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Section 1: 10-Q (FORM 10-Q)

 

 

 

UNITED STATES 

SECURITIES AND EXCHANGE COMMISSION 

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

Quarterly report pursuant to Section 13 or 15(d) of the

Securities Exchange Act of 1934

 

For the quarterly period ended September 30, 2018

 

Commission file number 001-11252

 

Hallmark Financial Services, Inc.

(Exact name of registrant as specified in its charter)

 

Nevada 87-0447375
(State or other jurisdiction of (I.R.S. Employer
Incorporation or organization) Identification No.)
   
777 Main Street, Suite 1000, Fort Worth, Texas 76102
(Address of principal executive offices) (Zip Code)

 

Registrant's telephone number, including area code: (817) 348-1600

 

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 x   No  ¨

 

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files). Yes x  No  ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer ¨ Accelerated filer x  
Non-accelerated filer ¨ Smaller reporting company  x   Emerging growth company ¨

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 15(a) of the Exchange Act.¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

 

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: Common Stock, par value $.18 per share – 18,058,676 shares outstanding as of November 7, 2018.

 

 

 

 

 

PART I

FINANCIAL INFORMATION

 

Item 1.Financial Statements

 

INDEX TO FINANCIAL STATEMENTS

 

Page Number

 
Consolidated Balance Sheets at September 30, 2018 (unaudited) and December 31, 2017 3
 
Consolidated Statements of Operations (unaudited) for the three months and nine months ended September 30, 2018 and September 30, 2017 4
 
Consolidated Statements of Comprehensive Income (unaudited) for the three months and nine months ended September 30, 2018 and September 30, 2017 5
 
Consolidated Statements of Stockholders’ Equity (unaudited) for the three months and nine months ended September 30, 2018 and September 30, 2017 6
 
Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2018 and September 30, 2017 7
 
Notes to Consolidated Financial Statements (unaudited) 8

 

 2 

 

 

Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Balance Sheets

($ in thousands, except par value)

 

   September 30, 2018   December 31, 2017 
    (unaudited)      
ASSETS          
Investments:          
Debt securities, available-for-sale, at fair value (cost: $571,657 in 2018 and $604,999 in 2017)  $574,470   $605,746 
Equity securities (cost: $45,426 in 2018 and $30,253 in 2017)   70,152    51,763 
Other investments (cost: $3,763 in 2018 and 2017)   3,085    3,824 
Total investments   647,707    661,333 
Cash and cash equivalents   59,925    64,982 
Restricted cash   3,519    2,651 
Ceded unearned premiums   135,567    112,323 
Premiums receivable   111,366    104,373 
Accounts receivable   1,464    1,513 
Receivable for securities   3,253    5,235 
Reinsurance recoverable   225,932    182,928 
Deferred policy acquisition costs   13,150    16,002 
Goodwill   44,695    44,695 
Intangible assets, net   8,174    10,023 
Deferred federal income taxes, net   1,042    1,937 
Federal income tax recoverable   -    7,532 
Prepaid expenses   2,526    1,743 
Other assets   12,471    13,856 
Total assets  $1,270,791   $1,231,126 
LIABILITIES AND STOCKHOLDERS' EQUITY          
Liabilities:          
Revolving credit facility payable  $30,000   $30,000 
Subordinated debt securities (less unamortized debt issuance cost of $911 in 2018 and $949 in 2017)   55,791    55,753 
Reserves for unpaid losses and loss adjustment expenses   530,816    527,100 
Unearned premiums   297,389    276,642 
Reinsurance balances payable   55,830    52,487 
Current federal income tax payable   144    - 
Pension liability   1,403    1,605 
Payable for securities   7,699    7,488 
Accounts payable and other accrued expenses   24,667    28,933 
Total liabilities  $1,003,739   $980,008 
Commitments and Contingencies (Note 17)          
Stockholders' equity:          
Common stock, $.18 par value, authorized 33,333,333; issued 20,872,831 shares in 2018 and 2017   3,757    3,757 
Additional paid-in capital   123,053    123,180 
Retained earnings   166,270    136,474 
Accumulated other comprehensive income   (443)   12,234 
Treasury stock (2,814,155 shares in 2018 and 2,703,803 in 2017), at cost   (25,585)   (24,527)
Total stockholders' equity  $267,052   $251,118 
Total liabilities and stockholders' equity  $1,270,791   $1,231,126 

 

The accompanying notes are an integral part of the consolidated financial statements

 

 3 

 

 

Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Statements of Operations

(Unaudited)

($ in thousands, except per share amounts)

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
   2018   2017   2018   2017 
                 
Gross premiums written  $169,112   $161,151   $495,836   $458,319 
Ceded premiums written   (81,100)   (66,102)   (226,545)   (173,857)
Net premiums written   88,012    95,049    269,291    284,462 
Change in unearned premiums   850    (6,261)   2,496    (15,744)
Net premiums earned   88,862    88,788    271,787    268,718 
                     
Investment income, net of expenses   4,860    5,295    13,706    14,361 
Investment gains, net   6,980    2,110    2,678    691 
Finance charges   1,347    892    3,548    2,881 
Commission and fees   869    570    2,604    1,295 
Other income   28    68    89    200 
Total revenues   102,946    97,723    294,412    288,146 
                     
Losses and loss adjustment expenses   64,245    72,379    191,568    204,925 
Other operating expenses   24,829    25,071    78,402    78,445 
Interest expense   1,180    1,181    3,335    3,530 
Amortization of intangible assets   617    617    1,851    1,851 
                     
Total expenses   90,871    99,248    275,156    288,751 
                     
Income (loss) before tax   12,075    (1,525)   19,256    (605)
Income tax expense   2,390    35    3,834    319 
Net income (loss)   9,685    (1,560)   15,422    (924)
                     
Net income (loss) per share:                    
                     
Basic  $0.54   $(0.09)  $0.85   $(0.05)
Diluted  $0.53   $(0.09)  $0.85   $(0.05)

 

The accompanying notes are an integral part of the consolidated financial statements

 

 4 

 

 

Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Statements of Comprehensive Income

(Unaudited)

($ in thousands)

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
   2018   2017   2018   2017 
                 
Net income (loss)  $9,685   $(1,560)  $15,422   $(924)
                     
Other comprehensive income :                    
                     
Change in net actuarial gain   27    37    80    107 
                     
Tax effect on change in net actuarial gain   (6)   (13)   (17)   (37)
                     
Unrealized holding gains arising during the period   342    308    1,909    8,208 
                     
Tax effect on unrealized holding gains arising during the period   (72)   (108)   (401)   (2,873)
                     
Reclassification adjustment for (gains) losses included in net income   166    (3,188)   159    (5,679)
                     
Tax effect on reclassification adjustment for (gains) losses included in net income   (35)   1,116    (33)   1,988 
                     
Other comprehensive income (loss), net of tax   422    (1,848)   1,697    1,714 
Comprehensive income (loss)  $10,107   $(3,408)  $17,119   $790 

 

The accompanying notes are an integral part of the consolidated financial statements

 

 5 

 

 

Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Statements of Stockholders’ Equity

(Unaudited)

($ in thousands)

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
   2018   2017   2018   2017 
Common Stock                    
Balance, beginning of period  $3,757   $3,757   $3,757   $3,757 
Balance, end of period   3,757    3,757    3,757    3,757 
                     
Additional Paid-In Capital                    
Balance, beginning of period   123,017    123,110    123,180    123,166 
Equity based compensation   36    51    37    97 
Shares issued under employee benefit plans   -    (5)   (164)   (107)
Balance, end of period   123,053    123,156    123,053    123,156 
                     
Retained Earnings                    
Balance, beginning of period   156,585    148,663    136,474    148,027 
Cumulative effect of adoption of updated accounting guidance for equity financial instruments at January 1, 2018   -    -    16,993    - 
Reclassification of certain tax effects from accumulated other comprehensive income at January 1, 2018   -    -    (2,619)   - 
Net income (loss)   9,685    (1,560)   15,422    (924)
Balance, end of period   166,270    147,103    166,270    147,103 
                     
Accumulated Other Comprehensive Income                    
Balance, beginning of period   (865)   13,933    12,234    10,371 
Cumulative effect of adoption of updated accounting guidance for equity financial instruments at January 1, 2018   -    -    (16,993)   - 
Reclassification of certain tax effects from accumulated other comprehensive income at January 1, 2018   -    -    2,619    - 
Additional minimum pension liability, net of tax   21    24    63    70 
Unrealized holding gains arising during period, net of tax   270    200    1,508    5,335 
Reclassification adjustment for losses (gains)  included in net income, net of tax   131    (2,072)   126    (3,691)
Balance, end of period   (443)   12,085    (443)   12,085 
                     
Treasury Stock                    
Balance, beginning of period   (25,585)   (23,763)   (24,527)   (19,585)
Acquisition of treasury stock   -    (883)   (1,464)   (5,308)
Shares issued under employee benefit plans   -    18    406    265 
Balance, end of period   (25,585)   (24,628)   (25,585)   (24,628)
                     
Total Stockholders' Equity  $267,052   $261,473    267,052    261,473 

 

The accompanying notes are an integral part of the consolidated financial statements

 

 6 

 

 

Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

($ in thousands)

 

   Nine Months Ended September 30, 
   2018   2017 
Cash flows from operating activities:          
Net income  $15,422   $(924)
           
Adjustments to reconcile net income to net cash (used in) provided by operating activities:          
Depreciation and amortization expense   3,801    3,467 
Deferred federal income taxes   445    (1,903)
Investment gains, net   (2,678)   (691)
Share-based payments expense   37    97 
Change in ceded unearned premiums   (23,244)   (22,488)
Change in premiums receivable   (6,993)   (11,943)
Change in accounts receivable   49    335 
Change in deferred policy acquisition costs   2,852    (52)
Change in unpaid losses and loss adjustment expenses   3,716    49,932 
Change in unearned premiums   20,747    38,233 
Change in reinsurance recoverable   (43,004)   (34,140)
Change in reinsurance balances payable   3,343    10,535 
Change in current federal income tax recoverable/payable   7,676    1,918 
Change in all other liabilities   (4,429)   (1,495)
Change in all other assets   3,277    3,448 
           
Net cash (used in) provided by operating activities   (18,983)   34,329 
           
Cash flows from investing activities:          
Purchases of property and equipment   (1,530)   (1,576)
Purchases of investment securities   (160,147)   (196,976)
Maturities, sales and redemptions of investment securities   177,693    175,527 
           
Net cash provided by (used in) investing activities   16,016    (23,025)
           
Cash flows from financing activities:          
Proceeds from exercise of employee stock options   242    158 
Purchase of treasury shares   (1,464)   (5,308)
           
Net cash used in financing activities   (1,222)   (5,150)
           
(Decrease) increase in cash and cash equivalents and restricted cash   (4,189)   6,154 
Cash, cash equivalents and restricted cash at beginning of period   67,633    86,959 
Cash, cash equivalents and restricted cash at end of period  $63,444   $93,113 

 

The accompanying notes are an integral part of the consolidated financial statements

 

 7 

 

 

Hallmark Financial Services, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

 

1. General

 

Hallmark Financial Services, Inc. (“Hallmark” and, together with subsidiaries, “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 product-specific operating units that are supported by our insurance company subsidiaries. Our Contract Binding operating unit offers commercial insurance products and services in the excess and surplus lines market. Our Specialty Commercial operating unit offers general aviation and satellite launch insurance products and services, low and middle market commercial umbrella and primary/excess liability insurance, medical and financial professional liability insurance products and services, and primary/excess commercial property coverages for both catastrophe and non-catastrophe exposures. Our Standard Commercial P&C operating unit offers industry-specific commercial insurance products and services in the standard market. Our Workers Compensation operating unit specializes in small and middle market workers compensation business. Effective July 1, 2015, this operating unit no longer markets or retains any risk on new or renewal policies. Our Specialty Personal Lines operating unit offers non-standard personal automobile and renters insurance products and services. Our insurance company subsidiaries supporting these operating units are American Hallmark Insurance Company of Texas (“AHIC”), Hallmark Insurance Company (“HIC”), Hallmark Specialty Insurance Company (“HSIC”), Hallmark County Mutual Insurance Company, Hallmark National Insurance Company and Texas Builders Insurance Company.

