U.S. SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-KSB Annual Report under Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended December 31, 2003 Commission file number 0-16090 HALLMARK FINANCIAL SERVICES, INC. ---------------------------------------------- (Name of Small Business Issuer in Its Charter) Nevada 87-0447375 ---------------------------- -------------------------- (State or Other Jurisdiction (I.R.S. Employer I.D. No.) of Incorporation Organization) 777 Main Street, Suite 1000, Fort Worth, Texas 76102 ---------------------------------------------- ---------- (Address of Principal Executive Offices) (Zip Code) Issuer's Telephone Number, Including Area Code: (817) 348-1600 Securities registered under Section 12(b) of the Exchange Act: Title of Each Class Name of Each Exchange on Which Registered --------------------------- ----------------------------------------- Common Stock $.03 par value American Stock Exchange Emerging Company Marketplace Securities registered under Section 12(g) of the Exchange Act: None Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [ XX ] No [ ] Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and no disclosure will be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. [ ] State issuer's revenues for its most recent fiscal year - $69,559,579. State the aggregate market value of the voting and non-voting common equity held by non-affiliates - $7,799,361 as of February 29, 2004. State the number of shares outstanding of each of the issuer's classes of common equity, as of the latest practicable date. Common Stock, $.03 par value 36,447,291 shares outstanding as of March 22, 2004. DOCUMENTS INCORPORATED BY REFERENCE The information required by Part III is incorporated by reference from the Registrant's definitive proxy statement to be filed with the Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this report. Risks Associated with Forward-Looking Statements Included in this Form 10-KSB ----------------------------------------------------------------------------- This Form 10-KSB contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created thereby. These statements include the plans and objectives of management for future operations, including plans and objectives relating to future growth of the Company's business activities and availability of funds. The forward-looking statements included herein are based on current expectations that involve numerous risks and uncertainties. Assumptions relating to the foregoing involve judgments with respect to, among other things, future economic, competitive and market conditions, regulatory framework, weather-related events and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond the control of the Company. Although the Company believes that the assumptions underlying the forward-looking statements are reasonable, any of the assumptions could be inaccurate and, therefore, there can be no assurance that the forward-looking statements included in this Form 10-KSB will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by the Company or any other person that the objectives and plans of the Company will be achieved. PART I Item 1. Description of Business. Introduction Hallmark Financial Services, Inc. ("HFS") and its wholly owned subsidiaries (collectively, the "Company") engage in the sale of property and casualty insurance products. The Company's business involves marketing and underwriting of non-standard personal automobile insurance in Texas, New Mexico and Arizona, commercial insurance in Texas, New Mexico, Idaho, Oregon and Washington, third party claims administration and other insurance related services. Overview The Company pursues its business activities through integrated insurance groups handling non-standard personal automobile insurance (the "Personal Lines Group") and commercial insurance (the "Commercial Lines Group"). The members of the Personal Lines group are a Texas domiciled property and casualty insurance company, American Hallmark Insurance Company of Texas ("Hallmark"); an Arizona domiciled property and casualty insurance company, Phoenix Indemnity Insurance Company ("Phoenix"), a managing general agency, American Hallmark General Agency, Inc. ("AHGA"); a premium finance company, Hallmark Finance Corporation ("HFC"); and an affiliated and third party claims administrator, Hallmark Claims Services, Inc. ("HCS"). The members of the Commercial Lines Group are a managing general agency, Hallmark General Agency, Inc. ("HGA") and a third party claims administrator, Effective Claims Management, Inc. ("ECM"). Hallmark writes non-standard automobile liability and physical damage coverage in Texas. Hallmark currently provides insurance through a reinsurance arrangement with an unaffiliated company, Old American County Mutual Fire Insurance Company ("OACM") for policies written after September 30, 2003. Prior to October 1, 2003, Hallmark provided insurance through a reinsurance arrangement with an unaffiliated company, State & County Mutual Fire Insurance Company ("State & County"). Through either State & County or OACM, Hallmark provides insurance for drivers who do not qualify for standard-rate insurance due to driving record, claims history, residency status, or type of vehicle. On January 27, 2003, the Company received final approval from the Arizona Department of Insurance ("AZDOI") for the acquisition of Phoenix, effective as of January 1, 2003. Phoenix is licensed in 24 states and writes non- standard automobile liability and physical damage coverage in Arizona and New Mexico. Phoenix underwrites its own policies and retains 100% of the business it writes. Phoenix targets non-urban markets and underwrites policies produced by approximately 135 independent agents. AHGA holds an appointment from OACM to manage the sale and servicing of OACM policies. Hallmark reinsures 45% of the OACM policies produced by AHGA under a related reinsurance agreement. AHGA markets OACM policies in Texas through approximately 353 independent agents operating under their own names. HFC offered premium financing for policies sold by independent agents managed by AHGA. The Company discontinued writing new and renewal premium finance policies effective July 1, 2003. HCS provides fee-based claims adjustment, salvage and subrogation recovery, and litigation services to Hallmark and unaffiliated MGAs. Effective December 1, 2002, the Company purchased HGA, ECM and a financial administrative service company, Financial and Actuarial Resources, Inc. ("FAR"). HGA, through approximately 150 independent agents operating under their own names, markets commercial insurance policies primarily in the rural areas of Texas, New Mexico, Idaho, Oregon and Washington. HGA currently produces policies on behalf of Clarendon National Insurance Company ("CNIC") and assumes none of the underwriting risk. HGA earns a commission based on a percentage of the earned premium it produces for CNIC. ECM provides fee-based claims adjustment, salvage and subrogation recovery, and litigation services on behalf of CNIC. The Company discontinued the business of FAR during the third quarter of fiscal 2003. Personal Lines Group Operations Formed in 1987, HFS commenced its current operations in 1990 when it acquired, through several transactions, most of the companies now referred to as the Personal Lines Group. HFS manages Hallmark, Phoenix, AHGA, HFC and HCS as an integrated Personal Lines Group that shares common management and office space. Hallmark offers both liability and physical damage (comprehensive and collision) coverages. Hallmark's bodily injury liability coverage is limited to $20,000 per person and $40,000 per accident, and property damage liability coverage is limited to $15,000 per accident. Physical damage coverage is limited to $40,000 and $30,000 for vehicles insured under six- month and monthly policies, respectively. Phoenix offers both liability and physical damage (comprehensive and collision) coverages. Phoenix's bodily injury liability coverage is limited to $15,000 per person and $30,000 per accident, and property damage liability coverage is limited to $10,000 per accident, for the Arizona direct bill program. Bodily injury liability coverage is limited to $25,000 per person and $50,000 per accident, and property damage liability coverage is limited to $10,000 per accident, for the New Mexico direct bill program. Physical damage coverage is limited to a vehicle value of $35,000 and $30,000 for the Arizona and New Mexico direct bill programs, respectively. Phoenix offers optional bodily injury liability coverage up to $100,000 per person and $300,000 per accident, and property damage liability coverage up to $50,000, for both programs. All purchasers of Hallmark and Phoenix policies are individuals. No single customer or group of related customers has accounted for more than 1% of its net premiums written during any of the last three years. The Company currently writes monthly and six-month policies. The Company's core net premium volume was composed of a policy mix of 6.2% annual, 43.6% monthly and 50.2% six-month policies in 2003, and 50.7% annual, 46.1% monthly and 3.2% six-month policies in 2002. The Company discontinued writing annual premium financed policies in July 2003 in order to focus on products which are more competitive in the current marketplace. The Company's typical customer is unable or unwilling to pay a half year's premium in advance. Accordingly, the Company offers monthly policies and six-month direct bill policies. HCS provides claims adjustment and related litigation services to both the Company and unaffiliated MGAs. Fees are charged on a per-file basis, as a percentage of earned premiums or, in certain instances, a combination of both methods. When HCS receives notice of a loss, a claim file and an estimated loss reserve are established. HCS's adjusters review, investigate and initiate claim payments. The Company has an in-house litigation department that closely manages its claims-related litigation. Management believes that the Company achieves superior efficiency and cost effectiveness by principally utilizing its trained employee-adjusters and in-house litigation department. The following table shows, for each of the years in the three year period ended December 31, 2003 (i) the amount of the Personal Lines Group gross premiums written, and (ii) the underwriting results of the Personal Lines Group, as measured by the net statutory loss and loss adjustment expense ("LAE") ratio, the statutory expense ratio, and the statutory combined ratio for the calendar year. The loss and LAE ratio is the ratio of incurred losses and LAE to net premiums earned, the statutory expense ratio is the ratio of underwriting and operating expenses to net premiums written, and the combined ratio is the sum of the loss and LAE ratio and the statutory expense ratio. 2003 2002 2001 -------- -------- -------- Gross Premiums Written $ 43,338 $ 51,643 $ 49,614 ======== ======== ======== Statutory Loss & LAE Ratio 72.5% 76.8% 98.6% Statutory Expense Ratio 28.6% 19.5% 16.7% -------- -------- -------- Statutory Combined Ratio 101.1% 96.3% 115.3% ======== ======== ======== Commercial Lines Group Operations The Company's Commercial Lines Group consists of a regional managing general agency, and a third party claims administration company which were acquired December 1, 2002. HGA markets commercial insurance policies through an independent agency force primarily in the rural areas of Texas, New Mexico, Idaho, Oregon, and Washington. ECM administers the claims on insurance policies produced by HGA. These insurance policies consist of small to medium sized commercial risks, which as a group have relatively stable loss ratios. The Commercial Lines Group's underwriting criteria exclude lines of business and classes of risks that are considered to be high hazard or volatile, or which involve latent injury potential or other long-tail liability exposures. Selection criteria include specific classes of businesses, occupancies, and operations with lower hazard ratings, which present a relatively lower exposure to loss and are charged with a correspondingly lower premium. The lines of business underwritten are primarily commercial auto, commercial multi-peril, business owner's policy, umbrella and other liability. HGA currently markets and underwrites these policies on behalf of CNIC and assumes none of the underwriting risk. HGA earns a commission based on a percentage of the earned premium it produces for CNIC. ECM receives a claim servicing fee based on a percentage of the earned premium it produces for CNIC with a portion deferred for casualty claims. Underwriting and Other Ratios An insurance company's underwriting performance is traditionally measured by its statutory loss and LAE ratio, its statutory expense ratio and its statutory combined ratio. The statutory loss and LAE ratio, which is calculated as the ratio of net losses and LAE incurred to net premiums earned, helps to assess the adequacy of the insurer's rates, the propriety of its underwriting guidelines and the performance of its claims department. The statutory expense ratio, which is calculated as the ratio of underwriting and operating expenses to net premiums written, assists in measuring the insurer's cost of processing and managing the business. The statutory combined ratio, which is the sum of the statutory loss and LAE ratio and the statutory expense ratio, is indicative of the overall profitability of an insurer's underwriting activities, with a combined ratio of less than 100% indicating profitable underwriting results. During 2003, 2002 and 2001, the Company experienced statutory loss and LAE ratios of 72.5%, 76.8% and 98.6%, respectively. During the same periods, it experienced statutory expense ratios of 28.6%, 19.5% and 16.7%, respectively, and statutory combined ratios of 101.1%, 96.3% and 115.3%, respectively. These statutory ratios do not reflect the deferral of policy acquisition costs, investment income, premium finance revenues, or the elimination of inter-company transactions required by accounting principles generally accepted in the United States of America ("GAAP"). The statutory expense ratio for 2003 increased over the 2002 statutory expense ratio primarily as a result of the change in the reinsurance structure effective April 1, 2003. Under the prior structure, Hallmark assumed 100% of the Texas non-standard automobile business produced by AHGA and underwritten by State & County and retroceded a portion to Dorinco Reinsurance Company ("Dorinco"). Under this arrangement, the ceding commission from Dorinco was treated as an offset to Hallmark's underwriting expenses. As of April 1, 2003, Dorinco directly assumes its share of the Texas non-standard automobile business produced by AHGA and underwritten either by State & County (for policies written from April 1, 2003 through September 30, 2003) or OACM (for policies written after September 30, 2003). Under this new arrangement, ceding commissions from Dorinco are treated as revenue to AHGA rather than an offset to the underwriting expenses of Hallmark. Under Texas Department of Insurance ("TDI") and AZDOI guidelines, property and casualty insurance companies are expected to maintain a premium-to- surplus ratio of not more than 3 to 1. The premium-to-surplus ratio measures the relationship between net premiums written in a given period (premiums written, less returned premiums and reinsurance ceded to other carriers) to surplus (admitted assets less liabilities), all determined on the basis of statutory accounting practices ("SAP") prescribed or permitted by insurance regulatory authorities. For 2003, 2002, and 2001, Hallmark's premium-to-surplus ratios were 1.50, 2.63, and 2.62 to 1, respectively. Phoenix's premium-to-surplus ratio was 2.15 to 1 for 2003. Reinsurance Arrangements For policies originated prior to April 1, 2003, Hallmark assumed the reinsurance of 100% of the Texas non-standard auto business produced by AHGA and underwritten by State & County and retroceded 55% of the business to Dorinco. Under this arrangement, Hallmark remained obligated to policyholders in the event that Dorinco did not meet its obligations under the retrocession agreement. Effective April 1, 2003, Hallmark assumes the reinsurance of 45% of the Texas non-standard automobile policies produced by AHGA and underwritten either by State & County (for policies written from April 1, 2003 through September 30, 2003) or OACM (for policies written after September 30, 2003). The remaining 55% of each policy is directly assumed by Dorinco. Under these new reinsurance arrangements, Hallmark is obligated to policyholders only for the portion of the risk assumed by Hallmark. Phoenix underwrites its own policies and does not cede any portion of the business to reinsurers. Under Hallmark's reinsurance arrangements, the Company earns ceding commissions based on Dorinco's loss ratio experience on the portion of policies reinsured by Dorinco. The Company receives a provisional commission as policies are produced as an advance against the later determination of the commission actually earned. The provisional commission is adjusted periodically on a sliding scale based on expected loss ratios. As of December 31, 2003 and 2002, the accrued ceding commission payable was $1.2 million and $2.5 million, respectively. This accrual represents the difference between the provisional ceding commission received and the ceding commission earned based on current loss ratios. The following table presents gross and net premiums written and earned and reinsurance recoveries for each of the last three years: (in thousands) 2003 2002 2001 -------- -------- -------- Gross premiums written $ 43,338 $ 51,643 $ 49,614 Ceded premiums written (6,769) (29,611) (33,822) -------- -------- -------- Net premiums written $ 36,569 $ 22,032 $ 15,792 ======== ======== ======== Gross premiums earned $ 57,447 $ 52,486 $ 49,525 Ceded premiums earned (15,472) (32,273) (33,149) -------- -------- -------- Net premiums earned $ 41,975 $ 20,213 $ 16,376 ======== ======== ======== Reinsurance recoveries $ 11,332 $ 21,161 $ 27,857 -------- -------- -------- Marketing The Company's customers for non-standard automobile insurance typically fall into two groups. The first are drivers who do not qualify for standard auto insurance due to driving record, claims history, residency status, type of vehicle or adverse credit history. The second group is drivers who live in areas in which there is limited availability of standard rate insurance. AHGA acts as a managing general agency for OACM to manage 353 independent agents in Texas writing non-standard automobile policies. Phoenix's policies are generated through 135 independent agents in New Mexico and Arizona. Field marketing representatives promote the Company's non-standard automobile insurance programs to prospective independent agents and service existing independent agents. The independent agents represent other insurers and sell other insurance products in addition to the Company's policies. During fiscal 2003, the top 10 independent agency groups produced 23%, and no individual agency group produced more than 4%, of the total premium volume of the Personal Lines Group. HGA markets commercial insurance policies through a force of approximately 150 independent agencies primarily in the rural areas of Texas, New Mexico, Idaho, Oregon, and Washington. HGA targets customers that are in low hazard classifications in the standard commercial market (typically referred to as "main street" accounts). The typical customer is a small to medium sized business and will have a policy that covers property, general liability and auto exposures. HGA has historically maintained excellent relationships with its producing agents. During fiscal 2003, the top 10 independent agency groups produced 29%, and no individual agency group produced more than 5%, of the total premium volume of the Commercial Lines Group. Competition The property and casualty insurance market, the Company's primary source of revenue, is highly competitive and, except for regulatory considerations, has very few barriers to entry. According to A.M. Best Company, Inc., there were 3,072 property and casualty insurance companies and 1,911 property and casualty insurance groups operating in North America as of July 22, 2003. The Company's Personal Lines Group competes with large national insurers such as Allstate, State Farm and Progressive, as well as numerous regional companies and managing general agencies. The Company's Commercial Lines Group competes with large national carriers such as Hartford, Zurich and Safeco, as well as numerous regional companies and managing general agencies. The Company's competitors include entities which have, or are affiliated with entities which have, greater financial and other resources than the Company. Generally, the Company competes based upon price, customer service, coverages offered, claims handling, financial stability, agent commission and support, customer recognition and geographic coverage. The Company competes with companies using independent agents, captive agent networks, direct marketing channels, or a combination thereof. The current competitive environment in the personal non-standard auto insurance market is driven largely by reinsurance capacity and terms. Beginning in 2000, the reinsurance capacity and terms generally available were not sufficient to continue to support programs with inadequate rates and poor performance. The result has been a contraction of the marketplace, allowing remaining competitors to obtain additional rate and/or premium growth. These conditions continued into 2003, albeit at a diminished pace, with the market moving into a more stabilized condition by the end of the year. By the close of 2003, the frequency of market driven rate and underwriting adjustments had slowed, and the degree of rate impact of these actions had diminished, when compared to recent prior years. The current competitive environment in the commercial insurance market is being impacted by a reduction in capacity as insurers, following a prolonged cyclical downturn in profitability, have reduced premium writing capacity in areas that have been unprofitable. The Company's primary source of revenue in this line of business has been the rural or non-urban markets which have historically provided favorable underwriting results. As with the personal non-standard auto industry, the commercial insurance marketplace has contracted, allowing remaining competitors to obtain additional rate and/or premium growth. Although these conditions continued during 2003, there is currently more resistance to rate increases. Insurance Regulation The operations of Hallmark, AHGA and HFC are regulated by the TDI. AZDOI regulates the operations of Phoenix. Hallmark and Phoenix are required to file quarterly and annual statements of their financial condition with TDI and AZDOI, respectively, prepared in accordance with SAP. Hallmark's and Phoenix's financial condition, including the adequacy of surplus, loss reserves and investments, is subject to review by TDI and AZDOI, respectively. Hallmark does not write its insurance directly, but assumes business written through a county mutual insurance company. Under Texas insurance regulation, premium rates and underwriting guidelines of county mutuals are not subject to the same degree of regulation imposed on standard insurance companies. AHGA is also subject to TDI licensing requirements. HFC is subject to licensing, financial reporting and certain financial requirements imposed by TDI and is also regulated by the Texas Office of Consumer Credit Commissioner. On June 10, 2003, the Governor of Texas signed Senate Bill 14, which has been described as comprehensive insurance reform affecting homeowners and personal automobile business. With respect to personal automobile insurance, the most significant provisions provide for additional rate regulation and limitations on the use of credit scoring. With the new law, broadened rulemaking authority has also been given to the Commissioner of Insurance. The Company currently writes all of its Texas personal automobile business pursuant to a fronting arrangement with a Texas county mutual insurance company. Although the new reforms are significant, the primary rate regulation provisions do not apply directly to the Company due to an exemption that applies to certain county mutual insurance companies. Additionally, the Company does not currently use credit or insurance scoring models. The Company does not believe the specific changes outlined in Senate Bill 14 will have a material adverse affect on its operations. However, the Company cannot determine the ultimate application of this legislation or the impact it may have on its business until certain rules are developed by the Commissioner. Any rule changes that would affect the Company's ability to charge adequate rates for the non-standard automobile line of business in the State of Texas would have a material adverse effect on its operations. TDI and AZDOI have broad authority to enforce insurance laws and regulations through examinations, administrative orders, civil and criminal enforcement proceedings, and suspension or revocation of an insurer's certificate of authority or an agent's license. In extreme cases, including actual or pending insolvency, they may take over, or appoint a receiver to take over, the management or operations of an insurer or an agent's business or assets. In addition, all insurance companies are subject to assessments for state administered funds which cover the claims and expenses of insolvent or impaired insurers. The size of the assessment is determined each year by the total claims on the fund that year. Each insurer is assessed a pro-rata share based on its direct premiums written. Payments to the fund may be recovered by the insurer through deductions from its premium taxes at a rate of 10% per year over ten years. HFS is also regulated as an insurance holding company by TDI and AZDOI. Financial transactions between HFS or any of its affiliates and Hallmark or Phoenix are subject to regulation. Applicable regulations require approval of management and expense sharing contracts, inter-company loans and asset transactions, investments in the Company's securities by Hallmark or Phoenix and similar transactions. Further, dividends and distributions to HFS by Hallmark or Phoenix are restricted. The National Association of Insurance Commissioners ("NAIC") requests property/casualty insurers to file a risk-based capital ("RBC") calculation according to a specified formula. The purpose of the NAIC-designed formula is twofold: (1) to assess the adequacy of an insurer's statutory capital and surplus based upon a variety of factors such as potential risks related to investment portfolio, ceded reinsurance and product mix; and (2) to assist state regulators under the RBC for Insurers Model Act (the "Model Act") by providing thresholds at which a state commissioner is authorized and expected to take regulatory action. Hallmark's 2003 and 2002 adjusted capital under the RBC calculation exceeded the minimum requirement by 186.3% and 142.9%, respectively. Phoenix's 2003 adjusted capital under the RBC calculation exceeded the minimum requirement by 161.5%. HGA is subject to and in compliance with the licensing requirements of the department of insurance in each state in which it produces business. Generally, each state requires one officer of HGA to maintain an agent license. Claims adjusters employed by ECM and HCS are also subject to the licensing requirements of each state in which they conduct business. Each claims adjuster employed by the Company either holds or has applied for the required licenses. Analysis of Hallmark's Losses and LAE The Company's consolidated financial statements include an estimated reserve for unpaid losses and LAE. The Company estimates its reserve for unpaid losses and LAE by using case-basis evaluations and statistical projections, which include inferences from both losses paid and losses incurred. The Company also uses recent historical cost data, periodic reviews of underwriting standards and claims management to modify the statistical projections. The Company gives consideration to the impact of inflation in determining its loss reserves, but does not discount reserve balances. The amount of reserves represents management's estimates of the ultimate net cost of all unpaid losses and LAE incurred through December of each year. These estimates are subject to the effect of trends in claim severity and frequency. Management continually reviews the estimates and adjusts them as claims experience develops and new information becomes known. Such adjustments are included in current operations, including increases and decreases, net of reinsurance, in the estimate of ultimate liabilities for insured events of prior years. (See Note 1 to the consolidated financial statements included in this report.) Changes in loss development patterns and claim payments can significantly affect the ability of insurers to estimate reserves for unpaid losses and related expenses. The Company seeks to continually improve its loss estimation process by refining its ability to analyze loss development patterns, claim payments and other information within a legal and regulatory environment which affects development of ultimate liabilities. Future changes in estimates of claim costs may adversely affect future period operating results. However, such effects cannot be reasonably estimated currently. Reconciliation of Reserve for Unpaid Losses and LAE. The following table provides a 2003 and 2002 reconciliation of the beginning and ending reserve balances, on a gross-of-reinsurance basis, to the gross amounts reported in the Company's balance sheet at December 31, 2003 and 2002 (in thousands): 2003 2002 -------- -------- Reserve for unpaid losses and LAE, net of reinsurance recoverables, January 1 $ 8,411 $ 7,919 Acquisition of Phoenix January 1, 2003 10,338 - Provision for losses and LAE for claims occurring in the current period 29,724 15,125 Increase in reserve for unpaid losses and LAE for claims occurring in prior periods 464 177 Payments for losses and LAE, net of reinsurance: Current period (21,895) (9,119) Prior periods (5,845) (5,691) -------- -------- Reserve for unpaid losses and LAE, net of reinsurance recoverable, December 31 $ 21,197 $ 8,411 Reinsurance recoverable on unpaid losses and LAE at December 31 7,259 9,256 -------- -------- Reserve for unpaid losses and LAE, gross of reinsurance at December 31 $ 28,456 $ 17,667 ======== ======== The 2003 provision for losses and LAE for claims occurring in the current period includes a $2.1 million settlement of a bad faith claim, net of reinsurance, and adverse development primarily related to newly acquired business. (See Item 3.) SAP/GAAP Reserve Reconciliation. The differences between the reserves for unpaid losses and LAE reported in the Company's consolidated financial statements prepared in accordance with GAAP and those reported in the annual statements filed with TDI and AZDOI in accordance with SAP for years 2003 and 2002 are summarized below (in thousands): December 31 2003 2002 ------ ------ Reserve for unpaid losses and LAE on a SAP basis (net of reinsurance recoverables on unpaid losses) $21,132 $ 8,296 Loss reserve discount from the Phoenix acquisition (155) - Unamortized risk premium reserve discount from the Phoenix acquisition 220 - Estimated future unallocated LAE reserve for HCS - 115 ------ ------ Reserve for unpaid losses and LAE on a GAAP basis (net of reinsurance recoverables on unpaid losses) $21,197 $ 8,411 ====== ====== Analysis of Loss and LAE Reserve Development The following table shows the development of the Company's loss reserves, net of reinsurance, for 1993 through 2003. Section A of the table shows the estimated liability for unpaid losses and LAE, net of reinsurance, recorded at the balance sheet date for each of the indicated years. This liability represents the estimated amount of losses and LAE for claims arising in prior years that are unpaid at the balance sheet date, including losses that have been incurred but not yet reported to Hallmark. Section B of the table shows the re-estimated amount of the previously recorded liability, based on experience as of the end of each succeeding year. The estimate is increased or decreased as more information becomes known about the frequency and severity of claims. Cumulative Redundancy/Deficiency (Section C of the table) represents the aggregate change in the estimates over all prior years. Thus, changes in ultimate development estimates are included in operations over a number of years, minimizing the significance of such changes in any one year. The effects on income in the past two years of changes in estimates of the liabilities for losses and LAE are shown in the table under reconciliation of reserves for unpaid losses and LAE. [This space left blank intentionally.] ANALYSIS OF LOSS AND LAE DEVELOPMENT (Thousands of dollars) Year Ended December 31 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 ---------------------- ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- ----- A. Reserve for 4321 4297 5923 5096 4668 4580 5409 7451 7919 8411 21197 Unpaid Losses & LAE, Net of Reinsurance Recoverables B. Net Reserve Re- estimated as of : One year later 4626 5175 5910 6227 4985 4594 5506 7974 8096 8875 Two years later 4499 5076 6086 6162 4954 4464 5277 7863 8620 Three years later 4288 5029 6050 6117 4884 4225 5216 7773 Four years later 4251 5034 6024 6070 4757 4179 5095 Five years later 4238 5031 6099 5954 4732 4111 Six years later 4239 5038 6044 5928 4687 Seven years later 4234 5030 6038 5900 Eight years later 4234 5030 6029 Nine years later 4234 5030 Ten years later 4234 C. Net Cumulative Redundancy (Deficiency) 87 (733) (106) (804) (19) 469 314 (322) (701) (464) D. Cumulative Amount of Claims Paid, Net of Reserve Recoveries, through: One year later 3028 3313 3783 4326 3326 2791 3229 5377 5691 5845 Two years later 3883 4442 5447 5528 4287 3476 4436 7070 7905 Three years later 4147 4861 5856 5860 4387 3911 4909 7584 Four years later 4207 4975 5933 5699 4571 4002 5014 Five years later 4218 5005 6018 5818 4618 4051 Six years later 4223 5030 6018 5853 4643 Seven years later 4234 5030 6029 5860 Eight years later 4234 5030 6029 Nine years later 4234 5030 Ten years later 4234 2002 2003 ------ ------ Net Reserve-December 31 $ 8,411 $21,197 Reinsurance Recoverables 9,256 7,259 ------ ------ Gross Reserve - December 31 $17,667 $28,456 ====== ====== Net Re-estimated Reserve 8,875 Re-estimated Reinsurance Recoverable 9,932 ------ Gross Re-estimated Reserve $18,807 ====== Gross Cumulative Deficiency $(1,140) ====== Investment Policy The Company's investment objective is to maximize current yield while maintaining safety of capital together with sufficient liquidity for ongoing insurance operations. The investment portfolio is composed of fixed income and equity securities. The fixed income securities are made up of 16% U.S. Government or U.S. Government agency securities, 79% state and local securities, and 5% other securities. The average maturity of the Hallmark and Phoenix fixed income portfolios is 7.8 years and 7.0 years, respectively. The fair value of the Company's fixed income securities as of December 31, 2003 was $31.0 million, of which $5.1 million is classified as restricted investments. If market rates were to change 1%, the fair value of the company's fixed income securities would change approximately $1.7 million as of December 31, 2003. Maturities, bond calls and prepayments of mortgage-backed securities totaled approximately $6.4 million in 2003. In addition, as part of the Company's overall investment strategy, the Company maintains an integrated cash management system utilizing on-line banking services and daily overnight investment accounts to maximize investment earnings on all available cash. During 2003, the Company's investment income totaled approximately $1.2 million compared to approximately $0.8 million for 2002. The increase in investment income from 2002 to 2003 was primarily attributable to the acquisition of Phoenix in January 2003. Employees On December 31, 2003, the Company employed 186 people on a full-time basis as compared to 203 people at December 31, 2002. None of the Company's employees are represented by labor unions. The Company considers its employee relations to be excellent. Item 2. Description of Property. The Company's corporate headquarters and commercial lines group are located at 777 Main Street, Suite 1000, Fort Worth, Texas. The suite is located in a high-rise office building and contains approximately 27,808 square feet of space. Effective June 1, 2003, the Company negotiated its lease for a period of 97 months to expire June 30, 2011. The rent is currently $31,168 per month. The Company's personal lines group is located at 14651 Dallas Parkway, Suite 400, Dallas, Texas. The suite is located in a high-rise office building and contains approximately 25,559 square feet of space. The Company renegotiated its lease on May 5, 2003 for a period of 66 months to expire November 30, 2008. The rent is currently $50,075 per month. Item 3. Legal Proceedings. The Company is engaged in various legal proceedings which are routine in nature and incidental to the Company's business. None of these proceedings, either individually or in the aggregate, are believed, in the opinion of management, to have a material adverse effect on the consolidated financial position of the Company or the results of operations. On May 30, 2003, Phoenix was served with a suit from the Superior Court of the State of Arizona in and for the County of Pima, alleging breach of contract and bad faith in connection with Phoenix's denial of coverage in an automobile accident. The Company settled the suit in the first quarter of 2004 for $2.1 million, net of applicable reinsurance recoverable. Item 4. Submission of Matters to a Vote of Security Holders. During the fourth quarter of 2003, the Company did not submit any matter to a vote of its security holders. PART II Item 5. Market for Common Equity and Related Stockholder Matters. The Company's Common Stock has traded on the American Stock Exchange's Emerging Company Marketplace under the symbol "HAF.EC" since January 6, 1994. The following table shows the Common Stock's high and low sales prices on the AMEX Emerging Company Marketplace for each quarter since January 1, 2002. Period High Sale Low Sale 2002 ---- First Quarter $ 0.60 $ 0.40 Second Quarter 0.60 0.40 Third Quarter 0.54 0.35 Fourth Quarter 0.70 0.30 2003 ---- First Quarter $ 0.75 $ 0.50 Second Quarter 0.95 0.65 Third Quarter 1.15 0.31 Fourth Quarter 0.80 0.50 2004 ---- First Quarter (through March 22) $ 0.79 $ 0.50 As of February 27, 2003 there were approximately 155 shareholders of record of the Company's common stock. The Company has never paid dividends on its Common Stock. The Board of Directors intends to continue this policy for the foreseeable future in order to retain earnings for development of the Company's business. Item 6. Management's Discussion and Analysis or Plan of Operation. The following discussion of the Company's financial condition and the results of its operations should be read in conjunction with the consolidated financial statements and related notes included in this report. Critical Accounting Policies The following discussion provides management's assessment of financial results and material changes in financial position for the Company. This discussion is based upon the Company's consolidated financial statements, which have been prepared in accordance with GAAP. The Company's significant accounting policies requiring management estimates and judgments are discussed below. Such estimates and judgments are based on historical experience, changes in laws and regulations, observance of industry trends and various information received from third parties. While the estimates and judgments associated with the application of these accounting policies may be affected by different assumptions or conditions, the Company believes the estimates and judgments associated with the reported consolidated financial statement amounts are appropriate in the circumstances. Investments. Investment income is an important source of revenue, and the Company's return on invested assets has a material effect on net income. The Company's investment policy is subject to the requirements of regulatory authorities. In addition, certain assets are held on deposit with various states and invested in specified securities in order to comply with state law. Although the Company closely monitors its investment portfolio, available yields on newly-invested funds and gains or losses on existing investments depend primarily on general market conditions. See Item 1 for additional discussion of the Company's investment policy. In 2003, the Company changed the classification of its investment portfolio to available-for-sale. A classification of available-for-sale means the changes in the fair market value of securities are reflected in other comprehensive income, a component of stockholders' equity. Prior to 2003, the Company used an investment strategy classified as held-to- maturity. A classification of held-to-maturity means that the Company reported its securities at amortized cost rather than fair market value. Short-term investments are carried at market value. Short-term investments are comprised of a certificate of deposit maturing in one year. Realized investment gains and losses are recognized in operations on the specific identification method. Deferred Policy Acquisition Costs. Policy acquisition costs (mainly commissions, underwriting and marketing expenses) that vary with and are primarily related to the production of new and renewal business are deferred and charged to operations over periods in which the related premiums are earned. Ceding commissions from reinsurers, which include expense allowances, are deferred and recognized over the period premiums are earned for the underlying policies reinsured. 