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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," "our," or the Company) 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 our insurance products, as well as providing other insurance related services. Our business is geographically concentrated in the south central and northwest regions ofthe United States , except for our Specialty Commercial business which is written on a national basis. We pursue our business activities through subsidiaries whose operations are organized into product-specific 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:
Specialty Commercial Segment. Our Specialty Commercial Segment includes our
Commercial Auto business unit which offers primary and excess commercial
vehicle insurance products and services; our E&S Casualty business unit which
offers primary and excess liability, excess public entity liability and E&S
package and garage liability insurance products and services; our E&S Property
business unit which offers primary and excess commercial property insurance for
? both catastrophe and non-catastrophe exposures; our Professional Liability
business unit which offers healthcare and financial lines professional
liability insurance products and services primarily for businesses, medical
professionals, medical facilities and, through 2020, senior care facilities;
and our Aerospace & Programs business unit which offers general aviation and,
until exited during 2020, satellite launch property/casualty insurance products
and services, as well as certain specialty programs.
Standard Commercial Segment. Our Standard Commercial Segment includes the
? package and monoline property/casualty and, until exited during 2016,
occupational accident insurance products and services
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handled by our Commercial Accounts business unit; and the runoff of workers
compensation insurance products handled by our former Workers Compensation
operating unit until discontinued during 2016.
Personal Segment. Our Personal Segment includes the non-standard personal
? automobile and renters insurance products and services handled by our Specialty
Personal Lines business unit.
The retained premium produced by these reportable segments is supported by ourAmerican Hallmark Insurance Company of Texas ("AHIC"),Hallmark Specialty Insurance Company ("HSIC"),Hallmark Insurance Company ("HIC"),Hallmark National Insurance Company ("HNIC") andTexas Builders Insurance Company ("TBIC") insurance subsidiaries. In addition, control and management ofHallmark County Mutual Insurance Company ("HCM") 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 inTexas . HCM does not retain any business. AHIC, HIC, HSIC and HNIC have entered into a pooling arrangement pursuant to which AHIC retains 32% of the total net premiums written by any of them, HIC retains 32% of our total net premiums written by any of them, HSIC retains 26% of our total net premiums written by any of them and HNIC retains 10% of our total net premiums written by any of them. Neither HCM nor TBIC is a party to the intercompany pooling arrangement.
Results of Operations
Management overview. During the three months endedMarch 31, 2022 , our total revenue was$85.7 million , representing a decrease of 24% from the$112.1 million in total revenue for the same period of 2021. During the three months endedMarch 31, 2022 , we reported a pre-tax loss of$4.1 million , as compared to a pre-tax income of$11.2 million reported during the same period the prior year. The decrease in revenue for the three months endedMarch 31, 2022 compared to the same period of the prior year was primarily due to lower net premiums earned of$19.4 million , lower net investment income of$1.2 million , lower finance charges of$0.1 million , and lower net investment gains of$5.7 million . The deterioration in pre-tax earnings for the first quarter of 2022 compared to the same period of the prior year was primarily due to the decreased revenue discussed above, partially offset by lower losses and loss adjustment expenses ("LAE") of$5.5 million and lower operating expenses of$5.6 million . The decrease in losses and LAE was primarily due to decreased net premiums earned and lower net catastrophe losses, partially offset by unfavorable net prior year loss reserve development during the first quarter of 2022 compared to favorable net prior year loss development during the same period of 2021. Losses and LAE for the first quarter of 2022 included$1.1 million of net catastrophe losses as compared to$5.9 million during the same period of the prior year. During the first quarter of 2022, we experienced$7.7 million of unfavorable net prior year loss reserve development, driven primarily by our exited contract binding line of business, compared to$2.1 million of favorable net prior year loss development during the same period of 2021. We reported a net loss of$3.2 million for the three months endedMarch 31, 2022 as compared to net income of$9.0 million for the same period in 2021. On a fully diluted basis, we reported a net loss of$0.18 per share for the three months endedMarch 31, 2022 , compared to net income of$0.49 per share for the same period in 2021. Our effective tax rate was 21.8% for the first three months of 2022 compared to 20.1% for the same period in 2021. The effective tax rates for the three months endedMarch 31, 2022 and 2021 varied from the statutory tax rates primarily due to tax-exempt interest income. 27
