. Excess and surplus lines insurance provides coverage for difficult to place
risks that do not fit the underwriting criteria of insurers operating in the standard market. The subsidiaries comprising our E&S
Commercial business unit include HSU, which is a regional managing general underwriter, TGASRI which is a Texas managing
general agency, and PAAC, which provides premium financing for policies marketed by HSU and certain unaffiliated general and
retail agents. HSU accounts for approximately 99% of the premium volume financed by PAAC.
Our E&S Commercial business unit focuses on middle market commercial risks that do not meet the underwriting requirements
of traditional standard insurers due to issues such as loss history, number of years in business, minimum premium size and
types of business operation. During 2013, commercial automobile, general liability and commercial property accounted for
approximately 83%, 12% and 4%, respectively, of the premiums produced by our E&S Commercial business unit. Target risks for
commercial automobile insurance are business auto and trucking for hire fleets, excluding hazardous or flammable materials
haulers. Target risks for general liability insurance are small business risk exposures including artisan contractors, sales and
service organizations, and building and premises liability exposures. Target risks for commercial property insurance are low- to
mid-value structures including office buildings, mercantile shops, restaurants and rental dwellings, in each case with aggregate
property limits of less than $500,000. The commercial insurance products offered by our E&S Commercial business unit include
the following:
•
Commercial automobile. Commercial automobile insurance provides third-party bodily injury and property damage
coverage and first-party property damage coverage against losses resulting from the ownership, maintenance or
use of automobiles and trucks in connection with an insured’s business.
• General liability. General liability insurance provides coverage for third-party bodily injury and property damage
claims arising from accidents occurring on the insured’s premises or from their general business operations.
•
•
•
Commercial property. Commercial property insurance provides first-party coverage for the insured’s real property,
business personal property, theft and business interruption losses caused by fire, wind, hail, water damage,
vandalism and other insured perils. Windstorm, hurricane and hail are generally excluded in coastal areas.
Commercial excess liability. Commercial excess liability insurance is designed to provide an extra layer of
protection for bodily injury, personal and advertising injury, or property damage losses above the primary layer of
commercial automobile, general liability and employer’s liability insurance. The excess insurance does not begin
until the limits of liability in the primary layer have been exhausted. The excess layer provides not only higher limits,
but catastrophic protection from large losses.
Commercial umbrella. Commercial umbrella insurance protects businesses for bodily injury, personal and
advertising injury, or property damage claims in excess of the limits of their primary commercial automobile,
general liability and employers liability policies, and for some claims excluded by their primary policies (subject to a
deductible). Umbrella insurance provides not only higher limits, but catastrophic protection for large losses.
Our E&S Commercial business unit markets its products in 26 states through 11 wholesale brokers, a program underwriter and
77 general agency offices, as well as 188 independent retail agents in Texas and Oregon. Our E&S Commercial business unit
strives to simplify the placement of its excess and surplus lines policies by providing our general agents with a web rating portal
8
which allows for instantaneous quoting and signature-ready applications which can be emailed or faxed to its independent
retail agents. During 2013, general agents produced 80%, the program underwriter produced 12%, retail agents produced 5%
and wholesale brokers produced 3% of total premiums produced by our E&S Commercial business unit. During 2013, the top
ten general agents produced approximately 36%, the top ten wholesale brokers produced approximately 3% and no general
agent produced more than 7%, of the total premium volume of our E&S Commercial business unit. During the same period, the
top ten retail agents produced approximately 3%, and no retail agent produced more than 1%, of the total premium volume of
our E&S Commercial business unit.
Through 2008, all business of our E&S Commercial business unit was produced under a fronting agreement with member
companies of the Republic Group (“Republic”), which granted our E&S Commercial business unit the authority to develop
underwriting programs, set rates, appoint retail and general agents, underwrite risks, issue policies and adjust and pay claims.
We assumed 70% of the risk under this arrangement in 2008. In 2009, our E&S Commercial business unit wrote a portion of its
policies under a fronting arrangement with Republic pursuant to which we assumed 100% of the risk. Commission revenue was
generated under the fronting agreement on the portion of premiums not assumed by AHIC. An additional commission may be
earned if certain loss ratio targets are met. Additional revenue was generated from fully earned policy fees and installment
billing fees charged on legacy personal lines products. Since 2010, in states where we were not yet licensed to offer a non-
admitted product, we utilized a fronting arrangement with a third party pursuant to which we assumed all of the risk and then
retroceded a portion of the risk to third party reinsurers.
The majority of the commercial policies written by our E&S Commercial business unit are for a term of 12 months. Exceptions
include certain commercial automobile policies that are written for a term that coincides with the annual harvest of crops and
special event general liability policies that are written for the term of the event, which is generally one to two days. Commercial
lines policies are paid in full up front or financed with various premium finance companies, including PAAC.
Hallmark Select business unit. Our Hallmark Select business unit offers small and middle market commercial excess liability,
umbrella and general liability insurance on both an admitted and non-admitted basis focusing primarily on trucking, specialty
automobile, and non-fleet automobile coverage, general aviation property/casualty insurance primarily for private and small
commercial aircraft and airports, satellite launch insurance products and medical professional liability insurance on an excess
and surplus lines basis.
The small and middle market commercial excess liability, umbrella and general liability insurance underwritten by our Hallmark
Select business unit is offered on an admitted and non-admitted basis in 49 states. Limits of liability offered are from
$1,000,000 to $5,000,000 in coverage in excess of the primary carrier’s limits of liability. The principal focus of the excess &
umbrella insurance products offered is transportation, specifically trucking for hire, specialty automobile and non-fleet
automobile coverage. The Hallmark Select business unit also provides umbrella and excess liability coverage for small to midsize
businesses in class categories such as contracting, manufacturing, hospitality and service. The majority of the excess &
umbrella and general liability insurance policies written by our Hallmark Select business unit are on an annual basis. However,
exceptions are common in an attempt to have policy effective dates coincide with those of the primary insurance policies.
Policy premiums are due in full 30 days from the inception date of the policy. Our excess & umbrella insurance and general
liability insurance products are offered through 117 wholesale brokers. During 2013, the top ten wholesale brokers accounted
for 52% of our excess & umbrella and general liability premium volume, with no single wholesale broker accounting for more
than 16%. During 2013, commercial excess liability risks accounted for 94% of the premiums, with the remaining 6% coming
from commercial umbrella and general liability risks. The commercial excess & umbrella and general liability insurance products
offered by our Hallmark Select business unit include the following:
•
•
Commercial excess liability. Commercial excess liability insurance is designed to provide an extra layer of
protection for bodily injury, personal and advertising injury, or property damage losses above the primary layer of
commercial automobile, general liability and employer’s liability insurance. The excess insurance does not begin
until the limits of liability in the primary layer have been exhausted. The excess layer provides not only higher limits,
but catastrophic protection from large losses.
Commercial umbrella. Commercial umbrella insurance protects businesses for bodily injury, personal and
advertising injury, or property damage claims in excess of the limits of their primary commercial automobile,
general liability and employers liability policies, and for some claims excluded by their primary policies (subject to a
deductible). Umbrella insurance provides not only higher limits, but catastrophic protection for large losses.
9
•
Commercial general liability. General liability insurance provides coverage for third-party bodily injury and
property damage claims arising from accidents occurring on the insured’s premises or from their general business
operations.
In states where we are not admitted, our excess & umbrella and general liability insurance policies are written under a fronting
arrangement pursuant to which we assume all of the risk and then retrocede a portion of the risk to third party reinsurers. We
presently reinsure or retrocede 80% of the excess & umbrella and general liability risk on policies written by our Hallmark Select
business unit.
Our Hallmark Select business unit markets, underwrites and services general aviation property/casualty insurance in 48 states.
The subsidiaries marketing our general aviation insurance products include Aerospace Insurance Managers, which markets
standard aviation coverages, ASRI, which markets excess and surplus lines aviation coverages, and ACMG, which handles claims
management. Aerospace Insurance Managers is one of only a few similar entities in the U.S. and has focused on developing a
well-defined niche centering on transitional pilots, older aircraft and small airports and aviation-related businesses. In addition,
our Hallmark Select business unit offers satellite launch property/casualty policies marketed through underwriting agencies
with technical knowledge of space insurance. The general aviation and satellite launch products offered by our Hallmark Select
business unit include the following:
•
•
•
Aircraft. Aircraft insurance provides third-party bodily injury and property damage coverage and first-party hull
damage coverage against losses resulting from the ownership, maintenance or use of aircraft.
Airport liability. Airport liability insurance provides coverage for third-party bodily injury and property damage
claims arising from accidents occurring on airport premises or from their operations.
Satellite. We can retain up to $2.0 million per risk for satellite launches and in-orbit coverage for up to 12 months.
Our Hallmark Select business unit distributes its general aviation insurance products through 192 aviation specialty brokers.
These specialty brokers submit to Aerospace Insurance Managers requests for aviation insurance quotations received from the
states in which we operate and our Hallmark Select business unit selectively determines the risks fitting its target niche for
which it will prepare a quote. During 2013, the top ten independent specialty brokers produced approximately 31%, and no
broker produced more than 6%, of the total general aviation premium volume of our Hallmark Select business unit. Our
Hallmark Select business unit independently develops, underwrites and prices each general aviation coverage written. We
target pilots who may lack experience in the type of aircraft they have acquired or are transitioning between types of aircraft.
We also target pilots who may be over the age limits of other insurers. We do not accept aircraft that are used for hazardous
purposes such as crop dusting or heli-skiing. Liability limits are controlled, with approximately 91% of the aircraft written in
2013 bearing per-occurrence limits of $1,000,000 and per-passenger limits of $100,000 or less. The average insured aircraft hull
value for aircraft written in 2013 was approximately $157,000. All general aviation policies produced by our Hallmark Select
business unit are written through our insurance company subsidiaries.
Our Hallmark Select business unit markets medical professional liability insurance on an excess and surplus lines basis. Medical
professional liability insurance provides coverage for third-party bodily injury claims resulting from professional services
provided by physicians, surgeons, podiatrists and medical entities. Our Hallmark Select business unit distributes its medical
professional liability insurance products through 18 wholesale brokers in 49 states.
Specialty Programs. Our Specialty Programs consist of fronting and agency arrangements which are managed at the parent
level. The Specialty Programs business presently consists primarily of a fronting arrangement in Texas for a third party
insurance company.
Personal Segment / Personal Lines Business Unit
The Personal Segment of our business presently consists solely of our Personal Lines business unit. Our Personal Lines business
unit markets and services non-standard personal automobile policies and low value dwelling/homeowners, renters and
manufactured homes in 15 states. We conduct this business under the name Hallmark Insurance Company. Hallmark Insurance
Company provides management, policy and claims administration services to HIC and includes the operations of American
Hallmark General Agency, Inc. and Hallmark Claims Services, Inc. Our non-standard personal automobile insurance generally
provides for the minimum limits of liability coverage mandated by state laws to drivers who find it difficult to purchase
automobile insurance from standard carriers as a result of various factors, including driving record, vehicle, age, claims history,
or limited financial resources. Products offered by our Personal Lines business unit include the following:
10
•
•
•
Personal automobile. Personal automobile insurance is the primary product offered by our Personal Lines business
unit. Our policies typically provide coverage to individuals for bodily injury and property damage at the minimum
limits required by law, and for physical damage to an insured’s own vehicle from collision and various other perils.
In addition, many states require policies to provide for first party personal injury protection, frequently referred to
as no-fault coverage.
Low value dwelling/homeowners. Low value dwelling/homeowners insurance provides coverage against insured’s
property being destroyed or damaged by various perils and coverage for liability exposure of the insured.
Renters. Renters insurance provides coverage for the contents of a renter’s home or apartment and for liability.
Renter’s policies are similar to homeowners insurance, except they do not cover the structure.
• Manufactured homes. Manufactured home insurance covers mobile home owners against various perils and may
include the liability exposure of the insured.
Our Personal Lines business unit markets its products through 3,335 independent retail agents operating in its target
geographic markets. Non-standard automobile represented 88% of the premiums produced during 2013. Our Personal Lines
business unit qualifies new agent appointments in order to establish an efficient network of independent agents to effectively
penetrate its highly competitive markets. Our Personal Lines business unit periodically evaluates its independent agents and
discontinues the appointment of agents whose production history does not satisfy certain standards. During 2013, the top ten
independent agency groups produced approximately 36%, and no individual agency group produced more than 16%, of the
total premium volume of our Personal Lines business unit.
During 2013, personal automobile liability coverage accounted for approximately 85% and personal automobile physical
damage coverage accounted for the remaining 15% of the total non-standard automobile premiums produced by our Personal
Lines business unit. Our most common policy term is a six month policy. We do offer additional terms of one-, two-, three and
twelve-month policies in certain markets. Our typical non-standard personal automobile customer is unable or unwilling to pay
a full or half year premium in advance. Accordingly, we currently offer a direct bill program where the premiums are directly
billed to the insured on a monthly basis. We charge installment fees for each payment under the direct bill program.
Our Personal Lines business unit markets its products in 15 states directly for HIC, AHIC and HNIC. In Texas, our Personal Lines
business unit also markets its policies through reinsurance arrangements with unaffiliated companies. We provide non-
standard personal automobile coverage in Texas through a reinsurance arrangement with Old American County Mutual Fire
Insurance Company (“OACM”) pursuant to which American Hallmark General Agency, Inc. holds a managing general agency
appointment from OACM to manage the sale and servicing of OACM policies. HIC reinsures 100% of the OACM policies
produced by American Hallmark General Agency, Inc. under these reinsurance arrangements. During the third quarter of 2009,
HCM began fronting a portion of the business previously written through OACM.
Our Competitive Strengths
We believe that we enjoy the following competitive strengths:
•
•
Specialized market knowledge and underwriting expertise. All of our business units possess extensive
knowledge of the specialty and niche markets in which they operate, which we believe allows them to effectively
structure and market their property/casualty insurance products. Our Personal Lines business unit has a
thorough understanding of the unique characteristics of the non-standard personal automobile market. Our
Standard Commercial P&C business unit and Workers Compensation business unit have significant underwriting
experience in their target markets for standard commercial property/casualty insurance products. In addition,
our E&S Commercial business unit and Hallmark Select business unit have developed specialized underwriting
expertise which enhances their ability to profitably underwrite non-standard property/casualty insurance
coverages.
Tailored market strategies. Each of our business units has developed its own customized strategy for
penetrating the specialty or niche markets in which it operates. These strategies include distinctive product
structuring, marketing, distribution, underwriting and servicing approaches by each business unit. As a result, we
are able to structure our property/casualty insurance products to serve the unique risk and coverage needs of
our insureds. We believe these market-specific strategies enable us to provide policies tailored to the target
11
customer that are appropriately priced and fit our risk profile.
•
Superior agent and customer service. We believe performing the underwriting, billing, customer service and
claims management functions at the business unit level allows us to provide superior service to both our
independent agents and insured customers. The easy-to-use interfaces and responsiveness of our business units
enhance their relationships with the independent agents who sell our policies. We also believe our consistency in
offering our insurance products through hard and soft markets helps to build and maintain the loyalty of our
independent agents. Our customized products, flexible payment plans and prompt claims processing are
similarly beneficial to our insureds.
• Market diversification. We believe operating in various specialty and niche segments of the property/casualty
insurance market diversifies both our revenues and our risks. We also believe our business units generally
operate on different market cycles, producing more earnings stability than if we focused entirely on one product.
As a result of the pooling arrangement among four of our insurance company subsidiaries, we are able to
efficiently allocate our capital among these various specialty and niche markets in response to market conditions
and expansion opportunities. We believe this market diversification reduces our risk profile and enhances our
profitability.
•
Experienced management team. Our senior corporate management has an average of over 20 years of
insurance experience. In addition, our business units have strong management teams, with an average of more
than 20 years of insurance industry experience for the heads of our business units and an average of more than
15 years of underwriting experience for our underwriters. Our management has significant experience in all
aspects of property/casualty
including underwriting, claims management, actuarial analysis,
reinsurance and regulatory compliance. In addition, Hallmark’s senior management has a strong track record of
acquiring businesses that expand our product offerings and improve our profitability profile.
insurance,
Our Strategy
We are striving to become a “Best in Class” specialty insurance company offering products in specialty and niche markets
through the following strategies:
•
•
•
Focusing on underwriting discipline and operational efficiency. We seek to consistently generate an
underwriting profit on the business we write in hard and soft markets. Our business units have a strong track
record of underwriting discipline and operational efficiency, which we seek to continue. We believe that in soft
markets our competitors often offer policies at a low or negative underwriting profit in order to maintain or
increase their premium volume and market share. In contrast, we seek to write business based on its profitability
rather than focusing solely on premium production. To that end, we provide financial incentives to many of our
underwriters and independent agents based on underwriting profitability.
Achieving organic growth in our existing business lines. We believe we can achieve organic growth in our
existing business lines by consistently providing our insurance products through market cycles, expanding
geographically, expanding our product offerings, expanding our agency relationships and further penetrating our
existing customer base. We believe our extensive market knowledge and strong agency relationships position us
to compete effectively in our various specialty and niche markets. We also believe there is a significant
opportunity to expand some of our existing business lines into new geographical areas and through new agency
relationships while maintaining our underwriting discipline and operational efficiency. In addition, we believe
there is an opportunity for some of our business units to further penetrate their existing customer bases with
additional products offered by other business units.
Pursuing selected, opportunistic acquisitions. We seek to opportunistically acquire insurance organizations that
operate in specialty or niche property/casualty insurance markets that are complementary to our existing
operations. We seek to acquire companies with experienced management teams, stable loss results and strong
track records of underwriting profitability and operational efficiency. Where appropriate, we intend to ultimately
retain profitable business produced by the acquired companies that would otherwise be retained by unaffiliated
insurers. Our management has significant experience in evaluating potential acquisition targets, structuring
transactions to ensure continued success and integrating acquired companies into our operational structure.
12
• Maintaining a strong balance sheet. We seek to maintain a strong balance sheet by employing conservative
investment, reinsurance and reserving practices and to measure our performance based on long-term growth in
book value per share.
Distribution
We market our property/casualty insurance products predominately through independent general agents, retail agents and
specialty brokers. Therefore, our relationships with independent agents and brokers are critical to our ability to identify, attract
and retain profitable business. Each of our business units has developed its own tailored approach to establishing and
maintaining its relationships with these independent distributors of our products. These strategies focus on providing excellent
service to our agents and brokers, maintaining a consistent presence in our target niche and specialty markets through hard
and soft market cycles and fairly compensating the agents and brokers who market our products. Our business units also
regularly evaluate independent general and retail agents based on the underwriting profitability of the business they produce
and their performance in relation to our objectives.
Except for the products of our Hallmark Select business unit, the distribution of property/casualty insurance products by our
business units is geographically concentrated. For the twelve months ended December 31, 2013, five states accounted for
approximately 67% of the gross premiums retained by our insurance company subsidiaries.
The following table reflects the geographic distribution of our insured risks, as represented by direct and assumed premiums
written by our business segments for the twelve months ended December 31, 2013.
State
Texas
Louisiana
Arizona
Oregon
New Mexico
All other states
Total gross premiums written
Percent of total
Underwriting
Standard
Commercial
Segment
Specialty
Commercial
Segment
Personal
Segment
Total
Percent of
Total
(dollars in thousands)
$
$
37,881
-
-
14,320
8,923
26,023
87,147
$
$
171,308
22,798
1,126
560
816
99,500
296,108
$
$
28,726
-
15,049
(7 )
4,927
28,077
76,772
$
237,915
22,798
16,175
14,873
14,666
153,600
460,027
$
18.9 %
64.4 %
16.7 %
100.0 %
51.7 %
5.0 %
3.5 %
3.2 %
3.2 %
33.4 %
The underwriting process employed by our business units involves securing an adequate level of underwriting information,
identifying and evaluating risk exposures and then pricing the risks we choose to accept. Each of our business units offering
commercial, healthcare professional or aviation insurance products employs its own underwriters with in-depth knowledge of
the specific niche and specialty markets targeted by that business unit. We employ a disciplined underwriting approach that
seeks to provide policies appropriately tailored to the specified risks and to adopt price structures that will be supported in the
applicable market. Our experienced commercial, healthcare professional and aviation underwriters have developed
underwriting principles and processes appropriate to the coverages offered by their respective business units.
We believe that managing the underwriting process through our business units capitalizes on the knowledge and expertise of
their personnel in specific markets and results in better underwriting decisions. All of our underwriters have established limits
of underwriting authority based on their level of experience. We also provide financial incentives to many of our underwriters
based on underwriting profitability.
To better diversify our revenue sources and manage our risk, we seek to maintain an appropriate business mix among our
business units. At the beginning of each year, we establish a target net loss ratio for each business unit. We then monitor the
actual net loss ratio on a monthly basis. If any line of business fails to meet its target net loss ratio, we seek input from our
13
underwriting, actuarial and claims management personnel to develop a corrective action plan. Depending on the particular
circumstances, that plan may involve tightening underwriting guidelines, increasing rates, modifying product structure, re-
evaluating independent agency relationships or discontinuing unprofitable coverages or classes of risk.
An insurance company’s underwriting performance is traditionally measured by its statutory loss and loss adjustment expense
ratio, its statutory expense ratio and its statutory combined ratio. The statutory loss and loss adjustment expense ratio, which is
calculated as the ratio of net losses and loss adjustment expenses (“LAE”) incurred to net premiums earned, helps to assess the
adequacy of the insurer’s rates, the propriety of its underwriting guidelines and the performance of its claims department. The
statutory expense ratio, which is calculated as the ratio of underwriting and operating expenses to net premiums written,
assists in measuring the insurer’s cost of processing and managing the business. The statutory combined ratio, which is the sum
of the statutory loss and LAE ratio and the statutory expense ratio, is indicative of the overall profitability of an insurer’s
underwriting activities, with a combined ratio of less than 100% indicating profitable underwriting results.
The following table shows, for the periods indicated, (i) our gross premiums written (in thousands); and (ii) our underwriting
results as measured by the net statutory loss and LAE ratio, the statutory expense ratio, and the statutory combined ratio.
Gross premiums written
$
460,027
$
389,842
$
354,881
Year Ended December 31,
2012
2013
2011
Statutory loss & LAE ratio
Statutory expense ratio
Statutory combined ratio
72.2 %
34.7 %
106.9 %
72.0 %
33.5 %
105.5 %
82.8 %
32.8 %
115.6 %
These statutory ratios do not reflect the deferral of policy acquisition costs, investment income, premium finance revenues, or
the elimination of inter-company transactions required by U.S. generally accepted accounting principles (“GAAP”).
The premium-to-surplus percentage measures the relationship between net premiums written in a given period (premiums
written, less returned premiums and reinsurance ceded to other carriers) to policyholders surplus (admitted assets less
liabilities), determined on the basis of statutory accounting practices prescribed or permitted by insurance regulatory
authorities. State insurance department regulators expect insurance companies to maintain a premium-to-surplus percentage
of not more than 300%. For the years ended December 31, 2013, 2012 and 2011, our consolidated premium-to-surplus ratios
were 184%, 188% and 176%, respectively.
Claims Management and Administration
We believe that effective claims management is critical to our success and that our claims management process is cost-
effective, delivers the appropriate level of claims service and produces superior claims results. Our claims management
philosophy emphasizes the delivery of courteous, prompt and effective claims handling and embraces responsiveness to
policyholders and agents. Our claims strategy focuses on thorough investigation, timely evaluation and fair settlement of
covered claims while consistently maintaining appropriate case reserves. We seek to compress the cycle time of claim
resolution in order to control both loss and claim handling cost. We also strive to control legal expenses by negotiating
competitive rates with defense counsel and vendors, establishing litigation budgets and monitoring invoices.
Each of our business units maintains its own dedicated staff of specialized claims personnel to manage and administer claims
arising under policies produced through their respective operations. The claims process is managed through a combination of
experienced claims managers, seasoned claims supervisors, trained staff adjusters and independent adjustment or appraisal
services, when appropriate. All adjusters are licensed in those jurisdictions for which they handle claims that require licensing.
Limits on settlement authority are established for each claims supervisor and staff adjuster based on their level of experience.
Certain independent adjusters have limited authority to settle claims. Claim exposures are periodically and systematically
reviewed by claim supervisors and managers as a method of quality and loss control. Large loss exposures are reviewed at least
quarterly with senior management of the business unit and monitored by Hallmark senior management.
Claims personnel receive in-house training and are required to attend various continuing education courses pertaining to topics
such as best practices, fraud awareness, legal environment, legislative changes and litigation management. Depending on the
criteria of each business unit, our claims adjusters are assigned a variety of claims to enhance their knowledge and ensure their
14
continued development in efficiently handling claims. As of December 31, 2013, our business units had a total of 91 claims
managers, supervisors and adjusters with an average experience of approximately 12 years.
Analysis of Losses and LAE
Our consolidated financial statements include an estimated reserve for unpaid losses and LAE. We estimate our reserve for
unpaid losses and LAE by using case-basis evaluations and statistical projections, which include inferences from both losses paid
and losses incurred. We also use recent historical cost data and periodic reviews of underwriting standards and claims
management practices to modify the statistical projections. We give consideration to the impact of inflation in determining our
loss reserves, but do not discount reserve balances.
The amount of reserves represents our estimate of the ultimate cost of all unpaid losses and LAE incurred. These estimates are
subject to the effect of trends in claim severity and frequency. We regularly review the estimates and adjust them as claims
experience develops and new information becomes known. Such adjustments are included in current operations, including
increases and decreases, net of reinsurance, in the estimate of ultimate liabilities for insured events of prior years.
Changes in loss development patterns and claim payments can significantly affect the ability of insurers to estimate reserves for
unpaid losses and related expenses. We seek to continually improve our loss estimation process by refining our ability to
analyze loss development patterns, claim payments and other information within a legal and regulatory environment that
affects development of ultimate liabilities. Future changes in estimates of claim costs may adversely affect future period
operating results. However, such effects cannot be reasonably estimated currently.
15
Reconciliation of reserve for unpaid losses and LAE. The following table provides a reconciliation of our beginning and ending
reserve balances on a net-of-reinsurance basis for the years ended December 31, 2013, 2012 and 2011, to the gross-of-
reinsurance amounts reported in our balance sheets at December 31, 2013, 2012 and 2011.
As of and for Year Ended December 31,
2012
(dollars in thousands)
2013
2011
Reserve for unpaid losses and LAE, net of reinsurance
recoverables, January 1
$
263,832
$
254,901
$
213,723
Acquisition of subsidiaries effective July 1
-
-
8,816
Provision for losses and LAE for claims occurring in the
current period
251,391
230,089
222,869
Increase (decrease) in reserve for unpaid losses and LAE
for claims occurring in prior periods
9,954
(3,675 )
16,366
Payments for losses and LAE, net of reinsurance:
Current period
Prior periods
(101,897 )
(110,812 )
(107,945 )
(109,538 )
(101,025 )
(105,848 )
Reserve for unpaid losses and LAE at December 31, net
of reinsurance recoverable
312,468
263,832
254,901
Reinsurance recoverable on unpaid losses and LAE at
December 31
70,172
49,584
42,044
Reserve for unpaid losses and LAE at December 31, gross
of reinsurance
$
382,640
$
313,416
$
296,945
The $10.0 million unfavorable development, $3.7 million favorable development and $16.4 million unfavorable development in
prior accident years recognized in 2013, 2012 and 2011, respectively, represent normal changes in our loss reserve estimates. In
2013 and 2011, the aggregate loss reserve estimates for prior years were increased to reflect unfavorable loss development
when the available information indicated a reasonable likelihood that the ultimate losses would be more than the previous
estimates. In 2012, the aggregate loss reserve estimates for prior years were decreased to reflect favorable loss development
when the available information indicated a reasonable likelihood that the ultimate losses would be less than the previous
estimates. Generally, changes in reserves are caused by variations between actual experience and previous expectations and by
reduced emphasis on the Bornhuetter-Ferguson method due to the aging of the accident years. (See “Item 7. Management’s
Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Estimates and Judgments -
Reserves for unpaid losses and loss adjustment expenses.”)
The $10.0 million increase in reserves for unpaid losses and LAE recognized in 2013 was attributable to $5.0 million unfavorable
development on claims incurred in the 2012 accident year, $1.7 million unfavorable development on claims incurred in the
2011 accident year and $3.3 million unfavorable development on claims incurred in the 2010 and prior accident years. Our E&S
Commercial business unit and Personal Lines business unit accounted for $16.0 million and $1.8 million of the increase in
reserves recognized during 2013. The increase in reserves for our E&S Commercial business unit was primarily related to
commercial auto liability line of business. The increase in reserves for our Personal Lines business unit was primarily related to
personal auto in the 2012 accident year. These unfavorable developments were partially offset by favorable prior years’ loss
development of $3.7 million in our Standard Commercial P&C business unit, $2.6 million in our Hallmark Select business unit
and $1.5 million in our Workers Compensation business unit. The decrease in reserves for our Standard Commercial P&C
business unit was primarily related to commercial auto and general liability line of business. The decrease in reserves for our
Hallmark Select business unit was driven by $2.3 million of favorable claims development in the 2011 and prior accident years
16
related to our aircraft liability lines of business, partially offset by $0.1 million unfavorable claims development in the 2012
accident year related to our aircraft hull coverage. Further contributing to the decrease in reserves for our Hallmark Select
business unit was $0.4 million of favorable claims development in our excess & umbrella lines of business. The decrease in
reserves for our Workers Compensation business unit was related to the 2012 and 2011 accident years.
The $3.7 million decrease in reserves for unpaid losses and LAE recognized in 2012 was attributable to $0.4 million favorable
development on claims incurred in the 2011 accident year, $0.8 million favorable development on claims incurred in the 2010
accident year and $2.5 million favorable development on claims incurred in the 2009 and prior accident years. Our Standard
Commercial P&C business unit, Hallmark Select business unit and E&S Commercial business unit accounted for $3.7 million,
$3.3 million and $0.3 million, respectively, of the decrease in reserves recognized during 2012. The decrease in reserves for our
Standard Commercial P&C business unit was primarily related to commercial auto, commercial property and general liability
lines of business. The decrease in reserves for our Hallmark Select business unit was primarily related to our aircraft liability
lines of business. The decrease in reserves for our E&S Commercial business unit was primarily related to general liability. These
favorable developments were partially offset by unfavorable prior years’ loss development of $3.6 million in our Personal Lines
business unit related to auto liability claims spread throughout various states and our low value dwelling/homeowners line of
business.
The $16.4 million increase in reserves for unpaid losses and LAE recognized in 2011 was attributable to $15.0 million
unfavorable development on claims incurred in the 2010 accident year, $3.6 million unfavorable development on claims
incurred in the 2009 accident year and $2.2 million favorable development on claims incurred in the 2008 and prior accident
years. Our Personal Lines business unit and E&S Commercial business unit accounted for $19.6 million and $3.7 million,
respectively, of the increase in reserves recognized during 2011. The $19.6 million increase in reserves during 2011 for our
Personal Lines business unit includes $10.3 million which was attributable to Florida developing much worse than expected due
primarily to rapid growth in the claim volume from Florida, the complexity related to Florida personal injury protection
coverage claims and the high incidence of fraudulent claims in that market. The remaining unfavorable prior years’ loss
development for our Personal Lines business unit was primarily due to rapid geographic expansion. The increase in reserves for
our E&S Commercial business unit was primarily related to commercial auto and physical damage and general liability lines of
business. These unfavorable developments were partially offset by favorable prior years’ loss development of $6.1 million in
our Hallmark Select business unit related to our aircraft liability lines of business and $0.8 million in our Standard Commercial
P&C business unit primarily related to our commercial property lines of business.
Analysis of loss and LAE reserve development. The following table shows the development of our loss reserves, net of
reinsurance, for years ended December 31, 2003 through 2013. Section A of the table shows the estimated liability for unpaid
losses and LAE, net of reinsurance, recorded at the balance sheet date for each of the indicated years. This liability represents
the estimated amount of losses and LAE for claims arising in prior years that are unpaid at the balance sheet date, including
losses that have been incurred but not yet reported to us. Section B of the table shows the re-estimated amount of the
previously recorded liability, based on experience as of the end of each succeeding year. The estimate is increased or decreased
as more information becomes known about the frequency and severity of claims.
Cumulative Redundancy/ (Deficiency) (Section C of the table) represents the aggregate change in the estimates over all prior
years. Thus, changes in ultimate development estimates are included in operations over a number of years, minimizing the
significance of such changes in any one year.
17
ANALYSIS OF LOSS AND LAE DEVELOPMENT
As of and for Year Ended December 31
A. Reserve for unpaid loss & LAE, net of reinsurance
recoverables
$ 21,197
$ 17,700
$ 25,997 $ 72,801 $ 120,849 $ 150,025 $ 176,250 $ 213,723 $ 254,901 $ $ 263,832 $ 312,468
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
B. Net reserve re-estimated as of:
One year later
Two years later
Three years later
Four years later
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
66,387 119,034 151,645 185,440 230,089 251,226 273,786
68,490 118,646 155,155 183,689 226,856 256,198
68,809 120,444 154,738 181,268 230,145
69,847 119,771 155,520 185,848
71,879 123,949 158,842
78,396 128,006
79,939
15,300 24,820
15,473 24,903
13,962 23,144
14,166 23,455
13,163 24,425
17,857 25,403
17,597 30,704
17,605 32,395
18,108
20,003
19,065
19,698
18,551
18,769
17,784
18,521
18,297
18,312
18,601
C. Net cumulative redundancy (deficiency)
2,596
(408 ) )
(6,398 )
(7,138 )
(7,157 )
(8,817 )
(9,598 )
(16,422 )
(1,297 )
)
(9,954
D. Cumulative amount of claims paid, net of reserve
recoveries through:
One year later
Two years later
Three years later
Four years later
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
Net reserve-December 31
Reinsurance recoverables
Gross reserve-December 31
Net re-estimated reserve
Re-estimated reinsurance recoverable
Gross re-estimated reserve
8,073 16,721
12,004 22,990
13,113 24,562
13,750 27,231
13,102 28,833
17,498 30,367
17,557 31,058
17,551 33,171
17,915
12,217
15,814
18,162
17,997
18,415
17,735
18,083
18,120
18,115
18,601
21,197
7,259
28,456
17,700 25,997
1,948
324
19,648 26,321
50,458 64,810 73,647 105,848 109,538 110,812
78,314 95,385 121,222 156,176 163,803
93,286 120,133 146,956 188,044
30,061
46,860
58,322
65,084 105,251 131,912 162,704
71,082 112,029 140,618
75,225 118,171
75,141
72,801 120,849 150,025 176,250 213,723 254,901
42,044
4,763
77,564 125,338 156,363 184,662 251,677 296,945
8,412 37,954
4,489
6,338
263,832 312,468
49,584
70,172
313,416 382,640
18,601 18,108 32,395
79,939 128,006 158,842 185,848 230,145 256,198
273,786
4,419
1,050
1,776
6,702
7,919
7,443
7,195
37,582
43,277
49,084
23,020 19,158 34,171
86,641 135,925 166,285 193,043 267,727 299,475
322,870
Gross cumulative redundancy (deficiency)
$ 5,436
$
490 $ (7,850 ) $
(9,077 ) $ (10,587 ) $ (9,922 ) ) $
(8,381 ) $ (16,050 ) $
(2,530 ) $
(9,454 )
18
Reinsurance
We reinsure a portion of the risk we underwrite in order to control our exposure to losses and to protect our capital resources.
