CONFORMED COPY
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
Quarterly report under Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the quarterly period ended June 30, 2002
Commission file number 0-16090
Hallmark Financial Services, Inc.
---------------------------------
(Exact name of small business issuer as specified in its charter)
Nevada 87-0447375
------------------------------- -------------------
(State or other jurisdiction of (I.R.S. Employer
Incorporation or organization) Identification No.)
14651 Dallas Parkway, Suite 900 Dallas, Texas 75240
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(Address of principal executive offices) (Zip Code)
Issuer's telephone number, including area code: (972) 404-1637
Check whether the issuer (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act
during the past 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days.
Yes X No
APPLICABLE ONLY TO CORPORATE ISSUERS
State the number of shares outstanding of each of the issuer's
classes of common equity, as of the latest practicable date:
Common Stock, par value $.03 per share - 11,049,133 shares
outstanding as of August 14, 2002.
PART I
FINANCIAL INFORMATION
Item 1. Financial Statements
INDEX TO FINANCIAL STATEMENTS
Page Number
-----------
Consolidated Balance Sheets at June 30, 2002 3
(unaudited) and December 31, 2001
Consolidated Statements of Operations (unaudited) 4
for the three and six months ended June 30, 2002
Consolidated Statements of Cash Flows (unaudited) 5
for the six months ended June 30, 2002 and June
Notes to Consolidated Financial Statements 6
(unaudited)
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands)
--------
June 30 December 31
ASSETS 2002 2001
----------- -----------
(Unaudited)
Investments:
Debt securities, held-to-maturity,
at amortized cost $ 3,876 $ 876
Equity securities, available-for-sale,
at market value 144 144
Short-term investments, at cost which
approximates market value 10,460 15,203
----------- -----------
Total investments 14,480 16,223
Cash and cash equivalents 5,901 5,533
Restricted cash 1,584 1,990
Prepaid reinsurance premiums 10,238 11,611
Premiums receivable from lender for
financed premiums (net of allowance
for doubtful accounts of $167 in
2002 and $208 in 2001) 13,120 13,740
Premiums receivable 880 414
Reinsurance recoverable 13,778 16,871
Deferred policy acquisition costs 1,211 761
Excess of cost over net assets acquired 4,431 4,431
Current federal income tax recoverable 678 696
Deferred federal income taxes 268 425
Accrued investment income 25 6
Other assets 447 904
----------- -----------
$ 67,041 $ 73,605
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Notes payable $ 13,271 $ 13,933
Unpaid losses and loss adjustment expenses 17,804 20,089
Unearned premiums 16,625 16,793
Reinsurance balances payable 3,641 4,426
Drafts outstanding 673 890
Accrued ceding commission refund 1,722 4,598
Accounts payable and other accrued expenses 2,599 2,508
----------- -----------
Total liabilities 56,335 63,237
----------- -----------
Stockholders' equity
Common stock, $.03 par value, authorized
100,000,000 shares issued 11,855,610
shares in 2002 and 2001 356 356
Capital in excess of par value 10,875 10,875
Retained earnings 518 180
Treasury stock, 806,477 shares in 2002
and 2001, at cost (1,043) (1,043)
----------- -----------
Total stockholders' equity 10,706 10,368
----------- -----------
$ 67,041 $ 73,605
=========== ===========
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands)
Three Months Ended Six Months Ended
June 30 June 30
--------------------- ----------------------
2002 2001 2002 2001
-------- -------- -------- --------
Gross premiums written $ 11,468 $ 14,087 $ 25,420 $ 29,834
Ceded premiums written (6,583) (9,704) (15,129) (20,263)
-------- -------- -------- --------
Net premiums written $ 4,885 $ 4,383 $ 10,291 $ 9,571
======== ======== ======== ========
Revenues:
Gross premiums earned 13,176 13,062 25,488 25,493
Ceded premiums earned (8,239) (8,731) (16,403) (16,787)
-------- -------- -------- --------
Net premiums earned 4,937 4,331 9,085 8,706
Investment income, net of expenses 146 232 272 543
Finance charges 635 862 1,290 1,694
