Our Personal Lines Operating Unit is located at 6500 Pinecrest, Suite 100, Plano, Texas. The suite is located in a one story office building and contains 16,814 square feet of space. The rent is currently $19,897 per month pursuant to a lease which expires January 31, 2016.
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 through subsidiaries whose operations are organized into operating units and are supported by our insurance carrier subsidiaries.
Hallmark Specialty Insurance Company presently retains a portion of the risks on the commercial property/casualty policies marketed within the Specialty Commercial Segment.
Hallmark Insurance Company presently retains a portion of the risks on both the personal policies marketed within the Personal Lines Operating Unit and the aviation property/casualty products marketed within the Specialty Commercial Segment.
Equity Investments: Some of the factors considered in evaluating whether a decline in fair value for an equity investment is other-than-temporary include: (1) our ability and intent to retain the investment for a period of time sufficient to allow for an anticipated recovery in value; (2) the recoverability of cost; (3) the length of time and extent to which the fair value has been less than cost; and (4) the financial condition and near-term and long-term prospects for the issuer, including the relevant industry conditions and trends, and implications of rating agency actions and offering prices. When it is determined that an equity investment is other-than-temporarily impaired, the security is written down to fair value, and the amount of the impairment is included in earnings as a realized investment loss. The fair value then becomes the new cost basis of the investment, and any subsequent recoveries in fair value are recognized at disposition. We recognize a realized loss when impairment is deemed to be other-than-temporary even if a decision to sell an equity investment has not been made. When we decide to sell a temporarily impaired available-for-sale equity investment and we do not expect the fair value of the equity investment to fully recover prior to the expected time of sale, the investment is deemed to be other-than-temporarily impaired in the period in which the decision to sell is made.
Goodwill. Our consolidated balance sheet as of December 31, 2009 includes goodwill of acquired businesses of $41.1 million which is assigned to our operating units as follows: AHIS Operating Unit - $2.1 million; TGA Operating Unit - $18.8 million; Aerospace Operating Unit - $9.7 million; Personal Lines Operating Unit - $2.8 million; and Heath XS Operating Unit - $7.7 million. This amount has been recorded as a result of prior business acquisitions accounted for under the purchase method of accounting. Under FASB Accounting Standards Codification (“ASC”) Topic 350, “Intangibles- Goodwill and Other” (“FASB ASC 350”) goodwill is tested for impairment annually. We completed our last annual test for impairment during the fourth quarter of 2009 and determined that there was no impairment.
The income approach to determining fair value computes 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 discount rate was based on a risk free rate plus a beta adjusted equity risk premium and specific company risk premium. The assumptions are 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 are reasonable, the inherent uncertainty in predicting future performance and market conditions may change over time and influence the outcome of future testing.
The market approach to determining fair value utilized observable key metrics of similar peer companies such as price to earnings ratios for current year earnings and forecasted 2010 earnings. Additionally, the direct capitalization of earnings method was utilized.
The fair values of each of our operating units were in excess of their respective carrying values, including goodwill, as a result of our last annual step one test for impairment during the fourth quarter 2009. However, a 12% decline in the fair value of our AHIS Operating Unit, a 9% decline in the fair value of our TGA Operating Unit, a 31% decline in the fair value of our Personal Lines Operating Unit, a 3% decline in the fair value of our Aerospace Operating Unit, or a 5% decline in the fair value of our Heath XS Operating Unit would have caused the carry value of the respective operating unit to be in excess of its fair value, resulting in the need to perform the second step of impairment testing prescribed by FASB ASC 350 which could have resulted in a material impairment to our goodwill.
Reserves for unpaid losses and LAE . 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. Unpaid losses and LAE represent the estimated ultimate net cost of all reported and unreported losses incurred through each balance sheet date. The reserves for unpaid losses and LAE are estimated using individual case-basis valuations and statistical analyses. These reserves are revised periodically and 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.”)
The range of unpaid losses and LAE estimated by our actuary as of December 31, 2009 was $148.4 million to $196.0 million. Our best estimate of unpaid losses and LAE as of December 31, 2009 is $184.7 million. Our carried reserve for unpaid losses and LAE as of December 31, 2009 is comprised of $91.1 million in case reserves and $93.6 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 $12.5 million higher than the midpoint or 94.2% of the high end of the actuarial range at December 31, 2009 as compared to $8.1 million above the midpoint or 92.5% of the high end of the actuarial range at December 31, 2008. 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.
Segment information. The following is additional business segment information for the years ended December 31, 2009 and 2008 (in thousands):
Pre-tax income for the Specialty Commercial Segment of $20.9 million was $0.4 million lower than the $21.3 million reported in 2008. Increased revenue, discussed above, was offset by increased losses and LAE of $9.5 million. Increased revenue was complemented by lower expenses of $5.5 million. These lower operating expenses for fiscal 2009 were primarily the combined result of (a) a $1.2 million premium receivable write-off due to the default of a producer in our TGA Operating Unit during the third quarter of 2008, lower production related expenses of $4.1 million due to lower produced premium, and lower operating expenses of $2.0 million in our Aerospace Operating Unit and TGA Operating Unit, partially offset by (b) increased operating expenses of $1.4 million and increased amortization of intangible assets of $0.4 million, in both cases related to the acquisition of our Heath XS Operating Unit effective August 29, 2008.