 

These operating units are segregated into three reportable industry segments for financial accounting purposes. The Specialty Commercial Segment includes our Contract Binding operating unit and our Specialty Commercial operating unit. The Standard Commercial Segment includes our Standard Commercial P&C operating unit and our Workers Compensation operating unit. The Personal Segment consists solely of our Specialty Personal Lines operating unit.

 

2. Basis of Presentation

 

Our unaudited consolidated financial statements included herein have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and include our accounts and the accounts of our subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to rules and regulations of the Securities and Exchange Commission (“SEC”) for interim financial reporting. These unaudited consolidated financial statements should be read in conjunction with our audited consolidated financial statements for the year ended December 31, 2017 included in our Annual Report on Form 10-K filed with the SEC.

 

The interim financial data as of September 30, 2018 and 2017 is unaudited. However, in the opinion of management, the interim data includes all adjustments, consisting of normal recurring adjustments, necessary for a fair statement of the results for the interim periods. The results of operations for the period ended September 30, 2018 are not necessarily indicative of the operating results to be expected for the full year.

 

 8 

 

 

Reclassifications

 

Certain prior year amounts have been reclassified to conform with current year presentation.

 

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.

 

Use of Estimates in the Preparation of the Financial Statements

 

Our preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect our reported amounts of assets and liabilities and our disclosure of contingent assets and liabilities at the date of our consolidated financial statements, as well as our reported amounts of revenues and expenses during the reporting period. Refer to “Critical Accounting Estimates and Judgments” under Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2017 for information on accounting policies that we consider critical in preparing our consolidated financial statements. Actual results could differ materially from those estimates.

 

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: A revolving credit facility with Frost Bank had a carried value of $30.0 million and a fair value of $30.2 million as of September 30, 2018.  The fair value is based on the lower of the discounted cash flows using a discount rate derived from LIBOR spot rates plus a market spread resulting in discount rates ranging between 4.5% to 5.3% for each future payment date and 100.5% of par.  This revolving credit facility would be included in Level 3 of the fair value hierarchy if it was reported at fair value.

 

 9 

 

 

Subordinated Debt Securities: Our trust preferred securities have a carried value of $55.8 million and a fair value of $47.4 million as of September 30, 2018. The fair value of our trust preferred securities is based on discounted cash flows using a current yield to maturity of 8.0%, which is based on similar issues to discount future cash flows. Our trust preferred securities 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 recoverable/payable, other assets and other liabilities, the carrying amounts approximate fair value because of the short maturity of such financial instruments.

 

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 have determined that we do not have a variable interest in the Trusts.  Therefore, the Trusts are not included in our consolidated financial statements.

 

We are also involved in the normal course of business with variable interest entities (“VIE’s”) primarily as a passive investor in mortgage-backed securities and certain collateralized corporate bank loans issued by third party VIE’s. The maximum exposure to loss with respect to these investments is the investment carrying values included in the consolidated balance sheets.

 

Adoption of New Accounting Pronouncements

 

In January 2017, the FASB issued ASU 2017-01, “Clarifying the Definition of a Business” (Topic 715). ASU 2017-01 is intended to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. ASU 2017-01 was effective for annual periods beginning after December 15, 2017, including interim periods within those annual periods. Effective January 1, 2018, we adopted this new guidance, which did not have a material impact on our financial results or disclosures.

 

On February 14, 2018, the FASB issued updated guidance that allows a reclassification of the stranded tax effects in accumulated other comprehensive income (AOCI) resulting from the Tax Cuts and Jobs Act of 2017 (TCJA). Current guidance requires the effect of a change in tax laws or rates on deferred tax balances to be reported in income from continuing operations in the accounting period that includes the period of enactment, even if the related income tax effects were originally charged or credited directly to AOCI. The amount of the reclassification would include the effect of the change in the U.S. federal corporate income tax rate on the gross deferred tax amounts and related valuation allowances, if any, at the date of the enactment of TCJA related to items in AOCI. The updated guidance was effective for reporting periods beginning after December 15, 2018 and is to be applied retrospectively to each period in which the effect of the TCJA related to items remaining in AOCI are recognized or at the beginning of the period of adoption. Early adoption is permitted. The Company adopted the updated guidance effective January 1, 2018 and elected to reclassify the income tax effects of the TCJA from AOCI to retained earnings as of January 1, 2018. This reclassification resulted in a decrease in retained earnings of $2.6 million as of January 1, 2018 and an increase in AOCI by the same amount.

 

 10 

 

 

In January 2016, the FASB issued ASU 2016-01, “Recognition and Measurement of Financial Assets and Financial Liabilities” (Subtopic 825-10). ASU 2016-01 requires equity investments that are not consolidated or accounted for under the equity method of accounting to be measured at fair value with changes in fair value recognized in net income. ASU 2016-01 also requires us to assess the ability to realize our deferred tax assets (“DTAs”) related to an available-for-sale debt security in combination with our other DTAs. ASU 2016-01 was effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The adoption of this guidance resulted in the recognition of $17.0 million of net after-tax unrealized gains on equity investments as a cumulative effect adjustment that increased retained earnings as of January 1, 2018 and decreased AOCI by the same amount. The Company elected to report changes in the fair value of equity investments in investment gains and (losses) in the Consolidated Statement of Operations. At December 31, 2017, equity investments were classified as available-for-sale on the Company's balance sheet. However, upon adoption, the updated guidance eliminated the available-for-sale balance sheet classification for equity investments.

 

In August 2016, the FASB issued ASU 2016-15, “Classification of Certain Cash Receipts and Cash Payments” (Topic 230). ASU 2016-15 will reduce diversity in practice on how eight specific cash receipts and payments are classified on the statement of cash flows. The ASU is effective for fiscal years beginning after December 15, 2017, including interim periods within those years. Effective January 1, 2018, we adopted this new guidance, which did not have a material impact on our financial results or disclosures.

 

In November 2016, the FASB issued ASU 2016-18, “Statement of Cash Flows (Topic 230): Restricted Cash.” The purpose of ASU 2016-18 is to eliminate the diversity in classifying and presenting changes in restricted cash in the statement of cash flows. The new guidance requires restricted cash to be combined with cash and cash equivalents when reconciling the beginning and ending balances of cash on the statement of cash flows, thereby no longer requiring transactions such as transfers between restricted and unrestricted cash to be treated as a cash flow activity. Further, the new guidance requires the nature of the restrictions to be disclosed, as well as a reconciliation between the balance sheet and the statement of cash flows on how restricted and unrestricted cash are segregated. The new guidance is effective for fiscal years beginning after December 15, 2017, and interim periods within that fiscal year, with early adoption permitted. Effective January 1, 2018, we retrospectively adopted this new guidance.

 

In May 2014, the FASB issued ASU 2014-09, guidance which revises the criteria for revenue recognition. Under the guidance, the transaction price is attributed to underlying performance obligations in the contract and revenue is recognized as the entity satisfies the performance obligations and transfers control of a good or service to the customer. Incremental costs of obtaining a contract may be capitalized to the extent the entity expects to recover those costs. The guidance is effective for reporting periods beginning after December 15, 2017 and is to be applied retrospectively. Revenue from insurance contracts is excluded from the scope of this new guidance. While insurance contracts are excluded from this guidance, policy fee income, billing and other fees and fee income related to property business written as a cover-holder through a Lloyds Syndicate is subject to this updated guidance. Effective January 1, 2018, we adopted this new guidance which did not have a material impact on our financial results or disclosures.

 

 11 

 

 

Recently Issued Accounting Pronouncements

 

In March 2017, the FASB issued ASU 2017-08, “Premium Amortization on Purchased Callable Securities” (Subtopic 310-20). ASU 2017-08 is intended to enhance the accounting for amortization of premiums for purchased callable debt securities. The guidance amends the amortization period for certain purchased callable debt securities held at a premium. Securities that contain explicit, noncontingent call features that are callable at fixed prices and on preset dates should shorten the amortization period for the premium to the earliest call date (and if the call option is not exercised, the effective yield is reset using the payment terms of the debt security). The standard is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018, and is to be applied on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings. We are currently evaluating the impact that the adoption of ASU 2017-08 will have on our financial results and disclosures.

 

In January 2017, the FASB issued ASU 2017-04, “Simplifying the Test for Goodwill Impairment” (Topic 350). ASU 2017-04 requires only a one-step quantitative impairment test, whereby a goodwill impairment loss will be measured as the excess of a reporting unit’s carrying amount over its fair value (not to exceed the total goodwill allocated to that reporting unit). It eliminates Step 2 of the current two-step goodwill impairment test, under which a goodwill impairment loss is measured by comparing the implied fair value of a reporting unit’s goodwill. The ASU is effective for annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019. We are currently evaluating the impact that the adoption of ASU 2017-04 will have on our financial results and disclosures.

 

In June 2016, the FASB issued ASU 2016-13, “Measurement of Credit Losses on Financial Instruments” (Topic 326). ASU 2016-13 requires organizations to estimate credit losses on certain types of financial instruments, including receivables and available-for-sale debt securities, by introducing an approach based on expected losses. The expected loss approach will require entities to incorporate considerations of historical information, current information and reasonable and supportable forecasts. ASU 2016-13 is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. ASU 2016-13 requires a modified retrospective transition method and early adoption is permitted. We are currently evaluating the impact that the adoption of this standard will have on our financial results and disclosures, but do not anticipate that any potential impact would be material.

 

In February 2016, the FASB issued ASU 2016-02, “Leases” (Topic 842). ASU 2016-02 requires organizations that lease assets to recognize on the balance sheet the assets and liabilities for the rights and obligations created by those leases. Additionally, ASU 2016-02 modifies current guidance for lessors' accounting. ASU 2016-02 is effective for interim and annual reporting periods beginning on or after January 1, 2019, with early adoption permitted. We do not anticipate that this standard will have a material impact on our results of operations, but we anticipate an increase to the value of our assets and liabilities related to leases, with no material impact to equity.

 

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.

 

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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 and an equity warrant classified as Other Investments.

 

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. We have not adjusted any prices received from third party pricing sources. 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.

