Our corporate headquarters and Standard Commercial business unit are located at 777 Main Street, Suite 1000, Fort Worth, Texas. The suite is located in a high-rise office building and contains 27,808 square feet of space. On February 28, 2011, an amendment to the office lease agreement was executed which extends the term of the lease for an additional period of 132 months commencing on July 1, 2011. After a twelve month rent abatement period, the initial rent will be $46,347 per month.
Our E&S Commercial business unit is presently located at 7550 IH-10 West, San Antonio, Texas. These leased premises consist of a 16,599 square foot office suite and 800 square feet of storage space. The rent is currently $30,488 per month pursuant to a lease that expires November 30, 2020. Our E&S Commercial business unit also maintains a small office in Chicago Illinois, the fixed rent on which is currently $7,867 per month under a lease that expires April 30, 2017.
· Standard Commercial Segment. The Standard Commercial Segment includes the standard lines commercial property/casualty insurance products and services handled by our Standard Commercial business unit and the workers compensation insurance products handled by our Workers Comp business unit. Our Standard Commercial business unit is comprised of our American Hallmark Insurance Services and ECM subsidiaries. Our Workers Comp business unit is comprised of our TBIC Holdings, TBIC and TBICRM subsidiaries. The Workers Comp business unit was acquired July 1, 2011.
· Personal Segment. The Personal Segment includes the non-standard personal automobile, low value dwelling/homeowners, renters, manufactured homes, motorcycle and business auto insurance products and services handled by our Personal Lines business unit, that is comprised of American Hallmark General Agency, Inc. and Hallmark Claims Services, Inc., both of which do business as Hallmark Insurance Company.
· Hallmark Specialty Insurance Company presently retains a portion of the risks on the commercial property/casualty and medical professional liability policies marketed within the Specialty Commercial Segment.
· Hallmark National Insurance Company was acquired on December 31, 2010. Commencing January 1, 2011, HNIC retains a portion of the risks on the personal policies marketed within the Personal Segment.
· Hallmark County Mutual Insurance Company control and management is maintained through our wholly owned subsidiary CYR Insurance Management Company (“CYR”). CYR has as its primary asset a management agreement with HCM, which provides for CYR to have management and control of HCM. HCM is used to front certain lines of business in our Specialty Commercial and Personal Segments in Texas. HCM does not retain any business.
· Texas Builders Insurance Company was acquired July 1, 2011 and retains a portion of the risks on the workers compensation policies marketed within our Standard Commercial Segment.
Debt Investments: We assess whether we intend to sell, or it is more likely than not that we will be required to sell, a fixed maturity investment before recovery of its amortized cost basis less any current period credit losses. For fixed maturity investments that are considered other-than-temporarily impaired and that we do not intend to sell and will not be required to sell, we separate the amount of the impairment into the amount that is credit related (credit loss component) and the amount due to all other factors. The credit loss component is recognized in earnings and is the difference between the investment’s amortized cost basis and the present value of its expected future cash flows. The remaining difference between the investment’s fair value and the present value of future expected cash flows is recognized in other comprehensive income.
Level 2 investment securities include corporate bonds, collateralized corporate bank loans, municipal bonds, U.S. Treasury securities, other obligations of the U.S. Government and mortgage-backed securities for which quoted prices are not available on active exchanges for identical instruments. We use a third party pricing service to determine fair values for each Level 2 investment security in all asset classes. Since quoted prices in active markets for identical assets are not available, these prices are determined using observable market information such as quotes from less active markets and/or quoted prices of securities with similar characteristics, among other things. We have reviewed the processes used by the pricing service and have determined that they result in fair values consistent with the requirements of ASC 820 for Level 2 investment securities.
Goodwill. Our consolidated balance sheet as of December 31, 2011 includes goodwill of acquired businesses of $44.7 million that is assigned to our business units as follows: Standard Commercial business unit - $2.1 million; E&S Commercial business unit - $19.9 million; General Aviation business unit - $9.7 million; Personal Lines business unit - $5.3 million; and Excess & Umbrella business 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 ASC 350, “Intangibles- Goodwill and Other,” goodwill is tested for impairment annually. We completed our last annual test for impairment during the fourth quarter of 2011 and determined that there was no impairment.