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First Quarter 2022 as Compared to First Quarter 2021
The following is additional business segment information for the three months
ended
Three Months Ended
Specialty Commercial Standard Commercial
Segment Segment Personal Segment Corporate Consolidated
2022 2021 2022 2021 2022 2021 2022 2021 2022 2021
Gross premiums
written $ 103,850 $ 113,990 $ 30,277 $ 29,735 $ 16,832 $ 19,293 $ - $ - $ 150,959
$ 163,018 Ceded premiums written (61,069) (61,204) (11,493) (10,250) (76) (67) - - (72,638) (71,521)
Net premiums written 42,781 52,786 18,784 19,485 16,756 19,226
- - 78,321
91,497
Change in unearned premiums 7,429 14,425 (2,077) (2,419) (1,197) (1,651) - - 4,155
10,355
Net premiums earned 50,210 67,211 16,707 17,066 15,559 17,575
- - 82,476
101,852
Total revenues 51,911 69,599 17,128
17,688 16,819 18,959 (186) 5,807 85,672
112,053
Losses and loss
adjustment expenses 39,312 42,983 12,133 12,091 12,579 14,405
- - 64,024
69,479
Pre-tax income (loss)
Net loss ratio (1) 78.3 % 64.0 % 72.6 % 70.8 % 80.8 % 82.0 % 77.6 %
68.2 %
Net expense ratio (1) 22.1 % 24.1 % 34.7 % 31.6 % 29.0 % 30.4 %
28.4 % 27.2 % Net combined ratio (1) 100.4 % 88.1 % 107.3 % 102.4 % 109.8 % 112.4 % 106.0 % 95.4 % Net (unfavorable) favorable prior year development$ (6,380) $ 1,899 $ 262 $ 1,361 $ (1,573) $ (1,174) $ (7,691) $ 2,086
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
(1) ratio is calculated as total underwriting expenses 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.
Specialty Commercial Segment
Gross premiums written for the Specialty Commercial Segment were$103.9 million for the three months endedMarch 31, 2022 , which was$10.1 million , or 9%, less than the$114.0 million reported for the same period of 2021. Net premiums written were$42.8 million for the three months endedMarch 31, 2022 as compared to$52.8 million for the same period of 2021. The decrease in gross and net premiums written was primarily the result of lower premium production in our Commercial Auto, Professional Liability and E&S Casualty business units, partially offset by increased premium production in ourE&S Property and Aerospace & Programs business units. The$51.9 million of total revenue for the three months endedMarch 31, 2022 was$17.7 million less than the$69.6 million reported by the Specialty Commercial Segment for the same period in 2021. This decrease in revenue was primarily due to lower net premiums earned of$17.0 million , driven primarily by decreased net premiums earned in our Commercial Auto and Professional Liability business units. Further contributing to the decrease in revenue was lower net investment income of$0.5 million for the three months endedMarch 31, 2022 as compared to the same period of 2021. The Specialty Commercial Segment reported pre-tax income of$2.6 million for the first quarter of 2022 as compared to pre-tax income of$11.3 million reported for the same period in 2021. The decrease in pre-tax income was primarily the result of the lower total revenue discussed above, partially offset by lower losses and LAE of$3.6 million and lower operating expenses of$5.4 million during the three months endedMarch 31, 2022 as compared to the same period during 2021. Our Specialty Commercial Segment reported lower losses and LAE for the quarter endedMarch 31, 2022 compared to the same period of the prior year as the combined result of (a) a$1.0 million decrease in losses and LAE in our Commercial Auto business unit, (b) a$4.5 million increase in losses and LAE in our E&S Property business unit, (c) a $1.3 million decrease in losses and LAE in our E&S Casualty business unit, (d) a$4.8 million decrease in losses and 28
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LAE in our Aerospace & Programs business unit, and (e) a$1.0 million decrease in losses and LAE attributable to our Professional Liability business unit. The Commercial Auto business unit's decrease in losses and LAE was primarily due to lower net premiums earned partially offset by$2.5 million of unfavorable net prior year loss reserve development for the first quarter of 2022 as compared to$1.3 million of favorable net prior year loss reserve development during the first quarter of 2021. The unfavorable development during the first quarter of 2022 included$8.9 million of unfavorable net prior year loss reserve development attributable to the exited contract binding line of business. The E&S Property business unit's increase in losses and LAE was primarily due to lower net premiums earned and$3.0 million unfavorable net prior year loss reserve development during the first quarter of 2022 as compared to$0.4 million favorable net prior year loss reserve development during the same period of 2021, partially offset by a$0.7 million improvement in net catastrophe losses and lower current accident year non-catastrophe losses. The