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. The Company routinely evaluates the realizability of deferred policy acquisition costs. At December 31, 2003 and 2002, there was no premium deficiency related to deferred policy acquisition costs. Business Combinations. The Company accounts for business combinations using the purchase method of accounting. The cost of an acquired entity is allocated to the assets acquired (including identified intangible assets) and liabilities assumed based on their estimated fair values. The excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed is an asset referred to as "excess of cost over net assets acquired" or "goodwill". Indirect and general expenses related to business combinations are expensed as incurred. Retirement Plans. Certain employees of the Commercial Lines Group were participants in a defined benefit cash balance plan covering all full-time employees who had completed at least 1,000 hours of service. The plan was frozen in March 2001 in anticipation of distribution of plan assets to members upon plan termination. All participants were vested when the plan was frozen. Management, in conjunction with its consulting actuaries, determined the appropriate assumptions to be used in valuing the projected benefit obligation of the plan at December 31, 2003. Assumptions used considered the expected payout period for the liabilities and underlying assets held to fund the obligation. Intangible Assets. On January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142 ("SFAS 142"), "Goodwill and Other Intangible Assets". SFAS 142 supersedes Accounting Principles Board ("APB") 17, "Intangible Assets", and primarily addresses the accounting for goodwill and intangible assets subsequent to their initial recognition. SFAS 142 (1) prohibits the amortization of goodwill and indefinite-lived intangible assets, (2) requires testing of goodwill and indefinite-lived intangible assets on an annual basis for impairment (and more frequently if the occurrence of an event or circumstance indicates an impairment), (3) requires that reporting units be identified for the purpose of assessing potential future impairments of goodwill, and (4) removes the forty-year limitation on the amortization period of intangible assets that have finite lives. Pursuant to SFAS 142, the Company has identified two components of goodwill and assigned the carrying value of these components into two reporting units: the Personal Lines Group and the Commercial Lines Group. During 2003, the Company completed the first step prescribed by SFAS 142 for testing for impairment and determined that there is no impairment. Prior to the acquisitions of the Commercial Lines Group in December 2002 and Phoenix in January 2003, the Company assigned the carrying value of goodwill to the insurance company reporting unit and the finance company reporting unit. In 2003, as a result of these acquisitions, the Company changed the way it views its operating segments. Effective December 1, 2002, the Company acquired the Commercial Lines Group. At acquisition, the Company valued the relationships with its independent agents at $542,580. This asset is classified as an other intangible asset and is being amortized over twenty years. The Company recognized $27,129 of amortization expense for the twelve months ending December 31, 2003 and will recognize $27,129 in amortization expense for each of the next five years and $377,545 for the remainder of the asset's life. Deferred Tax Assets. The Company files a consolidated federal income tax return. Deferred federal income taxes reflect the future tax consequences of differences between the tax bases of assets and liabilities and their financial reporting amounts at each year end. Deferred taxes are recognized using the liability method, whereby tax rates are applied to cumulative temporary differences based on when and how they are expected to affect the tax return. Deferred tax assets and liabilities are adjusted for tax rate changes. A valuation allowance is provided against the Company's deferred tax asset to the extent that management does not believe it is more likely than not that future taxable income will be adequate to realize these future tax benefits. This valuation allowance was $884,000 and $33,000 at December 31, 2003 and 2002, respectively. Reserves for Unpaid Losses and Loss Adjustment Expenses. Reserves for unpaid losses and LAE are established by the Company for claims which have already been incurred by the policyholder but which have not been paid by the Company. Losses and LAE represent the estimated ultimate net cost of all reported and unreported losses incurred through December 31, 2003 and 2002. The reserves for unpaid losses and LAE are estimated using individual case-basis valuations and statistical analyses. These estimates are subject to the effects of trends in loss severity and frequency. Although considerable variability is inherent in such estimates, management believes that the reserves for unpaid losses and LAE are adequate. The estimates are continually reviewed and adjusted as experience develops or new information becomes known. Such adjustments are included in current operations. The range of unpaid losses and LAE estimated by the Company's actuaries as of December 31, 2003 was $21.3 million to $32.6 million. Management's best estimate of unpaid losses and LAE as of December 31, 2003 is $28.5 million. In setting this estimate of unpaid losses and LAE, management has assumed, among other things, that current trends in loss frequency and severity will continue and that the actuarial analysis was empirically valid. In the absence of any specific factors indicating actual experience at either extreme of the actuarial range, management has established a moderately conservative estimate of unpaid losses and LAE, which is approximately $1.5 million higher than the midpoint of the actuarial range. This estimate of unpaid losses and LAE includes reserves related to settlement of a bad faith claim of $2.1 million, net of reinsurance and inadequate Phoenix pre-acquisition reserves. (See Item 3) The Company's reserve requirements are also interrelated with product pricing and profitability. The Company must price its products at a level sufficient to fund its policyholder benefits and still remain profitable. Because the Company's claim expenses represent the single largest category of its expenses, inaccuracies in the assumptions used to estimate the amount of such benefits can result in the Company failing to price its products appropriately and to generate sufficient premiums to fund its operations. Recognition of Premium Revenues. Insurance premiums and policy fees are earned pro rata over the terms of the policies. Upon cancellation, any unearned premium and policy fee is refunded to the insured. Insurance premiums written include gross policy fees of $3.0 million and $5.1 million and policy fees, net of reinsurance, of $2.3 million and $2.1 million for the years ended December 31, 2003 and 2002, respectively. Ceding Commissions of the Personal Lines Group. Ceding commissions from reinsurers on retroceded business, which include expense allowances, are deferred and recognized over the period premiums are earned for the underlying policies reinsured. Deferred ceding commissions are netted against deferred policy acquisition costs in the balance sheet. The change in deferred ceding commission income is netted against the change in deferred policy acquisition costs in the statement of operations. Under Hallmark's reinsurance arrangements, the Company earns ceding commissions based on Dorinco's loss ratio experience on the portion of policies reinsured by Dorinco. The Company receives a provisional commission as policies are produced as an advance against the later determination of the commission actually earned. The provisional commission is adjusted periodically on a sliding scale based on expected loss ratios. Recognition of Commission Revenues and Expenses of the Commercial Lines Group. Commission revenue and commission expense related to insurance policies serviced by HGA are recognized during the period covered by the policy. Profit sharing commission is calculated and recognized when the ratio of ultimate losses and loss expenses incurred to earned premium ("loss ratio") as determined by a qualified actuary deviate from contractual thresholds. The profit sharing commission is an estimate that varies with the estimated loss ratio and is sensitive to changes in that estimate. The following table details the profit sharing commission revenue sensitivity to the actual ultimate loss ratio for each effective quota share treaty at 0.5% above and below the provisional loss ratio. Treaty Effective Dates -------------------------------- 7/1/01 - 7/1/02 - 7/1/03 - 6/30/02 6/30/03 6/30/04 -------------------------------- Provisional loss ratio 60.0% 59.0% 59.0% Ultimate loss ratio booked to at 12/31/03 58.5% 59.0% 59.0% Effect of actual 0.5% above provisional ($206,115) ($270,254) ($40,099) Effect of actual 0.5% below provisional $144,280 $178,367 $26,465 As of December 31, 2003, the Company recorded a $0.4 million profit sharing receivable for the quota share treaty effective July 1, 2001 through June 30, 2002. The Company also recorded a $0.6 million receivable on the quota share treaty effective July 1, 2001 through June 30, 2002 because the Company has collected its commission on this treaty at the maximum loss ratio of 61.5% equal to a commission rate of 30.0% per the contractual commission slide. Recognition of Claim Servicing Fees. Claim servicing fees are recognized in proportion to the historical trends of the claim cycle. The Company uses historical claim count data that measures the close rate of claims in relation to the policy period covered to substantiate the service period. The following table summarizes the years in which claim fee revenue is recognized by type of business. Year Claim Fee Revenue Recognized --------------------------------- 1st 2nd 3rd 4th -------------------- Commercial property fees 80% 20% - - Commercial liability fees 60% 30% 10% - Personal property fees 90% 10% - - Personal liability fees 49% 33% 12% 6% Reinsurance. As is common in the insurance industry, prior to April 1, 2003, the Company reinsured, or ceded, portions of the coverage provided to policyholders to other insurance companies. Cession of reinsurance is utilized by an insurer to limit its maximum loss, thereby providing a greater diversification of risk and minimizing exposures on larger risks. Reinsurance does not discharge the primary liability of the original insurer with respect to such insurance. See Item 1 for further discussion of the Company's reinsurance arrangements. Statutory Accounting Practices. The Company is required to report its results of operations and financial position to TDI and AZDOI based upon SAP. Under SAP, unlike GAAP, the Company is required to expense all sales and other policy acquisition costs as they are incurred rather than capitalizing and amortizing them over the expected life of the policy. The immediate charge off of sales and acquisition expenses and other conservative valuations under SAP generally cause a lag between the sale of a policy and the emergence of reported earnings. Because this lag can reduce the Company's gain from operations on a SAP basis, it can have the effect of reducing the amount of funds available for dividend to HFS from Hallmark and Phoenix. Financial Condition and Liquidity The Company's sources of funds are principally derived from insurance related operations. The major sources of funds from operations include premiums collected (net of policy cancellations and premiums ceded), ceding commissions, and processing and service fees. Other sources of funds are from financing and investment activities. The following table shows future payments to be made under contractual obligations as of December 31, 2003 (in thousands): Payments by Period: ---------------------------------------------- Less than 1-3 3-5 More than Total 1 Year Years Years 5 Years ---------------------------------------------- Contractual obligations: (1) Long-term borrowings (2) $ 991 $ 728 $ 263 - - (1) Information regarding the Company's contractual obligations under operating leases as of December 31, 2003, is incorporated by reference to Note 16 of the consolidated financial statements included in this report. (2) Long-term borrowings consists of a 8.25% promissory note payable to Dorinco. Payments of principal and accrued interest are due in quarterly installments on the last day of March, June, September, and December with the last payment due June 30, 2005. (See Note 7 of the consolidated financial statements included in this report) On a consolidated basis, the Company's cash and investments increased approximately 60.3% as of December 31, 2003 as compared to December 31, 2002. This was primarily a result of the acquisition of Phoenix, which increased cash and investments by $24.7 million in 2003. Excluding Phoenix, the Company's liquidity decreased by approximately $9.5 million or 37.7%, primarily as a result of lower retained premium volume in Hallmark in 2003 as compared to 2002. The Company's consolidated cash, cash equivalents and investments at December 31, 2003 and 2002 were $40.4 million and $25.2 million, respectively, excluding restricted cash and investments of $5.4 million and $1.1 million, respectively, to secure State & County's credit exposure from the quota share reinsurance treaty with Hallmark effective April 1, 2003. The Company's operating activities provided $0.7 million in net cash during 2003 as compared to $1.9 million in 2002. The Company paid $26.1 million more in operating expenses and $8.7 million more in losses and LAE in 2003 as compared to 2002 primarily a result of the acquisitions of Phoenix in 2003 and the Commercial Lines Group in December 2002. These additional outlays of cash were partially offset by $18.2 million more ceding commissions collected, $11.5 million more premiums collected, net of reinsurance paid and $4.1 million more processing and service fees collected in 2003 as compared to 2002. Cash provided by investing activities during 2003 increased by $18.0 million as compared to 2002. Premium finance notes repaid over notes originated increased by $9.4 million in 2003 over 2002. During 2003, the Company received $6.9 million in cash from the acquisition of Phoenix and received $4.9 million more in cash from redemptions and maturities of investment securities than in 2002. The Company purchased $6.4 million more in debt and equity securities than in 2002. The Company also transferred $5.2 million more from cash and investments to restricted trust accounts in 2003 than in 2002 in connection with changes to the quota share reinsurance treaty with State & County effective April 1, 2003. During 2002, the Company purchased a note receivable in the amount of $6.5 million from a financial institution, which was secured by the stock of Phoenix, and purchased the Commercial Lines Group for $2.1 million plus assumption of certain liabilities. Cash used in financing activities increased by $17.6 million during 2003 as compared to 2002 primarily due to the repayment of a promissory note to a related party initiated in 2002 and a $9.4 million increase in net repayments to premium finance lender. Proceeds of the note were used to purchase the note receivable and Commercial Lines Group discussed above. The funds used to repay the promissory note were generated by a rights offering the Company completed in the third quarter of 2003. Net repayments to the premium finance lender increased as a result of the Company's discontinuation of its writing of premium financed policies effective July 1, 2003. HFS is dependent on dividend payments and management fees from its insurance company operations and free cash flow of its non-insurance companies to meet operating expenses and debt obligations. As of December 31, 2003, cash and invested assets of HFS were $1.9 million. Cash and invested assets of non-insurance subsidiaries were $3.2 million as of December 31, 2003. Property and casualty insurance companies domiciled in the State of Texas are limited in the payment of dividends to their shareholders in any twelve-month period, without the prior written consent of the Commissioner 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. During 2003, Hallmark's ordinary dividend capacity was $0.8 million. During 2003, Hallmark declared dividends to HFS of $0.4 million of which $0.2 million was paid. Based on surplus at December 31, 2003, Hallmark could pay up to $2.0 million in dividends to HFS during 2004 without TDI approval. Phoenix, domiciled in Arizona, is limited in the payment of dividends to the lesser of 10% of prior year policyholder surplus or prior year's net investment income, without prior written approval from the AZDOI. During 2003, Phoenix's ordinary dividend capacity was $0.6 million. Phoenix paid $0.6 million of dividends to HFS during 2003. The maximum dividend that Phoenix can pay HFS in 2004 without prior approval of the AZDOI is $0.6 million. TDI regulates financial transactions between Hallmark, HFS and affiliated companies. Applicable regulations require TDI's approval of management and expense sharing contracts and similar transactions. Although TDI has approved Hallmark's payment of management fees to HFS and commissions to AHGA, since the second half of 2000 management has elected not to pay all the approved commissions or management fees. Hallmark paid management fees of $0.6 million to HFS during 2003, as compared to $0.2 million in 2002. The AZDOI regulates financial transactions between Phoenix and affiliated companies. Applicable regulations require AZDOI's approval of management and expense sharing contracts and similar transactions. Although the AZDOI has approved payments of management fees to HFS, management elected not to pay a management fee to HFS in 2003 in order to strengthen Phoenix's surplus. Statutory capital and surplus is calculated as statutory assets less statutory liabilities. TDI requires that Hallmark maintain minimum statutory capital and surplus of $2.0 million and AZDOI requires that Phoenix maintain minimum statutory capital and surplus of $1.5 million. Hallmark and Phoenix exceed the minimum required statutory capital and surplus by 401% and 571%, respectively. At December 31, 2003, Hallmark reported statutory capital and surplus of $10.0 million, which reflects an increase of $1.6 million from the $8.4 million reported at December 31, 2002. At December 31, 2003, Phoenix reported statutory capital and surplus of $10.1 million. Hallmark reported statutory net income of $2.0 million during 2003 compared to $0.4 million in 2002. At December 31, 2003, Hallmark's premium-to-surplus ratio was 1.50 to 1 as compared to 2.63 to 1 for the year ended December 31, 2002. Phoenix had statutory net loss of $0.3 million for fiscal 2003. Phoenix's premium-to-surplus ratio was 2.15 to 1 for the year ended December 31, 2003. HFC previously entered into a secured financing arrangement and a servicing agreement with an unaffiliated third party, FPF, Inc., in order to fund HFC's premium finance activities. The Company discontinued writing premium financed policies in July 2003. The financing arrangement provided that HFC sell to the third party all eligible premium finance notes generated by HFC in connection with the financing of insurance policies. As of December 31, 2003, HFC did not have an outstanding balance on advances under the financing arrangement compared to an outstanding balance of $10.9 million as of December 31, 2002. Based on 2004 budgeted and year-to-date cash flow information, the Company believes that it has sufficient liquidity to meet its projected insurance obligations, operational expenses and capital expenditure requirements for the foreseeable future. However, management is continuing to investigate opportunities for future growth and additional capital may be required to fund further expansion of the Company. Results of Operations Income before tax, cumulative effect of change in accounting principle and extraordinary gain was $0.7 million for 2003, compared to $36,000 in 2002. The improvement in operating earnings in 2003 reflects better underwriting results for Hallmark and the acquisition of the Commercial Lines Group in December 2002, partially offset by the acquisition of Phoenix. Net income for 2003 includes $8.1 million of extraordinary gain resulting from the acquisition of Phoenix. In consideration for Phoenix, the Company retired $7.0 million of a $14.85 million note receivable from Millers American Group, Inc. ("Millers"). The Company had valued the note receivable on its balance sheet at its cost of $6.5 million. As of December 31, 2003, the Company fully allowed for the remaining balance of the note receivable. The gain is calculated as the difference between the fair value of the net assets of Phoenix of $14.6 million and the $6.5 million cost of the note receivable from Millers. The following is additional business segment information for the twelve months ended December 31 (in thousands): 2003 2002 Revenues -------- -------- -------- Personal Lines Group $ 49,665 $ 23,999 Commercial Lines Group 19,891 1,561 Corporate 3 237 -------- -------- Consolidated $ 69,559 $ 25,797 ======== ======== Pre-tax Income -------------- Personal Lines Group $ 1,350 $ (203) Commercial Lines Group 1,311 3 Corporate (1,975) 236 -------- -------- Consolidated $ 686 $ 36 ======== ======== Personal Lines Group Gross premiums written (prior to reinsurance) for 2003 decreased 16% and net premiums written (after reinsurance) increased 66% in relation to 2002. The decrease in gross premiums written is primarily due to the change in the reinsurance structure with Dorinco and the county mutual fronting companies (State & County and OACM). Effective April 1, 2003, the Company assumed a 45% share of the non-standard auto business produced by AHGA and underwritten by either State & County or OACM instead of the 100% share it assumed prior to that date. Also, effective April 1, 2003, Dorinco assumed its 55% share of this business directly, where prior to this date the Company retroceded 55% of the business to Dorinco. The decrease in gross premiums written is also impacted by Hallmark's cancellation of unprofitable agents, shift in marketing focus from annual term premium financed policies to six month term direct bill policies and increases in policy rates. These decreases are partially offset by the acquisition of Phoenix in 2003, which contributed $22.4 million in gross premiums written. The increase in net premiums written is due primarily to the acquisition of Phoenix in 2003, which contributed $21.6 million in 2003. Revenue for the Personal Lines Group increased 107% in 2003 to $49.7 million from $24.0 million in 2002. The increase is due mostly to the acquisition of Phoenix, which contributed $24.3 million in revenue in 2003 and AHGA commission revenue of $2.5 million from Dorinco on policies effective after March 31, 2003 due to the new reinsurance structure. Pre-tax income for the Personal Lines Group increased $1.6 million in 2003 to $1.4 million as compared to a pre-tax loss of $0.2 million in 2002. Contributing to the increased pre-tax income are lower Hallmark loss and LAE of $13.1 million in 2003 as compared to $15.3 million in 2002. Improved pricing in 2003 and Hallmark's termination of unprofitable agents in the first quarter of 2003 helped cause the Company's statutory loss and LAE ratio to improve to 72.5% for 2003 as compared to 76.8% for 2002. Partially offsetting these increases in pre-tax income is the acquisition of Phoenix, which reported a $0.4 million pre-tax loss. The results for Phoenix include a loss accrual of $2.1 million, net of applicable reinsurance, for the settlement of a bad faith claim. (See Item 3.) Commercial Lines Group Revenue for the Commercial Lines Group of $19.9 million in 2003 is mostly comprised of $15.0 million of commissions earned on policies serviced by HGA for CNIC. Revenue also includes $4.6 million of processing and service fees earned by ECM for claims processing for CNIC and by FAR for accounting administration for an unaffiliated third party, the contract for which ended in April 2003. The Commercial Lines Group reported revenue of $1.6 million for the one month ended December 31, 2002, which was mostly comprised of $1.1 million of commissions and $0.4 million of processing and service fees. These were new sources of revenue for the Company as a result of the acquisition of the Commercial Lines Group in December 2002. Pre-tax income for the Commercial Lines Group of $1.3 million in 2003 is comprised of $19.9 million in revenue as discussed above and $18.6 million in other operating costs and expenses. These costs primarily represent expenses associated with the production and servicing of insurance policies for CNIC, the largest component of which is independent retail agent commissions. Corporate Corporate pre-tax loss of $2.0 million in 2003 increased $2.2 million as compared to pre-tax income of $0.2 million for 2002. The primary reason for the increase in corporate pre-tax loss is because HFS took $1.2 million less in management fees from the Personal Lines Group in 2003 than it did in 2002. Other operating costs and expenses increased $0.5 million mostly as a result of legal and consulting fees associated with acquisitions and other corporate matters. Additionally, the shift in management structure from 2002 to 2003 increased salary related expenses and other overhead during 2003. Interest expense increased by $0.6 million in 2003 due to interest on a related party note payable. Proceeds from this note were used to acquire the Commercial Lines Group and Phoenix. The Company repaid this note in September 2003 from the proceeds of a rights offering of its stock in the third quarter of 2003. Investment income decreased by $0.2 million due to a note receivable secured by the stock of Phoenix acquired from a financial institution in the fourth quarter of 2002 being satisfied by the acquisition of Phoenix in 2003. Partially offsetting these increased expenses is $0.3 million of amortization of a $0.5 million risk premium reserve established in 2003 for Phoenix unpaid loss and LAE. The remainder of this reserve will be amortized into income over the next five years. Item 7. Financial Statements The following consolidated financial statements of the Company and its subsidiaries are filed as part of this report. Description Page Number ----------- ----------- Independent Auditors' Report F-2 Report of Independent Accountants F-3 Consolidated Balance Sheets at December 31, 2003 and 2002 F-4 Consolidated Statements of Operations for the Years Ended December 31, 2003 and 2002 F-5 Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 2003 and 2002 F-6 Consolidated Statements of Cash Flows for the Years Ended December 31, 2003 and 2002 F-7 Notes to Consolidated Financial Statements F-9 Item 8. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. On October 10, 2003, the Company dismissed PricewaterhouseCoopers LLP ("PWC") as its independent accountants and retained KPMG LLP as its new independent accountants to audit its financial statements for the fiscal year ended December 31, 2003. The information required by Item 304 of Regulation S-B is incorporated by reference from the Company's Current Report on Form 8-K filed October 17, 2003. Item 8A. Controls and Procedures. The Chief Executive Officer and the Chief Financial Officer of the Company have evaluated the Company's disclosure controls and procedures and have concluded that such controls and procedures are effective as of the end of the period covered by this report. During the most recent fiscal quarter, there have been no changes in the Company's internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. PART III Item 9. Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act. The information required by Part III, Item 9 is incorporated by reference from the Registrant's definitive proxy statement to be filed with the Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this report. Item 10. Executive Compensation. The information required by Part III, Item 10 is incorporated by reference from the Registrant's definitive proxy statement to be filed with the Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this report. Item 11. Security Ownership of Certain Beneficial Owners and Management. The information required by Part III, Item 11 is incorporated by reference from the Registrant's definitive proxy statement to be filed with the Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this report. Item 12. Certain Relationships and Related Transactions. The information required by Part III, Item 12 is incorporated by reference from the Registrant's definitive proxy statement to be filed with the Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this report. Item 13. Exhibits and Reports on Form 8-K. (a) The exhibits listed in the Exhibit Index appearing at page 23 of this report are filed with or incorporated by reference in this report. (b) The Company filed the following reports on Form 8-K during the fourth quarter of 2003: Form 8-K filed October 17, 2003 announcing a change in the Company's certifying accountant. Form 8-K filed November 14, 2003 containing a press release announcing financial results for the third quarter ended September 30, 2003. Form 8-K filed November 18, 2003 containing a press release announcing the resignation of President, Chief Operating Officer and member of the Board of Directors, Timothy A. Bienek. Item 14. Principal Accountant Fees and Services. The information required by Part III, Item 14 is incorporated by reference from the Registrant's definitive proxy statement to be filed with the Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this report. [This space left blank intentionally.] SIGNATURES In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. HALLMARK FINANCIAL SERVICES, INC. (Registrant) Date: March 30, 2004 /s/ Mark E. Schwarz ------------------------------------------ Mark E. Schwarz, Chairman (Chief Executive Officer) Date: March 30, 2004 /s/ Mark J. Morrison ------------------------------------------ Mark J. Morrison, Executive Vice President (Principal Financial Officer) Date: March 30, 2004 /s/ Jeffrey R. Passmore ------------------------------------------ Jeffrey R. Passmore, Senior Vice President (Principal Accounting Officer) In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date: March 30, 2004 /s/ Mark E. Schwarz ------------------------------------------ Mark E. Schwarz, Director Date: March 30, 2004 /s/ James H. Graves ------------------------------------------ James H. Graves, Director Date: March 30, 2004 /s/ George R. Manser ------------------------------------------ George R. Manser, Director Date: March 30, 2004 /s/ Scott T. Berlin ------------------------------------------ Scott T. Berlin, Director Date: March 30, 2004 /s/ James C. Epstein ------------------------------------------ James C. Epstein, Director EXHIBIT INDEX The following exhibits are either filed with this report or incorporated by reference. Exhibit Number Description ------ ----------- 3(a) Articles of Incorporation of the registrant, as amended (incorporated by reference to Exhibit 3(a) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1993). 3(b) By-Laws of the registrant, as amended (incorporated by reference to Exhibit 3(b) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1993). 3(c) Amendment of Article VII of the Amended and Restated Bylaws of Hallmark Financial Services, Inc., adopted July 19, 2002 (incorporated by reference to Exhibit 10(b) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended September 30, 2002). 4 Specimen certificate for Common Stock, $.03 par value, of the registrant (incorporated by reference to Exhibit 4 to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1991). 10(a) Office Lease for 14651 Dallas Parkway, Suite 900, dated January 1, 1995, between American Hallmark Insurance Company of Texas and Fults Management Company, as agent for The Prudential Insurance Company of America (incorporated by reference to Exhibit 10(a) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1994). 10(b) General Agency Agreement, effective March 1, 1992, between State & County Mutual Fire Insurance Company and Brokers General, Inc. (incorporated by reference to Exhibit 10(b) to Amendment No. 1 on Form 8 to the registrant's Quarterly Report on Form 10-QSB for the quarter ended September 30, 1992). 10(c) 1991 Key Employee Stock Option Plan of the registrant (incorporated by reference to Exhibit C to the definitive Proxy Statement relating to the registrant's Annual Meeting of Shareholders held May 20, 1991). 10(d) 1994 Key Employee Long Term Incentive Plan (incorporated by reference to Exhibit 10(f) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1994). 10(e) 1994 Non-Employee Director Stock Option Plan (incorporated by reference to Exhibit 10(g) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1994). 10(f) Addendum No. 1 to the 100% Quota Share Reinsurance Agreement, as restated between State & County Mutual Fire Insurance Company and American Hallmark Insurance Company of Texas effective November 22, 1994 (incorporated by reference to Exhibit 10(q) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1994). 10(g) Second, Third, Fourth and Fifth Amendments to Office Lease for 14651 Dallas Parkway, Suite 900, dated January 1, 1995, between American Hallmark Insurance Company of Texas and Fults Management Company, as agent for The Prudential Insurance Company of America (incorporated by reference to Exhibit 10(t) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1995). 