We cede to reinsurers a portion of these risks and pay premiums based upon the risk and exposure of the policies subject to
such reinsurance. Ceded reinsurance involves credit risk and is generally subject to aggregate loss limits. Although the reinsurer
is liable to us to the extent of the reinsurance ceded, we are ultimately liable as the direct insurer on all risks reinsured.
Reinsurance recoverables are reported after allowances for uncollectible amounts. We monitor the financial condition of
reinsurers on an ongoing basis and review our reinsurance arrangements periodically. Reinsurers are selected based on their
financial condition, business practices and the price of their product offerings. Our reinsurance facilities are subject to annual
renewal. In order to mitigate credit risk to reinsurance companies, most of our reinsurance recoverable balance as of December
31, 2013 was with reinsurers that had an A.M. Best rating of “A-” or better. We also mitigate our credit risk for the remaining
reinsurance recoverable by obtaining letters of credit.
The following table presents our gross and net premiums written and earned and reinsurance recoveries for each of the last
three years (in thousands).
Gross premiums written
Ceded premiums written
Net premiums written
Gross premiums earned
Ceded premiums earned
Net premiums earned
Reinsurance recoveries
$
$
$
$
$
Year Ended December 31,
2012
389,842
(57,353 )
332,489
2013
460,027
(99,262 )
360,765
$
$
$
$
2011
354,881
(51,005 )
303,876
437,226
(76,685 )
360,541
$
$
373,849
(54,413 )
319,436
$
$
350,080
(57,039 )
293,041
45,456
$
29,014
$
32,941
We currently reinsure the following exposures on business generated by our business units:
•
Property catastrophe. Our property catastrophe reinsurance reduces the financial impact a catastrophe could have on
our commercial and personal property insurance lines. Catastrophes might include multiple claims and policyholders.
Catastrophes include hurricanes, windstorms, earthquakes, hailstorms, explosions, severe winter weather and fires.
Our property catastrophe reinsurance is excess-of-loss reinsurance, which provides us reinsurance coverage for losses
in excess of an agreed-upon amount. We utilize catastrophe models to assist in determining appropriate retention
and limits to purchase. Effective July 1, 2013, the terms of our property catastrophe reinsurance are:
o We retain the first $6.0 million of property catastrophe losses; and
o Our reinsurers reimburse us 100% for any loss occurrence in excess of our $6.0 million retention up to $29.0
million for each catastrophic occurrence, subject to an aggregate limit of $58.0 million.
• Commercial property. Our commercial property reinsurance is excess-of-loss coverage intended to reduce the
financial impact a single-event or catastrophic loss may have on our results. Effective July 1, 2013, the terms of our
commercial property reinsurance are:
o We retain the first $1.0 million of loss for each commercial property risk;
o Our reinsurers reimburse us for the next $5.0 million for each commercial property risk, and $10.0 million
for all commercial property risk involved in any one occurrence, in all cases subject to an aggregate limit of
$30.0 million for all commercial property losses occurring during the treaty period; and
o
Individual risk facultative reinsurance is purchased on any commercial property with limits above $6.0
million.
19
•
Commercial casualty. Our commercial casualty reinsurance is excess-of-loss coverage intended to reduce the financial
impact a single-event loss may have on our results. Effective July 1, 2013, the terms of our commercial casualty
reinsurance are:
o We retain the first $1.0 million of any commercial liability risk; and
o Our reinsurers reimburse us for the next $5.0 million for each commercial liability risk.
•
Aviation. Effective July 1, 2013 we purchased proportional reinsurance where we cede 80% of the risk to reinsurers on
the aviation risks produced in all states by our Hallmark Select business unit.
• Occupational Accident. We purchase excess-of-loss reinsurance coverage for the occupational accident insurance
product produced by our Standard Commercial P&C business unit. The terms of occupational accident reinsurance
are:
o We retain the first $1.0 million of any occupational accident risk; and
o
Our reinsurers reimburse us for the next $5.0 million for each occupational accident risk up to $10.0
million for each occurrence.
• Workers Compensation. We purchase excess of loss reinsurance specific to the workers compensation risks
underwritten by our Workers Compensation business unit. The terms of our workers compensation reinsurance are:
o We retain the first $1.0 million of each workers compensation loss; and
o Our reinsurers reimburse us 100% for the next $14.0 million for each workers compensation loss, subject to a
maximum limit of $10.0 million for any one person and an aggregate limit of $28.0 million for all workers
compensation losses.
Person
Hallmark
•
•
•
•
•
•
Personal Property. Effective February 1, 2013 we purchased proportional reinsurance where we cede 60% of the risks
to reinsurers on the low value dwelling/homeowners, renters and manufactured homes coverages produced in all
states by our Personal Lines business unit.
Personal Auto. Effective October 1, 2013 we purchased proportional reinsurance where we cede 90% of the risks to
reinsurers on the nonstandard automobile risks produced in certain states by our Personal Lines business unit.
Standard Commercial P&C. We purchase proportional reinsurance where we cede 100% of the risks to reinsurers on
the equipment breakdown coverage on our commercial multi-peril property and business owner’s risks and on the
employment practices liability coverage on certain commercial multi-peril, general liability and business owner’s risks.
Excess & Umbrella. We purchase proportional reinsurance where we retain 20% of each risk and cede the remaining
80% to reinsurers on the commercial umbrella and excess liability insurance produced by our Hallmark Select
business unit. In states where we are not yet licensed to offer a non-admitted product, we utilize a fronting
arrangement pursuant to which we assume all of the risk and then retrocede a portion of that risk under the same
proportional reinsurance treaty.
Professional Liability. Effective June 1, 2013, we purchased proportional reinsurance on our medical professional
liability risks produced by our Hallmark Select business unit where we retain 60% of each risk and cede the remaining
40% to reinsurers. In states where we are not yet licensed to offer a non-admitted product, we utilize a fronting
arrangement pursuant to which we assume all of the risk and then retrocede a portion of that risk under the same
proportional reinsurance treaty.
E&S Commercial. We purchase facultative reinsurance on our commercial umbrella and excess liability risks produced
by our E&S Commercial business unit where we retain 10% of the first $1.0 million of risk and cede the remaining 90%
to reinsurers. We cede 100% of our commercial umbrella and excess liability risks in excess of $1.0 million.
• Hallmark County Mutual. HCM is used to front certain lines of business in our Specialty Commercial and Personal
Segments in Texas where we previously produced policies for third party county mutual insurance companies and
reinsured 100% for a fronting fee. In addition, HCM is used to front business produced by unaffiliated third parties.
HCM does not retain any business.
20
• Hallmark National Insurance Company. Simultaneous with the December 31, 2010 closing of our acquisition of HNIC,
HNIC entered into reinsurance contracts with an affiliate of the seller pursuant to which such affiliate of the seller
handles all claims and assumes all liabilities arising under policies issued by HNIC prior to closing or during a transition
period following the closing.
Investment Portfolio
Our investment objective is to maximize current yield while maintaining safety of capital together with sufficient liquidity for
ongoing insurance operations. Our investment portfolio is composed of fixed-income and equity securities. As of December 31,
2013, we had total invested assets of $461.3 million. If market rates were to increase by 1%, the fair value of our fixed-income
securities as of December 31, 2013 would decrease by approximately $12.2 million. The following table shows the fair values of
various categories of fixed-income securities, the percentage of the total fair value of our invested assets represented by each
category and the tax equivalent book yield based on fair value of each category of invested assets as of December 31, 2013 and
2012.
As of December 31, 2013
As of December 31, 2012
Percent
of
Total
Fair
Value
(in thousands)
Yield
Fair
Value
(in thousands)
Percent
of
Total
Yield
Category:
Corporate bonds
$
Collateralized corporate bank loans
Municipal bonds
US Treasury securities and
obligations of U.S. Government
Mortgage backed
43,875
102,178
157,552
78,753
27,737
10.7 %
24.9 %
38.4 %
19.2 %
6.8 %
3.8 %
$
4.0 %
5.0 %
0.5 %
2.7 %
81,547
106,371
163,732
40,061
9,724
20.3 %
26.5 %
40.8 %
10.0 %
2.4 %
4.6 %
4.8 %
5.1 %
0.3 %
2.9 %
Total
$
410,095
100.0 %
3.6 %
$
401,435
100.0 %
4.4 %
The weighted average credit rating for our fixed-income portfolio, using ratings assigned by Standard and Poor’s Rating Services
(a division of the McGraw-Hill Companies, Inc.), was A- at December 31, 2013. The following table shows the distribution of our
fixed-income portfolio by Standard and Poor’s rating as a percentage of total fair value as of December 31, 2013 and 2012:
As of
December 31, 2013
As of
December 31, 2012
Rating:
"AAA"
"AA"
"A"
"BBB"
"BB"
"B"
"CCC"
"NR"
Total
1.1 %
17.9 %
18.1 %
37.1 %
19.8 %
3.0 %
0.1 %
2.9 %
100.0 %
0.9 %
33.7 %
22.4 %
18.9 %
18.6 %
4.5 %
0.7 %
0.3 %
100.0 %
21
The following table shows the composition of our fixed-income portfolio by remaining time to maturity as of December 31,
2013 and 2012.
Remaining time to maturity:
Less than one year
One to five years
Five to ten years
More than ten years
Mortgage-backed
Total
As of December 31, 2013
As of December 31, 2012
Fair Value
(in thousands)
$
$
71,969
163,006
108,761
38,622
27,737
410,095
Percentage of
Total
Fair Value
Percentage of
Total
Fair Value
Fair Value
(in thousands)
17.6 %
$
39.7 %
26.5 %
9.4 %
6.8 %
100.0 %
$
68,739
169,811
102,770
50,391
9,724
401,435
17.1 %
42.3 %
25.6 %
12.6 %
2.4 %
100.0 %
Our investment strategy is to conservatively manage our investment portfolio by investing primarily in readily marketable,
investment-grade, fixed-income securities. As of December 31, 2013, 11% of our investment portfolio was invested in equity
securities. Our investment portfolio is managed internally. We regularly review our portfolio for declines in value. For fixed
maturity investments that are considered other-than-temporarily impaired and that we do not intend to sell and will not be
required to sell, we separate the amount of the impairment into the amount that is credit related (credit loss component) and
the amount due to all other factors. The credit loss component is recognized in earnings and is the difference between the
investment’s amortized cost basis and the present value of its expected future cash flows. The remaining difference between
the investment’s fair value and the present value of future expected cash flows is recognized in other comprehensive income.
The following table details the net unrealized gain balance by invested asset category as of December 31, 2013.
Category
Corporate bonds
Collateralized corporate bank loans
Municipal bonds
Equity securities
U.S. Treasury securities and obligations of U.S. Government
Mortgage-backed
Total
Net Unrealized
Gain Balance
(in thousands)
929
$
125
602
26,328
(141 )
(47 )
27,796
$
As part of our overall investment strategy, we also maintain an integrated cash management system utilizing on-line banking
services and daily overnight investment accounts to maximize investment earnings on all available cash.
Technology
The majority of our technology systems are based on products licensed from insurance-specific technology vendors that have
been substantially customized to meet the unique needs of our various business units. Our technology systems primarily consist
of integrated central processing computers, a series of server-based computer networks and various communications systems
that allow our various operations to share systems solutions and communicate to the corporate office in a timely, secure and
consistent manner. We maintain backup facilities and systems through a contract with a leading provider of computer disaster
recovery services. Each business unit bears the information services expenses specific to its operations as well as a portion of
the corporate services expenses. Increases to vendor license and service fees are capped per annum.
We believe the implementation of our various technology systems has increased our efficiency in the processing of our
business, resulting in lower operating costs. Additionally, our systems enable us to provide a high level of service to our agents
22
and policyholders by processing our business in a timely and efficient manner, communicating and sharing data with our agents
and providing a variety of methods for the payment of premiums. We believe these systems have also improved the
accumulation and analysis of information for our management.
Ratings
Many insurance buyers, agents and brokers use the ratings assigned by A.M. Best and other rating agencies to assist them in
assessing the financial strength and overall quality of the companies from which they are considering purchasing insurance.
A.M. Best has pooled its ratings of our AHIC, HIC, HSIC and HNIC subsidiaries and assigned a financial strength rating of “A-”
(Excellent) and an issuer credit rating of “a-” to each of these individual insurance company subsidiaries and to the pool formed
by the four insurance company subsidiaries. A.M. Best has also assigned a financial strength rating of “A-” (Excellent) and an
issuer credit rating of “a-” to HCM. A.M. Best does not assign a financial strength rating or an issuer credit rating to TBIC. An “A–
” rating is the fourth highest of 15 rating categories used by A.M. Best. In evaluating an insurer’s financial and operating
performance, A.M. Best reviews the company’s profitability, indebtedness and liquidity, as well as its book of business, the
adequacy and soundness of its reinsurance, the quality and estimated fair value of its assets, the adequacy of its loss reserves,
the adequacy of its surplus, its capital structure, the experience and competence of its management and its market presence.
A.M. Best’s ratings reflect its opinion of an insurer’s financial strength, operating performance and ability to meet its obligations
to policyholders and are not an evaluation directed at investors or recommendations to buy, sell or hold an insurer’s stock.
Competition
The property/casualty insurance market, our primary source of revenue, is highly competitive and, except for regulatory
considerations, has very few barriers to entry. According to A.M. Best, there were 3,196 property/casualty insurance companies
and 2,135 property/casualty insurance groups operating in North America as of July 16, 2013. Our Standard Commercial P&C
business unit competes with a variety of large national standard commercial lines carriers such as Liberty Mutual Group,
Travelers Companies, Inc., Cincinnati Financial Corporation and The Hartford Financial Services Group, as well as numerous
smaller regional companies. The primary competition for the occupational accident insurance product offered by our Standard
Commercial P&C unit includes such carriers as Great American Insurance Group, One Beacon Insurance Company, North
American Insurance Company and Service Lloyds. The primary competition for our Workers Compensation business unit
includes such carriers as Texas Mutual Insurance Company, Service Lloyds Insurance Company, Employers Insurance Company,
The Hartford Financial Services Group and FirstComp Insurance Company. The primary competition for our E&S Commercial
business unit includes such carriers as Accident Insurance Company, Atlantic Casualty Insurance Company, National Casualty,
National Liability & Fire Insurance Company, Northland Insurance Company, Scottsdale Insurance Company, Spirit Commercial
Auto Risk Retention Group and Lloyds of London. Our Hallmark Select business unit considers its primary competition for our
excess & umbrella and general liability insurance products to include such carriers as American International Group, Inc., First
Mercury Insurance Company, Axis Insurance Company, XL Specialty Insurance, W.R. Berkley Corporation and, to a lesser extent,
a number of national standard lines carriers such as Travelers Companies, Inc. and Liberty Mutual Group. The primary
competitors for our general aviation insurance products produced by our Hallmark Select business unit are Phoenix Aviation
Managers, Starr Aviation, Chartis, United States Specialty Insurance Company, W. Brown & Company, United States Aircraft
Insurance Group , Global Aerospace and Allianz Aviation Managers. The primary competition for the medical professional
liability insurance products produced by our Hallmark Select business unit are Admiral Insurance Company, Catlin Insurance
Company, CNA Financial Corporation, Evanston Insurance Company, Kinsale Insurance Company, Lexington Insurance
Company, ProAssurance Corporation, RSUI Group and TDC Companies. Although our Personal Lines business unit competes
with large national insurers such as Allstate Corporation, GEICO Corporation and Progressive Insurance Company, as a
participant in the non-standard personal automobile marketplace its competition is most directly associated with numerous
regional companies and managing general agencies. Our competitors include entities that have, or are affiliated with entities
that have, greater financial and other resources than we have.
Generally, we compete on price, customer service, coverages offered, claims handling, financial stability, agent commission and
support, customer recognition and geographic coverage. We compete with companies who use independent agents, captive
agent networks, direct marketing channels or a combination thereof.
23
Insurance Regulation
AHIC, HCM and TBIC are domiciled in Texas, HIC is domiciled in Arizona, HSIC is domiciled in Oklahoma and HNIC is domiciled in
Ohio. Therefore, our insurance operations are regulated by the Texas Department of Insurance, the Arizona Department of
Insurance, the Oklahoma Insurance Department and the Ohio Department of Insurance, as well as the applicable insurance
department of each state in which we issue policies. Our insurance company subsidiaries are required to file quarterly and
annual statements of their financial condition prepared in accordance with statutory accounting practices with the insurance
departments of their respective states of domicile and the applicable insurance department of each state in which they write
business. The financial conditions of our insurance company subsidiaries, including the adequacy of surplus, loss reserves and
investments, are subject to review by the insurance department of their respective states of domicile.
Periodic financial and market conduct examinations. The insurance departments of the states of domicile for our insurance
company subsidiaries have broad authority to enforce insurance laws and regulations through examinations, administrative
orders, civil and criminal enforcement proceedings, and suspension or revocation of an insurer’s certificate of authority or an
agent’s license. The state insurance departments that have jurisdiction over our insurance company subsidiaries may conduct
on-site visits and examinations of the insurance companies' affairs, especially as to their financial condition, ability to fulfill their
obligations to policyholders, market conduct, claims practices and compliance with other laws and applicable regulations.
Typically, these examinations are conducted every three to five years. In addition, if circumstances dictate, regulators are
authorized to conduct special or target examinations of insurance companies to address particular concerns or issues. The
results of these examinations can give rise to injunctive relief, regulatory orders requiring remedial or other corrective action on
the part of the company that is the subject of the examination, assessment of fines, or other penalties against that company. In
extreme cases, including actual or pending insolvency, the insurance department may take over, or appoint a receiver to take
over, the management or operations of an insurer or an agent’s business or assets.
Guaranty funds. All insurance companies are subject to assessments for state-administered funds that cover the claims and
expenses of insolvent or impaired insurers. The size of the assessment is determined each year by the total claims on the fund
that year. Each insurer is assessed a pro rata share based on its direct premiums written in that state. Payments to the fund
may generally be recovered by the insurer through deductions from its premium taxes over a specified period of years.
Transactions between insurance companies and their affiliates. Hallmark is also regulated as an insurance holding company by
the Texas Department of Insurance, the Arizona Department of Insurance, the Oklahoma Insurance Department and the Ohio
Insurance Department. Financial transactions between Hallmark or any of its affiliates and our insurance company subsidiaries
are subject to regulation. Transactions between our insurance company subsidiaries and their affiliates generally must be
disclosed to state regulators, and prior regulatory approval generally is required before any material or extraordinary
transaction may be consummated or any management agreement, services agreement, expense sharing arrangement or other
contract providing for the rendering of services on a regular, systematic basis is implemented. State regulators may refuse to
approve or may delay approval of such a transaction, which may impact our ability to innovate or operate efficiently.
Dividends. Dividends and distributions to Hallmark by our insurance company subsidiaries are restricted by the insurance
regulations of the respective state in which each insurance company subsidiary is domiciled. As property/casualty insurance
companies domiciled in the state of Texas, AHIC and TBIC may only pay dividends from unassigned surplus funds. In addition,
AHIC and TBIC must obtain the approval of the Texas Department of Insurance before the payment of extraordinary dividends,
which are defined as dividends or distributions of cash or other property the fair market value of which combined with the fair
market value of each other dividend or distribution made in the preceding 12 months exceeds the greater of: (1) statutory net
income as of the prior December 31st or (2) 10% of statutory policyholders’ surplus as of the prior December 31. HIC, domiciled
in Arizona, may pay dividends out of that part of its available surplus funds that is derived from realized net profits on its
business. Without prior written approval from the Arizona Department of Insurance, HIC may not pay extraordinary dividends,
which are defined as dividends or distributions of cash or other property the fair market value of which combined with the fair
market value of each other dividend or distribution made in the preceding 12 months exceeds the lesser of: (1) 10% of
statutory policyholders’ surplus as of the prior December 31 or (2) net investment income as of the prior December 31. HSIC,
domiciled in Oklahoma, may only pay dividends out of that part of its available surplus funds that is derived from realized net
profits on its business. Without prior written approval from the Oklahoma Insurance Department, HSIC may not pay
extraordinary dividends, which are defined as dividends or distributions of cash or other property the fair market value of which
combined with the fair market value of each other dividend or distribution made in the preceding 12 months exceeds the
greater of: (1) 10% of statutory policyholders’ surplus as of the prior December 31 or (2) statutory net income as of the prior
December 31, not including realized capital gains. HNIC, domiciled in Ohio, may only pay dividends out of that part of its
available surplus funds that is derived from earned surplus to shareholders. Without prior written approval from the Ohio
Department of Insurance, HNIC may not pay extraordinary dividends, which are defined as dividends or distributions of cash or
24
other property the fair market value of which combined with the fair market value of each other dividend or distribution made
in the preceding 12 months exceeds the greater of: (1) 10% of statutory policyholders’ surplus as of the prior December 31 or
(2) statutory net income as of the prior December 31. As a county mutual, dividends from HCM are payable to policyholders.
Risk-based capital requirements. The National Association of Insurance Commissioners requires property/casualty insurers to
file a risk-based capital calculation according to a specified formula. The purpose of the formula is twofold: (1) to assess the
adequacy of an insurer’s statutory capital and surplus based upon a variety of factors such as potential risks related to
investment portfolio, ceded reinsurance and product mix; and (2) to assist state regulators under the RBC for Insurers Model
Act by providing thresholds at which a state commissioner is authorized and expected to take regulatory action. As of
December 31, 2013, the adjusted capital under the risk-based capital calculation of each of our insurance company subsidiaries
substantially exceeded the minimum requirements.
Required licensing. Our non-insurance company subsidiaries are subject to and in compliance with the licensing requirements
of the department of insurance in each state in which they produce business. These licenses govern, among other things, the
types of insurance coverages, agency and claims services and products that we may offer consumers in these states. Such
licenses typically are issued only after we file an appropriate application and satisfy prescribed criteria. Generally, each state
requires one officer to maintain an agent license. Claims adjusters employed by us are also subject to the licensing
requirements of each state in which they conduct business. Each employed claim adjuster either holds or has applied for the
required licenses. Our premium finance subsidiaries are subject to licensing, financial reporting and certain financial
requirements imposed by the Texas Department of Insurance, as well as regulations promulgated by the Texas Office of
Consumer Credit Commissioner.
Regulation of insurance rates and approval of policy forms. The insurance laws of most states in which our subsidiaries
operate require insurance companies to file insurance rate schedules and insurance policy forms for review and approval. State
insurance regulators have broad discretion in judging whether our rates are adequate, not excessive and not unfairly
discriminatory and whether our policy forms comply with law. The speed at which we can change our rates depends, in part, on
the method by which the applicable state’s rating laws are administered. Generally, state insurance regulators have the
authority to disapprove our rates or request changes in our rates.
Restrictions on cancellation, non-renewal or withdrawal. Many states have laws and regulations that limit an insurance
company’s ability to exit a market. For example, certain states limit an automobile insurance company’s ability to cancel or not
renew policies. Some states prohibit an insurance company from withdrawing from one or more lines of business in the state,
except pursuant to a plan approved by the state insurance department. In some states, this applies to significant reductions in
the amount of insurance written, not just to a complete withdrawal. State insurance departments may disapprove a plan that
may lead to market disruption.
Investment restrictions. We are subject to state laws and regulations that require diversification of our investment portfolios
and that limit the amount of investments in certain categories. Failure to comply with these laws and regulations would cause
non-conforming investments to be treated as non-admitted assets for purposes of measuring statutory surplus and, in some
instances, would require divestiture.
Trade practices. The manner in which we conduct the business of insurance is regulated by state statutes in an effort to
prohibit practices that constitute unfair methods of competition or unfair or deceptive acts or practices. Prohibited practices
include disseminating false information or advertising; defamation; boycotting, coercion and intimidation; false statements or
entries; unfair discrimination; rebating; improper tie-ins with lenders and the extension of credit; failure to maintain proper
records; failure to maintain proper complaint handling procedures; and making false statements in connection with insurance
applications for the purpose of obtaining a fee, commission or other benefit.
Unfair claims practices. Generally, insurance companies, adjusting companies and individual claims adjusters are prohibited by
state statutes from engaging in unfair claims practices on a flagrant basis or with such frequency to indicate a general business
practice. Examples of unfair claims practices include:
•
•
misrepresenting pertinent facts or insurance policy provisions relating to coverages at issue;
failing to acknowledge and act reasonably promptly upon communications with respect to claims arising
under insurance policies;
25
•
•
•
•
•
•
•
•
•
•
failing to adopt and implement reasonable standards for the prompt investigation and settlement of claims
arising under insurance policies;
failing to affirm or deny coverage of claims within a reasonable time after proof of loss statements have
been completed;
attempting to settle a claim for less than the amount to which a reasonable person would have believed
such person was entitled;
attempting to settle claims on the basis of an application that was altered without notice to, or knowledge
and consent of, the insured;
compelling insureds to institute suits to recover amounts due under policies by offering substantially less
than the amounts ultimately recovered in suits brought by them;
refusing to pay claims without conducting a reasonable investigation;
making claim payments to an insured without indicating the coverage under which each payment is being
made;
delaying the investigation or payment of claims by requiring an insured, claimant or the physician of either
to submit a preliminary claim report and then requiring the subsequent submission of formal proof of loss
forms, both of which submissions contain substantially the same information;
failing, in the case of claim denials or offers of compromise or settlement, to promptly provide a reasonable
and accurate explanation of the basis for such actions; and
not attempting in good faith to effectuate prompt, fair and equitable settlements of claims in which liability
has become reasonably clear.
Employees
As of December 31, 2013, we employed 376 people on a full-time basis. None of our employees are represented by labor
unions. We consider our employee relations to be good.
Available Information
The Company’s executive offices are located at 777 Main Street, Suite 1000 Fort Worth, Texas 76102. The Company’s mailing
address is 777 Main Street, Suite 1000 Fort Worth, Texas 76102. Its telephone number is (817) 348-1600. The Company’s
website address is www.hallmarkgrp.com. The Company files annual, quarterly and current reports, proxy statements and
other information and documents with the U.S. Securities and Exchange Commission (the “SEC”), which are made available to
read and copy at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. You may obtain information
on the operation of the Public Reference Room by contacting the SEC at 1-800-SEC-0330. Reports filed with the SEC are also
made available at www.sec.gov. The Company makes available free of charge on its website its annual report on Form 10-K,
quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed with or furnished to the
SEC pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practical after it electronically
files them with or furnishes them to the SEC.
Item 1A. Risk Factors.
Our success depends on our ability to price accurately the risks we underwrite.
Our results of operations and financial condition depend on our ability to underwrite and set premium rates accurately for a
wide variety of risks. Adequate rates are necessary to generate premiums sufficient to pay losses, loss settlement expenses and
underwriting expenses and to earn a profit. To price our products accurately, we must collect and properly analyze a substantial
amount of data; develop, test and apply appropriate pricing techniques; closely monitor and timely recognize changes in
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trends; and project both severity and frequency of losses with reasonable accuracy. Our ability to undertake these efforts
successfully, and as a result price our products accurately, is subject to a number of risks and uncertainties, some of which are
outside our control, including:
•
•
•
•
the availability of sufficient reliable data and our ability to properly analyze available data;
the uncertainties that inherently characterize estimates and assumptions;
our selection and application of appropriate pricing techniques; and
changes in applicable legal liability standards and in the civil litigation system generally.
Consequently, we could underprice risks, which would adversely affect our profit margins, or we could overprice risks, which
could reduce our sales volume and competitiveness. In either case, our profitability could be materially and adversely affected.
Our results may fluctuate as a result of cyclical changes in the property/casualty insurance industry.
Our revenue is primarily attributable to property/casualty insurance, which as an industry is cyclical in nature and has
historically been characterized by soft markets followed by hard markets. A soft market is a period of relatively high levels of
price competition, less restrictive underwriting standards and generally low premium rates. A hard market is a period of capital
shortages resulting in lack of insurance availability, relatively low levels of competition, more selective underwriting of risks and
relatively high premium rates. If we find it necessary to reduce premiums or limit premium increases due to competitive
pressures on pricing in a softening market, we may experience a reduction in our premiums written and in our profit margins
and revenues, which could adversely affect our financial results.
Estimating reserves is inherently uncertain. If our loss reserves are not adequate, it will have an unfavorable impact on our
results.
We maintain loss reserves to cover our estimated ultimate liability for unpaid losses and LAE for reported and unreported
claims incurred as of the end of each accounting period. Reserves represent management’s estimates of what the ultimate
settlement and administration of claims will cost and are not reviewed by an independent actuary. These estimates, which
generally involve actuarial projections, are based on management’s assessment of facts and circumstances then known, as well
as estimates of future trends in claim severity and frequency, judicial theories of liability, and other factors. These variables are
affected by both internal and external events, such as changes in claims handling procedures, inflation, judicial trends and
legislative changes. Many of these factors are not quantifiable. Additionally, there may be a significant lag between the
occurrence of an event and the time it is reported to us. The inherent uncertainties of estimating reserves are greater for
certain types of liabilities, particularly those in which the various considerations affecting the type of claim are subject to
change and in which long periods of time may elapse before a definitive determination of liability is made. Reserve estimates
are continually refined in a regular and ongoing process as experience develops and further claims are reported and settled.
Adjustments to reserves are reflected in the results of the periods in which such estimates are changed. For example, a 1%
change in December 31, 2013 unpaid losses and LAE would have produced a $3.8 million change to pretax earnings. Our gross
loss and LAE reserves totaled $382.6 million at December 31, 2013. Our loss and LAE reserves, net of reinsurance recoverable
on unpaid loss and LAE, were $312.5 million at that date. Because setting reserves is inherently uncertain, there can be no
assurance that the current reserves will prove adequate.
Our failure to maintain favorable financial strength ratings could negatively impact our ability to compete successfully.
Third-party rating agencies assess and rate the claims-paying ability of insurers based upon criteria established by the agencies.
AHIC, HIC, HSIC and HNIC have entered into a pooling arrangement, pursuant to which AHIC retains 30% of the net premiums
written by any of them, HIC retains 27% of the net premiums written by any of them, HSIC retains 30% of the net premiums
written by any of them and HNIC retains 13% of the net premiums written by any of them. A.M. Best has pooled its ratings of
these four insurance company subsidiaries and assigned a financial strength rating of “A–” (Excellent) and an issuer credit rating
of “a-” to each of these individual insurance company subsidiaries and to the pool formed by these four insurance company
subsidiaries. Also, A.M. Best has assigned HCM a financial strength rating of “A–” (Excellent) and an issuer credit rating of “a-”.
A.M. Best does not assign a financial strength rating or an issuer credit rating to TBIC.
27
These financial strength ratings are used by policyholders, insurers, reinsurers and insurance and reinsurance intermediaries as
an important means of assessing the financial strength and quality of insurers. These ratings are not evaluations directed to
potential purchasers of our common stock and are not recommendations to buy, sell or hold our common stock. Our ratings are
subject to change at any time and could be revised downward or revoked at the sole discretion of the rating agencies. We
believe that the ratings assigned by A.M. Best are an important factor in marketing our products. Our ability to retain our
existing business and to attract new business in our insurance operations depends largely on these ratings. Our failure to
maintain our ratings, or any other adverse development with respect to our ratings, could cause our current and future
independent agents and insureds to choose to transact their business with more highly rated competitors. If A.M. Best
downgrades our ratings or publicly indicates that our ratings are under review, it is likely that we would not be able to compete
as effectively with our competitors, and our ability to sell insurance policies could decline. If that happens, our sales and
earnings would decrease. For example, many of our agencies and insureds have guidelines that require us to have an A.M. Best
financial strength rating of “A-” (Excellent) or higher. A reduction of our A.M. Best rating below “A-” would prevent us from
issuing policies to insureds or potential insureds with such ratings requirements.
Lenders and reinsurers also use our A.M. Best ratings as a factor in deciding whether to transact business with us. The failure of
our insurance company subsidiaries to maintain their current ratings could dissuade a lender or reinsurance company from
conducting business with us or might increase our interest or reinsurance costs. In addition, a ratings downgrade by A.M. Best
below “A-” would require us to post collateral in support of our obligations under certain of our reinsurance agreements
pursuant to which we assume business.
The loss of key executives could disrupt our business.
Our success will depend in part upon the continued service of certain key executives. Our success will also depend on our ability
to attract and retain additional executives and personnel. We do not have employment agreements with our Chief Executive
Officer or any of our other executive officers. The loss of key personnel, or our inability to recruit and retain additional qualified
personnel, could cause disruption in our business and could prevent us from fully implementing our business strategies, which
could materially and adversely affect our business, growth and profitability.
Our industry is very competitive, which may unfavorably impact our results of operations.
The property/casualty insurance market, our primary source of revenue, is highly competitive and, except for regulatory
considerations, has very few barriers to entry. According to A.M. Best, there were 3,196 property/casualty insurance companies
and 2,135 property/casualty insurance groups operating in North America as of July 16, 2013. Our competitors include entities
that have, or are affiliated with entities that have, greater financial and other resources than we have. In addition, competitors
may attempt to increase market share by lowering rates. In that case, we could experience reductions in our underwriting
margins, or sales of our insurance policies could decline as customers purchase lower-priced products from our competitors.
Losing business to competitors offering similar products at lower prices, or having other competitive advantages, could
adversely affect our results of operations.
Our results may be unfavorably impacted if we are unable to obtain adequate reinsurance.
As part of our overall risk and capacity management strategy, we purchase reinsurance for significant amounts of risk,
especially catastrophe risks that we and our insurance company subsidiaries underwrite. Our catastrophe and non-catastrophe
reinsurance facilities are generally subject to annual renewal. We may be unable to maintain our current reinsurance facilities
or to obtain other reinsurance facilities in adequate amounts and at favorable rates. The amount, availability and cost of
reinsurance are subject to prevailing market conditions beyond our control, and may affect our ability to write additional
premiums as well as our profitability. If we are unable to obtain adequate reinsurance protection for the risks we have
underwritten, we will either be exposed to greater losses from these risks or we will reduce the level of business that we
underwrite, which will reduce our revenue.
If the companies that provide our reinsurance do not pay our claims in a timely manner, we could incur severe losses.
We purchase reinsurance by transferring, or ceding, part of the risk we have assumed to a reinsurance company in exchange for
part of the premium we receive in connection with the risk. Although reinsurance makes the reinsurer liable to us to the extent
the risk is transferred or ceded to the reinsurer, it does not relieve us of our liability to our policyholders. Accordingly, we bear
credit risk with respect to our reinsurers. We cannot assure that our reinsurers will pay all of our reinsurance claims, or that
they will pay our claims on a timely basis. At December 31, 2013, we had a total of $121.8 million due us from reinsurers,
including $76.8 million of recoverables from losses and $45.0 million in ceded unearned premiums. The largest amount due us
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from a single reinsurer as of December 31, 2013 was $13.5 million reinsurance and premium recoverable from Partner
Reinsurance Company of the United States. If any of our reinsurers are unable or unwilling to pay amounts they owe us in a
timely fashion, we could suffer a significant loss or a shortage of liquidity, which would have a material adverse effect on our
business and results of operations.