E&S Casualty business unit's decrease in losses and LAE was primarily due to lower current accident year loss trends and$1.0 million of unfavorable prior year net loss reserve development during the first quarter of 2022 as compared to$1.3 million of unfavorable prior year net loss reserve development during the same period of 2021. The Aerospace & Programs business unit's decrease in losses and LAE was primarily due to lower current accident year net loss trends in its general aviation line of business and$0.7 million of favorable prior year net loss reserve development during the first quarter of 2022 as compared to$0.4 million of favorable prior year net loss reserve development during the same period of 2021. The Professional Liability business unit's decrease in losses and LAE was primarily due to lower current accident year loss trends partially offset by$0.2 million of favorable prior year net loss reserve development during the first quarter of 2022 as compared to$1.3 million of favorable prior year net loss reserve development during the same period of 2021. Operating expenses decreased$5.4 million primarily as the result of lower production related expenses of$4.8 million , lower salary and related expenses of$0.7 million and lower other operating expenses of$0.2 million , partially offset by higher professional services of$0.2 million and higher travel related expenses of$0.1 million . The Specialty Commercial Segment reported a net loss ratio of 78.3% for the three months endedMarch 31, 2022 as compared to 64.0% for the same period in 2021. The gross loss ratio before reinsurance was 86.9% for the three months endedMarch 31, 2022 as compared to 74.9% for the same period in 2021. The increase in the gross and net loss ratios was driven primarily by increased unfavorable prior year loss development primarily in our exited contract binding line of business, partially offset by lower catastrophe losses. The Specialty Commercial Segment reported unfavorable net loss reserve development of$6.4 million during the three months endedMarch 31, 2022 as compared to favorable net loss reserve development of$1.9 million during the same period of 2021. The Specialty Commercial Segment reported$3.5 million of gross catastrophe losses during the first quarter of 2022 as compared to$7.6 million during the same period of 2021. Net catastrophe losses were$1.1 million for the three months endedMarch 31, 2022 as compared to$5.9 million during the first quarter of 2021. The Specialty Commercial Segment reported a net expense ratio of 22.1% for the first quarter of 2022 as compared to 24.1% for the same period of 2021 driven primarily by lower operating expenses.
Standard Commercial Segment
Gross premiums written for the Standard Commercial Segment were$30.3 million for the three months endedMarch 31, 2022 , which was$0.6 million more than the$29.7 million reported for the same period in 2021. Net premiums written were$18.8 million for the three months endedMarch 31, 2022 as compared to$19.5 million for the same period in 2021. The increase in the gross premiums written was due to higher premium production in our Commercial Accounts business unit.
The decrease in net premiums written was due to higher ceded catastrophe
premiums during the first quarter of 2022.
Total revenue for the Standard Commercial Segment of$17.1 million for the three months endedMarch 31, 2022 , was$0.6 million less than the$17.7 million reported for the same period in 2021. This decrease in total revenue was due to lower net premiums earned of$0.4 million and lower net investment income of$0.2 million for the three months endedMarch 31, 2022 as compared to the same period of 2021. The Standard Commercial Segment reported a pre-tax loss of$0.7 million for the three months endedMarch 31, 2022 as compared to pre-tax income of$0.4 million for the same period of 2021. This deterioration in pre-tax earnings was primarily the result of lower revenue discussed above and higher operating expenses of$0.5 million . Increased 29
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operating expenses were primarily the result of higher salary and related
expenses of
higher professional services of
production related expenses of
The Standard Commercial Segment reported a net loss ratio of 72.6% for the three months endedMarch 31, 2022 as compared to 70.8% for the same period of 2021. The gross loss ratio before reinsurance for the three months endedMarch 31, 2022 was 58.6% as compared to 57.7% reported for the same period of 2021. The increase in the gross and net loss ratio was due primarily to higher current accident year loss trends and lower favorable net loss reserve development, partially offset by lower net catastrophe losses of$0.2 million during the first quarter of 2022 compared to$2.0 million for the same period of the prior year. The Standard Commercial Segment reported favorable net loss reserve development of$0.3 million during the three months endedMarch 31, 2022 as compared to$1.4 million during the same period of 2021. The Standard Commercial Segment reported a net expense ratio of 34.7% for the first quarter of 2022 as compared to 31.6% for the same period of 2021.