10(h) Quota Share Reinsurance Agreement between State & County Mutual Fire Insurance Company and American Hallmark Insurance Company of Texas effective July 1, 1996 (incorporated by reference to Exhibit 10(a) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 1996). 10(i) Quota Share Retrocession Agreement between American Hallmark Insurance Company of Texas and the Reinsurer (specifically identified as follows: Dorinco, Kemper and Skandia), effective July 1, 1996 (incorporated by reference to Exhibit 10(b) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 1996). Exhibit Number Description ------ ----------- 10(j) Guaranty Agreement effective July 1, 1996 provided by Dorinco Reinsurance Company in favor of State & County Mutual Fire Insurance Company (incorporated by reference to Exhibit 10(c) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 1996). 10(k) Guaranty of Performance and Hold Harmless Agreement effective July 1, 1996 between Hallmark Financial Services, Inc. and Dorinco America Reinsurance Corporation (incorporated by reference to Exhibit 10(f) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 1996). 10(l) Addendum No. 3 - Termination to 100% Quota Share Reinsurance Agreement between American Hallmark Insurance Company and State & County Mutual Fire Insurance Company (incorporated by reference to Exhibit 10(j) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 1996). 10(m) 100% Quota Share Reinsurance Agreement, effective January 1, 1997, between State & County Mutual Fire Insurance Company, Vaughn General Agency, Inc. and American Hallmark General Agency, Inc. (incorporated by reference to Exhibit 10(am) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1996). 10(n) General Agency Agreement, effective January 1, 1997, between Dorinco Reinsurance Company, State & County Mutual Fire Insurance Company and Vaughn General Agency, Inc. (incorporated by reference to Exhibit 10(an) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1996). 10(o) Administrative Services Agreement between State & County Mutual Fire Insurance Company, Vaughn General Agency, Inc. and American Hallmark General Agency, Inc. (incorporated by reference to Exhibit 10(ao) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1996). 10(p) Loan Agreement dated March 11, 1997, between Hallmark Financial Services, Inc. and Dorinco Reinsurance Company (incorporated by reference to Exhibit 10(ap) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1996). 10(q) Stock Pledge and Security Agreement dated March 11, 1997, between ACO Holdings, Inc. and Dorinco Reinsurance Company (incorporated by reference to Exhibit 10(ar) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1996). 10(r) Endorsement No. 1, effective July 1, 1996, to the 100% Quota Share Reinsurance Agreement between State & County Mutual Fire Insurance Company and American Hallmark Insurance Company of Texas, effective July 1, 1996 (incorporated by reference to Exhibit 10(a) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 1997). 10(s) Endorsement No. 1, effective July 1, 1997, to the Guaranty Agreement provided by Dorinco Reinsurance Corporation in favor of State & County Mutual Fire Insurance Company, effective July 1, 1996 (incorporated by reference to Exhibit 10(d) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 1997). 10(t) Endorsement No. 1 - Termination, effective January 1, 1997, to the Quota Share Retrocession Agreement between American Hallmark Insurance Company of Texas and the Reinsurers (Dorinco Reinsurance Company and Odyssey Reinsurance Corporation), effective July 1, 1996 (incorporated by reference to Exhibit 10(e) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 1997). 10(u) Endorsement No. 1, effective July 1, 1997, to the Quota Share Retrocession Agreement between American Hallmark Insurance Company of Texas and the Reinsurer (Dorinco Reinsurance Company) effective July 1, 1996 (incorporated by reference to Exhibit 10(h) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 1997). Exhibit Number Description ------ ----------- 10(v) Endorsement No. 2, effective January 1, 1997, to the Quota Share Retrocession Agreement between American Hallmark Insurance Company of Texas and Dorinco Reinsurance Company, effective January 1, 1997 (incorporated by reference to Exhibit 10(bh) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1997). 10(w) Endorsement No. 1, effective January 1, 1997, to the 100% Quota Share Reinsurance Agreement between State & County Mutual Fire Insurance Company, Vaughn General Agency, Inc. and American Hallmark General Agency, Inc. (incorporated by reference to Exhibit 10(bi) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1997). 10(x) Endorsement No. 2, effective July 1, 1997, to the 100% Quota Share Reinsurance Agreement between State & County Mutual Fire Insurance Company, Vaughn General Agency, Inc., American Hallmark General Agency, Inc. and the Reinsurers (Dorinco Reinsurance Company and Kemper Reinsurance Company) effective July 1, 1997 (incorporated by reference to Exhibit 10(bj) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1997). 10(y) Amendment No. 1 to the Loan Agreement dated March 11, 1997, between Hallmark Financial Services, Inc. and Dorinco Reinsurance Company (incorporated by reference to Exhibit 10(bg) to the registrant's annual Report on Form 10-KSB for the fiscal year ended December 31, 1998). 10(z) Retrocession Agreement effective March 1, 1998, between American Hallmark Insurance Company of Texas, Dorinco Reinsurance Company and Associated General Agency, Inc. (incorporated by reference to Exhibit 10(bh) to the registrant's annual Report on Form 10-KSB for the fiscal year ended December 31, 1998). 10(aa) Quota Share Retrocession Agreement effective September 1, 1998, between American Hallmark Insurance Company of Texas, Dorinco Reinsurance Company and Van Wagoner Companies, Inc. (incorporated by reference to Exhibit 10(bj) to the registrant's annual Report on Form 10-KSB for the fiscal year ended December 31, 1998). 10(ab) Endorsement No. 5, effective January 1, 1999, to the Quota Share Retrocession Agreement between American Hallmark Insurance Company of Texas and the Reinsurer (Dorinco Reinsurance Company), effective January 1, 1997 (incorporated by reference to Exhibit 10(a) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 1999). 10(ac) Endorsement No. 4, effective January 1, 1999, to the Quota Share Retrocession Agreement between American Hallmark Insurance Company of Texas and the Reinsurer (GE Reinsurance Company), effective January 1, 1996 (incorporated by reference to Exhibit 10(b) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 1999). 10(ad) Endorsement No. 2, effective July 1, 1997, to the 100% Quota Share Reinsurance Agreement between State & County Mutual Fire Insurance Company, Vaughn General Agency, Inc. and American Hallmark General Agency, Inc. (incorporated by reference to Exhibit 10(bg) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1999). 10(ae) Amendment No. 3 to the Loan Agreement dated March 11, 1997, between Hallmark Financial Services, Inc. and Dorinco Reinsurance Company (incorporated by reference to Exhibit 10(bh) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1999). 10(af) Endorsement No. 6, effective January 1, 1999, to the Quota Share Retrocession Agreement between American Hallmark Insurance Company of Texas and Dorinco Reinsurance Company, effective January 1, 1997 (incorporated by reference to Exhibit 10(bi) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1999). 10(ag) Sale and Assignment Agreement dated November 18, 1999, with Hallmark Finance Corporation as Seller and FPF, Inc. (incorporated by reference to Exhibit 10(bk) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1999). Exhibit Number Description ------ ----------- 10(ah) Premium Receivable Servicing Agreement dated November 18, 1999 between Hallmark Finance Corporation and FPF, Inc. (incorporated by reference to Exhibit 10(bl) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 1999). 10(ai) Seventh Amendment to Office Lease for 14651 Dallas Parkway, Suite 900, dated January 1, 1995, between American Hallmark Insurance Company of Texas and Fults Management Company, as agent for The Prudential Insurance Company of America (incorporated by reference to Exhibit 10(a) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 2000). 10(aj) Quota Share Retrocession Agreement, effective July 1, 2000, between American Hallmark Insurance Company of Texas and Dorinco Reinsurance Company (incorporated by reference to Exhibit 10(a) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended September 30, 2000). 10(ak) Addendum No. 2 to the Retrocession Contract, effective June 1, 1998, issued to Dorinco Reinsurance Company by American Hallmark Insurance Company of Texas, effective October 1, 1999 (incorporated by reference to Exhibit 10(b) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended September 30, 2000). 10(al) Eighth Amendment to Office Lease for 14651 Dallas Parkway, Suite 900, dated January 1, 1995, between American Hallmark Insurance Company of Texas and Fults Management Company, as agent for The Prudential Insurance Company of America (incorporated by reference to Exhibit 10(br) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2000). 10(am) Quota Share Retrocession Contract between Dorinco Reinsurance Company and American Hallmark Insurance Company of Texas, effective September 1, 2000 (incorporated by reference to Exhibit 10(bs) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2000). 10(an) Endorsement No. 5, effective July 1, 2000, to the 100% Quota Share Reinsurance Agreement issued to State and County Mutual Fire Insurance Company, effective January 1, 1997 (incorporated by reference to Exhibit 10(bt) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2000). 10(ao) Endorsement No. 4, effective July 1, 2000, to the 100% Quota Share Reinsurance Agreement between State and County Mutual Fire Insurance Company and American Hallmark Insurance Company of Texas, effective July 1,1996 (incorporated by reference to Exhibit 10(bu) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2000). 10(ap) Termination Addendum to the Quota Share Retrocession Agreement, effective May 28, 1999, issued to American Hallmark Insurance Company of Texas by Kemper Reinsurance Company, effective July 1, 1996 (incorporated by reference to Exhibit 10(bv) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2000). 10(aq) Termination Addendum to the Quota Share Retrocession Agreement, effective June 30, 2000, issued to Dorinco Reinsurance Company by American Hallmark Insurance Company of Texas, effective January 1, 1997 (incorporated by reference to Exhibit 10(bw) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2000). 10(ar) Termination Addendum to the Quota Share Retrocession Contract, effective September 1, 2000, issued to Dorinco Reinsurance Company by American Hallmark Insurance Company of Texas, effective September 1, 1998 (incorporated by reference to Exhibit 10(bx) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2000). 10(as) Termination Addendum to the Interests and Liability Agreement, effective June 30, 2000, of GE Reinsurance Corporation with respect to the 100% Quota Share Reinsurance Agreement, effective January 1, 1997 (incorporated by reference to Exhibit 10(by) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2001). Exhibit Number Description ------ ----------- 10(at) Termination Endorsement, effective July 1, 2000, to the Guaranty of Performance and Hold Harmless Agreement between Hallmark Financial Services, Inc. and GE Reinsurance Corporation (formerly Kemper Reinsurance Company), effective July 1, 1996 (incorporated by reference to Exhibit 10(cb) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2001). 10(au) Termination Endorsement, effective July 1, 2000, to the Guaranty Agreement provided by GE Reinsurance Corporation (formerly Kemper Reinsurance Company) in favor of State and County Mutual Fire Insurance Company, effective July 1, 1996 (incorporated by reference to Exhibit 10(cc) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2001). 10(av) Endorsement No. 2, effective July 1, 2000, to the Guaranty Agreement provided by Dorinco Reinsurance Company in favor of State and County Mutual Fire Insurance Company, effective July 1, 1996 (incorporated by reference to Exhibit 10(a) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended March 31, 2001). 10(aw) Cut-Through Agreement, dated as of June 26, 2001, by and among American Hallmark Insurance Company of Texas, American Hallmark General Agency, Inc., Hallmark Finance Corporation and FPF, Inc. (incorporated by reference to Exhibit 10(c) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 2001). 10(ax) First Modification Agreement to the Cut-Through Agreement dated as of June 26, 2001, by and among American Hallmark Insurance Company of Texas, American Hallmark General Agency, Inc., Hallmark Finance Corporation and FPF, Inc., entered into June 27, 2001 (incorporated by reference to Exhibit 10(d) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 2001). 10(ay) Letter of Agreement, dated August 3, 2001, between Hallmark Financial Services, Inc. and Dorinco Reinsurance Company (incorporated by reference to Exhibit 10(f) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 2001). 10(az) Letter of Agreement, dated August 6, 2001, between Hallmark Financial Services, Inc. and Dorinco Reinsurance Company (incorporated by reference to Exhibit 10(g) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 2001). 10(ba) Addendum No. 1 to the Quota Share Retrocession Agreement, effective July 1, 2000, between American Hallmark Insurance Company of Texas and Dorinco Reinsurance Company, effective January 1, 2001 (incorporated by reference to Exhibit 10(a) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended September 30, 2001). 10(bb) Addendum No. 2 to the Quota Share Retrocession Agreement, effective July 1, 2000, between American Hallmark Insurance Company of Texas and Dorinco Reinsurance Company, effective July 1, 2001 (incorporated by reference to Exhibit 10(b) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended September 30, 2001). 10(bc) Endorsement No. 1 to the Guaranty of Performance and Hold Harmless Agreement, effective July 1, 1996 between Hallmark Financial Services, Inc. and Dorinco Reinsurance Company, effective July 1, 2000 (incorporated by reference to Exhibit 10(c) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended September 30, 2001). 10(bd) Letter of Agreement, dated November 7, 2001 between Hallmark Financial Services, Inc. and Dorinco Reinsurance Company (incorporated by reference to Exhibit 10(d) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended September 30, 2001). Exhibit Number Description ------ ----------- 10(be) Second Amendment to Hallmark Financial Services, Inc. 1994 Non- Employee Director Stock Option Plan (incorporated by reference to Exhibit 10(e) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended September 30, 2001). 10(bf) Letter of Agreement, dated January 23, 2002, between Hallmark Financial Services, Inc. and Dorinco Reinsurance Company (incorporated by reference to Exhibit 10(bl) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2001). 10(bg) Amendment No. 4 to the Loan Agreement dated March 10, 1997, between Hallmark Financial Services, Inc. and Dorinco Reinsurance Company (incorporated by reference to Exhibit 10(bm) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2001). 10(bh) Second Modification Agreement, entered into December 11, 2001, to the Sale and Assignment Agreement, dated November 18, 1999, with Hallmark Finance Corporation as Seller and FPF, Inc. (incorporated by reference to Exhibit 10(bn) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2001). 10(bi) Addendum No. 2, entered into January 9, 2001, to the General Agency Agreement, effective March 1, 1992, between State & County Mutual Fire Insurance Company and Brokers General, Inc. (incorporated by reference to Exhibit 10(bo) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2001). 10(bj) Third Renewal Promissory Note, dated November 8, 2001, with Hallmark Financial Services, Inc. as Maker and Dorinco Reinsurance Company as Payee (incorporated by reference to Exhibit 10(bp) to the registrant's Annual Report on Form 10-KSB for the fiscal year ended December 31, 2001). 10(bk) Addendum No. 3 to the Quota Share Retrocession Agreement, effective July 1, 2000, between American Hallmark Insurance Company of Texas and Dorinco Reinsurance Company, effective June 30, 2001 (incorporated by reference to Exhibit 10(a) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended September 30, 2002). 10(bl) Form of Indemnification Agreement between Hallmark Financial Services, Inc. and its officers and directors, adopted July 19, 2002 (incorporated by reference to Exhibit 10(c) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended September 30, 2002). 10(bm) Loan Purchase and Sale Agreement, between Hallmark Financial Services, Inc and LaSalle Bank National Association dated November 1, 2002 (incorporated by reference to Exhibit 2 to the registrant's current report on Form 8-K filed November 8, 2002). 10(bn) Purchase Agreement dated November 26, 2002 between Hallmark Financial Services, Inc., Millers American Group, Inc. and The Millers Insurance Company (incorporated by reference to Exhibit 2(a) to the registrant's current report on Form 8-K filed December 4, 2002). 10(bo) Assumption Agreement dated December 1, 2002 between Millers Insurance Company, Millers General Agency, Inc. and Phoenix Indemnity Insurance Company (incorporated by reference to Exhibit 2(b) to the registrant's current report on Form 8-K filed December 4, 2002). 10(bp) First Amendment to Hallmark Financial Services, Inc. 1994 Key Employee Long Term Incentive Plan (incorporated by reference to Exhibit 10(bm) to the registrant's Annual Report on Form 10-KSB for the fiscal ended December 31, 2002). 10(bq) First Amendment to Hallmark Financial Services, Inc. 1994 Non- Employee Director Stock Option Plan (incorporated by reference to Exhibit 10(bn) to the registrant's Annual Report on Form 10-KSB for the fiscal ended December 31, 2002). Exhibit Number Description ------ ----------- 10(br) Addendum No. 1 to the Quota Share Retrocession Contract between Dorinco Reinsurance Company and American Hallmark Insurance Company of Texas, effective September 1, 2000 (incorporated by reference to Exhibit 10(bo) to the registrant's Annual Report on Form 10-KSB for the fiscal ended December 31, 2002). 10(bs) Letter of Agreement, dated October 31, 2002, between Hallmark Financial Services, Inc. and Dorinco Reinsurance Company (incorporated by reference to Exhibit 10(bp) to the registrant's Annual Report on Form 10-KSB for the fiscal ended December 31, 2002). 10(bt) Third Modification Agreement, entered into November 1, 2002, to the Sale and Assignment Agreement, dated November 18, 1999, with Hallmark Finance corporation as Seller and FPF, Inc. (incorporated by reference to Exhibit 10(bq) to the registrant's Annual Report on Form 10-KSB for the fiscal ended December 31, 2002). 10(bu) Letter of Agreement, dated December 30, 2002, between Hallmark Financial Services, Inc. and Dorinco Reinsurance Company (incorporated by reference to Exhibit 10(br) to the registrant's Annual Report on Form 10-KSB for the fiscal ended December 31, 2002). 10(bv) Letter of Agreement, dated December 30, 2002, between Hallmark Financial Services, Inc. and Dorinco Reinsurance Company (incorporated by reference to Exhibit 10(bs) to the registrant's Annual Report on Form 10-KSB for the fiscal ended December 31, 2002). 10(bw) Termination Agreement dated December 30, 2002, between Hallmark Financial Services, Inc. and Linda H. Sleeper (incorporated by reference to Exhibit 10(bt) to the registrant's Annual Report on Form 10-KSB for the fiscal ended December 31, 2002). 10(bx) Tenth Amendment to Office Lease for 14651 Dallas Parkway, Suite 900, dated May 5th, 2003, between American Hallmark Insurance Company of Texas and Fults Management Company, as agent for The Prudential Insurance Company of America (incorporated by reference to Exhibit 10(a) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended March 31, 2003). 10(by) General Agency Agreement between Millers General Agency, Inc and Clarendon National Insurance Company, effective August 15, 2001 (incorporated by reference to Exhibit 10(b) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended March 31, 2003). 10(bz) Claims Administration Agreement between Millers General Agency, Inc. and Clarendon National Insurance Company, effective August 15, 2001 (incorporated by reference to Exhibit 10(c) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended March 31, 2003). 10(ca) Claims Services Agreement between Millers General Agency, Inc. and Effective Claims Management, Inc., effective March 25, 2003 (incorporated by reference to Exhibit 10(d) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended March 31, 2003). 10(cb) Lease Agreement for 777 Main Street, Suite 1000, Fort Worth, Texas 76102, dated June 12, 2003 between Hallmark Financial Services, Inc. and Crescent Real Estate Funding I, L.P. (incorporated by reference to Exhibit 10(a) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 2003). 10(cc) Termination Addendum to the Quota Share Retrocession Agreement, effective March 31, 2003 between American Hallmark Insurance Company of Texas and Dorinco Reinsurance Company (incorporated by reference to Exhibit 10(b) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 2003). Exhibit Number Description ------ ----------- 10(cd) General Agency Agreement by and among American Hallmark General Agency, Inc., State and County Mutual Fire Insurance Company, American Hallmark Insurance Company of Texas and Dorinco Reinsurance Company, effective April 1, 2003 (incorporated by reference to Exhibit 10(c) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 2003). 10(ce) Security Fund Agreement between American Hallmark Insurance Company of Texas and State and County Mutual Fire Insurance Company, effective April 1, 2003 (incorporated by reference to Exhibit 10(d) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 2003). 10(cf) Quota Share Reinsurance Agreement by and among American Hallmark Insurance Company of Texas, American Hallmark General Agency, Inc. and State and County Mutual Insurance Company, effective April 1, 2003 (incorporated by reference to Exhibit 10(e) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 2003). 10(cg) Quota Share Reinsurance Agreement by and among American Hallmark General Agency, Inc., State and County Mutual Insurance Company and Dorinco Reinsurance Company, effective April 1, 2003 (incorporated by reference to Exhibit 10(f) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 2003). 10(ch) Fourth Modification Agreement effective June 19, 2003 by and among Hallmark Finance Corporation and FPF, Inc. (incorporated by reference to Exhibit 10(g) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended June 30, 2003). 10(ci) Technology Processing Services Agreement, effective December 1, 2003 between Phoenix Indemnity Insurance Company and CGI Information Systems & Management Consultants, Inc. (incorporated by reference to Exhibit 10(a) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended September 30, 2003). 10(cj) Policy and Claims Processing Services Agreement, effective September 1, 2003 between Phoenix Indemnity Insurance Company and CGI Information Systems & Management Consultants, Inc. (incorporated by reference to Exhibit 10(b) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended September 30, 2003). 10(ck) Processing Services Agreement, effective July 1, 2003 between Hallmark General Agency, Inc., Effective Claims Management, Inc. and CGI Information Systems & Management Consultants, Inc. (incorporated by reference to Exhibit 10(c) to the registrant's Quarterly Report on Form 10-QSB for the quarter ended September 30, 2003). 10(cl) * Managing General Agency Agreement, effective October 1, 2003, between Old American County Mutual Fire Insurance Company and American Hallmark General Agency, Inc. 10(cm) * Addendum No. 1 to the Managing General Agency Agreement , effective October 1, 2003, between Old American County Mutual Fire Insurance Company and American Hallmark General Agency, Inc. 10(cn) * Guaranty Agreement, effective September 1, 2003, between Old American County Mutual Fire Insurance Company and Hallmark Financial Services, Inc. 10(co) * 45% Quota Share Reinsurance Agreement, effective October 1, 2003, between Old American County Mutual Fire Insurance Company and American Hallmark General Agency, Inc. Exhibit Number Description ------ ----------- 10(cp) * Addendum No. 1 to the 45% Quota Share Reinsurance Agreement, effective October 1, 2003, between Old American County Mutual Fire Insurance Company and American Hallmark General Agency, Inc. 10(cq) * 55% Quota Share Reinsurance Agreement, effective October 1, 2003, between Old American County Mutual Fire Insurance Company and Dorinco Reinsurance Company. 10(cr) * Blanket Retrocession Agreement, effective October 1, 2003, between Dorinco Reinsurance Company and American Hallmark Insurance Company of Texas. 10(cs) * Letter of Termination dated November 2, 2003, to the Sale and Assignment Agreement dated November 17, 1999 by and among Hallmark Finance Corporation and FPF, Inc. 16 Letter from PricewaterhouseCoopers LLP to Securities and Exchange Commission dated October 15, 2003 (incorporated by reference from the Company's Current Report on Form 8-K filed October 17, 2003). 21 * List of subsidiaries of the registrant. 23.1 * Independent Auditors' Consent 23.2 * Consent of Independent Accountants. 31(a) * Certification of Chief Executive Officer required by Rule 13a-14(a) or Rule 15d-14(b). 31(b) * Certification of Chief Financial Officer required by Rule 13a-14(a) or Rule 15d-14(b). 32(a) * Certification of Chief Executive Officer pursuant to 18 U.S.C. 1350. 32(b) * Certification of Chief Financial Officer pursuant to 18 U.S.C. 1350. * Filed herewith HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Description Page Number ----------- ----------- Independent Auditors' Report F-2 Report of Independent Accountants F-3 Consolidated Balance Sheets at December 31, 2003 and 2002 F-4 Consolidated Statements of Operations for the Years Ended December 31, 2003 and 2002 F-5 Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 2003 and 2002 F-6 Consolidated Statements of Cash Flows for the Years Ended December 31, 2003 and 2002 F-7 Notes to Consolidated Financial Statements F-9 INDEPENDENT AUDITORS' REPORT ---------------------------- The Board of Directors and Stockholders Hallmark Financial Services, Inc.: We have audited the consolidated balance sheet of Hallmark Financial Services, Inc. and subsidiaries as of December 31, 2003 and the related consolidated statements of operations, stockholders' equity and comprehensive income and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audit. We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hallmark Financial Services, Inc. and subsidiaries as of December 31, 2003, and the results of their operations and their cash flows for the year ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. As described in note 1 to the consolidated financial statements, effective January 1, 2003 the Company adopted the prospective method provisions of Statement of Financial Standards No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure. /s/ KPMG LLP ------------ KPMG LLP Dallas, Texas March 24, 2004 Report of Independent Accountants --------------------------------- To the Board of Directors Hallmark Financial Services, Inc.: In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of operation, stockholders' equity and cash flows, present fairly, in all material respects, the financial position of Hallmark Financial Services, Inc. and subsidiaries (the "Company") at December 31, 2002, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audit of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. As discussed in Note 1, during 2002 the Company adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets." /s/ PricewaterhouseCoopers LLP ------------------------------ PricewaterhouseCoopers LLP Dallas, Texas March 16, 2003 HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, 2003 and 2002 (In thousands) --------------------------- ASSETS 2003 2002 ------ ---------- ---------- Investments: Debt securities, available-for-sale, at fair value in 2003 and held-to-maturity, at amortized cost in 2002 $ 25,947 $ 7,679 Equity securities, available-for-sale, at fair value 3,573 122 Short-term investments, available-for-sale, at fair value 335 8,927 ---------- ---------- Total investments 29,855 16,728 Cash and cash equivalents 10,520 8,453 Restricted cash and investments 5,366 1,072 Prepaid reinsurance premiums 291 8,956 Premiums receivable encumbered by premium financing activity (net of allowance for doubtful accounts of $3 in 2003 and $115 in 2002) 43 11,593 Premiums receivable 4,033 1,012 Accounts receivable 3,395 2,129 Reinsurance recoverable 10,516 12,929 Deferred policy acquisition costs 7,146 5,266 Excess of cost over fair value of net assets acquired 4,836 5,171 Intangible assets 513 540 Note receivable - 6,500 Current federal income tax recoverable 625 33 Deferred federal income taxes 3,961 1,021 Other assets 2,753 2,358 ---------- ---------- $ 83,853 $ 83,761 ========== ========== LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------ Liabilities: Notes payable $ 991 $ 1,803 Note payable to related party - 8,600 Net advances from lender for financed premiums - 10,905 Unpaid losses and loss adjustment expenses 28,456 17,667 Unearned premiums 5,862 15,957 Reinsurance balances payable - 3,764 Unearned revenue 10,190 6,872 Accrued agent profit sharing 1,511 450 Accrued ceding commission payable 1,164 2,536 Pension liability 1,237 604 Accounts payable and other accrued expense 7,045 6,068 ---------- ---------- 56,456 75,226 ---------- ---------- Commitments and Contingencies - - Stockholders' equity: Common stock, $.03 par value, authorized 100,000,000 shares; issued 36,856,610 shares in 2003 and 11,855,610 shares in 2002 1,106 356 Capital in excess of par value 19,693 10,875 Retained earnings (deficit) 7,254 (1,491) Accumulated other comprehensive income (93) (162) Treasury stock, 484,319 shares in 2003 and 806,477 shares in 2002, at cost (563) (1,043) ---------- ---------- Total stockholders' equity 27,397 8,535 ---------- ---------- $ 83,853 $ 83,761 ========== ========== The accompanying notes are an integral part of the consolidated financial statements HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS for the years ended December 31, 2003 and 2002 (In thousands, except per share amounts) ---------------------------- 2003 2002 ---------- ---------- Gross premiums written $ 43,338 $ 51,643 Ceded premiums written (6,769) (29,611) ---------- ---------- Net premiums written 36,569 22,032 Change in unearned premiums 5,406 (1,819) ---------- ---------- Net premiums earned 41,975 20,213 Investment income, net of expenses 1,198 773 Realized losses (88) (5) Finance charges 3,544 2,503 Commission and fees 17,544 1,108 Processing and service fees 4,900 921 Other income 486 284 ---------- ---------- Total revenues 69,559 25,797 Losses and loss adjustment expenses 30,188 15,302 Other operating costs and expenses 37,386 9,474 Interest expense 1,271 983 Amortization of intangible asset 28 2 ---------- ---------- Total expenses 68,873 25,761 Income before income tax, and cumulative effect of change in accounting principle and extraordinary gain 686 36 Income tax expense 25 13 ---------- ---------- Income before cumulative effect of change in accounting principle and extraordinary gain $ 661 $ 23 Cumulative effect of change in accounting principle, net of tax - (1,694) Extraordinary gain 8,084 - ---------- ---------- Net income (loss) $ 8,745 $ (1,671) ========== ========== Basic earnings (loss) per share: Income before cumulative effect of change in accounting principle and extraordinary gain $ 0.03 $ - Cumulative effect of change in accounting principle - (0.15) Extraordinary gain 0.44 - ---------- ---------- Net income (loss) $ 0.47 $ (0.15) ========== ========== Diluted earnings (loss) per share: Income before cumulative effect of change in accounting principle and extraordinary gain $ 0.03 $ - Cumulative effect of change in accounting principle - (0.15) Extraordinary gain 0.43 - ---------- ---------- Net income (loss) $ 0.46 $ (0.15) ========== ========== The accompanying notes are an integral part of the consolidated financial statements HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY for the years ended December 31, 2003 and 2002 (in thousands) --------------------------------------- Capital Accum. # In Other # Total Comp. of Par Excess of Retained Comp. Treasury of Stockholders' Income Shares Value Par Value Earnings Income Stock Shares Equity (Loss) ------ ----- --------- -------- ------ --------- ------ -------- -------- Balance at December 31, 2001 11,856 $ 356 $ 10,875 $ 180 - ($1,043) 806 $ 10,368 Comprehensive loss: Net loss (1,671) (1,671) $ (1,671) Other comprehensive income, (162) (162) (162) Additional minimum -------- pension liability, net of tax of $94 Comprehensive loss $ (1,833) ------ ----- --------- -------- ------ --------- ------ -------- ======== Balance at December 31, 2002 11,856 $ 356 $ 10,875 ($1,491) ($162) ($1,043) 806 $ 8,535 Rights offering 25,000 750 9,250 10,000 Issuance of common stock 1 - - Amortization of fair value of stock options granted 31 31 Stock options exercised (463) 480 (322) 17 Comprehensive income: Net income 8,745 8,745 $ 8,745 Other comprehensive income, Minimum pension liability (646) (646) (646) Net unrealized holding gains arising during period 667 667 667 Reclassification adjustment for losses included in net net income 88 88 88 ------ -------- -------- Net unrealized gains on securities 755 755 755 ------ -------- -------- Total other comprehensive income before tax 109 109 109 Tax effect on other comprehensive income (40) (40) (40) ------ -------- -------- Other comprehensive income after tax 69 69 69 Comprehensive income $ 8,814 ------ ----- --------- -------- ------ --------- ------ -------- ======== Balance at December 31, 2003 36,857 $1,106 $ 19,693 $ 7,254 ($93) ($563) 484 $ 27,397 ====== ===== ========= ======== ====== ========= ====== ======== The accompanying notes are an integral part of the consolidated financial statements HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the years ended December 31, 2003 and 2002 (In thousands) ---------------------------- 2003 2002 -------- -------- Cash flows from operating activities: Net income (loss) $ 8,745 $ (1,671) Adjustments to reconcile net loss to cash provided by (used in) operating activities: Depreciation and amortization expense 621 195 Change in deferred income taxes 114 48 Change in prepaid reinsurance premiums 8,297 3,061 Change in premiums receivable (1,276) (598) Change in accounts receivable (1,266) (170) Change in deferred policy acquisition costs (1,340) (641) Change in unpaid losses and loss adjustment expenses (5,097) (2,422) Change in unearned premiums (12,785) (1,242) Change in unearned revenue 3,271 183 Change in accrued agent profit sharing 944 72 Change in reinsurance recoverable 12,817 3,942 Change in reinsurance balances payable (3,082) (662) Cumulative effect of change in accounting principle - 1,694 Change in current federal income tax payable/recoverable (592) 662 Change in accrued ceding commission payable (1,372) (2,062) Gain on acquisition of subsidiary (8,084) - Change in all other liabilities 419 1,117 Change in all other assets 365 443 -------- -------- Net cash provided by operating activities 699 1,949 -------- -------- Cash flows from investing activities: Purchases of property and equipment (476) (254) Purchase of note receivable - (6,500) Acquisition of subsidiary, net of cash received 6,945 (2,100) Premium finance notes originated (15,734) (41,273) Premium finance notes repaid 27,284 43,420 Change in restricted cash and investments (4,294) 918 Purchases of debt and equity securities (19,075) (12,639) Maturities and redemptions of investment securities 8,131 5,858 Net redemptions of short-term investments 8,904 6,276 -------- -------- Net cash provided by (used in) investing activities 11,685 (6,294) -------- -------- Cash flows from financing activities: Proceeds from note payable - 8,600 Net repayments to premium finance lender (10,905) (1,308) Proceeds from rights offering 10,000 - Repayment of borrowings (9,412) (27) -------- -------- Net cash (used in) provided by financing activities (10,317) 7,265 -------- -------- Increase in cash and cash equivalents 2,067 2,920 Cash and cash equivalents at beginning of year 8,453 5,533 -------- -------- Cash and cash equivalents at end of year $ 10,520 $ 8,453 ======== ======== Supplemental cash flow information: Interest paid $ (1,456) $ (833) ======== ======== Income taxes recovered/(paid) $ (475) $ 696 ======== ======== In the first quarter of 2003, the Company retired a portion of a note receivable in consideration for all the stock of Phoenix as further explained in Note 1 Accounting Policy for Business Combinations. In conjunction with the acquisition, cash and cash equivalents were provided as follows: Value of note receivable exchanged $ 6,500 Extraordinary gain on acquisition 8,084 Fair value of tangible assets acquired excluding cash (27,167) Liabilities assumed 19,528 -------- Cash and cash equivalents provided by acquisition $ 6,945 ======== The accompanying notes are an integral part of the consolidated financial statements HALLMARK