Catastrophic losses are unpredictable and may adversely affect our results of operations, liquidity and financial condition.
Property/casualty insurance companies are subject to claims arising out of catastrophes that may have a significant effect on
their results of operations, liquidity and financial condition. Catastrophes can be caused by various events, including hurricanes,
windstorms, earthquakes, hail storms, explosions, severe winter weather and fires, and may include man-made events, such as
terrorist attacks. The incidence, frequency, and severity of catastrophes are inherently unpredictable. The extent of losses from
a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of
the event.
Claims from catastrophic events could reduce our net income, cause substantial volatility in our financial results for any fiscal
quarter or year or otherwise adversely affect our financial condition, liquidity or results of operations. Catastrophes may also
negatively affect our ability to write new business. Increases in the value and geographic concentration of insured property and
the effects of inflation could increase the severity of claims from catastrophic events in the future.
Catastrophe models may not accurately predict future losses.
Along with other insurers in the industry, we use models developed by third-party vendors in assessing our exposure to
catastrophe losses that assume various conditions and probability scenarios. However, these models do not necessarily
accurately predict future losses or accurately measure losses currently incurred. Catastrophe models, which have been evolving
since the early 1990s, use historical information about various catastrophes and detailed information about our in-force
business. While we use this information in connection with our pricing and risk management activities, there are limitations
with respect to their usefulness in predicting losses in any reporting period. Examples of these limitations are significant
variations in estimates between models and modelers and material increases and decreases in model results due to changes
and refinements of the underlying data elements and assumptions. Such limitations lead to questionable predictive capability
and post-event measurements that have not been well understood or proven to be sufficiently reliable. In addition, the models
are not necessarily reflective of company or state-specific policy language, demand surge for labor and materials or loss
settlement expenses, all of which are subject to wide variation by catastrophe. Because the occurrence and severity of
catastrophes are inherently unpredictable and may vary significantly from year to year, historical results of operations may not
be indicative of future results of operations.
We are subject to comprehensive regulation, and our results may be unfavorably impacted by these regulations.
We are subject to comprehensive governmental regulation and supervision. Most insurance regulations are designed to protect
the interests of policyholders rather than of the stockholders and other investors of the insurance companies. These
regulations, generally administered by the department of insurance in each state in which we do business, relate to, among
other things:
•
•
•
•
•
•
•
approval of policy forms and rates;
standards of solvency, including risk-based capital measurements, which are a measure developed by the
National Association of Insurance Commissioners and used by the state insurance regulators to identify
insurance companies that potentially are inadequately capitalized;
licensing of insurers and their agents;
restrictions on the nature, quality and concentration of investments;
restrictions on the ability of insurance company subsidiaries to pay dividends;
restrictions on transactions between insurance company subsidiaries and their affiliates;
requiring certain methods of accounting;
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•
•
•
•
•
•
•
•
•
•
periodic examinations of operations and finances;
the use of non-public consumer information and related privacy issues;
the use of credit history in underwriting and rating;
limitations on the ability to charge policy fees;
the acquisition or disposition of an insurance company or of any company controlling an insurance
company;
involuntary assignments of high-risk policies, participation in reinsurance facilities and underwriting
associations, assessments and other governmental charges;
restrictions on the cancellation or non-renewal of policies and, in certain jurisdictions, withdrawal from
writing certain lines of business;
prescribing the form and content of records of financial condition to be filed;
requiring reserves for unearned premium, losses and other purposes; and
with respect to premium finance business, the federal Truth-in-Lending Act and similar state statutes. In
states where specific statutes have not been enacted, premium finance is generally subject to state usury
laws that are applicable to consumer loans.
State insurance departments also conduct periodic examinations of the affairs of insurance companies and require filing of
annual and other reports relating to the financial condition of insurance companies, holding company issues and other matters.
Our business depends on compliance with applicable laws and regulations and our ability to maintain valid licenses and
approvals for our operations. Regulatory authorities may deny or revoke licenses for various reasons, including violations of
regulations. Changes in the level of regulation of the insurance industry or changes in laws or regulations themselves or
interpretations by regulatory authorities could have a material adverse affect on our operations. In addition, we could face
individual, group and class-action lawsuits by our policyholders and others for alleged violations of certain state laws and
regulations. Each of these regulatory risks could have an adverse effect on our profitability.
State statutes limit the aggregate amount of dividends that our subsidiaries may pay Hallmark, thereby limiting its funds to
pay expenses and dividends.
Hallmark is a holding company and a legal entity separate and distinct from its subsidiaries. As a holding company without
significant operations of its own, Hallmark’s principal sources of funds are dividends and other sources of funds from its
subsidiaries. State insurance laws limit the ability of Hallmark’s insurance company subsidiaries to pay dividends and require
our insurance company subsidiaries to maintain specified minimum levels of statutory capital and surplus. The aggregate
maximum amount of dividends permitted by law to be paid by an insurance company does not necessarily define an insurance
company’s actual ability to pay dividends. The actual ability to pay dividends may be further constrained by business and
regulatory considerations, such as the impact of dividends on surplus, by our competitive position and by the amount of
premiums that we can write. Without regulatory approval, the aggregate maximum amount of dividends that could be paid to
Hallmark in 2014 by our insurance company subsidiaries is $15.6 million. State insurance regulators have broad discretion to
limit the payment of dividends by insurance companies and Hallmark’s right to participate in any distribution of assets of one of
our insurance company subsidiaries is subject to prior claims of policyholders and creditors except to the extent that its rights,
if any, as a creditor are recognized. Consequently, Hallmark’s ability to pay debts, expenses and cash dividends to our
stockholders may be limited.
Our insurance company subsidiaries are subject to minimum capital and surplus requirements. Failure to meet these
requirements could subject us to regulatory action.
Our insurance company subsidiaries are subject to minimum capital and surplus requirements imposed under the laws of their
respective states of domicile and each state in which they issue policies. Any failure by one of our insurance company
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subsidiaries to meet minimum capital and surplus requirements imposed by applicable state law will subject it to corrective
action, which may include requiring adoption of a comprehensive financial plan, revocation of its license to sell insurance
products or placing the subsidiary under state regulatory control. Any new minimum capital and surplus requirements adopted
in the future may require us to increase the capital and surplus of our insurance company subsidiaries, which we may not be
able to do.
We are subject to assessments and other surcharges from state guaranty funds, mandatory reinsurance arrangements and
state insurance facilities, which may reduce our profitability.
Virtually all states require insurers licensed to do business therein to bear a portion of the unfunded obligations of impaired or
insolvent insurance companies. These obligations are funded by assessments, which are levied by guaranty associations within
the state, up to prescribed limits, on all member insurers in the state on the basis of the proportionate share of the premiums
written by member insurers in the lines of business in which the impaired, insolvent or failed insurer was engaged. Accordingly,
the assessments levied on us by the states in which we are licensed to write insurance may increase as we increase our
premiums written. In addition, as a condition to the ability to conduct business in certain states, insurance companies are
required to participate in mandatory reinsurance funds. The effect of these assessments and mandatory reinsurance
arrangements, or changes in them, could reduce our profitability in any given period or limit our ability to grow our business.
We monitor developments with respect to various state facilities, such as the Texas FAIR Plan and the Texas Windstorm
Insurance Association. The impact of any catastrophe experience on these facilities could result in the facilities recognizing a
financial deficit or a financial deficit greater than the level currently estimated. They may, in turn, have the ability to assess
participating insurers when financial deficits occur, adversely affecting our results of operations. While these facilities are
generally designed so that the ultimate cost is borne by policyholders, the exposure to assessments and the availability of
recoupments or premium rate increases from these facilities may not offset each other in our financial statements. Moreover,
even if they do offset each other, they may not offset each other in financial statements for the same fiscal period due to the
ultimate timing of the assessments and recoupments or premium rate increases, as well as the possibility of policies not being
renewed in subsequent years.
Adverse securities market conditions can have a significant and negative impact on our investment portfolio.
Our results of operations depend in part on the performance of our invested assets. As of December 31, 2013, 89% of our
investment portfolio was invested in fixed-income securities. Certain risks are inherent in connection with fixed-income
securities, including loss upon default and price volatility in reaction to changes in interest rates and general market factors. In
general, the fair value of a portfolio of fixed-income securities increases or decreases inversely with changes in the market
interest rates, while net investment income realized from future investments in fixed-income securities increases or decreases
along with interest rates. In addition, 12% of our fixed-income securities have call or prepayment options. This subjects us to
reinvestment risk should interest rates fall and issuers call their securities. Furthermore, actual net investment income and/or
cash flows from investments that carry prepayment risk, such as mortgage-backed and other asset-backed securities, may differ
from those anticipated at the time of investment as a result of interest rate fluctuations. An investment has prepayment risk
when there is a risk that cash flows from the repayment of principal might occur earlier than anticipated because of declining
interest rates or later than anticipated because of rising interest rates. The fair value of our fixed-income securities as of
December 31, 2013 was $410.1 million. If market interest rates were to increase 1%, the fair value of our fixed-income
securities would decrease by approximately $12.2 million as of December 31, 2013. The calculated change in fair value was
determined using duration modeling assuming no prepayments.
In addition to the general risks described above, although 76% of our portfolio is investment-grade, our fixed-income securities
are nonetheless subject to credit risk. If any of the issuers of our fixed-income securities suffer financial setbacks, the ratings on
the fixed-income securities could fall (with a concurrent fall in market value) and, in a worst case scenario, the issuer could
default on its obligations. As of December 31, 2013 Hallmark had $0.3 million exposed in its investment portfolio to sub-prime
mortgages and $27.7 million total exposure in mortgage-backed securities. Future changes in the fair value of our available-for-
sale securities will be reflected in other comprehensive income.
Similar treatment is not available for liabilities. Therefore, interest rate fluctuations could adversely affect our stockholders’
equity, total comprehensive income and/or cash flows.
We rely on independent agents and specialty brokers to market our products and their failure to do so would have a
material adverse effect on our results of operations.
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We market and distribute our insurance programs exclusively through independent insurance agents and specialty insurance
brokers. As a result, our business depends in large part on the marketing efforts of these agents and brokers and on our ability
to offer insurance products and services that meet the requirements of the agents, the brokers and their customers. However,
these agents and brokers are not obligated to sell or promote our products and many sell or promote competitors’ insurance
products in addition to our products. Some of our competitors have higher financial strength ratings, offer a larger variety of
products, set lower prices for insurance coverage and/or offer higher commissions than we do. Therefore, we may not be able
to continue to attract and retain independent agents and brokers to sell our insurance products. The failure or inability of
independent agents and brokers to market our insurance products successfully could have a material adverse impact on our
business, financial condition and results of operations.
We may experience difficulty in integrating acquisitions into our operations.
The successful integration of any newly acquired businesses into our operations will require, among other things, the retention
and assimilation of their key management, sales and other personnel; the coordination of their lines of insurance products and
services; the adaptation of their technology, information systems and other processes; and the retention and transition of their
customers. Unexpected difficulties in integrating any acquisition could result in increased expenses and the diversion of
management time and resources. If we do not successfully integrate any acquired business into our operations, we may not
realize the anticipated benefits of the acquisition, which could have a material adverse impact on our financial condition and
results of operations. Further, any potential acquisitions may require significant capital outlays and, if we issue equity or
convertible debt securities to pay for an acquisition, the issuance may be dilutive to our existing stockholders.
Our internal controls are not fail-safe.
We continually enhance our operating procedures and internal controls to effectively support our business and comply with our
regulatory and financial reporting requirements. As a result of the inherent limitations in all control systems, no system of
controls can provide absolute assurance that all control objectives have been or will be met, and that every instance of error or
fraud has been or will be detected. A control system, no matter how well conceived and operated, can provide only reasonable,
not absolute, assurance that the objectives of the control system are met. These inherent limitations include the realities that
judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Additionally,
controls can be circumvented by individual acts or by collusion of two or more persons. The design of any system of controls is
based in part upon assumptions about the likelihood of future events, and there can be no assurance that any design will
succeed in achieving its stated goals under all potential future conditions. Internal controls may also become inadequate
because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate. Further, the design
of a control system must reflect resource constraints, and the benefits of controls must be considered relative to their costs. As
a result of the inherent limitations in a cost-effective control system, misstatement due to error or fraud may occur and not be
detected. Accordingly, our internal controls and procedures are designed to provide reasonable, not absolute, assurance that
the control objectives are met.
Our geographic concentration ties our performance to the business, economic and regulatory conditions of certain states.
The following states accounted for 67% of our gross written premiums for 2013: Texas (52%), Louisiana (5%), Arizona (4%),
Oregon (3%) and New Mexico (3%). Our revenues and profitability are subject to the prevailing regulatory, legal, economic,
political, demographic, competitive, weather and other conditions in the principal states in which we do business. Changes in
any of these conditions could make it less attractive for us to do business in such states and would have a more pronounced
effect on us compared to companies that are more geographically diversified. In addition, our exposure to severe losses from
localized natural perils, such as windstorms or hailstorms, is increased in those areas where we have written significant
numbers of property/casualty insurance policies.
The exclusions and limitations in our policies may not be enforceable.
Many of the policies we issue include exclusions or other conditions that define and limit coverage, which exclusions and
conditions are designed to manage our exposure to certain types of risks and expanding theories of legal liability. In addition,
many of our policies limit the period during which a policyholder may bring a claim under the policy, which period in many
cases is shorter than the statutory period under which these claims can be brought by our policyholders. While these exclusions
and limitations help us assess and control our loss exposure, it is possible that a court or regulatory authority could nullify or
void an exclusion or limitation, or legislation could be enacted modifying or barring the use of these exclusions and limitations.
This could result in higher than anticipated losses and LAE by extending coverage beyond our underwriting intent or increasing
the number or size of claims, which could have a material adverse effect on our operating results. In some instances, these
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changes may not become apparent until sometime after we have issued the insurance policies that are affected by the changes.
As a result, the full extent of liability under our insurance contracts may not be known for many years after a policy is issued.
We rely on our information technology and telecommunications systems and the failure or disruption of these systems could
disrupt our operations and adversely affect our results of operations.
Our business is highly dependent upon the successful and uninterrupted functioning of our information technology and
telecommunications systems. We rely on these systems to process new and renewal business, provide customer service, make
claims payments and facilitate collections and cancellations, as well as to perform actuarial and other analytical functions
necessary for pricing and product development. Our systems could fail of their own accord or might be disrupted by factors
such as natural disasters, power disruptions or surges, computer hackers or terrorist attacks. Failure or disruption of these
systems for any reason could interrupt our business and adversely affect our results of operations.
Cyber security risks in particular are evolving and include malicious software, unauthorized access to data and other electronic
security breaches. We have not experienced cyber security attacks in the past and believe that we have adopted appropriate
measures to mitigate potential risks to our information technology systems. However, the timing, nature and scope of cyber
security attacks are difficult to predict and prevent. Therefore, we could be subject to operational delays, compromised
confidential or proprietary information, destruction or corruption of data, manipulation or improper use of our systems and
networks, financial losses from remedial actions and/or damage to our reputation from cyber security attacks. A cyber security
attack on our information technology systems could disrupt our business and adversely affect our results of operations and
financial position.
Global climate change may have an adverse effect on our financial statements.
Although uncertainty remains as to the nature and effect of greenhouse gas emissions, we could suffer losses if global climate
change results in an increase in the frequency and severity of natural disasters. As with traditional natural disasters, claims
arising from these incidents could increase our exposure to losses and have a material adverse impact on our business, results
of operations, and/or financial condition.
Item 1B. Unresolved Staff Comments.
Not applicable
Item 2. Properties.
Our corporate headquarters and Standard Commercial P&C business unit are located at 777 Main Street, Suite 1000, Fort
Worth, Texas. The suite is located in a high-rise office building and contains 27,808 square feet of space. The rent is currently
$47,505 per month pursuant to a lease which expires June 30, 2022.
Our Workers Compensation business unit is presently located at 11612 Bee Caves Road, Austin, Texas. The suite is located in a
low-rise office building and contains 8,373 square feet of space of which 1,037 square feet is sub-leased. The gross rent is
currently $17,269 per month pursuant to a lease which expires October 31, 2017.
Our E&S Commercial business unit is presently located at 7550 IH-10 West, San Antonio, Texas. These leased premises consist
of a 16,599 square foot office suite and 800 square feet of storage space. The rent is currently $32,632 per month pursuant to a
lease that expires November 30, 2020.
Our Hallmark Select business unit is located at 15280 Addison Road, Suites 250 and 260, Addison, Texas. The suites are located
in a low-rise office building and contain an aggregate of 12,277 square feet of space. The rent is currently $14,834 per month
pursuant to a lease that expires July 31, 2018. Our Hallmark Select business unit also maintains a branch office in Glendale,
California. Rent on the suite is currently $2,500 per month pursuant to a lease which expires July 31, 2015. Our Hallmark Select
business unit also maintains a small office in Chicago, Illinois, the fixed rent on which is currently $8,265 per month under a
lease that expires April 30, 2017.
Our Personal Lines business unit is located at 6500 Pinecrest, Suite 100, Plano, Texas. The suite is located in a one story office
building and contains 23,941 square feet of space. The rent is currently $28,611 per month pursuant to a lease that expires
January 31, 2016.
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Item 3. Legal Proceedings.
In December 2010, HSU was informed by the Texas Comptroller of Public Accounts that a surplus lines tax audit covering the
period January 1, 2007 through December 31, 2009 was complete. HSU frequently acts as a managing general underwriter
(“MGU”) authorized to underwrite policies on behalf of Republic Vanguard Insurance Company and HSIC, both Texas eligible
surplus lines insurance carriers. In its role as the MGU, HSU underwrites policies on behalf of these carriers while other agencies
located in Texas generally referred to as “producing agents” deliver the policies to the insureds and collect all premiums due
from the insureds. During the period under audit, the producing agents also collected the surplus lines premium taxes due on
the policies from the insureds, held them in trust, and timely remitted those taxes to the Comptroller. We believe this system
for collecting and paying the required surplus lines premium taxes complies in all respects with the Texas Insurance Code and
other regulations, which clearly require that the same party who delivers the policies and collects the premiums will also collect
premium taxes, hold premium taxes in trust, and pay premium taxes to the Comptroller. It also complies with long standing
industry practice. The Comptroller asserts that HSU is liable for the surplus lines premium taxes related to policy transactions
and premiums collected from surplus lines insureds during the audit period and that HSU therefore owes $4.5 million in
premium taxes, as well as $0.9 million in penalties and interest for the audit period.
We disagree with the Comptroller and intend to vigorously fight their assertion that HSU is liable for the surplus lines premium
taxes. During the past year we have been engaged in conversations with the Comptroller’s counsel. We are currently in
negotiations with the Comptroller to settle the matter. However, we are presently unable to reasonably estimate the possible
loss or legal costs that are likely to arise out of the surplus lines tax audit or any future proceedings relating to this matter.
Therefore we have not accrued any amount as of December 31, 2013 related to this matter.
We are engaged in various legal proceedings that are routine in nature and incidental to our business. None of these
proceedings, either individually or in the aggregate, are believed, in our opinion, to have a material adverse effect on our
consolidated financial position or our results of operations.
Item 4. Mine Safety Disclosures.
Not applicable.
34
PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity
Securities.
Market for Common Stock
Our common stock is currently traded on the Nasdaq Global Market under the symbol “HALL.” The following table shows the
high and low sales prices of our common stock on the Nasdaq Global Market for each quarter since January 1, 2012.
Period
Year Ended December 31, 2013:
First quarter
Second quarter
Third quarter
Fourth quarter
Year Ended December 31, 2012:
First quarter
Second quarter
Third quarter
Fourth quarter
Holders
High Sale
Low Sale
$
$
$
$
9.67
9.40
10.03
9.52
8.09
8.30
8.32
9.71
8.36
8.03
8.18
8.05
6.57
6.95
7.29
6.71
As of March 5, 2014, there were 1,866 shareholders of record of our common stock.
Dividends
Hallmark has never paid dividends on its common stock. Our board of directors intends to continue this policy for the
foreseeable future in order to retain earnings for development of our business.
Hallmark is a holding company and a legal entity separate and distinct from its subsidiaries. As a holding company, Hallmark is
dependent on dividend payments and management fees from its subsidiaries to pay dividends and make other payments. State
insurance laws limit the ability of our insurance company subsidiaries to pay dividends to Hallmark. As property/casualty
insurance companies domiciled in the state of Texas, AHIC and TBIC are limited in the payment of dividends to Hallmark in any
12-month period, without the prior written consent of the Texas Department of Insurance, to the greater of statutory net
income for the prior calendar year or 10% of statutory policyholders’ surplus as of the prior year end. HIC, domiciled in Arizona,
is limited in the payment of dividends to the lesser of 10% of prior year policyholders surplus or prior year’s net investment
income, without prior written approval from the Arizona Department of Insurance. HSIC, domiciled in Oklahoma, is limited in
the payment of dividends to the greater of 10% of prior year policyholders’ surplus or prior year’s statutory net income, not
including realized capital gains, without prior written approval from the Oklahoma Insurance Department. HNIC, domiciled in
Ohio, is limited to the greater of 10% of statutory policyholders’ surplus as of the prior December 31 or statutory net income as
of the prior December 31, without prior written approval from the Ohio Insurance Department. For all our insurance
companies, dividends may only be paid from unassigned surplus funds. As a county mutual, dividends from HCM are payable to
policyholders.
35
Equity Compensation Plan Information
The following table sets forth information regarding shares of our common stock authorized for issuance under our equity
compensation plans as of December 31, 2013.
Plan Category
Equity compensation plans approved by
security holders
Equity compensation plans not approved by
security holders
Total
Number of securities
to be issued upon
exercise of outstanding
options, warrants and
rights
(a)
Weighted-average
exercise price of
outstanding options,
warrants and rights
(b)
Number of securities
remaining available
for future issuance
under equity compensation
plans [excluding securities
reflected in column (a)](1)
(c)
1,387,489
$
-
1,387,489
$
9.66
-
9.66
241,401
-
241,401
(1) Securities remaining available for future issuance are net of a maximum of 355,277 shares of common stock issuable
pursuant to outstanding restricted stock units, subject to applicable vesting requirements and performance criteria. See Note
13 to the audited consolidated financial statements included in this report.
Issuer Repurchases
We did not repurchase any shares of our common stock during the fourth quarter of 2013.
36
Performance Graph
The following graph compares the five year cumulative total return provided shareholders on Hallmark’s common stock relative
to the cumulative total returns of the NASDAQ Composite Index, the NASDAQ Insurance Index, and the S&P Property &
Casualty Insurance Index. An investment of $100 (with reinvestment of all dividends) is assumed to have been made in our
common stock and in each index on December 31, 2008 and its relative performance is tracked through December 31, 2013.
COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among Hallmark Financial Services, Inc., the NASDAQ Composite Index,
the S&P Property & Casualty Insurance Index, and the NASDAQ Insurance Index
$300
$250
$200
$150
$100
$50
$0
12/08
12/09
12/10
12/11
12/12
12/13
Hallmark Financial Services, Inc.
NASDAQ Composite
S&P Property & Casualty Insurance
NASDAQ Insurance
*$100 invested on 12/31/08 in stock or index, including reinvestment of dividends.
Fiscal year ending December 31.
Copyright© 2014 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved.
37
Item 6. Selected Financial Data
Statement of Operations Data:
Gross premiums written
Ceded premiums written
Net premiums written
Change in unearned premiums
Net premiums earned
Investment income, net of expenses
Realized gains
Finance charges
Commission and fees
Other income
Total revenues
Loss and loss adjustment expenses
Other operating costs and expenses
Interest expense
Amortization of intangible assets
Total expenses
Income (loss) before tax
Income tax expense (benefit)
Net income (loss)
Less: Net income attributable to non-controlling
interest
Net income (loss) attributable to Hallmark
Financial Services, Inc.
Net income (loss) per share attributable to
Hallmark Financial Services, Inc. common
stockholders:
Basic
Diluted
2013
2012
2011
2010
2009
(in thousands, except per share data)
Year Ended December 31,
$
$
460,027
(99,262 )
360,765
(224 )
360,541
12,884
10,540
5,830
(487 )
120
389,428
261,345
109,289
4,599
3,115
378,348
11,080
2,835
8,245
-
$
389,842
(57,353 )
332,489
(13,053 )
319,436
15,293
1,943
5,957
(1,145 )
316
341,800
226,414
103,792
4,634
3,586
338,426
3,374
(474 )
3,848
324
354,881
(51,005 )
303,876
(10,835 )
293,041
15,880
3,633
6,826
3,175
216
322,771
239,235
95,106
4,631
3,586
342,558
(19,787 )
(8,954 )
(10,833 )
58
$
320,973
(39,332 )
281,641
(3,370 )
278,271
14,849
8,402
7,054
(1,575 )
59
307,060
202,544
87,882
4,598
3,665
298,689
8,371
863
7,508
105
$
287,558
(25,818 )
261,740
(10,668 )
251,072
14,947
3,032
5,874
12,011
103
287,039
153,619
92,233
4,602
3,328
253,782
33,257
8,630
24,627
52
8,245
3,524
(10,891 )
7,403
24,575
$
$
0.43
0.43
$
$
0.18
0.18
$
$
(0.55 )
(0.55 )
$
$
0.37
0.37
$
$
1.19
1.19
Balance Sheet Items:
Total investments
Total assets
Reserves for unpaid loss and loss adjustment expenses
Unearned premiums
Total liabilities
Total stockholders' equity
2013
$ 461,325
$ 909,023
$ 382,640
$ 185,303
$ 670,905
$ 238,118
$
$
$
$
$
$
As of December 31, 2013
2011
2010
2012
445,360
790,468
313,416
162,502
569,931
220,537
$
$
$
$
$
$
424,628
746,059
296,945
146,104
529,203
215,572
$
$
$
$
$
$
432,441
736,557
251,677
140,965
499,919
235,278
2009
$ 327,677
$ 628,869
$ 184,662
$ 125,089
$ 401,228
$ 226,517
Book value per share
$
12.36
$
11.45
$
11.19
$
11.69
$
11.26
38
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following discussion should be read together with our consolidated financial statements and the notes thereto. This
discussion contains forward-looking statements. Please see “Risks Associated with Forward-Looking Statements in this Form 10-
K” for a discussion of some of the uncertainties, risks and assumptions associated with these statements.
Overview
Hallmark is an insurance holding company which, through its subsidiaries, engages in the sale of property/casualty insurance
products to businesses and individuals. Our business involves marketing, distributing, underwriting and servicing our insurance
products, as well as providing other insurance related services. We pursue our business activities primarily through subsidiaries
whose operations are organized into business units and are supported by our insurance carrier subsidiaries.
Our insurance activities are organized by business units into the following reportable segments:
•
•
•
Standard Commercial Segment. The Standard Commercial Segment includes the standard lines commercial
property/casualty and occupational accident insurance products and services handled by our Standard Commercial
P&C business unit and the workers compensation insurance products handled by our Workers Compensation
business unit. Our Standard Commercial P&C business unit is comprised of our American Hallmark Insurance Services
and ECM subsidiaries. Our Workers Compensation business unit is comprised of our TBIC Holdings, TBIC and TBICRM
subsidiaries. The Workers Compensation business unit was acquired July 1, 2011.
Specialty Commercial Segment. Our Specialty Commercial Segment includes the excess and surplus lines commercial
property/casualty insurance products and services handled by our E&S Commercial business unit and the general
aviation, satellite launch, commercial umbrella and excess liability and medical professional liability insurance
products and services handled by our Hallmark Select business unit, as well as certain Specialty Programs which are
managed at the parent level. Our E&S Commercial business unit is comprised of our HSU, PAAC and TGASRI
subsidiaries. Our Hallmark Select business unit is comprised of our Aerospace Insurance Managers, ASRI, ACMG, HXS
and HDS subsidiaries.
Personal Segment. The Personal Segment
low value
dwelling/homeowners, renters, manufactured homes, motorcycle and business auto insurance products and services
handled by our Personal Lines business unit that is comprised of American Hallmark General Agency, Inc. and
Hallmark Claims Services, Inc., both of which do business as Hallmark Insurance Company.
includes the non-standard personal automobile,
The retained premium produced by these reportable segments is supported by our American Hallmark Insurance Company of
Texas, Hallmark Specialty Insurance Company, Hallmark Insurance Company, Hallmark National Insurance Company and Texas
Builders Insurance Company insurance subsidiaries. In addition, control and management of Hallmark County Mutual is
maintained through our wholly owned subsidiary, CYR Insurance Management Company (“CYR”). CYR has as its primary asset a
management agreement with HCM which provides for CYR to have management and control of HCM. HCM is used to front
certain lines of business in our Specialty Commercial and Personal Segments in Texas. HCM does not retain any business.
AHIC, HIC, HSIC and HNIC have entered into a pooling arrangement pursuant to which AHIC retains 30% of the net premiums
written by any of them, HIC retains 27% of the net premiums written by any of them, HSIC retains 30% of the net premiums
written by any of them and HNIC retains 13% of the net premiums written by any of them. Neither HCM nor TBIC is a party to
the intercompany pooling arrangement.
Critical Accounting Estimates and Judgments
The significant accounting policies requiring our estimates and judgments are discussed below. Such estimates and judgments
are based on historical experience, changes in laws and regulations, observance of industry trends and information received
from third parties. While the estimates and judgments associated with the application of these accounting policies may be
affected by different assumptions or conditions, we believe the estimates and judgments associated with the reported
consolidated financial statement amounts are appropriate in the circumstances. For additional discussion of our accounting
policies, see Note 1 to the audited consolidated financial statements included in this report.
39
Impairment of investments. We complete a detailed analysis each quarter to assess whether any decline in the fair value of any
investment below cost is deemed other-than-temporary. All securities with an unrealized loss are reviewed. We recognize an
impairment loss when an investment’s value declines below cost, adjusted for accretion, amortization and previous other-than-
temporary impairments and it is determined that the decline is other-than-temporary.
Debt Investments: We assess whether we intend to sell, or it is more likely than not that we will be required to sell, a fixed
maturity investment before recovery of its amortized cost basis less any current period credit losses. For fixed maturity
investments that are considered other-than-temporarily impaired and that we do not intend to sell and will not be required to
sell, we separate the amount of the impairment into the amount that is credit related (credit loss component) and the amount
due to all other factors. The credit loss component is recognized in earnings and is the difference between the investment’s
amortized cost basis and the present value of its expected future cash flows. The remaining difference between the
investment’s fair value and the present value of future expected cash flows is recognized in other comprehensive income.
Equity Investments: Some of the factors considered in evaluating whether a decline in fair value for an equity investment is
other-than-temporary include: (1) our ability and intent to retain the investment for a period of time sufficient to allow for an
anticipated recovery in value; (2) the recoverability of cost; (3) the length of time and extent to which the fair value has been
less than cost; and (4) the financial condition and near-term and long-term prospects for the issuer, including the relevant
industry conditions and trends, and implications of rating agency actions and offering prices. When it is determined that an
equity investment is other-than-temporarily impaired, the security is written down to fair value, and the amount of the
impairment is included in earnings as a realized investment loss. The fair value then becomes the new cost basis of the
investment, and any subsequent recoveries in fair value are recognized at disposition. We recognize a realized loss when
impairment is deemed to be other-than-temporary even if a decision to sell an equity investment has not been made. When we
decide to sell a temporarily impaired available-for-sale equity investment and we do not expect the fair value of the equity
investment to fully recover prior to the expected time of sale, the investment is deemed to be other-than-temporarily impaired
in the period in which the decision to sell is made.
Fair values of financial instruments. Accounting Standards Codification (“ASC”) 820 defines fair value, establishes a consistent
framework for measuring fair value and expands disclosure requirements about fair value measurements. ASC 820, among
other things, requires us to maximize the use of observable inputs and minimize the use of unobservable inputs when
measuring fair value. In addition, ASC 820 precludes the use of block discounts when measuring the fair value of instruments
traded in an active market, which were previously applied to large holdings of publicly traded equity securities.
We determine the fair value of our financial instruments based on the fair value hierarchy established in ASC 820. In accordance
with ASC 820, we utilize the following fair value hierarchy:
•
•
•
Level 1: quoted prices in active markets for identical assets;
Level 2: inputs to the valuation methodology include quoted prices for similar assets and liabilities in active
markets, inputs of identical assets for less active markets, and inputs that are observable for the asset or
liability, either directly or indirectly, for substantially the full term of the instrument; and
Level 3: inputs to the valuation methodology that are unobservable for the asset or liability.
This hierarchy requires the use of observable market data when available.
Under ASC 820, we determine fair value based on the price that would be received for an asset or paid to transfer a liability in
an orderly transaction between market participants on the measurement date. It is our policy to maximize the use of
observable inputs and minimize the use of unobservable inputs when developing fair value measurements, in accordance with
the fair value hierarchy described above. Fair value measurements for assets and liabilities where there exists limited or no
observable market data are calculated based upon our pricing policy, the economic and competitive environment, the
characteristics of the asset or liability and other factors as appropriate. These estimated fair values may not be realized upon
actual sale or immediate settlement of the asset or liability.
Where quoted prices are available on active exchanges for identical instruments, investment securities are classified within
Level 1 of the valuation hierarchy. Level 1 investment securities include common stock and preferred stock.
Level 2 investment securities include corporate bonds, collateralized corporate bank loans, municipal bonds, U.S. Treasury
securities, other obligations of the U.S. Government and mortgage-backed securities for which quoted prices are not available
40
on active exchanges for identical instruments. We use a third party pricing service to determine fair values for each Level 2
investment security in all asset classes. Since quoted prices in active markets for identical assets are not available, these prices
are determined using observable market information such as quotes from less active markets and/or quoted prices of securities
with similar characteristics, among other things. We have reviewed the processes used by the pricing service and have
determined that they result in fair values consistent with the requirements of ASC 820 for Level 2 investment securities. In
addition, using the prices received for the securities from the third party pricing services, we compare a sample of the prices
against additional sources. We have not adjusted any prices received from third-party pricing sources.
In cases where there is limited activity or less transparency around inputs to the valuation, investment securities are classified
within Level 3 of the valuation hierarchy. Level 3 investments are valued based on the best available data in order to
approximate fair value. This data may be internally developed and consider risk premiums that a market participant would
require. Investment securities classified within Level 3 include other less liquid investment securities.
Deferred policy acquisition costs. Policy acquisition costs (mainly commission, underwriting and marketing expenses) that vary
with and are primarily related to the successful acquisition of new and renewal insurance contracts are deferred and charged to
operations over periods in which the related premiums are earned. Ceding commissions from reinsurers, which include expense
allowances, are deferred and recognized over the period premiums are earned for the underlying policies reinsured.
The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated
realizable value. A premium deficiency exists if the sum of expected claim costs and claim adjustment expenses, unamortized
acquisition costs, and maintenance costs exceeds related unearned premiums and expected investment income on those
unearned premiums, as computed on a product line basis. We routinely evaluate the realizability of deferred policy acquisition
costs. At December 31, 2013 and 2012, there was no premium deficiency related to deferred policy acquisition costs.
