Hallmark is an insurance holding company which, through its subsidiaries, engages in the sale of property/casualty insurance products to businesses and individuals. Our business involves marketing, distributing, underwriting and servicing our insurance products, as well as providing other insurance related services. We pursue our business activities primarily through subsidiaries whose operations are organized into business units and are supported by our insurance carrier subsidiaries.
· Standard Commercial Segment. The Standard Commercial Segment includes the standard lines commercial property/casualty and occupational accident insurance products and services handled by our Standard Commercial P&C business unit and the workers compensation insurance products handled by our Workers Compensation business unit. Our Standard Commercial P&C business unit is comprised of our American Hallmark Insurance Services and ECM subsidiaries. Our Workers Compensation business unit is comprised of our TBIC Holdings, TBIC and TBICRM subsidiaries. The Workers Compensation business unit was acquired July 1, 2011.
AHIC, HIC, HSIC and HNIC have entered into a pooling arrangement pursuant to which AHIC retains 30% of the net premiums written by any of them, HIC retains 27% of the net premiums written by any of them, HSIC retains 30% of the net premiums written by any of them and HNIC retains 13% of the net premiums written by any of them. Neither HCM nor TBIC is a party to the intercompany pooling arrangement.
Impairment of investments. We complete a detailed analysis each quarter to assess whether any decline in the fair value of any investment below cost is deemed other-than-temporary. All securities with an unrealized loss are reviewed. We recognize an impairment loss when an investment’s value declines below cost, adjusted for accretion, amortization and previous other-than-temporary impairments and it is determined that the decline is other-than-temporary.
Fair values of financial instruments. Accounting Standards Codification (“ASC”) 820 defines fair value, establishes a consistent framework for measuring fair value and expands disclosure requirements about fair value measurements. ASC 820, among other things, requires us to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. In addition, ASC 820 precludes the use of block discounts when measuring the fair value of instruments traded in an active market, which were previously applied to large holdings of publicly traded equity securities.
A significant amount of judgment is required in performing goodwill impairment tests. Such tests include estimating the fair value of our reporting units. As required by ASC 350, we compare the estimated fair value of each reporting unit with its carrying amount, including goodwill. Under ASC 350, fair value refers to the amount for which the entire reporting unit may be bought or sold.
The income approach to determining fair value computed the projections of the cash flows that the reporting unit is expected to generate converted into a present value equivalent through discounting. Significant assumptions in the income approach model include income projections, discount rates and terminal growth values. The income projections reflect an improved premium pricing environment across most of our lines of business that began in 2012 and continued throughout 2013. The income projections also include loss and LAE assumptions which reflect recent historical claim trends and the movement towards a more favorable pricing environment. The income projections also include assumptions for expense growth and investment yields which are based on business plans for each of our business units. The discount rate was based on a risk free rate plus a beta adjusted equity risk premium and specific company risk premium. The assumptions were based on historical experience, expectations of future performance, expected market conditions and other factors requiring judgment and estimates. While we believe the assumptions used in these models were reasonable, the inherent uncertainty in predicting future performance and market conditions may change over time and influence the outcome of future testing.
Although considerable variability is inherent in such estimates, we believe that our reserves for unpaid losses and LAE are adequate. Due to the inherent uncertainty in estimating unpaid losses and LAE, the actual ultimate amounts may differ from the recorded amounts. A small percentage change could result in a material effect on reported earnings. For example, a 1% change in December 31, 2013 reserves for unpaid losses and LAE would have produced a $3.8 million change to pretax earnings. The estimates are continually reviewed and adjusted as experience develops or new information becomes known. Such adjustments are included in current operations.
The range of unpaid losses and LAE estimated by our actuary as of December 31, 2013 was $337.7 million to $388.6 million. Our best estimate of unpaid losses and LAE as of December 31, 2013 is $382.6 million. Our carried reserve for unpaid losses and LAE as of December 31, 2013 is comprised of $189.2 million in case reserves and $193.4 million in incurred but not reported reserves. In setting this estimate of unpaid losses and LAE, we have assumed, among other things, that current trends in loss frequency and severity will continue and that the actuarial analysis was empirically valid. We have established a best estimate of unpaid losses and LAE, which is approximately $19.5 million higher than the midpoint or 98.5% of the high end of the actuarial range at December 31, 2013 as compared to $18.7 million above the midpoint or 97.1% of the high end of the actuarial range at December 31, 2012. We expect our best estimate to move within the actuarial range from year to year due to changes in our operations and changes within the marketplace. Due to the inherent uncertainty in reserve estimates, there can be no assurance that the actual losses ultimately experienced will fall within the actuarial range. However, because of the breadth of the actuarial range, we believe that it is reasonably likely that actual losses will fall within such range.