Processing and service fees 72 306 215 729
Other income 90 60 166 106
-------- -------- -------- --------
Total revenues 5,880 5,791 11,028 11,778
-------- -------- -------- --------
Benefits, losses and expenses:
Losses and loss adjustment expenses 9,305 13,278 17,268 24,169
Reinsurance recoveries (5,491) (8,447) (10,275) (15,531)
-------- -------- -------- --------
Net losses and loss adjustment expenses 3,814 4,831 6,993 8,638
Acquisition costs, net (31) (147) (450) (90)
Other acquisition and underwriting expenses
(net of ceding commission of $4,107 in 2002
and $5,566 in 2001) 1,091 984 2,376 1,822
Operating expenses 572 901 1,171 2,010
Interest expense 221 256 426 550
Amortization of intangible assets - 39 - 79
-------- -------- -------- --------
Total benefits, losses and expenses 5,667 6,864 10,516 13,009
-------- -------- -------- --------
Income (loss) from operations before federal
income taxes 213 (1,073) 512 (1,231)
Federal income tax expense (benefit) 70 (363) 174 (422)
-------- -------- -------- --------
Net income (loss) $ 143 $ (710) $ 338 $ (809)
======== ======== ======== ========
Basic and diluted earnings (loss) per share $ 0.01 $ (0.06) $ 0.03 $ (0.07)
======== ======== ======== ========
Common stock shares outstanding 11,049,133 11,049,133 11,049,133 11,049,133
========== ========== ========== ==========
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(Unaudited)
(In thousands)
Six Months Ended
June 30
-------------------------
2002 2001
----------- -----------
Cash flows from operating activities:
Net income (loss) $ 338 $ (809)
Adjustments to reconcile net income (loss) to
cash (used in) provided by operating activities:
Depreciation and amortization expense 83 143
Change in deferred Federal income taxes 157 (104)
Change in prepaid reinsurance premiums 1,373 (3,476)
Change in premiums receivable (466) 681
Change in deferred policy acquisition costs (450) (90)
Change in unpaid losses and loss
adjustment expenses (2,285) 839
Change in unearned premiums (168) 4,341
Change in reinsurance recoverable 3,093 (1,521)
Change in reinsurance balances payable (785) 2,323
Change in current federal income
tax payable/recoverable 18 (227)
Change in litigation cost - (1,386)
Change in accrued ceding commission refund (2,876) 1,492
Change in all other liabilities (126) 44
Change in all other assets 450 (63)
----------- -----------
Net cash (used in) provided
by operating activities (1,644) 2,187
----------- -----------
Cash flows from investing activities:
Purchases of property and equipment (95) (134)
Premium finance notes originated (22,502) (29,408)
Premium finance notes repaid 23,122 25,156
Change in restricted cash 406 1,662
Purchases of debt securities (5,105) -
Maturities and redemptions
of investment securities 2,105 4,914
Purchase of short-term investments (16,497) (10,440)
Maturities of short-term investments 21,240 4,500
----------- -----------
Net cash provided by (used in)
investing activities 2,674 (3,750)
----------- -----------
Cash flows from financing activities:
Repayment of borrowings - (364)
Net advances from lender (662) 761
----------- -----------
Net cash (used in) provided
by financing activities (662) 397
----------- -----------
Increase (decrease) in cash and cash equivalents 368 (1,166)
Cash and cash equivalents at beginning of period 5,533 6,831
----------- -----------
Cash and cash equivalents at end of period $ 5,901 $ 5,665
=========== ===========
The accompanying notes are an integral part
of the consolidated financial statements
HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES
Item 1. Notes to Consolidated Financial Statements (Unaudited)
Note 1 - Summary of Accounting Policies
In the opinion of management, the accompanying consolidated financial
statements contain all adjustments, consisting primarily of normal recurring
adjustments, necessary to present fairly the financial position of Hallmark
Financial Services, Inc. and subsidiaries (the "Company") as of June 30,
2002 and the consolidated results of operations and cash flows for the
periods presented. The accompanying financial statements have been prepared
by the Company without audit.