The fair values of each of our business 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 2011. However, a 5% decline in the fair value of our Standard Commercial business unit, a 5% decline in the fair value of our E&S Commercial business unit, a 7% decline in the fair value of our Personal Lines business unit, a 2% decline in the fair value of our General Aviation business unit, or a 17% decline in the fair value of our Excess & Umbrella business unit would have caused the carrying value of the respective business unit to be in excess of its fair value, resulting in the need to perform the second step of impairment testing prescribed by ASC 350, which could have resulted in an impairment to our goodwill.
The market capitalization of Hallmark’s common stock has been below book value during 2011. We consider our market capitalization in assessing the reasonableness of the fair values estimated for our business units in connection with our goodwill impairment testing. We believe the current market displacement caused by global financial market conditions, including the European sovereign credit crisis, as well as the limited daily trading volume of Hallmark shares has resulted in a decrease in our market capitalization that is not representative of a long-term decrease in value. The valuation analysis discussed above supports our view that goodwill was not impaired at October 1, 2011. Through December 31, 2011, there were no indicators of impairment.
The following table details the profit sharing commission revenue sensitivity of the Standard Commercial 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).
The increase in revenue for the year ended December 31, 2011 was offset by increased loss and LAE due primarily to higher current accident year loss estimates, as well as unfavorable prior year loss development of $16.4 million for the year ended December 31, 2011 as compared to $9.2 million of unfavorable prior year development for the year ended December 31, 2010. 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 Lines Segment in Florida. In addition, the results for the year ended December 31, 2011 include $10.3 million in current accident year net losses from weather related claims. The adverse prior year development and the losses from the weather related claims contributed 9.1% to the 81.6% consolidated net loss ratio for the year ended December 31, 2011. As a result of the pre-tax loss and an increase in the proportion of tax-exempt income relative to total pre-tax loss, the Company reported an income tax benefit of $8.9 million, or an effective income tax rate of 45.3%, for the year ended December 31, 2011, as compared to income tax expense of $0.8 million, or an effective rate of 10.0%, for the same period during 2010.
The net loss ratio for the year ended December 31, 2011 was 78.9% as compared to the 78.5% reported for the same period of 2010. The gross loss ratio before reinsurance was 77.4% for the year ended December 31, 2011 as compared to 82.6% for the same period the prior year. The lower gross loss ratio for the year ended December 31, 2011 was primarily the result of favorable prior year development of $0.8 million as compared to $4.6 million of unfavorable development for the same period during the prior year, partially offset by higher current accident year claim activity due in large part to weather related losses of $7.7 million. The Standard Commercial Segment reported net expense ratios of 31.2% and 30.7% for the years ended December 31, 2011 and 2010, respectively.
Specialty Commercial Segment. The $142.8 million of total revenue for the year ended December 31, 2011 was $11.7 million higher than the $131.1 million reported for 2010. This 9% increase in revenue was due to higher net premiums earned of $11.4 million due predominately to increased production in our E&S Commercial business unit and a new space risk Specialty Program entered into during the first quarter of 2011 in which we can retain up to $2.0 million per risk for satellite launches. Further contributing to this increased revenue was higher net investment income of $0.3 million and a lower adverse profit sharing commission adjustment of $0.8 million for the year ended December 31, 2011 as compared to an adverse $1.0 million profit share commission adjustment for the same period the prior year, partially offset by lower finance charges of $0.2 million.
Pre-tax income for the Specialty Commercial Segment of $14.4 million was $1.1 million higher than the $13.3 million reported in 2010. The increase in pre-tax income was primarily due to increased revenue discussed above and lower amortization of intangible assets of $0.5 million and lower non-controlling interest of $0.1 million. The increase in pre-tax income was offset by higher loss and LAE expenses of $8.4 million and higher operating expenses of $2.8 million. The increase in operating expense was the combined result of (i) increased production related expenses of $1.9 million , (ii) higher salary and related expenses of $0.6 million, and (iii) increased other operating expenses of $0.3 million, primarily comprised of professional services.
The Specialty Commercial Segment reported a net loss ratio of 64.4% for 2011 as compared to 63.6% for 2010. The gross loss ratio before reinsurance was 63.1% for the year ended December 31, 2011 as compared to 61.9% for the same period the prior year. The higher gross and net loss ratio was impacted by higher current accident year loss trends predominately in our commercial auto and general liability lines of business. The gross loss results for the year ended December 31, 2011 included $2.4 million of favorable prior year development as compared to $1.5 million of unfavorable prior year development for the same period of 2010. The Specialty Commercial Segment reported a net expense ratio of 29.8% for 2011 as compared to 29.7% for 2010.
