Our corporate headquarters and Commercial Insurance Operation are located at 777 Main Street, Suite 1000, Fort Worth, Texas. The suite is located in a high-rise office building and contains approximately 27,808 square feet of space. Effective June 1, 2003, we renegotiated our lease for a period of 97 months to expire June 30, 2011. The rent is currently $32,327 per month.
For the year ended December 31, 2005, we reported net income of $9.2 million, representing a 57.1% increase over the $5.8 million reported for the prior year. On a diluted per share basis, net income was $0.13 for the year ended December 31, 2005, compared with net income of $0.14 per diluted share in 2004. The decrease in net income per diluted share was primarily attributable to an increase in the weighted average shares outstanding to 72.6 million diluted shares during 2005, compared to 42.8 million diluted shares during 2004, primarily as a result of a successful stockholder rights offering completed in the second quarter of 2005. In accordance with SFAS 128, we have restated the basic and diluted weighted average shares outstanding for 2004 and prior years for the effect of a bonus element from our stockholder rights offerings that were successfully completed in 2005 and 2003. According to SFAS 128, there is an assumed bonus element in a rights issue whose exercise price is less than the market value of the stock at the close of the rights offering period. This bonus element is treated as a stock dividend for reporting earnings per share.
The significant accounting policies requiring our 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, we believe the estimates and judgments associated with the reported consolidated financial statement amounts are appropriate in the circumstances. For additional discussion of our accounting policies, see Note 1 to the consolidated financial statements included in this report.
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. Unless other factors cause us to reach a contrary conclusion, investments with a fair market value significantly less than cost for more than 180 days are deemed to have a decline in value that is other-than-temporary. A decline in value that is considered to be other-than-temporary is charged to earnings based on the fair value of the security at the time of assessment, resulting in a new cost basis for the security.
Deferred Policy Acquisition Costs. Policy acquisition costs (mainly commission, underwriting and marketing expenses) that vary with and are primarily related to the production of new and renewal business are deferred and charged to operations over periods in which the related premiums are earned. Ceding commissions from reinsurers, which include expense allowances, are deferred and recognized over the period premiums are earned for the underlying policies reinsured.
The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. A premium deficiency exists if the sum of expected claim costs and claim adjustment expenses, unamortized acquisition costs, and maintenance costs exceeds related unearned premiums and expected investment income on those unearned premiums, as computed on a product line basis. We routinely evaluate the realizability of deferred policy acquisition costs. At December 31, 2005 and 2004, there was no premium deficiency related to deferred policy acquisition costs.
Goodwill. Our consolidated balance sheet as of December 31, 2005 includes goodwill of acquired businesses of approximately $4.8 million. This amount has been recorded as a result of prior business acquisitions accounted for under the purchase method of accounting. Under SFAS 142, which we adopted as of January 1, 2002, goodwill is tested for impairment annually. We completed our annual test for impairment during the fourth quarter of 2005 and determined that there was no indication of impairment.
Deferred Tax Assets. We file a consolidated federal income tax return. Deferred federal income taxes reflect the future tax consequences of differences between the tax bases 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. A valuation allowance is provided against our deferred tax asset to the extent that we do not believe it is more likely than not that future taxable income will be adequate to realize these future tax benefits. This valuation allowance was $884,000 at December 31, 2005 and 2004. This valuation allowance was necessary due to the limitation imposed by Section 382 of the Internal Revenue Code on utilizing the net operating loss acquired as part of the PIIC acquisition.
Although considerable variability is inherent in such estimates, we believe that the 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, 2005 unpaid losses and LAE would produce a $263 thousand change to pre-tax 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, 2005 was $17.8 million to $31.5 million. Our best estimate of unpaid losses and LAE as of December 31, 2005 is $26.3 million. Our carried reserve for unpaid losses and LAE as of December 31, 2005 is comprised of $14.5 million in case reserves and $11.8 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. In the absence of any specific factors indicating actual experience at either extreme of the actuarial range, we have established a best estimate of unpaid losses and LAE which is approximately $1.7 million higher than the midpoint of the actuarial range. It would be expected that management's best extimate would move within the actuarial range from year to year due to changes in our operations and changes within the marketplace.
The actuarial range is determined independently of management's best estimate and is only used to check the reasonableness of that estimate. There is no set method for determining ranges, and judgment enters into the process. The range was estimated primarily by measuring the variability of loss development patterns over time within each line of business. The results generated by multiple methods were also considered when determining the overall range. In light of the inherent uncertainty in the reserve estimates there can be no assurance that the actual losses ultimately experienced will fall within the actuarial range. However in light of the breath of the actuarial range, we believe that it is reasonably likely that actual losses will fall within such range.
