The Company's corporate headquarters and Commercial Lines Group 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, the Company negotiated its lease for a period of 97 months to expire June 30, 2011. The rent is currently $31,168 per month.
The Company's Personal Lines Group 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. The Company renegotiated its lease on May 5, 2003 for a period of 66 months to expire November 30, 2008. The rent is currently $50,075 per month.
Investments. The Company completes a detailed analysis each quarter to assess whether the 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 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.
Risks and uncertainties are inherent in the Company's other-than-temporary decline in value assessment methodology. Risks and uncertainties include, but are not limited to, incorrect or overly optimistic assumptions about financial condition or liquidity, incorrect or overly optimistic assumptions about future prospects, unfavorable changes in economic or social conditions and unfavorable changes in interest rates or credit ratings.
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. The Company routinely evaluates the realizability of deferred policy acquisition costs. At December 31, 2004 and 2003, there was no premium deficiency related to deferred policy acquisition costs.
A significant amount of judgment is required in performing goodwill impairment tests. Such tests include estimating the fair value of the Company's reporting units. As required by SFAS 142, the Company compares the estimated fair value of each reporting unit with its carrying amount, including goodwill. Under Statement No. 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.
Deferred Tax Assets. The Company files 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 the Company's deferred tax asset to the extent that management does 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, 2004 and 2003. 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 Phoenix acquisition.
Although considerable variability is inherent in such estimates, management believes 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, 2004 unpaid losses and LAE would produce a $196 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 the Company's actuaries as of December 31, 2004 was $13.0 million to $22.3 million. Management's best estimate of unpaid losses and LAE as of December 31, 2004 is $19.6 million. In setting this estimate of unpaid losses and LAE, management has 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, management has established a best estimate of unpaid losses and LAE, which is approximately $1.9 million higher than the midpoint of the actuarial range. The actuarial range is determined independently of management's best estimate and is only used to check the reasonableness of that estimate. It would be expected that management's best estimate would move within the actuarial range from year to year due to changes in the Company's operations and changes within the marketplace.
Ceding Commissions of the Personal Lines Group. Under Hallmark's reinsurance arrangements prior to October 1, 2004, the Company earned 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. The Company 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.
Treaty Effective Dates ---------------------------------------------- 7/1/01 - 7/1/02 - 7/1/03 - 7/1/04 - 6/30/02 6/30/03 6/30/04 6/30/05 ---------------------------------------------- Provisional loss ratio 60.0% 59.0% 59.0% 64.2% Ultimate loss ratio booked ---------------------------------------------- to at 12/31/04 57.5% 58.5% 59.0% 62.2% ----------------------------------------------
The Company's operating activities provided $7.3 million in net cash during 2004 as compared to $0.7 million in 2003. The Company collected $3.5 million more in ceding commissions in 2004 as a result of increased commission premium volume, paid $2.0 million less in loss and LAE, net of reinsurance, as a result of improved underwriting performance, and paid $1.4 million less in interest as a result of repaying a related party promissory note in 2003. These cash flow improvements were partially offset by a $0.4 million reduction in other income collected due to the sale of the Company's retail agencies in the first quarter of 2003.
Cash used in investing activities during 2004 was $4.0 million compared to cash provided by investing activities of $11.7 million in 2003. Premium finance notes repaid over notes originated decreased by $11.5 million in 2004 over 2003 due to the discontinuation of the premium finance program in 2003. During 2003, the Company received $6.9 million in cash from the acquisition of Phoenix. During 2004, the Company purchased $0.2 million more in investment securities than it redeemed whereas in 2003 the Company purchased $2.0 million more in investment securities that it redeemed. The Company also transferred $0.8 million less from cash and investments to restricted trust accounts in 2004 than in 2003. These restricted trust accounts are established to secure the credit exposure of OACM and State & County from their quota share reinsurance treaties with Hallmark.
Cash used in financing activities decreased by $9.4 million during 2004 as compared to 2003 primarily due to the discontinuation of the Company's premium finance program in 2003. The Company had net repayments to the premium finance lender of $10.9 million in 2003 which paid off all outstanding advances. Also contributing to the decrease in cash used in financing activities in 2004 was the repayment of an $8.6 million promissory note to a related party in 2003 from $10.0 million in proceeds from a rights offering the Company completed in the third quarter of 2003.