The Personal Segment reported a net loss ratio of 108.7% for the year ended December 31, 2011 as compared to 81.4% for the same period of 2010. The increase in the net loss ratio was primarily due to higher current accident year loss trends and claims developing much worse than anticipated due to rapid growth in the Florida claim volume and the complexity related to Florida personal injury protection claims. The net loss ratio for our Florida related business was 282.5% for the year ended December 31, 2011, which equates to approximately 20.6% of the net loss ratio reported as of December 31, 2011. During late 2010 and into 2011, a number of actions have been taken to address the issues in Florida. We have increased prices, changed policy renewal terms, suspended new business production, significantly increased our personal lines claims department capabilities and made other increases in our claims staffing, including hiring experienced claims personnel in Florida. Also contributing to the increase in the net loss ratio were higher current accident year loss trends in our legacy and expansion states, outside of Florida. We have implemented rate increases and changed policy down payment requirements in the underperforming states. We are also exiting certain underperforming states and closing unprofitable programs and products in order to focus on states and products where we can achieve desired returns. We expect that these actions will in time adjust our book of business back to profitable levels. The loss and LAE during the year ended December 31, 2011 includes $19.7 million of adverse prior year development as compared to $3.1 million of adverse prior year development for the same period during 2010. The Personal Segment reported a net expense ratio of 26.2% for the year ended December 31, 2011 as compared to 22.4% for the prior year. The increase in the expense ratio is due predominately to increased production expenses related to the renewal and appointment of agents from our recent acquisition of HNIC, increased salary and related expense and increased professional service fees.
Corporate pre-tax loss was $5.9 million for the year ended December 31, 2011 as compared to a $2.1 million pre-tax loss for the same period the prior year. The increase in pre-tax loss was the result of the decreased revenue discussed above, higher salary and other related expenses of $0.6 million due primarily to recent hires, higher professional fees of $0.2 million and higher occupancy and related expenses of $0.1 million, partially offset by a $0.9 million adjustment to the expected earn-out payable in conjunction with the acquisition of HNIC.
We reported net income attributable to Hallmark of $7.3 million for the year ended December 31, 2010, compared to $24.6 million for the year ended December 31, 2009. On a diluted per share basis, net income attributable to Hallmark was $0.36 for fiscal 2010 as compared to $1.19 for fiscal 2009. The decrease in net income for the year ended December 31, 2010 was primarily due to increased current accident year loss and LAE mostly caused by increased volatility of large losses, greater than anticipated Personal Segment expansion into Florida and weather related losses. Unfavorable prior year loss development of $9.2 million for the year ended December 31, 2010 as compared to $1.6 million for the same period during 2009 also contributed to the decrease in net income. Partially offsetting the increased loss and LAE was the increase in revenue discussed above, as well as lower operating expenses due to lower production related expenses in our Standard Commercial Segment and Specialty Commercial Segment and lower general and administrative costs in our Standard Commercial Segment. Our effective income tax rate for the year ended December 31, 2010 was 10.0% as compared to the 25.9% effective income tax rate for the same period during 2009. The decrease in the effective tax rate was primarily due to an increase in the proportion of tax exempt income relative to total pre-tax income and the recognition of tax benefits related to the disposal of certain securities.
Our Standard Commercial Segment reported pre-tax loss of $2.3 million for the year ended December 31, 2010 as compared to pre-tax income of $9.3 million for the same period of 2009. Higher loss and LAE of $7.1 million, primarily as a result of increased volatility of large property losses, weather related losses and unfavorable prior year development, and decreased revenue were the primary drivers of the pre-tax loss for the year ended December 31, 2010. Partially offsetting the decline in pre-tax results were lower operating expenses of $2.3 million driven by lower general and administrative costs due to benefits gained from cost saving measures and lower production related expenses.
Specialty Commercial Segment. The $131.1 million of total revenue for the year ended December 31, 2010 was $0.4 million lower than the $131.5 million reported for 2009. This decrease in revenue was primarily comprised of lower commission and fee income of $13.1 million primarily related to the shift from a third party agency structure to an insurance underwriting structure. Decreased finance charges of $0.3 million further contributed to this decrease in revenue. This decrease in revenue was partially offset by increased net premiums earned of $11.8 million as a result of the increased retention of business in our E&S Commercial business unit and increased earned premium in our Excess & Umbrella business unit. Net investment income also increased $1.2 million.
