Our Specialty Commercial operating unit is located at 13727 Noel Road, Dallas, Texas. These leased premises consist of 15,072 square feet of office space. The rent is currently $29,202 per month pursuant to a lease that expires November 30, 2022. Our Specialty Commercial operating unit also maintains branch offices in the following locations:
Our Specialty 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 23,941 square feet of space. The rent is currently $28,769 per month pursuant to a lease that expires December 31, 2020.
(1) Amounts have been adjusted for the adoption of ASU 2015-03 which requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts.
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 operating units and are supported by our insurance carrier subsidiaries.
· Specialty Commercial Segment. Our Specialty Commercial Segment includes the excess and surplus lines commercial property/casualty insurance products and services handled by our Contract Binding operating unit and the general aviation, satellite launch, commercial umbrella and primary/excess liability, medical and financial professional liability and primary/excess commercial property insurance products and services handled by our Specialty Commercial operating unit. Certain specialty programs are also managed by our Specialty Commercial operating unit. Our Contract Binding operating unit is comprised of our HSU, PAAC and TGASRI subsidiaries. Our Specialty Commercial operating unit is comprised of our Aerospace Insurance Managers, ASRI, ACMG, HXS and HDS 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 operating unit and the workers compensation insurance products handled by our Workers Compensation operating unit. Effective June 1, 2016, we ceased marketing new or renewal occupational accident policies. Effective July 1, 2015, the Workers Compensation operating unit ceased retaining any risk on new or renewal policies. Our Standard Commercial P&C operating unit is comprised of our American Hallmark Insurance Services and ECM subsidiaries. Our Workers Compensation operating unit is comprised of our TBIC Holdings, TBIC and TBICRM subsidiaries.
· Personal Segment. Our Personal Segment includes the non-standard personal automobile and renters insurance products and services handled by our Specialty Personal Lines operating unit. Our Specialty Personal Lines operating unit is comprised of our AHGA and HCS subsidiaries.
Where quoted prices are available on active exchanges for identical instruments, investment securities are classified within Level 1 of the valuation hierarchy. Level 1 investment securities include common stock, preferred stock and the equity warrant classified as Other Investments.
Goodwill. Goodwill is tested for impairment at the reporting unit level (operating unit or one level below an operating unit) on an annual basis (October 1) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. For purposes of evaluating goodwill for impairment, we have determined that our reporting units are the same as our operating units except for the Specialty Commercial operating unit for which reporting units are at the component level (“one level below”). Our consolidated balance sheet as of December 31, 2017 includes goodwill of acquired businesses of $44.7 million that is assigned to our operating units as follows: Standard Commercial P&C operating unit - $2.1 million; Contract Binding operating unit - $19.9 million; Specialty Commercial operating unit - $17.4 million (comprised of $7.7 million for the primary/excess and umbrella component and $9.7 million for the general aviation and satellite component); and Specialty Personal Lines operating unit - $5.3 million. This amount has been recorded as a result of prior business acquisitions accounted for under the acquisition method of accounting. Under ASC 350, “Intangibles - Goodwill and Other,” goodwill is tested for impairment annually. We completed our last annual test for impairment on the first day of the fourth quarter of 2017 and determined that there was no impairment.
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 rate environment across most of our lines of business that continued throughout 2017. 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 operating 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 (including factors such as prior year loss reserve development), expectations of future performance (including premium growth rates, premium rate increases and loss costs), 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.
The fair values of each of our operating units were in excess of their respective carrying values, including goodwill, as a result of our annual test for impairment during the fourth quarter 2017. However, an 8% decline in the fair value of our Standard Commercial P&C operating unit, a 5% decline in the fair value of our Contract Binding operating unit, a 6% decline in the fair value of our Specialty Personal Lines operating unit, a 69% decline in the fair value of our excess and umbrella component or a 23% decline in the fair value of our general aviation and satellite component would have caused the carrying value of the respective reporting 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 2017. We consider our market capitalization in assessing the reasonableness of the fair values estimated for our operating units in connection with our goodwill impairment testing. We believe 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, 2017. Through December 31, 2017, there were no indicators of impairment.
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, 2017 reserves for unpaid losses and LAE would have produced a $5.3 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.
Through December 31, 2005, our Standard Commercial P&C operating unit marketed policies on behalf of Clarendon National Insurance Company (“Clarendon”), a third-party insurer. Our Standard Commercial P&C operating unit earns a commission based on a percentage of the earned premium it produced for Clarendon. The commission percentage is determined by the underwriting results of the policies produced. Our Standard Commercial P&C operating unit presently markets all new and renewal policies exclusively for AHIC.