 

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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 September 30, 2018 and December 31, 2017 (in thousands):

 

   As of September 30, 2018 
   Quoted Prices in   Other         
   Active Markets for   Observable   Unobservable     
   Identical Assets   Inputs   Inputs     
   (Level 1)   (Level 2)   (Level 3)   Total 
                 
U.S. Treasury securities and obligations of U.S. Government  $-   $47,866   $-   $47,866 
Corporate bonds   -    249,177    325    249,502 
Collateralized corporate bank loans   -    135,309    -    135,309 
Municipal bonds   -    127,044    -    127,044 
Mortgage-backed   -    14,749    -    14,749 
Total debt securities   -    574,145    325    574,470 
                     
Total equity securities   70,152    -    -    70,152 
                     
Total other investments   3,085    -    -    3,085 
                     
Total investments  $73,237   $574,145   $325   $647,707 

 

   As of December 31, 2017 
   Quoted Prices in   Other         
   Active Markets for   Observable   Unobservable     
   Identical Assets   Inputs   Inputs     
   (Level 1)   (Level 2)   (Level 3)   Total 
                 
U.S. Treasury securities and obligations of U.S. Government  $-   $49,947   $-   $49,947 
Corporate bonds   -    278,760    313    279,073 
Collateralized corporate bank loans   -    125,937    -    125,937 
Municipal bonds   -    131,433    2,823    134,256 
Mortgage-backed   -    16,533    -    16,533 
Total debt securities   -    602,610    3,136    605,746 
                     
Total equity securities   51,142    -    621    51,763 
                     
Total other investments   3,824    -    -    3,824 
                     
Total investments  $54,966   $602,610   $3,757   $661,333 

 

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Due to significant unobservable inputs into the valuation model for one corporate bond as of September 30, 2018, we classified this investment as Level 3 in the fair value hierarchy. Due to significant unobservable inputs into the valuation model for certain municipal bonds, one corporate bond and one equity security as of December 31, 2017, we classified these investments 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 corporate bond is a convertible senior note and its fair value was estimated by the sum of the bond value using an income approach discounting the scheduled interest and principal payments and the conversion feature utilizing a binomial lattice model. We also estimated the fair value of the corporate bond utilizing an as-if converted basis into the underlying securities. Significant changes in the unobservable inputs in the fair value measurement of this corporate bond could result in a significant change in the fair value measurement. The equity security previously classified as Level 3 in the fair value hierarchy was transferred to Level 1 during the second quarter of 2018.

 

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 nine months ended September 30, 2018 and 2017 (in thousands):

 

Beginning balance as of January 1, 2018  $3,757 
Sales   (2,925)
Settlements   - 
Purchases   - 
Issuances   - 
Total realized/unrealized gains included in net income   114 
Net gains included in other comprehensive income   - 
Transfers into Level 3   - 
Transfers out of Level 3   (621)
Ending balance as of September 30, 2018  $325 
      
Beginning balance as of January 1, 2017  $5,945 
Sales   - 
Settlements   (150)
Purchases   775 
Issuances   - 
Total realized/unrealized gains included in net income   - 
Net gains included in other comprehensive income   607 
Transfers into Level 3   - 
Transfers out of Level 3   - 
Ending balance as of September 30, 2017  $7,177 

 

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4. Investments

 

The amortized cost and estimated fair value of investments in debt and equity securities by category is as follows (in thousands):

 

       Gross   Gross     
   Amortized   Unrealized   Unrealized   Fair 
As of September 30, 2018  Cost   Gains   Losses   Value 
                 
U.S. Treasury securities and obligations of U.S. Government  $48,730   $-   $(864)  $47,866 
Corporate bonds   250,739    403    (1,640)   249,502 
Collateralized corporate bank loans   134,807    642    (140)   135,309 
Municipal bonds   122,053    6,126    (1,135)   127,044 
Mortgage-backed   15,328    13    (592)   14,749 
                     
Total debt securities   571,657    7,184    (4,371)   574,470 
                     
Total equity securities   45,426    28,116    (3,390)   70,152 
                     
Total other investments   3,763    -    (678)   3,085 
                     
Total investments  $620,846   $35,300   $(8,439)  $647,707 
                     
As of December 31, 2017                    
                     
U.S. Treasury securities and obligations of U.S. Government  $50,088   $7   $(148)  $49,947 
Corporate bonds   278,611    1,204    (742)   279,073 
Collateralized corporate bank loans   125,536    702    (301)   125,937 
Municipal bonds   134,052    709    (505)   134,256 
Mortgage-backed   16,712    37    (216)   16,533 
                     
Total debt securities   604,999    2,659    (1,912)   605,746 
                     
Total equity securities   30,253    23,014    (1,504)   51,763 
                     
Total other investments   3,763    61    -    3,824 
                     
Total investments  $639,015   $25,734   $(3,416)  $661,333 

 

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Major categories of net investment gains (losses) on investments are summarized as follows (in thousands):

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
   2018   2017   2018   2017 
                 
U.S. Treasury securities and obligations of U.S. Government  $-   $-   $-   $- 
Corporate bonds   (44)   (107)   (66)   (125)
Collateralized corporate bank loans   23    8    70    56 
Municipal bonds   (145)   120    (164)   204 
Mortgage-backed   -    (1)   1    (1)
Realized (losses) gains on fixed maturities   (166)   20    (159)   134 
Realized gains on equity securities   -    3,168    359    5,545 
Realized (losses) gains on other investments   -    -    -    - 
Total realized (losses) gains on investments   (166)   3,188    200    5,679 
Other-than-temporary impairments   -    (850)   -    (4,257)
Unrealized gains (losses) on other investments   25    (228)   (739)   (731)
Unrealized gains (losses) on equity investments   7,121    -    3,217    - 
Investment gains (losses), net  $6,980   $2,110   $2,678   $691 

 

We realized gross gains on investments of $0.3 million and $3.4 million during the three months ended September 30, 2018 and 2017, respectively, and $0.9 million and $6.4 million for the nine months ended September 30, 2018 and 2017, respectively.  We realized gross losses on investments of $0.5 million and $0.2 million for the three months ended September 30, 2018 and 2017, respectively, and $0.7 million and $0.7 million for the nine months ended September 30, 2018 and 2017, respectively. We recorded proceeds from the sale of investment securities of $0.4 million and $11.4 million during the three months ended September 30, 2018 and 2017, respectively, and $14.6 million and $19.4 million for the nine months ended September 30, 2018 and 2017, respectively.  Realized investment gains and losses are recognized in operations on the first in-first out method.

 

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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 September 30, 2018 and December 31, 2017 (in thousands):

 

   As of September 30, 2018 
   12 months or less   Longer than 12 months   Total 
       Unrealized       Unrealized       Unrealized 
   Fair Value   Losses   Fair Value   Losses   Fair Value   Losses 
                         
U.S. Treasury securities and obligations of U.S. Government  $46,868   $(864)  $-   $-   $46,868   $(864)
Corporate bonds   181,467    (1,313)   47,968    (327)   229,435    (1,640)
Collateralized corporate bank loans   18,794    (117)   6,064    (23)   24,858    (140)
Municipal bonds   38,292    (638)   11,924    (497)   50,216    (1,135)
Mortgage-backed   5,862    (63)   5,454    (529)   11,316    (592)
Total debt securities   291,283    (2,995)   71,410    (1,376)   362,693    (4,371)
                               
Total equity securities   3,017    (2,654)   3,359    (736)   6,376    (3,390)
                               
Total other investments   3,085    (678)   -    -    3,085    (678)
                               
Total investments  $297,385   $(6,327)  $74,769   $(2,112)  $372,154   $(8,439)

 

   As of December 31, 2017 
   12 months or less   Longer than 12 months   Total 
       Unrealized       Unrealized       Unrealized 
   Fair Value   Losses   Fair Value   Losses   Fair Value   Losses 
                         
U.S. Treasury securities and obligations of U.S. Government  $28,825   $(145)  $1,997   $(3)  $30,822   $(148)
Corporate bonds   176,061    (736)   2,378    (6)   178,439    (742)
Collateralized corporate bank loans   30,008    (280)   2,517    (21)   32,525    (301)
Municipal bonds   35,200    (370)   8,917    (135)   44,117    (505)
Mortgage-backed   6,419    (127)   1,415    (89)   7,834    (216)
Total debt securities   276,513    (1,658)   17,224    (254)   293,737    (1,912)
                               
Total equity securities   8,375    (1,504)   -    -    8,375    (1,504)
                               
Total other investments   -    -    -    -    -    - 
                               
Total investments  $284,888   $(3,162)  $17,224   $(254)  $302,112   $(3,416)

 

At September 30, 2018, the gross unrealized losses more than twelve months old were attributable to 64 debt security positions and two equity securities. At December 31, 2017, the gross unrealized losses more than twelve months old were attributable to 25 debt security positions. We consider these losses as a temporary decline in value as they are predominately on securities 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.

 

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We complete a detailed analysis each quarter to assess whether any decline in the fair value of any fixed maturity investment below cost is deemed other-than-temporary. All fixed maturity investments 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 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.

 

Details regarding the carrying value of the other investments portfolio as of September 30, 2018 and December 31, 2017 are as follows (in thousands):

 

   September 30,   December 31, 
   2018   2017 
Investment Type          
Equity warrant  $3,085   $3,824 
Total other investments  $3,085   $3,824 

 

We acquired this warrant in an active market. The warrant entitles us to buy the underlying common stock of a publicly traded company at a fixed price until the expiration date of January 19, 2021.

 

The amortized cost and estimated fair value of debt securities at September 30, 2018 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   Fair 
   Cost   Value 
   (in thousands) 
Due in one year or less  $120,070   $120,698 
Due after one year through five years   287,661    291,063 
Due after five years through ten years   121,834    122,121 
Due after ten years   26,764    25,839 
Mortgage-backed   15,328    14,749 
   $571,657   $574,470 

 

5. Pledged Investments

 

We have pledged certain of our securities 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 $29.4 million and $26.2 million at September 30, 2018 and December 31, 2017, respectively.

 

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6. Reserves for Unpaid Losses and Loss Adjustment Expenses

 

Activity in the consolidated reserves for unpaid losses and LAE is summarized as follows (in thousands):

 

   September 30,   September 30, 
   2018   2017 
         
Balance at January 1  $527,100   $481,567 
Less reinsurance recoverable   154,612    123,237 
Net balance at January 1   372,488    358,330 
           
Incurred related to:          
Current year   185,506    184,685 
Prior years   6,062    20,240 
Total incurred   191,568    204,925 
           
Paid related to:          
Current year   56,687    61,288 
Prior years   184,337    128,329 
Total paid   241,024    189,617 
           
Net balance at September 30   323,032    373,638 
Plus reinsurance recoverable   207,784    157,861 
Balance at September 30  $530,816   $531,499 

 

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The impact from the unfavorable (favorable) net prior years’ loss development on each reporting segment is presented below:

 

   Nine Months Ended September 30, 
   2018   2017 
         
Specialty Commercial Segment  $15,730   $17,824 
Standard Commercial Segment   (8,829)   1,594 
Personal Segment   (839)   822 
Corporate   -    - 
           
Total unfavorable (favorable) net prior years' development  $6,062   $20,240 

 

The following describes the primary factors behind each segment’s prior accident year reserve development for the nine months ended September 30, 2018 and 2017:

 

Nine months ended September 30, 2018:

 

·Specialty Commercial Segment. Our Contract Binding operating unit experienced net unfavorable development in the 2016 and prior accident years primarily in the commercial auto liability line of business, partially offset by favorable development primarily in the commercial auto and general liability lines of business in the 2017 accident year. Our Specialty Commercial operating unit experienced net unfavorable development in general aviation, commercial excess liability, satellite launch insurance products, primary/excess commercial property, professional liability and specialty risk programs lines of business.