Personal Segment. Net premium written for our Personal Segment increased $23.4 million during the year ended December 31, 2010 to $95.1 million compared to $71.7 million in the year ended December 31, 2009. The increase in premium was due mostly to continued geographic expansion.
Our Personal Segment reported pre-tax loss of $0.7 million for the year ended December 31, 2010 as compared to pre-tax income of $11.0 million for the same period of 2009. The increased revenue, as discussed above, was offset by increased losses and LAE of $28.4 million and increased operating expenses of $6.2 million due mostly to production related expenses attributable to the increased earned premium.
AHIC and TBIC, domiciled in Texas, are limited in the payment of dividends to their stockholders in any 12-month period, without the prior written consent of the Texas Department 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. HIC, domiciled in Arizona, is limited in the payment of dividends to the lesser of 10% of prior year policyholders’ surplus or prior year's net investment income, without prior written approval from the Arizona Department of Insurance. HSIC, domiciled in Oklahoma, is limited in the payment of dividends to the greater of 10% of prior year policyholders’ surplus or prior year’s statutory net income, not including realized capital gains, without prior written approval from the Oklahoma Insurance Department. HNIC, domiciled in Ohio, is limited in the payment of dividends to the greater of 10% of statutory policyholders’ surplus as of the prior December 31 or statutory net income as of the prior December 31 without prior written approval from the Ohio Insurance Department. During 2012, the aggregate ordinary dividend capacity of these subsidiaries is $20.3 million, of which $15.0 million is available to Hallmark. As a county mutual, dividends from HCM are payable to policyholders. None of our insurance company subsidiaries paid a dividend during the years ended December 31, 2011 or 2010.
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, 2011, our insurance company subsidiaries reported statutory capital and surplus of $172.6 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, 2011, 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, 2011 and 2010 was 176% and 154%, respectively.
Comparison of Years Ended December 31, 2011 and December 31, 2010
Cash used by investing activities during the year ended December 31, 2011 was $3.8 million as compared to $88.0 million for the prior year. The decrease in cash used in investing activities was primarily attributable to a $146.1 million increase in maturities, sales and redemptions of investment securities and a $0.2 million decrease in purchases of property and equipment, partially offset by an increase of $39.5 million in purchases of debt and equity securities and a $1.9 million decrease in cash flow from restricted cash accounts. Further offsetting the decrease in cash used by investing activities was a $20.7 million increase in payments for acquisition of subsidiaries, net of cash received, which included consideration of $14.0 million settled in January 2011 for the December 2010 acquisition of HNIC which resulted in a $7.4 net cash inflow in 2010.
Cash used in financing activities during the year ended December 31, 2011 was $6.9 million of which $6.4 million related to the repurchase of the Company’s common stock during 2011. In addition the Company borrowed $1.3 million under its revolving credit agreement and paid off $1.7 million in notes payable as part of the acquisition of TBIC Holdings.
Our First Restated Credit Agreement with The Frost National Bank dated January 27, 2006 was most recently amended effective March 21, 2011 to increase the revolving commitment to $15.0 million from $5.0 million. This amendment further revised various affirmative and negative covenants. We pay interest on the outstanding balance at our election at a rate of the prime rate or LIBOR plus 2.5%. We pay an annual fee of 0.25% of the average daily unused balance of the credit facility. We pay letter of credit fees at the rate of 1.00% per annum. Our obligations under the revolving credit facility are secured by a security interest in the capital stock of all of our subsidiaries, guarantees of all of our subsidiaries and the pledge of all of our non-insurance company assets. The revolving credit facility contains covenants that, among other things, require us to maintain certain financial and operating ratios and restrict certain distributions, transactions and organizational changes. As of December 31, 2011, we were in compliance with or had obtained waivers of all of our covenants. As of December 31, 2011, we had $4.1 million outstanding under this facility.
Set forth below is a summary of long-term contractual obligations as of December 31, 2011. Amounts represent estimates of gross undiscounted amounts payable over time. In addition, certain unpaid losses and LAE are ceded to others under reinsurance contracts and are, therefore, recoverable. Such potential recoverables are not reflected in the table.
(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 2012 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.
The following consolidated financial statements of the Company and its subsidiaries are filed as part of this report.