Management overview. During fiscal 2017, our total revenues were $385.5 million, which was $9.5 million more than the $376.0 million in total revenues for fiscal 2016. During the year ended December 31, 2017, we reported a net loss before tax of $16.6 million as compared to income before tax of $8.5 million during the same period of 2016.
This increase in revenue was primarily attributable to higher net earned premiums in our Specialty Commercial Segment, partially offset by lower net earned premiums in our Standard Commercial Segment and our Personal Segment during the year ended December 31, 2017 as compared to the same period during 2016. Net earned premiums for the year ended December 31, 2017 include the impact of $1.3 million of ceded reinstatement premium attributable to Hurricane Harvey. Further contributing to this increase in revenues was higher net investment income, higher commission and fee revenue and higher net realized gains recognized on our investment portfolio during the year ended December 31, 2017 as compared to the same period during 2016. These increases in revenue during the year ended December 31, 2017 were partially offset by lower finance charges, and higher other-than-temporary impairments of the investment portfolio.
The pre-tax loss reported for the year ended December 31, 2017 was due primarily to increased loss and LAE of $34.6 million, partially offset by the increased revenue discussed above. The increase in loss and LAE was primarily the result of unfavorable net prior year loss reserve development and higher current accident year loss trends in our Contract Binding operating unit. During the twelve months ended December 31, 2017, we recorded unfavorable prior year net loss reserve development of $40.1 million as compared to $7.6 million of unfavorable prior year net loss reserve development for the same period of 2016. The unfavorable prior year reserve development during the twelve months ended December 31, 2017 was primarily driven by the continued emergence of increased frequency and severity trends in our primary commercial auto lines of business within our Contract Binding operating unit, which was representative of industry trends. These trends had an amplified impact on our consolidated result because this is the largest line of retained business in our portfolio. We incurred an aggregate of $7.8 million of net catastrophe losses during the year ended December 31, 2017 as compared to $11.0 million for the same period the prior year. Operating expenses during the year ended December 31, 2017 were unchanged from the same period during 2016 mostly as a result of a $1.8 million payment to settle the earn-out related to the previous acquisition of TBIC during the second quarter of 2016 and lower production related expenses due primarily to increased ceding commissions in our Specialty Commercial Segment, partially offset by increased salary and related expenses and other operating expenses driven by our investment in technology for the year ended December 31, 2017 as compared to the same periods during 2016.
Our Contract Binding operating unit reported a $35.9 million increase in loss and LAE due primarily to $38.6 million of unfavorable prior year net loss reserve development recognized during the year ended December 31, 2017 as compared to $11.3 million of unfavorable prior year net loss reserve development recognized for the same period the prior year, as well as higher current accident year loss trends. Our Specialty Commercial operating unit reported a $8.0 million increase in loss and LAE which consisted of (a) a $4.5 million increase in losses and LAE in our commercial umbrella and primary/excess liability line of business, (b) a $2.1 million increase in losses and LAE attributable to our primary/excess property insurance products due primarily to increased premium production and higher net catastrophe losses, (c) a $2.2 million increase in our general aviation line of business, (d) a $0.1 million increase in losses and LAE in our satellite launch insurance line of business, partially offset by (e) a $0.8 million decrease in losses and LAE attributable to our professional liability insurance products and (f) a $0.1 million decrease in losses and LAE in our specialty programs. The $0.5 million increase in operating expense was primarily the result of higher salary and related expenses of $3.3 million, higher occupancy and other operating expenses of $0.7 million and higher travel related expenses of $0.2 million, partially offset by lower production related expenses of $3.7 million due primarily to increased ceding commissions in our Specialty Commercial operating unit.
The net loss ratio for the year ended December 31, 2017 was 68.3% as compared to the 61.0% reported for the year ended December 31, 2016. The gross loss ratio before reinsurance was 63.3% for the year ended December 31, 2017 as compared to 59.6% for the prior year. Our Standard Commercial Segment’s net loss ratio included 4.9 additional loss ratio points attributable to the discontinued workers compensation and occupational accident business for the year ended December 31, 2017 as compared to 1.7 fewer loss ratio points for the same period the prior year. During the year ended December 31, 2017 the Standard Commercial Segment reported favorable prior year net loss reserve development of $1.0 million as compared to favorable prior year net loss reserve development of $9.9 million for the same period of 2016. During 2017, our Standard Commercial P&C operating unit experienced net favorable development primarily in the general liability line of business in the 2016 and prior accident years, partially offset by net unfavorable development in the 2016 and prior accident years in the occupational accident line of business. The Standard Commercial Segment reported $3.6 million of net catastrophe losses during the year ended December 31, 2017, of which $1.7 million was attributable to Hurricane Harvey, as compared to $8.4 million of net catastrophe losses during the same period of 2016. The Standard Commercial Segment reported a net expense ratio of 34.5% for the year ended December 31, 2017 as compared to 33.0% for the same period of 2016. The increase in the expense ratio is primarily due to increased salary and related expense of $0.9 million and increased other general expenses of $0.6 million primarily due to investments in technology, as well as the decreased earned premium.
