Our Personal Insurance Operation is located at 14651 Dallas Parkway, Suite 400, Dallas, Texas. The suite is located in a high-rise office building and contains approximately 25,559 square feet of space. We renegotiated our lease on May 5, 2003 for a period of 66 months to expire November 30, 2008. The rent is currently $50,075 per month.
The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included in this report.
The increase in earnings in 2005 reflects increased investment income attributable to additional capital raised from our shareholder rights offering and issuance of trust preferred securities in the second quarter of 2005. The improvement in 2005 earnings also reflects additional profit sharing commission revenue in the Commercial Insurance Operation due to favorable loss development in prior accident years, as well as improved loss experience on prior accident years in the Personal Insurance Operation.
A significant amount of judgment is required in performing goodwill impairment tests. Such tests include estimating the fair value of our reporting units. As required by SFAS 142, we compare the estimated fair value of each reporting unit with its carrying amount, including goodwill. Under SFAS 142, fair value refers to the amount for which the entire reporting unit may be bought or sold. Methods for estimating reporting unit values include market quotations, asset and liability fair values and other valuation techniques, such as discounted cash flows and multiples of earnings or revenues. With the exception of market quotations, all of these methods involve significant estimates and assumptions.
Reserves for Unpaid Losses and Loss Adjustment Expenses. Reserves for unpaid losses and LAE are established for claims which have already been incurred by the policyholder but which we have not yet paid. Losses and LAE represent the estimated ultimate net cost of all reported and unreported losses incurred through December 31, 2005 and 2004. The reserves for unpaid losses and LAE are estimated using individual case-basis valuations and statistical analyses. These estimates are subject to the effects of trends in loss severity and frequency. (See, "Item 1. Business - Analysis of Losses and LAE" and "-Analysis of Loss and LAE Reserve Development.")
Recognition of Profit Sharing Commission Revenues of the Commercial Insurance Operation. Profit sharing commission of the Commercial Insurance Operation is calculated and recognized when the loss ratio, as determined by a qualified actuary, deviates from contractual targets. We receive a provisional commission as policies are produced as an advance against the later determination of the profit sharing commission actually earned. The profit sharing commission is an estimate that varies with the estimated loss ratio and is sensitive to changes in that estimate. The following table details the profit sharing commission revenue sensitivity to the actual ultimate loss ratio for each effective quota share treaty at 0.5% above and below the provisional loss ratio.
Treaty Effective Dates --------------------------------------------- 7/1/01 7/1/02 7/1/03 7/1/04 Provisional loss ratio 60.0% 59.0% 59.0% 64.2% Ultimate loss ratio --------------------------------------------- booked to at 12/31/05 60.8% 57.5% 56.5% 62.2% ---------------------------------------------
Cash used by investing activities during 2005 was $73.1 million as compared to $4.0 million used during 2004. The increase in cash used in investing activities is mainly due to increased purchases of debt and equity securities of $51.9 million, increased net purchases of short-term investments of $12.2 million, a decrease in net maturities and redemptions of securities of $4.4 million and a $0.4 million increase in cash and investments transferred to restricted accounts.
As a holding company, Hallmark is dependent on dividend payments and management fees from its subsidiaries to meet operating expenses and debt obligations. As of December 31, 2005, Hallmark had $2.0 million in cash and invested assets. Cash and invested assets of our non-insurance subsidiaries were $3.6 million as of December 31, 2005.
TDI regulates financial transactions between AHIC and affiliated companies. Applicable regulations require TDI's approval of management fees, expense sharing contracts and similar transactions. PGA paid $1.8 million and $0.6 million in management fees to Hallmark during 2005 and 2004, respectively. AZDOI regulates financial transactions between PIIC and affiliated companies. Applicable regulations require AZDOI's approval of management fees, expense sharing contracts and similar transactions. PIIC paid $1.2 million in management fees to PGA during each of 2005 and 2004.
Conclusion. Based on 2006 budgeted and year-to-date cash flow information, we believe that we have sufficient liquidity to meet our projected insurance obligations, operational expenses and capital expenditure requirements for the foreseeable future. However, we expect additional capital to be required to satisfy the debt obligations to Newcastle which are payable on demand after June 30, 2006. We presently intend to retire this debt through a rights offering of our common stock to existing shareholders during the first half of 2006. However, there can be no assurance that we will be able to successfully complete such rights offering.
The following is additional business segment information for the twelve months ended December 31, 2005 and 2004 (in thousands):
Net premium written by our Personal Insurance Operation increased $3.9 million during 2005 to $37.0 million compared to $33.1 million during 2004. The increase was due mainly to AHIC assuming 100% of the Texas non-standard automobile business produced by AHGA and underwritten by a third party, effective October 1, 2004. Prior to October 1, 2004, AHIC assumed only 45% of this business. Total premium production for 2005 declined $6.6 million, or 15.4%, to $36.4 million from the $43.0 million produced in 2004. The decline in produced premium reflected increased rate competition.