Goodwill. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating
segment) on an annual basis (October 1) and between annual tests if an event occurs or circumstances change that would more
likely than not reduce the fair value of a reporting unit below its carrying value. For purposes of evaluating goodwill for
impairment, we have determined that our reporting units are the same as our business units except for the Hallmark Select
business unit for which reporting units are at the component level (“one level below”). Our consolidated balance sheet as of
December 31, 2013 includes goodwill of acquired businesses of $44.7 million that is assigned to our business units as follows:
Standard Commercial P&C business unit - $2.1 million; E&S Commercial business unit - $19.9 million; Hallmark Select business
unit- $17.4 million (comprised of $7.7 million for the excess & umbrella component and $9.7 million for the general aviation
and satellite component); and Personal Lines business unit - $5.3 million. This amount has been recorded as a result of prior
business acquisitions accounted for under the acquisition method of accounting. Under ASC 350, “Intangibles- Goodwill and
Other,” goodwill is tested for impairment annually. We completed our last annual test for impairment on the first day of the
fourth quarter of 2013 and determined that there was no impairment.
A significant amount of judgment is required in performing goodwill impairment tests. Such tests include estimating the fair
value of our reporting units. As required by ASC 350, we compare the estimated fair value of each reporting unit with its
carrying amount, including goodwill. Under ASC 350, fair value refers to the amount for which the entire reporting unit may be
bought or sold.
The determination of fair value was based on an income approach utilizing discounted cash flows. The valuation methodology
utilized is subject to key judgments and assumptions. Estimates of fair value are inherently uncertain and represent
management’s reasonable expectation regarding future developments. These estimates and the judgments and assumptions
upon which the estimates are based will, in all likelihood, differ in some respects from actual future results. Declines in
estimated fair value could result in goodwill impairments in future periods which could materially adversely affect our results of
operations or financial position.
The income approach to determining fair value computed the projections of the cash flows that the reporting unit is expected
to generate converted into a present value equivalent through discounting. Significant assumptions in the income approach
model include income projections, discount rates and terminal growth values. The income projections reflect an improved
premium pricing environment across most of our lines of business that began in 2012 and continued throughout 2013. The
income projections also include loss and LAE assumptions which reflect recent historical claim trends and the movement
towards a more favorable pricing environment. The income projections also include assumptions for expense growth and
investment yields which are based on business plans for each of our business units. The discount rate was based on a risk free
rate plus a beta adjusted equity risk premium and specific company risk premium. The assumptions were based on historical
experience, expectations of future performance, expected market conditions and other factors requiring judgment and
41
estimates. While we believe the assumptions used in these models were reasonable, the inherent uncertainty in predicting
future performance and market conditions may change over time and influence the outcome of future testing.
The fair values of each of our business units were in excess of their respective carrying values, including goodwill, as a result of
our annual test for impairment during the fourth quarter 2013. However, a 18% decline in the fair value of our Standard
Commercial P&C business unit, a 11% decline in the fair value of our E&S Commercial business unit, a 6% decline in the fair
value of our Personal Lines business unit, a 53% decline in the fair value of our excess & umbrella component or a 11% decline
in the fair value of our general aviation and satellite component would have caused the carrying value of the respective
reporting unit to be in excess of its fair value, resulting in the need to perform the second step of impairment testing prescribed
by ASC 350, which could have resulted in an impairment to our goodwill.
The market capitalization of Hallmark’s common stock has been below book value during 2013. We consider our market
capitalization in assessing the reasonableness of the fair values estimated for our business units in connection with our goodwill
impairment testing. We believe the current market displacement caused by global financial market conditions, as well as the
limited daily trading volume of Hallmark shares has resulted in a decrease in our market capitalization that is not representative
of a long-term decrease in value. The valuation analysis discussed above supports our view that goodwill was not impaired at
October 1, 2013. Through December 31, 2013, there were no indicators of impairment.
While we believe the estimates and assumptions used in determining the fair value of our business units were reasonable,
actual results could vary materially. If our actual results are not consistent with our estimates and assumptions used to
calculate fair value, we may be required to perform the second step of impairment testing prescribed by ASC 350 in future
periods and impairment of goodwill could result. We cannot predict future events that might impact the fair value of our
business units and goodwill impairment. Such events include, but are not limited to, increased competition in insurance
markets and global economic changes.
Deferred income tax assets and liabilities. We file a consolidated federal income tax return. Deferred federal income taxes
reflect the future tax consequences of differences between the tax basis of assets and liabilities and their financial reporting
amounts at each year end. Deferred taxes are recognized using the liability method, whereby tax rates are applied to
cumulative temporary differences based on when and how they are expected to affect the tax return. Deferred tax assets and
liabilities are adjusted for tax rate changes. A valuation allowance is provided against our deferred tax assets to the extent that
we do not believe it is more likely than not that future taxable income will be adequate to realize these future tax benefits.
Reserves for unpaid losses and LAE. Reserves for unpaid losses and LAE are established for claims that have already been
incurred by the policyholder but which we have not yet paid. Unpaid losses and LAE represent the estimated ultimate net cost
of all reported and unreported losses incurred through each balance sheet date. The reserves for unpaid losses and LAE are
estimated using individual case-basis valuations and statistical analyses. These reserves are revised periodically and are subject
to the effects of trends in loss severity and frequency. (See “Item 1. Business – Analysis of Losses and LAE” and “-Analysis of
Loss and LAE Reserve Development.”)
Although considerable variability is inherent in such estimates, we believe that our reserves for unpaid losses and LAE are
adequate. Due to the inherent uncertainty in estimating unpaid losses and LAE, the actual ultimate amounts may differ from
the recorded amounts. A small percentage change could result in a material effect on reported earnings. For example, a 1%
change in December 31, 2013 reserves for unpaid losses and LAE would have produced a $3.8 million change to pretax
earnings. The estimates are continually reviewed and adjusted as experience develops or new information becomes known.
Such adjustments are included in current operations.
An actuarial range of ultimate unpaid losses and LAE is developed independent of management’s best estimate and is only used
to assess the reasonableness of that estimate. There is no exclusive method for determining this range, and judgment enters
into the process. The primary actuarial technique utilized is a loss development analysis in which ultimate losses are projected
based upon historical development patterns. The primary assumption underlying this loss development analysis is that the
historical development patterns will be a reasonable predictor of the future development of losses for accident years which are
less mature. An alternate actuarial technique, known as the Bornhuetter-Ferguson method, combines an analysis of loss
development patterns with an initial estimate of expected losses or loss ratios. This approach is most useful for recent accident
years. In addition to assuming the stability of loss development patterns, this technique is heavily dependent on the accuracy of
the initial estimate of expected losses or loss ratios. Consequently, the Bornhuetter-Ferguson method is primarily used to
confirm the results derived from the loss development analysis.
42
The range of unpaid losses and LAE estimated by our actuary as of December 31, 2013 was $337.7 million to $388.6 million. Our
best estimate of unpaid losses and LAE as of December 31, 2013 is $382.6 million. Our carried reserve for unpaid losses and LAE
as of December 31, 2013 is comprised of $189.2 million in case reserves and $193.4 million in incurred but not reported
reserves. In setting this estimate of unpaid losses and LAE, we have assumed, among other things, that current trends in loss
frequency and severity will continue and that the actuarial analysis was empirically valid. We have established a best estimate
of unpaid losses and LAE, which is approximately $19.5 million higher than the midpoint or 98.5% of the high end of the
actuarial range at December 31, 2013 as compared to $18.7 million above the midpoint or 97.1% of the high end of the
actuarial range at December 31, 2012. We expect our best estimate to move within the actuarial range from year to year due to
changes in our operations and changes within the marketplace. Due to the inherent uncertainty in reserve estimates, there can
be no assurance that the actual losses ultimately experienced will fall within the actuarial range. However, because of the
breadth of the actuarial range, we believe that it is reasonably likely that actual losses will fall within such range.
Our reserve requirements are also interrelated with product pricing and profitability. We must price our products at a level
sufficient to fund our policyholder benefits and still remain profitable. Because claim expenses represent the single largest
category of our expenses, inaccuracies in the assumptions used to estimate the amount of such benefits can result in our failing
to price our products appropriately and to generate sufficient premiums to fund our operations.
Recognition of profit sharing commissions. Profit sharing commission is calculated and recognized when the loss ratio, as
determined by a qualified actuary, deviates from contractual targets. We receive a provisional commission as policies are
produced as an advance against the later determination of the profit sharing commission actually earned. The profit sharing
commission is an estimate that varies with the estimated loss ratio and is sensitive to changes in that estimate.
The following table details the profit sharing commission revenue sensitivity of the Standard Commercial P&C business unit to
the actual ultimate loss ratio for each effective quota share treaty at 5.0% above and below the current estimate, which we
believe is a reasonably likely range of variance ($ in thousands).
7/1/01
7/1/02
7/1/03
7/1/04
Treaty Effective Dates
Provisional loss ratio
Estimated ultimate loss ratio recorded at December
31, 2013
Effect of actual 5.0% above estimated loss ratio at
December 31, 2013
Effect of actual 5.0% below estimated loss ratio at
December 31, 2013
60.0 %
63.5 %
-
59.0 %
64.5 %
-
$
1,850
$
3,055
59.0 %
60.9 %
64.2 %
63.7 %
$
$
(3,360 )
2,667
$
$
(3,790 )
3,790
The following table details the profit sharing commission revenue sensitivity of the E&S Commercial business unit for each
effective quota share treaty at 5.0% above and below the current estimate, which we believe is a reasonably likely range of
variance ($ in thousands).
1/1/06
Treaty Effective Dates
1/1/07
1/1/08
Provisional loss ratio
Estimated ultimate loss ratio recorded at December 31, 2013
Effect of actual 5.0% above estimated loss ratio at December
31, 2013
Effect of actual 5.0% below estimated loss ratio at December
31, 2013
65.0 %
58.6 %
$
$
(3,096 )
2,854
$
$
65.0 %
63.2 %
(860 )
2,351
65.0 %
59.0 %
$
$
(1,618 )
1,626
Results of Operations
Comparison of Years ended December 31, 2013 and December 31, 2012
Management overview. During fiscal 2013, our total revenues were $389.4 million, representing an approximately 14%
increase over the $341.8 million in total revenues for fiscal 2012. The growth in revenue was primarily attributable to increased
premium production and resulting earned premium driven largely from our Specialty Commercial Segment and our Standard
Commercial Segment. Further contributing to the increase in revenue were higher net realized gains on our investment
43
portfolio and a lower adverse profit share commission revenue adjustment in our Standard Commercial Segment. These
increases in revenue were partially offset by lower net investment income and lower year to date earned premium in our
Personal Segment due mostly to the impact of discontinued products and a reduction of premium written in underperforming
states.
The increase in revenue for the year ended December 31, 2013 was accompanied by increased loss and LAE of $34.9 million as
compared to the same period of 2012. During the twelve months ended December 31, 2013 we recorded $10.0 million of
unfavorable prior year loss development. During the twelve months ended December 31, 2012 we recorded $3.7 million of
favorable prior year loss development. The increase in loss and LAE occurred despite a $1.5 million decrease in catastrophe
losses to $10.2 million during the year ended December 31, 2013 from $11.7 million reported for the same period of 2012.
Other operating expenses also increased due mostly to increased production related expenses in our E&S Commercial business
unit.
We reported net income of $8.2 million for the year ended December 31, 2013, as compared to net income of $3.5 million for
the year ended December 31, 2012. On a diluted per share basis, net income attributable to Hallmark was $0.43 per share for
fiscal 2013 as compared to net income of $0.18 per share for fiscal 2012.
Segment information
The following is additional business segment information for the years ended December 31, 2013 and 2012 (in thousands):
Year Ended December 31, 2013
Standard
Commercial
Segment
Specialty
Commercial
Segment
Personal
Segment
Corporate
Consolidated
Gross premiums written
Ceded premiums written
Net premiums written
Change in unearned premiums
Net premiums earned
2013
$ 87,147
(7,681 )
79,466
(1,290 )
78,176
2012
$ 77,091
2013
$ 296,108
(7,000 ) (60,453 ) (49,642 )
186,053
235,655
70,091
(936 ) (17,090 ) (17,223 )
168,830
218,565
69,155
2013
2012
$ 235,695 $ 76,772
(31,128 )
45,644
18,156
63,800
2012
$
2012
$ 77,056 $
2013
(711 )
76,345
5,106
81,451
-
-
-
-
-
2013
- $ 460,027
-
-
-
-
2012
$ 389,842
(99,262 ) (57,353 )
332,489
360,765
(224 ) (13,053 )
319,436
360,541
Total revenues
83,306
73,119
229,734
178,917
71,081
89,149
5,307
615
389,428
341,800
Losses and loss adjustment
expenses
Pre-tax income (loss), net of
non-controlling interest
56,143
52,828
152,546
103,980
52,656
69,606
-
-
261,345
226,414
1,980
(2,486 ) 19,527
25,932
(3,416 )
(8,535 )
(7,011 ) (11,861 ) 11,080
3,050
Net loss ratio (1)
Net expense ratio (1)
Net combined ratio (1)
71.8 %
32.2 %
104.0 %
76.4 %
33.2 %
109.6 %
69.8 %
26.6 %
96.4 %
61.6 %
28.3 %
89.9 %
82.5 %
26.7 %
109.2 %
85.5 %
28.5 %
114.0 %
72.5 %
29.2 %
101.7 %
70.9 %
30.8 %
101.7 %
Favorable (Unfavorable) Prior
Year Development
5,235
3,744
(13,381 )
3,577
(1,808 )
(3,646 )
-
-
(9,954 )
3,675
1
The net loss ratio is calculated as incurred losses and LAE divided by net premiums earned, each determined in accordance
with GAAP. The net expense ratio is calculated for our business units that retain 100% of produced premium as total
operating expenses for the unit offset by agency fee income, divided by net premiums earned, each determined in
accordance with GAAP. For the business units that do not retain 100% of the produced premium, the net expense ratio is
calculated as underwriting expenses of the insurance company subsidiaries for the unit offset by agency fee income,
divided by net premiums earned, each determined in accordance with GAAP. Net combined ratio is calculated as the sum
of the net loss ratio and the net expense ratio.
44
Standard Commercial Segment.
Gross premiums written for the Standard Commercial Segment were $87.1 million for the year ended December 31, 2013,
which was $10.0 million, or approximately 13%, more than the $77.1 million reported for the same period in 2012. Net
premiums written were $79.5 million for the year ended December 31, 2013 as compared to $70.1 million reported for the
same period in 2012. The increase in premium volume was primarily due to increased premium production in both our
Standard Commercial P&C and Workers Compensation business units.
Total revenue for the Standard Commercial Segment of $83.3 million for the year ended December 31, 2013 was $10.2 million
more than the $73.1 million reported during the year ended December 31, 2012. This increase in total revenue was the result
of increased net earned premiums of $9.0 million, higher net investment income of $0.1 million and a $1.1 million lower
adverse profit share commission revenue adjustment during the year ended December 31, 2013 as compared to the same
period during 2012.
Our Standard Commercial Segment reported pre-tax income was $2.0 million for the year ended December 31, 2013 as
compared to a pre-tax loss of $2.5 million for the same period of 2012. The increased revenue discussed above was the primary
driver of the increased pre-tax income for the year ended December 31, 2013, partially offset by higher loss and LAE of $3.3
million and higher operating expenses of $2.4 million consisting primarily of higher production related expenses due to
increased premium production.
The net loss ratio for the year ended December 31, 2013 was 71.8% as compared to the 76.4% reported for 2012. The gross loss
ratio before reinsurance was 67.8% for the year ended December 31, 2013 as compared to 74.8% for the prior year. The lower
gross and net loss ratios for the year ended December 31, 2013 were aided by lower catastrophe losses coupled with increased
favorable prior year loss reserve development. The net loss ratios for the years ended December 31, 2013 and 2012 included
catastrophe losses of $6.0 million and $9.5 million, respectively. During the years ended December 31, 2013 and 2012, the
Standard Commercial Segment reported favorable loss reserve development of $5.2 million and $3.7 million, respectively. The
Standard Commercial Segment reported a net expense ratio of 32.2% for the year ended December 31, 2013 as compared to
33.2% reported for the same period the prior year. The decrease in net expense ratio was due primarily to the increased
premium volume.
Specialty Commercial Segment.
Gross premiums written for the Specialty Commercial Segment were $296.1 million for the year ended December 31, 2013,
which was $60.4 million, or 26%, more than the $235.7 million reported for the same period in 2012. Net premiums written
were $235.7 million for the year ended December 31, 2013 as compared to $186.1 million reported for the same period in
2012. The increase in premium volume was due to increased premium production in both our E&S Commercial and Hallmark
Select business units.
The $229.7 million of total revenue for the year ended December 31, 2013 was $50.8 million higher than the $178.9 million
reported for 2012. This 28% increase in revenue was due to higher net premiums earned of $49.7 million due predominately to
increased production discussed above. Further contributing to this increased revenue was higher net investment income of
$1.6 million partially offset by lower profit share commission revenue adjustment of $0.5 million for the year ended December
31, 2013 as compared to the same period of 2012.
Pre-tax income for the Specialty Commercial Segment of $19.5 million for the year ended December 31, 2013 was $6.4 million
lower than the $25.9 million reported for the same period in 2012. The decrease in pre-tax income was primarily due to higher
loss and LAE expenses of $48.6 million and higher operating expenses of $9.4 million, partially offset by lower amortization of
intangible assets of $0.5 million, lower non-controlling interest of $0.3 million and the increased revenue discussed above. Our
E&S Commercial business unit reported a $45.7 million increase in loss and LAE due primarily to increased premium volume and
$16.0 million of unfavorable prior year loss reserve development as compared to $0.3 million of favorable development during
the same period of 2012. In addition, our Hallmark Select business unit reported a $2.9 million increase in loss and LAE which
consisted of (a) a $1.4 million increase in loss and LAE due to increased premium production in our commercial umbrella and
excess liability line of business, (b) a $2.5 million increase in loss and LAE primarily due to large loss volatility in our aircraft hull
coverage during fiscal 2013, (c) a $0.3 million increase in loss and LAE attributable to our medical professional liability insurance
products and (d) a $1.3 million decrease in loss and LAE in our satellite insurance products due primarily to decreased premium
volume as well as lower current accident year loss trends. The increase in operating expense was the combined result of
increased production related expenses of $8.7 million, higher salary and related expenses of $0.4 million, higher professional
service fees of $0.5 million partially offset by lower other operating expenses of $0.2 million.
45
The Specialty Commercial Segment reported a net loss ratio of 69.8% for the year ended December 31, 2013 as compared to
61.6% for the same period during 2012. The gross loss ratio before reinsurance was 68.5% for the year ended December 31,
2013 as compared to 61.1% for the same period in 2012. The higher gross and net loss ratio included $13.4 million of
unfavorable prior year loss reserve development for the year ended December 31, 2013 as compared to $3.6 million of
favorable prior year loss reserve development for the same period during 2012. The Specialty Commercial Segment reported a
net expense ratio of 26.6% for the year ended December 31, 2013 as compared to 28.3% reported for the same period the prior
year. The decrease in the net expense ratio was due primarily to increased net premium volume.
Personal Segment.
Gross premiums written for the Personal Segment were $76.8 million for the year ended December 31, 2013, which was $0.3
million less than the $77.1 million reported for the same period in 2012. Net premiums written for our Personal Segment were
$45.6 million in the year ended December 31, 2013, which was a decrease of $30.7 million, or 40%, from the $76.3 million
reported for the same period of 2012. The decrease in net premium written was due mostly to exiting certain underperforming
states and programs and quota share reinsurance contracts entered into during the first quarter of 2013 on our low value
dwelling/homeowners, renters, and manufactured homes lines of business and during the fourth quarter of 2013 on our non-
standard automobile risks produced in certain states.
Total revenue for the Personal Segment decreased 20% to $71.1 million for the year ended December 31, 2013 from $89.1
million the prior year. Lower net premiums earned of $17.7 million and lower net investment income of $0.4 million, partially
offset by higher other income of $0.1 million, were the primary reason for the decrease in revenue for the period.
Our Personal Segment reported a pre-tax loss of $3.4 million for the year ended December 31, 2013 as compared to a pre-tax
loss of $8.5 million for the same period of 2012. The lower pre-tax loss was the result of lower losses and LAE of $16.9 million
and lower operating expenses of $6.2 million, primarily due to lower production related expenses driven by increased ceding
commission on the quota share agreements entered into during 2013. The decline in pre-tax loss was partially offset by lower
revenue discussed above.
The Personal Segment reported a net loss ratio of 82.5% for the year ended December 31, 2013 as compared to 85.5% for 2012.
The gross loss ratio before reinsurance was 80.6% for the year ended December 31, 2013 as compared to 85.6% for the same
period in 2012. The lower gross and net loss ratio were primarily the result of lower current accident year loss trends as well as
lower unfavorable prior year loss reserve development for the year ended December 31, 2013 as compared to the same period
of 2012. Loss and LAE during the years ended December 31, 2013 and 2012 included unfavorable prior years’ loss reserve
development of $1.8 million and $3.6 million, respectively. The Personal Segment reported a net expense ratio of 26.7% for the
year ended December 31, 2013 as compared to 28.5% for the same period of 2012. The decrease in the expense ratio was due
predominately to lower production related expenses.
Corporate.
Total revenue for Corporate was $5.3 million for the year ended December 31, 2013 as compared to $0.6 million for the same
period of 2012. Net realized gains recognized on our investment portfolio were $10.5 million for the year ended December 31,
2013 as compared to $1.9 million during the same period during 2012. Net investment income decreased $3.7 million for the
year ended December 31, 2013 as compared to the same period during 2012. Other income decreased $0.2 million for the year
ended December 31, 2013 as compared to the same period during 2012.
Corporate pre-tax loss was $7.0 million for the year ended December 31, 2013 as compared to a $11.9 million pre-tax loss for
the same period the prior year. The decrease in pre-tax loss was the result of the increased revenue discussed above and lower
operating expenses of $0.2 million due primarily to lower salary and related expenses during the year ended December 31,
2013 as compared to the same period the prior year.
Comparison of Years ended December 31, 2012 and December 31, 2011
Management overview. During fiscal 2012, our total revenues were $341.8 million, representing an approximately 6% increase
over the $322.8 million in total revenues for fiscal 2011. The growth in revenue was primarily attributable to increased
premium production and resulting earned premium driven largely from our E&S Commercial business unit and from the
acquisition of our Workers Compensation business unit during the third quarter of 2011. The increase in revenue was partially
offset by an adverse profit share commission revenue adjustment in our Standard Commercial P&C business unit, combined
46
with lower finance charges and earned premium in our Personal Segment due mostly to the impact of a reduction of premium
written in underperforming states and products exited over the past twelve months. Further offsetting the increase in revenue
was lower net realized gains for the period ended December 31, 2012.
The increase in revenue for the year ended December 31, 2012 was complemented by decreased loss and LAE due primarily to
improved current accident year loss trends in our Standard Commercial P&C business unit and Personal Lines business unit as
well as $3.7 million of favorable prior year loss reserve development for the year ended December 31, 2012 as compared to
$16.4 million of adverse reserve development recognized during the prior year. Of the $16.4 million unfavorable development
recognized for the year ended December 31, 2011, $10.3 million was a result of adverse prior year loss reserve development in
our Personal Segment in Florida. In addition, the results for the years ended December 31, 2012 and 2011 included $11.7
million and $10.3 million, respectively, in current accident year net losses from weather related claims.
We reported net income attributable to Hallmark of $3.5 million for the year ended December 31, 2012, as compared to a net
loss of $10.9 million for the year ended December 31, 2011. On a diluted per share basis, net income attributable to Hallmark
was $0.18 per share for fiscal 2012 as compared to a net loss of $0.55 per share for fiscal 2011.
Segment information.
The following is additional business segment information for the years ended December 31, 2012 and 2011 (in thousands):
Year Ended December 31, 2012
Standard
Commercial
Segment
Specialty
Commercial
Segment
Personal
Segment
Corporate
Consolidated
Gross premiums written
Ceded premiums written
Net premiums written
Change in unearned premiums
Net premiums earned
2012
$ 77,091
(7,000 )
70,091
(936 )
69,155
2011
$ 69,420
2012
$ 235,695
2011
$ 185,020
(5,476 ) (49,642 ) (40,743 )
186,053
63,944
144,277
(17,223 ) (8,784 )
642
135,493
168,830
64,586
2012
2012
$ 77,056
(711 )
76,345
5,106
81,451
2011
$ 100,441 $
(4,786 )
95,655
(2,693 )
92,962
2011
- $
-
-
-
-
2012
- $ 389,842
-
-
-
-
2011
$ 354,881
(57,353 ) (51,005 )
332,489
303,876
(13,053 ) (10,835 )
293,041
319,436
Total revenues
73,119
72,830
178,917
142,838
89,149
101,351
615 5,752
341,800
322,771
Losses and loss adjustment
expenses
Pre-tax income (loss), net of
non-controlling interest
52,828
50,940
103,980
87,265
69,606
101,030
-
-
226,414
239,235
(2,486 )
1,335
25,932
14,348
(8,535 )
(29,647 )
(11,861 ) (5,881 )
3,050
(19,845 )
Net loss ratio (1)
Net expense ratio (1)
Net combined ratio (1)
76.4 %
33.2 %
109.6 %
78.9 %
32.3 %
111.2 %
61.6 %
28.3 %
89.9 %
64.4 %
29.6 %
94.0 %
85.5 %
28.5 %
114.0 %
108.7 %
25.8 %
134.5 %
70.9 %
30.8 %
81.6 %
30.8 %
101.7 % 112.4 %
Favorable (Unfavorable) Prior
Year Development
3,744
848
3,577
2,436
(3,646 ) (19,650 )
-
-
3,675
(16,366 )
1
The net loss ratio is calculated as incurred losses and LAE divided by net premiums earned, each determined in accordance
with GAAP. The net expense ratio is calculated for our business units that retain 100% of produced premium as total
operating expenses for the unit offset by agency fee income, divided by net premiums earned, each determined in
accordance with GAAP. For the business units that do not retain 100% of the produced premium, the net expense ratio is
calculated as underwriting expenses of the insurance company subsidiaries for the unit offset by agency fee income,
divided by net premiums earned, each determined in accordance with GAAP. Net combined ratio is calculated as the sum
of the net loss ratio and the net expense ratio.
47
Standard Commercial Segment.
Gross premiums written for the Standard Commercial Segment were $77.1 million for the year ended December 31, 2012,
which was $7.7 million, or approximately 11%, more than the $69.4 million reported for the same period in 2011. Net
premiums written were $70.1 million for the year ended December 31, 2012 as compared to $63.9 million reported for the
same period in 2011. The increase in gross premium volume was due predominately to the acquisition of our Workers
Compensation business unit during the third quarter of 2011.
Total revenue for the Standard Commercial Segment of $73.1 million for the year ended December 31, 2012 was $0.3 million
more than the $72.8 million reported during the year ended December 31, 2011. This increase in total revenue was the result
of increased net earned premiums of $4.6 million due primarily to the acquisition of our Workers Compensation business unit
during the third quarter of 2011 and higher net investment income of $0.9 million. This increase in revenue was partially offset
by an adverse profit share commission revenue adjustment of $1.5 million during the year ended December 31, 2012 as
compared to a favorable profit share commission revenue adjustment of $3.7 million during the same period of 2011.
Our Standard Commercial Segment reported a pre-tax loss of $2.5 million for the year ended December 31, 2012 as compared
to pre-tax income of $1.3 million for the same period of 2011. Higher operating expenses of $2.2 million primarily due to the
acquisition of our Workers Compensation business unit during the third quarter of 2011 and higher loss and LAE of $1.9 million
contributed to this increase in pre-tax loss for the year ended December 31, 2012. Partially offsetting this increase in pre-tax
loss was the increased revenue discussed above.
The net loss ratio for the year ended December 31, 2012 was 76.4% as compared to the 78.9% reported for 2011. The gross loss
ratio before reinsurance was 74.8% for the year ended December 31, 2012 as compared to 77.4% for the prior year. The lower
gross and net loss ratios for the year ended December 31, 2012 were aided by lower current accident year loss trends excluding
catastrophe losses. The net loss ratios for the years ended December 31, 2012 and 2011 include $9.5 million and $7.7 million,
respectively, of weather related losses. During the years ended December 31, 2012 and 2011 the Standard Commercial
Segment reported $3.7 million and $0.8 million, respectively, of favorable prior years’ loss reserve development.
Specialty Commercial Segment.
Gross premiums written for the Specialty Commercial Segment were $235.7 million for the year ended December 31, 2012,
which was $50.7 million, or 27%, more than the $185.0 million reported for the same period in 2011. Net premiums written
were $186.1 million for the year ended December 31, 2012 as compared to $144.3 million reported for the same period in
2011. The increase in premium volume was primarily due to increased premium production in our E&S Commercial business
unit and Hallmark Select business units.
The $178.9 million of total revenue for the year ended December 31, 2012 was $36.1 million higher than the $142.8 million
reported for 2011. This 25% increase in revenue was due to higher net premiums earned of $33.3 million due predominately to
increased production discussed above. Further contributing to this increased revenue was higher net investment income of
$2.0 million and an adverse profit share commission revenue adjustment of $0.8 million for the year ended December 31, 2011.
Pre-tax income for the Specialty Commercial Segment of $25.9 million for the year ended December 31, 2012 was $11.6 million
higher than the $14.3 million reported for the same period in 2011. The increase in pre-tax income was primarily due to the
increased revenue discussed above partially offset by higher loss and LAE expenses of $16.7 million, higher operating expenses
of $7.6 million and $0.3 million in expense related to the acquisition of the non-controlling interest in our Hallmark Select
business unit during the third quarter of 2012. Our E&S Commercial business unit reported a $11.8 million increase in loss and
LAE due primarily to increased premium volume partially offset by lower accident year loss trends. Our Hallmark Select business
reported a $4.9 million increase in loss and LAE which consisted of (a) a $0.8 million increase in loss and LAE due to increased
premium production in our commercial umbrella and excess liability line of business, (b) a $1.7 million increase in loss and LAE
primarily due to increased current accident year loss trends in our general aviation line of business, (c) a $1.6 million increase in
loss and LAE in our satellite insurance business due primarily to increased current accident year loss trends and (d) a $0.8
million increase in loss and LAE in our medical professional liability insurance products. The increased operating expenses
during 2012 were primarily the result of increased production related expenses of $6.6 million, higher salary and related
expense of $1.1 million and higher other operating expenses of $0.2 million, partially offset by lower professional service fees
of $0.3 million.
The Specialty Commercial Segment reported a net loss ratio of 61.6% for 2012 as compared to 64.4% for 2011. The lower net
loss ratio was due primarily to overall lower current accident year loss trends and favorable prior year development for the year
48
ended December 31, 2012 of $3.6 million as compared to $2.4 million favorable prior year development for the same period of
2011.
Personal Segment.
Gross premiums written for the Personal Segment were $77.1 million for the year ended December 31, 2012, which was $23.3
million, or 23%, less than the $100.4 million reported for the same period in 2011. The decrease in premium was due mostly to
exiting Florida and certain other underperforming states and programs.
Total revenue for the Personal Segment decreased 12% to $89.1 million for the year ended December 31, 2012 from $101.4
million the prior year. Lower earned premium of $11.5 million and lower finance charges of $0.7 million were the primary
reason for the decrease in revenue for the period.
Our Personal Segment reported a pre-tax loss of $8.5 million for the year ended December 31, 2012 as compared to a pre-tax
loss of $29.6 million for the same period of 2011. The lower pre-tax loss was the result of lower losses and LAE of $31.4 million
and lower operating expenses of $1.8 million, primarily production related expenses. The decline in pre-tax loss was partially
offset by lower revenue discussed above.
The Personal Segment reported a net loss ratio of 85.5% for the year ended December 31, 2012 as compared to 108.7% for
2011. The decrease in the net loss ratio was primarily due to normalizing claims experience during 2012 as compared to
extremely adverse claims development during 2011 due to rapid growth in the Florida claim volume and the complexity related
to Florida personal injury protection claims. The loss ratio for the year ended December 31, 2012 included improving current
accident year loss trends in our non-standard auto line of business partially offset by increased weather and fire related losses
in our low value dwelling/homeowners line of business. The loss and LAE during the year ended December 31, 2012 included
$3.6 million of adverse prior year development as compared to $19.7 million of adverse prior year development for the same
period during 2011. The Personal Segment reported a net expense ratio of 28.5% for the year ended December 31, 2012 as
compared to 25.8% for the prior year. The increase in the expense ratio was due predominately to growth in staffing.
Corporate.
Total revenue for corporate decreased by $5.1 million for the year ended December 31, 2012 as compared to the prior year.
This decrease in total revenue was due primarily to gains of $1.9 million recognized on our investment portfolio for the year
ended December 31, 2012 as compared to $3.7 million of gains recognized during the same period in 2011. Further
contributing to this decrease in revenue was lower net investment income of $3.4 million for the year ended December 31,
2012 as compared to the same period of the prior year.
Corporate pre-tax loss was $11.9 million for the year ended December 31, 2012 as compared to a $5.9 million pre-tax loss for
the same period the prior year. The increase in pre-tax loss was the result of the decreased revenue discussed above and higher
operating expenses of $0.9 million due primarily to lower reductions recorded to the expected earn-out payable in conjunction
with the acquisition of HNIC for the year ended December 31, 2012 as compared to the same period in 2011.
Liquidity and Capital Resources
Sources and Uses of Funds
Our sources of funds are from insurance-related operations, financing activities and investing activities. Major sources of funds
from operations include premiums collected (net of policy cancellations and premiums ceded), commissions and processing and
service fees. As a holding company, Hallmark is dependent on dividend payments and management fees from its subsidiaries to
meet operating expenses and debt obligations. As of December 31, 2013, Hallmark had $8.1 million in unrestricted cash and
invested assets. Unrestricted cash and invested assets of our non-insurance subsidiaries were $8.4 million as of December 31,
2013. As of that date, our insurance subsidiaries held $125.2 million of cash and cash equivalents as well as $410.1 million in
debt securities with an average modified duration of 3.0 years. Accordingly, we do not anticipate selling long-term debt
instruments to meet any liquidity needs.
AHIC and TBIC, domiciled in Texas, are limited in the payment of dividends to their stockholders in any 12-month period,
without the prior written consent of the Texas Department of Insurance, to the greater of statutory net income for the prior
calendar year or 10% of statutory policyholders’ surplus as of the prior year end. HIC, domiciled in Arizona, is limited in the
payment of dividends to the lesser of 10% of prior year policyholders’ surplus or prior year's net investment income, without
49
prior written approval from the Arizona Department of Insurance. HSIC, domiciled in Oklahoma, is limited in the payment of
dividends to the greater of 10% of prior year policyholders’ surplus or prior year’s statutory net income, not including realized
capital gains, without prior written approval from the Oklahoma Insurance Department. HNIC, domiciled in Ohio, is limited in
the payment of dividends to the greater of 10% of statutory policyholders’ surplus as of the prior December 31 or statutory net
income as of the prior December 31 without prior written approval from the Ohio Insurance Department. For all our insurance
companies, dividends may only be paid from unassigned surplus funds. During 2014, the aggregate ordinary dividend capacity
of these subsidiaries is $22.5 million, of which $15.6 million is available to Hallmark. As a county mutual, dividends from HCM
are payable to policyholders. None of our insurance company subsidiaries paid a dividend during the years ended December 31,
2013 or 2012.