Certain information and disclosures normally included in financial
statements prepared in accordance with accounting principles generally
accepted in the United States ("GAAP") have been condensed or omitted.
Reference is made to the Company's annual consolidated financial statements
for the year ended December 31, 2001 for a description of accounting
policies and certain other disclosures. Certain items in the 2001 interim
financial statements have been reclassified to conform to the 2002
presentation.
The results of operations for the period ended June 30, 2002 are not
necessarily indicative of the operating results to be expected for the full
year.
Note 2 - Reinsurance
The Company is involved in the assumption and cession of reinsurance
from/to other companies. The Company remains obligated to its policyholders
in the event that reinsurers do not meet their obligations under the
reinsurance agreements.
Effective March 1, 1992, the Company entered into a reinsurance
arrangement with State & County Mutual Fire Insurance Company ("State &
County"), an unaffiliated company, to assume 100% of the nonstandard auto
business produced by the Company and underwritten by State & County. The
arrangement is supplemented by a separate retrocession agreement effective
July 1, 2000 between the Company and Dorinco Reinsurance Company
("Dorinco"). Under the agreement, the Company, upon mutual agreement with
Dorinco, may elect on a quarterly basis to retain 30% to 45% of the risk.
The Company currently retains 40% of the risk and cedes 60% to Dorinco. For
the period of January 1, 2002 through March 31, 2002, the Company retained
35% of the risk and ceded 65% to Dorinco. Prior to January 1, 2002, the
Company retained 30% of the risk and ceded 70% to Dorinco.
Note 3 - Intangible Assets
When the Company's primary operating subsidiaries were purchased, the
excess cost over the fair value of the net assets acquired was recorded as
goodwill and was amortized on a straight-line basis over forty years. Other
intangible assets consist of a trade name, a managing general agent's
license and non-compete arrangements, all of which were fully amortized at
June 30, 2002.
In June 2001, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 141 ("SFAS 141"), "Business
Combinations", and No. 142 ("SFAS 142"), "Goodwill and Other Intangible
Assets". SFAS 141 supersedes Accounting Principles Board Opinion ("APB")
No. 16, "Business Combinations". SFAS 141 (1) requires that the purchase
method of accounting be used for all business combinations initiated after
June 30, 2001, (2) provides specific criteria for the initial recognition
and measurement of intangible assets apart from goodwill, and (3) requires
that unamortized negative goodwill be written off immediately as an
extraordinary gain. SFAS 142 supersedes APB No. 17, "Intangible Assets,"
and is effective for fiscal years beginning after December 15, 2001. SFAS
142 primarily addresses the accounting for goodwill and intangible assets
subsequent to their initial recognition. SFAS 142 (1) prohibits the
amortization of goodwill and indefinite-lived intangible assets, (2)
requires testing of goodwill and indefinite-lived intangible assets on an
annual basis for impairment (and more frequently if the occurrence of an
event or circumstance indicates an impairment), (3) requires that reporting
units be identified for the purpose of assessing potential future
impairments of goodwill, and (4) removes the forty-year limitation on the
amortization period of intangible assets that have finite lives.
The Company adopted the provisions of SFAS 142 during the first quarter
of 2002 and immediately ceased recording amortization expense of its
goodwill. A reconciliation of net income and earnings per share as reported
to illustrate the impact of goodwill amortization for the six months ended
June 30, 2002 and 2001 is as follows:
Three Months Six Months
Ended June 30 Ended June 30
(In thousands except for earnings 2002 2001 2002 2001
per share amounts) ----- ----- ----- -----
Reported net income (loss) $ 143 $ (710) $ 338 $ (809)
Add back: Goodwill amortization - 39 - 79
----- ----- ----- -----
Adjusted net income (loss) $ 143 $ (671) $ 338 $ (730)
===== ===== ===== =====
Basic and diluted earnings per share:
Reported net income (loss) $ 0.01 $(0.06) $ 0.03 $(0.07)
Add back: Goodwill amortization - - - -
----- ----- ----- -----
Adjusted net income (loss) $ 0.01 $(0.06) $ 0.03 $(0.07)
===== ===== ===== =====
SFAS 142 requires that goodwill be tested annually for impairment using
a two-step process. The first step is to determine reporting units and
compare the fair value of each reporting unit as of the beginning of the
fiscal year with its carrying amount (including goodwill) to identify
any potential impairment. The Company has completed this first step and
determined that an impairment of goodwill exists.