Personal Segment
Gross premiums written for the Personal Segment were$16.8 million for the three months endedMarch 31, 2022 as compared to$19.3 million for the same period in the prior year. Net premiums written for the Personal Segment were$16.8 million in the first quarter of 2022, which was a decrease of$2.4 million from the$19.2 million reported for the first quarter of 2021. The decrease in gross and net written premiums was primarily due to lower premium production in our current geographical footprint. Total revenue for the Personal Segment was$16.8 million for the first quarter of 2022 as compared to$19.0 million for the same period in 2021. The decrease in revenue was primarily due to lower net premiums earned of$2.0 million and lower finance charges of$0.2 million during the first quarter of 2022 as compared to the same period during 2021. Pre-tax loss for the Personal Segment was$1.0 million for the three months endedMarch 31, 2022 as compared to a pre-tax loss of$1.6 million for the same period of 2021. The reduction in pre-tax loss was primarily the result of lower losses and LAE of$1.8 million and decreased operating expenses of$1.0 million for the three months endedMarch 31, 2022 as compared to the same period during 2021, partially offset by the decreased revenue as discussed above. However, rising inflationary trends, specifically loss costs, continue to impact the profitability of our Personal Segment. The Personal Segment reported a net loss ratio of 80.8% for the three months endedMarch 31, 2022 as compared to 82.0% for the same period of 2021. The gross loss ratio before reinsurance was 81.1% for the three months endedMarch 31, 2022 as compared to 84.4% for the same period in 2021. The lower gross and net loss ratios were impacted by lower losses and LAE despite$0.4 million higher net unfavorable prior year loss reserve development during the first quarter of 2022 as compared to the same period of 2021. The Personal Segment reported a net expense ratio of 29.0% for the first quarter of 2022 as compared to 30.4% for the same period of 2021. The decrease in the expense ratio was due primarily to lower operating expenses.
Corporate
Total revenue for Corporate decreased by$6.0 million for the three months endedMarch 31, 2022 as compared to the same period the prior year. This decrease in total revenue was due predominately to lower net investment income of$0.4 million for the three months endedMarch 31, 2022 as compared to the same period during 2021, as well as a$5.6 million reduction in investment gains during the first quarter of 2022 as compared to the same period of 2021.
Corporate pre-tax loss was
2022
The pre-tax loss for the first quarter of 2022 was primarily due to the lower
revenue discussed above and higher operating expenses of
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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 ofMarch 31, 2022 , Hallmark and its non-insurance company subsidiaries had$11.4 million in unrestricted cash and cash equivalents. As of that date, our insurance subsidiaries held$172.0 million of unrestricted cash and cash equivalents, as well as$388.3 million in debt securities with an average modified duration of 1.0 years. Accordingly, we do not anticipate selling long-term debt instruments to meet liquidity needs. AHIC and TBIC, domiciled inTexas , are limited in the payment of dividends to their stockholders in any 12-month period, without the prior written consent of theTexas 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 and HNIC, both domiciled inArizona , are limited in the payment of dividends to the lesser of 10% of prior year policyholders' surplus or prior year's statutory net income, without prior written approval from theArizona Department of Insurance . HSIC, domiciled inOklahoma , 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 theOklahoma Insurance Department . During 2022, the aggregate ordinary dividend capacity of these subsidiaries is$32.0 million , of which$22.7 million is available to Hallmark. As a county mutual, dividends from HCM are payable to policyholders. During the first three months of 2022 and 2021, our insurance subsidiaries did not pay any dividends to Hallmark. During the first three months of 2022 and 2021, our insurance subsidiaries paid$3.0 million and$4.5 million in management fees to Hallmark, respectively.
Comparison of
On a consolidated basis, our cash (excluding restricted cash) and investments atMarch 31, 2022 were$624.2 million compared to$691.6 million atDecember 31, 2021 . The primary reasons for this decrease in unrestricted cash and investments were cash used by operations and purchases of investment securities.