The state insurance departments also regulate financial transactions between our insurance subsidiaries and their affiliated
companies. Applicable regulations require approval of management fees, expense sharing contracts and similar transactions.
The net amount paid in management fees by our insurance subsidiaries to Hallmark and our non-insurance company
subsidiaries was $8.2 million, $9.0 million and $6.0 million during each of 2013, 2012 and 2011, respectively.
Statutory capital and surplus is calculated as statutory assets less statutory liabilities. The various state insurance departments
that regulate our insurance company subsidiaries require us to maintain a minimum statutory capital and surplus. As of
December 31, 2013, our insurance company subsidiaries reported statutory capital and surplus of $196.3 million, substantially
greater than the minimum requirements for each state. Each of our insurance company subsidiaries is also required to satisfy
certain risk-based capital requirements. (See, “Item 1. Business – Insurance Regulation – Risk-based Capital Requirements.”). As
of December 31, 2013, the adjusted capital under the risk-based capital calculation of each of our insurance company
subsidiaries substantially exceeded the minimum requirements. Our total statutory premium-to-surplus percentage for the
years ended December 31, 2013 and 2012 was 184% and 188%, respectively.
Comparison of December 31, 2013 to December 31, 2012
On a consolidated basis, our cash and investments, excluding restricted cash and investments, at December 31, 2013 were
$603.0 million compared to $530.5 million at December 31, 2012. Cash from operating activities was the primary reason for this
increase.
Comparison of Years Ended December 31, 2013 and December 31, 2012
Net cash provided by our consolidated operating activities was $68.3 million for the year ended December 31, 2013 compared
to $33.7 million for the year ended December 31, 2012. The increase in operating cash flow was primarily due to higher
collected premiums written by our Specialty Commercial Segment during the year ended December 31, 2013 as compared to
the same period in 2012, partially offset by increased operating expense payments and federal income tax payments during
2013 as compared to federal income tax refunds during 2012.
Cash used in investing activities during the year ended December 31, 2013 was $11.8 million as compared to $18.1 million for
the prior year. The decrease in cash used in investing activities was primarily attributable to a $65.8 million increase in
maturities, sales and redemptions of investment securities, partially offset by a $54.8 million increase in purchases of
investment securities, a $0.6 million increase in purchases of property and equipment and $4.1 million increase in cash flow
into restricted cash accounts.
There were no financing cash flow activities during the year ended December 31, 2013. Cash used in financing activities during
the year ended December 31, 2012 was $4.9 million as a result of a $2.6 million repayment on our revolving credit facility, a
$0.3 million payment of holdback consideration for the acquisition of TBIC, $1.7 million paid during the fourth quarter of 2012
for the acquisition of the 20% non-controlling interest in the subsidiaries comprising our Excess & Umbrella business unit and a
$0.3 million distribution to non-controlling interest for our Excess & Umbrella business unit.
Credit Facilities
Our First Restated Credit Agreement with The Frost National Bank dated January 27, 2006, as amended to date, provides a
revolving credit facility of $15.0 million. We pay interest on the outstanding balance at our election at a rate of the prime rate
or LIBOR plus 2.5%. We pay an annual fee of 0.25% of the average daily unused balance of the credit facility. We pay letter of
credit fees at the rate of 1.00% per annum. Our obligations under the revolving credit facility are secured by a security interest
in the capital stock of all of our subsidiaries, guarantees of all of our subsidiaries and the pledge of all of our non-insurance
company assets. The revolving credit facility contains covenants that, among other things, require us to maintain certain
50
financial and operating ratios and restrict certain distributions, transactions and organizational changes. We are in compliance
with all of our covenants. As of December 31, 2013, the balance on the revolving note was $1.5 million. The revolving note
currently bears interest at 2.75% per annum.
Subordinated Debt Securities
On June 21, 2005, we entered into a trust preferred securities transaction pursuant to which we issued $30.9 million aggregate
principal amount of subordinated debt securities due in 2035. To effect the transaction, we formed Hallmark Statutory Trust I
(“Trust I”) as a Delaware statutory trust. Trust I issued $30.0 million of preferred securities to investors and $0.9 million of
common securities to us. Trust I used the proceeds from these issuances to purchase the subordinated debt securities. Our
Trust I subordinated debt securities bear an initial interest rate of 7.725% until June 15, 2015, at which time interest will adjust
quarterly to the three-month LIBOR rate plus 3.25 percentage points. Trust I pays dividends on its preferred securities at the
same rate. Under the terms of our Trust I subordinated debt securities, we pay interest only each quarter and the principal of
the note at maturity. The subordinated debt securities are uncollateralized and do not require maintenance of minimum
financial covenants. As of December 31, 2013, the balance of our Trust I subordinated debt was $30.9 million.
On August 23, 2007, we entered into a trust preferred securities transaction pursuant to which we issued $25.8 million
aggregate principal amount of subordinated debt securities due in 2037. To effect the transaction, we formed Hallmark
Statutory Trust II (“Trust II”) as a Delaware statutory trust. Trust II issued $25.0 million of preferred securities to investors and
$0.8 million of common securities to us. Trust II used the proceeds from these issuances to purchase the subordinated debt
securities. Our Trust II subordinated debt securities bear an initial interest rate of 8.28% until September 15, 2017, at which
time interest will adjust quarterly to the three-month LIBOR rate plus 2.90 percentage points. Trust II pays dividends on its
preferred securities at the same rate. Under the terms of our Trust II subordinated debt securities, we pay interest only each
quarter and the principal of the note at maturity. The subordinated debt securities are uncollateralized and do not require
maintenance of minimum financial covenants. As of December 31, 2013, the balance of our Trust II subordinated debt was
$25.8 million.
Long-Term Contractual Obligations
Set forth below is a summary of long-term contractual obligations as of December 31, 2013. Amounts represent estimates of
gross undiscounted amounts payable over time. In addition, certain unpaid losses and LAE are ceded to others under
reinsurance contracts and are, therefore, recoverable. Such potential recoverables are not reflected in the table.
Notes payable
$
Subordinated debt securities
Interest on notes payable
Interest on subordinated debt securities
Unpaid losses and LAE (1)
Operating leases
Purchase obligations
1,473
56,702
54
91,199
382,640
11,440
1,706
Total
After 2018
-
$
$
$
2014
2017-2018
Estimated Payments by Period (in thousands)
2015-2016
1,473
-
13
8,573
128,070
3,610
126
-
41
4,388
152,852
1,987
1,580
-
-
7,976
51,871
2,677
-
-
$
-
56,702
-
70,262
49,847
3,166
-
(1) The payout pattern for unpaid losses and LAE is based upon historical payment patterns and does not represent
actual contractual obligations. The timing and amount ultimately paid will likely vary from these estimates.
Based on 2014 budgeted and year-to-date cash flow information, we believe that we have sufficient liquidity to meet our
projected insurance obligations, operational expenses and capital expenditure requirements for the next 12 months.
Effects of Inflation
We do not believe that inflation has a material effect on our results of operations, except for the effect that inflation may have
on interest rates and claim costs. The effects of inflation are considered in pricing and estimating reserves for unpaid losses and
LAE. The actual effects of inflation on results of operations are not known until claims are ultimately settled. In addition to
general price inflation, we are exposed to the upward trend in the judicial awards for damages. We attempt to mitigate the
effects of inflation in the pricing of policies and establishing reserves for losses and LAE.
51
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
We believe that interest rate risk, credit risk and equity risk are the types of market risk to which we are principally exposed.
Interest rate risk. Our investment portfolio consists largely of investment-grade, fixed-income securities, all of which are
classified as available-for-sale. Accordingly, the primary market risk exposure to these securities is interest rate risk. In general,
the fair value of a portfolio of fixed-income securities increases or decreases inversely with changes in market interest rates,
while net investment income realized from future investments in fixed-income securities increases or decreases along with
interest rates. The fair value of our fixed-income securities as of December 31, 2013 was $410.1 million. The effective duration
of our portfolio as of December 31, 2013 was 3.0 years. Should interest rates increase 1.0%, our fixed-income investment
portfolio would be expected to decline in market value by 3.0%, or $12.2 million, representing the effective duration multiplied
by the change in market interest rates. Conversely, a 1.0% decline in interest rates would be expected to result in a 3.0%, or
$12.2 million, increase in the fair value of our fixed-income investment portfolio.
Credit risk. An additional exposure to our fixed-income securities portfolio is credit risk. We attempt to manage the credit risk
by investing primarily in investment-grade securities and limiting our exposure to a single issuer. As of December 31, 2013, our
fixed-income investments were in the following: U.S. Treasury bonds – 19.2%; municipal bonds – 38.4%; collateralized
corporate bank loans – 24.9%; corporate bonds – 10.7%; and asset-backed – 6.8%. As of December 31, 2013, 75.9% of our
fixed-income securities were rated investment-grade by nationally recognized statistical rating organizations.
We are also subject to credit risk with respect to reinsurers to whom we have ceded underwriting risk. Although a reinsurer is
liable for losses to the extent of the coverage it assumes, we remain obligated to our policyholders in the event that the
reinsurers do not meet their obligations under the reinsurance agreements. In order to mitigate credit risk to reinsurance
companies, most of our reinsurance recoverable balance as of December 31, 2013 was with reinsurers having an A.M. Best
rating of “A-” or better.
Equity price risk. Investments in equity securities that are subject to equity price risk made up 11.1% of our portfolio as of
December 31, 2013. The carrying values of equity securities are based on quoted market prices as of the balance sheet date.
Market prices are subject to fluctuation and, consequently, the amount realized in the subsequent sale of an investment may
significantly differ from the reported fair value. Fluctuation in the market price of a security may result from perceived changes
in the underlying economic characteristics of the issuer, the relative price of alternative investments and general market
conditions. Furthermore, amounts realized in the sale of a particular security may be affected by the relative quantity of the
security being sold.
The fair value of our equity securities as of December 31, 2013 was $51.2 million. The fair value of our equity securities would
increase or decrease by $15.4 million assuming a hypothetical 30% increase or decrease in market prices as of the balance
sheet date. This would increase or decrease stockholders’ equity by 4.2%. The selected hypothetical change does not reflect
what should be considered the best or worsed case scenario.
Item 8. Financial Statements and Supplementary Data.
The following consolidated financial statements of Hallmark and its subsidiaries are filed as part of this report.
Description
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets at December 31, 2013 and 2012
Consolidated Statements of Operations for the Years Ended December 31, 2013, 2012 and 2011
Consolidated Statements of Comprehensive Income (Loss) for the Years Ended December 31, 2013, 2012
and 2011
Consolidated Statements of Stockholders’ Equity for the Years Ended
December 31, 2013, 2012 and 2011
Consolidated Statements of Cash Flows for the Years Ended
December 31, 2013, 2012 and 2011
Notes to Consolidated Financial Statements
Financial Statement Schedules
Page Number
F-2
F-3
F-4
F-5
F-6
F-7
F-8
F-41
52
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
Item 9A. Controls and Procedures.
Evaluation of Disclosure Controls and Procedures
The principal executive officer and principal financial officer of Hallmark have evaluated our disclosure controls and procedures
and have concluded that, as of the end of the period covered by this report, such disclosure controls and procedures were
effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Securities
Exchange Act of 1934 is timely recorded, processed, summarized and reported. The principal executive officer and principal
financial officer also concluded that such disclosure controls and procedures were effective in ensuring that information
required to be disclosed by us in the reports that we file or submit under such Act is accumulated and communicated to our
management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions
regarding required disclosure.
During the three month period ended December 31, 2013, there were no changes in internal control over financial reporting
that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Management’s Report on Internal Control over Financial Reporting
Management is responsible for establishing and maintaining adequate “internal control over financial reporting,” as such
phrase is defined in Exchange Act Rule 13a-15(f). Under the supervision and with the participation of management, including
our Chief Executive Officer and Chief Accounting Officer, an evaluation of the effectiveness of our internal control over financial
reporting was conducted based upon the framework in Internal Control-Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission (1992 Framework). Based upon that evaluation, management has
concluded that our internal control over financial reporting was effective as of December 31, 2013.
Ernst & Young LLP, the independent registered public accounting firm that audited our consolidated financial statements as of
December 31, 2013 included in this Annual Report on Form 10-K, has issued an attestation report on our internal control over
financial reporting as of December 31, 2013. The Ernst & Young LLP attestation report, which expresses an unqualified opinion
on the effectiveness of our internal control over financial reporting as of December 31, 2013, is included in this Item under the
heading “Attestation Report of Independent Registered Public Accounting Firm.”
53
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of
Hallmark Financial Services, Inc. and subsidiaries
We have audited Hallmark Financial Services, Inc. and subsidiaries’ (the Company) internal control over financial reporting
as of December 31, 2013, based on criteria established in Internal Control-Integrated Framework issued by the Committee
of Sponsoring Organizations of the Treadway Commission (1992 Framework) (the COSO criteria). The Company’s
management is responsible for maintaining effective internal control over financial reporting and for its assessment of the
effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal
Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over
financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United
States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an
understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and
evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such
other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis
for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial statements for external purposes in accordance with
generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and
procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the
transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are
recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting
principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of
management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the
financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also,
projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may
deteriorate.
In our opinion, Hallmark Financial Services, Inc. and subsidiaries maintained, in all material respects, effective internal
control over financial reporting as of December 31, 2013, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United
States), the consolidated balance sheets of Hallmark Financial Services, Inc. and subsidiaries as of December 31, 2013 and
2012, and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity, and cash
flows for each of the three years in the period ended December 31, 2013 of Hallmark Financial Services, Inc. and
subsidiaries and our report dated March 12, 2014 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Fort Worth, Texas
March 12, 2014
54
Item 9B. Other Information.
None.
Item 10. Directors, Executive Officers and Corporate Governance.
PART III
The information required by Item 10 is incorporated by reference from the Registrant’s definitive proxy statement to be filed
with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal
year covered by this report.
Item 11. Executive Compensation.
The information required by Item 11 is incorporated by reference from the Registrant’s definitive proxy statement to be filed
with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal
year covered by this report.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
The information required by Item 12 is incorporated by reference from the Registrant’s definitive proxy statement to be filed
with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal
year covered by this report.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
The information required by Item 13 is incorporated by reference from the Registrant’s definitive proxy statement to be filed
with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal
year covered by this report.
Item 14. Principal Accounting Fees and Services.
The information required by Item 14 is incorporated by reference from the Registrant's definitive proxy statement to be filed
with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal
year covered by this report.
55
Item 15. Exhibits, Financial Statement Schedules.
PART IV
(a)(1)
(a)(2)
(a)(3)
Financial Statements
The following consolidated financial statements, notes thereto and related information are included in Item 8 of
this report:
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets at December 31, 2013 and 2012
Consolidated Statements of Operations for the Years Ended December 31, 2013, 2012 and 2011
Consolidated Statements of Comprehensive Income (Loss) for the Years Ended December 31, 2013, 2012 and
2011
Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2013, 2012 and 2011
Consolidated Statements of Cash Flows for the Years Ended December 31, 2013, 2012 and 2011
Notes to Consolidated Financial Statements
Financial Statement Schedules
The following financial statement schedules are included in this report:
Schedule II – Condensed Financial Information of Registrant (Parent Company Only)
Schedule III – Supplemental Insurance Information
Schedule IV – Reinsurance
Schedule VI – Supplemental Information Concerning Property-Casualty Insurance Operations
Exhibit Index
The following exhibits are either filed with this report or incorporated by reference:
Exhibit
Number
3.1
3.2
4.1
4.2
4.3
Description
Restated Articles of Incorporation of the registrant (incorporated by reference to Exhibit 3.1 to Amendment No. 1 to
the registrant’s Registration Statement on Form S-1 [Registration No. 333-136414] filed September 8, 2006).
Amended and Restated By-Laws of the registrant (incorporated by reference to Exhibit 3.1 to the registrant’s Current
Report on Form 8-K filed October 1, 2007).
Specimen certificate for common stock, $0.18 par value, of the registrant (incorporated by reference to Exhibit 4.1 to
Amendment No. 1 to the registrant’s Registration Statement on Form S-1 [Registration No. 333-136414] filed
September 8, 2006).
Indenture dated June 21, 2005, between Hallmark Financial Services, Inc. and JPMorgan Chase Bank, National
Association (incorporated by reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed June 27,
2005).
Amended and Restated Declaration of Trust of Hallmark Statutory Trust I dated as of June 21, 2005, among Hallmark
Financial Services, Inc., as sponsor, Chase Bank USA, National Association, as Delaware trustee, and JPMorgan Chase
Bank, National Association, as institutional trustee, and Mark Schwarz and Mark Morrison, as administrators
(incorporated by reference to Exhibit 4.2 to the registrant’s Current Report on Form 8-K filed June 27, 2005).
4.4
Form of Junior Subordinated Debt Security Due 2035 (included in Exhibit 4.2 above).
4.5
Form of Capital Security Certificate (included in Exhibit 4.3 above).
4.6
4.7
4.8
First Restated Credit Agreement dated January 27, 2006, between Hallmark Financial Services, Inc. and The Frost
National Bank (incorporated by reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed February
2, 2006).
Indenture dated as of August 23, 2007, between Hallmark Financial Services, Inc. and The Bank of New York Trust
Company, National Association (incorporated by reference to Exhibit 4.1 to the registrant’s Current Report on Form
8-K filed August 24, 2007).
Amended and Restated Declaration of Trust of Hallmark Statutory Trust II dated as of August 23, 2007, among
Hallmark Financial Services, Inc., as sponsor, The Bank of New York (Delaware), as Delaware trustee, and The Bank of
New York Trust Company, National Association, as institutional trustee, and Mark Schwarz and Mark Morrison, as
56
administrators (incorporated by reference to Exhibit 4.2 to the registrant’s Current Report on Form 8-K filed August
24, 2007).
4.9
Form of Junior Subordinated Debt Security Due 2037 (included in Exhibit 4.7 above).
4.10
Form of Capital Security Certificate (included in Exhibit 4.8 above).
4.11
4.12
4.13
4.14
4.15
4.16
4.17
10.1
10.2
Fifth Amendment to First Restated Credit Agreement among Hallmark Financial Services, Inc. and its subsidiaries and
The Frost National Bank dated February 20, 2008 (incorporated by reference to Exhibit 99.1 to the registrant’s
Current Report on Form 8-K filed February 25, 2008).
Sixth Amendment to First Restated Credit Agreement among Hallmark Financial Services, Inc. and its subsidiaries and
The Frost National Bank dated January 21, 2010 (incorporated by reference to Exhibit 99.1 to the registrant’s Current
Report on Form 8-K filed January 25, 2010).
Seventh Amendment to First Restated Credit Agreement among Hallmark Financial Services, Inc. and its subsidiaries
and The Frost National Bank dated May 27, 2010 (incorporated by reference to Exhibit 10.1 to the registrant’s
Current Report on Form 8-K filed June 17, 2010).
Eighth Amendment to First Restated Credit Agreement among Hallmark Financial Services, Inc. and its subsidiaries
and The Frost National Bank dated March 21, 2011 (incorporated by reference to Exhibit 10.1 to the registrant’s
Current Report on Form 8-K filed March 21, 2011).
Ninth Amendment to First Restated Credit Agreement among Hallmark Financial Services, Inc. and its subsidiaries
and Frost Bank dated July 10, 2012 (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on
Form 8-K filed July 12, 2012).
Tenth Amendment to First Restated Credit Agreement among Hallmark Financial Services, Inc. and its subsidiaries
and Frost Bank dated September 30, 2012 (incorporated by reference to Exhibit 10.1 to the registrant’s Current
Report on Form 8-K filed October 1, 2012).
Eleventh Amendment to First Restated Credit Agreement among Hallmark Financial Services, Inc. and its subsidiaries
and Frost Bank dated July 26, 2013 (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on
Form 8-K filed July 30, 2013).
Office Lease for 6500 Pinecrest, Plano, Texas, dated July 22, 2008, between Hallmark Financial Services, Inc. and
Legacy Tech IV Associates, Limited Partnership (incorporated by reference to Exhibit 99.1 to the registrant’s Current
Report on Form 8-K filed July 29, 2008).
Lease Agreement for 777 Main Street, Fort Worth, Texas, dated June 12, 2003 between Hallmark Financial Services,
Inc. and Crescent Real Estate Funding I, L.P. (incorporated by reference to Exhibit 10(a) to the registrant’s Quarterly
Report on Form 10-QSB for the quarter ended June 30, 2003).
10.3
Office Lease by and between SAOP Northwest Center, L.P. and Hallmark Specialty Underwriters, Inc. dated January 29,
2010 (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed February 2, 2010).
10.4
Office Lease by and between Minol Center, L.P. and Aerospace Insurance Managers, Inc. dated August 9, 2010
(incorporated by reference to Exhibit 99.1 to the registrant’s Current Report on Form 8-K filed August 17, 2010).
10.5
Office Lease by and between Civic Opera, L.P. and Hallmark Specialty Underwriters, Inc. dated December 27, 2010
(incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed January 4, 2011).
10.6
First Amendment to Office Lease between MS Crescent One SPV, LLC and Hallmark Financial Services, Inc., dated
February 28, 2011 (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed March
1, 2011).
10.7* Form of Indemnification Agreement between Hallmark Financial Services, Inc. and its officers and directors, adopted July
19, 2002 (incorporated by reference to Exhibit 10(c) to the registrant’s Quarterly Report on Form 10-QSB for the quarter
ended September 30, 2002).
10.8* Hallmark Financial Services, Inc. 2005 Long Term Incentive Plan (incorporated by reference to Exhibit 10.1 to the
57
registrant’s Current Report on Form 8-K filed June 3, 2005).
10.9* Form of Incentive Stock Option Grant Agreement (incorporated by reference to Exhibit 10.2 to the registrant’s Current
Report on Form 8-K filed June 3, 2005).
10.10* Form of Non-Qualified Stock Option Agreement (incorporated by reference to Exhibit 10.3 to the registrant’s Current
Report on Form 8-K filed June 3, 2005).
10.11 Guarantee Agreement dated as of June 21, 2005, by Hallmark Financial Services, Inc. for the benefit of the holders of
trust preferred securities (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed
June 27, 2005).
10.12* Hallmark Financial Services, Inc. Amended and Restated 2005 Long Term Incentive Plan (incorporated by reference to
Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed June 3, 2013).
10.13* + Form of Restricted Stock Unit Award Agreement.
10.14 Guarantee Agreement dated as of August 23, 2007, by Hallmark Financial Services, Inc. for the benefit of the holders of
trust preferred securities (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed
August 24, 2007).
10.15 Stock Purchase Agreement dated March 25, 2011, between American Hallmark Insurance Company of Texas and Robert
C. Siddons, Stephen W. Gurasich, Andrew J. Reynolds, Paul W. Keller, Kerry A. Keller and Austin Engineering Co., Inc.
(incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K dated March 25, 2011).
21+
List of subsidiaries of the registrant.
23 (a)+ Consent of Independent Registered Public Accounting Firm.
31(a)+ Certification of principal executive officer required by Rule 13a-14(a) or Rule 15d-14(b).
31(b)+ Certification of principal financial officer required by Rule 13a-14(a) or Rule 15d-14(b).
32(a)+ Certification of principal executive officer pursuant to 18 U.S.C. 1350.
32(b)+ Certification of principal financial officer pursuant to 18 U.S.C. 1350.
101
INS+
101
SCH+
101
CAL+
101
LAB+
101
PRE+
101
DEF+
XBRL Instance Document.
XBRL Taxonomy Extension Schema Document.
XBRL Taxonomy Extension Calculation Linkbase Document.
XBRL Taxonomy Extension Label Linkbase Document.
XBRL Taxonomy Extension Presentation Linkbase Document.
XBRL Taxonomy Extension Definition Linkbase Document.
* Management contract or compensatory plan or arrangement.
+ Filed herewith.
58
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this
report to be signed on its behalf by the undersigned, thereunto duly authorized.
SIGNATURES
Date:
March 12, 2014
Date:
March 12, 2014
HALLMARK FINANCIAL SERVICES, INC.
(Registrant)
By: /s/ Mark J. Morrison
Mark J. Morrison, Chief Executive Officer and
President
By:
/s/ Jeffrey R. Passmore
Jeffrey R. Passmore, Chief Accounting Officer and Senior
Vice President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following
persons on behalf of the registrant and in the capacities and on the dates indicated.
Date:
March 12, 2014
/s/ Mark J. Morrison
Date:
March 12, 2014
Mark J. Morrison, Chief Executive Officer and
President (Principal Executive Officer)
/s/ Jeffrey R. Passmore
Jeffrey R. Passmore, Chief Accounting Officer and Senior
Vice President (Principal Financial Officer and Principal
Accounting Officer)
Date:
Date:
Date:
Date:
March 12, 2014
/s/ Mark E. Schwarz
Mark E. Schwarz, Executive Chairman
March 12, 2014
March 12, 2014
March 12, 2014
/s/ James H. Graves
James H. Graves, Director
/s/ Jim W. Henderson
Jim W. Henderson, Director
/s/ Scott T. Berlin
Scott T. Berlin, Director
59
Exhibit 21
Subsidiaries of Hallmark Financial Services, Inc.
Name of Subsidiary
Jurisdiction of Incorporation
o Aerospace Claims Management Group, Inc.*
o Aerospace Flight, Inc.*
o Aerospace Holdings, LLC*
o Aerospace Insurance Managers, Inc.*
o Aerospace Special Risk, Inc.*
o American Hallmark General Agency, Inc.
(d/b/a Hallmark Insurance Company)
o American Hallmark Insurance Company of Texas*
o American Hallmark Insurance Services, Inc.*
o CYR Insurance Management Company*
o Effective Claims Management, Inc.*
o Hallmark Claims Service, Inc.
(d/b/a Hallmark Insurance Company)
o Hallmark County Mutual Insurance Company*
(controlled through a management agreement)
o Hallmark Finance Corporation*
o Hallmark Insurance Company*
o Hallmark National Insurance Company*
o Hallmark Specialty Insurance Company*
o Hardscrabble Data Solutions, LLC*
o Heath XS, LLC*
o Pan American Acceptance Corporation*
o TBIC Holding Corporation, Inc.*
o TBIC Risk Management, Inc.*
o Texas Builders Insurance Company*
o Hallmark Specialty Underwriters, Inc.*
o TGA Special Risk, Inc.*
* Conducts business under its corporate name.
Texas
Texas
Texas
Texas
Texas
Texas
Texas
Texas
Texas
Texas
Texas
Texas
Texas
Arizona
Ohio
Oklahoma
New Jersey
New Jersey
Texas
Texas
Texas
Texas
Texas
Texas
60
Exhibit 23(a)
Consent Of Independent Registered Public Accounting Firm
We consent to the incorporation by reference in the following Registration Statements:
(1) Registration Statement (Form S-8 No. 333-41220) pertaining to the Hallmark Financial Services, Inc. 1991 Key
Employee Stock Option Plan, Hallmark Financial Services, Inc. 1994 Key Employee Long Term Incentive Plan and
Hallmark Financial Services, Inc. 1994 Non-Employee Director Stock Option Plan;
(2) Registration Statement (Form S-8 No. 333-140000) pertaining to Hallmark Financial Services, Inc. 2005 Long Term
Incentive Plan;
(3) Registration Statement (Form S-8 No. 333-160050) pertaining to Hallmark Financial Services, Inc. 2005 Long Term
Incentive Plan; and
(4) Registration Statement (Form S-3 No. 333-171696) and related Prospectus pertaining to the registration of
3,274,830 shares of common stock;
of our reports dated March 12, 2014, with respect to the consolidated financial statements and schedules of Hallmark Financial
Services, Inc. and subsidiaries and the effectiveness of internal control over financial reporting of Hallmark Financial Services,
Inc. and subsidiaries included in this Annual Report (Form 10-K) for the year ended December 31, 2013.
/s/ Ernst & Young LLP
Fort Worth, Texas
March 12, 2014
61
Exhibit 31(a)
CERTIFICATIONS
I, Mark J. Morrison, certify that:
1.
I have reviewed this annual report on Form 10-K of Hallmark Financial Services, Inc.;
2. Based on my knowledge, this 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 report;
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present
in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods
presented in this report;
4. The Registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and
procedures [as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)] and internal control over financial reporting [as defined
in Exchange Act Rules 13a-15(f) and 15d-15(f)] for the Registrant and have:
a)
designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be
designed under our supervision, to ensure that material information relating to the Registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being
prepared;
b)
designed such internal control over financial reporting, or caused such internal control over financial
reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
c)
evaluated the effectiveness of the Registrant’s disclosure controls and procedures and presented in this
report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by
this report based on such evaluation; and
d)
disclosed in this report any change in the Registrant’s internal control over financial reporting that occurred
during the Registrant’s most recent fiscal quarter (the Registrant’s fourth fiscal quarter in the case of an annual report) that has
materially affected, or is reasonably likely to materially affect, the Registrant’s internal control over financial reporting; and
5.
The Registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control
over financial reporting, to the Registrant’s auditors and the audit committee of the Registrant’s board of directors (or persons
performing the equivalent functions):
a)
all significant deficiencies and material weaknesses in the design or operation of internal control over
financial reporting which are reasonably likely to adversely affect the Registrant’s ability to record, process, summarize and
report financial information; and
b)
any fraud, whether or not material, that involves management or other employees who have a significant
role in the Registrant’s internal control over financial reporting.
Date: March 12, 2014
/s/ Mark J. Morrison
Mark J. Morrison, Chief Executive Officer
62
Exhibit 31(b)
CERTIFICATIONS
I, Jeffrey R. Passmore, certify that:
1.
I have reviewed this annual report on Form 10-K of Hallmark Financial Services, Inc.;
2. Based on my knowledge, this 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 report;
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly
present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the
periods presented in this report;
4. The Registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and
procedures [as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)] and internal control over financial reporting [as defined
in Exchange Act Rules 13a-15(f) and 15d-15(f)] for the Registrant and have:
a)
designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be
designed under our supervision, to ensure that material information relating to the Registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being
prepared;
b)
designed such internal control over financial reporting, or caused such internal control over financial
reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
c)
evaluated the effectiveness of the Registrant’s disclosure controls and procedures and presented in this
report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by
this report based on such evaluation; and
d)
disclosed in this report any change in the Registrant’s internal control over financial reporting that occurred
during the Registrant’s most recent fiscal quarter (the Registrant’s fourth fiscal quarter in the case of an annual report) that has
materially affected, or is reasonably likely to materially affect, the Registrant’s internal control over financial reporting; and
5.
The Registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control
over financial reporting, to the Registrant’s auditors and the audit committee of the Registrant’s board of directors (or persons
performing the equivalent functions):
a)
all significant deficiencies and material weaknesses in the design or operation of internal control over
financial reporting which are reasonably likely to adversely affect the Registrant’s ability to record, process, summarize and
report financial information; and
b)
any fraud, whether or not material, that involves management or other employees who have a significant
role in the Registrant’s internal control over financial reporting.
Date: March 12, 2014
/s/ Jeffrey R. Passmore
Jeffrey R. Passmore, Chief Accounting Officer
63
Exhibit 32(a)
CERTIFICATION PURSUANT TO 18 U.S.C. § 1350
I, Mark J. Morrison, Chief Executive Officer of Hallmark Financial Services, Inc. (the "Company"), hereby certify
that the accompanying annual report on Form 10-K for the fiscal year ended December 31, 2013, and filed with the Securities
and Exchange Commission on the date hereof (the "Report"), fully complies with the requirements of Section 13(a) or 15(d) of
the Securities Exchange Act of 1934, as amended. I further certify that the information contained in the Report fairly presents,
in all material respects, the financial condition and results of operations of the Company.
Date: March 12, 2014
/s/ Mark J. Morrison
Mark J. Morrison,
Chief Executive Officer
64
Exhibit 32(b)
CERTIFICATION PURSUANT TO 18 U.S.C. § 1350
I, Jeffrey R. Passmore, Chief Accounting Officer of Hallmark Financial Services, Inc. (the "Company"), hereby certify
that the accompanying annual report on Form 10-K for the fiscal year ended December 31, 2013, and filed with the Securities
and Exchange Commission on the date hereof (the "Report"), fully complies with the requirements of Section 13(a) or 15(d) of
the Securities Exchange Act of 1934, as amended. I further certify that the information contained in the Report fairly presents,
in all material respects, the financial condition and results of operations of the Company.
Date: March 12, 2014
/s/ Jeffrey R. Passmore
Jeffrey R. Passmore,
Chief Accounting Officer
65
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Description
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets at December 31, 2013 and 2012
Consolidated Statements of Operations for the Years Ended December 31, 2013, 2012 and 2011
Consolidated Statements of Comprehensive Income (Loss) for the Years Ended December 31, 2013, 2012
and 2011
Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2013, 2012 and 2011
Consolidated Statements of Cash Flows for the Years Ended December 31, 2013, 2012 and 2011
Notes to Consolidated Financial Statements
Financial Statement Schedules
Page
Number
F-2
F-3
F-4
F-5
F-6
F-7
F-8
F-41
F-1
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of
Hallmark Financial Services, Inc. and subsidiaries
We have audited the accompanying consolidated balance sheets of Hallmark Financial Services, Inc. and subsidiaries
(the Company) as of December 31, 2013 and 2012, and the related consolidated statements of operations,
comprehensive income (loss), stockholders’ equity, and cash flows for each of the three years in the period ended
December 31, 2013. Our audits also included the financial statement schedules listed in Item 15(a)(2). These financial
statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an
opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with the auditing standards of the Public Company Accounting Oversight Board
(United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated
financial position of Hallmark Financial Services, Inc. and subsidiaries at December 31, 2013 and 2012, and the
consolidated results of their operations and their cash flows for each of the three years in the period ended December
31, 2013, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial
statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all
material respects, the information set forth therein.
We also have audited in accordance with the standards of the Public Company Oversight Board (United States),
Hallmark Financial Services, Inc. and subsidiaries internal control over financial reporting as of December 31, 2013,
based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (1992 Framework) and our report dated March 12, 2014 expressed an
unqualified opinion thereon.