The following table details the profit sharing commission revenue sensitivity of the Standard Commercial P&C business unit to the actual ultimate loss ratio for each effective quota share treaty at 5.0% above and below the current estimate, which we believe is a reasonably likely range of variance ($ in thousands).
Comparison of Years ended December 31, 2013 and December 31, 2012
Total revenue for the Personal Segment decreased 20% to $71.1 million for the year ended December 31, 2013 from $89.1 million the prior year. Lower net premiums earned of $17.7 million and lower net investment income of $0.4 million, partially offset by higher other income of $0.1 million, were the primary reason for the decrease in revenue for the period.
Our Personal Segment reported a pre-tax loss of $3.4 million for the year ended December 31, 2013 as compared to a pre-tax loss of $8.5 million for the same period of 2012. The lower pre-tax loss was the result of lower losses and LAE of $16.9 million and lower operating expenses of $6.2 million, primarily due to lower production related expenses driven by increased ceding commission on the quota share agreements entered into during 2013. The decline in pre-tax loss was partially offset by lower revenue discussed above.
The Personal Segment reported a net loss ratio of 82.5% for the year ended December 31, 2013 as compared to 85.5% for 2012. The gross loss ratio before reinsurance was 80.6% for the year ended December 31, 2013 as compared to 85.6% for the same period in 2012. The lower gross and net loss ratio were primarily the result of lower current accident year loss trends as well as lower unfavorable prior year loss reserve development for the year ended December 31, 2013 as compared to the same period of 2012. Loss and LAE during the years ended December 31, 2013 and 2012 included unfavorable prior years’ loss reserve development of $1.8 million and $3.6 million, respectively. The Personal Segment reported a net expense ratio of 26.7% for the year ended December 31, 2013 as compared to 28.5% for the same period of 2012. The decrease in the expense ratio was due predominately to lower production related expenses.
Comparison of Years ended December 31, 2012 and December 31, 2011
The increase in revenue for the year ended December 31, 2012 was complemented by decreased loss and LAE due primarily to improved current accident year loss trends in our Standard Commercial P&C business unit and Personal Lines business unit as well as $3.7 million of favorable prior year loss reserve development for the year ended December 31, 2012 as compared to $16.4 million of adverse reserve development recognized during the prior year. Of the $16.4 million unfavorable development recognized for the year ended December 31, 2011, $10.3 million was a result of adverse prior year loss reserve development in our Personal Segment in Florida. In addition, the results for the years ended December 31, 2012 and 2011 included $11.7 million and $10.3 million, respectively, in current accident year net losses from weather related claims.
The following is additional business segment information for the years ended December 31, 2012 and 2011 (in thousands):
Total revenue for the Standard Commercial Segment of $73.1 million for the year ended December 31, 2012 was $0.3 million more than the $72.8 million reported during the year ended December 31, 2011. This increase in total revenue was the result of increased net earned premiums of $4.6 million due primarily to the acquisition of our Workers Compensation business unit during the third quarter of 2011 and higher net investment income of $0.9 million. This increase in revenue was partially offset by an adverse profit share commission revenue adjustment of $1.5 million during the year ended December 31, 2012 as compared to a favorable profit share commission revenue adjustment of $3.7 million during the same period of 2011.
The net loss ratio for the year ended December 31, 2012 was 76.4% as compared to the 78.9% reported for 2011. The gross loss ratio before reinsurance was 74.8% for the year ended December 31, 2012 as compared to 77.4% for the prior year. The lower gross and net loss ratios for the year ended December 31, 2012 were aided by lower current accident year loss trends excluding catastrophe losses. The net loss ratios for the years ended December 31, 2012 and 2011 include $9.5 million and $7.7 million, respectively, of weather related losses. During the years ended December 31, 2012 and 2011 the Standard Commercial Segment reported $3.7 million and $0.8 million, respectively, of favorable prior years’ loss reserve development.
