HALLMARK FINANCIAL SERVICES INC – 10-Q – Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 The following discussion should be read together with our consolidated financial statements and the notes thereto. This discussion contains forward-looking statements. Please see "Risks Associated with Forward-Looking Statements in this Form 10-Q" for a discussion of some of the uncertainties, risks and assumptions associated with these statements.    Introduction    Hallmark Financial Services, Inc. ("Hallmark" and, together with subsidiaries, "we," "us" or "our") is an insurance holding company that, through its subsidiaries, engages in the sale of property/casualty insurance products to businesses and individuals. Our business involves marketing, distributing, underwriting and servicing commercial insurance, personal insurance and general aviation insurance, as well as providing other insurance related services. Our business is geographically concentrated in the south central and northwest regions of the United States, except for our Hallmark Select business which is written on a national basis. We pursue our business activities through subsidiaries whose operations are organized into five business units, which are supported by our insurance company subsidiaries.    

Our non-carrier insurance activities are segregated by business units into the following reportable segments:

· Standard Commercial Segment.Our Standard Commercial Segment includes the

standard lines commercial property/casualty insurance products and services

handled by our Standard Commercial P&C business unit and the workers

compensation insurance products handled by our Workers Compensation business

   unit.    

· Specialty Commercial Segment.Our Specialty Commercial Segment includes the

excess and surplus lines commercial property/casualty insurance products and

services handled by our E&S Commercial business unit and the general aviation,

commercial umbrella and excess liability and medical professional liability

insurance products and services handled by our Hallmark Select business unit,

as well as certain Specialty Programs which are managed at the parent level.

· Personal Segment. Our 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.    

The retained premium produced by these reportable segments is supported by the following insurance company subsidiaries:

· American Hallmark Insurance Company of Texas ("AHIC") presently retains a

portion of the risks on the commercial property/casualty and workers

compensation policies marketed within the Standard Commercial Segment, retains

   a portion of the risks on personal policies marketed within the Personal    Segment and retains a portion of the risks on the commercial, medical    professional liability, aviation and satellite launch property/casualty    policies marketed within the Specialty Commercial Segment.    

· Hallmark Specialty Insurance Company ("HSIC") presently retains a portion of

the risks on the commercial property/casualty and medical professional

liability policies marketed within the Specialty Commercial Segment and a

portion of the commercial property/casualty policies marketed within the

Standard Commercial Segment.

    29       

· Hallmark Insurance Company ("HIC") presently retains a portion of the risks on

   both the personal policies marketed within the Personal Segment and the    commercial and aviation property/casualty products marketed within the    Specialty Commercial Segment.    

· Hallmark National Insurance Company ("HNIC") presently retains a portion of the

   risks on the personal policies marketed within the Personal Segment.    

· Hallmark County Mutual Insurance Company ("HCM") 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 ("TBIC") retains a portion of the risks on the

workers compensation policies marketed within our Standard Commercial Segment.

     AHIC, HIC, HSIC and HNIC have entered into a pooling arrangement pursuant to which AHIC retains 30% of the total net premiums written by any of them, HIC retains 27% of our total net premiums written by any of them, HSIC retains 30% of our total net premiums written by any of them and HNIC retains 13% of our total premiums written by any of them. Neither HCM nor TBIC is a party to the intercompany pooling arrangement. This pooling arrangement has no impact on our consolidated financial statements reported in accordance with U.S. generally accepted accounting principles ("GAAP").    Results of Operations   

Management Overview During the three months ended March 31, 2013, our total revenues were $93.1 million, representing a 12% increase from the $83.0 million in total revenues for the same period of 2012.  This increase in revenue was primarily attributable to increased earned premium due to increased production in our Specialty Commercial Segment and our Standard Commercial Segment. Further contributing to the increase in revenue were net realized gains on our investment portfolio during the first quarter of 2013 as compared to net realized losses reported during the first quarter of 2012. The increase in revenue was partially offset by lower earned premium in our Personal Segment due mostly to the impact of a reduction of premium written in underperforming states and products exited.    The increase in revenue for the three months ended March 31, 2013, was accompanied by increased loss and LAE of $6.9 million as compared to the same period during 2012 due primarily to increased premium volume, as well as $2.0 million of unfavorable prior year loss reserve development for the three months ended March 31, 2013 as compared to favorable prior year loss reserve development of $3.0 million for the same period of 2012. This increase in loss and LAE was partially offset by favorable current accident year loss trends in our E&S Commercial business unit. Further offsetting the increase in loss and LAE was a $3.9 million decrease in weather related losses to $0.8 million for the three months ended March 31, 2013 from $4.7 million reported during the same period of 2012. Other operating expenses also increased due mostly to increased production related expenses in our E&S Commercial business unit.    30        As a result, we reported net income of $1.7 million for the three months ended March 31, 2013, which was a $1.5 million improvement from the $0.2 million net income reported for the first quarter of 2012.  On a diluted basis per share, net income was $0.09 per share for the three months ended March 31, 2013, as compared to net income of $0.01 per share for the same period in 2012.    