/s/ Ernst & Young LLP
Fort Worth, Texas
March 12, 2014
F-2
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 2013 and 2012
($ in thousands)
Investments:
ASSETS
Debt securities, available-for-sale, at fair value (cost; $408,627 in 2013 and $397,800 in 2012)
Equity securities, available-for-sale, at fair value (cost; $24,902 in 2013 and $31,502 in 2012)
$
Total investments
Cash and cash equivalents
Restricted cash
Ceded unearned premiums
Premiums receivable
Accounts receivable
Receivable for securities
Reinsurance recoverable
Deferred policy acquisition costs
Goodwill
Intangible assets, net
Deferred federal income taxes, net
Prepaid expenses
Other assets
$
$
Total assets
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Revolving credit facility payable
Subordinated debt securities
Reserves for unpaid losses and loss adjustment expenses
Unearned premiums
Reinsurance balances payable
Pension liability
Payable for securities
Federal income tax payable
Deferred federal income taxes, net
Accounts payable and other accrued expenses
Total liabilities
Commitments and contingencies (Note 16)
Stockholders’ equity:
Common stock, $.18 par value, authorized 33,333,333 shares; issued 20,872,831 shares in 2013
and 2012
Additional paid-in capital
Retained earnings
Accumulated other comprehensive income
Treasury stock (1,609,374 shares in 2013 and 2012), at cost
2013
2012
$
410,095
51,230
461,325
401,435
43,925
445,360
141,666
12,190
44,988
71,157
2,382
1,320
76,818
22,586
44,695
19,953
-
1,531
8,412
909,023
1,473
56,702
382,640
185,303
20,598
1,433
206
719
2,825
19,006
670,905
$
$
85,145
8,707
22,411
66,683
3,110
3
51,970
24,911
44,695
23,068
1,940
1,480
10,985
790,468
1,473
56,702
313,416
162,502
7,330
3,685
-
1,518
-
23,305
569,931
3,757
122,827
106,209
16,883
(11,558 )
3,757
122,475
97,964
7,899
(11,558 )
Total stockholders’ equity
238,118
220,537
The accompanying notes are an integral part of the consolidated financial statements
$
909,023
$
790,468
F-3
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
For the years ended December 31, 2013, 2012 and 2011
($ in thousands, except per share amounts)
Gross premiums written
Ceded premiums written
Net premiums written
Change in unearned premiums
Net premiums earned
Investment income, net of expenses
Net realized gains
Finance charges
Commission and fees
Other income
2013
2012
2011
$
$
460,027
(99,262 )
360,765
(224 )
360,541
$
389,842
(57,353 )
332,489
(13,053 )
319,436
12,884
10,540
5,830
(487 )
120
15,293
1,943
5,957
(1,145 )
316
354,881
(51,005 )
303,876
(10,835 )
293,041
15,880
3,633
6,826
3,175
216
Total revenues
389,428
341,800
322,771
Losses and loss adjustment expenses
Operating expenses
Interest expense
Amortization of intangible assets
261,345
109,289
4,599
3,115
226,414
103,792
4,634
3,586
239,235
95,106
4,631
3,586
Total expenses
378,348
338,426
342,558
Income (loss) before tax
Income tax expense (benefit)
Net income (loss)
Less: Net income attributable to non-controlling interest
11,080
2,835
8,245
-
3,374
(474 )
3,848
324
(19,787 )
(8,954 )
(10,833 )
58
Net income (loss) attributable to Hallmark Financial Services, Inc.
$
8,245
$
3,524
$
(10,891 )
Net income (loss) per share attributable to
Hallmark Financial Services, Inc. common stockholders:
Basic
Diluted
$
$
0.43
0.43
$
$
0.18
0.18
$
$
(0.55 )
(0.55 )
The accompanying notes are an integral part of the consolidated financial statements
F-4
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
For the years ended December 31, 2013, 2012 and 2011
(In thousands)
Net income (loss)
Other comprehensive income (loss):
Change in net actuarial gain (loss)
Tax effect on change in net actuarial gain (loss)
2013
2012
2011
$
8,245
$
3,848
$
(10,833 )
2,268
(794 )
37
(13 )
(1,468 )
514
191
(67 )
Unrealized holding gains arising during the period
22,094
4,388
Tax effect on unrealized holding gains arising during the period
(7,733 )
(1,536 )
Reclassification adjustment for gains included in net income (loss)
(10,540 )
(2,189 )
(3,633 )
Tax effect on reclassification adjustment for gains included in net income (loss)
3,689
766
1,272
Other comprehensive income (loss), net of tax
Comprehensive income (loss)
Less: comprehensive income attributable to non-controlling interest
Comprehensive income (loss) attributable to Hallmark Financial Services, Inc.
8,984
17,229
-
17,229
$
$
$
$
1,453
5,301
324
4,977
$
$
(3,191 )
(14,024 )
58
(14,082 )
The accompanying notes are an integral part of the consolidated financial statements
F-5
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
For the years ended December 31, 2013, 2012 and 2011
(In thousands)
Number
of
Shares
20,873
Par
Value
$ 3,757
Additional
Paid-In
Capital
$ 121,815
Retained
Earnings
$ 105,331
Accumulated Other
Comprehensive
Income (Loss)
9,637
-
-
-
-
-
-
-
-
-
-
-
-
-
709
(6 )
$
-
-
-
(31 )
-
-
(10,891 )
-
-
-
-
(3,191 )
Total
Stockholders'
Equity
Treasury
Stock
$ (5,262 )
(6,401 )
-
-
-
Number
of
Shares
749
$
875
-
(15 )
-
105
-
-
-
-
-
-
235,278
(6,401 )
709
99
(31 )
(10,891 )
(3,191 )
20,873
-
$ 3,757
-
$ 122,487
380
$ 94,440
-
$
6,446
-
$ (11,558 )
-
1,609
-
$
215,572
380
-
-
-
-
-
-
(392 )
-
-
3,524
-
-
-
-
1,453
-
-
-
-
-
-
(392 )
3,524
1,453
20,873
-
-
$ 3,757
-
-
$ 122,475
352
-
$ 97,964
-
8,245
$
7,899
-
-
$ (11,558 )
-
-
$
1,609
-
-
220,537
352
8,245
-
20,873
-
$ 3,757
-
$ 122,827
-
$ 106,209
$
8,984
16,883
-
$ (11,558 )
-
1,609
$
8,984
238,118
Balance at January 1, 2011
Acquisition of treasury shares
Equity incentive plan activity
Stock options exercised
Accretion of redeemable non-
controlling interest
Net loss, as adjustedc
Other comprehensive loss, net of
tax
Balance at December 31, 2011
Equity incentive plan activity
Accretion of redeemable non-
controlling interest
Net income
Other comprehensive income, net
of tax
Balance at December 31, 2012
Equity incentive plan activity
Net income
Other comprehensive income, net
of tax
Balance at December 31, 2013
The accompanying notes are an integral part of the consolidated financial statements
F-6
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the years ended December 31, 2013, 2012 and 2011
($ in thousands)
Cash flows from operating activities:
Net income (loss)
Adjustments to reconcile net income (loss) to cash provided by operating activities:
2013
2012
2011
$
8,245
$
3,848
$
(10,833 )
Depreciation and amortization expense
Deferred federal income taxes
Net realized gains
Share-based payments expense
Change in ceded unearned premiums
Change in premiums receivable
Change in accounts receivable
Change in deferred policy acquisition costs
Change in unpaid losses and loss adjustment expenses
Change in unearned premiums
Change in reinsurance recoverable
Change in reinsurance balances payable
Change in current federal income tax (recoverable)payable
Change in all other liabilities
Change in all other assets
Net cash provided by operating activities
Cash flows from investing activities:
Purchases of property and equipment, net
Acquisitions of subsidiaries, net of cash received
Net transfers (into) from restricted cash
Purchases of investment securities
Maturities, sales and redemptions of investment securities
Net cash used in investing activities
Cash flows from financing activities:
Activity under revolving credit facility, net
Repayment of notes payable of acquired subsidiary
Redemption of non-controlling interest
Distribution to non-controlling interest
Payment of contingent consideration
Proceeds from exercise of employee stock options
Purchase of treasury shares
Net cash used in financing activities
Increase in cash and cash equivalents
Cash and cash equivalents at beginning of year
Cash and cash equivalents at end of year
Supplemental cash flow information:
Interest paid
Income taxes (paid) recovered
Supplemental schedule of non-cash activities:
Change in receivable for securities related to investment disposals that settled after the
balance sheet date
Change in payable for securities related to investment purchases that settled after the
balance sheet date
4,300
(257 )
(10,540 )
352
(22,577 )
(4,474 )
728
2,325
69,224
22,801
(24,848 )
13,268
(799 )
(6,551 )
17,141
68,338
(673 )
-
(3,483 )
(222,399 )
214,738
(11,817 )
-
-
-
-
-
-
-
-
56,521
85,145
141,666
(4,599 )
(3,891 )
(1,317 )
206
$
$
$
$
$
$
$
$
$
$
4,421
(2,851 )
(1,943 )
380
(2,941 )
(13,170 )
836
(2,357 )
16,471
16,398
(9,236 )
4,191
8,256
5,396
5,983
33,682
(107 )
-
665
(167,626 )
148,968
(18,100 )
(2,577 )
-
(1,700 )
(281 )
(350 )
-
-
(4,908 )
10,674
74,471
85,145
(4,656 )
5,879
2,614
(203 )
5,064
(2,895 )
(3,633 )
709
6,034
(3,842 )
2,347
(1,621 )
33,088
4,801
227
(246 )
(2,470 )
(5,707 )
3,587
24,610
(1,586 )
(13,334 )
(4,095 )
(265,684 )
280,918
(3,781 )
1,250
(1,660 )
-
(165 )
-
99
(6,401 )
(6,877 )
13,952
60,519
74,471
(4,620 )
3,589
(402 )
(2,290 )
$
$
$
$
$
The accompanying notes are an integral part of the consolidated financial statements
F-7
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
1. Accounting Policies:
General
Hallmark Financial Services, Inc. (“Hallmark” and, together with subsidiaries, the “Company”, “we,” “us” or “our”) is an insurance
holding company engaged in the sale of property/casualty insurance products to businesses and individuals. Our business involves
marketing, distributing, underwriting and servicing our insurance products, as well as providing other insurance related services.
We pursue our business activities primarily through subsidiaries whose operations are organized into five business units that are
supported by our insurance company subsidiaries. Our Standard Commercial P&C business unit handles commercial insurance
products and services and is comprised of American Hallmark Insurance Services, Inc. (“American Hallmark Insurance Services”) and
Effective Claims Management, Inc. (“ECM”). Our Workers Compensation business unit specializes in small and middle market workers
compensation business and is comprised of TBIC Holding Corporation, Inc. (“TBIC Holding”), Texas Builders Insurance Company
(“TBIC”) and TBIC Risk Management (“TBICRM”). The subsidiaries comprising our Workers Compensation business unit were acquired
July 1, 2011. Our E&S Commercial business unit handles primarily commercial insurance products and services and is comprised of
Hallmark Specialty Underwriters, Inc. (“HSU”), Pan American Acceptance Corporation (“PAAC”) and TGA Special Risk, Inc. (“TGASRI”).
Our Hallmark Select business unit offers (i) general aviation insurance products and services, (ii) low and middle market commercial
umbrella and excess liability insurance, (iii) medical professional liability insurance products and services, and (iv) satellite launch
insurance products. Our Hallmark Select business unit is the combination of our operations previously known as our General Aviation
business unit, our Excess & Umbrella business unit, the medical professional liability business previously handled by our E&S
Commercial business unit and the satellite launch insurance products previously managed at the parent level. Our Hallmark Select
business unit is comprised of Aerospace Insurance Managers, Inc. (“Aerospace Insurance Managers”), Aerospace Special Risk, Inc.
(“ASRI”), Aerospace Claims Management Group, Inc. (“ACMG”), Heath XS, LLC (“HXS”) and Hardscrabble Data Solutions, LLC (“HDS”).
Our Personal Lines business unit handles personal insurance products and services and is comprised of American Hallmark General
Agency, Inc. and Hallmark Claims Services, Inc. (both of which do business as Hallmark Insurance Company). Our insurance company
subsidiaries supporting these business units are American Hallmark Insurance Company of Texas (“AHIC”), Hallmark Insurance
Company (“HIC”), Hallmark Specialty Insurance Company (“HSIC”), Hallmark County Mutual Insurance Company (“HCM”), Hallmark
National Insurance Company (“HNIC”) and TBIC.
These five business units are segregated into three reportable industry segments for financial accounting purposes. The Standard
Commercial Segment includes our Standard Commercial P&C business unit and our Workers Compensation business unit. The
Specialty Commercial Segment includes our E&S Commercial business unit and our Hallmark Select business unit, as well as certain
specialty risk programs (“Specialty Programs”) which are managed by Hallmark. The Personal Segment presently consists solely of our
Personal Lines business unit.
Basis of Presentation
The accompanying consolidated financial statements include the accounts and operations of Hallmark and its subsidiaries.
Intercompany accounts and transactions have been eliminated. The accompanying consolidated financial statements have been
prepared in conformity with U.S. generally accepted accounting principles (“GAAP”) which, as to our insurance company subsidiaries,
differ from statutory accounting practices prescribed or permitted for insurance companies by insurance regulatory authorities.
Use of Estimates in the Preparation of Financial Statements
Our preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that
affect our reported amounts of assets and liabilities at the dates of the financial statements and our reported amounts of revenues
and expenses during the reporting periods. Management evaluates its estimates and assumptions on an ongoing basis using historical
experience and other factors, including the current economic environment, which management believes to be reasonable under the
circumstances. We adjust such estimates and assumptions when facts and circumstances dictate. Since future events and their effects
cannot be determined with precision, actual results could differ significantly from these estimates. Changes in estimates resulting
from continuing changes in the economic environment may be reflected in the financial statements in future periods.
F-8
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
Fair Value of Financial Instruments
Fair value estimates are made at a point in time, based on relevant market data as well as the best information available about the
financial instruments. Fair value estimates for financial instruments for which no or limited observable market data is available are
based on judgments regarding current economic conditions, credit and interest rate risk. These estimates involve significant
uncertainties and judgments and cannot be determined with precision. As a result, such calculated fair value estimates may not be
realizable in a current sale or immediate settlement of the instrument. In addition, changes in the underlying assumptions used in the
fair value measurement technique, including discount rate and estimates of future cash flows, could significantly affect these fair
value estimates.
Cash and Cash Equivalents: The carrying amounts reported in the balance sheet for these instruments approximate their fair values.
Restricted Cash: The carrying amount for restricted cash reported in the balance sheet approximates the fair value.
Revolving Credit Facility Payable: The carrying value of our bank revolving credit facility approximates the fair value based on the
current interest rate.
Subordinated debt securities: Our trust preferred securities are reported at carry value of $56.7 million and $56.7 million, and have a
fair value of $53.2 million and $48.2 million, as of December 31, 2013 and 2012, respectively. The fair value of our trust preferred
securities is based on discounted cash flows using current yields to maturity of 8.0% and 8.0% as of December 31, 2013 and 2012,
respectively, which are based on similar issues to discount future cash flows and would be included in Level 3 of the fair value
hierarchy if they were reported at fair value.
For reinsurance balances, premiums receivable, federal income tax payable, other assets and other liabilities, the carrying amounts
approximate fair value because of the short maturity of such financial instruments.
Investments
Debt and equity securities available for sale are reported at fair value. Unrealized gains and losses are recorded as a component of
stockholders’ equity, net of related tax effects. Equity securities that are determined to have other-than-temporary impairment are
recognized as a loss on investments in the consolidated statements of operations. Debt securities that are determined to have other-
than-temporary impairment are recognized as a loss on investments in the consolidated statements of operations for the portion that
is related to credit deterioration with the remaining portion recognized in other comprehensive income. Debt security premiums and
discounts are amortized into earnings using the effective interest method. Maturities of debt securities and sales of equity securities
are recorded in receivable for securities until the cash is settled. Purchases of debt and equity securities are recorded in payable for
securities until the cash is settled.
Realized investment gains and losses are recognized in operations on the specific identification method.
Cash and Cash Equivalents
We consider all highly liquid investments with an original maturity of three months or less to be cash equivalents.
Restricted Cash
We collect premiums from customers and, after deducting authorized commissions, remit these premiums to the Company’s
consolidated insurance subsidiaries. Unremitted insurance premiums are held in a fiduciary capacity until disbursed to the Company’s
consolidated insurance subsidiaries.
Premiums Receivable
Premiums receivable represent amounts due from policyholders or independent agents for premiums written and uncollected. These
balances are carried at net realizable value.
F-9
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
Reinsurance
We are routinely involved in reinsurance transactions with other companies. Reinsurance premiums, losses and loss adjustment
expenses (“LAE”) are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of
the reinsurance contracts. (See Note 7.)
Deferred Policy Acquisition Costs
Policy acquisition costs (mainly commission, underwriting and marketing expenses) that are directly related to the successful
acquisition of new and renewal insurance contracts are deferred and charged to operations over periods in which the related
premiums are earned. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs
to their estimated realizable value. In determining estimated realizable value, the computation gives effect to the premium to be
earned, expected investment income, losses and LAE and certain other costs expected to be incurred as the premiums are earned. If
the computation results in an estimated net realizable value less than zero, a liability will be accrued for the premium deficiency.
During 2013, 2012 and 2011, we deferred $55.0 million, $62.2 million and $49.4 million of policy acquisition costs and amortized
$57.3 million, $59.8 million and $47.8 million of deferred policy acquisition costs, respectively. Therefore, the net (amortization)
deferrals of policy acquisition costs were ($2.3) million, $2.4 million and $1.6 million for 2013, 2012 and 2011, respectively.
Business Combinations
We account for business combinations using the acquisition method of accounting pursuant to Accounting Standards Codification
(“ASC”) 805, “Business Combinations.” The base cash purchase price plus the estimated fair value of any non-cash or contingent
consideration given for an acquired business is allocated to the assets acquired (including identified intangible assets) and liabilities
assumed based on the estimated fair values of such assets and liabilities. The excess of the fair value of the total consideration given
for an acquired business over the aggregate net fair values assigned to the assets acquired and liabilities assumed is recorded as
goodwill. Contingent consideration is recognized as a liability at fair value as of the acquisition date with subsequent fair value
adjustments recorded in the consolidated statements of operations. The valuation of contingent consideration requires assumptions
regarding anticipated cash flows, probabilities of cash flows, discount rates and other factors. Significant judgment is employed in
determining the propriety of these assumptions as of the acquisition date and for each subsequent period. Accordingly, future
business and economic conditions, as well as changes in any of the assumptions, can materially impact the amount of contingent
consideration expense we record in any given period. Indirect and general expenses related to business combinations are expensed
as incurred.
Goodwill and Intangible Assets, net
We account for our goodwill and intangible assets according to ASC 350, “Intangibles – Goodwill and Other.” ASC 350 (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 testing of definite-lived intangible assets if the occurrence of an event or circumstances indicates an impairment, (4) requires
that reporting units be identified for the purpose of assessing potential future impairments of goodwill, and (5) removes the forty-
year limitation on the amortization period of intangible assets that have finite lives. We have elected to perform our goodwill
impairment test on the first day of the fourth quarter, October 1, of each year.
Leases
We have several leases, primarily for office facilities and computer equipment, which expire in various years through 2022. Some of
these leases include rent escalation provisions throughout the term of the lease. We expense the average annual cost of the lease
with the difference to the actual rent invoices recorded as deferred rent which is classified in accounts payable and other accrued
expenses on our consolidated balance sheets.
F-10
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
Property and Equipment
Property and equipment (including leasehold improvements), aggregating $14.7 million and $13.6 million, at December 31, 2013 and
2012, respectively, which is included in other assets, is recorded at cost and is depreciated using the straight-line method over the
estimated useful lives of the assets (three to ten years). Depreciation expense for 2013, 2012 and 2011 was $1.2 million, $1.2 million
and $1.5 million, respectively. Accumulated depreciation was $12.6 million and $11.4 million at December 31, 2013 and 2012,
respectively.
Variable Interest Entities
On June 21, 2005, we formed Hallmark Statutory Trust I (“Trust I”), an unconsolidated trust subsidiary, for the sole purpose of issuing
$30.0 million in trust preferred securities. Trust I used the proceeds from the sale of these securities and our initial capital
contribution to purchase $30.9 million of subordinated debt securities from Hallmark. The debt securities are the sole assets of Trust
I, and the payments under the debt securities are the sole revenues of Trust I.
On August 23, 2007, we formed Hallmark Statutory Trust II (“Trust II”), an unconsolidated trust subsidiary, for the sole purpose of
issuing $25.0 million in trust preferred securities. Trust II used the proceeds from the sale of these securities and our initial capital
contribution to purchase $25.8 million of subordinated debt securities from Hallmark. The debt securities are the sole assets of Trust
II, and the payments under the debt securities are the sole revenues of Trust II.
We evaluate on an ongoing basis our investments in Trust I and Trust II (collectively, (the “Trusts”)) and we do not have variable
interests in the Trusts. Therefore, the Trusts are not consolidated in our consolidated financial statements.
We are also involved in the normal course of business with variable interest entities primarily as a passive investor in mortgage-
backed securities and certain collateralized corporate bank loans issued by third party variable interest entities. The maximum
exposure to loss with respect to these investments is limited to the investment carrying values included in the consolidated balance
sheets.
Losses and Loss Adjustment Expenses
Losses and LAE represent the estimated ultimate net cost of all reported and unreported losses incurred through December 31, 2013,
2012 and 2011. The reserves for unpaid losses and LAE are estimated using individual case-basis valuations and statistical analyses.
These estimates are subject to the effects of trends in loss severity and frequency. Although considerable variability is inherent in
such estimates, we believe that the reserves for unpaid losses and LAE are adequate. The estimates are continually reviewed and
adjusted as experience develops or new information becomes known. Such adjustments are included in current operations.
Redeemable Non-Controlling Interest
We accreted the redeemable non-controlling interest to its redemption value from the date of issuance to the redemption date using
the interest method. Changes in redemption value were considered a change in accounting estimate. We followed the two class
method of computing earnings per share. We treated only the portion of the periodic adjustment to the redeemable non-controlling
interest carrying amount that reflects a redemption in excess of fair value as being akin to an actual dividend. Effective September 30,
2012, we exercised our call option and acquired the remaining 20% membership interests in the subsidiaries for $1.7 million.
Activity related to non-controlling interest for the years ended December 31, 2013 and 2012 is as follows (in thousands):
Beginning balance
Accretion of redeemable non-controlling interest
Net income attributable to non-controlling interest
Distribution to non-controlling interest
Redemption of non-controlling interest
Other
Ending balance
2013
2012
-
-
-
-
-
-
-
$
$
1,284
392
324
(281 )
(1,700 )
(19 )
-
$
$
F-11
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
Recognition of Premium Revenues
Insurance premiums are earned pro rata over the terms of the policies. Insurance policy fees are earned as of the effective date of the
policy. Upon cancellation, any unearned premium is refunded to the insured. Insurance premiums written include gross policy fees of
$13.2 million, $11.8 million and $13.5 million for the years ended December 31, 2013, 2012, and 2011, respectively. Insurance
premiums on monthly reporting workers’ compensation policies are earned on the conclusion of the monthly coverage period.
Deposit premiums for workers’ compensation policies are earned upon the expiration of the policy.
Finance Charges
We receive premium installment fees for each direct bill payment from policyholders. Installment fee income is classified as finance
charges on the consolidated statement of operations and is recognized as the fee is invoiced.
Relationship with Third Party Insurers
Through December 31, 2005, our Standard Commercial P&C business unit marketed policies on behalf of Clarendon National
Insurance Company (“Clarendon”), a third-party insurer. Through December 31, 2008, all business of our E&S Commercial business
unit was produced under a fronting agreement with member companies of the Republic Group (“Republic”), a third-party insurer.
These insurance contracts on third party paper are accounted for under agency accounting. Ceding commissions and other fees
received under these arrangements were classified as unearned commission revenue until earned pro rata over the terms of the
policies.
Profit sharing commission is calculated and recognized when the loss ratio, as determined by a qualified actuary, deviates from
contractual targets. We received a provisional commission as policies were produced as an advance against the later determination of
the profit sharing commission actually earned. The profit sharing commission is an estimate that varies with the estimated loss ratio
and is sensitive to changes in that estimate. Profit share commission is classified as commissions and fees on the consolidated
statement of operations
The following table details the profit sharing commission provisional loss ratio compared to the estimated ultimate loss ratio for each
effective quota share treaty between the Standard Commercial P&C business unit and Clarendon.
Provisional loss ratio
Estimated ultimate loss ratio recorded to at December 31,
2013
07/1/01
Treaty Effective Dates
07/1/03
07/1/02
07/1/04
60.0 %
63.5 %
59.0 %
64.5 %
59.0 %
60.9 %
64.2 %
63.7 %
As of December 31, 2013, we had a net receivable of $0.1 million on these profit share treaties. The payable or receivable is the
difference between the cash received to date and the recognized commission revenue based on the estimated ultimate loss ratio.
The following table details the profit sharing commission revenue provisional loss ratio compared to the estimated ultimate loss ratio
for the effective quota share treaty between the E&S Commercial business unit and Republic.
Treaty Effective Dates
01/01/07
01/01/06
01/01/08
Provisional loss ratio
Estimated ultimate loss ratio recorded to at December 31, 2013
65.0 %
58.6 %
65.0 %
63.2 %
65.0 %
59.0 %
As of December 31, 2013, we had a net payable of $1.2 million on these profit share treaties. The payable or receivable is the
difference between the cash received to date and the recognized commission revenue based on the estimated ultimate loss ratio.
F-12
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
Agent Commissions
We pay monthly commissions to agents based on written premium produced, but generally recognize the expense pro rata over the
term of the policy. If the policy is cancelled prior to its expiration, the unearned portion of the agent commission is refundable to us.
The unearned portion of commissions paid to agents is included in deferred policy acquisition costs. Commission expenses related to
the insurance policies issued by our Hallmark Select business unit for third party insurance carriers and not assumed by our insurance
company subsidiaries are recognized as of the effective date of the policy.
We annually pay a profit sharing commission to our independent agency force based upon the results of the business produced by
each agent. We estimate and accrue this liability to commission expense in the year the business is produced.
Commission expense is classified as other operating expenses in the consolidated statement of operations.
Income Taxes
We file a consolidated federal income tax return. Deferred federal income taxes reflect the future tax consequences of differences
between the tax basis of assets and liabilities and their financial reporting amounts at each year end. Deferred taxes are recognized
using the liability method, whereby tax rates are applied to cumulative temporary differences based on when and how they are
expected to affect the tax return. Deferred tax assets and liabilities are adjusted for tax rate changes in effect for the year in which
these temporary differences are expected to be recovered or settled.
Earnings Per Share
The computation of earnings per share is based upon the weighted average number of common shares outstanding during the period
plus the effect of common shares potentially issuable (in periods in which they have a dilutive effect), primarily from stock options.
(See Notes 11 and 13.)
Adoption of New Accounting Pronouncements
In January 2013, we adopted new guidance issued by the Financial Accounting Standards Board (“FASB”) related to reporting and
disclosure requirements about changes in accumulated other comprehensive income balances and reclassifications out of
accumulated other comprehensive income. The new guidance is effective prospectively for fiscal and interim periods beginning after
December 15, 2012. The adoption of this guidance did not have a material impact on our financial position or results of operations
but did require additional disclosures.
F-13
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
2.
Investments:
The amortized cost and estimated fair value of investments in debt and equity securities by category is as follows (in thousands):
As of December 31, 2013
U.S. Treasury securities and obligations of U.S. Government
Corporate bonds
Collateralized corporate bank loans
Municipal bonds
Mortgage-backed
$
$
78,894
42,946
102,053
156,950
27,784
$
24
1,379
614
2,577
460
Fair
Value
$ 78,753
43,875
102,178
157,552
27,737
(165 )
(450 )
(489 )
(1,975 )
(507 )
Amortized
Cost
Gross
Unrealized
Gains
Gross
Unrealized
Losses
Total debt securities
408,627
5,054
(3,586 )
410,095
Total equity securities
24,902
26,642
(314 )
51,230
Total debt and equity securities
$
433,529
$
31,696
$
(3,900 )
$ 461,325
As of December 31, 2012
U.S. Treasury securities and obligations of U.S. Government
Corporate bonds
Collateralized corporate bank loans
Municipal bonds
Mortgage-backed
$
$
40,050
79,516
106,093
162,479
9,662
$
14
2,794
1,021
4,023
97
(3 )
(763 )
(743 )
(2,770 )
(35 )
$ 40,061
81,547
106,371
163,732
9,724
Total debt securities
397,800
7,949
(4,314 )
401,435
Total equity securities
31,502
12,938
(515 )
43,925
Total debt and equity securities
$
429,302
$
20,887
$
(4,829 )
$ 445,360
F-14
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
Major categories of net investment income are summarized as follows (in thousands):
U.S. Treasury securities and obligations of U.S. Government
Corporate bonds
Collateralized corporate bank loans
Municipal bonds
Mortgage-backed
Equity securities
Cash and cash equivalents
Investment expenses
Investment income, net of expenses
Twelve Months Ended
December 31
2012
2011
2013
$
$
143
2,341
4,653
5,245
737
484
157
13,760
(876 )
12,884
$
$
53
4,218
5,261
5,616
106
534
246
16,034
(741 )
15,293
$
$
115
3,851
5,284
6,632
86
484
163
16,615
(735 )
15,880
No investments in any entity or its affiliates exceeded 10% of stockholders’ equity at December 31, 2013 or 2012.
Major categories of net realized gains on investments are summarized as follows (in thousands):
Twelve Months Ended
December 31
2012
2013
2011
U.S. Treasury securities and obligations of U.S. Government
Corporate bonds
Collateralized corporate bank loans
Municipal bonds
Equity securities
Net realized gain
Other-than-temporary impairments
Gain on investments
$
$
$
-
853
373
(156 )
9,470
10,540
-
10,540
$
$
-
13
391
(441 )
2,226
2,189
(246 )
1,943
$
35
300
699
(500 )
3,099
3,633
-
3,633
We realized gross gains on investments of $10.9 million, $2.9 million, and $4.6 million during the years ended December 31, 2013,
2012 and 2011, respectively. We realized gross losses on investments of $0.4 million, $0.7 million and $1.0 million during the years
ended December 31, 2013, 2012 and 2011, respectively. We recorded proceeds from the sale of investment securities of $33.4
million, $12.4 million and $62.7 million during the years ended December 31, 2013, 2012 and 2011, respectively. Realized investment
gains and losses are recognized in operations on the specific identification method.
F-15
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
The following schedules summarize the gross unrealized losses showing the length of time that investments have been continuously in an
unrealized loss position as of December 31, 2013 and December 31, 2012 (in thousands):
U.S. Treasury securities and
obligations of U.S. Government
Corporate bonds
Collateralized corporate bank loans
Municipal bonds
Mortgage-backed
Total debt securities
As of December 31, 2013
12 months or less
Longer than 12 months
Total
Fair Value
Unrealized
Losses
Fair Value
Unrealized
Losses
Fair Value
Unrealized
Losses
$
$
47,162
5,649
23,026
35,719
1,383
112,939
$
(165 )
(56 )
(422 )
(413 )
(229 )
(1,285 )
$
-
4,421
6,968
34,684
4,840
50,913
-
(394 )
(67 )
(1,562 )
(278 )
(2,301 )
$ 47,162
10,070
29,994
70,403
6,223
163,852
$
(165 )
(450 )
(489 )
(1,975 )
(507 )
(3,586 )
Total equity securities
Total debt and equity securities
$
316
113,255
$
(2 )
(1,287 )
$
2,721
53,634
$
(312 )
(2,613 )
3,037
$ 166,889
(314 )
$ (3,900 )
U.S. Treasury securities and
obligations of U.S. Government
Corporate bonds
Collateralized corporate bank loans
Municipal bonds
Mortgage-backed
Total debt securities
12 months or less
As of December 31, 2012
Longer than 12 months
Total
Fair Value
Unrealized
Losses
Fair Value
Unrealized
Losses
Fair Value
Unrealized
Losses
$
23,998 $
10,802
6,273
30,073
7,367
78,513
(3 ) $
(38 )
(97 )
(362 )
(32 )
(532 )
- $
- $
6,910
14,236
28,809
84
50,039
(725 )
(646 )
(2,408 )
(3 )
(3,782 )
23,998 $
17,712
20,509
58,882
7,451
128,552
(3 )
(763 )
(743 )
(2,770 )
(35 )
(4,314 )
Total equity securities
Total debt and equity securities
3,363
81,876
$
$
(515 )
(1,047 )
$
-
50,039
$
-
(3,782 )
$
3,363
131,915
$
(515 )
(4,829 )
At December 31, 2013, the gross unrealized losses more than twelve months old were attributable to 84 debt security positions. At
December 31, 2012, the gross unrealized losses more than twelve months old were attributable to 56 debt security positions. We consider
these losses as a temporary decline in value as they are predominately on bonds that we do not intend to sell and do not believe we will
be required to sell prior to recovery of our amortized cost basis. We see no other indications that the decline in values of these securities is
other-than-temporary.
Based on evidence gathered through our normal credit evaluation process, we presently expect that all debt securities held in our
investment portfolio will be paid in accordance with their contractual terms. Nonetheless, it is at least reasonably possible that the
performance of certain issuers of these debt securities will be worse than currently expected resulting in future write-downs within our
portfolio of debt securities.
F-16
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
Also, as a result of the challenging market conditions, we expect the volatility in the valuation of our equity securities to continue in the
foreseeable future. This volatility may lead to impairments on our equity securities portfolio or changes regarding retention strategies for
certain equity securities.
We complete a detailed analysis each quarter to assess whether any decline in the fair value of any investment below cost is deemed
other-than-temporary. All securities with an unrealized loss are reviewed. We recognize an impairment loss when an investment's value
declines below cost, adjusted for accretion, amortization and previous other-than-temporary impairments and it is determined that the
decline is other-than-temporary. We did not recognized other-than-temporary losses on our debt securities portfolio during 2013.
Debt Investments: We assess whether we intend to sell, or it is more likely than not that we will be required to sell, a fixed maturity
investment before recovery of its amortized cost basis less any current period credit losses. For fixed maturity investments that are
considered other-than-temporarily impaired and that we do not intend to sell and will not be required to sell, we separate the amount of
the impairment into the amount that is credit related (credit loss component) and the amount due to all other factors. The credit loss
component is recognized in earnings and is the difference between the investment’s amortized cost basis and the present value of its
expected future cash flows. The remaining difference between the investment’s fair value and the present value of future expected cash
flows is recognized in other comprehensive income.
Equity Investments: Some of the factors considered in evaluating whether a decline in fair value for an equity investment is other-than-
temporary include: (1) our ability and intent to retain the investment for a period of time sufficient to allow for an anticipated recovery in
value; (2) the recoverability of cost; (3) the length of time and extent to which the fair value has been less than cost; and (4) the financial
condition and near-term and long-term prospects for the issuer, including the relevant industry conditions and trends, and implications of
rating agency actions and offering prices. When it is determined that an equity investment is other-than-temporarily impaired, the security
is written down to fair value, and the amount of the impairment is included in earnings as a realized investment loss. The fair value then
becomes the new cost basis of the investment, and any subsequent recoveries in fair value are recognized at disposition. We recognize a
realized loss when impairment is deemed to be other-than-temporary even if a decision to sell an equity investment has not been made.
When we decide to sell a temporarily impaired available-for-sale equity investment and we do not expect the fair value of the equity
investment to fully recover prior to the expected time of sale, the investment is deemed to be other-than-temporarily impaired in the
period in which the decision to sell is made.
