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 $30,525 per month pursuant to a lease that expires December 31, 2020.
We have entered into a lease for new office space in a high-rise office building commonly known as Two Lincoln Centre located at 5420 LBJ Freeway, Dallas, Texas. We intend to relocate our corporate headquarters, our Standard Commercial P&C and our Specialty Commercial operating units. The leased premises consist of 47,172 square feet of office space (“Suite 1100”) and approximately 3,000 square feet of storage space (“Suite 380”). The initial term of the lease commences June 1, 2019 and expires May 31, 2032, and we have the right to renew the lease for up to ten years at market rental rates prevailing at the time of renewal. The initial base rent for Suite 1100 of $121,861 per month is waived for the first 12 months of the lease and the initial base rent for Suite 380 of $4,250 per month is waived for the first 48 months of the lease. We estimate that additional rent based on a share of certain expenses of the building will initially be approximately $5,000 per month.
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.
Prior to the adoption of ASU 2016-01, 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 was determined that an equity investment was other-than-temporarily impaired, the security was written down to fair value, and the amount of the impairment was included in earnings as a realized investment loss. The fair value then became the new cost basis of the investment, and any subsequent recoveries in fair value were recognized at disposition. We recognized a realized loss when impairment was deemed to be other-than-temporary even if a decision to sell an equity investment had not been made. If we decided to sell a temporarily impaired available-for-sale equity investment and we did not expect the fair value of the equity investment to fully recover prior to the expected time of sale, the investment was deemed to be other-than-temporarily impaired in the period in which the decision to sell was made.
Level 2: inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, inputs of identical assets for less active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the instrument; and
Under ASC 820, we determine fair value based on the price that would be received for an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date. It is our policy to maximize the use of observable inputs and minimize the use of unobservable inputs when developing fair value measurements, in accordance with the fair value hierarchy described above. Fair value measurements for assets and liabilities where there exists limited or no observable market data are calculated based upon our pricing policy, the economic and competitive environment, the characteristics of the asset or liability and other factors as appropriate. These estimated fair values may not be realized upon actual sale or immediate settlement of the asset or liability.
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, 2018 and 2017, there was no premium deficiency related to deferred policy acquisition costs.
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 2018 and determined that there was no impairment.
The market capitalization of Hallmark’s common stock has been below book value during 2018. 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, 2018. Through December 31, 2018, there were no indicators of impairment.
While we believe the estimates and assumptions used in determining the fair value of our operating units were reasonable, actual results could vary materially. If our actual results are not consistent with our estimates and assumptions used to calculate fair value, we may be required to perform the second step of impairment testing prescribed by ASC 350 in future periods and impairment of goodwill could result. We cannot predict future events that might impact the fair value of our
Reserves for unpaid losses and LAE. Reserves for unpaid losses and LAE are established for claims that 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 Note 6 to the audited consolidated financial statements included in this report.)
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, 2018 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.
This decrease in revenue was largely due to investment losses of $10.2 million during the year ended December 31, 2018 as compared to investment losses of $0.2 million during the same period of 2017, as well as lower net investment income and lower other income, partially offset by higher net earned premiums, higher commissions and fees and higher finance charges. The investment losses for the year ended December 31, 2018 included $9.3 million in loss attributable to the adoption effective January 1, 2018 of Accounting Standards Update No. 2016-01, “Recognition and Measurement of Financial Assets and Financial Liabilities” (“ASU 2016-01”) which requires equity investments that are not consolidated or accounted for under the equity method of accounting to be measured at fair value with changes in fair value recognized in net income. We adopted ASU 2016-01 using the modified-retrospective approach pursuant to which we recorded a cumulative effect adjustment to retained earnings of $17.0 million as of January 1, 2018 and decreased accumulated other comprehensive income by the same amount and did not restate prior periods.
We reported net income of $10.3 million for the year ended December 31, 2018, as compared to a net loss of $11.6 million for the year ended December 31, 2017. On a diluted per share basis, net income was $0.57 per share for fiscal 2018 as compared to a net loss of $0.63 per share for fiscal 2017. Our effective tax rate was 19.2% for the year ended December 31, 2018 as compared to 30.3% for the same period in 2017. The effective tax rate for 2018 was favorably impacted by the lower statutory rate from the enactment of the Tax Cuts and Jobs Act (“TCJA”) on December 22, 2017. The rate for 2017 varied from the statutory tax rate primarily due to a $1.3 million charge from the revaluation of deferred tax balances from a 35% statutory rate to the new 21% statutory tax rate under the TCJA as well as a correction of an immaterial error in prior years’ deferred tax on bond premium amortization, partially offset by the amount of tax exempt income in relation to total pre-tax income.
Gross premiums written for the Specialty Commercial Segment were $501.8 million for the year ended December 31, 2018, which was $37.1 million, or 8%, more than the $464.7 million reported for the same period in 2017. The increase in gross premiums written were primarily the result of increased premium production in our Specialty Commercial operating unit, partially offset by lower premium production in our Contract Binding operating unit. Net premiums written were $251.7 million for the year ended December 31, 2018 as compared to $265.0 million reported for the same period in 2017. The decrease in net premiums written was due to a change in mix towards business with higher ceded premium as a percentage of the gross premium.