First Quarter 2013 as Compared to First Quarter 2012

The following is additional business segment information for the three months ended March 31, 2013 and 2012 (in thousands):

                                                                                     Three Months Ended March 31                                  Standard                     Specialty                                 Commercial                   Commercial                    Personal                                  Segment                      Segment                      Segment                     Corporate                   Consolidated                             2013          2012          2013           2012           2013          2012          2013           2012          2013     

2012

Gross premiums written $ 21,642 18,847 $ 65,306 54,885 $ 21,199 23,663 $ -

              -      $ 

108,147 97,395 Ceded premiums written (1,995 ) (1,457 ) (10,932 ) (10,814 ) (1,324 ) (162 )

           -              -        

(14,251 ) (12,433 ) Net premiums written 19,647 17,390 54,374 44,071 19,875 23,501

             -              -         93,896         84,962 Change in unearned premiums                    (1,117 )        (561 )       (5,521 )       (6,036 )        (770 )      (1,157 )           -              -         

(7,408 ) (7,754 ) Net premiums earned 18,530 16,829 48,853 38,035 19,105 22,344

             -              -         

86,488 77,208

  Total revenues              20,288        18,106         51,680         40,393        20,978        24,431           195             56         

93,141 82,986

Losses and loss adjustment expenses 12,583 13,764 34,436 23,009 14,719 18,018

             -              -         

61,738 54,791

  Pre-tax income (loss), net of non-controlling interest                     1,477        (1,362 )        3,698          5,977           (64 )      (1,191 )      (2,948 )       (3,230 )        2,163            194  Net loss ratio (1)            67.9 %        81.8 %         70.5 %         60.5 %        77.0 %        80.6 %                                      

71.4 % 71.0 % Net expense ratio (1) 33.7 % 31.1 % 27.5 % 28.5 % 27.1 % 26.6 %

30.2 % 31.4 % Net combined ratio (1) 101.6 % 112.9 % 98.0 % 89.0 % 104.1 % 107.2 %

                                     101.6 %        102.4 %  Favorable (Unfavorable) Prior Year Development               726         2,943         (2,990 )          876           253          (790 )           -              -         (2,011 )        3,029    

(1) The net loss ratio is calculated as incurred losses and LAE divided by net premiums earned, each determined in accordance with GAAP. The net expense ratio is calculated for our business units that retain 100% of produced premium as total operating expenses for the unit offset by agency fee income divided by net premiums earned, each determined in accordance with GAAP. For the business units that do not retain 100% of the produced premium, the net expense ratio is calculated as underwriting expenses of the insurance company subsidiaries for the unit offset by agency fee income, divided by net premiums earned, each determined in accordance with GAAP. Net combined ratio is calculated as the sum of the net loss ratio and the net expense ratio.    31        Standard Commercial Segment    Gross premiums written for the Standard Commercial Segment were $21.6 million for the three months ended March 31, 2013, which was $2.8 million, or 15%, more than the $18.8 million reported for the same period in 2012. Net premiums written were $19.6 million for the three months ended March 31, 2013 as compared to $17.4 million reported for the same period in 2012. The increase in premium volume was primarily due to increased premium production in both our Standard Commercial P&C and Workers Compensation business units.  Total revenue for the Standard Commercial Segment of $20.3 million for the three months ended March 31, 2013 was $2.2 million, or 12%, more than the $18.1 million$1.7 million as well as higher net investment income of $0.2 million and a favorable profit share commission revenue adjustment of $0.3 million during the first quarter of 2013.    Our Standard Commercial Segment reported pre-tax income of $1.5 million for the three months ended March 31, 2013 as compared to a pre-tax loss of $1.4 million for the same period of 2012. The increased revenue discussed above and lower loss and LAE of $1.2 million were the primary drivers of the increased pre-tax income for the three months ended March 31, 2013, partially offset by higher operating expenses of $0.5 million, consisting primarily of production related expenses.   