 

·Standard Commercial Segment. Our Standard Commercial P&C operating unit experienced net favorable development in the 2016 and prior accident years primarily in the general liability line of business, partially offset by net unfavorable development primarily in the commercial property line of business in the 2017 accident year and net unfavorable development in the 2017 and prior accident years in the occupational accident line of business. Our Workers Compensation operating unit experienced net favorable development in the 2016 and prior accident years.

 

·Personal Segment. Net favorable development in our Specialty Personal Lines operating unit was mostly attributable to the 2013 through 2017 accident years, partially offset by unfavorable development in the 2012 and prior accident years.

 

Nine months ended September 30, 2017:

 

·Specialty Commercial Segment. Our Contract Binding operating unit experienced net unfavorable development primarily in the commercial auto liability line of business in the 2015 and prior accident years, partially offset by favorable development in the 2016 accident year. Our Specialty Commercial operating unit experienced net unfavorable development in general aviation primarily in the 2010 accident year, commercial excess liability primarily in the 2013 accident year and specialty risk programs primarily in the 2015 and prior accident years, partially offset by net favorable development in the medical professional liability and primary/excess commercial property lines of business primarily in the 2016 accident years.

 

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·Standard Commercial Segment. Our Standard Commercial P&C operating unit experienced net unfavorable development in the 2016 and prior accident years in the occupational accident line of business, partially offset by net favorable development primarily in the general liability line of business in the 2016 and prior accident years.

 

·Personal Segment. Net unfavorable development in our Specialty Personal Lines operating unit was mostly attributable to the 2016, 2014 and 2013 accident years, partially offset by favorable development in the 2015 accident year.

 

7. 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 and expired by its terms on May 27, 2015. As of September 30, 2018, there were outstanding incentive stock options to purchase 1,074 shares of our common stock and outstanding non-qualified stock options to purchase 244,157 shares of our common stock. 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.

 

Our 2015 Long Term Incentive Plan (“2015 LTIP”) was approved by shareholders on May 29, 2015. There are 2,000,000 shares authorized for issuance under the 2015 LTIP. As of September 30, 2018, restricted stock units representing the right to receive up to 508,345 shares of our common stock were outstanding under the 2015 LTIP. There were no stock option awards granted under the 2015 LTIP as of September 30, 2018.

 

Stock Options:

 

Incentive stock options granted under the 2005 LTIP prior to 2009 vested 10%, 20%, 30% and 40% on the first, second, third and fourth anniversary dates of the grant, respectively, and terminated five to ten years from the date of grant. Incentive stock options granted in 2009 vest in equal annual increments on each of the first seven 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.

 

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A summary of the status of our stock options as of September 30, 2018 and changes during the nine months then ended is presented below:

  

           Average     
       Weighted   Remaining   Aggregate 
       Average   Contractual   Intrinsic 
   Number of   Exercise   Term   Value 
   Shares   Price   (Years)   ($000) 
                 
Outstanding at January 1, 2018   406,731   $7.85           
Granted   -    -           
Exercised   (36,500)  $6.61           
Forfeited or expired   (125,000)  $10.60           
Outstanding at September 30, 2018   245,231   $6.63    0.7   $1,071 
Exercisable at September 30, 2018   245,231   $6.63    0.7   $1,071 

 

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):

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
   2018   2017   2018   2017 
                 
Intrinsic value of options exercised  $-   $9   $122   $110 
                     
Cost of share-based payments (non-cash)  $-   $-   $-   $- 
                     
Income tax benefit of share-based payments recognized in income  $-   $-   $-   $- 

 

As of September 30, 2018, there was no unrecognized compensation cost related to non-vested stock options granted under our plans which is expected to be recognized in the future.

 

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 during the first nine months of 2018 or 2017.

 

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Restricted Stock Units:

 

Restricted stock units awarded under the 2015 LTIP represent the right to receive shares of common stock upon the satisfaction of vesting requirements, performance criteria and other terms and conditions. Restricted stock units vest and, if performance criteria have been satisfied, shares of common stock become issuable on March 31 of the third calendar year following the year of grant.

 

The performance criteria for all restricted stock units require that we achieve certain compound average annual growth rates in book value per share as well as certain average combined ratio percentages 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. Grantees of restricted stock units do not have any rights of a stockholder, and do not participate in any distributions to our common stockholders, until the award fully vests upon satisfaction of the vesting schedule, performance criteria and other conditions set forth in their award agreement. Therefore, unvested restricted stock units are not considered participating securities under ASC 260, “Earnings Per Share,” and are not included in the calculation of basic or diluted earnings per share.

 

Compensation cost is measured as an amount equal to the fair value of the restricted stock units on the date of grant 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 our best estimate of the ultimate achievement level. The grant date fair value of restricted stock units granted in 2015, 2016, 2017 and 2018 was $11.10, $11.41, $10.20 and $10.87 per unit, respectively. We incurred compensation expense of $36 thousand and $37 thousand related to restricted stock units during the three months and nine months ended September 30, 2018, respectively. We incurred compensation expense of $51 thousand and $97 thousand related to restricted stock units during the three months and nine months ended September 30, 2017, respectively. We recorded income tax benefit of $8 thousand related to restricted stock units during both the three months and nine months ended September 30, 2018. We recorded income tax benefit of $18 thousand and $34 thousand related to restricted stock units during the three months and nine months ended September 30, 2017, respectively.

 

The following table details the status of our restricted stock units as of and for the nine months ended September 30, 2018 and 2017:

  

   Number of 
   Restricted 
   Stock Units 
   2018   2017 
         
Non-vested at January 1   385,779    296,574 
Granted   144,059    138,712 
Vested   (8,198)   (5,998)
Forfeited   (182,743)   (43,509)
Non-vested at September 30   338,897    385,779 

 

As of September 30, 2018, there was $2.4 million of unrecognized grant date compensation cost related to unvested restricted stock units. Based on the current performance estimate, we expect to recognize $1.9 million of compensation cost related to unvested restricted stock units, of which $0.2 million is expected to be recognized during the remainder of 2018, $0.8 million is expected to be recognized in 2019, $0.7 million is expected to be recognized in 2020 and $0.2 million is expected to be recognized in 2021.

 

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8. Segment Information

 

The following is business segment information for the three and nine months ended September 30, 2018 and 2017 (in thousands):

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
   2018   2017   2018   2017 
Revenues:                
Specialty Commercial Segment  $68,302   $69,721   $213,507   $205,057 
Standard Commercial Segment   19,857    17,401    57,979    52,449 
Personal Segment   9,355    9,404    24,891    31,951 
Corporate   5,432    1,197    (1,965)   (1,311)
Consolidated  $102,946   $97,723   $294,412   $288,146 
                     
Pre-tax income (loss):                    
Specialty Commercial Segment  $2,452   $1,288   $20,980   $13,018 
Standard Commercial Segment   7,264    229    11,239    881 
Personal Segment   684    (661)   661    (2,311)
Corporate   1,675    (2,381)   (13,624)   (12,193)
Consolidated  $12,075   $(1,525)  $19,256   $(605)

 

The following is additional business segment information as of the dates indicated (in thousands):

 

   September 30,   December 31, 
   2018   2017 
Assets:          
Specialty Commercial Segment  $854,360   $810,133 
Standard Commercial Segment   163,478    162,152 
Personal Segment   230,397    232,441 
Corporate   22,556    26,400 
   $1,270,791   $1,231,126 

 

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9. 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 September 30, 2018 was with reinsurers that had an A.M. Best rating of “A–” or better.

 

The following table shows earned premiums ceded and reinsurance loss recoveries by period (in thousands):

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
   2018   2017   2018   2017 
                 
Ceded earned premiums  $73,038   $54,769   $203,302   $151,370 
Reinsurance recoveries  $48,962   $45,122   $142,389   $103,552 

 

10. Revolving Credit Facility

 

Our Second Restated Credit Agreement with Frost Bank (“Frost”) dated June 30, 2015, as amended to date, provides a $15.0 million revolving credit facility (“Facility A”), with a $5.0 million letter of credit sub-facility. The outstanding balance of the Facility A bears interest at a rate equal to the prime rate or LIBOR plus 2.5%, at our election. We pay an annual fee of 0.25% of the average daily unused balance of Facility A and letter of credit fees at the rate of 1.00% per annum.  All principal and accrued interest on Facility A becomes due and payable on June 30, 2020. As of September 30, 2018, we had no outstanding borrowings under Facility A.

 

The Second Restated Credit Agreement with Frost also provides a $30.0 million revolving credit facility (“Facility B”), in addition to Facility A. We may use Facility B loan proceeds solely for the purpose of making capital contributions to AHIC and HIC. We may borrow, repay and reborrow under Facility B until December 17, 2019, at which time all amounts outstanding under Facility B are converted to a term loan. Through December 17, 2019, we pay Frost a quarterly fee of 0.25% per annum of the average daily unused balance of Facility B. Facility B bears interest at a rate equal to the prime rate or LIBOR plus 3.00%, at our election. Until December 17, 2019, interest only on amounts from time to time outstanding under Facility B are payable quarterly. Any amounts outstanding on Facility B as of December 17, 2019 are converted to a term loan payable in quarterly installments over five years based on a seven year amortization of principal plus accrued interest. All remaining principal and accrued interest on Facility B become due and payable on December 17, 2024. As of September 30, 2018, we had $30.0 million outstanding under Facility B.

 

The obligations under both Facility A and Facility B are secured by a security interest in the capital stock of AHIC and HIC.  Both Facility A and Facility B contain covenants that, among other things, require us to maintain certain financial and operating ratios and restrict certain distributions, transactions and organizational changes. We are in compliance with all of these covenants.

 

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11. 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. The interest rate on our Trust I subordinated debt securities was 7.725% until June 15, 2015, after which interest adjusts 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 September 30, 2018, the principal balance of our Trust I subordinated debt was $30.9 million and the interest rate was 5.58% per annum.

 

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. The interest rate on our Trust II subordinated debt securities was 8.28% until September 15, 2017, after which interest adjusts 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 September 30, 2018, the principal balance of our Trust II subordinated debt was $25.8 million and the interest rate was 5.23% per annum.