FINANCIAL SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ___________ 1. Accounting Policies: ------------------- General ------- Hallmark Financial Services, Inc. ("HFS") and its wholly owned subsidiaries (collectively, the "Company") engage in the sale of property and casualty insurance products. The Company's business involves marketing and underwriting of non-standard personal automobile insurance in Texas, New Mexico and Arizona, commercial insurance in Texas, New Mexico, Idaho, Oregon and Washington, third party claims administration and other insurance related services. The Company discontinued producing new premium financed non-standard personal automobile insurance in July 2003. The Company pursues its business activities through integrated insurance groups handling non-standard personal automobile insurance (the "Personal Lines Group") and commercial insurance (the "Commercial Lines Group"). The Personal Lines Group focuses on providing non-standard automobile liability and physical damage insurance in Texas, New Mexico and Arizona for drivers who do not qualify for or cannot obtain standard rate insurance. The members of the Personal Lines group are a Texas domiciled property and casualty insurance company, American Hallmark Insurance Company of Texas ("Hallmark"); an Arizona domiciled property and casualty insurance company, Phoenix Indemnity Insurance Company ("Phoenix"); a managing general agency, American Hallmark General Agency, Inc. ("AHGA"); a premium finance company, Hallmark Finance Corporation ("HFC"); and a third party claims administrator, Hallmark Claims Service, Inc. ("HCS"). Once the premium financed business completely runs off, HFC will discontinue operations. The Commercial Lines Group markets, underwrites and administers low hazard commercial insurance policies primarily in the rural areas of Texas, New Mexico, Idaho, Oregon and Washington. The members of the Commercial Lines Group are a managing general agency, Hallmark General Agency, Inc. ("HGA", formerly known as Millers General Agency, Inc.); and a third party claims administrator, Effective Claims Management, Inc. ("ECM", formerly known as Effective Litigation Management, Inc.). Principles of Consolidation --------------------------- The accompanying consolidated financial statements include the accounts and operations of HFS and its subsidiaries. Inter-company accounts and transactions have been eliminated. Basis of Presentation --------------------- The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America ("GAAP") which, as to Hallmark and Phoenix, differ from statutory accounting practices prescribed or permitted for insurance companies by insurance regulatory authorities. Investments ----------- Debt and equity securities available for sale are reported at market value. Unrealized gains and losses are recorded as a component of stockholders' equity, net of related tax effects. Prior to 2003, debt securities were reported at amortized cost and classified as held-to- maturity. Debt and equity securities that are determined to have other than temporary impairment are recognized as a realized loss in the Statement of Operations. Short-term investments consist of a certificate of deposit carried at amortized cost, which approximates market. Realized investment gains and losses are recognized in operations on the specific identification method. Cash Equivalents ---------------- The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. Recognition of Premium Revenues ------------------------------- Insurance premiums and policy fees are earned pro rata over the terms of the policies. Upon cancellation, any unearned premium and policy fee is refunded to the insured. Insurance premiums written include gross policy fees of $3.0 million and $5.1 million and policy fees, net of reinsurance, of $2.3 million and $2.1 million for the years ended December 31, 2003 and 2002, respectively. Recognition of Commission Revenues and Expenses of the Commercial ----------------------------------------------------------------- Lines Group ----------- Commission revenue and commission expense related to insurance policies serviced by HGA are recognized during the period covered by the policy. Profit sharing commission is calculated and recognized when the ratio of ultimate losses and loss expenses incurred to earned premium ("loss ratio") as determined by a qualified actuary deviate from contractual thresholds. The profit sharing commission is an estimate that varies with the estimated loss ratio and is sensitive to changes in that estimate. The following table details the profit sharing commission revenue sensitivity to the actual ultimate loss ratio for each effective quota share treaty at 0.5% above and below the provisional loss ratio. Treaty Effective Dates -------------------------------- 7/1/01 - 7/1/02 - 7/1/03 - 6/30/02 6/30/03 6/30/04 -------------------------------- Provisional loss ratio 60.0% 59.0% 59.0% Ultimate loss ratio booked to at 12/31/03 58.5% 59.0% 59.0% Effect of actual 0.5% above provisional ($206,115) ($270,254) ($40,099) Effect of actual 0.5% below provisional $144,280 $178,367 $26,465 As of December 31, 2003, the Company recorded a $0.4 million profit sharing receivable for the quota share treaty effective July 1, 2001 through June 30, 2002. The Company also recorded a $0.6 million receivable on the quota share treaty effective July 1, 2001 through June 30, 2002 because the Company has collected its commission on this treaty at the maximum loss ratio of 61.5% equal to a commission rate of 30.0% per the contractual commission slide. Recognition of Claim Servicing Fees ----------------------------------- Claim servicing fees are recognized in proportion to the historical trends of the claim cycle. The Company uses historical claim count data that measures the close rate of claims in relation to the policy period covered to substantiate the service period. The following table summarizes the year in which claim fee revenue is recognized by type of business. Year Claim Fee Revenue Recognized --------------------------------- 1st 2nd 3rd 4th -------------------- Commercial property fees 80% 20% - - Commercial liability fees 60% 30% 10% - Personal property fees 90% 10% - - Personal liability fees 49% 33% 12% 6% Finance Charges --------------- The majority of Hallmark's annual insurance premiums are financed through the Company's premium finance program offered by its wholly- owned subsidiary, HFC. Hallmark discontinued producing new premium financed annual term policies in July 2003. Finance charges on the premium finance notes are recorded as interest earned. This interest is earned on the Rule of 78's method which approximates the interest method for such short-term notes. The Company receives premium installment fees between $3.00 and $12.50 per direct bill payment from policyholders. Installment fee income is classified as finance charges on the statement of operations and is recognized as the fee is invoiced. Property and Equipment ---------------------- Property and equipment (including leasehold improvements), aggregating $3.1 million and $3.2 million, at December 31, 2003 and 2002, respectively, which is included in other assets, is recorded at cost and is depreciated using the straight-line method over the estimated useful lives of the assets (three to ten years). Depreciation expense for 2003 and 2002 was $0.6 million and $0.2 million, respectively. Accumulated depreciation was $2.2 million and $2.0 million at December 31, 2003 and 2002, respectively. Premiums Receivable Encumbered by Premium Financing Activity ------------------------------------------------------------ Receivable from lender for financed premiums represents payments due to HFC as a result of a secured financing agreement with an unaffiliated third party which are carried at cost net of allowance for doubtful accounts. Hallmark discontinued producing new premium financed annual term policies in July 2003. (See Note 9.) Premiums Receivable ------------------- Premiums receivable represent amounts due from either non-standard automobile policyholders directly or independent agents for premiums written and uncollected. These balances are carried at net realizable value. Deferred Policy Acquisition Costs and Ceding Commissions of the Personal ------------------------------------------------------------------------ Lines Group ----------- Policy acquisition costs (mainly commissions, underwriting and marketing expenses) that vary with and are primarily related to the production of new and renewal business are deferred and charged to operations over periods in which the related premiums are earned. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. In determining estimated realizable value, the computation gives effect to the premium to be earned, related investment income, losses and loss expenses and certain other costs expected to be incurred as the premiums are earned. If the computation results in an estimated net realizable value less than zero, a liability will be accrued for the premium deficiency. Ceding commissions from reinsurers on retroceded business, which include expense allowances, are deferred and recognized over the period premiums are earned for the underlying policies reinsured. Deferred ceding commissions from this business are netted against deferred policy acquisition costs in the accompanying balance sheet. The change in deferred ceding commission income is netted against the change in deferred policy acquisition costs in the accompanying income statement. During 2003 and 2002, the Company amortized ($0.4) million and ($0.6) million of deferred policy acquisition costs, respectively. Under Hallmark's reinsurance arrangements, the Company earns ceding commissions based on the reinsurer's loss ratio experience on the portion of policies reinsured. The Company receives a provisional commission as policies are produced as an advance against the later determination of the commission actually earned. The provisional commission is adjusted periodically on a sliding scale based on expected loss ratios. Losses and Loss Adjustment Expenses ----------------------------------- Losses and loss adjustment expenses represent the estimated ultimate net cost of all reported and unreported losses incurred through December 31, 2003 and 2002. The reserves for unpaid losses and loss adjustment expenses are estimated using individual case-basis valuations and statistical analyses. These estimates are subject to the effects of trends in loss severity and frequency. Although considerable variability is inherent in such estimates, management believes that the reserves for unpaid losses and loss adjustment expenses are adequate. The estimates are continually reviewed and adjusted as experience develops or new information becomes known. Such adjustments are included in current operations. Agent Profit Sharing Commissions -------------------------------- Both the Personal Lines and Commercial Lines Groups annually pay a profit sharing commission to their independent agency force based upon the results of the business produced by each agent. The Company estimates and accrues this liability to commission expense in the year the business is produced. Reinsurance ----------- Hallmark is routinely involved in reinsurance transactions with other companies. Reinsurance premiums, losses, and loss adjustment expenses are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. (See Note 5.) Income Taxes ------------ The Company files a consolidated federal income tax return. Deferred federal income taxes reflect the future tax consequences of differences between the tax bases of assets and liabilities and their financial reporting amounts at each year end. Deferred taxes are recognized using the liability method, whereby tax rates are applied to cumulative temporary differences based on when and how they are expected to affect the tax return. Deferred tax assets and liabilities are adjusted for tax rate changes in effect for the year in which these temporary differences are expected to be recovered or settled. Net Income Per Share -------------------- The computation of net income per share is based upon the weighted average number of common shares outstanding during the period, plus (in periods in which they have a dilutive effect) the effect of common shares potentially issuable, primarily from stock options. (See Notes 11 and 13.) Business Combinations --------------------- The Company accounts for business combinations using the purchase method of accounting. The cost of an acquired entity is allocated to the assets acquired (including identified intangible assets) and liabilities assumed based on their estimated fair values. The excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed is an asset referred to as "excess of cost over net assets acquired" or "goodwill". Indirect and general expenses related to business combinations are expensed as incurred. On January 27, 2003, the Company received final approval from the Arizona Department of Insurance ("AZDOI") for the acquisition of Phoenix from Millers effective January 1, 2003. In consideration for Phoenix, the Company retired $7.0 million of a $14.85 million balance on a note receivable from Millers. The Company had valued the note receivable on its balance sheet at its cost of $6.5 million. As of December 31, 2003, the Company fully allowed for the remaining balance of the note receivable. The results of operations of Phoenix are included in the Consolidated Statement of Operations from the effective date of the acquisition. The pro forma results for the twelve months ended December 31, 2002 as if the Company had acquired Phoenix at January 1, 2002 are as follows (in thousands, except per share amounts): 2002 -------- Revenues $ 43,143 Loss before cumulative effect of change in accounting principle (1,397) Net loss (3,091) Basic loss per share $ (0.28) Diluted loss per share $ (0.28) The acquisition of Phoenix was accounted for in accordance with Statement of Financial Accounting Standards No. 141, "Business Combinations" ("SFAS 141"). This statement requires that the Company estimate the fair value of assets acquired and liabilities assumed by the Company as of the date of the acquisition. In accordance with the application of SFAS 141, the Company recognized an extraordinary gain of $8.1 million for the acquisition of Phoenix in its Consolidated Statement of Operations for the twelve months ended December 31, 2003. The gain is calculated as the difference between the fair value of the net assets of Phoenix of $14.6 million and the $6.5 million cost of the note receivable from Millers. Intangible Assets ----------------- On January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142 ("SFAS 142"), "Goodwill and Other Intangible Assets". SFAS 142 supersedes APB 17, "Intangible Assets", and primarily addresses the accounting for goodwill and intangible assets subsequent to their initial recognition. SFAS 142 (1) prohibits the amortization of goodwill and indefinite-lived intangible assets, (2) requires testing of goodwill and indefinite-lived intangible assets on an annual basis for impairment (and more frequently if the occurrence of an event or circumstance indicates an impairment), (3) requires that reporting units be identified for the purpose of assessing potential future impairments of goodwill and (4) removes the forty-year limitation on the amortization period of intangible assets that have finite lives. Pursuant to SFAS 142, the Company has identified two components of goodwill and assigned the carrying value of these components into two reporting units: the Personal Lines Group and the Commercial Lines Group. During 2003, the Company completed the first step prescribed by SFAS 142 for testing for impairment and determined that there is no impairment. Prior to the acquisitions of the Commercial Lines Group in December 2002 and Phoenix in January 2003, the Company assigned the carrying value of goodwill to the insurance company reporting unit and the finance company reporting unit. In 2003, as a result of these acquisitions, the Company changed the way it views its operating segments. During 2002, the Company recorded a charge to earnings that is reported as a cumulative effect of change in accounting principle of $1.7 million to reflect an impairment loss determined by the two step process prescribed by SFAS 142. Effective December 1, 2002, the Company acquired the Commercial Lines Group. At acquisition, the Company valued the relationships with its independent agents at $542,580. This asset is classified as an other intangible asset and is being amortized over twenty years. The Company recognized $27,129 of amortization expense for the twelve months ending December 31, 2003 and will recognize $27,129 in amortization expense for each of the next five years and $377,545 for the remainder of the asset's life. Use of Estimates in the Preparation of Financial Statements ----------------------------------------------------------- The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date(s) of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Fair Value of Financial Instruments ----------------------------------- Cash and Short-term Investments: The carrying amounts reported in the balance sheet for these instruments approximate their fair values. Investment Securities: Fair values are obtained from an independent pricing service. (See Note 2.) Receivable from Lender for Financed Premiums: The carrying amount reported in the balance sheet for this instrument approximates its fair value as the term of the receivable is less than one year. Notes Payable: The carrying amounts reported in the balance sheet for these instruments approximate their fair values. (See Note 7.) Stock-based Compensation ------------------------ In December 2002, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure" ("SFAS 148"). The statement amends FASB Statement No. 123 ("SFAS 123") to provide alternative methods of transition for voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. SFAS 148 is effective for financial statements for fiscal years ending after December 15, 2002. Effective January 1, 2003, the Company adopted the prospective method provisions of SFAS 148. At December 31, 2003, the Company had two stock-based employee compensation plans, which are described more fully in Note 13. Prior to 2003, the Company accounted for those plans under the recognition and measurement provisions of APB Opinion No. 25, "Accounting for Stock Issued to Employees", and related Interpretations. No stock-based employee compensation cost was reflected in 2002 net income. Effective January 1, 2003, the Company adopted the fair value recognition provisions of SFAS 123. Under the prospective method of adoption selected by the Company under the provisions of SFAS 148, compensation cost is recognized for all employee awards granted, modified, or settled after the beginning of the fiscal year in which the recognition provisions are first applied. Results for prior years have not been restated. The following table illustrates the effect on net income (loss) and net income (loss) per share if the fair value based method had been applied to all outstanding and unvested awards in each period. 2003 2002 -------- -------- Net income (loss) $ 8,745 $ (1,671) Add: Stock-based employee compensation expenses included in reported net income, net of related tax effects 30 - Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (84) (32) -------- -------- Pro Forma net income $ 8,691 $ (1,703) ======== ======== Net income (loss) per share: Basic - as reported $ 0.47 $ (0.15) Basic - pro forma $ 0.47 $ (0.15) Diluted - as reported $ 0.46 $ (0.15) Diluted - pro forma $ 0.46 $ (0.15) Reclassification ---------------- Certain previously reported amounts have been reclassified to conform to current year presentation. Such reclassification had no effect on net income (loss) or stockholders' equity. 2. Investments: ------------ Major categories of net investment income (in thousands) are summarized as follows: Years ended December 31, ------------------------ 2003 2002 -------- -------- Debt securities $ 752 $ 421 Equity securities 189 5 Short-term investments 102 163 Cash equivalents 171 186 -------- -------- 1,214 775 Investment expenses (16) (2) -------- -------- Net investment income $ 1,198 $ 773 ======== ======== No investment in any entity or its affiliates exceeded 10% of stockholders' equity at December 31, 2003 or 2002. The amortized cost and estimated market value of investments in debt and equity securities (in thousands) by category is as follows: Gross Gross Amortized Unrealized Unrealized Market Cost Gains Losses Value -------- ------ ------- --------- At December 31, 2003 -------------------- U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 5,004 $ 23 $ 45 $ 4,982 Corporate debt securities 1,122 - - 1,122 Municipal bonds 19,339 525 21 19,843 Mortgage backed securities - - - - -------- ------ ------- --------- Total debt securities 25,465 548 66 25,947 Equity securities 3,396 326 149 3,573 -------- ------ ------- --------- Total debt and equity securities $ 28,861 $ 874 $ 215 $ 29,520 ======== ====== ======= ========= At December 31, 2002 -------------------- U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 7,221 $ 38 $ - $ 7,259 Mortgage backed securities 458 - - 458 -------- ------ ------- --------- Total debt securities 7,679 38 - 7,717 Equity securities 122 - - 122 -------- ------ ------- --------- Total debt and equity securities $ 7,801 $ 38 $ - $ 7,839 ======== ====== ======= ========= The amortized cost and estimated market value of investments in debt and equity securities with a gross unrealized loss position at December 31, 2003 (in thousands) is as follows: Gross Amortized Market Unrealized Cost Value Loss ------ ------ ------ 5 Equity Positions $ 1,024 $ 875 $ (149) 7 Bond Positions 7,681 7,615 (66) ------ ------ ------ $ 8,705 $ 8,490 $ (215) ====== ====== ====== All of the $0.2 million unrealized loss recorded at December 31, 2003 is less than twelve months old and is considered a temporary decline in value. In 2003, the Company realized an impairment loss of $0.3 million on certain securities acquired in the Phoenix acquisition. The Company also realized a $0.2 million gain on sale of securities in 2003. Prior to 2003, the Company used an investment strategy classified as held-to-maturity. Held-to-maturity securities were reported at amoritized cost. In 2003, due to the change in the Company's management philosophy, the Company changed the classification of the investment portfolio to available-for-sale. Available-for-sale securities are reported at their fair market value. Changes in fair market values are reflected in other comprehensive income, a component of stockholders' equity. The amortized cost and estimated market value of debt securities at December 31, 2003 by contractual maturity, are as follows. Expected maturities may differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties. Maturity (in thousands): Cost Value ----------------------- -------- -------- Due in one year or less $ 4,222 $ 4,191 Due after one year through five years 4,215 4,195 Due after five years through ten years 14,600 15,072 Due after ten years 2,278 2,329 Mortgage backed securities 150 160 -------- -------- $ 25,465 $ 25,947 ======== ======== At December 31, 2003 and 2002, investments in debt securities with an approximate carrying value of $100,000 were on deposit with TDI as required by insurance regulations. Proceeds from investment securities of $6.4 million and $5.9 million during 2003 and 2002, respectively, were from maturities, bond calls and prepayments of mortgage-backed securities. 3. Restricted Cash and Investments; ------------------------------- The Company has cash and investments held in a trust account, to secure State & County Mutual Fire Insurance Company's ("State & County") credit exposure from the quota share reinsurance treaty with Hallmark effective April 1, 2003. These funds are recorded on the Company's balance sheet at fair value, with unrealized gains and losses reported as accumulated other comprehensive income; a component of shareholders' equity. The market value of these funds as of December 31, 2003 was $5.1 million. The amortized cost and estimated market value of cash and investments in debt securities held in trust for State & County (in thousands) by category as of December 31, 2003 is as follows: Gross Gross Amortized Unrealized Unrealized Market Cost Gains Losses Value ---------------------------------------- Municipal bonds $ 4,500 $ 96 $ - $ 4,596 Corporate debt securities 507 - - 507 ---------------------------------------- Total debt securities $ 5,007 $ 96 $ - $ 5,103 Cash (3) -------- Total funds held in trust for State & County $ 5,100 ======== The amortized cost and estimated market value of investments in debt securities held in trust for State & County (in thousands) by contractual maturity are as follows: Amortized Market Cost Value ------------------ Due in one year or less $ 507 $ 507 Due after one yearthrough 5 years - - Due after 5 years through 10 years 2,747 2,826 Due after 10 years 1,753 1,770 ------------------ $ 5,007 $ 5,103 ================== The Company also has funds held for Dorinco Reinsurance Company in cash of $266 thousand as of December 31, 2003. 4. Reserves for Unpaid Losses and Loss Adjustment Expenses: -------------------------------------------------------- Activity in the reserves for unpaid losses and loss adjustment expenses (in thousands) is summarized as follows: 2003 2002 -------- -------- Balance at January 1 $ 17,667 $ 20,089 Plus acquisition of Phoenix at January 1 10,338 - Less reinsurance recoverables 9,256 12,170 -------- -------- Net Balance at January 1 18,749 7,919 -------- -------- Incurred related to: Current year 29,724 15,125 Prior years 464 177 -------- -------- Total incurred 30,188 15,302 -------- -------- Paid related to: Current year 21,895 9,119 Prior years 5,845 5,691 -------- -------- Total paid 27,740 14,810 -------- -------- Net Balance at December 31 21,197 8,411 Plus reinsurance recoverables 7,259 9,256 -------- -------- Balance at December 31 $ 28,456 $ 17,667 ======== ======== The 2003 increase in current year incurred includes a $2.1 million settlement of a bad faith claim, net of reinsurance, and adverse development primarily related to newly acquired business. 5. Reinsurance: ------------ For policies originated prior to April 1, 2003, Hallmark assumed the reinsurance of 100% of the Texas non-standard auto business produced by AHGA and underwritten by State & County and retroceded 55% of the business to Dorinco. Under this arrangement, Hallmark remained obligated to policyholders in the event that Dorinco did not meet its obligations under the retrocession agreement. Effective April 1, 2003, Hallmark assumes the reinsurance of 45% of the Texas non-standard automobile policies produced by AHGA and underwritten either by State & County (for policies written from April 1, 2003 through September 30, 2003) or OACM (for policies written after September 30, 2003). The remaining 55% of each policy is directly assumed by Dorinco. Under these new reinsurance arrangements, Hallmark is obligated to policyholders only for the portion of the risk assumed by Hallmark. Phoenix underwrites its own policies and does not cede any portion of the business to reinsurers. Under Hallmark's reinsurance arrangements, the Company earns ceding commissions based on Dorinco's loss ratio experience on the portion of policies reinsured by Dorinco. The Company receives a provisional commission as policies are produced as an advance against the later determination of the commission actually earned. The provisional commission is adjusted periodically on a sliding scale based on expected loss ratios. The following table shows earned premiums ceded and reinsurance loss recoveries by period (in thousands): Twelve Months Ended December 31, 2003 2002 ------------------------ Ceded earned premiums $ 15,472 $ 32,273 Reinsurance recoveries $ 11,332 $ 21,161 6. Note Receivable: ---------------- On November 1, 2002, the Company purchased from a major bank all of the right, title and interest in a promissory note (the "Millers Note") payable to the bank by Millers American Group, Inc. ("Millers"), together with all related loan documentation and collateral, for a cash purchase price of $6.5 million. At the time of such acquisition, the Millers Note was in default and had an outstanding balance of approximately $15.1 million. The Company had valued the Millers Note on its balance sheet at its $6.5 million cost. The Millers Note was guaranteed by Trilogy Holdings, Inc. ("Trilogy"), a wholly-owned subsidiary of Millers, and secured by all of the issued and outstanding capital stock of Millers Insurance Company ("MIC"), a Texas-based property and casualty insurance carrier, and Phoenix, each of which was a wholly-owned subsidiary of Trilogy at the time of the acquisition. Effective January 1, 2003, the Company acquired all of the outstanding capital stock of Phoenix in satisfaction of $7.0 million of the outstanding balance of the Millers Note. The remaining Millers Note balance is carried at no value as a result of credit concerns with respect to remaining collateral. 7. Notes Payable: -------------- Effective March 11, 1997, the Company entered into a loan agreement with Dorinco, whereby the Company borrowed $7.0 million (the "Dorinco Loan") to contribute to HFC. Proceeds from this loan were used by HFC primarily to fund premium finance notes. The loan agreement provides for a seven- year term at a fixed interest rate of 8.25%. In November 2001 the note was amended to provide for interest only payments from December 2001 through and including December 2002 with a final principal pay-off date of June 30, 2005. As long as certain financial covenants defined as "triggering events" are maintained, collateral for the Dorinco Loan is limited to the stock of HFC and a covenant by the Company not to pledge the stock of Hallmark or AHGA. To avoid a triggering event, Hallmark must (1) maintain a combined ratio and loss ratio which do not exceed 107.0% and 83.0%, respectively, and (2) maintain statutory surplus of $4.2 million and experience no decreases to surplus in any one year that exceeds 15% of the prior year surplus. If a triggering event should occur, the Company has ten days to pledge the stock of AHGA and Hallmark as additional collateral for the Dorinco Loan. There were no triggering events during 2002 or 2003. The loan agreement also contains covenants which require the Company to satisfy certain financial ratios which are less restrictive than the triggering event ratios and, among other things, restrict capital expenditures, payment of dividends, and incurrence of additional debt. The Company also carried two notes payable to MIC at December 31, 2002. Each of these notes carried an interest rate of 9% and matured in March 2003. A summary of the Company's notes payable (in thousands) is as follows: December 31, ------------------------ 2003 2002 -------- -------- Note payable to Dorinco $ 991 $ 1,720 Notes payable to MIC - 83 -------- -------- $ 991 $ 1,803 ======== ======== Scheduled annual principal payments on the note payable (in thousands) to Dorinco are as follows at December 31, 2003: 2004 $ 728 2005 263 -------- Total $ 991 ======== 8. Note Payable to Related Party: ------------------------------ On November 1, 2002, the Company entered into a promissory note with Newcastle (a related party) whereby the Company could borrow up to $9.0 million. The Company borrowed $6.5 million on November 1, 2002 to purchase the Millers Note. (See further discussion of note receivable in Note 6.) On December 3, 2002, the Company borrowed an additional $2.1 million to purchase the Commercial Lines Group from MIC. The note agreement provided for a fixed interest rate of 11.75%. The Company retired this note with the majority of the proceeds received from the completion of its rights offering in September 2003. 9. Net Advances from Lender for Financed Premiums: ----------------------------------------------- Effective November 18, 1999, HFC entered into a secured financing arrangement (the "Financing Arrangement") and a servicing agreement with an unaffiliated third party in order to fund HFC's premium finance activities. As a result of the Company ceasing to provide new premium financed policies beginning in July 2003, the Company terminated the Financing Arrangement effective December 31, 2003. As of December 31, 2003 and 2002, HFC had an outstanding balance on advances under the Financing Arrangement of zero and $10.9 million, respectively. 10. Segment Information: -------------------- The Company pursues its business activities through integrated insurance groups managing non-standard automobile insurance (the "Personal Lines Group") and commercial insurance (the "Commercial Lines Group"). The members of the Personal Lines Group are Hallmark, an authorized Texas property and casualty insurance company; Phoenix, an authorized Arizona property and casualty insurance company; AHGA, a managing general agency; and HCS, a claims administrator. Effective February 28, 2003, the Company sold its four Hallmark Agencies offices (Amarillo, Corpus Christi, Lubbock and Lancaster) for a total purchase price of $0.2 million to three unaffiliated third parties. Effective December 1, 2002, the Company purchased the Commercial Lines Group. The members of the Commercial Lines Group are HGA, a managing general agency, and ECM, a third party claims administrator. The Company changed the segment structure in 2003 with the acquisitions of Phoenix and the Commercial Lines Group. Prior year information has been restated for the new structure. The following is additional business segment information for the twelve months ended December 31 (in thousands): 2003 2002 Revenues -------- -------- -------- Personal Lines Group $ 49,665 $ 23,999 Commercial Lines Group 19,891 1,561 Corporate 3 237 -------- -------- Consolidated $ 69,559 $ 25,797 ======== ======== Pre-tax Income -------------- Personal Lines Group $ 1,350 $ (203) Commercial Lines Group 1,311 3 Corporate (1,975) 236 -------- -------- Consolidated $ 686 $ 36 ======== ======== The following is additional business segment information as of the following dates (in thousands): December 31, ------------------------ 2003 2002 Assets -------- -------- ------ Personal Lines Group $ 68,247 $ 64,488 Commercial Lines Group 13,365 11,839 Corporate 2,241 7,434 -------- -------- Consolidated $ 83,853 $ 83,761 ======== ======== 11. Earnings per Share: ------------------- The Company has adopted the provisions of Statement of Financial Accounting Standards No. 128 (" SFAS No. 128"), "Earnings Per Share," requiring presentation of both basic and diluted earnings per share. A reconciliation of the numerators and denominators of the basic and diluted per-share computations (in thousands, except per share amounts) as required by SFAS No. 128 is presented below: Income Shares Per-Share (Numerator) (Denominator) Amount ----------- ------------- ------ For the year ended December 31, 2003: Basic Earnings per Share Income available to common stockholders: Income before extraordinary gain $ 661 18,518 $ 0.03 Extraordinary gain 8,084 18,518 0.44 ------- ------- ------ Net income $ 8,745 18,518 $ 0.47 ======= ======= ====== Diluted Earnings per Share Income available to common stockholders: Income before extraordinary gain $ 661 18,518 $ 0.03 Effect of Dilutive Securities: Stock options - 269 - ------- ------- ------ Income before extraordinary gain 661 18,787 0.03 Extraordinary gain 8,084 18,787 0.43 ------- ------- ------ Net income $ 8,745 18,787 $ 0.46 ======= ======= ====== For the year ended December 31, 2002: Basic Earnings per Share Income available to common stockholders: Income before cumulative effect $ 23 11,049 $ - of change in accounting principle Cumulative effect of change in accounting principle (1,694) 11,049 (.15) ------- ------- ------ Net loss $ (1,671) 11,049 $ (.15) ======= ======= ====== Diluted Earnings per Share Income available to common stockholders: Income before cumulative effect of change in accounting principle $ 23 11,049 $ - Effect of Dilutive Securities: Options and warrants - 78 - ------- ------- ------ Income before cumulative effect of change in accounting principle 23 11,127 - Cumulative effect of change in accounting principle (1,694) 11,127 (.15) ------- ------- ------ Net loss $ (1,671) 11,127 $ (.15) ======= ======= ====== Options to purchase 126,000 and 1,532,000 shares of common stock at prices ranging from $0.75 to $1.00 and $0.44 to $1.00 were outstanding at December 31, 2003 and December 31, 2002, respectively, but were not included in the computation of diluted earnings per share because the inclusion would result in an antidilutive effect in periods where the option exercise price exceeded the average market price per share for the period. 