The second step of the goodwill impairment test under SFAS 142 is to
quantify the amount of any impairment loss as of the beginning of the fiscal
year. This process must be completed not later than the end of the fiscal
year. In accordance with SFAS 142, the Company presently expects to record
a significant charge to earnings resulting from the completion of this
transitional impairment test. Although the amount of such charge cannot
presently be reasonably estimated, the Company anticipates that the
implementation of this mandatory change in accounting principles will have a
material adverse impact on net income in the quarter recognized and for 2002
as a whole.
[This space left blank intentionally]
Item 2. Management's Discussion and Analysis or Plan of Operation.
Introduction. Hallmark Financial Services, Inc. ("HFS") and its wholly
owned subsidiaries (collectively referred to herein as the "Company") engage
in the sale of property and casualty insurance products. The Company's
business primarily involves marketing, underwriting and premium financing of
non-standard automobile insurance, as well as claims adjusting and other
insurance related services.
The Company pursues its business activities through an integrated
insurance group, (collectively, the "Insurance Group"), the members of which
are an authorized Texas property and casualty insurance company, American
Hallmark Insurance Company of Texas ("Hallmark"); a managing general agency,
American Hallmark General Agency, Inc. ("AHGA"); a network of four insurance
agencies known as the American Hallmark Agencies ("Hallmark Agencies"); a
premium finance company, Hallmark Finance Corporation ("HFC"); and a claims
handling and adjustment firm, Hallmark Claims Service, Inc. ("HCS"). The
Company operates only in Texas.
Hallmark provides non-standard automobile liability and physical damage
insurance through a reinsurance arrangement with an unaffiliated company,
State and County Mutual Fire Insurance Company ("State & County"). Through
State & County, Hallmark provides insurance primarily for high-risk drivers
who do not qualify for standard-rate insurance. Under a supplementary quota-
share reinsurance agreement with Dorinco Reinsurance Company ("Dorinco"),
Hallmark, upon mutual agreement with its reinsurer, may elect on a quarterly
basis to retain 30% to 45% of the risk while ceding the remaining percentage
to its reinsurer. HFC finances annual and six-month policy premiums
through its premium finance program. AHGA manages the marketing of Hallmark
policies through the Hallmark Agencies and independent agents. Additionally,
AHGA provides premium processing, underwriting, reinsurance accounting and
cash management for unaffiliated managing general agents ("MGAs"). HCS
provides fee-based claims adjustment, salvage, subrogation recovery and
litigation services to Hallmark and unaffiliated MGAs.
Financial Condition and Liquidity
The Company's sources of funds are principally derived from insurance
related operations. Major sources of funds from operations include premiums
collected (net of policy cancellations and premiums ceded), ceding
commissions and premium finance charges. Other sources of funds are from
financing and investment activities, as well as service fees.
On a consolidated basis, the Company's total cash, cash equivalents and
investments (excluding restricted cash) at June 30, 2002 and December 31,
2001 were $20.4 million and $21.8 million, respectively. The Company's
liquidity decreased 6% during the first six months of 2002 as compared to
December 31, 2001 principally as a result of an annual ceding commission
adjustment with its reinsurer in the amount of $3.4 million during the first
quarter of 2002.
Net cash used by the Company's consolidated operating activities was
$1.6 million for the first six months of 2002 compared to net cash provided
by operating activities of approximately $2.2 million for the first six
months of 2001. The approximate $3.4 million ceding commission adjustment
paid to reinsurers during the first quarter of 2002 was partially offset by
an increase in monthly policy production, and by the increase in the
Company's retention of State & County business to 40% (from 35% at January
1, 2002 and 30% prior to 2002) effective April 1, 2002 under the Company's
quota share retrocession agreement with Dorinco.