Ceding Commissions of the Personal Insurance Operation. Under our reinsurance arrangements with Dorinco prior to October 1, 2004, we earn ceding commissions based on Dorinco's loss ratio (ultimate losses and loss expenses incurred to earned premium) experience on the portion of policies reinsured by Dorinco. We received a provisional commission as policies were produced as an advance against the later determination of the commission actually earned. The ceding commission is an estimate that varies with the estimated loss ratio and is sensitive to changes in that estimate. The provisional commission is adjusted periodically on a sliding scale based on expected loss ratios. The following table details the ceding commission sensitivity to the actual ultimate loss ratio for each effective quota share treaty with Dorinco at 0.5% above and below the provisional loss ratio.
Effect of actual 0.5% --------------------------------------------- above provisional ($201,899) ($306,424) ($346,720) ($167,653) Effect of actual 0.5% below --------------------------------------------- provisional $141,329 $202,240 $228,835 $167,653 ---------------------------------------------
On a consolidated basis, our cash and investments increased $94.6 million to $139.6 million as of December 31, 2005 as compared to $45.0 million at December 31, 2004. This 210% increase is mostly attributable to net proceeds of $44.9 million from a stockholder rights offering and $29.1 million from the issuance of trust preferred securities during 2005. These amounts exclude restricted cash and investments of $13.8 million and $6.5 million at December 31, 2005 and 2004, respectively, which secure the credit exposure of third parties arising from our various quota share reinsurance treaties and agency agreements.
Net cash provided by our consolidated operating activities was $29.5 million during 2005 compared to $7.3 million during 2004. The increase in operating cash flow primarily resulted from increased premiums collected of $32.9 million due largely to the assumption from Clarendon of business produced by HGA and the issuance of AHIC policies for business produced by HGA since July 1, 2005. Also contributing to the increase in collected premium is the 100% retention of the Texas non-standard auto premium produced by PGA. Prior to October 1, 2004, we retained only 45% of this business. Partially offsetting the increased operating cash flow is a $4.6 million increase in paid operating expenses due mostly to additional ceding commissions paid to Clarendon for the assumed premium, paid incentive compensation and paid retail agent profit sharing commissions. Also partially offsetting the increased operating cash flow is a $4.0 million increase in paid loss and loss adjustment expenses due mostly to the AHIC direct and assumed business produced by HGA during the last half of 2005 as well as the 100% retention of the Texas non-standard auto premium produced by PGA. Additional paid interest of $1.1 million from the trust preferred securities and $1.1 million in additional tax deposits also partially offset the increase in collected premium.
Cash provided by financing activities during 2005 was $75.1 million as compared to cash used in financing activities of $0.9 million during 2004. The cash provided in 2005 was from net proceeds of $44.9 million from the stockholder rights offering, $30.0 million from the issuance of trust preferred securities net of debt issuance costs and $0.2 million from the exercise of stock options. The cash used in 2004 was from $1.0 million repaid on a note payable that was partially offset by $48 thousand in proceeds from the exercise of stock options.
Property and casualty insurance companies domiciled in the State of Texas are limited in the payment of dividends to their shareholders in any twelve- month period, without the prior written consent of TDI, 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. During 2005, AHIC's ordinary dividend capacity was $1.5 million. PIIC, domiciled in Arizona, is limited in the payment of dividends to the lesser of 10% of prior year policyholder's surplus or prior year's net investment income, without prior written approval from AZDOI. During 2005, PIIC's ordinary dividend capacity was $0.8 million. Neither AHIC nor PIIC paid a dividend to Hallmark during 2005. The maximum dividend that AHIC can pay Hallmark in 2006 without prior approval from TDI is $6.4 million. The maximum dividend that PIIC can pay Hallmark in 2006 without prior approval from AZDOI is $1.6 million.
Credit facility. On June 29, 2005, we entered into a credit facility with The Frost National Bank. The credit agreement was amended on July 15, 2005, and was further amended and restated on January 27, 2006. The restated credit agreement provides for a $20.0 million revolving credit facility, with a $5.0 million letter of credit sub-facility. The borrowings under the revolving credit facility will accrue interest at an annual rate of three month LIBOR plus 2.00% and we will pay letter of credit fees at the rate of 1.00% per annum. Our obligations under the restated credit agreement are secured by a security interest in the capital stock of all of our subsidiaries, guaranties of all of our subsidiaries and the pledge of substantially all of our assets (subject to applicable insurance law and regulations). The restated credit agreement contains covenants which, among other things, require us to maintain certain financial and operating ratios and restrict certain distributions, transactions and organizational changes. As of December 31, 2005, there were no outstanding amounts due under our credit facility, and we were in compliance with or had obtained waivers of all of our covenants. In the third quarter of 2005, we issued a $4.0 million letter of credit under the sub-facility to collateralize certain obligations under the agency agreement between HGA and Clarendon effective July 1, 2004. In January, 2006, we borrowed $15.0 million under the revolving credit facility in connection with the TGA acquisition. (See, "Item 1. Business - Recent Events.")