The Standard Commercial Segment reported a net loss ratio of 67.9% for the three months ended March 31, 2013 as compared to 81.8% for the same period of 2012. The gross loss ratio before reinsurance for the three months ended March 31, 2013 was 64.9% as compared to the 72.3% reported for the same period of 2012. The lower gross and net loss ratio is due primarily to lower weather related losses. The gross and net loss results for the three months ended March 31, 2013 and 2012 include $0.3 million and $4.0 million, respectively of weather related losses. During the three months ended March 31, 2013 and 2012, the Standard Commercial Segment reported favorable prior year loss reserve development of $0.7 million and $2.9 million, respectively. The Standard Commercial Segment reported a net expense ratio of 33.7% for the three months ended March 31, 2013 as compared to 31.1% for the same period in 2012. The increase in the expense ratio is in large part due to our Workers Compensation business unit generating a greater portion of the Standard Commercial Segment's net earned premium for the three months ended March 31, 2013 as compared to the same period during 2012.    

Specialty Commercial Segment

    Gross premiums written for the Specialty Commercial Segment were $65.3 million for the three months ended March 31, 2013, which was $10.4 million, or 19%, more than the $54.9 million reported for the same period in 2012. Net premiums written were $54.4 million for the three months ended March 31, 2013 as compared to $44.1 million reported for the same period in 2012. The increase in premium volume was primarily due to increased premium production in our E&S Commercial business unit and our Hallmark Select business unit.    The $51.7 million of total revenue for the three months ended March 31, 2013 was $11.3 million higher than the $40.4 million reported for 2012. This 28% increase in revenue was due to higher net premiums earned of $10.8 million due predominately to increased production discussed above. Further contributing to this increased revenue was higher net investment income of $0.6 million, partially offset by lower favorable profit share commission revenue adjustment of $0.1 million for the three months ended March 31, 2013 as compared to the first quarter of 2012.    32       

Pre-tax income for the Specialty Commercial Segment of $3.7 million for the first quarter of 2013 was $2.3 million lower than the $6.0 million reported for the same period in 2012. The decrease in pre-tax income was primarily due to higher loss and LAE expenses of $11.4 million and higher operating expenses of $2.2 million, partially offset by the increased revenue discussed above. Our E&S Commercial business unit reported a $10.0 million increase in loss and LAE due primarily to increased premium volume and $3.5 million of unfavorable prior year loss reserve development as compared to $0.9 million of favorable development during the same period of 2012. In addition, our Hallmark Select business unit reported a $1.4 million increase in loss and LAE which consisted of a $0.3 million increase in loss and LAE due to increased premium production in our commercial umbrella and excess liability line of business, a $0.6 million increase in loss and LAE primarily due to large loss volatility in our aircraft hull coverage during the first quarter of 2013 partially offset by $0.5 million of favorable prior year loss reserve development and a $0.5 million increase in loss and LAE in our Specialty Programs due primarily to increased current accident year loss trends. The increase in operating expense was the combined result of increased production related expenses of $2.0 million, higher professional service fees of $0.1 million and higher other operating expenses of $0.1 million.   

The Specialty Commercial Segment reported a net loss ratio of 70.5% for the three months ended March 31, 2013 as compared to 60.5% for the same period during 2012. The gross loss ratio before reinsurance was 68.8% for the three months ended March 31, 2013 as compared to 59.5% for the same period in 2012. The higher gross loss ratio includes large hull loss volatility and $3.5 million of unfavorable prior year development for the three months ended March 31, 2013 as compared to $0.9 million of favorable prior year development for the same period during 2012. The Specialty Commercial Segment reported a net expense ratio of 27.5% for the first quarter of 2013 as compared to 28.5% reported for the same period the prior year. The decrease in the expense ratio is due primarily to increased net earned premium.    Personal Segment   

Gross premiums written for the Personal Segment were $21.2 million for the three months ended March 31, 2013, which was $2.5 million, or 10%, less than the $23.7 million reported for the same period in 2012. Net premiums written for our Personal Segment were $19.9 million in the first quarter of 2013, which was a decrease of $3.6 million, or 15%, from the $23.5 million reported for the first quarter of 2012. The decrease in net premium written was due mostly to exiting certain underperforming states and programs and a quota share reinsurance contract entered into during the first quarter of 2013 on our low value dwelling/homeowners, renters, and manufactured homes lines of business.    Total revenue for the Personal Segment decreased 14% to $21.0 million for the first quarter of 2013 from $24.4 million for the first quarter of 2012. Lower earned premium of $3.2 million due to lower premium production discussed above and decreased finance charges of $0.2 million were the primary reasons for the decrease in revenue for the period.    Pre-tax loss for the Personal Segment was $0.1 million for the three months ended March 31, 2013 as compared to pre-tax loss of $1.2 million for the same period of 2012. The lower pre-tax loss was the result of decreased losses and LAE of $3.3 million and lower operating expenses of $1.3 million, the combined result of lower production related expenses of $0.8 million, lower salary and related expenses of $0.2 million and lower other operating expenses of $0.3 million. The decline in pre-tax loss was partially offset by lower revenue