Cash provided by investing activities during the first six months of
2002 increased by $6.4 million as compared to the same period of 2001. This
increase in cash provided by investing activities was primarily the combined
result of increased maturities of short-term investments and an increase in
repayments of premium finance notes when netted against originations of
premium finance notes during the first six months of 2002 as compared to the
first six months of 2001. This increase was partially offset by
reinvestment in both long and short-term investments during the first six
months of 2002.
Cash used by financing activities increased approximately $1.1 million
during the first six months of 2002 as compared to the first six months of
2001 primarily due to a decrease in net advances from the Company's premium
finance lender. The decrease in net advances was attributable to decreased
production of annual policies during the first six months of 2002 as
compared to the same period of 2001.
A substantial portion of the Company's liquid assets is held by
Hallmark and is not available for general corporate purposes. Of the
Company's consolidated liquid assets of $20.4 million at June 30, 2002, and
$21.8 million at December 31, 2001, $1.6 million and $1.9 million,
respectively, represented non-restricted cash. Since state insurance
regulations restrict financial transactions between an insurance company and
its affiliates, HFS is limited in its ability to use Hallmark funds for its
own working capital purposes. Furthermore, dividends and loans by Hallmark
to the Company are restricted and subject to Texas Department of Insurance
("TDI") approval. Although TDI has sanctioned the payment of management
fees, commissions and claims handling fees by Hallmark to HFS and
affiliates, since the second half of 2000, Hallmark has elected not to pay
all of the commissions allowed to AHGA. These steps were taken to preserve
Hallmark's surplus. During the first six months of 2002, Hallmark accrued
$93,000 of management fees to HFS. Management anticipates that Hallmark may
pay management fees periodically during the remainder of 2002. The Company
has never received a dividend from Hallmark, and there is no immediate plan
to pay a dividend.
Ceding commission income represents a significant source of funds to
the Company. Ceding commission income for the first six months of 2002
decreased $1.5 million (representing a 26% decrease) as compared to the
similar period of 2001. This decrease was the result of the combined effect
of (1) less favorable reinsurance terms during the first quarter of 2002
compared to 2001, (2) a decrease in core State & County premium volume, and
(3) an increase in Hallmark's risk retention to 40% effective April 1, 2002
and to 35% effective January 1, 2002 from 30% prior to January 1, 2002. In
accordance with GAAP, a portion of ceding commission income and policy
acquisition costs is deferred and recognized as income and expense,
respectively, as related net premiums are earned. Deferred policy
acquisition costs (net of deferred ceding commission) increased to $1.2
million at June 30, 2002 from $0.8 million at December 31, 2001. The
increase in net deferred acquisition costs was principally due to the
decrease in ceding commission partially offset by a decrease in underwriting
expenses.
At June 30, 2002, Hallmark reported statutory capital and surplus of
approximately $6.3 million, which reflects an increase of approximately $0.3
million since December 31, 2001. Hallmark's premium to surplus ratio for the
twelve months ended June 30, 2002 was 2.64 to 1 as compared to 2.62 for the
twelve months ended December 31, 2001. Effective January 1, 2001, TDI
adopted the Codification of Statutory Accounting Principles (the
"Codification"), which replaced the National Association of Insurance
Commissioners primary guidance on statutory accounting. As a result of the
implementation of the Codification, Hallmark recognized a deferred tax
asset. The deferred tax adjustment required by Codification is recognized by
TDI as an increase to surplus; however, certain rating agencies, such as
A.M. Best, do not recognize the adjustment as an increase to surplus.
Hallmark's premium-to-surplus ratio, without the Codification, for the
twelve months ended June 30, 2002 was 2.89 to 1 as compared to 2.83 to 1 for
the year ended December 31, 2001.
The Company provides on-going program administration and claims
handling for unaffiliated MGAs. The Company currently provides these
services for one unaffiliated MGA which continues to produce new business.
Hallmark assumes a pro-rata share of the business produced under this
unaffiliated MGA program, and Dorinco assumes the remainder. Three other
unaffiliated MGAs for whom the Company provided similar services have
discontinued writing new business due to the inability to obtain reinsurance
and are in run-off.