 

12. Deferred Policy Acquisition Costs

 

The following table shows total deferred and amortized policy acquisition cost activity by period (in thousands):

 

    Three Months Ended   Nine Months Ended 
    September 30,   September 30, 
    2018   2017   2018   2017 
                  
 Deferred   $11,001   $9,759   $27,672   $31,472 
 Amortized    (11,909)   (9,849)   (30,524)   (31,420)
                       
 Net   $(908)  $(90)  $(2,852)  $52 

 

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13. Earnings per Share

 

The following table sets forth basic and diluted weighted average shares outstanding for the periods indicated (in thousands):

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
   2018   2017   2018   2017 
                 
Weighted average shares - basic   18,059    18,180    18,097    18,404 
Effect of dilutive securities   108    -    106    - 
Weighted average shares - assuming dilution   18,167    18,180    18,203    18,404 

 

For the three and nine months ended September 30, 2018, no shares and 43,004 shares, respectively, of common stock potentially issuable upon the exercise of employee stock options were excluded from the weighted average number of shares outstanding on a diluted basis because the effect of such options would be anti-dilutive. For each of the three and nine months ended September 30, 2017, 417,830 shares of common stock potentially issuable upon the exercise of employee stock options were excluded from the weighted average number of shares outstanding on a diluted basis because the effect of such options would be anti-dilutive.

 

14. Net Periodic Pension Cost

 

The following table details the net periodic pension cost incurred by period (in thousands):

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
   2018   2017   2018   2017 
Interest cost  $106   $111   $318   $333 
Amortization of net loss   26    37    79    107 
Expected return on plan assets   (173)   (164)   (520)   (487)
Net periodic pension cost  $(41)  $(16)  $(123)  $(47)
Contributed amount  $-   $-   $-   $- 

 

Refer to Note 14 to the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2017 for more discussion of our retirement plans.

 

15. Income Taxes

 

Our effective income tax rate for the nine months ended September 30, 2018 and 2017 was 19.9% and (52.7) %, respectively. The effective tax rate for 2018 was favorably impacted by the lower statutory rate from the enactment of the Tax Cuts and Jobs Act on December 22, 2017. The rate for 2017 varied from the statutory tax rate primarily due to a correction of an immaterial error in prior years’ deferred tax on bond premium amortization, partially offset by the amount of tax exempt income in relation to total pre-tax income.

 

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16. Supplemental Cash Flow Information

 

The following table provides a reconciliation of cash, cash equivalents and restricted cash reported in the consolidated balance sheet to the total of the same such amounts shown in the statement of cash flows:

 

   As of September 30, 
   2018   2017 
         
Cash and cash equivalents  $59,925   $89,770 
Restricted cash   3,519    3,343 
Total cash, cash equivalents and restricted cash shown in the statement of cash flows  $63,444   $93,113 

 

Restricted cash represents amounts required to be set aside by a contractual agreement with a third-party insurer and amounts pledged for the benefit of various state insurance departments.

 

The following table provides supplemental cash flow information for the nine months ended September 30, 2018 and 2017:

 

   Nine Months Ended September 30, 
   2018   2017 
         
Interest paid  $3,325   $3,505 
           
Income taxes (recovered) paid  $(4,287)  $304 
           
Supplemental schedule of non-cash investing activities:          
           
Change in receivable for securities related to investment disposals that settled  after the balance sheet date  $1,982   $1,338 
           
Change in payable for securities related to investment purchases that settled after the balance sheet date  $211   $(6,580)

 

17. Commitments and Contingencies

 

We are engaged in various 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.

 

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18. Changes in Accumulated Other Comprehensive Income Balances

 

The changes in accumulated other comprehensive income balances as of September 30, 2018 and 2017 were as follows (in thousands):

 

   Minimum       Accumulated Other 
   Pension   Unrealized   Comprehensive 
   Liability   Gains (Losses)   Income 
             
Balance at December 31, 2016  $(2,666)  $13,037   $10,371 
Other comprehensive income:               
Change in net actuarial gain   107    -    107 
Tax effect on change in net actuarial gain   (37)   -    (37)
Net unrealized holding gains arising during the period   -    8,208    8,208 
Tax effect on unrealized gains arising during the period   -    (2,873)   (2,873)
Reclassification adjustment for gains included in investment gains   -    (5,679)   (5,679)
Tax effect on reclassification adjustment for gains included in income tax expense   -    1,988    1,988 
Other comprehensive income, net of tax   70    1,644    1,714 
Balance at September 30, 2017  $(2,596)  $14,681   $12,085 
                
Balance at December 31, 2017  $(2,310)  $14,544   $12,234 
Other comprehensive income:               
Change in net actuarial gain   80    -    80 
Tax effect on change in net actuarial gain   (17)   -    (17)
Net unrealized holding gains arising during the period   -    1,909    1,909 
Tax effect on unrealized gains arising during the period   -    (401)   (401)
Reclassification adjustment for realized gains included in investment gains   -    159    159 
Tax effect on reclassification adjustment for realized gains included in income tax expense   -    (33)   (33)
Other comprehensive income, net of tax   63    1,634    1,697 
Reclassification of certain tax effects from accumulated other comprehensive income at January 1, 2018   (569)   3,188    2,619 
Cumulative effect of adoption of updated accounting guidance for equity financial instruments at January 1, 2018   -    (16,993)   (16,993)
Balance at September 30, 2018  $(2,816)  $2,373   $(443)

 

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Item 2. 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-Q” for a discussion of some of the uncertainties, risks and assumptions associated with these statements.

 

Introduction

 

Hallmark Financial Services, Inc. (“Hallmark” and, together with subsidiaries, “we,” “us” or “our”) is an insurance holding company that, 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. Our business is geographically concentrated in the south central and northwest regions of the United States, except for our Specialty Commercial business which is written on a national basis. We pursue our business activities through subsidiaries whose operations are organized into product-specific operating units, which are supported by our insurance company subsidiaries.

 

Our non-carrier insurance activities are segregated by operating units into the following reportable segments:

 

·Specialty Commercial Segment. Our Specialty Commercial Segment includes the excess and surplus lines commercial property/casualty insurance products and services handled by our Contract Binding operating unit and the general aviation, satellite launch, commercial umbrella and primary/excess liability, medical and financial professional liability and primary/excess commercial property insurance products and services handled by our Specialty Commercial operating unit, as well as certain specialty risk programs.

 

·Standard Commercial Segment. Our Standard Commercial Segment includes the standard lines commercial property/casualty and occupational accident insurance products and services handled by our Standard Commercial P&C operating unit and the workers compensation insurance products handled by our Workers Compensation operating unit. Effective June 1, 2016, we ceased marketing new or renewal occupational accident policies. Effective July 1, 2015, the Workers Compensation operating unit ceased retaining any risk on new or renewal policies.

 

·Personal Segment. Our Personal Segment includes the non-standard personal automobile and renters insurance products and services handled by our Specialty Personal Lines operating unit.

 

The retained premium produced by these reportable segments is supported by our American Hallmark Insurance Company of Texas (“AHIC”), Hallmark Specialty Insurance Company (“HSIC”), Hallmark Insurance Company (“HIC”), Hallmark National Insurance Company (“HNIC”) and Texas Builders Insurance Company (“TBIC”) insurance subsidiaries. In addition, control and management of Hallmark County Mutual (“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.

 

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AHIC, HIC, HSIC and HNIC have entered into a pooling arrangement pursuant to which AHIC retains 34% of the total net premiums written by any of them, HIC retains 32% of our total net premiums written by any of them, HSIC retains 24% of our total net premiums written by any of them and HNIC retains 10% of our total net premiums written by any of them. Neither HCM nor TBIC is a party to the intercompany pooling arrangement.

 

Results of Operations

 

Management overview. During the three and nine months ended September 30, 2018, our total revenues were $102.9 million and $294.4 million, representing an increase of 5% and 2%, respectively, from the $97.7 million and $288.1 million in total revenues for the same periods of 2017.  During the three and nine months ended September 30, 2018, our income before tax was $12.1 million and $19.3 million, respectively, representing an increase of $13.6 million and $19.9 million, respectively, from the loss before tax of $1.5 million and $0.6 million reported during the same periods the prior year.

 

The increase in revenue for the three and nine months ended September 30, 2018 was largely due to investment gains of $7.0 million and $2.7 million, respectively, as compared to $2.1 million and $0.7 million during the same periods of 2017, as well as higher net earned premiums, higher commissions and fees and higher finance charges, partially offset by lower net investment income and lower other income. The investment gains for the nine months ended September 30, 2018 included $3.2 million in loss attributable to the adoption effective January 1, 2018 of Accounting Standards Update No. 2016-01, “Recognition and Measurement of Financial Assets and Financial Liabilities” (“ASU 2016-01”) which requires equity investments that are not consolidated or accounted for under the equity method of accounting to be measured at fair value with changes in fair value recognized in net income. We adopted ASU 2016-01 using the modified-retrospective approach pursuant to which we recorded a cumulative effect adjustment to retained earnings of $17.0 million as of January 1, 2018 and decreased accumulated other comprehensive income by the same amount and did not restate prior periods. The decrease in net investment income for the three and nine months ended September 30, 2018 was primarily the result of the final distribution on a fixed income security during the third quarter of the prior year.

 

The increase in income before tax for the three and nine months ended September 30, 2018 was due primarily to the increase in revenue discussed above as well as decreased losses and loss adjustment expenses (“LAE”) of $8.1 million and $13.4 million, respectively, as compared to the same periods in 2017. The decrease in losses and LAE was primarily the result of improvement in unfavorable net prior year loss reserve development to $1.6 million and $6.1 million for the three and nine months ended September 30, 2018 as compared to $10.6 million and $20.2 million during the same periods of 2017.

 

We reported net income of $9.7 million for the three months ended September 30, 2018 as compared to a net loss of $1.6 million for the same period of 2017. We reported net income of $15.4 million during the nine months ended September 30, 2018 as compared to a net loss of $0.9 million for the same period during 2017. On a diluted basis per share, we reported net income of $0.53 per share for the three months ended September 30, 2018, as compared to a net loss of $0.09 per share for the same period in 2017.  On a diluted basis per share, we reported net income of $0.85 per share for the nine months ended September 30, 2018, as compared to a net loss of $0.05 per share for the same period in 2017. Our effective tax rate was 19.9% for the first nine months of 2018 as compared to -52.7% for the same period in 2017. The effective tax rate for 2018 was favorably impacted by the lower statutory rate from the enactment of the Tax Cuts and Jobs Act on December 22, 2017. The rate for 2017 varied from the statutory tax rate primarily due to a correction of an immaterial error in prior years’ deferred tax on bond premium amortization, partially offset by the amount of tax exempt income in relation to total pre-tax income.

