The following discussion of the Company's financial condition and the results of its operations should be read in conjunction with the consolidated financial statements and related notes included in this report.
The Company's business involves marketing and underwriting of non-standard personal automobile insurance in Texas, New Mexico and Arizona; marketing commercial insurance in Texas, New Mexico, Idaho, Oregon and Washington; affiliate and third party claims administration; and other insurance related services. The Company pursues its business activities through subsidiaries organized into a Personal Lines Group, which handles non-standard personal automobile insurance, and a Commercial Lines Group, which handles commercial insurance.
For the year ended December 31, 2004, the Company reported income before extraordinary gain of $5.8 million, representing a 785% increase over the $0.7 million reported for the prior year. The Company reported net income of $5.8 million for the year ended December 31, 2004, compared with net income of $8.7 million for 2003, which included an $8.1 million extraordinary gain related to the acquisition of a new Personal Lines Group subsidiary.
On a diluted per share basis, net income was $0.16 for the year ended December 31, 2004, compared with net income of $0.47 per diluted share in 2003. The decrease in net income per diluted share was primarily attributable to the combined impact of the $8.1 million extraordinary gain in 2003 and an increase in the weighted average shares outstanding to 36.7 million diluted shares during 2004, compared to 18.8 million diluted shares during 2003, primarily as a result of a successful shareholder rights offering completed in the third quarter of 2003.
The increased operating earnings in 2004 reflect benefits achieved from the integration of recent acquisitions, ongoing initiatives to improve underwriting performance and sustained favorable market conditions. Both the Personal Lines Group and the Commercial Lines Group contributed to the enhanced operating results for 2004. The improvement in the Personal Lines Group operating earnings in 2004 was primarily driven by better underwriting results. The improvement in the Commercial Lines Group operating earnings in 2004 was driven largely by increased commission revenue attributable to the combination of increased premiums written and favorable underwriting performance.
The Company's significant accounting policies requiring management estimates and judgments are discussed below. Such estimates and judgments are based on historical experience, changes in laws and regulations, observance of industry trends and information received from third parties. While the estimates and judgments associated with the application of these accounting policies may be affected by different assumptions or conditions, the Company believes the estimates and judgments associated with the reported consolidated financial statement amounts are appropriate in the circumstances. For additional discussion of the Company's accounting policies, see Note 1 to the consolidated financial statements included in this report.
Reserves for Unpaid Losses and Loss Adjustment Expenses. Reserves for unpaid losses and LAE are established by the Company for claims which have already been incurred by the policyholder but which have not been paid by the Company. Losses and LAE represent the estimated ultimate net cost of all reported and unreported losses incurred through December 31, 2004 and 2003. 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 Hallmark's Losses and LAE" and "-Analysis of Loss and LAE Reserve."
The Company's reserve requirements are also interrelated with product pricing and profitability. The Company must price its products at a level sufficient to fund its policyholder benefits and still remain profitable. Because the Company's claim expenses represent the single largest category of its expenses, inaccuracies in the assumptions used to estimate the amount of such benefits can result in the Company failing to price its products appropriately and to generate sufficient premiums to fund its operations.
Recognition of Profit Sharing Commission Revenues of the Commercial Lines Group. Profit sharing commission of the Commercial Lines Group is calculated and recognized when the loss ratio, as determined by a qualified actuary, deviates from contractual thresholds. 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.
Effect of actual 0.5% ---------------------------------------------- above provisional ($199,402) ($305,122) ($298,457) ($44,755) Effect of actual 0.5% ---------------------------------------------- below provisional $139,581 $201,381 $196,982 $44,755 ----------------------------------------------
The Company's sources of funds are principally derived from insurance related operations. The major sources of funds from operations include premiums collected (net of policy cancellations and premiums ceded), ceding commissions, and processing and service fees. Other sources of funds are from financing and investment activities.
On a consolidated basis, the Company's cash and investments increased approximately 11.5% as of December 31, 2004 as compared to December 31, 2003. This was primarily a result of improved underwriting results and increased commercial premium volume in 2004. The Company's consolidated cash, cash equivalents and investments at December 31, 2004 and 2003 were $45.0 million and $40.4 million, respectively. These amounts exclude restricted cash and investments of $6.5 million and $5.4 million, respectively, which primarily secures the credit exposure of OACM and State & County on their quota share reinsurance treaties with Hallmark.
The AZDOI regulates financial transactions between Phoenix and affiliated companies. Applicable regulations require AZDOI's approval of management and expense sharing contracts and similar transactions. Phoenix paid $1.2 million in management fees to AHGA during 2004 and paid no management fees in 2003.
Based on 2005 budgeted and year-to-date cash flow information, the Company believes that it has sufficient liquidity to meet its projected insurance obligations, operational expenses and capital expenditure requirements for the foreseeable future. However, management is pursuing opportunities for future growth, and additional capital may be required to fund further expansion of the Company.
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 the Personal Lines Group partially offset by a $3.7 million increase in total revenues from the Commercial Lines Group. However, income before tax and extraordinary gain for 2004 increased $7.9 million as compared to 2003. The improvement in operating earnings in 2004 reflects better underwriting results for the Personal Lines Group, additional commission revenue in the Commercial Lines Group and an overall reduction in interest expense as a result of the repayment of a related party note in September 2003.