Management is continuing to investigate opportunities to enhance and
expand the Company's operations. While additional capital or strategic
alliances may be required to fund future expansion, operational enhancements
through increased information technology capabilities are in progress.
During the summer of 2001, the Company rolled out its web-based information
system (named e-Integrity and referred to as the "Integrity System") which
is designed to enhance Company and agency relationships by improving content
and timeliness of information to support agents in servicing their
customers. The second phase of the Integrity System is composed of two
parts. Part One relates to electronic reporting and communication
capabilities, and Part Two encompasses, among other things, payment and new
business upload to support agents in more promptly and efficiently producing
new business, as well as to improve the quality and timeliness of service to
existing policyholders. Part One alleviates certain manual processes and
results in daily communication of time-sensitive information to agents, thus
decreasing labor, supplies and postage costs and increasing the agent's
likelihood of policyholder retention. This phase was completed during the
first quarter of 2002. Part Two, which will further reduce processing
costs, is targeted to be completed by year-end 2002 with related cost
savings to commence in 2003.
Results of Operations
Overview
The Company had profitable results for the first six months of 2002
principally due to its focus on rate adequacy, underwriting discipline and
agent management. For the first six months ended June 30, 2002, net income
was $0.3 million compared to a net loss of $0.8 million for the same period
of 2001. Gross premiums written for the first six months of 2002 decreased
approximately 15% as compared to 2001, while net premiums written for the
first six months of 2002 increased by approximately 8% to $10.3 million for
2002 compared to $9.6 million in the first six months of 2001. Net premiums
earned of $9.1 million for the first six months of 2002 increased 4% in
relation to net premiums earned of $8.7 million for the comparable period of
2001.
The Company's net incurred loss ratios declined to 77% for the first
six months of 2002 from 99.2% for the first six months of 2001. Certain key
financial operational ratios follow:
First six First six
Months of Months of
2002 2001
---- ----
GAAP Incurred Loss Ratio (excluding storm 66.2% 90.5%
and loss corridor)
GAAP Loss Corridor Incurred Loss Ratio (1) 8.8% 4.9%
GAAP Storm\Flood Incurred Loss Ratio (2) 2.0% 3.8%
---- ----
GAAP Incurred Loss Ratio 77.0% 99.2%
GAAP Expense Ratio (3) 20.9% 17.7%
---- -----
GAAP Combined Ratio 97.9% 116.9%
==== =====
(1) Effective April 1, 2001, the Company's reinsurance agreement
was amended to include a loss corridor provision. Losses incurred
within the loss corridor range are retained 100% by the Company.
The loss corridors for the six months ended June 30, 2002 and 2001
were $0.8 million and $0.4 million, respectively.
(2) Net storm losses retained by the Company were approximately
$0.2 million and $0.3 million for the six months ended June 30,
2002 and 2001, respectively.
(3) The GAAP expense ratio represents underwriting expenses and
other income less certain expenses as a percentage of net premiums
written. The principal reason for the increased GAAP expense
ratio is the decrease in ceding commission income. As a percentage
of net premiums written, ceding commission income declined 18.3%,
as discussed in the Financial Condition and Liquidity section.
Analysis
Gross premiums written (prior to reinsurance) for the three and six
months ended June 30, 2002 decreased 19% and 15%, respectively, in relation
to gross premiums written during the same periods in 2001. The decrease in
gross premiums written was principally due to the Company's strategic focus
on underwriting profitability rather than market share. This focus included
increased attention to rate adequacy, agent performance and underwriting
discipline. Net premiums written (after reinsurance) for the three and six
months ended June 30, 2002 increased 11% and 8%, respectively, over the same
periods in 2001. The disparity between gross premiums written and net
premiums written is primarily due to the increase in the Company's retention
of premiums from 30% to 35% effective January 1, 2002 and further to 40%
effective April 1, 2002.