Gross premiums written for the Specialty Commercial Segment were $388.9 million for the year ended December 31, 2016, which was $37.9 million, or 11%, more than the $351.0 million reported for the same period in 2015. Net premiums written were $249.1 million for the year ended December 31, 2016 as compared to $241.8 million reported for the same period in 2015. The increase in gross and net premiums written was due to increased premium production in both our Contract Binding and our Specialty Commercial operating units.
The $255.9 million of total revenue for the year ended December 31, 2016 was $6.0 million higher than the $249.9 million reported for 2015. This 2% increase in revenue was due to higher net premiums earned of $4.3 million due predominately to increased production discussed above. Further contributing to this increased revenue was higher net investment income of $1.4 million, higher commission and fees of $0.3 million and higher other income of $0.1 million, partially offset by lower finance charges of $0.1 million.
Pre-tax income for the Specialty Commercial Segment of $24.4 million for the year ended December 31, 2016 was $15.9 million lower than the $40.3 million reported for the same period in 2015. This decrease in pre-tax income was primarily due to higher loss and LAE expenses of $20.5 million and higher operating expense of $1.4 million, partially offset by the increased revenue discussed above.
Our Contract Binding operating unit reported a $16.5 million increase in loss and LAE due primarily to $11.3 million of unfavorable prior year net loss reserve development recognized during the year ended December 31, 2016 as compared to $1.2 million of unfavorable prior year net loss reserve development recognized for the same period the prior year, as well as higher current accident year loss trends. Our Specialty Commercial operating unit reported a $2.1 million increase in loss and LAE which consisted of (a) a $1.6 million increase in loss and LAE attributable to our medical professional liability insurance products, (b) a $0.8 million increase in loss and LAE in our commercial umbrella and primary/excess liability line of business, (c) a $0.8 million increase in loss and LAE attributable to our primary/excess property insurance products, partially offset by (d) a $1.1 million decrease in loss and LAE attributable to our satellite launch insurance line of business due primarily to favorable current accident year loss trend. Our specialty programs reported a $1.9 million increase in loss and LAE due primarily to $0.7 million of unfavorable prior year net loss reserve development recognized during the year ended December 31, 2016 as compared to $1.4 million of favorable prior year net loss reserve development recognized for the same period the prior year. The increase of $1.4 million in operating expense was the combined result of increased salary and related expenses of $3.8 million, higher travel related expenses of $0.2 million, higher occupancy and other expenses of $0.9 million and higher professional service fee expenses of $0.1 million, partially offset by lower production related expenses of $3.6 million due primarily to increased ceding commissions in our Specialty Commercial operating unit.
Gross premiums written for the Standard Commercial Segment were $76.9 million for the year ended December 31, 2016, which was $5.0 million, or 6%, less than the $81.9 million reported for the same period in 2015. Net premiums written were $68.5 million for the year ended December 31, 2016 as compared to $71.1 million reported for the same period in 2015. The decrease in premium volume was primarily due to lower premium production in our Workers Compensation operating unit due to the renewal rights agreement entered into during the second quarter of 2015 and subsequently amended during the third quarter of 2015 to cede substantially all of the unearned premium effective July 1, 2015.
Total revenue for Corporate decreased by $1.8 million for the year ended December 31, 2016 as compared to the same period the prior year. This decrease in total revenue was due to lower net realized gains recognized on our investment portfolio of $3.3 million for the year ended December 31, 2016 as compared to the same period of 2015, partially offset by higher net investment income of $1.1 million and lower other-than-temporary impairments of $0.4 million.
Our sources of funds are from insurance-related operations, financing activities and investing activities. Major sources of funds from operations include premiums collected (net of policy cancellations and premiums ceded), commissions and processing and service fees. As a holding company, Hallmark is dependent on dividend payments and management fees from its subsidiaries to meet operating expenses and debt obligations. As of December 31, 2017, we had $11.8 million in unrestricted cash and cash equivalents, as well as $0.1 million in debt securities, at the holding company and our non-insurance subsidiaries. As of that date, our insurance subsidiaries held $53.2 million of unrestricted cash and cash equivalents as well as $605.6 million in debt securities with an average modified duration of 1.6 years. Accordingly, we do not anticipate selling long-term debt instruments to meet any liquidity needs.
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, 2017, our insurance company subsidiaries reported statutory capital and surplus of $233.3 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, 2017, 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, 2017 and 2016 was 157% and 146%, respectively.