Pre-tax Income -------------- Personal Lines Group $ 8,109 $ 1,950 Commercial Lines Group 3,028 1,311 Corporate (2,535) (2,575) -------- -------- Consolidated $ 8,602 $ 686 ======== ========
Although revenue for the Personal Lines Group declined, its 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 Phoenix 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.
Corporate pre-tax loss was $2.5 million for 2004 as compared to $2.6 million for 2003. The Company 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.
Gross premiums written (prior to reinsurance) for 2003 decreased 16.1% and net premiums written (after reinsurance) increased 66.0% in relation to 2002. The decrease in gross premiums written is primarily due to the change in the reinsurance structure with Dorinco and the county mutual fronting companies (State & County and OACM). Effective April 1, 2003, the Company assumed a 45% share of the non-standard auto business produced by AHGA and underwritten by either State & County or OACM instead of the 100% share it assumed prior to that date. Also, effective April 1, 2003, Dorinco assumed its 55% share of this business directly, where prior to this date the Company retroceded 55% of the business to Dorinco. The decrease in gross premiums written was also impacted by Hallmark's cancellation of unprofitable agents, shift in marketing focus from annual term premium financed policies to six month term direct bill policies and increases in policy rates. These decreases were partially offset by the acquisition of Phoenix in 2003, which contributed $22.4 million in gross premiums written. The increase in net premiums written is due primarily to the acquisition of Phoenix in 2003, which contributed $21.6 million in net premiums written.
Revenue for the Personal Lines Group increased 106.9% in 2003 to $49.7 million from $24.0 million in 2002. The increase is due mostly to the acquisition of Phoenix, which contributed $24.3 million in revenue in 2003 and AHGA commission revenue of $2.5 million from Dorinco on policies effective after March 31, 2003 due to the revised reinsurance structure.
Pre-tax income for the Personal Lines Group increased $0.4 million in 2003 to $2.0 million as compared to $1.6 million in 2002. Improved pricing in 2003 and Hallmark's termination of unprofitable agents in the first quarter of 2003 helped improve underwriting results (excluding Phoenix) as evidenced by a loss ratio of 66.3% in 2003 as compared to 75.9% in 2002. Partially offsetting this improvement was increased salary and related expenses (excluding Phoenix) of $0.3 million, the discontinuation of the premium finance program which reduced finance charge revenue by $0.5 million, partially offset by reduced interest expense of $0.3 million, and the acquisition of Phoenix in 2003 which reported a $0.4 million pre-tax loss. The results for Phoenix included a loss accrual of $2.1 million, net of applicable reinsurance, for the settlement of a bad faith claim.
Revenue for the Commercial Lines Group of $19.9 million in 2003 was mostly comprised of $15.0 million of commissions earned on policies serviced by HGA for CNIC. Revenue also included $4.6 million of processing and service fees earned by ECM for claims processing for CNIC and by FAR for accounting administration for an unaffiliated third party, the contract for which ended in April 2003. The Commercial Lines Group reported revenue of $1.6 million for the one month ended December 31, 2002, which was mostly comprised of $1.1 million of commissions and $0.4 million of processing and service fees. These were new sources of revenue for the Company as a result of the acquisition of the Commercial Lines Group in December 2002.
Corporate pre-tax loss of $2.6 million in 2003 increased $1.0 million as compared to $1.6 million for 2002. Other operating costs and expenses increased $0.5 million mostly as a result of legal and consulting fees associated with acquisitions and other corporate matters. Additionally, the shift in management structure from 2002 to 2003 increased salary related expenses and other overhead during 2003. Interest expense was increased by $0.6 million in 2003 due to interest on a related party note payable. Proceeds from this note were used to acquire the Commercial Lines Group and Phoenix. The Company repaid this note in September 2003 from the proceeds of a rights offering of its stock in the third quarter of 2003. Investment income decreased by $0.2 million due to a note receivable secured by the stock of Phoenix acquired from a financial institution in the fourth quarter of 2002 being satisfied by the acquisition of Phoenix in 2003. Partially offsetting these increased expenses was $0.3 million of amortization of a $0.5 million risk premium reserve established in 2003 for Phoenix unpaid loss and LAE. The remainder of this reserve will be amortized into income over the next five years.
Management does not believe that inflation has a material effect on the Company's results of operations, except for the effect that inflation may have on interest rates and claim costs. The effects of inflation are considered in pricing and estimating reserves for unpaid losses and LAE. The actual effects of inflation on results of operations are not known until claims are ultimately settled. In addition to general price inflation, the Company is exposed to the upward trend in the cost of judicial awards for damages. The Company attempts to mitigate the effects of inflation in the pricing of policies and establishing loss and LAE reserves.
Consolidated Statements of Operations for the Years Ended December 31, 2004, 2003 and 2002
Consolidated Statements of Stockholders' Equity and Comprehensive Income for the Years Ended December 31, 2004, 2003 and 2002