Despite the decrease in gross premiums written compared to the same
period of the prior year, gross premiums earned (prior to reinsurance) for
the three and six months ended June 30, 2002 remained relatively the same as
compared to the same periods of 2001. This was principally due to the
combined effect of a shift in policy mix from annual to monthly policies and
the continued earnings of annual premiums written at a higher volume level
during 2001. For the three and six months ended June 30, 2002, net premiums
earned (after reinsurance) increased 14% and 4%, respectively, as compared
to the same periods of 2001. The disproportionate change in premiums earned
prior to and after reinsurance is due to the impact of the increased
retention of core State & County premium volume which has reduced ceded
premiums and ultimately increased net premiums written.
Net incurred loss ratios (computed on net premiums earned after
reinsurance) for the three and six months ended June 30, 2002 were 77.3% and
77.0%, respectively, compared to 111.6% and 99.2% for the same periods of
2001. During the second quarter of 2001, the Company's reinsurance
agreement was amended to include a loss corridor provision which increases
net losses incurred by the Company between certain loss ratio levels. If
the loss corridor had not been in place during the first six months of 2002
and the second quarter of 2001, the net incurred loss ratios would have been
68.2% and 94.3%, respectively. Additionally, severe storms occurring in the
spring of 2002 and the Houston flood of May 2001 impacted the 2002 and 2001
loss ratios. Excluding the impact of storms and the loss corridor, the loss
ratios for 2002 and 2001 would have been 66.2% and 90.5%, respectively. The
significant improvement in the loss ratio in 2002 compared to 2001 is
principally the result of the Company's increasing focus on underwriting
profitability during 2001 which is now reflected in 2002 results. Specific
strategies implemented in late 2000 and 2001 to improve the Company's loss
ratio included multiple rate increases, more restrictive underwriting
guidelines, reductions in agency force and emphasis on fast payment of
claims.
Investment income decreased approximately 50% during the first six
months of 2002 compared to the same period of 2001. The decrease is
attributable to the combined effect of decreased yield currently available
in the marketplace and maturities/calls of higher yield investments.
Finance charges, which decreased $0.4 million during the first six
months of 2002 as compared to the same period of 2001, represent interest
earned on premium notes issued by HFC. This decrease is directly correlated
to the decrease in annual policy premium volume.
Processing and service fees represent fees earned on third party
processing and servicing contracts with unaffiliated MGAs. Processing and
service fees for the first six months of 2002 decreased $0.5 million (71%)
compared to the same period of 2001, as a result of cancellation of the
service contracts with three unaffiliated MGAs (which are currently in run-
off).
Acquisition costs, net represents the amortization of acquisition costs
(and credits) deferred over the past twelve months and the deferral of
acquisition costs (and credits) incurred in the current period. The $0.4
million decrease in acquisition costs, net is primarily due to the combined
effect of a decrease in ceding commission income due to changes in the
Company's reinsurance terms and an increase in the deferral rate as a result
of the Company increasing its retention of State & County business under its
quota share retrocession agreement.
Other acquisition and underwriting expenses for the three and six
months ended June 30, 2002 increased 11% and 30%, respectively, as compared
to the same periods of 2001. The increase in expenses is primarily
attributable to decreased ceding commission income as a result of increases
in the Company's retention of its core business since year end 2001, less
favorable reinsurance terms, and decreased core State & County premium
volume. This was partially offset by a decrease in variable expenses, such
as commissions, front fees and premium taxes. Additionally, certain other
underwriting expenses which fluctuate with premium volume decreased due to
information technology enhancements.
Operating expenses include expenses related to premium finance
operations, general corporate overhead, and third party administrative and
claims handling contracts. Related revenues are derived from finance
charges and processing and service fees. Operating expenses decreased 37%
and 42%, respectively, during the three and six months ended June 30, 2002
as compared to the same periods of 2001. The majority of this decrease in
operating expenses is attributable to decreased operating costs related to
third party processing and claims handling.
Interest expense decreased $0.1 million during the first half of 2002
as compared to 2001. This decrease is principally the result of a decrease
in the effective interest rate related to the premium finance line of credit
and to lower premium note volume as a result of lower annual premium volume.