12. Regulatory Capital Restrictions: -------------------------------- Hallmark's 2003 and 2002 net income and stockholders' equity (capital and surplus), as determined in accordance with statutory accounting practices, were $2.0 million and $0.4 million, and $10.0 million and $8.4 million, respectively. The minimum statutory capital and surplus required for Hallmark by the TDI is $2.0 million. Texas state law limits the payment of dividends to stockholders by property and casualty insurance companies. The maximum dividend that may be paid without prior approval of the Commissioner of Insurance is limited to the greater of 10% of statutory surplus as regards policyholders as of the preceding calendar year end or the statutory net income of the preceding calendar year. During 2003, Hallmark declared dividends to HFS of $0.4 million of which $0.2 million was paid. Based on surplus at December 31, 2003, Hallmark could pay a dividend of up to $2.0 million to HFS during 2004 without TDI approval. Hallmark paid management fees of $0.6 million to HFS during 2003 as compared to $0.2 million in 2002. Phoenix's 2003 net loss and stockholders' equity (capital and surplus), as determined in accordance with statutory accounting practices, were $0.3 million and $10.1 million, respectively. The minimum statutory capital and surplus required for Phoenix by AZDOI is $1.5 million. Arizona insurance regulations generally limit distributions made by property and casualty insurers in any one year, without prior regulatory approval, to the lesser of 10% of statutory surplus of the previous year end or net investment income for the prior year. The maximum dividend that may be paid in 2004 without prior approval of the AZDOI is $0.6 million. Phoenix paid dividends of $0.6 million to HFS during 2003. The NAIC requests property/casualty insurers to file a risk-based capital ("RBC") calculation according to a specified formula. The purpose of the NAIC-designed formula is twofold: (1) to assess the adequacy of an insurer's statutory capital and surplus based upon a variety of factors such as potential risks related to investment portfolio, ceded reinsurance and product mix; and (2) to assist state regulators under the RBC for Insurers Model Act (the "Model Act") by providing thresholds at which a state commissioner is authorized and expected to take regulatory action. Hallmark's 2003 and 2002 adjusted capital under the RBC calculation exceeded the minimum requirement by 186.3% and 142.9%, respectively. Phoenix's 2003 adjusted capital under the RBC calculation exceeded the minimum requirement by 116.8%. 13. Stock Option Plans: ------------------- The Company has a stock option plan for key employees, the 1994 Key Employee Long Term Incentive Plan, and a non-qualified plan for non- employee directors. The number of shares reserved for future issuance under the 1994 employee plan and the non-employee director plan is 603,500 and 775,000, respectively. The option prices under the plans are not to be less than the closing price of the common stock on the day preceding the grant date. Pursuant to the stock option plans, the Company has granted incentive stock options under Section 422 of the Internal Revenue Code of 1986. The stock options granted to employees vest over a 3 year period on a graded schedule, 40% in the first 6 months and 20% on each anniversary date of the grant date. The stock options granted to the directors vest over a 6 year period on a graded schedule, 40% in the first 6 months and 10% on each anniversary date of the grant date. A summary of the status of the Company's stock options as of December 31, 2003 and December 31, 2002 and the changes during the years ended on those dates is presented below: 2003 2002 ----------------------- ---------------------- Number Weighted Number Weighted of Shares of Average of Shares of Average Underlying Exercise Underlying Exercise Options Prices Options Prices ------- ------ ------- ------ Outstanding at beginning of the year 2,379,000 $ 0.50 2,679,000 $ 0.49 Granted 205,000 $ 0.67 200,000 $ 0.43 Exercised (575,000) $ 0.39 - $ - Forfeited (745,500) $ 0.49 (500,000) $ 0.41 Expired - $ - - $ - Outstanding at end of year 1,263,500 $ 0.58 2,379,000 $ 0.50 Exercisable at end of year 1,006,500 $ 0.57 1,913,000 $ 0.50 Weighted-average fair value of all options granted $ 0.36 $ 0.22 The fair value of each stock option granted is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions: 2003 2002 ---- ---- Expected Term 5.00 5.00 Expected Volatility 61.05% 53.37% Risk-Free Interest Rate 2.97% 4.91% The following table summarizes information about stock options outstanding at December 31, 2003: Options Outstanding Options Exercisable ------------------- --------------------- Weighted Avg. Weighted Number Remaining Number Avg. Range of Outstanding Contractual Weighted Avg. Exercisable Exercise Exercise Prices at 12/31/03 Actual Life Exercise Price at 12/31/03 Price --------------- ----------- ----------- -------------- ----------- -------- $ .38 to $ .44 582,500 6.4 $ .41 537,500 $ .41 $ .45 to $ .69 555,000 6.1 $ .68 358,000 $ .68 $ .70 to $1.00 126,000 3.5 $ .97 111,000 $ .98 --------- --------- $ .38 to $1.00 1,263,500 6.0 $ .58 1,006,500 $ .57 ========= ========= 14. Retirement Plans ---------------- Certain employees of the Commercial Lines Group were participants in a defined benefit cash balance plan covering all full-time employees who had completed at least 1,000 hours of service. This plan was frozen in March 2001 in anticipation of distribution of plan assets to members upon plan termination. All participants were vested when the plan was frozen. The following tables provide detail of the changes in benefit obligations, components of benefit costs and weighted-average assumptions, and plan assets for the Retirement Plan as of and for the twelve months ending December 31, 2003 and for the one month ending December 31, 2002 (in thousands) using a measurement date of November 30: 12 Months 1 month Ending Ending 12/31/03 12/31/02 -------- -------- Assumptions (end of period) Discount rate used in determining benefit obligation 6.00% 6.50% Rate of compensation increase N/A N/A Reconciliation of funded status (end of period): Vested benefit obligation $ (12,482) $ (11,756) Accumulated benefit obligation (12,517) (11,758) Projected benefit obligation (12,517) (11,758) Fair value of plan assets 11,280 11,154 -------- -------- Funded status $ (1,237) $ (604) Unrecognized net obligation - - Unrecognized prior service cost - - Unrecognized actuarial (gain)/loss 887 268 -------- -------- Prepaid/(accrued) pension cost $ (350) $ (336) ======== ======== Changes in projected benefit obligation: Benefit obligation as of beginning of period $ 11,758 $ 11,794 Service cost - - Interest cost 762 64 Plan amendments - - Actuarial liability (gain)/loss 1,085 (4) Effect of curtailment (plan freeze) - - Benefits paid (1,088) (96) -------- -------- Benefit obligation as of end of period $ 12,517 $ 11,758 ======== ======== 12 Months 1 month Ending Ending 12/31/03 12/31/02 -------- -------- Change in plan assets: Fair value of plan assets as of beginning of period $ 11,154 $ 11,446 Actual return on plan assets (net of expenses) 1,214 (196) Employer contributions - - Benefits paid (1,088) (96) -------- -------- Fair value of plan assets as of end of period $ 11,280 $ 11,154 ======== ======== Net periodic pension cost: Service cost - benefits earned during the period $ - $ - Interest cost on projected benefit obligation 762 64 Expected return on plan assets (749) (76) Amortizations Net obligation/(asset) - - Unrecognized prior service cost - - Unrecognized (gain)/loss - - -------- -------- Net periodic pension cost (credit) $ 13 $ (12) ======== ======== Discount rate 6.00% 6.50% Expected return on plan assets 8.00% 7.00% Rate of compensation increase N/A N/A As of December 31, 2003, the fair value of the plan assets was composed of cash and cash equivalents of $0.4 million, bonds and notes of $5.2 million and equity securities of $5.7 million. As of December 31, 2002, the fair value of the plan assets was composed of cash and cash equivalents of $0.7 million, bonds and notes of $5.7 million and equity securities of $4.8 million. The Company recorded a $1.2 million pension liability at December 31, 2003, of which, $0.9 million was additional minimum pension liability. The investment objectives of the Company are to preserve capital and to achieve long-term growth through a favorable rate of return equal to or greater than 5% over the long-term (60 yr.) average inflation rate as measured by the consumers price index. The Company has prohibited all investments in options, futures, precious metals, short sales and purchase on margin. In 2003, management instructed an asset allocation of 50% to 55% in equity securities to take a more conservative investment strategy. To develop the expected long-term rate of return on assets assumption, the Company considered the historical returns and the future expectations for returns for each asset class, as well as the target asset allocation of the pension portfolio. This resulted in the selection of the 8% long-term rate of return on assets assumption. The Company estimates it will contribute $0.3 million to the defined benefit cash balance plan during 2004. The following table shows the weighted-average asset allocation for the defined benefit cash balance plan held as of December 31, 2003 and 2002. 12/31/03 12/31/02 -------------------- Asset Category: Debt securities 46% 50% Equity securities 51% 43% Other 3% 7% -------------------- Total 100% 100% The Company sponsors two defined contribution plans. Under these plans, employees may contribute a portion of their compensation on a tax- deferred basis, and the Company may contribute a discretionary amount each year. The Company's contribution amounted to $0.1 million for each of the years ended December 31, 2003 and 2002. 15. Income Taxes: ------------- The composition of deferred tax assets and liabilities and the related tax effects (in thousands) as of December 31, 2003 and 2002, are as follows: 2003 2002 -------- -------- Deferred tax liabilities: Deferred policy acquisition costs ( $ 2,429) ( $ 1,906) Profit sharing commission ( 357) ( 320) Agency relationship ( 188) ( 200) Goodwill - ( 2) Unrealized holding gains on investments ( 449) - Guaranty assessment fund ( 39) - Fixed asset depreciation ( 130) - Loss reserve discount ( 53) - Other ( 76) ( 25) -------- -------- Total deferred tax liabilities ( $ 3,721) ( $ 2,453) Deferred tax assets: Unearned premiums $ 379 $ 476 Loss reserve discounting, net of salvage and subrogation - 232 Deferred ceding commissions 2,839 2,304 Pension liability 421 223 Net operating loss carryforward 1,796 109 Allowance for bad debt 141 92 Unpaid loss and loss adjustment expense 489 - Goodwill 1,782 - Rent reserve 133 - Investment impairments 207 - Unearned revenue 81 - Risk premium reserve 75 - Other 223 71 -------- -------- Total deferred tax assets $ 8,566 $ 3,507 ======== ======== Net deferred tax asset $ 4,845 $ 1,054 Valuation allowance 884 33 -------- -------- Net deferred tax asset $ 3,961 $ 1,021 ======== ======== A valuation allowance is provided against the Company's deferred tax asset to the extent that management does not believe it is more likely than not that future taxable income will be adequate to realize these future tax benefits. This allowance was $0.9 million and $33,000 at December 31, 2003 and December 31, 2002, respectively. The valuation allowance is provided against a net operating loss carryforward subject to limitations on its utilization. Based on the evidence available as of December 31, 2003, management believes that it is more likely than not that the remaining net deferred tax assets will be realized. However, this assessment may change during 2004 if the Company's financial results do not meet management's current expectations. A reconciliation of the income tax provisions (in thousands) based on the prevailing corporate tax rate of 34% to the provision reflected in the consolidated financial statements for the years ended December 31, 2003 and 2002, is as follows: 2003 2002 -------- -------- Computed expected income tax provision (benefit) at statutory regulatory tax rate $ 233 $ 12 Meals and entertainment 5 1 Tax exempt interest ( 122) - Dividends received deduction ( 28) - State (net of federal benefit) ( 6) - Other ( 57) - -------- -------- Income tax provision (benefit) $ 25 $ 13 ======== ======== Current income tax benefit ( $ 89) ( $ 32) Deferred tax provision 114 45 -------- -------- Federal income tax provision (benefit) $ 25 $ 13 ======== ======== The company has available, for federal income tax purposes, unused net operating loss of approximately $5.3 million at December 31, 2003. The losses were acquired as part of the Phoenix acquisition and may be used to offset future taxable income. Utilization of the losses is limited under Internal Revenue Code Section 382. Due to this limitation, the company believes that $2.6 million of the net operating loss carryforwards may expire unutilized. Therefore, a valuation allowance of $2. 6 million has been established against these net operating loss carryforwards. The Internal Revenue Code has provided that effective with tax years beginning September 1997, the carryback and carryforward periods are 2 years and 20 years, respectively, with respect to newly generated operating losses. The net operating losses (in thousands) will expire, if unused, as follows: Year ---- 2021 $ 2,600 2022 2,700 ------- $ 5,300 ======= 16. Commitments and Contingencies: ------------------------------ The Company has several leases, primarily for office facilities and computer equipment, which expire in various years through 2011. Certain of these leases contain renewal options. Rental expense amounted to $1.3 million and $0.8 million for the years ended December 31, 2003 and 2002, respectively. Future minimum lease payments (in thousands) under noncancellable operating leases as of December 31, 2003 are as follows: Year ---- 2004 $ 1,085 2005 1,072 2006 1,020 2007 1,020 2008 956 2009 and thereafter 1,032 ------- Total minimum lease payments $ 6,185 ======= From time to time, assessments are levied on the Company by the guaranty association of the State of Texas. Such assessments are made primarily to cover the losses of policyholders of insolvent or rehabilitated insurers. Since these assessments can be recovered through a reduction in future premium taxes paid, the Company capitalizes the assessments, as they are paid, and amortizes the capitalized balance against its premium tax expense. There were no assessments during 2003 or 2002. 17. Concentrations of Credit Risk: ------------------------------ The Company maintains cash equivalents in accounts with five financial institutions in excess of the amount insured by the Federal Deposit Insurance Corporation. The Company monitors the financial stability of the depository institutions regularly, and management does not believe excessive risk of depository institution failure exists at December 31, 2003. The Company's reinsurance coverage has substantially been provided by one company (Dorinco) since July 1, 2000. EX-10.CL 3 exh10cl.txt MANAGING GENERAL AGENCY AGREEMENT EXHIBIT 10(cl) Managing General Agency Agreement Number HFS-03-001 Table of Contents Article 1 Appointment Article 2 Authority of the Managing General Agent Article 3 Compensation Article 4 Accounting and Records Article 5 Reports and Remittances Article 6 Expenses Article 7 Premium Escrow Accounts Article 8 Control of Expirations Article 9 Independent Contractor Relationship Article 10 Advertising Article 11 Agents Licensing Article 12 Agency Sale or Transfer Article 13 Hold Harmless Article 14 Arbitration Article 15 Termination Article 16 Claims Handling Article 17 Rate Filings and Underwriting Guidelines Article 18 Reinsurance Article 19 Miscellaneous MANAGING GENERAL AGENCY AGREEMENT HFS-03-001 This Agreement is made and entered into by and between OLD AMERICAN COUNTY MUTUAL FIRE INSURANCE COMPANY, a Texas Corporation (Company) and AMERICAN HALLMARK GENERAL AGENCY, INC. a Texas Corporation with administrative offices in Dallas, Texas, (Managing General Agent). THE COMPANY AND THE MANAGING GENERAL AGENT AGREE AS FOLLOWS: ARTICLE 1 - APPOINTMENT ----------------------- 1.1 The Company appoints the Managing General Agent to act as its Managing General Agent as that term is defined in Article 21.07-3 of the Texas Insurance Code and the Texas Administrative Code. This appointment is continuous in nature and shall remain in effect until terminated in accordance with Article 15 or natural expiry at September 30, 2006, whichever comes first. 1.2 The Managing General Agent acknowledges and agrees that the Company's appointment of the Managing General Agent does not restrict in any manner the Company's right to appoint agents writing any lines of insurance the Company writes through any other agent, sub-agent or managing general agent either direct to the Company or through other agents. ARTICLE 2 - AUTHORITY --------------------- 2.1 The Managing General Agent has the authority and duty to act on behalf of the Company in all respects, insofar as necessary for the Managing General Agent to perform the function of a Managing General Agent for the Company. The Company may, from time-to-time, place reasonable written restrictions upon the Managing General Agent. The Managing General Agent's authority includes, but is not limited to, production, appointment and supervision of agents for the Company, underwriting, accounting and claims handling. All acts of the Managing General Agent, insofar as the Company's business is concerned, are subject to the ultimate authority of the Company. 2.2 The Managing General Agent has the authority to develop a unique rate plan and underwriting guidelines that the Company shall file with the Texas Department of Insurance. The Managing General Agent shall certify that each and every filing is in accordance with the laws of the State and that its rate increases in any calendar year do not exceed 10%. 2.3 The original source of all business produced under this Agreement shall be property/ casualty, general lines, or limited lines agents in the State of Texas (Agent(s)). 2.4 The Managing General Agent has the authority to accept, on forms approved by the Company, applications, binders, and/or Policies written by or through Agents, for classes or lines of insurance as described in the attached Schedule of Business and in the Quota Share Reinsurance Agreement Number HFS-03-001 between the Company and Subscribing Reinsurers (the Reinsurer) effective October 1, 2003, (Reinsurance Agreement), a copy of said Agreement is attached hereto and fully incorporated herein. 2.5 The Managing General Agent acknowledges and agrees that the term(s) of any Policy shall not exceed twelve (12) months. "Policy" is defined as any policy, endorsement, binder, certificate, proposal for insurance or any other document that binds the Company to insurance coverage. 2.6 The Managing General Agent has the authority to cancel Policies, at its discretion, subject to the requirements imposed by law and in compliance with the applicable provisions contained in this Agreement and the Policies. 2.7 The Managing General Agent has the authority to receive and receipt for premiums and to retain commissions out of such collected premiums subject to the terms and conditions of this Agreement. 2.8 The Managing General Agent or its designated claims handler shall have the authority to set loss reserves and adjust and pay claims on behalf of the Company. 2.9 The Company shall retain the authority to restrict the premium volume. 2.10 The Managing General Agent may not authorize policy issuance on behalf of the Company to any broker, agent, managing general agent or any other entity without the prior written consent of the Company. 2.11 Any and all agreements with Agent(s) shall be made directly between the Managing General Agent and such Agent(s). It is understood that the Agent shall have no claim or cause of action against the Company and said Agent(s) shall look solely to the Managing General Agent for any and all expenses, costs, causes of action and damages, including, but not limited to, extra contractual obligations, arising in any manner from actions or inactions by the Agent(s) or the Managing General Agent. 2.12 The Managing General Agent shall bear sole responsibility to oversee the proper licensing of any Agents(s). Should any fines be levied against the Company as the result of the Managing General Agent accepting business from an unlicensed Agent, the Managing General Agent shall hold the Company harmless and reimburse the Company for any and all expenses so incurred including, but not limited to, legal fees, fines and travel expenses. ARTICLE 3 - COMPENSATION ------------------------ 3.1 The Managing General Agent's compensation shall be the commission allowed under the Reinsurance Agreement less fronting fees and premium taxes. As used in this Article, the term "Net Written Premium" is defined as the total of all premium amounts on policies written by the Managing General Agent between the Company and the Managing General Agent less return premium and cancellations. 3.2 On the net written premium and policy fees for each underwriting year, fronting fees shall be charged at a rate of one and three-quarters percent (1.75%). Minimum fronting fees shall be the lesser of $2,500,000 for the term of the contract with a minimum of $650,000 in year 1 and $850,000 in year two, or two percent (2.00%) of net written premium and policy fees for all three years. 3.3 The tax provision of one and three-quarters percent (1.75%) of net written premium and net policy fees charged includes premium tax and the Texas Overhead Assessment. The Company retains the right to adjust the premium tax of 1.75% to any new effective rate determined by the Texas Department of Insurance or other such agency. The Company will be liable for remitting state premium taxes based on net written premium and net policy fees charged. 3.4 Should service fees be charged on any policy covered by this Agreement, and such fees are deemed taxable for premium tax purposes, then such service fees are to be added to the net written premium and net policy fees charged to determine the amount subject to Fronting Fees. 3.5 In the event there is no Agent to receive the designated commission on a Policy, the Managing General Agent may retain the commission. 3.6 The commission may, from time to time, be amended upon mutual agreement of the Company and the Managing General Agent without otherwise affecting the terms and conditions of this Agreement. 3.7 The Company agrees to pass through to the Managing General Agent any Contingent or Profit Commission allowed by the Reinsurer(s) referenced in Article 9 of the Reinsurance Agreement. ARTICLE 4 - ACCOUNTING AND RECORDS ---------------------------------- 4.1 The Managing General Agent shall provide and maintain all necessary books, records, policies, claim files, dailies and correspondence with policyholders to determine the amount of liability of the Company and the amount of premiums there from. 4.2 The Managing General Agent shall prepare separate, itemized, monthly statements for each Agent on the business placed by the Agent through the Managing General Agent, and furnish the Agent with an IRS Form 1099 each year when required. 4.3 All records shall be kept in such manner and form as is generally recognized as acceptable in the insurance industry or as may be required by the Company. Such records shall be maintained for at least five (5) years or for any longer applicable retention period required by the Texas Department of Insurance. All records must be located in Texas, unless approved by the Texas Department of Insurance under Article 1.28 of the Texas Insurance Code. 4.4 All records applicable to the Company's business shall be opened for inspection and/or audit at all reasonable times by the Company, its reinsurers, insurance department personnel or other governmental authorities. 4.5 Upon request and pursuant to regulatory requirements, the Managing General Agent shall forward as reasonably required to the Company or the Company's Designated Accountant and/or Statistical Agent, exact, as written, copies of all applications, binders, policies, daily reports, monthly reporting forms and endorsements issued by or through licensed Agent(s), including all other evidence of insurance written, modified or terminated. 4.6 The Managing General Agent shall be solely responsible for and shall keep accurate records of all policies assigned to the Managing General Agent and shall account to the Company, upon the Company's reasonable request, for all outstanding and unused policy supplies. In the event canceled or terminated policies or binders are unavailable, the Managing General Agent shall forward, or cause to be forwarded, properly executed Lost Policy Receipts. 4.7 At renewal of any Policy issued by the Managing General Agent, the Managing General Agent shall be responsible to the insured for the renewal or non-renewal of the Policy and shall timely communicate any renewal quote or notice of non-renewal to the insured to preclude the extension of coverage beyond the expiration date of the current in-force policy. 4.8 The Company shall conduct or cause to be conducted four (4) examinations of the Managing General Agent. This examination will take place at the Managing General Agent's business offices or premises where necessary records are maintained, and the Managing General Agent will bear the total cost of $500 per audit plus out of pocket expenses actually and reasonably incurred by the Company to conduct each examination. Such examination must remain on file with the Company for three (3) years, be available to the Commissioner of Insurance for review, and contain, at a minimum, the following information: a. claims control procedures; b. timeliness of claims payments; c. timeliness of premium reporting and collection; d. compliance with underwriting guidelines; and e. reconciliation of policy inventory. If within any thirty (30) day period, the Company's aggregate premium volume increases by thirty percent (30%) or more, the Company shall conduct, within ninety (90) days of said period, an examination of the Managing General Agent if the Managing General Agent: a. writes greater than twenty percent (20%) of the Company's aggregate premium volume; and b. has experienced an increase of twenty percent (20%) or more of premium volume during the thirty (30) day period. Any such examination shall contain the information required pursuant to Article 4.8. ARTICLE 5 - MANAGING GENERAL AGENT'S REPORTS AND REMITTANCES ------------------------------------------------------------ 5.1 The Managing General Agent shall submit a report to the Company, within thirty (30) days after the close of business each calendar month, summarizing the business transacted under this Agreement during the prior month. Such report shall include the following items: a. gross premiums written less returns and cancellations; b. Agent's commissions; c. losses paid less recoveries and salvage; d. loss adjustment expenses paid; e. outstanding loss reserves; f. outstanding loss expense reserves; g. losses incurred but not reported; h. unearned premium reserve; and i. earned premium. 5.2 The Managing General Agent shall remit all amounts due directly to the Company within forty-five (45) days after the close of the calendar month for which the account is rendered. 5.3 In addition to the return of premium, the Managing General Agent shall refund commissions on policy cancellations, reductions in premiums or any other return premiums at the same rate at which such commissions were originally retained. 5.4 The Company may, at its sole option, reasonably alter the frequency and/or content of the Managing General Agent's report; provided, however, such report is made no less frequently than monthly. 5.5 The omission of any item(s) from a monthly statement shall not affect the responsibility of either party to account for and pay all amounts due the other party, nor shall it prejudice the rights of either party to collect all such amounts due from the other party. 5.6 The Managing General Agent shall annually furnish to the Company the following summary information in such form as to enable the Company to record such information in its annual statement: a. summaries, with data segregated by major classes, of net premium written, gross loss paid, net salvage, subrogation and adjusting expenses paid during the year; and b. details of in-force and unearned premium running twelve (12) months or less from the policy inception date. 5.7 The Managing General Agent agrees to furnish the Company with any additional reports necessary to provide the Company's monthly, quarterly and/or annual statements to regulatory authorities including, but not limited to, TICO or ISO statistical reporting. 5.8 The Managing General Agent shall annually furnish the Company current financial statements of the Managing General Agent. These financial statements shall include, but not be limited to, Profit and Loss, Balance Sheet and Cash Flow Statements. ARTICLE 6 - EXPENSES -------------------- 6.1 The Managing General Agent is responsible for and shall promptly pay all expenses attributable to the producing and servicing of business under this Agreement, except as specified in Article 6.2. This responsibility shall not be altered whether the expense is billed to the Managing General Agent or the Company. These expenses include but are not limited to: a. salaries and all other benefits of all employees of the Managing General Agent; b. transportation, lodging, and meals of employees of the Managing General Agent; c. postage and other delivery charges; d. advertising; e. printing of all policies, forms and endorsements; f. EDP hardware, software, and programming; g. license and appointment fees for agents, brokers, and solicitors; h. adjustment expenses arising from claims on insurance written under this Agreement, except for expenses incurred at the direction of the Company; i. provision of office space, equipment and other facilities necessary for the operation of Managing General Agent; and j. legal, audit and other expenses relating to any rate filing, regulation, or rules affecting the business of the Managing General Agent pursuant to this Agreement. 6.2 The Company is responsible for and shall promptly pay all expenses attributable to the actions of the Company as a result of business produced under this Agreement. This responsibility shall not be altered whether the expense is billed to the Company or the Managing General Agent. These expenses include but are not limited to: a. salaries and all other benefits of all employees of the Company; b. transportation, lodging, and meals of employees of the Company; c. State or Guaranty Fund Assessments; d. losses and loss adjustment expenses incurred at the direction of the Company; e. cost of reinsurance; and f. legal and auditing expense incurred at the direction of the Company (other than as provided for in Article 4.8). ARTICLE 7 - PREMIUM ESCROW ACCOUNTS ----------------------------------- 7.1 The Managing General Agent shall accept in a fiduciary capacity all premiums collected and other funds relating to the business written under this Agreement. The privilege of retaining commissions shall not be construed as changing the fiduciary capacity. 7.2 The Managing General Agent assumes responsibility for, and shall promptly pay, the net earned premium currently due the Company, whether collected or not, on Policies issued by the Managing General Agent or, the Company on behalf of the Managing General Agent, subject to any deductions provided herein. 7.3 The Managing General Agent shall establish and maintain a Premium Escrow Account entitled "AHGA/Old American Premium Escrow Account". Escrow Accounts shall be in a bank, which is a member of the Federal Reserve System and is mutually agreeable to the Managing General Agent and the Company. All premiums collected by the Managing General Agent on business produced under this Agreement shall be deposited promptly into said account. 7.4 The Managing General Agent shall not commingle any premium or escrow funds with its personal accounts or other agency funds or funds held by the Managing General Agent in any other capacity. 7.5 The Managing General Agent and an officer of the Company shall maintain signature authority on said Premium Escrow Account. 7.6 The Managing General Agent shall act as trustee for the Company on the Premium Escrow Account. 7.7 Interest income and the cost of maintaining Escrow Accounts shall belong to the Managing General Agent. 7.8 Escrow Accounts may consist of: a. checking, savings, or money market accounts; b. certificates of deposit; or c. United States Treasury bills, notes or bonds. 7.9 The Managing General Agent may use any and all premium and other funds collected by the Managing General Agent for and on behalf of the Company under this Agreement solely for the payment of: a. premium balances due minus deductions allowed in accordance with this Agreement; b. the return of unearned premiums arising due to cancellation or endorsement; c. the Managing General Agent's and Agent(s) commission; d. losses and loss adjustment expenses; or e. such other items as mutually agreed upon in writing by the Managing General Agent and the Company. 7.10 The Company shall not be liable for any loss which occurs by reason of the default or failure of the bank in which an account is carried and such loss shall not affect the Managing General Agent's obligations under this Agreement. ARTICLE 8 - CONTROL OF EXPIRATIONS ---------------------------------- 8.1 The Managing General Agent's records and the use and control of expirations of the business produced by the Agents appointed by the Managing General Agent or by the Company at the Managing General Agent's request shall remain the property of the Managing General Agent and be left in the Managing General Agent's undisputed possession, provided the Managing General Agent is not in default and accounts for and pays over all premium and other sums for which the Managing General Agent may be liable to the Company. 8.2 Ownership of the records, use and control of expirations and the goodwill relating thereto shall be vested in the Managing General Agent; provided, however, in the event the Managing General Agent is in default hereunder, and does not remedy such default within a reasonable time and does not account for and pay all premiums or other sums for which it may be liable to the company within a reasonable time following the due date, such records, use and control of expirations and the good will relating thereto shall become the property of Company. 8.3 The Managing General Agent assigns to the Company as security for, but not in payment of, the obligations of the Managing General Agent under this Agreement all sums due or to become due to the Managing General Agent from any insured(s) for whom the Managing General Agent or Agent(s) provided a Policy on behalf of the Company. In the event of default, the Company shall have full authority to demand and collect such sums and the Managing General Agent or Agent(s) shall not be entitled to any commissions and/or policy fees on any premium so collected by the Company. The Company may also assign any rights it acquires to the Reinsurer. 8.4 The Managing General Agent pledges and/or grants to the Company, so as to further secure payment of any and all sums due the Company under this Agreement, any and all of the Managing General Agent's records of expirations of Policies, including but not limited to, the ownership and exclusive use of said expirations. In the event of default, the Company shall have the rights of the holder of a security interest granted by law, including but not limited to the rights of foreclosure to effectuate such security interest, and the Managing General Agent hereby agrees to peaceably surrender possession of such records to the Company upon demand. ARTICLE 9 - INDEPENDENT CONTRACTOR RELATIONSHIP ----------------------------------------------- 9.1 Nothing contained in this Agreement shall be construed to create the relationship of employer and employee, or joint venture or partnership, between the Company and the Managing General Agent, or between the Company and any employees, representatives or Agents of the Managing General Agent. ARTICLE 10 - ADVERTISING ------------------------ 10.1 Any advertising is the responsibility of, and shall be in the name of the Managing General Agent. The Managing General Agent is prohibited from using the Company's name or logo without prior written consent of the Company. 10.2 In the event an advertisement containing the Company's name or logo is used by the Managing General Agent or Agent(s), the Managing General Agent shall send a copy of the advertisement to the Company and maintain a copy and full details concerning where, when, and how it was used, and comply with all legal requirements regarding content, review and approval of advertising and maintenance of records. ARTICLE 11 - AGENTS LICENSING ----------------------------- 11.1 The Managing General Agent shall maintain current license(s) or certificate(s) of authority as required by law for the conduct of business pursuant to this Agreement. 11.2 The Managing General Agent shall assure that all Agents maintain appropriate license(s), certificate(s) of authority and appointments as required by law for conduct of business under this Agreement. 11.3 The Managing General Agent shall maintain in force an Agency Agreement, in a form satisfactory to the Company, with all Agents. 11.4 Any termination by the Managing General Agent of an Agent shall comply with the Texas Insurance Code and any other applicable law or regulation. ARTICLE 12 - AGENCY SALE OR TRANSFER ------------------------------------ 12.1 In the event a controlling interest (10% or more of outstanding shares) of the Managing General Agent is to be sold or transferred or the Managing General Agent is to merge or be consolidated with another firm (not affiliated with current ownership), the Managing General Agent shall give thirty (30) days advance written notice to the Company. 