discussed above.    33        The Personal Segment reported a net loss ratio of 77.0% for the three months ended March 31, 2013 as compared to 80.6% for the first quarter of 2012. The gross loss ratio before reinsurance was 75.0% for the three months ended March 31, 2013 as compared to 79.6% for the same period in 2012. The loss and LAE during the three months ended March 31, 2013 included $0.3 million of favorable prior year loss reserve development as compared to $0.8 million of adverse prior year loss reserve development for the same period during 2012. The Personal Segment reported a net expense ratio of 27.1% for the first quarter of 2013 as compared to 26.6% for the same period of 2012. The increase in the expense ratio was due predominately to lower net earned premiums and lower finance charges.    Corporate    Total revenue for Corporate was $0.2 million for the three months ended March 31, 2013 as compared to $0.1 million for the same period the prior year. This increase in total revenue was due primarily to gains of $1.2 million recognized on our investment portfolio for the three months ended March 31, 2013 as compared to losses of $0.1 million recognized during the same period in 2012. Partially offsetting this increase in revenue was lower net investment income of $0.9 million and a decrease in other income of $0.2 million for the three months ended March 31, 2013 as compared to the same period of the prior year.    Corporate pre-tax loss was $2.9 million for the three months ended March 31, 2013 as compared to $3.2 million pre-tax loss for the same period the prior year. The decrease in pre-tax loss was the result of the increased revenue discussed above and lower salary and related expenses of $0.3 million partially offset by higher other operating expenses of $0.2 million due primarily to lower reductions recorded to the expected earn-out payable in conjunction with the acquisition of HNIC for the three months ended March 31, 2013 as compared to the same period in 2012.   

Financial Condition and Liquidity

   Sources and Uses of Funds    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 March 31, 2013, Hallmark had $1.3 million in unrestricted cash and invested assets at the holding company. Unrestricted cash and invested assets of our non-insurance subsidiaries were $10.7 million as of March 31, 2013. As of that date, our insurance subsidiaries held $79.4 million of cash and cash equivalents as well as $407.7 million in debt securities with an average modified duration of 2.5 years. Accordingly, we do not anticipate selling long-term debt instruments to meet any liquidity needs.    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 2013, the aggregate ordinary dividend capacity of these subsidiaries is $21.0 million, of which $15.1 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 to Hallmark during the first three months of 2013 or the 2012 fiscal year.    34       

Comparison of March 31, 2013 to December 31, 2012

    On a consolidated basis, our cash and investments (excluding restricted cash) at March 31, 2013 were $552.0 million compared to $530.5 million at December 31, 2012. The acquisition and disposition of debt securities settled subsequent to quarter end was the primary reason for this increase, as well as cash flow from operations and an increase in investment fair value.    

Comparison of Three Months Ended March 31, 2013 and March 31, 2012

Net cash provided by our consolidated operating activities was $5.8 million for the first three months of 2013 compared to net cash provided by operating activities of $4.8 million for the first three months of 2012. The increase in operating cash flow was primarily due to higher collected premiums written by our E&S Commercial business unit during the first quarter of 2013, partially offset by increased claim and operating expense payments.    Net cash provided by investing activities during the first three months of 2013 was $0.5 million as compared to net cash used by investing activities of $6.4 million for the same period of 2012.  The increase in cash provided by investing activities during the first quarter of 2013 was due to an increase in maturities, sales and redemptions of investment securities of $16.4 million, partially offset by a $7.1 million increase in purchases of debt and equity securities, a $2.3 million increase in transfers into restricted cash and an increase in purchases of property and equipment of $0.1 million.    There were no financing cash flow activities during the first three months of 2013. Cash used in financing activities during the first three months of 2012 was $2.6 million as a result of a $2.5 million repayment on our revolving credit facility and a distribution to non-controlling interest.    Credit Facilities    Our First Restated Credit Agreement with The Frost National Bank dated January 27, 2006, as amended to date, provides a revolving credit facility of $15.0 million. 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. We are in compliance with all of our covenants.  As of March 31, 2013, the balance on the revolving note was $1.5 million. The revolving note currently bears interest at 2.78% per annum.    35        Subordinated Debt Securities

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 a Delaware statutory trust, Hallmark Statutory Trust I ("Trust I"). 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. Our Trust I subordinated debt securities bear 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. 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 March 31, 2013, the balance of our Trust I subordinated debt was $30.9 million.    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 a Delaware statutory trust, Hallmark Statutory Trust II ("Trust II"). 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 bear an initial interest rate of 8.28% until September 15, 2017, at which time interest will adjust 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 uncollaterized and do not require maintenance of minimum financial covenants. As of March 31, 2013, the balance of our Trust II subordinated debt was $25.8 million.