Recent Developments
The Company has recently negotiated the renewal of its quota-share
reinsurance agreement with Dorinco to be effective October 1, 2002. The
Company believes the terms of the renewal agreement are modestly more
beneficial to the Company than those contained in the current quota-share
reinsurance agreement.
Risks Associated with Forward-Looking Statements Included in this Form
10-QSB
This Form 10-QSB contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934, which are intended to be covered by the
safe harbors created thereby. These statements include the plans and
objectives of management for future operations, including plans and
objectives relating to future growth of the Company's business activities
and availability of funds. The forward-looking statements included herein
are based on current expectations that involve numerous risks and
uncertainties. Assumptions relating to the foregoing involve judgments with
respect to, among other things, future economic, competitive and market
conditions, regulatory framework, and future business decisions, all of
which are difficult or impossible to predict accurately and many of which
are beyond the control of the Company. Although the Company believes that
the assumptions underlying the forward-looking statements are reasonable,
any of the assumptions could be inaccurate and, therefore, there can be no
assurance that the forward-looking statements included in this Form 10-QSB
will prove to be accurate. In light of the significant uncertainties
inherent in the forward-looking statements included herein, the inclusion of
such information should not be regarded as a representation by the Company
or any other person that the objectives and plans of the Company will be
achieved.
PART II
OTHER INFORMATION
Item 1. Legal Proceedings.
Except for routine litigation incidental to the business
of the Company, neither the Company nor any of the
properties of the Company was subject to any material
pending or threatened legal proceedings as of the date of
this Report.
Item 2. Changes in Securities.
None.
Item 3. Defaults on Senior Securities.
None.
Item 4. Submission of Matters to a Vote of Security-Holders.
( a ) The Company's Annual Meeting of Shareholders was held on
May 21, 2002. Of the 11,049,133 shares of common stock
of the Company entitled to vote at the meeting, 9,721,506
shares were present in person or by proxy.
( b ) The following individuals were elected to serve as
directors of the Company and received the number of votes
set forth opposite their respective names:
Director Votes Received
Mark E. Schwarz 9,720,456
Linda H. Sleeper 9,720,306
James H. Graves 9,720,456
George R. Manser 9,720,456
Scott T. Berlin 9,720,456
( c ) There was no other business to come before the Annual meeting.
Item 5. Other Information.
None.
Item 6. Exhibits and Reports on Form 8-K.
(a) The exhibit listed in the Exhibit Index appearing on page 16
is filed herewith.
(b) The Company did not file any Form 8-K Current Reports during
the second quarter of 2002.
Exhibit Index
-------------
Exhibit Description
Number -----------
------
99 Certification Pursuant to 18 U.S.C. 1350 Enacted by
Section 906 of the Sarbanes-Oxley Act of 2002.
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant has
caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.
HALLMARK FINANCIAL SERVICES, INC.
(Registrant)
Date: August 14, 2002 /s/ Linda H. Sleeper
---------------------------
Linda H. Sleeper, President
(Chief Executive Officer)
Date: August 14, 2002 /s/ John J. DePuma
---------------------------
John J. DePuma,
Chief Financial Officer
*******************************************************************************
Exhibit 99
CERTIFICATION
PURSUANT TO 18 U.S.C. SECTION 1350
ENACTED BY SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report on Form 10-QSB of Hallmark
Financial Services, Inc. (the "Company") for the period ended June 30, 2002,
as filed with the Securities and Exchange Commission as of the date hereof
(the "Report"), and pursuant to 18 U.S.C. 1350 as enacted by Section 906 of
the Sarbanes-Oxley Act of 2002, the undersigned Chief Executive Officer and
Chief Financial Officer of the Company hereby certify as follows:
(1) The Report fully complies with the requirements of Section 13(a)
or 15(d) of the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in all
material respects, the financial condition and results of
operations of the Company.
Dated: August 14, 2002 /s/ Linda H. Sleeper
---------------------------
Linda H. Sleeper
Chief Executive Officer
Dated: August 14, 2002 /s/ John J. DePuma
---------------------------
John J. DePuma
Chief Financial Officer