Beginning in the third quarter of 2005, our Commercial Insurance Operation began retaining written premium through AHIC. Our Commercial Insurance Operation written premium was accomplished through the assumption of in-force policies from Clarendon at July 1, 2005, the assumption of Clarendon policies issued subsequent to July 1, 2005, and the issuance of AHIC policies. This resulted in net written premium of $51.2 million for 2005.
Pre-tax income for our Commercial Insurance Operation of $6.6 million for 2005 increased $3.6 million, or 119.6%, over the $3.0 million reported for 2004. Increased revenue, as discussed above, was the primary reason for the increase in pre-tax income, partially offset by loss and LAE of $12.6 million and additional production expenses of $3.2 million caused by increased retail agent commissions from higher premium production as well as additional ceding commission expense from the assumption of premium from Clarendon.
Corporate pre-tax loss was $4.8 million for 2005 as compared to $2.5 million for 2004. The increase was due mostly to additional interest expense of $1.2 million from the issuance of trust preferred securities in June 2005, increased salary expense of $0.6 million from increased headcount (including the transfer of accounting positions from both operations to Corporate late in 2004) and additional audit and legal fees of $0.2 million due primarily to the implementation of our capital plan in 2005.
Total revenues for 2004 decreased $6.4 million, or 9.3%, as compared to 2003, primarily as a result of a $10.1 million decline in total revenues from our Personal Insurance Operation partially offset by a $3.7 million increase in total revenues from our Commercial Insurance Operation. However, income before tax and extraordinary gain for 2004 increased $7.9 million as compared to 2003. The improvement in operating earnings in 2004 reflected better underwriting results for our Personal Insurance Operation, additional commission revenue in our Commercial Insurance Operation and an overall reduction in interest expense as a result of the repayment of a related party note in September 2003.
2004 2003 Revenues -------- -------- -------- Personal Insurance Operation $ 39,555 $ 49,665 Commercial Insurance Operation 23,563 19,891 Corporate 3 3 -------- -------- Consolidated $ 63,121 $ 69,559 ======== ========
Net premiums written decreased $3.5 million, or 9.6% during 2004 to $33.1 million compared to $36.6 million in 2003. The decrease in net premiums written was primarily attributable to the cancellation of unprofitable agents and programs, a shift in marketing focus from annual term premium financed policies to six month term direct bill policies, a reduction in policy counts caused by targeted rate adjustments and increased competition from newly capitalized entities entering the marketplace. Net premiums earned decreased $9.6 million, or 22.7%, to $32.4 million in 2004 compared to $42.0 million in 2003. Primarily as a result of the decline in net premiums earned, total revenue for our Personal Insurance Operation decreased $10.1 million, or 20.4%, to $39.6 million in 2004 compared to $49.7 million in 2003.
Although revenue for our Personal Insurance Operation declined, our pre-tax income increased $6.2 million, or 315.8%, to $8.1 million in 2004 as compared to $2.0 million in 2003. The increase in pre-tax income was primarily due to improved underwriting results, as evidenced by a loss and LAE ratio of 59.3% for 2004 as compared to 72.5% for 2003. Also contributing to the improved pre-tax results were reduced salary and related expenses of $1.0 million due to the successful integration of the PIIC operations in late 2003 and the overall reduction in premium volume and increased net investment income of $0.2 million. These improvements were partially offset by the discontinuation of the premium finance program which caused finance charge revenue to decrease by $1.5 million which was partially offset by reduced interest expense of $0.4 million.
Total revenue for our Commercial Insurance Operation of $23.6 million for 2004 was $3.7 million, or 18.5%, more than the $19.9 million reported for 2003. The improvement was primarily due to a $2.9 million increase in commission revenue and a $0.7 million increase in claim servicing revenue. Commercial premium volume growth was the primary cause of the increased commission and claim fee revenue for 2004. Earned premium generated by our Commercial Insurance Operation for 2004 was $72.5 million compared to $62.9 million for 2003. We did not bear the primary underwriting risk for this business in 2004 or 2003 and, therefore, the resulting premiums and claims are not reflected in our reported results.
Pre-tax income for the Commercial Insurance Operation of $3.0 million in 2004 increased $1.7 million, or 131.0%, over the $1.3 million reported in 2003. Increased revenue, as discussed above, was the primary reason for the increase in pre-tax income, partially offset by additional compensation and production related costs of $2.1 million attributable to the increased premium volume.
Corporate pre-tax loss was $2.5 million for 2004 as compared to $2.6 million for 2003. We saved $0.8 million in interest expense in 2004 due to the repayment of a related party note in September 2003. This was partially offset by a $0.7 million increase in salary and related expenses in 2004.