 

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Third Quarter 2018 as Compared to Third Quarter 2017

 

The following is additional business segment information for the three months ended September 30, 2018 and 2017 (in thousands):

 

   Three Months Ended September 30 
   Specialty   Standard             
   Commercial
Segment
   Commercial
Segment
   Personal Segment   Corporate   Consolidated 
   2018   2017   2018   2017   2018   2017   2018   2017   2018   2017 
Gross premiums written  $125,599   $127,062   $21,560   $19,240   $21,953   $14,849   $-   $-   $169,112   $161,151 
Ceded premiums written   (66,404)   (56,200)   (2,398)   (2,889)   (12,298)   (7,013)   -    -    (81,100)   (66,102)
Net premiums written   59,195    70,862    19,162    16,351    9,655    7,836    -    -    88,012    95,049 
Change in unearned premiums   3,203    (6,274)   (449)   (420)   (1,904)   433    -    -    850    (6,261)
Net premiums earned   62,398    64,588    18,713    15,931    7,751    8,269    -    -    88,862    88,788 
                                                   
Total revenues   68,302    69,721    19,857    17,401    9,355    9,404    5,432    1,197    102,946    97,723 
                                                   
Losses and loss adjustment expenses   52,106    53,899    6,261    11,760    5,878    6,720    -    -    64,245    72,379 
                                                   
Pre-tax income (loss)   2,452    1,288    7,264    229    684    (661)   1,675    (2,381)   12,075    (1,525)
                                                   
Net loss ratio (1)   83.5%   83.5%   33.5%   73.8%   75.8%   81.3%             72.3%   81.5%
Net expense ratio (1)   22.4%   21.9%   34.1%   34.2%   20.2%   31.2%             25.8%   27.1%
Net combined ratio (1)   105.9%   105.4%   67.6%   108.0%   96.0%   112.5%             98.1%   108.6%
                                                   
Favorable (Unfavorable) Prior Year Development   (8,869)   (9,492)   7,269    (1,330)   (9)   266              (1,609)   (10,556)

 

(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 as total underwriting expenses 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.

 

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Specialty Commercial Segment

 

Gross premiums written for the Specialty Commercial Segment were $125.6 million for the three months ended September 30, 2018, which was $1.5 million, or 1%, less than the $127.1 million reported for the same period of 2017. The decrease in gross premiums written was primarily the result of decreased premium production in our Contract Binding operating unit, partially offset by higher premium production in our Specialty Commercial operating unit. Net premiums written were $59.2 million for the three months ended September 30, 2018 as compared to $70.9 million for the same period of 2017. The decrease in net premiums written was due to a change in mix towards business with higher ceded premium as a percentage of the gross premium.

 

The $68.3 million of total revenue for the three months ended September 30, 2018 was $1.4 million less than the $69.7 million reported by the Specialty Commercial Segment for the same period in 2017. This decrease in revenue was primarily due to lower net premiums earned of $2.2 million due to lower premium production in our Contract Binding operating unit partially offset by increased premium production in our Specialty Commercial operating unit, as well as higher net investment income of $0.3 million and higher commission and fees of $0.5 million for the three months ended September 30, 2018 as compared to the same period of 2017.

 

Pre-tax income for the Specialty Commercial Segment of $2.5 million for the third quarter of 2018 was $1.2 million higher than the $1.3 million reported for the same period in 2017. The increase in pre-tax income was primarily the result of lower losses and LAE of $1.8 million and lower operating expenses of $0.8 million, partially offset by the decreased revenue discussed above during the three months ended September 30, 2018 as compared to the same period during 2017.

 

Our Contract Binding operating unit reported an $8.2 million decrease in losses and LAE due largely to decreased net earned premiums, as well as $7.8 million of unfavorable prior year net loss reserve development recognized during the three months ended September 30, 2018 as compared to $8.9 million of unfavorable prior year net loss reserve development during the same period of 2017. Our Specialty Commercial operating unit reported a $6.4 million increase in losses and LAE which consisted of (a) a $1.8 million increase in losses and LAE attributable to our professional liability insurance products due primarily to increased net premiums earned and favorable prior year loss development in the same period of 2017, partially offset by lower current accident year loss trends, (b) a $0.6 million increase in losses and LAE in our satellite launch insurance line of business due primarily to higher current accident year loss trends, (c) a $1.3 million increase in losses and LAE in our commercial umbrella and primary/excess liability line of business due primarily to increased net premiums earned as well as unfavorable prior year loss reserve development, (d) a $0.1 million decrease in our general aviation line of business due primarily to lower unfavorable prior year net loss reserve development during the third quarter of 2018 as compared to the third quarter of 2017, partially offset by higher current accident year loss trends, (e) a $1.8 million increase in losses and LAE attributable to our primary/excess property insurance products due to increased net premiums earned as well as net unfavorable prior year loss reserve development during the third quarter of 2018, and (f) a $1.0 million increase in losses and LAE in our specialty programs due primarily to increased net premiums earned.

 

Operating expenses decreased $0.8 million primarily as the result of lower production related expenses of $2.4 million due primarily to increased ceding commissions in our Specialty Commercial operating unit, partially offset by increased salary and related expenses of $1.1 million, increased professional services of $0.3 million and increased occupancy and other operating expenses of $0.2 million.

 

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The Specialty Commercial Segment reported a net loss ratio of 83.5% for both the three months ended September 30, 2018 and 2017. The gross loss ratio before reinsurance was 73.8% for the three months ended September 30, 2018 as compared to 83.0% for the same period in 2017. The lower gross loss ratio was largely the result of $8.9 million of unfavorable prior year net loss reserve development for the three months ended September 30, 2018 as compared to unfavorable prior year net loss reserve development of $9.5 million for the same period of 2017, as well as lower gross catastrophe losses during the third quarter of 2018 as compared to the same period during 2017. The Specialty Commercial Segment reported $1.1 million of net catastrophe losses during the third quarter of 2018 as compared to $2.2 million of net catastrophe losses during the same period of 2017. The Specialty Commercial Segment reported a net expense ratio of 22.4% for the third quarter of 2018 as compared to 21.9% for the same period of 2017. The increase in the expense ratio was due predominately to the impact of lower net premiums earned in our Contract Binding operating unit, partially offset by increased ceding commissions in our Specialty Commercial operating unit.

 

Standard Commercial Segment

 

Gross premiums written for the Standard Commercial Segment were $21.6 million for the three months ended September 30, 2018, which was $2.4 million, or 12%, more than the $19.2 million reported for the same period in 2017. Net premiums written were $19.2 million for the three months ended September 30, 2018 as compared to $16.4 million for the same period in 2017. The increase in gross and net premiums written was due to higher premium production in our Standard Commercial P&C operating unit.

 

Total revenue for the Standard Commercial Segment of $19.9 million for the three months ended September 30, 2018, was $2.5 million, or 14%, more than the $17.4 million reported for the same period in 2017. This increase in total revenue was due to higher net premiums earned of $2.8 million due primarily to growth in our Standard Commercial P&C operating unit, partially offset by lower net investment income of $0.1 million and lower commission and fees of $0.2 million during the third quarter of 2018 as compared to the same period during 2017.

 

Our Standard Commercial Segment reported pre-tax income of $7.3 million for the three months ended September 30, 2018 as compared to $0.2 million reported for the same period of 2017. The increase in pre-tax income was the result of the increased revenue discussed above and lower losses and LAE of $5.5 million, partially offset by higher operating expenses of $0.9 million largely the result of higher production related expenses.

 

The Standard Commercial Segment reported a net loss ratio of 33.5% for the three months ended September 30, 2018 as compared to 73.8% for the same period of 2017. The gross loss ratio before reinsurance for the three months ended September 30, 2018 was 51.9% as compared to the 78.5% reported for the same period of 2017. The decreases in the gross and net loss ratios were primarily due to net favorable prior year loss reserve development of $7.3 million for the three months ended September 30, 2018 as compared to net unfavorable prior year loss reserve development of $1.3 million for the three months ended September 30, 2017. The Standard Commercial Segment also reported $0.9 million of net catastrophe losses during the third quarter of 2018 as compared to $2.1 million of net catastrophe losses during the same period of 2017. These improvements were partially offset by higher non-catastrophe current accident year loss trends. The Standard Commercial Segment reported a net expense ratio of 34.1% for the third quarter of 2018 as compared to 34.2% for the same period of 2017. The decrease in the expense ratio was primarily due to the increased net earned premium.

 

Personal Segment

 

Gross premiums written for the Personal Segment were $22.0 million for the three months ended September 30, 2018 as compared to $14.8 million for the same period in the prior year. Net premiums written for our Personal Segment were $9.7 million in the third quarter of 2018, which was an increase of $1.9 million, or 23%, from the $7.8 million reported for the third quarter of 2017. The increase in gross and net written premiums was primarily due to higher premium production in our current geographical footprint.

 

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Total revenue for the Personal Segment was $9.4 million for both the third quarter of 2018 and 2017. Net premiums earned decreased $0.5 million, offset by higher finance charges of $0.5 million reported during the third quarter of 2018 as compared to the same period during 2017.

 

Pre-tax income for the Personal Segment was $0.7 million for the three months ended September 30, 2018 as compared to pre-tax loss of $0.7 million for the same period of 2017. The pre-tax income was primarily the result of decreased losses and LAE of $0.8 million and decreased operating expenses of $0.6 million for the three months ended September 30, 2018 as compared to the same period during 2017.

 

The Personal Segment reported a net loss ratio of 75.8% for the three months ended September 30, 2018 as compared to 81.3% for the same period of 2017. The gross loss ratio before reinsurance was 66.2% for the three months ended September 30, 2018 as compared to 79.7% for the same period in 2017. The lower gross and net loss ratios were primarily the result of lower current accident year loss trends, partially offset by unfavorable prior year net loss reserve development of $9 thousand during the three months ended September 30, 2018 as compared to favorable net loss reserve development of $0.3 million reported during the same period of 2017. The Personal Segment reported a net expense ratio of 20.2% for the third quarter of 2018 as compared to 31.2% for the same period of 2017. The decrease in the expense ratio was due predominately to higher finance charges and lower production related expenses, partially offset by lower net premiums earned.

 

Corporate

 

Total revenue for Corporate increased by $4.2 million for the three months ended September 30, 2018 as compared to the same period the prior year. This increase in total revenue was due predominately to investment gains of $7.0 million during the third quarter of 2018 as compared to investment gains of $2.1 million reported for the same period of 2017, partially offset by lower net investment income of $0.7 million for the three months ended September 30, 2018 as compared to the same period during 2017.

 

Corporate pre-tax income was $1.7 million for the three months ended September 30, 2018 as compared to a pre-tax loss of $2.4 million for the same period of 2017. The pre-tax income was primarily due to the higher revenue discussed above, partially offset by higher operating expenses of $0.1 million.

 

Operating expenses increased $0.1 million primarily as a result of higher professional service fees of $0.2 million, partially offset by lower other expenses of $0.1 million. 

 

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Nine Months Ended September 30, 2018 as Compared to Nine Months Ended September 30, 2017

 

The following is additional business segment information for the nine months ended September 30, 2018 and 2017 (in thousands):

 

   Nine Months Ended September 30 
   Specialty   Standard             
   Commercial
Segment
   Commercial
Segment
   Personal Segment   Corporate   Consolidated 
   2018   2017   2018   2017   2018   2017   2018   2017   2018   2017 
Gross premiums written  $376,491   $350,374   $65,931   $59,702   $53,414   $48,243   $-   $-   $495,836   $458,319 
Ceded premiums written   (189,145)   (144,510)   (7,598)   (6,816)   (29,802)   (22,531)   -    -    (226,545)   (173,857)
Net premiums written   187,346    205,864    58,333    52,886    23,612    25,712    -    -    269,291    284,462 
Change in unearned premiums   9,071    (14,563)   (3,648)   (3,859)   (2,927)   2,678    -    -    2,496    (15,744)
Net premiums earned   196,417    191,301    54,685    49,027    20,685    28,390    -    -    271,787    268,718 
                                                   
Total revenues   213,507    205,057    57,979    52,449    24,891    31,951    (1,965)   (1,311)   294,412    288,146 
                                                   
Losses and loss adjustment expenses   148,001    146,018    28,562    34,669    15,005    24,238    -    -    191,568    204,925 
                                                   
Pre-tax income (loss)   20,980    13,018    11,239    881    661    (2,311)   (13,624)   (12,193)   19,256    (605)
                                                   
Net loss ratio (1)   75.4%   76.3%   52.2%   70.7%   72.5%   85.4%             70.5%   76.3%
Net expense ratio (1)   22.8%   23.6%   33.5%   34.9%   29.2%   27.7%             27.0%   27.9%
Net combined ratio (1)   98.2%   99.9%   85.7%   105.6%   101.7%   113.1%             97.5%   104.2%
                                                   
Favorable (Unfavorable) Prior Year Development   (15,730)   (17,824)   8,829    (1,594)   839    (822)             (6,062)   (20,240)

 

(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 as total underwriting expenses 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.