On a consolidated basis, our cash and investments, excluding restricted cash and investments, at December 31, 2017 were $726.3 million compared to $733.8 million at December 31, 2016. The primary reasons for the decrease in unrestricted cash and investments were settlement of prior year investment trades, capital expenditures and repurchases of common stock, partially offset by cash flow from operations.
Comparison of Years Ended December 31, 2017 and December 31, 2016
Net cash provided by our consolidated operating activities was $7.2 million for the year ended December 31, 2017 compared to $30.9 million for the year ended December 31, 2016. The decrease in operating cash flow was primarily due to increased paid losses including timing of reinsurance claim settlements, lower collected net premiums and lower finance charges collected, partially offset by lower taxes paid, lower net paid operating expenses and higher collected net investment income.
Cash used in financing activities during the year ended December 31, 2017 was $5.1 million as a result of $5.3 million related to the repurchase of our common stock, partially offset by $0.2 million related to proceeds from the exercise of employee stock options. Cash used in financing activities during the year ended December 31, 2016 was $7.4 million as a result of $6.1 million related to the repurchase of our common stock and $1.8 million payment of the settlement of contingent consideration to the sellers of TBIC, partially offset by $0.5 million related to proceeds from the exercise of employee stock options.
Our Second Restated Credit Agreement with Frost Bank (“Frost”) dated June 30, 2015, reinstated the credit facility with Frost which expired by its terms on April 30, 2015. The Second Restated Credit Agreement also amended certain provisions of the credit facility and restated the agreement with Frost in its entirety. The Second Restated Credit Agreement provides a $15.0 million revolving credit facility (“Facility A”), with a $5.0 million letter of credit sub-facility, which expires on June 30, 2018. The outstanding balance of the Facility A bears interest at a rate equal to the prime rate or LIBOR plus 2.5%, at our election. We pay an annual fee of 0.25% of the average daily unused balance of Facility A and letter of credit fees at the rate of 1.00% per annum. All principal and accrued interest on Facility A becomes due and payable on June 30, 2018. As of December 31, 2017, we had no outstanding borrowings under Facility A.
On December 17, 2015, we entered into a First Amendment to Second Restated Credit Agreement and a Revolving Facility B Agreement (the “Facility B Agreement”) with Frost to provide a new $30.0 million revolving credit facility (“Facility B”), in addition to Facility A. On November 1, 2016, we amended the Facility B Agreement with Frost to extend by one year the termination date for draws under Facility B and the maturity date for amounts outstanding thereunder. We paid Frost a commitment fee of $75,000 when Facility B was established and an additional $30,000 fee when Facility B was extended. On December 20, 2017, we entered into a Second Amendment to Second Restated Credit Agreement and a Second Amendment to Revolving Facility B Agreement with Frost. The Second Amendment to Second Restated Credit Agreement revised certain definitions in the Second Restated Credit Agreement. The Second Amendment to Revolving Facility B Agreement amended the Revolving Facility B Agreement to further extend by one year the termination date for draws thereunder and the maturity date for amounts outstanding thereunder. During the fourth quarter of 2017 we accrued a $30,000 fee payable to Frost when Facility B was extended.
The obligations under both Facility A and Facility B are secured by a security interest in the capital stock of AHIC and HIC. Both Facility A and Facility B contain covenants that, among other things, require us to maintain certain financial and operating ratios and restrict certain distributions, transactions and organizational changes. We are in compliance with or have obtained a waiver of all of these covenants.
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. The initial interest rate on our Trust I subordinated debt securities was 7.725% until June 15, 2015, after which interest adjusts 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 uncollaterized and do not require maintenance of minimum financial covenants. As of December 31, 2017, the principal balance of our Trust I subordinated debt was $30.9 million and the interest rate was 4.84% per annum.
On August 23, 2007, we entered into a trust preferred securities transaction pursuant to which we issued $25.8 million aggregate principal amount of subordinated debt securities due in 2037. To effect the transaction, we formed Hallmark Statutory Trust II (“Trust II”) as a Delaware statutory trust. Trust II issued $25.0 million of preferred securities to investors and $0.8 million of common securities to us. Trust II used the proceeds from these issuances to purchase the subordinated debt securities. Our Trust II subordinated debt securities bore an initial interest rate of 8.28% until September 15, 2017, after which interest adjusts quarterly to the three-month LIBOR rate plus 2.90 percentage points. Trust II pays dividends on its preferred securities at the same rate. Under the terms of our Trust II 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, 2017, the principal balance of our Trust II subordinated debt was $25.8 million and the interest rate was 4.49% per annum.
(1) The subordinated debt securities excludes unamortized debt issuance costs of $0.9 million.
(3) Minimum payments have not been reduced by minimum sublease rentals of $35 thousand due in the future under non-cancelable subleases.