12.2 The Managing General Agent shall also give notice to the Company if there is a change in any principal officer and/or director of the Managing General Agent within 30 days. Under any of these circumstances, the Company may, at its election: a. consent to the assignment of this Agreement to the successor; b. enter into a new Managing General Agency Agreement with the successor; or terminate this Agreement pursuant to Article 15. The Company shall notify the Managing General Agent of its decision within thirty (30) days of the receipt of the notice. ARTICLE 13 - HOLD HARMLESS -------------------------- 13.1 The Managing General Agent shall indemnify and hold the Company harmless from any and all claims, demands, causes of action, damages, judgments and expenses (including, but not limited to, attorney's fees and costs of court) which may be made against the Company and which arise, either directly or indirectly, out of any action or inaction of the Managing General Agent or the Managing General Agent's employees or representatives in connection with any rights or obligations of the Managing General Agent incurred in connection with this Agreement or with asserting rights hereunder including, but not limited to, any action or inaction of the Managing General Agent concerning the termination of Agent(s) pursuant to the Texas Insurance Code or any other applicable law or regulation. 13.2 The Company shall indemnify and hold the Managing General Agent harmless from any and all claims, demands, causes of action, damages, judgments and expenses (including, but not limited to, attorney's fees and costs of court) which may be made against the Managing General Agent and which arise, either directly or indirectly, out of any action or inaction of the Company including, but not limited to, any such acts of negligence by the Company in connection with any rights or obligations of the Company incurred in connection with this Agreement or with asserting rights hereunder. 13.3 The Reinsurer is hereby named as a third party beneficiary to all promises, duties and obligations of indemnification made by the Managing General Agent to the Company to the extent of all damages, fines, penalties and/or loss incurred by the Reinsurer as a direct result of indemnifying and holding the Company harmless for the actions and/or inactions of the Managing General Agent. Upon indemnification by the Reinsurer, the Company shall assign its rights of recourse against the Managing General Agent to the Reinsurer, provided always that any benefit or right of recourse extended to the Reinsurer shall be subordinate to that of the Company. ARTICLE 14 - ARBITRATION ------------------------ 14.1 Unless both parties mutually agree to waive arbitration with respect to a particular dispute, the parties to this Agreement hereby agree that binding arbitration shall be the sole remedy for any and all dispute(s) arising between them with reference to any transactions, terms or conditions under this Agreement including its formation and validity. Arbitration proceedings brought hereunder shall be referred for final determination to the majority decision of a Panel of three disinterested arbitrators. Notice of demand for arbitration shall be made in writing and shall be served via certified or registered mail, return receipt requested, on the Respondent to the Arbitration at the Respondent's current address. The notice requesting arbitration shall identify the Agreement(s) involved in the dispute, the issues to be resolved in the view of the Petitioner, and the arbitrator selected by the Petitioner. The term "days" as used herein shall mean calendar days. 14.2 The Respondent shall appoint an arbitrator within 30 days of receiving a request by the Petitioner in writing and served via certified or registered mail, return receipt requested, to do so. At the same time as the appointment, the Respondent shall identify in writing any issues which in its view must be resolved in the arbitration proceeding and which were not identified by the Petitioner. If the Respondent fails to appoint its arbitrator within 30 days of being requested to do so, in writing, by the Petitioner, the Petitioner shall have the right to appoint the second arbitrator. Within 30 days after their appointment, the two arbitrators so chosen shall select a third arbitrator to act as umpire. If the two arbitrators do not agree as to the selection of a third arbitrator within 60 days after their appointment, the third arbitrator shall be selected from a list of six individuals (three named by each arbitrator) by a judge of the federal district court or state court in Dallas County, Texas. 14.3 Each arbitrator shall be a disinterested, active or retired official or officer of an insurance or reinsurance company, not under the control or management of either party to this Agreement, and shall have experience in the class and type of business subject to this dispute. 14.4 Within 30 days after notice of appointment of all arbitrators, the Petitioner and the Respondent shall each submit a statement of position to the Panel. 14.5 Within 60 days after notice of appointment of all arbitrators, each party shall provide the other with its relevant books, records, and/or other papers not protected from disclosure by either the work-product or attorney client privilege. Other than the exchange of relevant documents, both parties shall refrain from engaging in any type of discovery including, but not limited to, depositions and interrogatories. 14.6 Within 30 days following the exchange of documents, the Petitioner and the Respondent shall submit hearing briefs to the Panel. 14.7 Unless some other location is mutually agreeable to the parties, arbitration proceedings shall take place within Dallas County, Texas. Arbitration shall commence as soon as practicable but in no event longer than 120 days after selection of the third arbitrator with notice thereof to the parties. The specific time and site of arbitration shall be promptly agreed to by the parties, or if no Consent is reached, then determined by the Panel. 14.8 The Panel shall be relieved from applying the strict rules of evidence and/or procedure and shall make its decision based on the custom and practice of the insurance and reinsurance business with a view toward effecting this Agreement in a reasonable manner. Should either party fail to appear at the arbitration and/or fail to furnish the Panel with any subpoenaed papers or information, the Panel is empowered to proceed ex parte. The Panel shall make its award within 60 days following the close of the hearing. The majority decision of the Panel shall be final and binding upon the parties and shall be reduced to a written award, which may include factual findings, and shall be signed by any two of the three arbitrators, dated and delivered overnight to the parties. The Panel may award pre- judgment and post-judgment interest, but in no case shall the authority of the Panel extend to awarding punitive or exemplary damages. Judgment may be entered upon the award by any court having jurisdiction. 14.9 Each party shall bear the expense of its own arbitrator, but shall equally share with the other the expense of the third arbitrator. In the event that the two arbitrators are chosen by one party, as above provided, the expense of the two arbitrators, the third arbitrator and the arbitration shall be equally divided between the Petitioner and the Respondent. Unless mutually agreed other wise, a court reporter transcript shall be taken of the hearing with costs to be divided equally between the parties. The Panel shall allocate the remaining costs of arbitration. 14.10 The Arbitration proceeding brought hereunder, any or all provisions contained herein, and arbitration awards entered pursuant to this Article are specifically governed by, subject to and enforceable under the Federal Arbitration Act (Title 9, United States Code, Sections 1-14, as amended.) 14.11 Each party agrees that time is of the essence with respect to all terms and conditions referenced in this Article. All deadlines contained in this Article may be extended by mutual consent of the parties, and if the Panel has been selected, the Panel's Consent must also be obtained. 14.12 Each party agrees that any arbitration award entered pursuant to and governed by this Article shall not have any precedential or collateral estoppel effect on future arbitrations, proceedings, or controversies, if any, between the parties. Any claim of res judicata or claim preclusion shall itself be subject to arbitration. 14.13 This Article shall survive the termination of this Agreement. ARTICLE 15 - TERMINATION ------------------------ 15.1 This Agreement shall automatically terminate simultaneous with and upon the cancellation or termination of the reinsurance agreement referred to in Articles 2.4 and 17, except as provided in Article 15.7. 15.2 The right to solicit and place new business, or renewal, or any modification of existing business, shall be suspended as provided in Article 15.5 in the event of default by the Managing General Agent. The term "default" means any material breach or material failure to comply with the terms and conditions of this Agreement and includes, but is not limited to, the following: a. failure to remit balances due as required by this Agreement; b. failure to adjust all claims arising from all business written under this Agreement; c. failure to maintain Agent's license(s) or certificate(s) as required by any public authority; and failure to comply with any and all provisions of the Texas Insurance Code and/or Texas Administrative Code. 15.3 In the event that the Company determines that the Managing General Agent is in default, the Company may, at its sole discretion, suspend the authority of the Managing General Agent. Such suspension shall be effective immediately. The Managing General Agent shall have thirty (30) days to cure the default. 15.4 In the event of cancellation of this Agreement due to fraud or breach of conditions, any indebtedness of the Managing General Agent to the Company and all premiums in the possession of the Managing General Agent, or for the collection of which the Managing General Agent is responsible, shall, notwithstanding any provisions to the contrary, become immediately due the Company. 15.5 The failure of the Company or Managing General Agent to declare promptly a default or breach of any of the terms and conditions of this Agreement shall not be construed as a waiver of any of said terms and conditions, nor estop either party from thereafter demanding a full and complete compliance herewith. 15.6 After the effective date of this Agreement, if new laws are enacted that would eliminate the advantages of issuing policies through the Company, then this Agreement can be terminated at any time by the Managing General Agent issuing the Company a written notice at least ninety (90) days prior to the termination date. Soley for termination under this provision, minimum fronting fees shall not apply for the year the Agreement terminates and any subsequent years. 15.7 In the event the Company restricts volume under Article 2.9 for reasons other than default under 15.2, at the request of a reinsurer, or is required to by the Texas Department of Insurance or other governing body, then the Managing General Agent may terminate this Agreement by issuing the Company a written notice at least ninety (90) days prior to the termination date. Soley for termination under this provision, minimum fronting fees shall not apply for the year the Agreement terminates and any subsequent years. 15.8 Notwithstanding the termination of this Agreement, the provisions of this Agreement shall continue to apply to all unfinished business to the end that all obligations and liabilities incurred by each party as a result of this Agreement shall be fully performed and discharged. In the event this Agreement is terminated, all fronting fees previously collected will be considered fully earned. ARTICLE 16 - CLAIMS HANDLING ---------------------------- 16.1 The Managing General Agent, or its appointed claims handler, shall have the authority to settle all claims arising from business placed with the Company under this Agreement in accordance with established Company procedures. At the sole option of the Company, the Company may assume any or all of this responsibility. 16.2 The Managing General Agent, or its appointed claims handler, shall carry a minimum E&O policy that includes claims practices of $5,000,000 and the Company shall be a named insured of the policy. 16.3 The authority of the Managing General Agent to settle claims shall not exceed $30,000 per claim without notification to and consent of the Company. The Company retains authority over disputes concerning claims settlement and setting of loss reserves. 16.4 The Managing General Agent warrants that HCS shall promptly report to the Company and the Reinsurers any and all claims involving: a. Fatalities; b. Bodily injuries involving: 1. Brain stem, quadriplegic, paraplegic or severe paralysis; 2. Serious burns; 3. Amputations of major limbs; 4 Serious impairment of vision. c. Any bodily injury loss reserve of $20,000 or greater; d. Potential coverage disputes, bad faith situations or demands which may give rise to a payment for excess of Policy limits or extra contractual obligations; e. violations of the Texas Deceptive Trade Practices Act or Article 21.21 of the Texas Insurance Code; or f. Any claims that do not fall within the above categories, but have a potential of significant liability to the Reinsurer. 16.5 The Managing General Agent may appoint (subject to the approval of the Company, which shall not be unreasonably withheld) appropriate claims adjustment firms to handle certain investigations and settlements relating to claims. 16.6 Payment of losses shall be made on checks or drafts in the name of the Company. Any expense not directly connected with the settlement of losses or recovery by way of salvage or subrogation shall be incurred solely by the Managing General Agent except as from time to time specifically authorized by the Company. 16.7 The Managing General Agent shall be responsible for the safekeeping of all checks and/or drafts of the Company used for settling claims and shall perform the following: a. the Managing General Agent shall immediately return all voided checks and/or drafts to the Company; b. the Managing General Agent shall immediately notify the Company of any irregularities, theft, disappearance or destruction of checks and/or drafts; and c. the Managing General Agent shall see to it that all checks and/or drafts are sequentially numbered and issued in order, with all voided checks and/or drafts properly marked and accounted for. ARTICLE 17 - REINSURANCE ------------------------ 17.1 The Managing General Agent may not bind reinsurance or retrocessions on behalf of the Company, may not commit the Company to participate in insurance or reinsurance syndicates and may not collect a premium from a reinsurer or commit the Company to a claims settlement with a reinsurer without the prior written approval of the Company. If the Company gives such prior approval, the Managing General Agent must promptly forward a report to the Company. 17.2 The Managing General Agent is prohibited from ceding reinsurance on behalf of the Company. 17.3 All business coming within the scope of this Agreement shall be reinsured under the attached Reinsurance Agreement. Because of the nature of the Reinsurance Agreement, the Reinsurer shall have the right to act on all such matters coming within the scope of this Agreement as though the Reinsurer were the Company, but by doing so or not doing so, shall not invalidate the right of the Company to act hereunder. 17.4 Any violation of the terms and/or conditions of the Reinsurance Agreement resulting in any diminution of the Reinsurer's liability to the Company shall be the sole responsibility of the Managing General Agent and the Managing General Agent shall indemnify and hold the Company harmless from any such liability. ARTICLE 18 - MISCELLANEOUS -------------------------- 18.1 Any obligations and undertakings of each of the parties to this Agreement shall be performable in Dallas County, Texas. The Managing General Agent agrees to pay to the Company all sums of money which may become payable to Company under this Agreement. 18.2 Complaints by Insureds - All Texas Department of Insurance (TDI) complaints are to be handled by the Managing General Agent as follows: a. the Managing General Agent is to notify the Company immediately of any TDI complaints received and forward a copy of the complaint to the Company; b. the Company will promptly notify the Managing General Agent of any complaints it receives on the business written pursuant to this Agreement; c. the Managing General Agent is to promptly research the circumstances of each complaint and provide the Company with a written reasonable explanation of the Managing General Agent's position and intention; and d. the Managing General Agent is to maintain complete records of each complaint and all supporting documentation. 18.3 As regards non-TDI complaints, the Managing General Agent is to maintain a log and complete records of each complaint and all supporting documentation in a form approved by the Company. 18.4 The underwriting guidelines of the Company, as may be promulgated from time to time by the Managing General Agent, are incorporated herein by reference. 18.5 The Managing General Agent is prohibited from offsetting balances due under this Agreement with any offset due under any other contract. 18.6 As regards the subject matter of this Agreement, this Agreement supersedes all previous Managing General Agency Agreements, if any, whether written and oral, between the Company and the Managing General Agent. 18.7 The Managing General Agent shall satisfy the financial responsibility requirement under Insurance Code, Article 21.07-3. 18.8 No amendments to or modifications of this Agreement shall be valid unless made in writing and executed by the Company and the Managing General Agent in the form of an Amendment to this Agreement. 18.9 The Managing General Agent shall cause Hallmark Financial Services to execute a guaranty of the Managing General Agent's obligations under this Agreement. 18.10 The Managing General Agent shall not directly or indirectly assign its rights and obligations under this Agreement in whole or in part to any non-affiliated party without the prior written approval of the Company. 18.11 Wherever from the context it appears appropriate, each term stated in either the singular or plural shall include the singular and plural and any term stated in either the masculine, the feminine or the neuter gender shall include the masculine, the feminine and the neuter gender. All captions and section headings are intended to be for purposes of reference only and do not affect the substance of the articles to which they refer. 18.12 Each party hereto agrees to perform any further acts and execute and deliver any further documents, which may be reasonably necessary to carry out the provisions of this Agreement. 18.13 In the event that any of the provisions, or portions thereof, of this Agreement are held to be illegal, invalid or unenforceable by any court of competent jurisdiction, the validity and enforceability of the remaining provisions, or portions thereof, shall not be affected by the illegal, invalid or unenforceable provisions or by its severance here from. 18.14 Any and all notices required or permitted to be given under this Agreement shall be in writing and will be deemed given when deposited in the United States Postal Service, Certified Mail, Return Receipt Requested, to the parties' address as provided below. This Agreement shall be effective the 1st day of September 2003 and shall terminate October 31, 2006. The Company: The Managing General Agent: OLD AMERICAN COUNTY MUTUAL AMERICAN HALLMARK GENERAL FIRE INSURANCE COMPANY AGENCY, INC. By: By: -------------------------- ----------------------------- Name: Thomas A. McCall Name: -------------------------- ----------------------------- Title: President Title: -------------------------- ----------------------------- Date: July 3, 2003 Date: -------------------------- ----------------------------- SCHEDULE OF BUSINESS The Company, the Reinsurer and the Managing General Agent agree that the Managing General Agent has the authority to accept, on forms approved by the Company, any Policy, endorsement, binder, certificate, or proposal for insurance. The Managing General Agent's authority is limited by this Schedule of Business. Overall: Projected premium volume $40,000,000 Territory Texas only Maximum policy term Twelve months Lines of business and maximum limits of liability Coverage Maximum Limits Bodily Injury Liability $ 25,026 each person $ 50,026 each accident Property Damage Liability $ 25,026 each accident Uninsured/Underinsured Motorists Bodily Injury $ 25,026 each person $ 50,026 each accident Property Damage $ 25,026 each accident Personal Injury Protection $ 2,526 each person Medical payments $ 526 each person Physical Damage $ 50,000 each automobile This Agreement does not apply to and specifically excludes the following: a. Any business not produced by AMERICAN HALLMARK GENERAL AGENCY, INC. or b. Any business not classified as private passenger automobile liability or physical damage, or c. Exclusions specified within the Quota Share Reinsurance Agreement Number HFS-03-001. The Company: The Managing General Agent: OLD AMERICAN COUNTY MUTUAL AMERICAN HALLMARK GENERAL FIRE INSURANCE COMPANY AGENCY, INC. By: By: -------------------------- ----------------------------- Name: Bryan K. Ward Name: -------------------------- ----------------------------- Title: Vice President Title: -------------------------- ----------------------------- Date: Date: -------------------------- ----------------------------- EX-10.CM 4 exh10cm.txt ADDENDUM NO. 1 TO THE MANAGING GENERAL AGENCY AGREEMENT EXHIBIT 10(cm) ADDENDUM NUMBER 1 TO THE MANAGING GENERAL AGENCY AGREEMENT NUMBER HFS-03-001 BY AND BETWEEN OLD AMERICAN COUNTY MUTUAL FIRE INSURANCE COMPANY AND AMERICAN HALLMARK GENERAL AGENCY, INC. It is mutually agreed that effective October 1, 2003: Article 5.1 is hereby withdrawn and replaced as follows: 5.1 The Managing General Agent shall submit a report to the Company, within thirty (30) days after the close of business each calendar month, summarizing the business transacted under this Agreement during the prior month. Such report shall include the following items: a. gross premiums written less returns and cancellations; b. Agent's commissions; c. losses paid less recoveries and salvage; d. loss adjustment expenses equal to 10% of earned premium; e. outstanding loss reserves; f. outstanding loss expense reserves; g. losses incurred but not reported; h. unearned premium reserve; and i. earned premium. Article 6.3 is added: 6.3 The Company will reimburse the Managing General Agent for loss adjustment expenses paid equaling 10% of earned premium in accordance with the Reinsurance Agreement. If the Managing General Agent, on behalf of the Company, incurs loss adjustment expenses in excess of 10% of earned premium, the excess loss adjustment expense will be paid by the Managing General Agent. The Schedule of Business is hereby withdrawn and replaced as follows: SCHEDULE OF BUSINESS The Company, the Reinsurer and the Managing General Agent agree that the Managing General Agent has the authority to accept, on forms approved by the Company, any Policy, endorsement, binder, certificate, or proposal for insurance. The Managing General Agent's authority is limited by this Schedule of Business. Overall: Projected premium volume $40,000,000 Territory Texas only Maximum policy term Twelve months Lines of business and maximum limits of liability Coverage Maximum Limits Bodily Injury Liability $ 25,027 each person $ 50,027 each accident Property Damage Liability $ 25,027 each accident Uninsured/Underinsured Motorists Bodily Injury $ 25,027 each person $ 50,027 each accident Property Damage $ 25,027 each accident Personal Injury Protection $ 2,527 each person Medical payments $ 527 each person Physical Damage $ 50,000 each automobile This Agreement does not apply to and specifically excludes the following: a. Any business not produced by AMERICAN HALLMARK GENERAL AGENCY, INC., or b. Any business not classified as private passenger automobile liability or physical damage, or c. Exclusions specified within the Quota Share Reinsurance Agreement Number HFS-03-001." All other terms and conditions shall remain unchanged. In witness whereof, the parties hereto by their respective duly authorized officers have executed this Agreement in duplicate as of the date below: This 2th day of October, 2003 This ______ day of _______________, 2003 OLD AMERICAN COUNTY MUTUAL FIRE AMERICAN HALLMARK GENERAL INSURANCE COMPANY AGENCY, INC. By: By: -------------------------- ----------------------------- Name: Bryan K. Ward Name: -------------------------- ----------------------------- Title: Treasurer Title: -------------------------- ----------------------------- EX-10.CN 5 exh10cn.txt GUARANTY AGREEMENT EXHIBIT 10(cn) STATE OF TEXAS COUNTY OF DALLAS GUARANTY AGREEMENT ============================================================================ This Agreement is effective this 1st day of September, 2003, between OLD AMERICAN COUNTY MUTUAL FIRE INSURANCE COMPANY, an insurance company domiciled in Texas (Company) and HALLMARK FINANCIAL SERVICES, INC. a Texas Corporation (Guarantor). FOR AND IN CONSIDERATION OF THE MUTUAL PREMISES AND COVENANTS SET FORTH HEREIN, the Company and Guarantor hereby agree as follows: PURPOSE ------- The Company desires to appoint AMERICAN HALLMARK GENERAL AGENCY INC. (Managing General Agent) a Texas Managing General Agency to act as the Company's Managing General Agent. Guarantor wishes to facilitate such appointment by individually guaranteeing the performance of the Managing General Agent to the Company. GUARANTY -------- 1. On September 1, 2003, the Company and the Managing General Agent entered into a Managing General Agency Agreement (Managing General Agency Agreement) whereby the Managing General Agent agreed to provide various specified services to the Company for certain commissions and/or fees specified therein. 2. Guarantor agrees to guarantee the performance of any and all obligations of the Managing General Agent under the Managing General Agency Agreement, including, without limitation, the payment of all funds owed to the Company, insureds, finance companies, claimants, or agents by the Managing General Agent and all Managing General Agent's balances arising pursuant to such Managing General Agency Agreement. This Guaranty expressly includes any reasonable attorneys' fees and expenses incurred by the Company by reason of the Managing General Agent's failure to satisfy any such obligation. 3. This Guaranty shall be absolute and unconditional. The Company shall have the right in its sole discretion to proceed against Guarantor for any indebtedness within the scope of this Agreement without first exhausting its remedies against the Managing General Agent. This Guaranty is of payment, not of collection. 4. Guarantor hereby acknowledges the adequacy and receipt of the Company's appointment of AMERICAN HALLMARK GENERAL AGENCY, INC. as the Managing General Agent pursuant to the Managing General Agency Agreement, any amendment to the Managing General Agency Agreement, and any subsequent agency agreements entered into by the parties herein as valuable consideration for this Agreement. TERM ---- 5. This Agreement shall continue in full force and effect with regard to the obligations of Guarantor until all obligations under the Managing General Agency Agreement are satisfied. 6. Termination of the Reinsurance Agreement and/or Managing General Agency Agreement, however, shall not affect, in any manner, the liabilities of Guarantor arising under this Agreement. This Agreement shall, therefore, continue in full force and effect until the complete satisfaction of such obligations guaranteed under this Agreement and then automatically terminates without any notice requirements on the part of any party. MISCELLANEOUS ------------- 7. Provisions of this Agreement, if any, required to be approved by the Board of Directors of the Company or Guarantor have been so approved. 8. If any action at law or in equity is necessary to enforce or interpret the terms of this Agreement, the prevailing party shall be entitled to reasonable attorneys' fees. 9. The paragraph headings herein are for convenience only and shall in no manner be construed as part of this Agreement. 10. This Agreement shall not be assigned by either party without the prior written consent of the other party. 11. This Agreement shall be interpreted by, construed in accordance with, and governed by the laws of the State of Texas. 12. If all, or any part of any covenant, condition or other provision of this Agreement is declared by a court of competent jurisdiction to be invalid and not binding, such declaration shall in no way affect the validity of the other remaining covenants, conditions and provisions of this Agreement. 13. This Agreement shall be binding on, inure to the benefit of and be enforceable by either party and its respective successors and assigns. 14. This Agreement supersedes all prior agreements, written or oral, between the parties hereto concerning this Agreement, and all such prior agreements shall be of no further force or effect. This Agreement may be amended or modified only by written instrument signed by both parties. 15. Each party, by his/her signature, represents and warrants that he/she has the authority to execute this Agreement in the capacity and for the purposes for which he/she signs. 16. This Agreement may be executed in any number of counterparts, each of which shall be deemed an original, but all of which together shall constitute one and the same instrument. 17. This Guaranty Agreement is executed and delivered as incident to a Managing General Agency Agreement between AMERICAN HALLMARK GENERAL AGENCY, INC. and the Company. The agreements were negotiated, consummated and are performable in Dallas County, Dallas, Texas. OLD AMERICAN COUNTY MUTUAL FIRE HALLMARK FINANCIAL SERVICES INC. INSURANCE COMPANY By: __________________________ By: ______________________________ Bryan K. Ward, Vice President Timothy A. Bienek, President & COO EX-10.CO 6 exh10co.txt 45% QUOTA SHARE REINSURANCE AGREEMENT EXHIBIT 10(co) OLD AMERICAN COUNTY MUTUAL FIRE INSURANCE COMPANY 45% QUOTA SHARE REINSURANCE AGREEMENT Effective: October 1, 2003 Quota Share Reinsurance Agreement Number HFS-03-001 Table of Contents Article 1 Recitals Article 2 Definitions Article 3 Business Reinsured Article 4 Obligatory Agreement Article 5 Terms and Cancellation Article 6 Consideration Article 7 Loss and Loss Adjustment Expense Article 8 Reports and Remittances Article 9 Ceding Commission, Fronting Fees, Premium Taxes and Sliding Scale Commission Article 10 Exclusions Article 11 Errors and Omissions Article 12 Inspection of Records Article 13 Offset Clause Article 14 Arbitration Article 15 Honorable Undertaking Article 16 Assessments and Assignments Article 17 Conservation, Liquidation or Insolvency Article 18 Hold Harmless Article 19 Regulatory Matters Article 20 Loss in Excess of Policy Limits/Extra Contractual Obligations Article 21 Savings Clause Article 22 Unauthorized (Non-Admitted) Reinsurance Article 23 Program Review Article 24 Miscellaneous Article 25 Intermediary QUOTA SHARE REINSURANCE AGREEMENT NUMBER HFS-03-001 This Agreement is made and entered into by and between OLD AMERICAN COUNTY MUTUAL FIRE INSURANCE COMPANY (hereinafter referred to as the "Company") and AMERICAN HALLMARK INSURANCE COMPANY OF TEXAS (hereinafter referred to as the "Reinsurer"). THE COMPANY AND REINSURER HEREBY AGREE AS FOLLOWS: ARTICLE 1 - RECITALS -------------------- 1.1 The Company and Reinsurer hereby wish to enter into a reinsurance arrangement through which the Company is to bear no business, credit or insurance risk whatsoever (save the risk of the Reinsurer's insolvency). The Reinsurer shall hold the Company fully harmless and indemnify it for these and all risks arising pursuant to this Agreement. 1.2 The Company and Reinsurer hereby agree that the full consideration provided by the Company in exchange for the fees set forth herein, is to permit the Policies as defined herein to be issued in the name of the Company and which are reinsured one hundred percent (100%) under this Agreement and a certain Quota Share Reinsurance Agreement between the Company and Dorinco Reinsurance Company (Corresponding Reinsurer) dated effective October 1, 2003 (the "Corresponding Agreement"). 1.3 It is understood and agreed that neither the Company nor the Reinsurer is obligated by any representations or warranties made by any of the parties involved in this transaction unless such representations and warranties are formally included in this Agreement. 1.4 All business reinsured hereunder shall be produced by AMERICAN HALLMARK GENERAL AGENCY, INC. (Managing General Agent), in accordance with the terms and conditions of the Managing General Agency Agreement effective September 1, 2003, (Managing General Agency Agreement) between the Managing General Agent and the Company, a copy of said Agreement is attached hereto and fully incorporated herein. 1.5 This Agreement sets forth all of the duties and obligations between the Company and the Reinsurer and supersedes any and all prior or contemporaneous or written agreements with respect to matters referred to in this Agreement. This Agreement may not be modified, amended or changed except by an agreement in writing signed by both parties. ARTICLE 2 - DEFINITIONS ----------------------- 2.1 "Policies" is defined as all policies, endorsements, certificates, contracts, agreements and binders of insurance issued or renewed on or after the effective date of this Agreement on behalf of the Company. 2.2 "Net Written Premium" is defined as the gross written premium) on all original and renewal Policies written by the Company including policy fees, less return premium and cancellations. 2.3 "Loss in Excess of Policy Limits" (XPL) is defined as any amount which the Company pays or would have been contractually held liable to pay had it not been for the limit of the original Policy. 2.4 "Extra Contractual Obligation"(ECO) is defined as those liabilities not covered under any other provision of this Agreement which arise from the handling of any claim on business covered hereunder, because of, but not limited to, failure by the Company to settle within the policy limit, or by reason of alleged or actual negligence, fraud or bad faith in rejecting an offer of settlement or in the preparation of the defense or in the trial of any action against its insured or reinsured or in the preparation or prosecution of an appeal consequent upon such action. The date on which any ECO is incurred by the Company shall be deemed, in all circumstances, to be the date of the original disaster and/or casualty. 2.5 "Loss Adjustment Expense" shall mean expenditures by the Company that are not part of the indemnity under the original policy (i.e. which do not contribute to exhaustion of the original policy limit), made in connection with the disposition of a claim, loss or legal proceeding (including investigation, negotiation, cost of bonds, court costs, statutory penalties, prejudgment interest or delayed damages, and interest on any judgment or award and legal expenses of litigation) and the Company's defense costs and legal expenses incurred in direct connection with legal actions (including, but not limited to, Declaratory Judgment actions) brought to determine the Company's defense and/or indemnification obligations that are allocable only to Policies and claims under Policies subject to this Agreement. Any Declaratory Judgment action expenses shall be deemed to have been fully incurred on the same date as the original loss (if any) giving rise to the action. 2.6 "Prejudgment Interest" or "Delayed Damages" shall mean interest or damages added to a settlement, verdict, award or judgment based on the amount of time prior to the settlement, verdict, award or judgment whether or not made part of the settlement, verdict, award or judgment. ARTICLE 3 - BUSINESS REINSURED ------------------------------ 3.1 The Reinsurer hereby reinsures the Company for a forty- five percent (45%) quota share in respect of all liability, including, but not limited to, losses and loss adjustment expenses, under Policies issued or renewed on or after the effective date hereon on behalf of the Company by the Managing General Agent or its designated representative as classified by the Company in the attached Schedule of Business. 3.2 It is understood that the classes of business reinsured under this Agreement are deemed to include coverages required for non-resident drivers under the motor vehicle financial responsibility law or the motor vehicle compulsory insurance law or any similar law of any state or province, following the provisions of the Company's policies when they include or are deemed to include so-called "Out of State Insurance" provisions. 3.3 All insurance under this Agreement shall be subject to the same rates, terms, conditions and waivers, and to the same modifications and alterations as the respective Policies of the Company. ARTICLE 4 - OBLIGATORY AGREEMENT -------------------------------- 4.1 The Company agrees to cede to the Reinsurer, and the Reinsurer agrees to accept from the Company, a forty-five percent (45%) quota share reinsurance participation under all Policies effective on or after the effective date hereof by the Company covering risks situated in Texas. The liability of the Reinsurer shall commence obligatorily and simultaneously with that of the Company subject to the terms, conditions and limitations set forth in this Agreement. 4.2 Business ceded hereunder shall include every original policy, rewrite, renewal or extension (whether before or after the termination of this Agreement) required by statute or by rule or regulation of the Texas Department of Insurance, or other authority having competent jurisdiction, of any policy of insurance originally ceded hereunder by the Company to the Reinsurer. 