 

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Specialty Commercial Segment

 

Gross premiums written for the Specialty Commercial Segment were $376.5 million for the nine months ended September 30, 2018, which was $26.1 million, or 7%, more than the $350.4 million reported for the same period in 2017. The increase in gross premiums written were primarily the result of increased premium production in our Specialty Commercial operating unit, partially offset by lower premium production in our Contract Binding operating unit. Net premiums written were $187.3 million for the nine months ended September 30, 2018 as compared to $205.9 million for the same period of 2017. The decrease in net premiums written was due to a change in mix towards business with higher ceded premium as a percentage of the gross premium.

 

The $213.5 million of total revenue for the nine months ended September 30, 2018 was $8.4 million more than the $205.1 million reported by the Specialty Commercial Segment for the same period in 2017. This increase in revenue was primarily due to higher net premiums earned of $5.1 million due to increased premium production in our Specialty Commercial operating unit partially offset by decreased premium production in our Contract Binding operating unit. Further contributing to the increased revenue was higher net investment income of $2.1 million and higher commission and fees of $1.3 million, partially offset by lower other income of $0.1 million for the nine months ended September 30, 2018 as compared to the same period of 2017.

 

Pre-tax income for the Specialty Commercial Segment of $21.0 million for the nine months ended September 30, 2018 was $8.0 million higher than the $13.0 million reported for the same period in 2017. The increase in pre-tax income was primarily the result of increased revenue discussed above and lower operating expenses of $1.5 million, partially offset by higher losses and LAE of $1.9 million during the nine months ended September 30, 2018 as compared to the same period during 2017.

 

Our Contract Binding operating unit reported a $15.3 million decrease in losses and LAE due largely to decreased net earned premiums, as well as $11.3 million of unfavorable prior year net loss reserve development recognized during the nine months ended September 30, 2018 as compared to $16.4 million of unfavorable prior year net loss reserve development during the same period of 2017. Our Specialty Commercial operating unit reported a $17.2 million increase in losses and LAE which consisted of (a) a $6.7 million increase in losses and LAE attributable to our professional liability insurance products due primarily to increased net earned premiums as well as higher current accident year loss trends and net unfavorable prior year loss reserve development as compared to favorable prior year loss development during the same period of 2017, (b) a $1.0 million increase in losses and LAE in our satellite launch insurance line of business due to higher current accident year loss trends as well as net unfavorable prior year loss reserve development during the nine months ended September 30, 2018, (c) a $4.0 million increase in losses and LAE in our commercial umbrella and primary/excess liability line of business due primarily to increased net earned premiums as well as increased net unfavorable prior year loss reserve development during the nine months ended September 30, 2018 as compared to the nine months ended September 30, 2017, (d) a $0.5 million increase in our general aviation line of business due primarily to higher current accident year loss trends, partially offset by lower unfavorable prior year loss development for the nine months ended September 30, 2018 as compared to the prior year to date, (e) a $2.7 million increase in losses and LAE attributable to our primary/excess property insurance products due primarily to increased net earned premiums as well as unfavorable prior year reserve development for the nine months ended September 30, 2018 as compared to favorable prior year reserve development for the same period during 2017, partially offset by lower current accident year loss trends driven by lower catastrophe losses, and (f) a $2.3 million increase in losses and LAE in our specialty programs due primarily to increased net earned premiums.

 

Operating expenses decreased $1.5 million primarily as a result of lower production related expenses of $5.3 million due primarily to increased ceding commissions in our Specialty Commercial operating unit, partially offset by increased salary and related expenses of $2.5 million, increased professional services of $0.8 million and increased occupancy and other operating expenses of $0.5 million.

 

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The Specialty Commercial Segment reported a net loss ratio of 75.4% for the nine months ended September 30, 2018 as compared to 76.3% for the same period during 2017. The gross loss ratio before reinsurance was 72.5% for the nine months ended September 30, 2018 as compared to 73.5% for the same period in 2017. The lower gross and net loss ratios were largely the result of $15.7 million of unfavorable prior year net loss reserve development for the nine months ended September 30, 2018 as compared to unfavorable prior year net loss reserve development of $17.8 million for the same period of 2017 , partially offset by higher current accident year loss trends during the nine months ended September 30, 2018 as compared to the same period during 2017. The Specialty Commercial Segment reported $1.6 million of net catastrophe losses during the nine months ended September 30, 2018 as compared to $2.6 million of net catastrophe losses during the same period of 2017. The Specialty Commercial Segment reported a net expense ratio of 22.8% for the nine months ended September 30, 2018 as compared to 23.6% for the same period of 2017. The decrease in the expense ratio was due predominately to increased ceding commissions in our Specialty Commercial operating unit.

 

Standard Commercial Segment

 

Gross premiums written for the Standard Commercial Segment were $65.9 million for the nine months ended September 30, 2018, which was $6.2 million, or 10%, more than the $59.7 million reported for the same period in 2017. The increase in gross premiums written was due to higher premium production of $6.5 million in our Standard Commercial P&C Operating unit, partially offset by a $0.3 million decrease in gross premiums written related to the discontinued marketing of new and renewal occupational accident policies effective June 1, 2016. Net premiums written were $58.3 million for the nine months ended September 30, 2018 as compared to $52.9 million for the same period in 2017. The increase in net premiums written was due to higher net premiums written of $5.7 million in our Standard Commercial P&C Operating unit, partially offset by a $0.3 million decrease in net premiums written related to the discontinued marketing of new and renewal occupational accident policies.

 

Total revenue for the Standard Commercial Segment of $58.0 million for the nine months ended September 30, 2018, was $5.6 million, or 11%, more than the $52.4 million reported for the same period in 2017. This increase in total revenue was primarily due to higher net premiums earned of $5.7 million as a result of increased net premiums earned of $6.2 million in our Standard Commercial P&C operating unit, partially offset by a $0.5 million decrease in net premiums earned primarily related to the discontinued marketing of new and renewal occupational accident policies and lower net investment income of $0.1 million for the nine months ended September 30, 2018 as compared to the same period in 2017.

 

Our Standard Commercial Segment reported pre-tax income of $11.2 million for the nine months ended September 30, 2018 as compared to pre-tax income of $0.9 million reported for the same period of 2017. The increase in pre-tax income was the result of the increased revenue discussed above and lower losses and LAE of $6.1 million, partially offset by higher operating expenses of $1.4 million primarily as the result of higher production related expenses.

 

The Standard Commercial Segment reported a net loss ratio of 52.2% for the nine months ended September 30, 2018 as compared to 70.7% for the same period of 2017. The gross loss ratio before reinsurance for the nine months ended September 30, 2018 was 60.5% as compared to the 66.8% reported for the same period of 2017. The decreases in the gross and net loss ratios were due predominantly to favorable prior year net loss reserve development of $8.8 million during the nine months ended September 30, 2018 as compared to $1.6 million of unfavorable prior year net loss reserve development for the same period of 2017. Further contributing to the lower gross and net loss ratios were lower catastrophe losses during the nine months ended September 30, 2018 as compared to the same period of 2017. The Standard Commercial Segment reported $3.2 million of net catastrophe losses during the nine months ended September 30, 2018 as compared to $3.4 million of net catastrophe losses during the same period of 2017. The Standard Commercial Segment reported a net expense ratio of 33.5% during the nine months ended September 30, 2018 as compared to 34.9% for the same period of 2017. The decrease in the expense ratio was primarily due to the increased earned premium.

 

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Personal Segment

 

Gross premiums written for the Personal Segment were $53.4 million for the nine months ended September 30, 2018 as compared to $48.2 million for the same period in the prior year. Net premiums written for our Personal Segment were $23.6 million in the nine months ended September 30, 2018, which was a decrease of $2.1 million, or 8%, from the $25.7 million reported for the same period of 2017. The increase in gross written premiums was due primarily to increased production in our current geographical footprint. The decline in net written premiums was due to the impact of a new quota share reinsurance contract entered into during the fourth quarter of 2017.

 

Total revenue for the Personal Segment was $24.9 million for the nine months ended September 30, 2018 as compared to $32.0 million for the same period in 2017. The $7.1 million decrease in revenue was primarily the result of lower net premiums earned of $7.7 million due to lower net written premium volume and lower net investment income of $0.1 million, partially offset by higher finance charges of $0.7 million reported during the nine months ended September 30, 2018 as compared to the same period during 2017.

 

Pre-tax income for the Personal Segment was $0.7 million for the nine months ended September 30, 2018 as compared to pre-tax loss of $2.3 million for the same period of 2017. The pre-tax income was primarily the result of decreased losses and LAE of $9.2 million and lower operating expenses of $0.9 million for the nine months ended September 30, 2018 as compared to the same period during 2017, partially offset by the decreased revenue discussed above.

 

The Personal Segment reported a net loss ratio of 72.5% for the nine months ended September 30, 2018 as compared to 85.4% for the same period of 2017. The gross loss ratio before reinsurance was 67.9% for the nine months ended September 30, 2018 as compared to 82.1% for the same period in 2017. The lower gross and net loss ratios were primarily the result of favorable prior year net loss reserve development of $0.8 million during the nine months ended September 30, 2018 as compared to unfavorable net loss reserve development of $0.8 million reported during the same period of 2017, as well as lower current accident year loss trends. The Personal Segment reported a net expense ratio of 29.2% for the nine months ended September 30, 2018 as compared to 27.7% for the same period of 2017. The increase in the expense ratio was due predominately to lower net premiums earned.

 

Corporate

 

Total revenue for Corporate decreased by $0.7 million for the nine months ended September 30, 2018 as compared to the same period the prior year. This decrease in total revenue was due predominately to lower net investment income of $2.7 million for the nine months ended September 30, 2018 as compared to the same period during 2017, partially offset by investment gains of $2.7 million during the nine months ended September 30, 2018 as compared to investment gains of $0.7 million reported for the same period of 2017. The investment gains during the first nine months of 2018 include $3.2 million in loss attributable to the adoption of ASU 2016-01 effective January 1, 2018.

 

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Corporate pre-tax loss was $13.6 million for the nine months ended September 30, 2018 as compared to a pre-tax loss of $12.2 million for the same period of 2017. The increase in pre-tax loss was primarily due to higher operating expenses of $0.9 million and the lower revenue discussed above, partially offset by lower interest expense of $0.2 million.