The $280.3 million of total revenue for the year ended December 31, 2018 was $2.4 million higher than the $277.9 million reported for 2017. This increase in revenue was primarily due to higher net investment income of $2.5 million and higher commission and fees of $1.0 million, partially offset by lower other income of $0.2 million and lower net premiums earned of $0.9 million due to decreased premium production in our Contract Binding operating unit, partially offset by increased premium production in our Specialty Commercial operating unit.
Our Contract Binding operating unit reported a $44.9 million decrease in loss and LAE due primarily to $11.2 million of unfavorable prior year net loss reserve development recognized during the year ended December 31, 2018 as compared to $38.6 million of unfavorable prior year net loss reserve development recognized for the prior year. Our Specialty Commercial operating unit reported a $26.1 million increase in loss and LAE which consisted of (a) a $9.3 million increase in losses and LAE attributable to our professional liability insurance products due primarily to increased net earned
premiums as well as net unfavorable prior year loss reserve development as compared to favorable prior year loss development during the same period of 2017, (b) a $7.7 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 $3.9 million increase in losses and LAE in our commercial umbrella and primary/excess liability line of business due primarily to increased net earned premiums as well as increased net unfavorable prior year loss reserve development as compared to the same period during 2017, (d) a $3.8 million increase in losses and LAE in our specialty programs due primarily to increased net earned premiums, (e) a $1.1 million increase in losses and LAE in our satellite launch insurance line of business due to higher current accident year loss trends as well as net unfavorable prior year loss reserve development during 2018, and (f) a $0.3 million increase in losses and LAE in our general aviation line of business due primarily to higher current accident year loss trends, partially offset by lower unfavorable prior year loss development as compared to the same period during 2017. The $5.6 million decrease in operating expense was primarily the result of lower production related expenses of $9.2 million due primarily to increased ceding commissions in our Specialty Commercial operating unit, partially offset by increased salary and related expenses of $2.0 million, increased professional services of $0.8 million, increased occupancy and other operating expenses of $0.7 million and increased travel and related expenses of $0.1 million.
The Specialty Commercial Segment reported a net loss ratio of 75.2% for the year ended December 31, 2018 as compared to 82.2% for the same period during 2017. The gross loss ratio before reinsurance was 73.4% for the year ended December 31, 2018 as compared to 76.5% for the same period in 2017. The lower gross and net loss ratios were largely the result of $16.5 million of unfavorable prior year net loss reserve development for the year ended December 31, 2018 as compared to unfavorable prior year net loss reserve development of $40.5 million for the same period of 2017, as well as lower gross current accident year loss trends during the year ended December 31, 2018 as compared to the same period during 2017. The Specialty Commercial Segment reported $6.0 million of net catastrophe losses during the year ended December 31, 2018 as compared to $3.8 million of net catastrophe losses during the same period of 2017. The Specialty Commercial Segment reported a net expense ratio of 22.6% for the year ended December 31, 2018 as compared to 23.7% for the same period of 2017. The decrease in the expense ratio was due predominately to increased ceding commissions in our Specialty Commercial operating unit.
Total revenue for the Personal Segment decreased 5% to $38.6 million for the year ended December 31, 2018 from $40.4 million for the same period during 2017. The $1.8 million decrease in revenue was primarily the result of lower net premiums earned of $3.1 million due to the earning impact of intentionally reducing certain underperforming portions of this business to address loss ratio performance early in 2018 and the deferred earning impact of the subsequent growth later in 2018, partially offset by higher finance charges of $1.3 million reported during the year ended December 31, 2018 as compared to the same period during 2017.
Corporate pre-tax loss was $32.1 million for the year ended December 31, 2018 as compared to a pre-tax loss of $18.0 million for the same period of 2017. The increase in pre-tax loss was primarily due to the lower revenue discussed above and higher operating expenses of $1.1 million.
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. During 2018 and 2017 our insurance subsidiaries did not pay management fees to Hallmark or our non-insurance company subsidiaries.
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, 2018, our insurance company subsidiaries reported statutory capital and surplus of $247.0 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, 2018, the adjusted capital under the risk-based capital calculation of each of our insurance company subsidiaries substantially exceeded the minimum requirements. Our total statutory net premium-to-surplus percentage for the years ended December 31, 2018 and 2017 was 147% and 157%, respectively.
On a consolidated basis, our cash and investments, excluding restricted cash and investments, at December 31, 2018 were $663.5 million compared to $726.3 million at December 31, 2017. The primary reasons for this decrease in unrestricted cash and investments were cash used by operations, a decrease in investment fair values, purchases of property and equipment and repurchases of our common stock.
Comparison of Years Ended December 31, 2018 and December 31, 2017
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, 2018, the principal balance of our Trust I subordinated debt was $30.9 million and the interest rate was 6.04% per annum.
Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2018 and 2017
Consolidated Statements of Cash Flows for the Years Ended December 31, 2018 and 2017