4.3 The parties understand and intend that the Reinsurer shall follow the fortunes of the Company in every respect to activities engaged in hereunder. ARTICLE 5 - TERM AND CANCELLATION --------------------------------- 5.1 This Agreement shall become effective 12:00:01 a.m. (Central Standard Time) on the first day of October 2003, as respects losses arising under Policies effective on or after such date, and shall remain continuously in force unless terminated by either party. 5.2 This Agreement may be terminated by either party at any calendar quarter end giving the other party written notice at least ninety (90) days prior to such date. 5.3 When the Agreement terminates for any reason, reinsurance hereunder shall continue to apply to the business in force at the time and date of termination until expiration or cancellation of such business. The parties understand and agree that any Policies with effective dates prior to the termination date, but issued after the termination date, are covered under this Agreement. Additionally, the reinsurance hereunder shall continue to apply as to Policies which must be issued or renewed, as a matter of state law or regulation or because an agent (appointed by the Company at the request of the Reinsurer) has not been timely canceled, until the expiration dates on said Policies. 5.4 Upon termination of this Agreement, the Reinsurer and the Company shall not be relieved or released from any obligation which relate to outstanding insurance business created by or under this Agreement. The parties hereto expressly covenant and agree that they will cooperate with each other in the handling of all such run-off insurance business until all Policies have expired and all outstanding losses and loss adjustment expenses have been settled. While by law and regulations, the Company recognizes its primary obligations to its Policyholders, the Reinsurer recognizes that there shall be no cost or involvement by the Company, unless specifically agreed, in servicing this run-off. The Reinsurer shall bear all costs and expenses associated with handling of such run-off business following the cancellation or termination of this Agreement. If for any reason any managing general agent or agent fails to service any such run-off business (or any business while the Agreement is still in effect), including the payment of claims, then consistent with this Agreement, the Reinsurer's obligation with respect to such run-off business shall continue and the Reinsurer shall either service such run-off business directly or appoint, at the Reinsurer's expense, a successor to such managing general agent and/or agent, subject to the approval of the Company, which approval shall not be unreasonably withheld. Such successor shall perform all of the duties and obligations of the managing general agent and/or agent with respect to servicing such run- off business. 5.5 In addition to the provisions set forth in Article 5.2 herein, this Agreement may be terminated at any time in accordance with the following terms and conditions: a. After thirty (30) days written notice by the Company in the event the Reinsurer: (i) is acquired and/or merged by or in any manner becomes under the control of any other company or corporation; (ii) changes a majority of its officers or board of directors; or (iii) is the subject of a filing or petition or initiation of any proceeding for supervision, rehabilitation, conservation or liquidation, or any other proceedings for the protection of a creditor. b. After thirty (30) days written notice by the Reinsurer in the event the Company: (i) is acquired and/or merged by or in any manner becomes under the control of any other company or corporation; (ii) changes a majority of its officers or board of directors; or (iii) is the subject of a filing or petition or initiation of any proceeding for supervision, rehabilitation, conservation or liquidation, or any other proceedings for the protection of a creditor. c. By the Company immediately and automatically without prior written notice should the Texas Department of Insurance require cancellation or disallow credit for this reinsurance. d. After fifteen (15) days written notice by the Reinsurer or the Company, in the event of breach of conditions, fraud or default by either party under the terms and conditions of the Agreement. 5.6 Notices hereunder shall be provided in accordance with Article 24.2, hereof. ARTICLE 6 - CONSIDERATION ------------------------- 6.1 In consideration of the acceptance by the Reinsurer of forty-five percent (45%) of the Company's liability on insurance business reinsured hereunder, the Reinsurer is entitled to forty-five percent (45%) of the Net Premiums written by the managing general agent and/or agent or the Reinsurer on Policies reinsured less the ceding commission allowed to the Company, which includes premium taxes and fronting fees on Policies subject to reinsurance hereunder. ARTICLE 7 - LOSS AND LOSS ADJUSTMENT EXPENSE -------------------------------------------- 7.1 All loss settlements, judgments and all interest on said judgments, including losses in excess of policy limits (XPL) and extra contractual obligations (ECO) made by the Company or the Company's designee under the terms of this Agreement, whether under strict policy conditions or by way of compromise, shall be unconditionally binding upon the Reinsurer. The Reinsurer shall also be liable for and pay on behalf of the Company all loss adjustment expenses as defined in Article 2.5. The Reinsurer shall be credited with all salvage or recoveries by the Company on business reinsured hereunder 7.2 Claims handling shall be accomplished by the Managing General Agent or its designated representative ("Claims Agent") pursuant to the Managing General Agency Agreement and whose designation is subject to the Company's continuing approval and shall not be inconsistent with the terms and conditions of this Agreement. Payment of claims handling fees to the designated representative (if any) shall be made by the Reinsurer. 7.3 The Reinsurer's share of losses, loss adjustment expenses and loss recoveries shall be carried into the monthly account for which provision is hereinafter made; however, when the amount of loss paid by the Company under insurance subject to this Agreement exceeds the balance due the Reinsurer pursuant to Article 8, the Reinsurer will, at the option and the demand of the Company, be immediately reimbursed by special remittance. The Reinsurer shall retain the right to deduct from any such special remittance any overdue balance due the Reinsurer by the Company. It is also agreed, that if the Reinsurer's share of any loss is equal to or greater than $100,000, the Reinsurer will pay its share of said loss as promptly as possible after receipt of reasonable evidence of the amount paid by the Company. ARTICLE 8 - REPORTS AND REMITTANCES ----------------------------------- 8.1 Within thirty-five (45) days after the end of each calendar month, the Company shall report to the Reinsurer the following: a. Ceded gross written premium for the month; b. Ceded premiums earned for the month; c. Provisional ceding commission on b above; d. Ceded losses and loss adjustment expenses paid during the month (net of any recoveries during the month for cash calls); e. Salvage, subrogation or other recoveries on losses; f. Ceded unearned premium at the end of the month; g. Ceded outstanding losses and loss adjustment expense reserves at the end of the month. 8.2 Balances due under this Agreement will be equal to (b) less (c) less (d) plus (e). Any positive balances shown to be due the Reinsurer shall be remitted by the General Agent within 60 days. Any negative balance shown to be due the General Agent shall be remitted by the Reinsurer as promptly as possible after receipt and verification of the General Agent's report, not to exceed 60 days. Notwithstanding the foregoing, in the event the Reinsurer terminates this Agreement reports shall be due within 15 days after the end of the month and remittances shall be due within 30 days after the end of the month. ARTICLE 9 - CEDING COMMISSION, FRONTING FEES, PREMIUM TAXES AND SLIDING ------------------------------------------------------------------------ SCALE COMMISSION ---------------- 9.1 The Reinsurer will pay to the Company a provisional Ceding commission of 31.00%, which shall be calculated on the basis of earned premium on policies reinsured hereunder. 9.2 The Company will be liable for remitting state premium taxes based on net written premium and net policy fees charged. Should service fees be charged on any policy covered by this Agreement, and such fees be deemed taxable for premium tax purposes, then such service fees are to be added to the net written premium and net policy fees charged to determine the amount subject to Fronting Fees. Should service fees be deemed taxable, they shall be reported and remitted in a consistent manner as premium written in Article 8 above. 9.3 The Reinsurer acknowledges that the Company is not responsible for any contingent commission adjustment, and such adjustment shall be settled directly between the Managing General Agent and the Reinsurer. The Reinsurer shall seek recovery for any contingent commission adjustment directly from the Managing General Agent. 9.4 The provisional commission allowed the Company shall be adjusted periodically in accordance with the provisions set forth herein. The first adjustment period shall be from the effective date of this Agreement through October 1, 2004, and each subsequent 12 month period shall be a separate adjustment period. However, if this Agreement is terminated, the final adjustment period shall be from the beginning of the then current adjustment period through the effective date of termination. 9.5 The adjusted commission rate shall be calculated as follows and be applied to premiums earned for the period under consideration: a. If the ratio of losses incurred to premiums earned is 65.50% or greater, the adjusted commission rate for the period under consideration shall be 28.00%; b. If the ratio of losses incurred to premiums earned is less than 65.50%, but not less than 62.50%, the adjusted commission rate for the period under consideration shall be 28.00%, plus 100% of the difference in percentage points between 65.50% and the actual ratio of losses incurred to premiums earned; c. If the ratio of losses incurred to premiums earned is 62.50% or less, but not less than 53.50% the adjusted commission rate for the period under consideration shall be 31.00%, plus the difference in percentage points between 62.50% and the actual ratio of losses incurred to premiums earned; d. If the ratio of losses incurred to premiums earned is 53.50% or less, the adjusted commission rate for the period under consideration shale be 40.00%. 9.6 If the ratio of losses incurred to premiums earned for any period is greater than 65.50%, the difference in percentage points between the actual ratio of losses incurred to premiums earned and 65.50% shall be multiplied by premiums earned for the period and the product shall be carried forward to the next adjustment period as a debit to losses incurred. If the ratio of losses incurred to premiums earned for any period is less than 53.50%, the difference in percentage points between 53.50% and the actual ratio of losses incurred to premiums earned shall be multiplied by premiums earned for the period and the product shall be carried forward to the next adjustment period as a credit to losses incurred. 9.7 Within 18 months from the inception of the Underwriting Year, and after the end of each 12 month period thereafter the General Agent shall calculate and report the adjusted commission on premiums earned for the adjustment period. If the adjusted commission on premiums earned is less than commissions previously allowed by the Reinsurer on premiums earned for the adjustment period, the General Agent shall remit the difference to the Reinsurer with its report. If the adjusted commission on premiums earned is greater than commissions previously allowed by the Reinsurer on premiums earned for the adjustment period, the Reinsurer shall remit the difference to the General Agent as promptly as possible after receipt and verification of the Company's report. 9.8 "Losses incurred" as used herein shall mean ceded losses and loss adjustment expense paid as of the effective date of calculation, plus the ceded reserves for losses and loss adjustment expense outstanding as of the same date, plus the debit or minus the credit from the preceding adjustment period, it being understood and agreed that all losses and related loss adjustment expense under policies with effective or renewal dates during an adjustment period shall be charged to that adjustment period, regardless of the date said losses actually occur, unless this Agreement is terminated on a "cutoff" basis, in which event the Reinsurer shall have no liability for losses occurring after the effective date of termination. 9.9 "Premiums earned" as used herein shall mean ceded net written premiums for policies with effective or renewal dates during the adjustment period, less the unearned portion thereof as of the effective date of calculation, it being understood and agreed that all premiums for policies with effective or renewal dates during an adjustment period shall be credited to that adjustment period, unless this Agreement is terminated on a "cutoff" basis, in which event the unearned reinsurance premium (less previously allowed ceding commission) as of the effective date of termination shall be returned by the Reinsurer to the Company. ARTICLE 10 - EXCLUSIONS ----------------------- This Agreement does not apply to and specifically excludes the following: a. Any automobile not classified as private passenger automobile. b. Garagekeepers legal liability. c. Vendors single interest. d. Nuclear risks as defined in the "Nuclear Incident Exclusion Clause - Physical Damage - Reinsurance" and the "Nuclear Incident Exclusion Clause - Liability - Reinsurance" attached to and forming part of this Agreement. e. Liability as a member, subscriber or reinsurer of any Pool, Syndicate or Association, but this exclusion shall not apply to Assigned Risk Plans or similar plans. f. Mobile homes. g. Automobile dealers. h. Automobile Liability with respect to any vehicle used principally as: 1) A Taxicab, public or livery conveyance or bus, it being understood that this exclusion does not apply to school or church buses; 2) An ambulance, fire department or law enforcement vehicle; 3) A racing or exhibition vehicle. i. Loss or damage caused by or resulting from war, invasion, hostilities, acts of foreign enemies, civil war, insurrection, military or usurped power, martial law or confiscation by order of any government of public authority, but not excluding loss or damage which would be covered under a policy or standard form containing a standard war exclusion clause. j. Loss or damage or cost or expenses arising from seepage and/or pollution and/or contamination, other than contamination from smoke damage. Nevertheless, this exclusion does not preclude any payments of the cost of the removal of debris of property damage by a loss otherwise covered hereunder, but subject always to a limit of 25% of the Company's Property Business loss under the original policy. If any business falling within the scope of one or more of the exclusions is assigned to the Company under an Assigned Risk Plan, such exclusion(s) shall not apply, it being understood and agreed that the limits of liability extended by the Company as respects such policies shall not exceed the minimum statutory limits of liability prescribed in such Assigned Risk Plan. If the Company is bound, without the knowledge of and contrary to the instructions of the Company's supervisory underwriting personnel, on any business falling within the scope of one or more of the exclusions set forth in this Article, these exclusions shall be suspended with respect to such business until 30 days after an underwriting supervisor of the Company acquires knowledge of such business. ARTICLE 11 - ERRORS AND OMISSIONS --------------------------------- 11.1 Inadvertent delays, errors or omissions made in connection with this Agreement or any transaction hereunder shall not relieve either party from any liability which would have attached had such delay, error or omission not occurred, provided always that such error or omission is rectified as soon as possible after discovery. ARTICLE 12 - INSPECTION OF RECORDS ---------------------------------- 12.1 All records pertaining to Policies issued on behalf of the Company through or by the Reinsurer or its designated representative subject to this Agreement, shall be deemed to be jointly owned records of the Company and the Reinsurer, and shall be made immediately available to the Company or the Reinsurer or their representative or any duly appointed examiner for any State within the United States; and these records shall be kept in the State of Texas. Notwithstanding the foregoing, the Reinsurer is authorized to maintain duplicate working files of all such records outside the State of Texas. The Company and the Reinsurer agree that neither will destroy any such records in their possession without the prior written approval of the other, except that the Company shall not be required to retain files longer than required by the guidelines set by the Texas Department of Insurance. ARTICLE 13 - OFFSET CLAUSE -------------------------- 13.1 The Company or the Reinsurer shall have the right to offset any balance or amounts due from one party to the other under the terms of this Agreement. The party asserting the right of offset may exercise such right at any time whether the balances due are on account of premiums or losses or otherwise. ARTICLE 14 - ARBITRATION ------------------------ 14.1 Unless both parties mutually agree to waive arbitration with respect to a particular dispute, the parties to this Agreement hereby agree that binding arbitration shall be the sole remedy for any and all dispute(s) arising between them with reference to any transactions, terms or conditions under this Agreement including its formation and validity. Arbitration proceedings brought hereunder shall be referred for final determination to the majority decision of a Panel of three disinterested arbitrators. Notice of demand for arbitration shall be made in writing and shall be served via certified or registered mail, return receipt requested, on the Respondent to the Arbitration at the Respondent's current address. The notice requesting arbitration shall identify the Agreement(s) involved in the dispute, the issues to be resolved in the view of the Petitioner, and the arbitrator selected by the Petitioner. The term "days" as used herein shall mean calendar days. 14.2 The Respondent shall appoint an arbitrator within 30 days of receiving a request by the Petitioner in writing and served via certified or registered mail, return receipt requested, to do so. At the same time as the appointment, the Respondent shall identify in writing any issues which in its view must be resolved in the arbitration proceeding and which were not identified by the Petitioner. If the Respondent fails to appoint its arbitrator within 30 days of being requested to do so, in writing, by the Petitioner, the Petitioner shall have the right to appoint the second arbitrator. Within 30 days after their appointment, the two arbitrators so chosen shall select a third arbitrator to act as umpire. If the two arbitrators do not agree as to the selection of a third arbitrator within 60 days after their appointment, the third arbitrator shall be selected from a list of six individuals (three named by each arbitrator) by a judge of the federal district court in Dallas County, Texas. 14.3 Each arbitrator shall be a disinterested, active or retired official or officer of an insurance or reinsurance company, not under the control or management of either party to this Agreement, and shall have experience in the class and type of business subject to this dispute. 14.4 Within 30 days after notice of appointment of all arbitrators, the Petitioner and the Respondent shall each submit a statement of position to the Panel. 14.5 Within 60 days after notice of appointment of all arbitrators, each party shall provide the other with its relevant books, records, and/or other papers not protected from disclosure by either the work-product or attorney client privilege. Other than the exchange of relevant documents, both parties shall refrain from engaging in any type of discovery including, but not limited to, depositions and interrogatories. 14.6 Within 30 days following the exchange of documents, the Petitioner and the Respondent shall submit re-hearing briefs to the Panel. 14.7 Unless some other location is mutually agreeable to the parties, arbitration proceedings shall take place within the municipality wherein the Home Office of the Company is located. Arbitration shall commence as soon as practicable but in no event longer than 120 days after selection of the third arbitrator with notice thereof to the parties. The specific time and site of arbitration shall be promptly agreed to by the parties, or if no Contract is reached, then determined by the Panel. 14.8 The Panel shall be relieved from applying the strict rules of evidence and/or procedure and shall make its decision based on the custom and practice of the insurance and reinsurance business with a view toward effecting this Agreement in a reasonable manner. Should either party fail to appear at an arbitration hearing and/or fail to furnish the Panel with any subpoenaed papers or information, the Panel is empowered to proceed ex parte. The Panel shall make its award within 60 days following the close of the hearing. The majority decision of the Panel shall be final and binding upon the parties and shall be reduced to a written award, which may include factual findings, and shall be signed by any two of the three arbitrators, dated and delivered overnight to the parties. The Panel may award pre- judgment and post-judgment interest, but in no case shall the authority of the Panel extend to awarding punitive or exemplary damages. Judgment may be entered upon the award by any court having jurisdiction. 14.9 The expense of its own arbitrator, but shall equally share with the other the expense of the third arbitrator. In the event that the two arbitrators are chosen by one party, as above provided, the expense of the two arbitrators, the third arbitrator and the arbitration shall be equally divided between the Petitioner and the Respondent. Unless mutually agreed other wise, a court reporter transcript shall be taken of the hearing with costs to be divided equally between the parties. The remaining costs of arbitration shall be allocated by the Panel. 14.10 The Arbitration proceeding brought hereunder, any or all provisions contained herein, and arbitration awards entered pursuant to this Article are specifically governed by, subject to and enforceable under the Federal Arbitration Act (Title 9, United States Code, Sections 1-14, as amended.) 14.11 Each party agrees that time is of the essence with respect to all terms and conditions referenced in this Article. All deadlines contained in this Article may be extended by mutual Contract of the parties, and if the Panel has been selected, the Panel's Contract must also be obtained. 14.12 Each party agrees that any arbitration award entered pursuant to and governed by this Article shall not have any precedential or collateral estoppel effect on future arbitrations, proceedings, or controversies, if any, between the parties. Any claim of res judicata or claim preclusion shall itself be subject to arbitration. 14.13 This Article shall survive the termination of this Agreement. ARTICLE 15 - HONORABLE UNDERTAKING ---------------------------------- 15.1 The purposes of this Agreement are not to be defeated by narrow or technical legal interpretations of its provisions. This Agreement shall be construed as an honorable undertaking and should be interpreted for the purpose of giving effect to the intentions of the parties hereto. ARTICLE 16 - ASSESSMENTS AND ASSIGNMENTS ---------------------------------------- 16.1 The Reinsurer hereby assumes liability for its forty-five percent (45%) quota share reinsurance participation with respect to any and all costs, assessments or assignments imposed as a result of Policies reinsured hereunder (whether before or after the termination of this Agreement) levied or made by a guaranty fund, insolvency fund, plan, pool, association, or other arrangement created by statute or regulation including, but not limited to, assessments levied by the Texas Property & Casualty Insurance Guaranty Association. The Company shall account to the Reinsurer for any recovery or any credit allowed to the Company against its premium taxes, and return to the Reinsurer its share of any recovery or credit. ARTICLE 17 - CONSERVATION, LIQUIDATION OR INSOLVENCY ---------------------------------------------------- 17.1 In the event of the insolvency of the Company, the Reinsurance afforded by this Agreement shall be payable directly by the Reinsurer to the Company or its liquidator, receiver or statutory successor on the basis of the liability of the Company under the Policies, without diminution because of the insolvency of the Company, in accordance with the provisions of any State Law which may be involved except: a. where the Agreement specifically provides another payee of such reinsurance in the event of the insolvency of the Company; or b. where the Reinsurer with the consent of the direct insured(s) has assumed such Policy obligations of the Company as direct obligations of the Reinsurer to the payees under such policies and in substitution for the obligations of the Company to the payees. 17.2 In the event of the insolvency of the Company, the liquidator, receiver or statutory successor of the Company shall give written notice to the Reinsurer of the pendency of a claim against the insolvent Company on a Policy within a reasonable time after such claim is filed in the insolvency proceedings. During the pendency of such claim, the Reinsurer may investigate such claim and interpose at its own expense, in the proceeding where such claim is to be adjudicated, any defense or defenses which it may deem available to the Company or its liquidator, receiver or statutory successor. The expense thus incurred by the Reinsurer shall be chargeable, subject to court approval, against the insolvent Company as part of the expense of liquidation to the extent of the proportionate share of the benefits which may accrue to the Company solely as a result of the defense undertaken by the Reinsurer. 17.3 If two (2) or more reinsurers are involved in the same claim and a majority in interest elects to interpose defense to such claim, the expense shall be apportioned in accordance with the terms of this Agreement as though such expense had been incurred by the Company. 17.4 As respects subject business assumed as reinsurance under this Agreement, the parties agree that if the Company has a conservator, liquidator, or receiver appointed for it, or becomes the subject of any conservation, liquidation or insolvency proceeding, and the Company is permitted to have all its liabilities under the Policies reinsured hereunder assumed by another licensed insurer, such assuming insurer shall be substituted for the Company as payee of any reinsurance recoverable hereunder in respect of losses under Policies subject hereto, and the Reinsurer shall make payments thereof directly to the substituted insurer. 17.5 In the event the foregoing provisions apply, all the other provisions of this Agreement shall apply to the substituted insurer in the same manner as if said insurer were substituted for the Company as the reinsured party hereunder, and to the extent this Agreement reinsures such substituted insurer, coverage hereunder shall be excluded as respects the Company. ARTICLE 18 - HOLD HARMLESS -------------------------- 18.1 In consideration of these presents and the reciprocal benefits derived by the Company and the Reinsurer, the Reinsurer assumes liability for any and all uncollected balances, unsettled finance agreements, claims, commission adjustments, losses, loss corridors, demands, causes of action (including, but not limited to, violations of the Texas Deceptive Trade Practices Act or insurance laws or regulations), damages (including, but not limited to, any and all extra contractual or liability in excess of policy limits), judgments and expenses (including, but not limited to, attorney's fees and costs of court) which may be made against the Company and which are incurred, either directly or indirectly, in connection with this Agreement or contracts related to this Agreement or any actions or failure to take action by the Managing General Agent or any agent or by the Company in successfully asserting its rights hereunder in connection with or with respect to this Agreement. Notwithstanding anything to the contrary, this provision shall not apply to: a. fraud, dishonesty, theft or collusion on the part of any Director, Officer or employee of the Company; or b. policies not reinsured hereunder; or c. the Company's failure to perform its duties and obligations under this Agreement due to the Company's gross negligence. 18.2 If, for any reason, the Managing General Agent or agent fails, or is unable, to administer the Policies reinsured hereunder (whether the Agreement is still in effect or the business is being run-off), the Reinsurer shall appoint, a third party, subject to the Company's approval, to administer the business in accordance with the terms and conditions of this Agreement and the agreement with the Managing General Agent. The Reinsurer shall be responsible for the cost of such administration. The Company agrees to cooperate with the Reinsurer and the third party administrator in the run-off of the business. If return premiums or other funds need to be returned or paid to premium finance companies, policyholders, sub-agents or any other party, the Reinsurer shall pay these amounts if the Managing General Agent or agent does not. ARTICLE 19 - REGULATORY MATTERS ------------------------------- 19.1 It is the parties' understanding that the Texas Department of Insurance views current premium due over ninety (90) days past due (aged by item and effective date) from insureds or their designated representative to the Company as non-admitted assets. In confirmation of the liabilities assumed by the Reinsurer under this Agreement, the Reinsurer hereby assumes its share of all liability and responsibility for all premiums in the course of collection. 19.2 The Reinsurer shall agree, at no cost to the Company, to take those actions (including, but not limited to, modifications in how funds are handled and how accounts are cleared and settled) and agree to those arrangements necessary to ensure that the Company suffers no adverse impact because of this reinsurance program and is in compliance with the laws of the State of Texas and regulations promulgated by any governmental entity thereof, including the Texas Department of Insurance, insofar as this reinsurance program is concerned, subject to the provisions of Article 17. 19.3 The Reinsurer and the Company shall not offset obligations arising under this Agreement with obligations arising under any other agreement except to the extent permitted under state law and/or regulations. ARTICLE 20 - LOSS IN EXCESS OF POLICY LIMITS/EXTRA CONTRACTUAL OBLIGATIONS -------------------------------------------------------------------------- 20.1 This Agreement shall protect the Company for forty-five percent (45%) of any loss in excess of Policy limits (XPL) and/or forty-five percent (45%) of the extra contractual obligations (ECO) shall be deemed to be a loss under the Policy involved and shall be subject to this Agreement. However, any amount in excess of a $1,000,000 ECO and/or XPL loss the Reinsurer will retain 100% of such amount in excess of $1,000,000 subject to a limit of liability to the Reinsurer of $9,000,000 any one risk Further, any amount in excess of a $10,000,000 ECO and/or XPL loss the Company will retain 100%.' 20.2 Notwithstanding anything stated herein, this Agreement shall not apply to any extra contractual obligation (ECO) incurred by the Company as a result of any fraudulent and/or criminal act by any officer or director of the Company acting individually or collectively or in collusion with any individual or corporation or any other organization or party involved in the presentation, defense or settlement of any claim covered hereunder. ARTICLE 21 - SAVINGS CLAUSE --------------------------- 21.1 If any law or regulation of any Federal, State or Local Government of the United States of America, or the ruling of officials having supervision over insurance companies, should prohibit or render illegal this Agreement or any portion thereof, as to risks or properties located in the jurisdiction of such authority, either the Company or the Reinsurer may, upon written notice to the other, suspend or abrogate this Agreement insofar as it relates to risks or properties located within such jurisdiction to such extent as may be necessary to comply with such law, regulation or ruling. Such illegality shall in no way affect any other portion thereof, provided, however, that the Reinsurer or the Company may terminate or suspend this Agreement insofar as it relates to the Business to which such law or regulation may apply. 21.2 Should any portion of this Agreement be held to be unenforceable by Arbitration or any court of competent jurisdiction, the remainder of such Agreement shall be construed as if originally written without the unenforceable portion thereof, giving effect to the extent possible of the original intent of the parties hereto as expressed in such Agreement as originally written. ARTICLE 22 - UNAUTHORIZED (NON-ADMITTED) REINSURANCE ---------------------------------------------------- 22.1 In the event the Company is unable to take reserve credit under this Agreement or the Reinsurers A.M. Best rating is below "A-", the Reinsurer hereby agrees to secure delivery to the Company, prior to the effective date of this Agreement, a clean, irrevocable, evergreen, unconditional letter of credit drawn on a bank that is a member of the Federal Reserve System and approved by the National Association of Insurance Commissioners, and in accordance with the rules and regulations as set forth by the Texas Department of Insurance or any other regulatory authority having jurisdiction, for an amount equal to the Reinsurer's share of the reserves for unearned premium and outstanding losses and loss expenses, including incurred but not reported losses. The Company agrees to furnish the Reinsurer with necessary accounting data to establish the amount of such letter of credit. 22.2 In the event the Reinsurer and the Company mutually agree, the Reinsurer may, instead of complying with Article 22.1, enter into a trust agreement and establish a trust account for the benefit of the Company in a bank that is a member of the Federal Reserve System, approved by the National Association of Insurance Commissioners and in accordance with the rules and regulations as set forth by the Texas Department of Insurance or any other regulatory authority having jurisdiction. Such amount shall be determined in accordance with Article 22.1 above. 22.3 The assets deposited in the trust account shall be valued, according to their current fair market value, and shall consist only of cash, certificates of deposit, and/or investments of the types permitted by the Texas Insurance Code, Article 5.75-1 (d), provided that such investments are issued by an institution that is not the parent, subsidiary, or affiliate of either the guarantor or the beneficiary. 22.4 The trust agreement shall further require that all settlements of account between the Company and the Reinsurer be made in cash or its equivalent. 22.5 The Reinsurer and the Company hereby agree that the Letter of Credit or the assets in the trust account established pursuant to this Agreement may be withdrawn by the Company at any time, notwithstanding any other provisions in this Agreement. Such withdrawals shall be utilized and applied by the Company or its successors in interest by operation of law, including without limitation any liquidator, rehabilitator, receiver, or conservator of such Company, without diminution because of insolvency on the part of the Company or the Reinsurer, only for the following purposes: a. to reimburse the Company for the Reinsurer's share of premiums returned to the owners of Policies reinsured under this Agreement on account of cancellations of such Policies; or b. to reimburse the Company for the Reinsurer's share of surrenders and benefits or losses paid by the Company pursuant to the provisions of the Policies reinsured under this Agreement; or c. in the event of notice of termination of the trust, to fund an account with the Company in an amount at least equal to the reinsurers share of reserves described in Article 22.1 above; or d. to pay any other amounts due the Company under this Agreement. ARTICLE 23 - PROGRAM REVIEW --------------------------- 23.1 The Reinsurer acknowledges that it has been afforded the opportunity to review the records of the Managing General Agent including but not limited to rate levels, rate filings, underwriting guidelines and claims handling. Although the Company may perform reviews as well, it is understood that the participation of the Reinsurer on this Agreement is based upon its continuing due diligence and not based upon due diligence performed by the Company. ARTICLE 24 - MISCELLANEOUS -------------------------- 24.1 This Agreement has been made and entered into in the State of Texas. 