HFS is dependent on dividend payments and management fees from its insurance company operations and free cash flow of its non-insurance companies to meet operating expenses and debt obligations. As of December 31, 2004, cash and invested assets of HFS were $0.6 million. Cash and invested assets of non-insurance subsidiaries were $8.1 million as of December 31, 2004. 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 the Commissioner of Insurance, 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 2004, Hallmark's ordinary dividend capacity was $2.2 million. During 2004, Hallmark paid $0.2 million in dividends to HFS that were declared in 2003. Based on surplus at December 31, 2004, Hallmark could pay up to $1.5 million in dividends to HFS during 2005 without TDI approval. Phoenix, domiciled in Arizona, is limited in the payment of dividends to the lesser of 10% of prior year policyholder surplus or prior year's net investment income, without prior written approval from the AZDOI. During 2004, Phoenix's ordinary dividend capacity was $0.6 million. In order to strengthen policyholder surplus, Phoenix did not declare any dividends in 2004. The maximum dividend that Phoenix can pay HFS in 2005 without prior approval of the AZDOI is $0.8 million.
TDI regulates financial transactions between Hallmark, HFS and affiliated companies. Applicable regulations require TDI's approval of management and expense sharing contracts and similar transactions. Although TDI has approved Hallmark's payment of management fees to HFS and commissions to AHGA, since the second half of 2000 management has elected not to pay all the approved commissions or management fees. AHGA paid management fees of $0.6 million to HFS during 2004 and 2003.
The following is additional business segment information for the twelve months ended December 31, 2004 and 2003 (in thousands):
2004 2003 Revenues -------- -------- -------- Personal Lines Group $ 39,555 $ 49,665 Commercial Lines Group 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 the Personal Lines Group decreased $10.1 million, or 20.4%, to $39.6 million in 2004 compared to $49.7 million in 2003.
Total revenue for the Commercial Lines Group 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 the Commercial Lines Group for 2004 was $72.5 million compared to $62.9 million for 2003. The Company does not bear the primary underwriting risk for this business and, therefore, the resulting premiums and claims are not reflected in the Company's reported results.
Pre-tax income for the Commercial Lines Group 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.
Income before tax, cumulative effect of change in accounting principle and extraordinary gain was $0.7 million for 2003, compared to $36,000 in 2002. The improvement in operating earnings in 2003 reflected better underwriting results for Hallmark and the acquisition of the Commercial Lines Group in December 2002, partially offset by the acquisition of Phoenix. Net income for 2003 included $8.1 million of extraordinary gain resulting from the acquisition of Phoenix. In consideration for Phoenix, the Company cancelled $7.0 million of a $14.85 million note receivable from Millers American Group, Inc. ("Millers"). The Company had valued the note receivable on its balance sheet at its cost of $6.5 million. As of December 31, 2003, the Company fully reserved for the remaining balance of the note receivable. The gain was calculated as the difference between the fair value of the net assets of Phoenix of $14.6 million and the $6.5 million cost of the note receivable from Millers.
The following is additional business segment information for the twelve months ended December 31, 2003 and 2002 (in thousands):
2003 2002 Revenues -------- -------- -------- Personal Lines Group $ 49,665 $ 23,999 Commercial Lines Group 19,891 1,561 Corporate 3 237 -------- -------- Consolidated $ 69,559 $ 25,797 ======== ======== Pre-tax Income -------------- Personal Lines Group $ 1,950 $ 1,595 Commercial Lines Group 1,311 3 Corporate (2,575) (1,562) -------- -------- Consolidated $ 686 $ 36 ======== ========
Pre-tax income for the Commercial Lines Group of $1.3 million in 2003 was comprised of $19.9 million in revenue as discussed above and $18.6 million in other operating costs and expenses. These costs primarily represented expenses associated with the production and servicing of insurance policies for CNIC, the largest component of which was independent retail agent commissions.