Pre-tax income for the Specialty Commercial Segment of $25.9 million for the year ended December 31, 2012 was $11.6 million higher than the $14.3 million reported for the same period in 2011. The increase in pre-tax income was primarily due to the increased revenue discussed above partially offset by higher loss and LAE expenses of $16.7 million, higher operating expenses of $7.6 million and $0.3 million in expense related to the acquisition of the non-controlling interest in our Hallmark Select business unit during the third quarter of 2012. Our E&S Commercial business unit reported a $11.8 million increase in loss and LAE due primarily to increased premium volume partially offset by lower accident year loss trends. Our Hallmark Select business reported a $4.9 million increase in loss and LAE which consisted of (a) a $0.8 million increase in loss and LAE due to increased premium production in our commercial umbrella and excess liability line of business, (b) a $1.7 million increase in loss and LAE primarily due to increased current accident year loss trends in our general aviation line of business, (c) a $1.6 million increase in loss and LAE in our satellite insurance business due primarily to increased current accident year loss trends and (d) a $0.8 million increase in loss and LAE in our medical professional liability insurance products. The increased operating expenses during 2012 were primarily the result of increased production related expenses of $6.6 million, higher salary and related expense of $1.1 million and higher other operating expenses of $0.2 million, partially offset by lower professional service fees of $0.3 million.
Gross premiums written for the Personal Segment were $77.1 million for the year ended December 31, 2012, which was $23.3 million, or 23%, less than the $100.4 million reported for the same period in 2011. The decrease in premium was due mostly to exiting Florida and certain other underperforming states and programs.
Our Personal Segment reported a pre-tax loss of $8.5 million for the year ended December 31, 2012 as compared to a pre-tax loss of $29.6 million for the same period of 2011. The lower pre-tax loss was the result of lower losses and LAE of $31.4 million and lower operating expenses of $1.8 million, primarily production related expenses. The decline in pre-tax loss was partially offset by lower revenue discussed above.
Statutory capital and surplus is calculated as statutory assets less statutory liabilities. The various state insurance departments that regulate our insurance company subsidiaries require us to maintain a minimum statutory capital and surplus. As of December 31, 2013, our insurance company subsidiaries reported statutory capital and surplus of $196.3 million, substantially greater than the minimum requirements for each state. Each of our insurance company subsidiaries is also required to satisfy certain risk-based capital requirements. (See, “Item 1. Business - Insurance Regulation - Risk-based Capital Requirements.”). As of December 31, 2013, the adjusted capital under the risk-based capital calculation of each of our insurance company subsidiaries substantially exceeded the minimum requirements. Our total statutory premium-to-surplus percentage for the years ended December 31, 2013 and 2012 was 184% and 188%, respectively.
On a consolidated basis, our cash and investments, excluding restricted cash and investments, at December 31, 2013 were $603.0 million compared to $530.5 million at December 31, 2012. Cash from operating activities was the primary reason for this increase.
Net cash provided by our consolidated operating activities was $68.3 million for the year ended December 31, 2013 compared to $33.7 million for the year ended December 31, 2012. The increase in operating cash flow was primarily due to higher collected premiums written by our Specialty Commercial Segment during the year ended December 31, 2013 as compared to the same period in 2012, partially offset by increased operating expense payments and federal income tax payments during 2013 as compared to federal income tax refunds during 2012.
On June 21, 2005, we entered into a trust preferred securities transaction pursuant to which we issued $30.9 million aggregate principal amount of subordinated debt securities due in 2035. To effect the transaction, we formed Hallmark Statutory Trust I (“Trust I”) as a Delaware statutory trust. Trust I issued $30.0 million of preferred securities to investors and $0.9 million of common securities to us. Trust I used the proceeds from these issuances to purchase the subordinated debt securities. Our Trust I subordinated debt securities bear an initial interest rate of 7.725% until June 15, 2015, at which time interest will adjust quarterly to the three-month LIBOR rate plus 3.25 percentage points. Trust I pays dividends on its preferred securities at the same rate. Under the terms of our Trust I subordinated debt securities, we pay interest only each quarter and the principal of the note at maturity. The subordinated debt securities are uncollateralized and do not require maintenance of minimum financial covenants. As of December 31, 2013, the balance of our Trust I subordinated debt was $30.9 million.