Comparison of Three Months Ended
During the three months endedMarch 31, 2022 , our cash flow used by operations was$62.0 million compared to cash flow provided by operations of$29.5 million during the same period the prior year. The cash flow used in operations was driven primarily by higher reinsurance balances paid during the first quarter of 2022 of$50.0 mllion due primarily to the correction of immaterial errors relating to certain reinsurance treaties reported during the third quarter of 2021, an increase in net paid claims and lower collected investment income, partially offset by decreased paid operating expenses during the three months endedMarch 31, 2022 as compared to the same period the prior year. Net cash used in investing activities during the first three months of 2022 was$107.1 million as compared to net cash provided by investing activities of$149.5 million during the first three months of 2021. The net cash used in investing activities during the first three months of 2022 was primarily comprised of an increase of$139.0 million in purchases of debt and equity securities, a decrease of$117.0 million in maturities, sales and redemptions of investment securities and a$0.6 million increase in purchases of fixed assets.
The Company did not report any net cash from financing activities during the
first three months of 2022 or 2021.
Senior Unsecured Notes
On
("Notes") due
6.25% per annum and is payable semi-annually in arrears commencing
2020
subsidiaries and are not subject
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to any sinking fund requirements. At Hallmark's option, the Notes are redeemable, in whole or in part, prior to the stated maturity subject to certain provisions intended to make the holders of the Notes whole on scheduled interest and principal payments. The indenture governing the Notes contains certain covenants which, among other things, restrict Hallmark's ability to incur additional indebtedness, make certain payments, create liens on the stock of certain subsidiaries, dispose of certain assets, or merge or consolidate with other entities. The terms of the indenture prohibits payments or other distributions on any security of the Company that ranks junior to the Notes when the Company's debt to capital ratio (as defined in the indenture) is greater than 35%. The Company's debt to capital ratio was 38.3% as ofMarch 31, 2022 .
OnJune 21, 2005 , we formed Hallmark Statutory Trust I ("Trust I"), an unconsolidated trust subsidiary, for the sole purpose of issuing$30.0 million in trust preferred securities. Trust I used the proceeds from the sale of these securities and our initial capital contribution to purchase$30.9 million of junior subordinated debt securities from Hallmark. The debt securities are the sole assets of Trust I, and the payments under the debt securities are the sole revenues of Trust I. OnAugust 23, 2007 , we formed Hallmark Statutory Trust II ("Trust II"), an unconsolidated trust subsidiary, for the sole purpose of issuing$25.0 million in trust preferred securities. Trust II used the proceeds from the sale of these securities and our initial capital contribution to purchase$25.8 million of subordinated debt securities from Hallmark. The debt securities are the sole assets of Trust II, and the payments under the debt securities are the sole revenues of Trust II. Each trust pays dividends on its preferred securities at the same rate each quarter as interest is paid on the junior subordinated debt securities. Under the terms of the trust subordinated debt securities, we pay interest only each quarter and the principal of each note at maturity. We may elect to defer payments of interest on the trust subordinated debt securities by extending the interest payment period for up to 20 consecutive quarterly periods. During any such extension period, interest continues to accrue on the trust subordinated debt securities, as well as interest on such accrued interest. In order to maintain compliance with the terms of our senior unsecured Notes, we have elected to defer payment of interest on the trust subordinated securities until our debt to capital ratio (as defined in the indenture governing the Notes) is less than 35%. The subordinated debt securities of each trust are uncollateralized and do not require maintenance of minimum financial covenants.
The following table summarizes the nature and terms of the junior subordinated
debt and trust preferred securities:
Hallmark Hallmark
Statutory Statutory
Trust I Trust II
Issue date June 21, 2005 August 23, 2007
Principal amount of trust preferred
securities $ 30,000 $ 25,000
Principal amount of junior
subordinated debt securities $ 30,928 $ 25,774
Maturity date of junior subordinated
debt securities June 15, 2035 September 15, 2037
Trust common stock $ 928 $ 774
Interest rate, per annum Three Month LIBOR + 3.25% Three Month LIBOR + 2.90%
Current interest rate at March 31,
2021 4.08%
3.73%
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