The amortized cost and estimated fair value of debt securities at December 31, 2013 by contractual maturity are as follows. Expected
maturities may differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or
without penalties.
Amortized
Cost
Fair
Value
Due in one year or less
Due after one year through five years
Due after five years through ten years
Due after ten years
Mortgage-backed
$
$
$
(in thousands)
71,490
162,203
107,915
39,235
27,784
408,627
71,969
163,006
108,761
38,622
27,737
410,095
$
We have certain of our securities pledged for the benefit of various state insurance departments and reinsurers. These securities are
included with our available-for-sale debt securities because we have the ability to trade these securities. We retain the interest earned on
these securities. These securities had a carrying value of $29.1 million at December 31, 2013 and a carrying value of $24.3 million at
December 31, 2012.
F-17
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
3. Fair Value:
ASC 820 defines fair value, establishes a consistent framework for measuring fair value and expands disclosure requirements about
fair value measurements. ASC 820, among other things, requires us to maximize the use of observable inputs and minimize the use of
unobservable inputs when measuring fair value. In addition, ASC 820 precludes the use of block discounts when measuring the fair
value of instruments traded in an active market, which were previously applied to large holdings of publicly traded equity securities.
We determine the fair value of our financial instruments based on the fair value hierarchy established in ASC 820. In accordance with
ASC 820, we utilize the following fair value hierarchy:
•
•
•
Level 1: quoted prices in active markets for identical assets;
Level 2: inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets,
inputs of identical assets for less active markets, and inputs that are observable for the asset or liability, either directly
or indirectly, for substantially the full term of the instrument; and
Level 3: inputs to the valuation methodology that are unobservable for the asset or liability.
This hierarchy requires the use of observable market data when available.
Under ASC 820, we determine fair value based on the price that would be received for an asset or paid to transfer a liability in an
orderly transaction between market participants on the measurement date. It is our policy to maximize the use of observable inputs
and minimize the use of unobservable inputs when developing fair value measurements, in accordance with the fair value hierarchy
described above. Fair value measurements for assets and liabilities where there exists limited or no observable market data are
calculated based upon our pricing policy, the economic and competitive environment, the characteristics of the asset or liability and
other factors as appropriate. These estimated fair values may not be realized upon actual sale or immediate settlement of the asset
or liability.
Where quoted prices are available on active exchanges for identical instruments, investment securities are classified within Level 1 of
the valuation hierarchy. Level 1 investment securities include common and preferred stock.
Level 2 investment securities include corporate bonds, collateralized corporate bank loans, municipal bonds, U.S. Treasury securities,
other obligations of the U.S. Government and mortgage-backed securities for which quoted prices are not available on active
exchanges for identical instruments. We use third party pricing services to determine fair values for each Level 2 investment security
in all asset classes. Since quoted prices in active markets for identical assets are not available, these prices are determined using
observable market information such as quotes from less active markets and/or quoted prices of securities with similar characteristics,
among other things. We have reviewed the processes used by the pricing services and have determined that they result in fair values
consistent with the requirements of ASC 820 for Level 2 investment securities. In addition, using the prices received for the securities
from the third party pricing services, we compare a sample of the prices against additional sources. We have not adjusted any prices
received from third party pricing services. There were no transfers between Level 1 and Level 2 securities.
In cases where there is limited activity or less transparency around inputs to the valuation, investment securities are classified within
Level 3 of the valuation hierarchy. Level 3 investments are valued based on the best available data in order to approximate fair value.
This data may be internally developed and consider risk premiums that a market participant would require. Investment securities
classified within Level 3 include other less liquid investment securities.
F-18
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
The following table presents for each of the fair value hierarchy levels, our assets that are measured at fair value on a recurring basis at
December 31, 2013 and December 31, 2012 (in thousands).
U.S. Treasury securities and obligations of U.S. Government
Corporate bonds
Collateralized corporate bank loans
Municipal bonds
Mortgage-backed
Total debt securities
Total equity securities
Total debt and equity securities
$
$
As of December 31, 2013
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
Other
Observable
Inputs
(Level 2)
Unobservable
Inputs
(Level 3)
$
-
-
-
-
-
-
$
78,753
43,875
101,585
140,628
27,737
392,578
$
-
-
593
16,924
-
17,517
Total
78,753
43,875
102,178
157,552
27,737
410,095
51,230
51,230
$
-
392,578
$
-
17,517
$
51,230
461,325
U.S. Treasury securities and obligations of U.S.
Government
Corporate bonds
Collateralized corporate bank loans
Municipal bonds
Mortgage-backed
Total debt securities
Total equity securities
Total debt and equity securities
$
$
As of December 31, 2012
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
Other
Observable
Inputs
(Level 2)
Unobservable
Inputs
(Level 3)
$
-
-
-
-
-
-
$
40,061
81,547
105,463
144,972
9,724
381,767
$
-
-
908
18,760
-
19,668
Total
40,061
81,547
106,371
163,732
9,724
401,435
43,925
43,925
$
-
381,767
$
-
19,668
$
43,925
445,360
F-19
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
Due to significant unobservable inputs into the valuation model for certain municipal bonds and a collateralized corporate bank loan in
illiquid markets, we classified these as level 3 in the fair value hierarchy. We used an income approach in order to derive an estimated fair
value of the municipal bonds classified as Level 3, which included inputs such as expected holding period, benchmark swap rate,
benchmark discount rate and a discount rate premium for illiquidity. The fair value of the collateralized corporate bank loan classified as
level 3 is based on discounted cash flows using current yield to maturity of 9.3%, which is based on the relevant spread over LIBOR for this
particular loan to discount future cash flows. Significant changes in the unobservable inputs in the fair value measurement of our
municipal bonds and collateralized corporate bank loan could result in a significant change in the fair value measurement.
The following table summarizes the changes in fair value for all financial assets measured at fair value on a recurring basis using significant
unobservable inputs (Level 3) during the year ended December 31, 2013 and 2012 (in thousands).
2013
2012
Beginning balance as of January 1
Sales
Settlements
Purchases
Issuances
Total realized/unrealized gains included in net income
Net gains (losses) included in other comprehensive
income
Transfers into Level 3
Transfers out of Level 3
Ending balance as of December 31
$
$
$
19,668
(3,157 )
-
-
-
-
1,006
-
-
17,517
$
20,608
(429 )
-
-
-
-
(511 )
-
-
19,668
4. Goodwill and Intangible Assets:
Effective August 29, 2008, we acquired 80% of the issued and outstanding membership interests in Heath XS, LLC and Hardscrabble
Data Solutions, LLC for consideration of $15.0 million. In connection with the acquisition, we executed an operating agreement for
each subsidiary. The operating agreements granted us the right to purchase the remaining 20% membership interests in the
subsidiaries and granted an affiliate of the seller the right to require us to purchase such remaining membership interests. Effective
September 30, 2012, we exercised our call option and acquired the remaining 20% membership interests in the subsidiaries for $1.7
million.
Effective July 1, 2011, we acquired all of the issued and outstanding capital stock of TBIC Holding for initial consideration of $1.6
million paid in cash on July 1, 2011. In addition, a holdback purchase price of $350 thousand was paid during the third quarter of
2012. A contingent purchase price of up to $3.0 million may become payable following 16 full calendar quarters after closing based
upon a formula contained in the acquisition agreement. We recorded a bargain purchase gain of $165 thousand on the acquisition
which is reported in other income. The gain resulted from the difference in the estimated purchase price and the fair value of the net
assets acquired and liabilities assumed as of July 1, 2011. TBIC is a Texas domiciled insurance company that writes workers
compensation insurance through independent agents in Texas only.
Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an
annual basis (October 1) and between annual tests if an event occurs or circumstances change that would more likely than not reduce
the fair value of a reporting unit below its carrying value. For purposes of evaluating goodwill for impairment, we have determined
that our reporting units are the same as our business units except for the Hallmark Select business unit for which reporting units are
at the component level (“one level below”). Our consolidated balance sheet as of December 31, 2013 includes goodwill of acquired
businesses of $44.7 million that is assigned to our business units as follows: Standard Commercial P&C business unit - $2.1 million;
E&S Commercial business unit - $19.9 million; Hallmark Select business unit- $17.4 million (comprised of $7.7 million for the excess &
umbrella component and $9.7 million for the general aviation and satellite component); and Personal Lines business unit - $5.3
million. This amount has been recorded as a result of prior business acquisitions accounted for under the acquisition method of
accounting. Under ASC 350, “Intangibles- Goodwill and Other,” goodwill is tested for impairment annually. We completed our last
annual test for impairment on the first day of the fourth quarter of 2013 and determined that there was no impairment.
F-20
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
The income approach to determining fair value computed the projections of the cash flows that the reporting unit was expected to
generate converted into a present value equivalent through discounting. Significant assumptions in the income approach model
included income projections, discount rates and terminal growth values. The income projections reflected an improved premium
pricing environment across most of our lines of business that began in 2012 and continued throughout 2013. The income projections
also included loss and LAE assumptions which reflected recent historical claim trends and the movement towards a more favorable
pricing environment. The income projections also included assumptions for expense growth and investment yields which were based
on business plans for each of our business units. The discount rate was based on a risk free rate plus a beta adjusted equity risk
premium and specific company risk premium. The assumptions were based on historical experience, expectations of future
performance, expected market conditions and other factors requiring judgment and estimates. While we believe the assumptions
used in these models were reasonable, the inherent uncertainty in predicting future performance and market conditions may change
over time and influence the outcome of future testing.
During 2013, 2012, and 2011, we completed the first step prescribed by ASC 350 for testing for impairment and determined that
there was no impairment.
We have obtained various intangible assets from several acquisitions since 2002. The table below details the gross and net carrying
amounts of these assets by major category (in thousands):
Gross Carrying Amount:
Customer/agent relationships
Tradename
Management agreement
Non-compete & employment agreements
Insurance licenses
Total gross carrying amount
Accumulated Amortization:
Customer/agent relationships
Tradename
Management agreement
Non-compete & employment agreements
Total accumulated amortization
Total net carrying amount
December 31,
2013
2012
$
32,177
3,440
3,232
4,235
1,300
44,384
32,177
3,440
3,232
4,235
1,300
44,384
(15,322 )
(1,700 )
(3,232 )
(4,177 )
(24,431 )
19,953
$
(13,084 )
(1,471 )
(2,895 )
(3,866 )
(21,316 )
23,068
$
$
Insurance licenses are not amortized because they have an indefinite life. We amortize definite-lived intangible assets straight line
over their respective lives. The estimated aggregate amortization expense for definite-lived intangible assets for the next five years is
as follows (in thousands):
2014
2015
2016
2017
2018
$
$
$
$
$
2,526
2,468
2,468
2,468
2,468
The weighted average amortization period for definite-lived intangible assets by major class is as follows:
Tradename
Customer relationships
Management agreement
Non-compete agreements
Years
15
15
4
5
The aggregate weighted average period to amortize these assets is approximately 13 years.
F-21
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
5. Other Assets:
The following table details our other assets as of December 31, 2013 and 2012 (in thousands):
Profit sharing commission receivable
Accrued investment income
Debt issuance costs
Investment in unconsolidated trust subsidiaries
Fixed assets
Other assets
2013
2012
641
3,030
1,156
1,702
1,773
110
8,412
$
$
2,083
3,568
1,207
1,702
2,284
141
10,985
$
$
6. Reserves for Unpaid Losses and Loss Adjustment Expenses:
Activity in the reserves for unpaid losses and LAE is summarized as follows (in thousands):
Balance at January 1
Less reinsurance recoverable
Net Balance at January 1
$
2013
313,416
49,584
263,832
$
2012
296,945
42,044
254,901
$
2011
251,677
37,954
213,723
Acquisition of subsidiaries effective July 1
-
-
8,816
Incurred related to:
Current year
Prior years
Total incurred
Paid related to:
Current year
Prior years
Total paid
Net Balance at December 31
Plus reinsurance recoverable
Balance at December 31
251,391
9,954
261,345
230,089
(3,675 )
226,414
222,869
16,366
239,235
101,897
110,812
212,709
107,945
109,538
217,483
101,025
105,848
206,873
312,468
70,172
382,640
$
263,832
49,584
313,416
$
254,901
42,044
296,945
$
The $10.0 million unfavorable development, $3.7 million favorable development and $16.4 million unfavorable development in prior
accident years recognized in 2013, 2012 and 2011, respectively, represent normal changes in our loss reserve estimates. In 2013 and 2011,
the aggregate loss reserve estimates for prior years were increased to reflect unfavorable loss development when the available
information indicated a reasonable likelihood that the ultimate losses would be more than the previous estimates. In 2012, the aggregate
loss reserve estimates for prior years were decreased to reflect favorable loss development when the available information indicated a
reasonable likelihood that the ultimate losses would be less than the previous estimates. Generally, changes in reserves are caused by
variations between actual experience and previous expectations and by reduced emphasis on the Bornhuetter-Ferguson method due to
the aging of the accident years.
F-22
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
The $10.0 million increase in reserves for unpaid losses and LAE recognized in 2013 was attributable to $5.0 million unfavorable
development on claims incurred in the 2012 accident year, $1.7 million unfavorable development on claims incurred in the 2011 accident
year and $3.3 million unfavorable development on claims incurred in the 2010 and prior accident years. Our E&S Commercial business
unit and Personal Lines business unit accounted for $16.0 million and $1.8 million of the increase in reserves recognized during 2013. The
increase in reserves for our E&S Commercial business unit was primarily related to commercial auto liability line of business. The increase
in reserves for our Personal Lines business unit was primarily related to personal auto in the 2012 accident year. These unfavorable
developments were partially offset by favorable prior years’ loss development of $3.7 million in our Standard Commercial P&C business
unit, $2.6 million in our Hallmark Select business unit and $1.5 million in our Workers Compensation business unit. The decrease in
reserves for our Standard Commercial P&C business unit was primarily related to commercial auto and general liability line of business.
The decrease in reserves for our Hallmark Select business unit was driven by $2.3 million of favorable claims development in the 2011 and
prior accident years related to our aircraft liability lines of business, partially offset by $0.1 million unfavorable claims development in the
2012 accident year related to our aircraft hull coverage. Further contributing to the decrease in reserves for our Hallmark Select business
unit was $0.4 million of favorable claims development in our excess & umbrella lines of business. The decrease in reserves for our Workers
Compensation business unit was related to the 2012 and 2011 accident years.
The $3.7 million decrease in reserves for unpaid losses and LAE recognized in 2012 was attributable to $0.4 million favorable development
on claims incurred in the 2011 accident year, $0.8 million favorable development on claims incurred in the 2010 accident year and $2.5
million favorable development on claims incurred in the 2009 and prior accident years. Our Standard Commercial P&C business unit,
Hallmark Select business unit and E&S Commercial business unit accounted for $3.7 million, $3.3 million and $0.3 million, respectively, of
the decrease in reserves recognized during 2012. The decrease in reserves for our Standard Commercial P&C business unit was primarily
related to commercial auto, commercial property and general liability lines of business. The decrease in reserves for our Hallmark Select
business unit was primarily related to our aircraft liability lines of business. The decrease in reserves for our E&S Commercial business unit
was primarily related to general liability. These favorable developments were partially offset by unfavorable prior years’ loss development
of $3.6 million in our Personal Lines business unit related to auto liability claims spread throughout various states and our low value
dwelling/homeowners line of business.
The $16.4 million increase in reserves for unpaid losses and LAE recognized in 2011 was attributable to $15.0 million unfavorable
development on claims incurred in the 2010 accident year, $3.6 million unfavorable development on claims incurred in the 2009 accident
year and $2.2 million favorable development on claims incurred in the 2008 and prior accident years. Our Personal Lines business unit and
E&S Commercial business unit accounted for $19.6 million and $3.7 million, respectively, of the increase in reserves recognized during
2011. The $19.6 million increase in reserves during 2011 for our Personal Lines business unit includes $10.3 million, which was attributable
to Florida developing much worse than expected due primarily to rapid growth in the claim volume from Florida, the complexity related to
Florida personal injury protection coverage claims and the high incidence of fraudulent claims in that market. The remaining unfavorable
prior years’ loss development for our Personal Lines business unit was primarily due to rapid geographic expansion. The increase in
reserves for our E&S Commercial business unit was primarily related to commercial auto and physical damage and general liability lines of
business. These unfavorable developments were partially offset by favorable prior years’ loss development of $6.1 million in our Hallmark
Select business unit related to our aircraft liability lines of business and $0.8 million in our Standard Commercial P&C business unit
primarily related to our commercial property lines of business.
7. Reinsurance:
We reinsure a portion of the risk we underwrite in order to control the exposure to losses and to protect capital resources. We cede to
reinsurers a portion of these risks and pay premiums based upon the risk and exposure of the policies subject to such reinsurance. Ceded
reinsurance involves credit risk and is generally subject to aggregate loss limits. Although the reinsurer is liable to us to the extent of the
reinsurance ceded, we are ultimately liable as the direct insurer on all risks reinsured. Reinsurance recoverables are reported after
allowances for uncollectible amounts. We monitor the financial condition of reinsurers on an ongoing basis and review our reinsurance
arrangements periodically. Reinsurers are selected based on their financial condition, business practices and the price of their product
offerings. In order to mitigate credit risk to reinsurance companies, most of our reinsurance recoverable balance as of December 31, 2013
was with reinsurers that had an A.M. Best rating of “A-” or better. We also mitigate our credit risk for the remaining reinsurance
recoverable by obtaining letters of credit.
F-23
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
The following table presents our gross and net premiums written and earned and reinsurance recoveries for each of the last three years (in
thousands):
2013
2012
2011
Premium Written :
Direct
Assumed
Ceded
Premium Earned:
Direct
Assumed
Ceded
Reinsurance recoveries
$
$
$
$
$
458,020
2,007
(99,262 )
360,765
$
$
434,022
3,204
(76,685 )
360,541
$
$
385,624
4,218
(57,353 )
332,489
$ 350,089
4,792
(51,005 )
$ 303,876
369,735
4,114
(54,413 )
319,436
$ 344,642
5,438
(57,039 )
$ 293,041
45,456
$
29,014
$ 32,941
Included in reinsurance recoverable on the consolidated balance sheets are paid loss recoverables of $6.1 million and $1.0 million as of
December 31, 2013 and 2012, respectively.
We currently reinsure the following exposures on business generated by our business units:
•
Property catastrophe. Our property catastrophe reinsurance reduces the financial impact a catastrophe could have on our
commercial and personal property insurance lines. Catastrophes might include multiple claims and policyholders. Catastrophes
include hurricanes, windstorms, earthquakes, hailstorms, explosions, severe winter weather and fires. Our property catastrophe
reinsurance is excess-of-loss reinsurance, which provides us reinsurance coverage for losses in excess of an agreed-upon
amount. We utilize catastrophe models to assist in determining appropriate retention and limits to purchase. Effective July 1,
2013 the terms of our property catastrophe reinsurance are:
and
o We retain the first $6.0 million of property catastrophe losses; and
o
Our reinsurers reimburse us 100% for any loss occurrence in excess of our $6.0 million retention up to $29.0 million
for each catastrophic occurrence, subject to an aggregate limit of $58.0 million.
•
Commercial property. Our commercial property reinsurance is excess-of-loss coverage intended to reduce the financial impact a
single-event or catastrophic loss may have on our results. Effective July 1, 2013 the terms of our commercial property
reinsurance are:
o We retain the first $1.0 million of loss for each commercial property risk;
o Our reinsurers reimburse us for the next $5.0 million for each commercial property risk, and $10.0 million for all
commercial property risk involved in any one occurrence, in all cases subject to an aggregate limit of $30.0 million for
all commercial property losses occurring during the treaty period; and
o
Individual risk facultative reinsurance is purchased on any commercial property with limits above $6.0 million.
F-24
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
•
Commercial casualty. Our commercial casualty reinsurance is excess-of-loss coverage intended to reduce the financial impact a
single-event loss may have on our results. Effective July 1, 2013 the terms of our commercial casualty reinsurance are:
o We retain the first $1.0 million of any commercial liability risk; and
o
Our reinsurers reimburse us for the next $5.0 million for each commercial liability risk.
•
Aviation. Effective July 1, 2013 we purchased proportional reinsurance where we cede 80% of the risk to reinsurers on the
aviation risks produced in all states by our Hallmark Select business unit.
• Occupational Accident. We purchase excess-of-loss reinsurance coverage for the occupational accident insurance product
produced by our Standard Commercial P&C business unit. The terms of occupational accident reinsurance are:
o We retain the first $1.0 million of any occupational accident risk; and
o Our reinsurers reimburse us for the next $5.0 million for each occupational accident risk up to $10.0 million for each
occurrence.
• Workers Compensation. We purchase excess of loss reinsurance specific to the workers compensation risks underwritten by our
Workers Compensation business unit. The terms of our workers compensation reinsurance are:
o We retain the first $1.0 million of each workers compensation loss; and
o Our reinsurers reimburse us 100% for the next $14.0 million for each workers compensation loss, subject to a
maximum limit of $10.0 million for any one person and an aggregate limit of $28.0 million for all workers
compensation losses.
Personal Property. Effective February 1, 2013 we purchased proportional reinsurance where we cede 60% of the risks to
reinsurers on the low value dwelling/homeowners, renters and manufactured homes coverages produced in all states by our
Personal Lines business unit.
Personal Auto. Effective October 1, 2013 we purchased proportional reinsurance where we cede 90% of the risks to reinsurers on
the nonstandard automobile risks produced in certain states by our Personal Lines business unit.
Standard Commercial P&C. We purchase proportional reinsurance where we cede 100% of the risks to reinsurers on the
equipment breakdown coverage on our commercial multi-peril property and business owners risks and on the employment
practices liability coverage on certain commercial multi-peril, general liability and business owners risks.
Excess & Umbrella. We purchase proportional reinsurance where we retain 20% of each risk and cede the remaining 80% to
reinsurers on the commercial umbrella and excess liability insurance produced by our Hallmark Select business unit. In states
where we are not yet licensed to offer a non-admitted product, we utilize a fronting arrangement pursuant to which we assume
all of the risk and then retrocede a portion of that risk under the same proportional reinsurance treaty.
Professional Liability. Effective June 1, 2013, we purchased proportional reinsurance on our medical professional liability risks
produced by our Hallmark Select business unit where we retain 60% of each risk and cede the remaining 40% to reinsurers. In
states where we are not yet licensed to offer a non-admitted product, we utilize a fronting arrangement pursuant to which we
assume all of the risk and then retrocede a portion of that risk under the same proportional reinsurance treaty.
E&S Commercial. We purchase facultative reinsurance on our commercial umbrella and excess liability risks produced by our E&S
Commercial business unit where we retain 10% of the first $1.0 million of risk and cede the remaining 90% to reinsurers. We cede
100% of our commercial umbrella and excess liability risks in excess of $1.0 million.
•
•
•
•
•
•
• Hallmark County Mutual. HCM is used to front certain lines of business in our Specialty Commercial and Personal Segments in
Texas where we previously produced policies for third party county mutual insurance companies and reinsured 100% for a
fronting fee. In addition, HCM is used to front business produced by unaffiliated third parties. HCM does not retain any business.
F-25
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
• Hallmark National Insurance Company. Simultaneous with the December 31, 2010 closing of our acquisition of HNIC, HNIC
entered into reinsurance contracts with an affiliate of the seller pursuant to which such affiliate of the seller handles all claims
and assumes all liabilities arising under policies issued by HNIC prior to closing or during a transition period following the closing.
8. Revolving Credit Facility and Notes Payable:
Our First Restated Credit Agreement with The Frost National Bank dated January 27, 2006, as amended to date, provides a revolving
credit facility of $15.0 million. We pay interest on the outstanding balance at our election at a rate of the prime rate or LIBOR plus
2.5%. We pay an annual fee of 0.25% of the average daily unused balance of the credit facility. We pay letter of credit fees at the rate
of 1.00% per annum. Our obligations under the revolving credit facility are secured by a security interest in the capital stock of all of
our subsidiaries, guarantees of all of our subsidiaries and the pledge of all of our non-insurance company assets. The revolving credit
facility contains covenants that, among other things, require us to maintain certain financial and operating ratios and restrict certain
distributions, transactions and organizational changes. As of December 31, 2013, we were in compliance with all of our covenants. As
of December 31, 2013 and 2012, the balance on the revolving note was $1.5 million and $1.5 million, respectively. The revolving note
currently bears interest at 2.75% per annum.
9. Subordinated Debt Securities:
On June 21, 2005, we entered into a trust preferred securities transaction pursuant to which we issued $30.9 million aggregate
principal amount of subordinated debt securities due in 2035. To effect the transaction, we formed Trust I as a Delaware statutory
trust. Trust I issued $30.0 million of preferred securities to investors and $0.9 million of common securities to us. Trust I used the
proceeds from these issuances to purchase the subordinated debt securities. Our Trust I subordinated debt securities bear an initial
interest rate of 7.725% until June 15, 2015, at which time interest will adjust quarterly to the three-month LIBOR rate plus 3.25
percentage points. Trust I pays dividends on its preferred securities at the same rate. Under the terms of our Trust I subordinated
debt securities, we pay interest only each quarter and the principal of the note at maturity. The subordinated debt securities are
uncollaterized and do not require maintenance of minimum financial covenants. As of December 31, 2013, the balance of our Trust I
subordinated debt was $30.9 million.
On August 23, 2007, we entered into a trust preferred securities transaction pursuant to which we issued $25.8 million aggregate
principal amount of subordinated debt securities due in 2037. To effect the transaction, we formed Trust II as a Delaware statutory
trust. Trust II issued $25.0 million of preferred securities to investors and $0.8 million of common securities to us. Trust II used the
proceeds from these issuances to purchase the subordinated debt securities. Our Trust II subordinated debt securities bear an initial
interest rate of 8.28% until September 15, 2017, at which time interest will adjust quarterly to the three-month LIBOR rate plus 2.90
percentage points. Trust II pays dividends on its preferred securities at the same rate. Under the terms of our Trust II subordinated
debt securities, we pay interest only each quarter and the principal of the note at maturity. The subordinated debt securities are
uncollaterized and do not require maintenance of minimum financial covenants. As of December 31, 2013, the balance of our Trust II
subordinated debt was $25.8 million.
10. Segment Information:
We pursue our business activities primarily through subsidiaries whose operations are organized into producing units and are
supported by our insurance carrier subsidiaries. Our non-carrier insurance activities are organized by business units into the following
reportable segments:
•
Standard Commercial Segment. The Standard Commercial Segment
lines commercial
property/casualty and occupational accident insurance products and services handled by our Standard Commercial P&C
business unit and the workers compensation insurance products handled by our Workers Compensation business unit. Our
Standard Commercial P&C business unit is comprised of our American Hallmark Insurance Services and ECM subsidiaries.
Our Workers Compensation business unit is comprised of our TBIC Holdings, TBIC and TBICRM subsidiaries. The Workers
Compensation business unit was acquired July 1, 2011.
includes the standard
•
Specialty Commercial Segment. The Specialty Commercial Segment includes the excess and surplus lines commercial
property/casualty insurance products and services handled by our E&S Commercial business unit and the general aviation,
F-26
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
commercial umbrella and excess liability, medical professional liability and satellite launch insurance products and services
handled by our Hallmark Select business unit, as well as certain Specialty Programs which are managed at the parent level.
Our E&S Commercial business unit is comprised of our HSU, PAAC and TGASRI subsidiaries. Our Hallmark Select business
unit is comprised of our Aerospace Insurance Managers, ASRI, ACMG, HXS and HDS subsidiaries.
•
Personal Segment. The Personal Segment
low value
dwelling/homeowners, renters and motorcycle insurance products and services handled by our Personal Lines business
unit which is comprised of American Hallmark General Agency, Inc. and Hallmark Claims Services, Inc., both of which do
business as Hallmark Insurance Company.
the non-standard personal automobile,
includes
The retained premium produced by these reportable segments is supported by our AHIC, HSIC, HIC, HNIC and TBIC insurance
company subsidiaries. In addition, control and management of HCM is maintained through our wholly owned subsidiary, CYR
Insurance Management Company (“CYR”). CYR has as its primary asset a management agreement with HCM which provides for CYR
to have management and control of HCM. HCM is used to front certain lines of business in our Specialty Commercial and Personal
Segments in Texas. HCM does not retain any business.
AHIC, HIC, HSIC and HNIC have entered into a pooling arrangement, pursuant to which AHIC retains 30% of the net premiums written
by any of them, HIC retains 27% of the net premiums written by any of them, HSIC retains 30% of the net premiums written by any of
them and HNIC retains 13% of the net premiums written by any of them. Neither HCM nor TBIC is a party to the intercompany pooling
arrangement.
F-27
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
The following is additional business segment information for the twelve months ended December 31, 2013, 2012 and 2011 (in thousands):
2013
2012
2011
Revenues
Standard Commercial Segment
Specialty Commercial Segment
Personal Segment
Corporate
Consolidated
Depreciation and Amortization Expense
Standard Commercial Segment
Specialty Commercial Segment
Personal Segment
Corporate
Consolidated
Interest Expense
Standard Commercial Segment
Specialty Commercial Segment
Personal Segment
Corporate
Consolidated
Tax Expense (Benefit)
Standard Commercial Segment
Specialty Commercial Segment
Personal Segment
Corporate
Consolidated
Pre-tax Income (Loss), net of non-controlling interest
Standard Commercial Segment
Specialty Commercial Segment
Personal Segment
Corporate
Consolidated
$
$
$
$
$
$
$
$
$
$
83,306
229,734
71,081
5,307
389,428
201
2,896
1,111
92
4,300
-
-
-
4,599
4,599
312
3,613
(398 )
(692 )
2,835
1,980
19,527
(3,416 )
(7,011 )
11,080
$
$
$
$
$
$
$
$
$
$
73,119
178,917
89,149
615
341,800
186
2,892
1,230
113
4,421
-
-
-
4,634
4,634
372
1,875
(968 )
(1,753 )
(474 )
(2,486 )
25,932
(8,535 )
(11,861 )
3,050
$
$
$
$
$
$
$
$
$
$
72,830
142,838
101,351
5,752
322,771
174
3,293
1,431
166
5,064
-
-
-
4,631
4,631
(376 )
4,454
(13,991 )
959
(8,954 )
1,335
14,348
(29,647 )
(5,881 )
(19,845 )
F-28
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
The following is additional business segment information as of the following dates (in thousands):
Assets
Standard Commercial Segment
Specialty Commercial Segment
Personal Segment
Corporate
Consolidated
December 31,
2013
2012
$ 142,143
536,894
210,825
19,161
$ 909,023
$
$
145,162
432,208
200,356
12,742
790,468
11. Earnings Per Share:
We have adopted the provisions of ASC 260, “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 calculations is presented below (in
thousands, except per share amounts):
2013
2012
2011
Numerator for both basic and diluted earnings per share:
Net income (loss) attributable to Hallmark Financial Services, Inc.
$
8,245
$
3,524
$ (10,891 )
Denominator, basic shares
Effect of dilutive securities:
Stock-based compensation awards
Denominator, diluted shares
Basic earnings per share:
Diluted earnings per share:
19,263
98
19,361
19,263
19,673
6
19,269
-
19,673
$
$
0.43
$
0.18
$
(0.55 )
0.43
$
0.18
$
(0.55 )
We had 779,999 shares, 794,999 shares and 809,999 shares of common stock potentially issuable upon exercise of employee stock
options for years ended December 31, 2013, 2012 and 2011, respectively, that were excluded from the weighted average number of
shares outstanding on a diluted basis because the effect of such options would be anti-dilutive. These instruments expire at varying
times from 2016 to 2021.
F-29
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
12. Regulatory Capital Restrictions:
Hallmark, as a holding company, is dependent on dividend payments and management fees from its subsidiaries to fund its operating
expenses, debt obligations and capital needs, including the ability to pay dividends to its stockholders. Hallmark has never paid
dividends on its common stock. Hallmark intends to continue this policy for the foreseeable future in order to retain earnings for
development of its business. There are no regulatory or contractual restrictions on the ability of Hallmark to pay dividends other than
customary default provisions and the impact of any dividend payment on financial ratio covenants in certain credit agreements.
However there are restrictions on the ability of Hallmark’s insurance carrier subsidiaries to transfer funds to the holding company.
The amount of retained earnings that is unrestricted for the payment of dividends by Hallmark to its shareholders was $29.8 million
as of December 31, 2013.
AHIC and TBIC, domiciled in Texas, are limited in the payment of dividends to their stockholders in any 12-month period, without the
prior written consent of the Texas Department of Insurance, to the greater of statutory net income for the prior calendar year or 10%
of statutory policyholders’ surplus as of the prior year end. HIC, domiciled in Arizona, is limited in the payment of dividends to the
lesser of 10% of prior year policyholders’ surplus or prior year’s net investment income, without prior written approval from the
Arizona Department of Insurance. HSIC, domiciled in Oklahoma, is limited in the payment of dividends to the greater of 10% of prior
year policyholders’ surplus or prior year’s statutory net income, not including realized capital gains, without prior written approval
from the Oklahoma Insurance Department. HNIC, domiciled in Ohio, is limited in the payment of dividends to the greater of 10% of
statutory policyholders’ surplus as of the prior December 31 or statutory net income as of the prior December 31 without prior
written approval from the Ohio Insurance Department. For all our insurance companies, dividends may only be paid from unassigned
surplus funds. During 2014, the aggregate ordinary dividend capacity of these subsidiaries is $22.5 million, of which $15.6 million is
available to Hallmark. As a county mutual, dividends from HCM are payable to policyholders. None of our insurance company
subsidiaries paid a dividend during the years ended December 31, 2013 or 2012. The total restricted net assets of our insurance
company subsidiaries as of December 31, 2013, was approximately $208.3 million.
The state insurance departments also regulate financial transactions between our insurance subsidiaries and their affiliated
companies. Applicable regulations require approval of management fees, expense sharing contracts and similar transactions. The net
amount paid in management fees by our insurance subsidiaries to Hallmark and our non-insurance company subsidiaries was $8.2
million, $9.0 million and $6.0 million during each of 2013, 2012 and 2011, respectively.
Statutory capital and surplus is calculated as statutory assets less statutory liabilities. The various state insurance departments that
regulate our insurance company subsidiaries require us to maintain a minimum statutory capital and surplus. As of December 31,
2013 and 2012, our insurance company subsidiaries reported statutory capital and surplus of $196.3 million and $176.5 million,
respectively, substantially greater than the minimum requirements for each state. For the years ended December 31, 2013, 2012,
2011, respectively, our insurance company subsidiaries reported statutory net income of $6.1 million, statutory net income of $3.1
million and statutory net loss of $17.2 million, respectively.
The National Association of Insurance Commissioners requires property/casualty insurers to file a risk-based capital calculation
according to a specified formula. The purpose of the formula is twofold: (1) to assess the adequacy of an insurer’s statutory capital
and surplus based upon a variety of factors such as potential risks related to investment portfolio, ceded reinsurance and product
mix; and (2) to assist state regulators under the RBC for Insurers Model Act by providing thresholds at which a state commissioner is
authorized and expected to take regulatory action. As of December 31, 2013, the adjusted capital under the risk-based capital
calculation of each of our insurance company subsidiaries substantially exceeded the minimum requirements.