Management overview. During fiscal 2008, our total revenues were $268.7 million, representing an approximately 2% decrease over the $275.2 million in total revenues for fiscal 2007. The decrease in total revenue during 2008 was primarily due to recognized losses on our investment portfolio and lower commission income partially offset by higher earned premium and investment income. Standard Commercial Segment revenues decreased $2.4 million during 2008 due primarily to lower earned premium as a result of increased competition, rate pressure, and deterioration of the economic environment in the United States. Increased retention of business and the acquisition of our Heath XS Operating Unit in 2008 drove the $1.3 million increase in revenue by our Specialty Commercial Segment during 2008 compared to 2007. Revenues from our Personal Segment increased $6.2 million during 2008, due largely to geographic expansion into new states. Corporate revenue decreased $11.6 million during 2008 as compared to 2007 primarily due to recognized losses on our investment portfolio of $11.3 million as compared to recognized gains of $2.6 million during 2007, partially offset by increased investment income of $2.3 million for the period ended December 31, 2008, as compared to the same period during 2007.
The net loss ratio is calculated as incurred losses and LAE divided by net premiums earned, each determined in accordance with GAAP. During the second quarter of 2009 we changed the method in which the net expense ratio is calculated. The net expense ratio is now calculated for our operating units that retain 100% of produced premium as total operating expenses for the unit offset by agency fee income divided by net premiums earned, each determined in accordance with GAAP. For the operating units that do not retain 100% of the produced premium, the net expense ratio is calculated as underwriting expenses of the insurance company subsidiaries for the unit 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. All prior periods have been restated to conform to the new method, resulting in an increase to the consolidated net expense ratio of 1.7% and 1.3% for the twelve months ended December 31, 2008 and 2007, respectively.
Total revenue for the Personal Segment increased approximately 11% to $64.5 million for the year ended December 31, 2008 from $58.3 million the prior year. Higher earned premium of $5.5 million was the primary reason for the increase in revenue for the period. Increased finance charges of $0.6 million and higher commissions and processing fee revenue of $0.1 million further contributed to this increase in revenue during 2008.
The Personal Segment reported a net loss ratio of 66.2% for the year ended December 31, 2008 as compared to 67.2% for the prior year. The decline in the net loss is a result of the maturing of the new business impact associated with geographic expansion. We recognized $0.6 million of favorable prior accident year development during the year ended December 31, 2008 as compared to $0.9 million during 2007. The Personal Segment reported a net expense ratio of 22.0% for the year ended December 31, 2008 as compared to 22.2% for the prior year.
The state insurance departments also regulate financial transactions between our insurance subsidiaries and their affiliated companies. Applicable regulations require approval of management fees, expense sharing contracts and similar transactions. American Hallmark General Agency, Inc. paid $5.6 million, $4.5 million and $1.9 million in management fees to Hallmark during 2009, 2008 and 2007, respectively. HIC paid $1.2 million in management fees to American Hallmark General Agency, Inc. during each of 2009, 2008 and 2007. AHIC paid $4.5 million and $3.3 million in management fees to American Hallmark General Agency, Inc. during 2009 and 2008, respectively. AHIC did not pay any management fees during 2007. HSIC paid $60,000 in management fees to TGA during each of 2009, 2008, and 2007.
On a consolidated basis, our cash and investments, excluding restricted cash and investments, at December 31, 2009 were $439.9 million compared to $352.7 million at December 31, 2008. Increases in market value of our investment portfolio for the period and cash from operating activities were the primary reasons for this increase.
Cash used by investing activities during the year ended December 31, 2009 was $2.0 million as compared to $126.1 million for the prior year. Contributing to the decrease in cash used in investing activities was a decrease of $594.3 million in purchases of debt and equity securities and a $7.6 million reduction in payments for acquisitions of subsidiaries, net of cash received, partially offset by (i) a $4.1 million reduction in the change in restricted cash, (ii) a $473.5 million reduction in maturities, sales and redemptions of investment securities and (iii) a $0.1 million increase in purchases of property and equipment. The change in payments for acquisitions of subsidiaries resulted from the combined impact of a net cash payment of $3.9 million, net of cash acquired, for the acquisition of a management agreement controlling HCM and a $3.3 million payment of contingent consideration to the sellers of the subsidiaries comprising our TGA Operating Unit in 2009, compared to a net cash payment of $14.8 million, net of cash acquired for the acquisition of our Heath XS Operating Unit in 2008.
Cash used in financing activities during the year ended December 31, 2009 was $6.6 million as compared to $9.7 million for the same period of 2008. The cash used during 2009 was primarily for repayment of bank debt and the repurchase of the Company’s common stock during the third quarter of 2009. The cash used during 2008 was primarily for the payment of consideration to the sellers of the subsidiaries comprising our TGA Operating Unit. As of December 31, 2009 we had fully repaid our obligation to the sellers.
(1) The payout pattern for unpaid losses and loss adjustment expenses is based upon historical payment patterns and does not represent actual contractual obligations. The timing and amount ultimately paid will likely vary from these estimates.
Based on 2010 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 next 12 months.