Trust preferred securities. On June 21, 2005, our newly formed trust entity completed a private placement of $30.0 million of 30-year floating rate trust preferred securities. Simultaneously, we borrowed $30.9 million from the trust subsidiary and contributed $30.0 million to AHIC in order to increase policyholder surplus. The note bears 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. Under the terms of the note, we pay interest only each quarter and the principal of the note at maturity. As of December 31, 2005, the note balance was $30.9 million.
Other debt obligations. On January 3, 2006, we executed a promissory note payable to Newcastle in the amount of $12.5 million in order to obtain funding to complete the acquisition of Aerospace. The promissory note bears interest at 10% per annum prior to maturity and at the maximum rate allowed under applicable law upon default. Interest is payable on the first business day of each month. The principal of the promissory note, together with accrued but unpaid interest, is due on demand at any time after June 30, 2006.
On January 27, 2006, we issued $25.0 million in subordinated convertible promissory notes to the Opportunity Funds. Each convertible note bears interest at 4% per annum, which rate increases to 10% per annum in the event of default. Interest is payable quarterly in arrears commencing March 31, 2006. Principal and all accrued but unpaid interest is due at maturity on July 27, 2007. Subject to shareholder approval, the convertible notes are convertible by the holders into approximately 19.5 million shares of our common stock (subject to certain anti-dilution provisions), and will be automatically converted to such common stock at maturity.
Estimated Payments by Period -------------------------------------------------- Total 2006 2007-2008 2009-2010 After 2010 ------- ------- --------- --------- ---------- Notes payable $30,928 $ - $ - $ - $30,928 Interest on note payable 68,366 2,318 4,635 4,635 56,778 Unpaid losses and loss adjustment expenses 26,321 15,187 8,739 1,737 658 Operating leases 4,027 1,103 1,964 773 187
2005 2004 -------- -------- Revenues -------- Personal Insurance Operation $ 43,907 $ 39,555 Commercial Insurance Operation 43,067 23,563 Corporate 61 3 -------- -------- Consolidated $ 87,035 $ 63,121 ======== ========
Pre-tax Income -------------- Personal Insurance Operation $ 11,647 $ 8,109 Commercial Insurance Operation 6,651 3,028 Corporate (4,830) (2,535) -------- -------- Consolidated $ 13,468 $ 8,602 ======== ========
Revenue for our Personal Insurance Operation increased 11.0% to $43.9 million for 2005 from $39.6 million for 2004. Increased net premium earned of $5.0 million due to higher assumed premium volume was the primary cause of this increase. Also driving the increased revenue was a $0.9 million increase in investment income due to an increase in the investment portfolio from the completion of our capital plan. These increases were partially offset by a $1.2 million decrease in ceding commission income resulting from AHIC assuming 100% of the Texas non-standard automobile business effective October 1, 2004.
Pre-tax income for our Personal Insurance Operation increased $3.5 million, or 43.6%, for 2005 compared to 2004. Net investment income and realized gains and losses contributed $1.0 million to the increase in pre- tax income for 2005 over 2004. Improved underwriting results as evidenced by a loss ratio of 56.7% in 2005 as compared to 59.3% in 2004 contributed $1.0 million to the increase in pre-tax income in 2005. Taking into consideration the effect on ceding commissions, loss and LAE and premium production costs, the changes in premium volume produced and assumed contributed approximately $0.9 million to the increase in pre-tax income. Lower technical service costs from integrating PIIC's back office systems that were previously outsourced contributed $0.4 million and lower salary and related expenses contributed $0.3 million to the increase in pre-tax income.
Pre-tax Income -------------- Personal Insurance Operation $ 8,109 $ 1,950 Commercial Insurance Operation 3,028 1,311 Corporate (2,535) (2,575) -------- -------- Consolidated $ 8,602 $ 686 ======== ========
We do not believe that inflation has a material effect on our 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, we are exposed to the upward trend in the cost of judicial awards for damages. We attempt to mitigate the effects of inflation in the pricing of policies and establishing loss and LAE reserves.
The following consolidated financial statements of the Company and it subsidiaries are filed as part of this report.
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