F-30
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
13. Share-based Payment Arrangements:
Our 2005 Long Term Incentive Plan (“2005 LTIP”) is a stock compensation plan for key employees and non-employee directors that
was initially approved by the shareholders on May 26, 2005. There are 2,000,000 shares authorized for issuance under the 2005 LTIP.
As of December 31, 2013, there were outstanding incentive stock options to purchase 1,083,332 shares of our common stock, non-
qualified stock options to purchase 304,157 shares of our common stock and restricted stock units representing the right to receive
up to 355,277 shares of our common stock. There are 241,401 shares reserved for future issuance under the 2005 LTIP. The exercise
price of all such outstanding stock options is equal to the fair market value of our common stock on the date of grant.
Stock Options:
Incentive stock options granted under the 2005 LTIP prior to 2009 vest 10%, 20%, 30% and 40% on the first, second, third and fourth
anniversary dates of the grant, respectively, and terminate five to ten years from the date of grant. Incentive stock options granted in
2009 and one grant of 5,000 incentive stock options in 2011 vest in equal annual increments on each of the first seven anniversary
dates and terminate ten years from the date of grant. One grant of 25,000 incentive stock options in 2010 and one grant of 10,000
incentive stock options in 2011 vest in equal annual increments on each of the first three anniversary dates and terminate ten years
from the date of grant. Non-qualified stock options granted under the 2005 LTIP generally vest 100% six months after the date of
grant and terminate ten years from the date of grant. One grant of 200,000 non-qualified stock options in 2009 vests in equal annual
increments on each of the first seven anniversary dates and terminates ten years from the date of grant.
A summary of the status of our stock options as of December 31, 2013 and changes during the year then ended is presented below:
Outstanding at January 1, 2013
Granted
Exercised
Forfeited or expired
Outstanding at December 31, 2013
Exercisable at December 31, 2013
Weighted
Average
Exercise
Price
Remaining
Contractual
Term
(Years)
Aggregate
Intrinsic
Value
($000)
$
$
$
$
9.63
7.58
9.66
10.19
4.2
4.0
$
$
1,329
866
Number of
Shares
1,404,989
-
-
(17,500 )
1,387,489
1,181,417
The following table details the intrinsic value of options exercised, total cost of share-based payments charged against income before
income tax benefit and the amount of related income tax benefit recognized in income for the periods indicated (in thousands):
Intrinsic value of options exercised
Cost of share-based payments (non-cash)
Income tax benefit of share-based payments recognized in
income
2013
2012
2011
-
207
$
$
-
380
$
$
4
709
30
$
38
$
30
$
$
$
As of December 31, 2013, there was $0.5 million of total unrecognized compensation cost related to non-vested stock options
granted under our plans, of which $0.2 million is expected to be recognized each year in 2014 and 2015, $54 thousand is expected to
be recognized in 2016 and $3 thousand is expected to be recognized in 2017.
The fair value of each stock option granted is estimated on the date of grant using the Black-Scholes option pricing model. Expected
volatilities are based on the historical volatility of Hallmark’s and similar companies’ common stock for a period equal to the expected
term. The risk-free interest rates for periods within the contractual term of the options are based on rates for U.S. Treasury Notes
with maturity dates corresponding to the options’ expected lives on the dates of grant. Expected term is determined based on the
simplified method as we do not have sufficient historical exercise data to provide a basis for estimating the expected term.
There were no stock options granted in 2013 or 2012. Stock options granted in 2011 had a weighted average grant date fair value of
$2.52, expected term of 5.8 years, expected volatility of 30.9% and risk free interest rate of 1.4%.
F-31
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
Restricted Stock Units:
The 2005 LTIP was amended by the stockholders on May 30, 2013 to authorize the grant of restricted stock units, in addition to the other
types of awards available thereunder. Restricted stock units represent the right to receive shares of common stock upon the satisfaction
of vesting requirements, performance criteria and other terms and conditions. On July 27, 2012 and April 10, 2013, an aggregate of
129,463 and 122,823 restricted stock units, respectively, were conditionally granted to certain employees of the Company subject to
shareholder approval of the amendments to the 2005 LTIP at the May 30, 2013 shareholder meeting. One conditional grant of 9,280
restricted stock units was forfeited prior to approval at the shareholder meeting.
The performance criteria for all restricted stock units require that the Company achieve certain compound average annual growth rates in
book value per share over the vesting period in order to receive shares of common stock in amounts ranging from 50% to 150% of the
number of restricted stock units granted. In addition, certain restricted stock units contain an additional performance criteria related to
the attainment of an average combined ratio percentage over the vesting period. If and to the extent specified performance criteria have
been achieved, the restricted stock units granted on July 27, 2012 will vest on March 31, 2015, and the restricted stock units granted on
April 10, 2013 will vest on March 31, 2016.
Compensation cost is measured as an amount equal to the fair value of the restricted stock units and is expensed over the vesting period if
achievement of the performance criteria is deemed probable, with the amount of the expense recognized based on the Company’s best
estimate of the ultimate achievement level. The grant date fair value of the restricted stock units is $9.20 per unit. The Company incurred
$145 thousand of compensation expense related to the restricted stock units during the year ended December 31, 2013.
A summary of the status of our restricted stock units as of December 31, 2013 and changes during the year then ended is presented
below:
Nonvested at January 1, 2013
Granted
Vested
Forfeited
Nonvested at December 31, 2013
Number of
Restricted
Stock Units
-
243,006
-
(6,155)
236,851
As of December 31, 2013, there was $0.5 million of total unrecognized compensation cost related to non-vested restricted stock units
granted under our 2005 LTIP, of which $0.2 million is expected to be recognized in 2014, $0.2 million is expected to be recognized in 2015
and $49 thousand is expected to be recognized in 2016.
14. Retirement Plans:
Certain employees of the Standard Commercial Segment were participants in a defined cash balance plan covering all full-time
employees who had completed at least 1,000 hours of service. This plan was frozen in March 2001 in anticipation of distribution of
plan assets to members upon plan termination. All participants were vested when the plan was frozen.
The following tables provide detail of the changes in benefit obligations, components of benefit costs, weighted-average assumptions,
and plan assets for the retirement plan as of and for the twelve months ending December 31, 2013, 2012 and 2011 (in thousands)
using a measurement date of December 31.
F-32
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
Assumptions (end of period):
Discount rate used in determining benefit obligation
Rate of compensation increase
Reconciliation of funded status (end of period):
Accumulated benefit obligation
Projected benefit obligation
Fair value of plan assets
Funded status
Net actuarial loss
Accumulated other comprehensive loss
Prepaid pension cost
Net amount recognized as of December 31
Changes in projected benefit obligation:
Benefit obligation as of beginning of period
Interest cost
Actuarial liability (gain)/loss
Benefits paid
Benefit obligation as of end of period
Change in plan assets:
Fair value of plan assets as of beginning of period
Actual return on plan assets (net of expenses)
Employer contributions
Benefits paid
Fair value of plan assets as of end of period
Net periodic pension cost:
Service cost - benefits earned during the period
Interest cost on projected benefit obligation
Expected return on plan assets
Recognized actuarial loss
Net periodic pension cost
Discount rate
Expected return on plan assets
Rate of compensation increase
2013
2012
2011
4.49 %
N/A
3.89 %
N/A
4.50 %
N/A
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
(12,284 )
(12,284 )
10,851
(1,433 )
(2,277 )
(2,277 )
844
(1,433 )
13,439
505
(824 )
(836 )
12,284
9,754
1,565
368
(836 )
10,851
-
505
(615 )
495
385
3.89 %
6.50 %
N/A
$
$
$
$
$
$
$
$
$
$
(13,439 )
(13,439 )
9,754
(3,685 )
(4,545 )
(4,545 )
860
(3,685 )
12,990
564
700
(815 )
13,439
9,019
839
711
(815 )
9,754
-
564
(584 )
482
462
4.50 %
6.50 %
N/A
(12,990 )
(12,990 )
9,019
(3,971 )
(4,582 )
(4,582 )
611
(3,971 )
12,050
609
1,160
(829 )
12,990
9,217
(4 )
635
(829 )
9,019
-
609
(590 )
287
306
5.25 %
6.50 %
N/A
F-33
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
Estimated future benefit payments by fiscal year (in thousands):
2014
2015
2016
2017
2018
2019-2023
889
$
897
$
885
$
884
$
$
878
$ 4,170
As of December 31, 2013, the fair value of the plan assets was composed of cash and cash equivalents of $0.3 million, bonds and
notes of $3.5 million and equity securities of $7.1 million.
Our investment objectives are to preserve capital and to achieve long-term growth through a favorable rate of return equal to or
greater than 5% over the long-term (60 year) average inflation rate as measured by the consumer price index. The objective of the
equity portion of the portfolio is to achieve a return in excess of the Standard & Poor’s 500 index. The objective of the fixed income
portion of the portfolio is to add stability, consistency, safety and total return to the total fund portfolio.
We prohibit investments in options, futures, precious metals, short sales and purchase on margin. We also restrict the investment in
fixed income securities to “A” rated or better by Moody’s or Standard & Poor’s rating services and restrict investments in common
stocks to only those that are listed and actively traded on one or more of the major United States stock exchanges, including
NASDAQ. We manage to an asset allocation of 45% to 75% in equity securities. An investment in any single stock issue is restricted to
5% of the total portfolio value and 90% of the securities held in mutual or commingled funds must meet the criteria for common
stocks.
To develop the expected long-term rate of return on assets assumption, we consider the historical returns and the future
expectations for returns for each asset class, as well as the target asset allocation of the pension portfolio. This resulted in the
selection of the 6.5% long-term rate of return on assets assumption. To develop the discount rate used in determining the benefit
obligation we used the Mercer Yield Curve at the measurement date to match the timing and amounts of projected future benefits.
We estimate contributing $0.7 million to the defined benefit cash balance plan during 2014. We expect our 2014 periodic pension
cost to be $(4) thousand, the components of which are interest cost of $0.5 million, expected return on plan assets of ($0.7) million
and amortization of actuarial loss of $0.2 million.
The following table shows the weighted-average asset allocation for the defined benefit cash balance plan held as of December 31,
2013 and 2012.
Asset Category:
Fixed income securities
Equity securities
Other
Total
12/31/13
12/31/12
32 %
65 %
3 %
100 %
33 %
63 %
4 %
100 %
Effective January 1, 2008, we determine the fair value of our financial instruments based on the fair value hierarchy established in
ASC 820. (See Note 3.)
F-34
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
The following table presents, for each of the fair value hierarchy levels, our plan assets that are measured at fair value on a
recurring basis at December 31, 2013 and December 31, 2012 (in thousands).
Debt securities
Equity securities
Total
Debt securities
Equity securities
Total
As of December 31, 2013
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
Other
Observable
Inputs
(Level 2)
Unobservable
Inputs
(Level 3)
$
$
-
7,080
7,080
$
$
3,448
-
3,448
$
$
-
-
-
$
$
Total
3,448
7,080
10,528
As of December 31, 2012
Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
Other
Observable
Inputs
(Level 2)
Unobservable
Inputs
(Level 3)
$
$
-
6,153
6,153
$
$
3,188
-
3,188
$
$
-
-
-
$
$
Total
3,188
6,153
9,341
Our plan assets also include cash and cash equivalents of $0.3 million and $0.4 million at December 31, 2013 and 2012,
respectively, and are carried at cost which approximates fair value.
We sponsor two defined contribution plans. Under these plans, employees may contribute a portion of their compensation on a
tax-deferred basis, and we may contribute a discretionary amount each year. We contributed $0.3 million, $0.1 million and $0.2
million for the years ended December 31, 2013, 2012 and 2011, respectively.
F-35
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
15.
Income Taxes:
The composition of deferred tax assets and liabilities and the related tax effects as of December 31, 2013 and 2012, are as
follows (in thousands):
Deferred tax liabilities:
Deferred policy acquisition costs
Net unrealized holding gain on investments
Agency relationship
Intangible assets
Goodwill
Fixed assets
Other
Total deferred tax liabilities
Deferred tax assets:
Unearned premiums
Alternative minimum tax
Amortization of non-compete agreements
Pension liability
Net operating loss carry-forward
Unpaid loss and loss adjustment expense
Rent reserve
Investment impairments
Other
Total deferred tax assets
2013
2012
$
$
(7,905 )
(9,730 )
(85 )
(6,129 )
(325 )
(499 )
(263 )
(24,936 )
(8,719 )
(5,622 )
(94 )
(6,852 )
(116 )
(685 )
(275 )
(22,363 )
9,822
442
417
797
611
8,173
366
660
823
22,111
9,806
1,651
476
1,591
702
7,549
363
1,256
909
24,303
Deferred federal income taxes, net
$
(2,825 )
$
1,940
A reconciliation of the income tax provisions based on the statutory tax rate to the provision reflected in the consolidated
financial statements for the years ended December 31, 2013, 2012 and 2011, is as follows (in thousands):
Computed expected income tax expense (benefit) at statutory
regulatory tax rate
Meals and entertainment
Tax exempt interest
Dividends received deduction
State taxes (net of federal benefit)
Other
Income tax expense (benefit)
Current income tax expense (benefit)
Deferred tax benefit
Income tax expense (benefit)
2013
2012
2011
$
$
$
$
3,878
25
(1,314 )
(101 )
276
71
2,835
$
$
1,181
28
(1,631 )
(111 )
298
(239 )
(474 )
$
$
(6,926 )
44
(1,835 )
(99 )
84
(222 )
(8,954 )
3,092
(257 )
2,835
$
$
2,377
(2,851 )
(474 )
$
$
(6,059 )
(2,895 )
(8,954 )
F-36
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
We have available, for federal income tax purposes, unused net operating loss of approximately $1.7 million at December 31, 2013. The
losses were acquired as part of the HIC and HCM acquisitions and may be used to offset future taxable income. Utilization of the losses is
limited under Internal Revenue Code Section 382. The Internal Revenue Code provides that effective with tax years beginning September
1997, the carry-back and carry-forward periods are 2 years and 20 years, respectively, with respect to newly generated operating losses.
The net operating losses will expire if unused, as follows (in thousands):
Year
2021
2022
2028
2030
2031
2032
2033
$
$
650
878
2
25
45
77
70
1,747
We are no longer subject to U.S. federal, state, local or non-U.S. income tax examinations by tax authorities for years prior to
2010. The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. There were no
uncertain tax positions at December 31, 2013.
16.
Commitments and Contingencies:
We have several leases, primarily for office facilities and computer equipment, which expire in various years through 2022.
Certain of these leases contain renewal options. Rental expense amounted to $2.2 million, $2.3 million and $2.0 million for the
years ended December 31, 2013, 2012, and 2011, respectively.
Future minimum lease payments under non-cancelable operating leases as of December 31, 2013 are as follows (in thousands):
Year
2014
2015
2016
2017
2018
2019 and thereafter
Total minimum lease payments
$ 1,987
1,969
1,641
1,484
1,193
3,166
$ 11,440
From time to time, assessments are levied on us by the guaranty association of the states where we offer our insurance products.
Such assessments are made primarily to cover the losses of policyholders of insolvent or rehabilitated insurers. Since these
assessments can generally be recovered through a reduction in future premium taxes paid, we capitalize the assessments that can
be recovered as they are paid and amortize the capitalized balance against our premium tax expense. We paid an assessment of
$29 thousand in 2013. We paid an assessment of $0.1 million in 2012 that was expensed. There were no assessments during
2011.
In December 2010, HSU was informed by the Texas Comptroller of Public Accounts that a surplus lines tax audit covering the
period January 1, 2007 through December 31, 2009 was complete. HSU frequently acts as a managing general underwriter
(“MGU”) authorized to underwrite policies on behalf of Republic Vanguard Insurance Company and HSIC, both Texas eligible
F-37
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
surplus lines insurance carriers. In its role as the MGU, HSU underwrites policies on behalf of these carriers while other agencies
located in Texas generally referred to as “producing agents” deliver the policies to the insureds and collect all premiums due from
the insureds. During the period under audit, the producing agents also collected the surplus lines premium taxes due on the
policies from the insureds, held them in trust, and timely remitted those taxes to the Comptroller. We believe this system for
collecting and paying the required surplus lines premium taxes complies in all respects with the Texas Insurance Code and other
regulations, which clearly require that the same party who delivers the policies and collects the premiums will also collect
premium taxes, hold premium taxes in trust, and pay premium taxes to the Comptroller. It also complies with long standing
industry practice. The Comptroller asserts that HSU is liable for the surplus lines premium taxes related to policy transactions and
premiums collected from surplus lines insureds during the audit period and that HSU therefore owes $4.5 million in premium
taxes, as well as $0.9 million in penalties and interest for the audit period.
We disagree with the Comptroller and intend to vigorously fight their assertion that HSU is liable for the surplus lines premium
taxes. During the past year we have been engaged in conversations with the Comptroller’s counsel. We are currently in
negotiations with the Comptroller to settle the matter. However, we are presently unable to reasonably estimate the possible
loss or legal costs that are likely to arise out of the surplus lines tax audit or any future proceedings relating to this matter.
Therefore we have not accrued any amount as of December 31, 2013 related to this matter.
We are engaged in legal proceedings in the ordinary course of business, none of which, either individually or in the aggregate, are
believed likely to have a material adverse effect on our consolidated financial position or results of operations, in the opinion of
management. The various legal proceedings to which we are a party are routine in nature and incidental to our business.
F-38
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
17.
Changes in Accumulated Other Comprehensive Income Balances:
The changes in accumulated other comprehensive income balances as of December 31, 2013, 2012, and 2011 were as follows (in
thousands):
Balance at January 1, 2011
Other comprehensive loss:
Change in net actuarial loss
Tax effect on change in net actuarial loss
Unrealized holding gains arising during the period
Tax effect on unrealized gains arising during the period
Reclassification adjustment for gains included in net realized gains
Tax effect on reclassification adjustment for gains included in income
tax expense
Other comprehensive loss, net of tax
Balance at December 31, 2011
Other comprehensive income:
Change in net actuarial gain
Tax effect on change in net actuarial gain
Unrealized holding gains arising during the period
Tax effect on unrealized gains arising during the period
Reclassification adjustment for gains included in net realized gains
Tax effect on reclassification adjustment for gains included in income
tax expense
Other comprehensive income, net of tax
Pension
Liability
Unrealized
Gains (Loss)
$
(2,024 ) $
11,661 $
(1,468 )
514
-
-
-
-
(954 )
-
-
191
(67 )
(3,633 )
1,272
(2,237 )
$
(2,978 ) $
9,424 $
37
(13 )
-
-
-
-
24
-
-
4,388
(1,536 )
(2,189 )
766
1,429
Balance at December 31, 2012
Other comprehensive income:
Change in net actuarial gain
Tax effect on change in net actuarial gain
Unrealized holding gains arising during the period
Tax effect on unrealized gains arising during the period
Reclassification adjustment for gains included in net realized gains
Tax effect on reclassification adjustment for gains included in income
tax expense
Other comprehensive income, net of tax
$
(2,954 ) $
10,853 $
2,268
(794 )
-
-
-
-
1,474
-
-
22,094
(7,733 )
(10,540 )
3,689
7,510
Balance at December 31, 2013
$
(1,480 ) $
18,363 $
F-39
Accumulated Other
Comprehensive
Income (Loss)
9,637
(1,468 )
514
191
(67 )
(3,633 )
1,272
(3,191 )
6,446
37
(13 )
4,388
(1,536 )
(2,189 )
766
1,453
7,899
2,268
(794 )
22,094
(7,733 )
(10,540 )
3,689
8,984
16,883
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2013, 2012, and 2011
18.
Concentrations of Credit Risk:
We maintain cash and cash equivalents in accounts with seven financial institutions in excess of the amount insured by the
Federal Deposit Insurance Corporation. We monitor the financial stability of the depository institutions regularly and do not
believe excessive risk of depository institution failure existed at December 31, 2013.
We are also subject to credit risk with respect to reinsurers to whom we have ceded underwriting risk. Although a reinsurer is
liable for losses to the extent of the coverage it assumes, we remain obligated to our policyholders in the event that the
reinsurers do not meet their obligations under the reinsurance agreements. In order to mitigate credit risk to reinsurance
companies, we monitor the financial condition of reinsurers on an ongoing basis and review our reinsurance arrangements
periodically. Most of our reinsurance recoverable balances as of December 31, 2013 were with reinsurers that had an A.M. Best
rating of “A-” or better. We also mitigate our credit risk for the remaining reinsurance recoverable by obtaining letters of credit.
19.
Unaudited Selected Quarterly Financial Information:
Following is a summary of the unaudited interim results of operations for the years ended December 31, 2013 and 2012 (in
thousands, except per share data). In the opinion of management, all adjustments necessary to present fairly the results of
operations for such periods have been made.
Total revenue
Total expense
Income (loss) before tax
Income tax expense (benefit)
Net income (loss)
Net income attributable to non-
controlling interest
Net income (loss) attributable to
Hallmark Financial Services, Inc.
2013
2012
Q1
$ 93,141
90,978
2,163
469
1,694
Q2
$ 99,299
104,616
(5,317 )
(2,166 )
(3,151 )
Q3
$ 108,613
99,141
9,472
3,198
6,274
Q4
$ 88,375
83,613
4,762
1,334
3,428
Q1
$ 82,986
82,769
217
23
194
Q2
$ 84,571
88,722
(4,151 )
(2,351 )
(1,800 )
Q3
$ 85,620
80,599
5,021
1,350
3,671
Q4
$ 88,623
86,336
2,287
504
1,783
-
-
-
-
23
43
258
-
$ 1,694
(3,151 )
$ 6,274
$ 3,428
$
171
$ (1,843 )
$ 3,413
$ 1,783
Basic earnings (loss) per share:
$
0.09
$
(0.16 )
$
0.33
$
0.18
$
0.01
$
(0.10 )
$
0.18
$
0.09
Diluted earnings (loss) per share:
$
0.09
$
(0.16 )
$
0.32
$
0.18
$
0.01
$
(0.10 )
$
0.18
$
0.09
F-40
FINANCIAL STATEMENT SCHEDULES
Schedule II – Condensed Financial Information of Registrant (Parent Company Only)
HALLMARK FINANCIAL SERVICES, INC.
BALANCE SHEETS
December 31, 2013 and 2012
(In thousands)
ASSETS
Cash and cash equivalents
Investment in subsidiaries
Deferred federal income taxes
Other assets
LIABILITIES AND STOCKHOLDERS’ EQUITY
Liabilities:
Revolving credit facility payable
Subordinated debt securities
Current federal income tax payable
Accounts payable and other accrued expenses
2013
2012
$
8,063
316,295
930
3,729
$
1,112
296,258
2,112
3,416
$
329,017
$
302,898
$
$
1,473
56,702
3,353
29,371
90,899
1,473
56,702
7,047
17,139
82,361
Stockholders’ equity:
Common stock, $.18 par value, authorized 33,333,333 shares; issued 20,872,831
shares in 2013 and in 2012
Capital in excess of par value
Retained earnings
Accumulated other comprehensive income
Treasury stock (1,609,374 shares in 2013 and 2012), at cost
3,757
122,827
106,209
16,883
(11,558 )
3,757
122,475
97,964
7,899
(11,558 )
Total stockholders’ equity
238,118
220,537
Total liabilities and stockholders’ equity
$
329,017
$
302,898
See accompanying report of independent registered public accounting firm.
F-41
FINANCIAL STATEMENT SCHEDULES
Schedule II (Continued) – Condensed Financial Information of Registrant (Parent Company Only)
HALLMARK FINANCIAL SERVICES, INC.
STATEMENTS OF OPERATIONS
For the years ended December 31, 2013, 2012 and 2011
(In thousands)
Investment loss, net of expenses
Management fee income
Operating expenses
Interest expense
Amortization of intangible assets
Loss before equity in undistributed earnings (loss) of subsidiaries and
income tax benefit
Income tax benefit
Loss before equity in undistributed earnings (loss) of subsidiaries
Equity in undistributed share of earnings (loss) in subsidiaries
Net income (loss)
Comprehensive income (loss)
2013
2012
2011
$
(190 )
8,518
8,328
7,764
4,599
-
$
(181 )
8,485
8,304
8,079
4,634
17
(194 )
7,288
7,094
7,851
4,631
42
12,363
12,730
12,524
(4,035 )
(4,426 )
(5,430 )
(1,227 )
(1,627 )
(1,669 )
(2,808 )
11,053
8,245
17,229
$
$
(2,799 )
6,323
3,524
4,977
$
$
(3,761 )
(7,130 )
(10,891 )
(14,082 )
$
$
$
See accompanying report of independent registered public accounting firm.
F-42
FINANCIAL STATEMENT SCHEDULES
Schedule II (Continued) – Condensed Financial Information of Registrant (Parent Company Only)
HALLMARK FINANCIAL SERVICES, INC.
STATEMENTS OF CASH FLOWS
For the years ended December 31, 2013, 2012 and 2011
(In thousands)
2013
2012
2011
Cash flows from operating activities:
Net income (loss)
$
8,245
$
3,524
$
(10,891 )
Adjustments to reconcile net income (loss) to cash provided by (used in)
operating activities:
Depreciation and amortization expense
Deferred income tax expense (benefit)
Undistributed share of (earnings) loss of subsidiaries
Change in current federal income tax (recoverable)payable
Change in all other liabilities
Change in all other assets
92
1,182
(11,053 )
(3,694 )
12,232
63
113
(1,725 )
(6,323 )
4,030
357
450
168
(215
)
7,130
)
(4,838
5,155
1,074
)
)
)
)
Net cash provided by (used in) operating activities
7,067
426
)
(2,417
)
Cash flows from investing activities:
Purchases of property and equipment, net
Net cash used in investing activities
Cash flows from financing activities:
Proceeds from exercise of employee stock options
Purchase of treasury shares
Activity under revolving credit facility, net
Net cash used in financing activities
Increase (decrease) in cash and cash equivalents
Cash and cash equivalents at beginning of year
Cash and cash equivalents at end of year
Supplemental cash flow information:
Interest paid
Income taxes (paid) recovered
(116 )
(116 )
-
-
-
-
6,951
1,112
8,063
(46 )
(46 )
-
-
(2,577 )
(2,577 )
(2,197 )
3,309
$
1,112
(4,599 )
(1,285 )
$
$
(4,656 )
3,932
)
(205
)
)
(205
)
)
)
99
(6,401
)
1,250
(5,052 )
(7,674
)
10,983
3,309
)
(4,620
)
)
(3,383
)
$
$
$
$
$
$
See accompanying report of independent registered public accounting firm.
F-43
FINANCIAL STATEMENT SCHEDULES
Schedule III - Supplementary Insurance Information
(In thousands)
Column A
Segment
2013
Column B
Deferred
Policy
Acquisition
Costs
Column C
Future
Policy
Benefits,
Losses,
Claims and
Loss
Adjustment
Expenses
Column D
Unearned
Premiums
Column E
Other
Policy
Claims
and Benefits
Payable
Column F
Premium
Revenue
Column G
Net
Investment
Income
Column H
Benefits,
Claims, Losses
and Settlement
Expenses
Column I
Amortization
of Deferred
Policy
Acquisition
Costs
Column J
Other
Operating
Expenses
Column K
Net
Premiums
Written
Personal Segment
$
660
$
38,294
$ 17,989
$
-
$
63,800
$
Standard Commercial Segment
6,124
111,473
36,309
Specialty Commercial Segment
Corporate
15,802
-
232,873
-
131,005
-
-
-
-
78,176
218,565
-
Consolidated
$ 22,586
$ 382,640
$ 185,303
$
-
$
360,541
$
$
2,065
5,031
11,021
(5,233 )
12,884
$
52,656
$
17,759
$ 16,957
$ 45,644
56,143
8,254
25,313
79,466
152,546
-
31,264
-
56,974
7,720
235,655
-
261,345
$
57,277
$ 106,964
$ 360,765
2012
Personal Segment
Standard Commercial Segment
Specialty Commercial Segment
Corporate
$
$
4,952
5,968
13,991
-
$
40,387
103,610
169,419
-
$ 21,125
35,073
106,304
-
$
-
-
-
-
$
81,451
69,155
168,830
-
$
2,449
4,925
9,435
(1,516 )
$
69,606
52,828
103,980
-
17,250
10,825
31,730
-
$ 26,413
22,742
49,170
7,825
$ 76,345
70,091
186,053
-
Consolidated
$ 24,911
$ 313,416
$ 162,502
$
-
$
319,436
$
15,293
$
226,414
$
59,805
$ 106,150
$ 332,489
2011
Personal Segment
Standard Commercial Segment
Specialty Commercial Segment
Corporate
$
$
6,020
5,976
10,558
-
$
53,280
100,487
143,178
-
$ 26,307
32,854
86,943
-
$
-
-
-
-
$
92,962
64,586
135,493
-
$
2,470
4,061
7,416
1,933
$
101,030
50,940
87,265
-
13,865
12,721
21,189
-
$ 29,706
20,589
39,471
6,962
$ 95,655
63,944
144,277
-
Consolidated
$ 22,554
$ 296,945
$ 146,104
$
-
$
293,041
$
15,880
$
239,235
$
47,775
$ 96,728
$ 303,876
See accompanying report of independent registered public accounting firm.
F-44
Schedule IV – Reinsurance
(In thousands)
Column A
Year Ended December 31, 2013
Life insurance in force
Premiums
Life insurance
Accident and health insurance
Property and liability insurance
Title Insurance
Total premiums
Year Ended December 31, 2012
Life insurance in force
Premiums
Life insurance
Accident and health insurance
Property and liability insurance
Title Insurance
Total premiums
Year Ended December 31, 2011
Life insurance in force
Premiums
Life insurance
Accident and health insurance
Property and liability insurance
Title Insurance
Total premiums
$
$
$
$
$
$
$
$
$
FINANCIAL STATEMENT SCHEDULES
Column B
Gross
Amount
-
$
-
-
434,022
-
434,022
$
$
Column C
Ceded to
Other
Companies
-
-
-
76,685
-
76,685
$
$
$
Column D
Assumed
From Other
Companies
Column E
Net
Amount
Column F
Percentage
of Amount
Assumed to Net
-
$
-
-
-
3,204
-
3,204
$
-
-
360,541
-
$ 360,541
-
$
-
$
-
$
-
$
-
$
-
$
-
-
-
369,735
-
369,735
$
-
54,413
-
54,413
$
-
4,114
-
4,114
-
319,436
-
$ 319,436
-
$
-
$
-
$
-
$
-
-
344,642
-
344,642
$
-
-
57,039
-
57,039
$
$
-
-
5,438
-
5,438
$
-
-
293,041
-
$ 293,041
0.89 %
0.89 %
1.29 %
1.29 %
1.86 %
1.86 %
See accompanying report of independent registered public accounting firm.
F-45
FINANCIAL STATEMENT SCHEDULES
Schedule VI - Supplemental Information Concerning Property-Casualty Insurance Operations
(In thousands)
Column A
Column B
Column C
Column D
Column E
Column F
Column G
Deferred
Policy
Acquisition
Costs
Reserves
for Unpaid
Claims and
Claim Adjustment
Expenses
Discount
if any,
Deducted
In Column C
Unearned
Premiums
Earned
Premiums
Net
Investment
Income
Affiliation
With
Registrant
(a) Consolidated
property-casualty
Entities
Column H
Claims and Claim
Adjustment
Expenses Incurred Related to
(1)
Current
Year
(2)
Prior
Years
Column I
Column J
Column K
Net Premiums
Written
Amortization
of Deferred
Policy
Acquisition
Costs
Paid
Claims and
Claims
Adjustment
Expenses
2013
2012
2011
$
$
$
22,586
24,911
22,554
$
$
$
382,640
313,416
296,945
$
$
$
-
-
-
$ 185,303
$ 162,502
$ 146,104
$ 360,541
$ 319,436
$ 293,041
$
$
$
12,884
15,293
15,880
$
$
$
251,391
230,089
222,869
$
$
$
9,954
(3,675 )
16,366
$
$
$
57,277
59,805
47,775
$ 212,709
$ 217,483
$ 206,873
$
$
$
360,765
332,489
303,876
See accompanying report of independent registered public accounting firm.
F-46
NASDAQ: HALL
Headquartered in Fort Worth, Texas,
Hallmark Financial Services, Inc. is a publicly traded
holding company with wholly owned subsidiaries
engaged in property and casualty insurance.
HAllMAR k'S BuSIneSS PlAn
ouR coRPoRATe STRATegy
is to operate as a diversified underwriter of niche property and casualty
insurance products. This plan is executed by five wholly owned business
units, each with separate specialty product focus. each business unit is
independent of each other and has their own senior management, under-
writing, and claims staff.
is to create a “Best-in-class” Specialty Insurance company focused on
under writing profitability and long-term growth of stockholders’ book
value per share. our specialty product focus and niche market strategy
enable us to develop and retain in-house underwriting expertise and spe-
cialized market knowledge, which helps differentiate Hallmark from our
competitors. each business unit tailors its products and product distribu-
tion to the unique nature of the risk and coverages they provide.
ouR FInAncIAl goAl
is to earn a consistent underwriting profit and build long-term shareholder
value by focusing on profitability and operating efficiency versus topline
premium growth and market share.
Corporate Information
BoARd oF dIRecToRS
Mark E. Schwarz
Executive Chairman
Scott T. Berlin
Managing director,
Brown, gibbons, lang & company
James H. Graves
Partner, erwin, graves & Associates, lP
Jim W. Henderson
Chairman & Chief Executive Officer
AssuredPartners, Inc.
MAnAgeMenT TeAM
Mark E. Schwarz
Executive Chairman
Mark J. Morrison
President & Chief Executive Officer
Kevin T. Kasitz
Executive Vice President &
Chief Operating Officer
Jeffrey R. Passmore
Senior vice President &
Chief Accounting Officer
Donald E. Meyer
President of e&S commercial
Business unit
Robert B. Wilson
President of Standard commercial
Business unit
James A. Damonte
President of Hallmark Select
Business unit
Michael P. Binns
President of Personal lines
Business unit
IndePendenT RegISTeRed PuBlIc
AccounTAnTS
Ernst & Young LLP
201 Main Street
Suite 1100
Ft. Worth, Texas 76102
STock SyMBol
Hallmark Financial Services, Inc.
common stock is listed on the
nASdAQ global Market under
the symbol “HAll.”
TRAnSFeR Agen T
Securities Transfer Corporation
2591 dallas Parkway
Suite 102
Frisco, Texas 75034
(469) 633-0101
legAl counSel
McGuire, Craddock & Strother, P.C.
dallas, Texas
STockHoldeR MeeTIng
The annual meeting of stockholders will be held
at 10:00 a.m. cdT on May 30, 2014 at 777 Main
Street, 11th Floor conference Room, Ft. Worth,
Texas 76102.
coRPoRATe HeAdQuARTeRS
Hallmark Financial Services, Inc.
777 Main Street
Suite 1000
Ft. Worth, Texas 76102
(817) 348-1600
www.hallmarkgrp.com
Annual Report 2013
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777 Main Street, Suite 1000 I Fort Worth, Texas 76102 I P (817) 348-1600 I www.hallmarkgp.com