 

Operating expenses increased $0.9 million primarily as a result of higher salary and related expenses of $0.8 million due primarily to higher incentive compensation accruals during the first nine months of 2018.  Further contributing to the higher operating expenses were increased occupancy and related expenses of $0.4 million primarily related to the early termination of our Ft. Worth office lease.   These increases to operating expenses were partially offset by lower professional service fees and other expenses of $0.3 million. 

 

Financial Condition and Liquidity

 

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 September 30, 2018, we had $16.2 million in unrestricted cash and cash equivalents, as well as $0.9 million in debt securities, at the holding company and our non-insurance subsidiaries. As of that date, our insurance subsidiaries held $43.7 million of unrestricted cash and cash equivalents, as well as $573.6 million in debt securities with an average modified duration of 1.5 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. Dividends may only be paid from unassigned surplus funds. HIC and HNIC, both domiciled in Arizona, are limited in the payment of dividends to the lesser of 10% of prior year policyholders’ surplus or prior year's net 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. During 2018, the aggregate ordinary dividend capacity of these subsidiaries is $20.0 million, of which $13.2 million is available to Hallmark. As a county mutual, dividends from HCM are payable to policyholders. During the first nine months of 2018 and 2017, our insurance company subsidiaries paid $4.6 million and $9.8 million in dividends to Hallmark, respectively.

 

Comparison of September 30, 2018 to December 31, 2017

 

On a consolidated basis, our cash (excluding restricted cash) and investments at September 30, 2018 were $707.6 million compared to $726.3 million at December 31, 2017. The primary reasons for this decrease in unrestricted cash and investments were cash used by operations and repurchases of our common stock.

 

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Comparison of Nine Months Ended September 30, 2018 and September 30, 2017

 

During the nine months ended September 30, 2018, our cash flow used by operations was $19.0 million compared to cash flow provided by operations of $34.3 million during the same period the prior year.  The decrease in operating cash flow was driven by a decrease in collected net premiums due predominately to an intentional shift in the mix of business away from a commercial auto concentration in our portfolio towards targeted growth in the Specialty Commercial operating unit, a larger portion of which is ceded to third party reinsurers, as well as a temporary acceleration of paid claims as we improved our claims practices to address the increase in frequency and severity in our commercial auto portfolio. This decrease in operating cash flow was partially offset by higher collected ceding commissions and collected income tax recoverable during the nine months ended September 30, 2018 as compared to the same period the prior year. 

 

Net cash provided by investing activities during the first nine months of 2018 was $16.0 million as compared to net cash used in investing activities of $23.0 million during the first nine months of 2017.  The cash provided by investing activities during the first nine months of 2018 was primarily comprised of an increase of $2.2 million in maturities, sales and redemptions of investment securities and a decrease in purchases of debt and equity securities of $36.8 million.

 

Cash used in financing activities during the first nine months of 2018 was $1.2 million primarily as a result of repurchases of our common stock. Cash used in financing activities during the first nine months of 2017 was $5.2 million primarily as a result of repurchases of our common stock.

 

Credit Facilities

 

Our Second Restated Credit Agreement with Frost Bank (“Frost”) dated June 30, 2015, as amended to date, provides a $15.0 million revolving credit facility (“Facility A”), with a $5.0 million letter of credit sub-facility. The outstanding balance of the Facility A bears interest at a rate equal to the prime rate or LIBOR plus 2.5%, at our election. We pay an annual fee of 0.25% of the average daily unused balance of Facility A and letter of credit fees at the rate of 1.00% per annum.  All principal and accrued interest on Facility A becomes due and payable on June 30, 2020. As of September 30, 2018, we had no outstanding borrowings under Facility A.

 

The Second Restated Credit Agreement with Frost also provides a $30.0 million revolving credit facility (“Facility B”), in addition to Facility A. We may use Facility B loan proceeds solely for the purpose of making capital contributions to AHIC and HIC. We may borrow, repay and reborrow under Facility B until December 17, 2019, at which time all amounts outstanding under Facility B are converted to a term loan. Through December 17, 2019, we pay Frost a quarterly fee of 0.25% per annum of the average daily unused balance of Facility B. Facility B bears interest at a rate equal to the prime rate or LIBOR plus 3.00%, at our election. Until December 17, 2019, interest only on amounts from time to time outstanding under Facility B are payable quarterly. Any amounts outstanding on Facility B as of December 17, 2019 are converted to a term loan payable in quarterly installments over five years based on a seven year amortization of principal plus accrued interest. All remaining principal and accrued interest on Facility B become due and payable on December 17, 2024. As of September 30, 2018, we had $30.0 million outstanding under Facility B.

 

The obligations under both Facility A and Facility B are secured by a security interest in the capital stock of AHIC and HIC.  Both Facility A and Facility B contain covenants that, among other things, require us to maintain certain financial and operating ratios and restrict certain distributions, transactions and organizational changes. We are in compliance with all of these covenants.

 

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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 a Delaware statutory trust, Hallmark Statutory Trust I (“Trust I”). 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. The interest rate on our Trust I subordinated debt securities was 7.725% until June 15, 2015, after which interest adjusts 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 September 30, 2018, the principal balance of our Trust I subordinated debt was $30.9 million and the interest rate was 5.58% per annum.

 

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 a Delaware statutory trust, Hallmark Statutory Trust II (“Trust II”). 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. The interest rate on our Trust II subordinated debt securities was 8.28% until September 15, 2017, after which interest adjusts 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 September 30, 2018, the principal balance of our Trust II subordinated debt was $25.8 million and the interest rate was 5.23% per annum.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

 

There have been no material changes to the market risks discussed in Item 7A to Part II of our Form 10-K for the fiscal year ended December 31, 2017.

 

 

Item 4. 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 most recent fiscal quarter, there have been no changes in our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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Risks Associated with Forward-Looking Statements Included in this Form 10-Q

 

This Form 10-Q 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 our business activities and availability of funds. The forward-looking statements included herein are based on current expectations that involve numerous risks and uncertainties. Assumptions relating to the foregoing involve judgments with respect to, among other things, future economic, competitive and market conditions, regulatory framework, weather-related events and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond our control. Although we believe 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-Q 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 us or any other person that our objectives and plans will be achieved.

 

PART II

OTHER INFORMATION

 

Item 1.Legal Proceedings.

 

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 1A.Risk Factors.

 

Not required for a smaller reporting company.

 

Item 2.Unregistered Sales of Equity Securities and Use of Proceeds.

 

Our stock buyback program initially announced on April 18, 2008, authorized the repurchase of up to 1,000,000 shares of our common stock in the open market or in privately negotiated transactions (the “Stock Repurchase Plan”). On January 24, 2011, we announced an increased authorization to repurchase up to an additional 3,000,000 shares. The Stock Repurchase Plan does not have an expiration date. We did not repurchase any shares of our common stock during the three months ended September 30, 2018.

 

Item 3.Defaults Upon Senior Securities.

 

None.

 

Item 4.Mine Safety Disclosures.

 

None.

 

Item 5.Other Information.

 

None.

 

 44 

 

 

Item 6.Exhibits.

 

The following exhibits are filed herewith or incorporated herein by reference:

 

Exhibit
Number
  Description
3(a)   Restated Articles of Incorporation of the registrant, as amended (incorporated by reference to Exhibit 3.1 to the registrant’s Registration Statement on Form S-1 [Registration No. 333-136414] filed September 8, 2006).
     
3(b)   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 March 28, 2017).
     
10(a)   Office Lease between Hallmark Financial Services, Inc. and Teachers Insurance and Annuity Association of America dated August 6, 2018 (incorporated by reference to Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed August 8, 2018).
     
31(a)   Certification of principal executive officer required by Rule 13a-14(a) or Rule 15d-14(a).
     
31(b)   Certification of principal financial officer required by Rule 13a-14(a) or Rule 15d-14(a).
     
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+   XBRL Instance Document.
     
101 SCH+   XBRL Taxonomy Extension Schema Document.
     
101 CAL+   XBRL Taxonomy Extension Calculation Linkbase Document.
     
101 LAB+   XBRL Taxonomy Extension Label Linkbase Document.
     
101 PRE+   XBRL Taxonomy Extension Presentation Linkbase Document.
     
101 DEF+   XBRL Taxonomy Extension Definition Linkbase Document.
     
+   Filed with this Quarterly Report on Form 10-Q and included in Exhibit 101 to this report are the following documents formatted in XBRL (Extensible Business Reporting Language): (i) Consolidated Balance Sheets as of September 30, 2018 and December 31, 2017, (ii) Consolidated Statements of Operations for the three and nine months ended September 30, 2018 and 2017, (iii) Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2018 and 2017, (iv) Consolidated Statements of Stockholder’s Equity for the three and nine months ended September 30, 2018 and 2017, (v) Consolidated Statements of Cash Flows for the nine months ended September 30, 2018 and 2017 and (vi) related notes.

 

 45 

 

 

SIGNATURES

 

In accordance with the requirements of the Exchange Act, the registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

HALLMARK FINANCIAL SERVICES, INC.

(Registrant)

 

Date: November 7, 2018   /s/ Naveen Anand
    Naveen Anand, Chief Executive Officer and President
     
Date: November 7, 2018   /s/ Jeffrey R. Passmore
    Jeffrey R. Passmore, Chief Accounting Officer and Senior Vice President

 

 46 

 

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Section 2: EX-31.A (EXHIBIT 31.A)

 

Exhibit 31 (a)

CERTIFICATION

 

I, Naveen Anand, certify that:

 

1.     I have reviewed this quarterly report on Form 10-Q 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: November 7, 2018  
   
  /s/ Naveen Anand
  Naveen Anand,
  Chief Executive Officer
  (principal executive officer)

 

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Section 3: EX-31.B (EXHIBIT 31.B)

 

Exhibit 31 (b)

CERTIFICATION

 

I, Jeffrey R. Passmore, certify that:

 

1.     I have reviewed this quarterly report on Form 10-Q 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: November 7, 2018  
   
  /s/Jeffrey R. Passmore
  Jeffrey R. Passmore
  Chief Accounting Officer
  (principal financial officer)

 

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Section 4: EX-32.A (EXHIBIT 32.A)

 

Exhibit 32(a)

CERTIFICATION PURSUANT TO 18 U.S.C. § 1350

 

I, Naveen Anand, Chief Executive Officer of Hallmark Financial Services, Inc. (the "Company"), hereby certify that the accompanying report on Form 10-Q for the quarter ended September 30, 2018, and filed with the Securities and Exchange Commission on the date hereof (the "Report"), fully complies with the requirements of Section 13(a) 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: November 7, 2018  
   
  /s/ Naveen Anand
  Naveen Anand,
  Chief Executive Officer
  (principal executive officer)

 

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Section 5: EX-32.B (EXHIBIT 32.B)

 

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 report on Form 10-Q for the quarter ended September 30, 2018 and filed with the Securities and Exchange Commission on the date hereof (the "Report"), fully complies with the requirements of Section 13(a) 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: November 7, 2018  
   
  /s/Jeffrey R. Passmore
  Jeffrey R. Passmore
  Chief Accounting Officer
  (principal financial officer)

 

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