24.2 All notices required to be given hereunder shall be deemed to have been duly given by personally delivering such notice in writing or by mailing it, Certified Mail, return receipt requested, with postage prepaid. Any party may change the address to which notices and other communications hereunder are to be sent to such party by giving the other party written notice thereof in accordance with this provision. 24.3 This Agreement shall be binding upon the parties hereto, together with their respective executors, administrators, personal representatives, heirs and assigns. 24.4 This Agreement may be executed in one or more counterparts, each of which shall be deemed an original, but all of which together shall constitute one and the same instrument. 24.5 This Agreement may be amended, modified or supplemented only by a written instrument executed by all parties hereto. 24.6 This Agreement is the entire Agreement between the parties and supersedes one and all previous agreements, written or oral, and amendments thereto. 24.7 A waiver by the Company, the Reinsurer or its designated representative of any breach or default by the other party under this Agreement shall not constitute a continuing waiver or a waiver by the Company, the Reinsurer or its designated representative of any subsequent act in breach or of default hereunder. 24.8 Headings used in this agreement are for reference purposes only and shall not be deemed a part of this Agreement. ARTICLE 25 - INTERMEDIARY ------------------------- Benfield Inc. is hereby recognized as the Intermediary negotiating this Agreement for all business hereunder. All communications (including but not limited to notices, statements, premium, return premium, commissions, taxes, losses, loss adjustment expense, salvages and loss settlements) relating thereto shall be transmitted to the Company or the Reinsurer through the Intermediary located at 3600 West 80th Street, Minneapolis, Minnesota 55431. Payments by the Company to the Intermediary shall be deemed to constitute payment to the Reinsurer. Payments by the Reinsurer to the Intermediary shall be deemed to constitute payment to the Company only to the extent that such payments are actually received by the Company. SCHEDULE OF BUSINESS The Company, the Reinsurer and the Managing General Agent agree that the Managing General Agent has the authority to accept, on forms approved by the Company, any Policy, endorsement, binder, certificate, or proposal for insurance. The Managing General Agent's authority is limited by this Schedule of Business. Overall: Projected premium volume $40,000,000 Territory Texas only Maximum policy term Twelve months Lines of business and maximum limits of liability Coverage Maximum Limits Bodily Injury Liability $ 25,026 each person $ 50,026 each accident Property Damage Liability $ 25,026 each accident Uninsured/Underinsured Motorists Bodily Injury $ 25,026 each person $ 50,026 each accident Property Damage $ 25,026 each accident Personal Injury Protection $ 2,526 each person Medical payments $ 526 each person Physical Damage $ 50,000 each automobile This Agreement does not apply to and specifically excludes the following: a. Any business not produced by AMERICAN HALLMARK GENERAL AGENCY, INC., or b. Any business not classified as private passenger automobile liability or physical damage, or c. Exclusions specified within the Quota Share Reinsurance Agreement Number HFS-03-001. IN WITNESS WHEREOF, the Company and Reinsurer hereto by their respective duly authorized representatives have executed this Agreement as of the date first above written. AMERICAN HALLMARK INSURANCE COMPANY OF TEXAS BY:_____________________________________ ITS:____________________________________ OLD AMERICAN COUNTY MUTUAL FIRE INSURANCE COMPANY BY:_____________________________________ ITS:____________________________________ EX-10.CP 7 exh10cp.txt ADDENDUM NO. 1 TO THE 45% QUOTA SHARE REINSURANCE AGREEMENT EXHIBIT 10(cp) Addendum No. 1 to the 45% Quota Share Reinsurance Agreement Effective: October 1, 2003 issued to Old American County Mutual Fire Insurance Company Dallas, Texas (hereinafter referred to as the "Company") It is Hereby Agreed, effective October 1, 2003, that Article 1.1 - RECITALS shall be deleted and the following substituted therefore: "1.1 The Company and Reinsurer hereby wish to enter into a reinsurance arrangement through which the Company is to bear no business, credit or insurance risk whatsoever, except for (a) the risk of the Reinsurer's insolvency and (b) the risk of ECO and/or XPL exceeding the limits provided in Article 20. Further, the Reinsurer shall be liable for any business or credit risk or insurance risk incurred under the Corresponding Agreement. The Reinsurer shall hold the Company fully harmless and indemnify it for these and all risks arising as per the above." It is Further Agreed, effective October 1, 2003 that Article 2 - DEFINITIONS shall be deleted in its entirety and the following substituted therefore: "2.1 "Policies" is defined as all policies, endorsements, certificates, contracts, agreements and binders of insurance issued or renewed on or after the effective date of this Agreement on behalf of the Company. 2.2 "Net Written Premium" is defined as the gross written premium on all original and renewal Policies written by the Company including policy fees, less return premium and cancellations. 2.3 "Loss in Excess of Policy Limits" (XPL) is defined as any amount which the Company pays or would have been contractually held liable to pay had it not been for the limit of the original Policy. 2.4 "Extra Contractual Obligation"(ECO) is defined as those liabilities not covered under any other provision of this Agreement which arise from the handling of any claim on business covered hereunder, because of, but not limited to, failure by the Company to settle within the policy limit, or by reason of alleged or actual negligence, fraud or bad faith in rejecting an offer of settlement or in the preparation of the defense or in the trial of any action against its insured or reinsured or in the preparation or prosecution of an appeal consequent upon such action. The date on which any ECO is incurred by the Company shall be deemed, in all circumstances, to be the date of the original disaster and/or casualty. 2.5 "Loss Adjustment Expense" shall mean expenditures by the Company that are not part of the indemnity under the original policy (i.e. which do not contribute to exhaustion of the original policy limit), made in connection with the disposition of a claim, loss or legal proceeding (including investigation, negotiation, cost of bonds, court costs, statutory penalties, prejudgment interest or delayed damages, and interest on any judgment or award and legal expenses of litigation) and the Company's defense costs and legal expenses incurred in direct connection with legal actions (including, but not limited to, Declaratory Judgment actions) brought to determine the Company's defense and/or indemnification obligations that are allocable only to Policies and claims under Policies subject to this Agreement. Any Declaratory Judgment action expenses shall be deemed to have been fully incurred on the same date as the original loss (if any) giving rise to the action. Nonetheless, loss adjustment expense including legal expense shall be 10% of earned premium and included in the monthly account. 2.6 "Prejudgment Interest" or "Delayed Damages" shall mean interest or damages added to a settlement, verdict, award or judgment based on the amount of time prior to the settlement, verdict, award or judgment whether or not made part of the settlement, verdict, award or judgment. 2.7 "Underwriting Year" as used herein shall mean the period October 1, 2003 to September 30, 2004, both days inclusive, and each subsequent 12- month period (or portion thereof) shall be a separate underwriting year. All premiums and losses from policies allocated to an underwriting year shall be credited or charged, respectively, to such underwriting year, regardless of the date said premiums earn or such losses occur. It is understood that a policy will be allocated to the underwriting year, which is in effect as of: 1. As respects all new policies, the effective date of such policies; 2. As respects renewals of one year or less term policies, the renewal date of such policies. Such policies shall remain in the same underwriting year, as originally allocated, until the next renewal date or premium anniversary date, at which time such policies shall be reallocated to the underwriting year in effect as of such date as provided in subparagraphs 2 above. The term of any policy issued with respect to business covered hereunder shall not exceed 12 months." It is Further Agreed, effective October 1, 2003 that Article 3.3 and 3.4 - BUSINESS REINSURED shall be deleted and the following substituted therefore: "3.3 All reinsurance under this Agreement shall be subject to the same rates, terms, conditions and waivers, and to the same modifications and alterations as the respective Policies of the Company. 3.4 It is warranted the Net Written Premium shall not exceed $75,000,000 (45% of $75,000,000 = $33,750,000 subject written premium) for the October 1, 2003 to September 30, 2004 underwriting year. However, at any time during the underwriting year the Company and the Reinsurer may amend such maximum Net Written Premium amount by mutual agreement. In addition, the Reinsurer shall be liable for any written premium amount above 55% of $75,000,000 = $ 41,250,000 in the Corresponding Agreement. Notwithstanding the provisions of the paragraph above, in the event the Company's Net Written Premium exceeds $75,000,000, the cession percentage hereunder, as respects that underwriting year, shall be reduced to the proportion that $75,000,000 bears to the Company's Net Written Premium for that underwriting year. In the event of a reduction of the cession percentage for any underwriting year under the provisions of this paragraph, the premiums and losses paid hereunder for that underwriting year shall be adjusted retroactively to the beginning of the year." It is Further Agreed, effective October 1, 2003 that Article 7 - LOSS AND LOSS ADJUSTMENT EXPENSE shall be deleted in its entirety and the following substituted therefore: "7.1 All loss settlements, judgments and all interest on said judgments, including losses in excess of policy limits (XPL) and extra contractual obligations (ECO) made by the Company or the Company's designee under the terms of this Agreement, whether under strict policy conditions or by way of compromise, shall be unconditionally binding upon the Reinsurer. The Reinsurer shall be credited with all salvage or recoveries by the Company on business reinsured hereunder. 7.2 The Reinsurer shall be liable for an amount of loss adjustment expense equal to 10.0% of the premiums earned under this Agreement (as defined in Article 2 - Definitions). 7.3 Claims handling shall be accomplished by the Managing General Agent or its designated representative ("Claims Agent") pursuant to the Managing General Agency Agreement and whose designation is subject to the Company's continuing approval and shall not be inconsistent with the terms and conditions of this Agreement. Payment of claims handling fees to the designated representative (if any) shall be made by the Reinsurer. 7.4 It is further agreed, that if the Reinsurer's share of any loss is equal to or greater than $100,000, the Reinsurer will pay its share of said loss as promptly as possible after receipt of reasonable evidence of the amount paid by the Company." It is Further Agreed, effective October 1, 2003 that Article 8 - REPORTS AND REMITTANCES shall be deleted in its entirety and the following substituted therefore: "8.1 Within thirty-five (45) days after the end of each calendar month, the Company shall report to the Reinsurer the following: a. Ceded Net Written Premium for the month; b. Ceded premiums earned for the month; c. Provisional ceding commission on b above; d. Ceded losses paid during the month (net of any recoveries during the month for cash calls); e. Salvage, subrogation or other recoveries on losses; f. 10.0% of (b), representing the Reinsurer's share of loss adjustment which includes legal expense; g. Ceded unearned premium at the end of the month; h. Ceded outstanding losses and loss adjustment expense reserves at the end of the month. 8.2 Balances due under this Agreement will be equal to (b) less (c) less (d) plus (e) less (f). Any positive balances shown to be due the Reinsurer shall be remitted by the General Agent within 60 days. Any negative balance shown to be due the General Agent shall be remitted by the Reinsurer as promptly as possible after receipt and verification of the General Agent's report, not to exceed 15 days from receipt of the General Agent's report. Notwithstanding the foregoing, in the event the Reinsurer terminates this Agreement reports shall be due within 15 days after the end of the month and remittances shall be due within 30 days after the end of the month." It is Further Agreed, effective October 1, 2003 that Article 9.4 and 9.8 - CEDING COMMISSION, FRONTING FEES, PREMIUM TAXES AND SLIDING SCALE COMMISSION shall be deleted and the following substituted therefore: "9.4 The provisional commission allowed the Company shall be adjusted periodically in accordance with the provisions set forth herein. The first adjustment period shall be from the effective date of this Agreement through September 30, 2004, and each subsequent 12 month period shall be a separate adjustment period. However, if this Agreement is terminated, the final adjustment period shall be from the beginning of the then current adjustment period through the effective date of termination. 9.8 "Losses incurred" as used herein shall mean ceded losses paid as of the effective date of calculation, plus the 10.0% allowance for loss adjustment expense, plus the ceded reserves for losses outstanding as of the same date, plus the debit or minus the credit from the preceding adjustment period, it being understood and agreed that all losses and related loss adjustment expense under policies with effective or renewal dates during an adjustment period shall be charged to that adjustment period, regardless of the date said losses actually occur, unless this Agreement is terminated on a "cutoff" basis, in which event the Reinsurer shall have no liability for losses occurring after the effective date of termination." It is Further Agreed, effective October 1, 2003 that Article 20.1 - LOSS IN EXCESS OF POLICY LIMITS/EXTRA CONTRACUTAL OBLIGATIONS shall be deleted and the following substituted therefore: "20.1 This Agreement shall protect the Company for forty-five percent (10045%) of any loss in excess of Policy limits (XPL) and/or forty-five percent (10045%) of the extra contractual obligations (ECO) and shall be deemed to be a loss under the Policy involved and shall be subject to this Agreement. However, any amount in excess of a $1,000,000 ECO and/or XPL loss the Reinsurer will retain 100% of such amount in excess of $1,000,000 subject to a limit of liability to the Reinsurer of $9,000,000 any one occurrence.the maximum ECO/XPL loss the Reinsurer shall be liable for is subject to $9,450,000 for any one risk. Further, any amount in excess of a $10,000,000 ECO and/or XPL loss the Company will retain 100%." It is Further Agreed, effective October 1, 2003 that the SCHEDULE OF BUSINESS attached to this agreement shall be deleted and the following substituted therefore: "SCHEDULE OF BUSINESS The Company, the Reinsurer and the Managing General Agent agree that the Managing General Agent has the authority to accept, on forms approved by the Company, any Policy, endorsement, binder, certificate, or proposal for insurance. The Managing General Agent's authority is limited by this Schedule of Business. Overall: Projected premium volume $40,000,000 Territory Texas only Maximum policy term Twelve months Lines of business and maximum limits of liability Coverage Maximum Limits Bodily Injury Liability $ 25,027 each person $ 50,027 each accident Property Damage Liability $ 25,027 each accident Uninsured/Underinsured Motorists Bodily Injury $ 25,027 each person $ 50,027 each accident Property Damage $ 25,027 each accident Personal Injury Protection $ 2,527 each person Medical payments $ 527 each person Physical Damage $ 50,000 each automobile This Agreement does not apply to and specifically excludes the following: a. Any business not produced by AMERICAN HALLMARK GENERAL AGENCY, INC., or b. Any business not classified as private passenger automobile liability or physical damage, or c. Exclusions specified within the Quota Share Reinsurance Agreement Number HFS-03-001." The provisions of this agreement shall otherwise remain unchanged. In Witness Whereof, the Company by its duly authorized representative has executed this Addendum No. 1 as of the date undermentioned at: Dallas, Texas,this ______ day of ___________________ in the year ________. __________________________________________________________ OLD AMERICAN COUNTY MUTUAL FIRE INSURANCE COMPANY Dallas, Texas,this ______ day of ___________________ in the year ________. __________________________________________________________ AMERICAN HALLMARK INSURANCE COMPANY OF TEXAS EX-10.CQ 8 exh10cq.txt 55% QUOTA SHARE REINSURANCE AGREEMENT EXHIBIT 10(cq) OLD AMERICAN COUNTY MUTUAL FIRE INSURANCE COMPANY 55% QUOTA SHARE REINSURANCE AGREEMENT Effective: October 1, 2003 Quota Share Reinsurance Agreement Number HFS-03-002 Table of Contents Article 1 Recitals Article 2 Definitions Article 3 Business Reinsured Article 4 Obligatory Agreement Article 5 Terms and Cancellation Article 6 Consideration Article 7 Loss and Loss Adjustment Expense Article 8 Reports and Remittances Article 9 Ceding Commission, Fronting Fees, Premium Taxes and Sliding Scale Commission Article 10 Exclusions Article 11 Errors and Omissions Article 12 Inspection of Records Article 13 Offset Clause Article 14 Arbitration Article 15 Honorable Undertaking Article 16 Assessments and Assignments Article 17 Conservation, Liquidation or Insolvency Article 18 Loss in Excess of Policy Limits/Extra Contractual Obligations Article 19 Savings Clause Article 20 Unauthorized (Non-Admitted) Reinsurance Article 21 Program Review Article 22 Miscellaneous Article 23 Intermediary QUOTA SHARE REINSURANCE AGREEMENT NUMBER HFS-03-002 This Agreement is made and entered into by and between OLD AMERICAN COUNTY MUTUAL FIRE INSURANCE COMPANY (hereinafter referred to as the "Company") and DORINCO REINSURANCE COMPANY (hereinafter referred to as the "Reinsurer"). THE COMPANY AND REINSURER HEREBY AGREE AS FOLLOWS: ARTICLE 1 - RECITALS -------------------- 1.1 The Company and Reinsurer hereby wish to enter into a reinsurance arrangement through which the Company is to bear no business or insurance risk whatsoever, except for (a) the risk of the Reinsurer's insolvency; (b) the risk of ECO and/or XPL exceeding the limits provided in Article 18; (c) the risk on business which would be subject to this Agreement were it not for the exclusions delineated in Article 10; (d) the risk of reduction in the quota share percentage due to Net Written Premium exceeding the premium cap set forth in Article 3; and (e) the risk of excess administrative costs as provided in Article 5 1.2 The Company and Reinsurer hereby agree that the full consideration provided by the Company in exchange for the fees set forth herein, is to permit the Policies as defined herein to be issued in the name of the Company and which are reinsured one hundred percent (100%) under this Agreement and a certain Quota Share Reinsurance Agreement between the Company and American Hallmark Insurance Company of Texas (Corresponding Reinsurer) dated effective October 1, 2003 (the "Corresponding Agreement"). 1.3 It is understood and agreed that neither the Company nor the Reinsurer is obligated by any representations or warranties made by any of the parties involved in this transaction unless such representations and warranties are formally included in this Agreement. 1.4 All business reinsured hereunder shall be produced by AMERICAN HALLMARK GENERAL AGENCY, INC. (Managing General Agent), in accordance with the terms and conditions of the Managing General Agency Agreement effective September 1, 2003, (Managing General Agency Agreement) between the Managing General Agent and the Company, a copy of said Agreement is attached hereto and fully incorporated herein. 1.5 This Agreement sets forth all of the duties and obligations between the Company and the Reinsurer and supersedes any and all prior or contemporaneous or written agreements with respect to matters referred to in this Agreement. This Agreement may not be modified, amended or changed except by an agreement in writing signed by both parties. ARTICLE 2 - DEFINITIONS ----------------------- 2.1 "Policies" is defined as all policies, endorsements, certificates, contracts, agreements and binders of insurance issued or renewed on or after the effective date of this Agreement on behalf of the Company. 2.2 "Net Written Premium" is defined as the gross written premium on all original and renewal Policies written by the Company including policy fees, less return premium and cancellations. 2.3 "Loss in Excess of Policy Limits" (XPL) is defined as any amount which the Company pays or would have been contractually held liable to pay had it not been for the limit of the original Policy. 2.4 "Extra Contractual Obligation"(ECO) is defined as those liabilities not covered under any other provision of this Agreement which arise from the handling of any claim on business covered hereunder, because of, but not limited to, failure by the Company to settle within the policy limit, or by reason of alleged or actual negligence, fraud or bad faith in rejecting an offer of settlement or in the preparation of the defense or in the trial of any action against its insured or reinsured or in the preparation or prosecution of an appeal consequent upon such action. The date on which any ECO is incurred by the Company shall be deemed, in all circumstances, to be the date of the original disaster and/or casualty. However, the maximum ECO and/or XPL loss the Reinsurer shall be liable for is subject to $550,000 any one occurrence. 2.5 "Loss Adjustment Expense" shall mean expenditures by the Company that are not part of the indemnity under the original policy (i.e. which do not contribute to exhaustion of the original policy limit), made in connection with the disposition of a claim, loss or legal proceeding (including investigation, negotiation, cost of bonds, court costs, statutory penalties, prejudgment interest or delayed damages, and interest on any judgment or award and legal expenses of litigation) and the Company's defense costs and legal expenses incurred in direct connection with legal actions (including, but not limited to, Declaratory Judgment actions) brought to determine the Company's defense and/or indemnification obligations that are allocable only to Policies and claims under Policies subject to this Agreement. Any Declaratory Judgment action expenses shall be deemed to have been fully incurred on the same date as the original loss (if any) giving rise to the action. Nonetheless, loss adjustment expense including legal expense shall be 10% of earned premium and included in the monthly account. 2.6 "Prejudgment Interest" or "Delayed Damages" shall mean interest or damages added to a settlement, verdict, award or judgment based on the amount of time prior to the settlement, verdict, award or judgment whether or not made part of the settlement, verdict, award or judgment. 2.7 "Underwriting Year" as used herein shall mean the period October 1, 2003 to September 30, 2004, both days inclusive, and each subsequent 12- month period (or portion thereof) shall be a separate underwriting year. All premiums and losses from policies allocated to an underwriting year shall be credited or charged, respectively, to such underwriting year, regardless of the date said premiums earn or such losses occur. It is understood that a policy will be allocated to the underwriting year, which is in effect as of: 1. As respects all new policies, the effective date of such policies; 2. As respects renewals of one year or less term policies, the renewal date of such policies. Such policies shall remain in the same underwriting year, as originally allocated, until the next renewal date or premium anniversary date, at which time such policies shall be reallocated to the underwriting year in effect as of such date as provided in subparagraphs 2 above. The term of any policy issued with respect to business covered hereunder shall not exceed 12 months. ARTICLE 3 - BUSINESS REINSURED ------------------------------ 3.1 The Reinsurer hereby reinsures the Company for a fifty-five percent (55%) quota share in respect of all liability, including, but not limited to, losses and loss adjustment expenses, under Policies issued or renewed on or after the effective date hereon on behalf of the Company by the Managing General Agent or its designated representative as classified by the Company in the attached Schedule of Business. 3.2 It is understood that the classes of business reinsured under this Agreement are deemed to include coverages required for non-resident drivers under the motor vehicle financial responsibility law or the motor vehicle compulsory insurance law or any similar law of any state or province, following the provisions of the Company's policies when they include or are deemed to include so-called "Out of State Insurance" provisions. 3.3 All reinsurance under this Agreement shall be subject to the same rates, terms, conditions and waivers, and to the same modifications and alterations as the respective Policies of the Company. 3.4 It is warranted the Net Written Premium shall not exceed $75,000,000 (55% of $75,000,000 = $41,250,000 subject written premium) for the October 1, 2003 to September 30, 2004 underwriting year. However, at any time during the underwriting year the Company and the Reinsurer may amend such maximum Net Written Premium amount by mutual agreement. Notwithstanding the provisions of the paragraph above, in the event the Company's Net Written Premium exceeds $75,000,000, the cession percentage hereunder, as respects that underwriting year, shall be reduced to the proportion that $75,000,000 bears to the Company's Net Written Premium for that underwriting year. In the event of a reduction of the cession percentage for any underwriting year under the provisions of this paragraph, the premiums and losses paid hereunder for that underwriting year shall be adjusted retroactively to the beginning of the year. ARTICLE 4 - OBLIGATORY AGREEMENT -------------------------------- 4.1 The Company agrees to cede to the Reinsurer, and the Reinsurer agrees to accept from the Company, a fifty-five percent (55%) quota share reinsurance participation under all Policies effective on or after the effective date hereof by the Company covering risks situated in Texas. The liability of the Reinsurer shall commence obligatorily and simultaneously with that of the Company subject to the terms, conditions and limitations set forth in this Agreement. 4.2 Business ceded hereunder shall include every original policy, rewrite, renewal or extension (whether before or after the termination of this Agreement) required by statute or by rule or regulation of the Texas Department of Insurance, or other authority having competent jurisdiction, of any policy of insurance originally ceded hereunder by the Company to the Reinsurer. 4.3 The parties understand and intend that the Reinsurer shall follow the fortunes of the Company in every respect to activities engaged in hereunder. ARTICLE 5 - TERM AND CANCELLATION --------------------------------- 5.1 This Agreement shall become effective 12:00:01 a.m. (Central Standard Time) on the first day of October 2003, as respects losses arising under Policies effective on or after such date, and shall remain continuously in force unless terminated by either party. 5.2 This Agreement may be terminated by either party at any calendar quarter end giving the other party written notice at least ninety (90) days prior to such date. 5.3 When the Agreement terminates for any reason, reinsurance hereunder shall continue to apply to the business in force at the time and date of termination until expiration or cancellation of such business. The parties understand and agree that any Policies with effective dates prior to the termination date, but issued after the termination date, are covered under this Agreement. Additionally, the reinsurance hereunder shall continue to apply as to Policies which must be issued or renewed, as a matter of state law or regulation or because an agent (appointed by the Company at the request of the Reinsurer) has not been timely canceled, until the expiration dates on said Policies. 5.4 Upon termination of this Agreement, the Reinsurer and the Company shall not be relieved or released from any obligation which relate to outstanding insurance business created by or under this Agreement. The parties hereto expressly covenant and agree that they will cooperate with each other in the handling of all such run-off insurance business until all Policies have expired and all outstanding losses and loss adjustment expenses have been settled. While by law and regulations, the Company recognizes its primary obligations to its Policyholders, the Reinsurer recognizes that there shall be no cost or involvement by the Company, unless specifically agreed, in servicing this run-off. The Reinsurer shall bear all costs and expenses associated with handling of such run-off business following the cancellation or termination of this Agreement. If for any reason any managing general agent or agent fails to service any such run-off business (or any business while the Agreement is still in effect), then consistent with this Agreement, the Reinsurer's obligation with respect to such run-off business shall continue and the Reinsurer shall either service such run-off business directly or appoint, at the Reinsurer's expense, subject to a maximum run off cost of $2,000,000 (55% of $2,000,000 = $1,100,000) a successor to such managing general agent and/or agent, subject to the approval of the Company, which approval shall not be unreasonably withheld. Such successor shall perform all of the duties and obligations of the managing general agent and/or agent with respect to servicing such run-off business. 5.5 In addition to the provisions set forth in Article 5.2 herein, this Agreement may be terminated at any time in accordance with the following terms and conditions: a. After thirty (30) days written notice by the Company in the event the Reinsurer: (i) is acquired and/or merged by or in any manner becomes under the control of any other company or corporation; (ii) changes a majority of its officers or board of directors; or (iii) is the subject of a filing or petition or initiation of any proceeding for supervision, rehabilitation, conservation or liquidation, or any other proceedings for the protection of a creditor. b. After thirty (30) days written notice by the Reinsurer in the event the Company: (i) is acquired and/or merged by or in any manner becomes under the control of any other company or corporation; (ii) changes a majority of its officers or board of directors; or (iii) is the subject of a filing or petition or initiation of any proceeding for supervision, rehabilitation, conservation or liquidation, or any other proceedings for the protection of a creditor. c. By the Company immediately and automatically without prior written notice should the Texas Department of Insurance require cancellation or disallow credit for this reinsurance. d. After fifteen (15) days written notice by the Reinsurer or the Company, in the event of breach of conditions, fraud or default by either party under the terms and conditions of the Agreement. 5.6 By the Reinsurer immediately in the event American Hallmark Insurance Company of Texas' surplus drops below $5,000,000. 5.7 Notices hereunder shall be provided in accordance with Article 22.2, hereof. ARTICLE 6 - CONSIDERATION ------------------------- 6.1 In consideration of the acceptance by the Reinsurer of fifty-five percent (55%) of the Company's liability on insurance business reinsured hereunder, the Reinsurer is entitled to fifty-five percent (55%) of the Net Premiums written by the managing general agent and/or agent or the Reinsurer on Policies reinsured less the ceding commission allowed to the Company, which includes premium taxes and fronting fees on Policies subject to reinsurance hereunder. ARTICLE 7 - LOSS AND LOSS ADJUSTMENT EXPENSE -------------------------------------------- 7.1 All loss settlements, judgments and all interest on said judgments, including losses in excess of policy limits (XPL) and extra contractual obligations (ECO) made by the Company or the Company's designee under the terms of this Agreement, whether under strict policy conditions or by way of compromise, shall be unconditionally binding upon the Reinsurer. The Reinsurer shall be credited with all salvage or recoveries by the Company on business reinsured hereunder. 7.2 The Reinsurer shall be liable for an amount of loss adjustment expense equal to 10.0% of the premiums earned under this Agreement (as defined in Article 2 - Definitions). 7.3 Claims handling shall be accomplished by the Managing General Agent or its designated representative ("Claims Agent") pursuant to the Managing General Agency Agreement and whose designation is subject to the Company's continuing approval and shall not be inconsistent with the terms and conditions of this Agreement. Payment of claims handling fees to the designated representative (if any) shall be made by the Reinsurer. 7.4 It is further agreed, that if the Reinsurer's share of any loss is equal to or greater than $100,000, the Reinsurer will pay its share of said loss as promptly as possible after receipt of reasonable evidence of the amount paid by the Company. ARTICLE 8 - REPORTS AND REMITTANCES ----------------------------------- 8.1 Within thirty-five (45) days after the end of each calendar month, the Company shall report to the Reinsurer the following: a. Ceded Net Written Premium for the month; b. Ceded premiums earned for the month; c. Provisional ceding commission on b above; d. Ceded losses paid during the month (net of any recoveries during the month for cash calls); e. Salvage, subrogation or other recoveries on losses; f. 10.0% of (b), representing the Reinsurer's share of loss adjustment which includes legal expense; g. Ceded unearned premium at the end of the month; h. Ceded outstanding losses and loss adjustment expense reserves at the end of the month. 8.2 Balances due under this Agreement will be equal to (b) less (c) less (d) plus (e) less (f). Any positive balances shown to be due the Reinsurer shall be remitted by the General Agent within 60 days. Any negative balance shown to be due the General Agent shall be remitted by the Reinsurer as promptly as possible after receipt and verification of the General Agent's report, not to exceed 15 days from receipt of the General Agent's report. Notwithstanding the foregoing, in the event the Reinsurer terminates this Agreement reports shall be due within 15 days after the end of the month and remittances shall be due within 30 days after the end of the month. ARTICLE 9 - CEDING COMMISSION, FRONTING FEES, PREMIUM TAXES AND SLIDING ---------------------------------------------------------------------------- SCALE COMMISSION ---------------- 9.1 The Reinsurer will pay to the Company a provisional Ceding commission of 31.00%, which shall be calculated on the basis of earned premium on policies reinsured hereunder. 9.2 The Company will be liable for remitting state premium taxes based on net written premium and net policy fees charged. Should service fees be charged on any policy covered by this Agreement, and such fees be deemed taxable for premium tax purposes, then such service fees are to be added to the net written premium and net policy fees charged to determine the amount subject to Fronting Fees. Should service fees be deemed taxable, they shall be reported and remitted in a consistent manner as premium written in Article 8 above. 9.3 The Reinsurer acknowledges that the Company is not responsible for any contingent commission adjustment, and such adjustment shall be settled directly between the Managing General Agent and the Reinsurer. The Reinsurer shall seek recovery for any contingent commission adjustment directly from the Managing General Agent. 9.4 The provisional commission allowed the Company shall be adjusted periodically in accordance with the provisions set forth herein. The first adjustment period shall be from the effective date of this Agreement through September 30, 2004, and each subsequent 12 month period shall be a separate adjustment period. However, if this Agreement is terminated, the final adjustment period shall be from the beginning of the then current adjustment period through the effective date of termination. 9.5 The adjusted commission rate shall be calculated as follows and be applied to premiums earned for the period under consideration: a. If the ratio of losses incurred to premiums earned is 65.50% or greater, the adjusted commission rate for the period under consideration shall be 26.00%; b. If the ratio of losses incurred to premiums earned is less than 65.50%, but not less than 62.50%, the adjusted commission rate for the period under consideration shall be 26.00%, plus 100% of the difference in percentage points between 65.50% and the actual ratio of losses incurred to premiums earned; c. If the ratio of losses incurred to premiums earned is 60.50% or less, but not less than 53.50% the adjusted commission rate for the period under consideration shall be 31.00%, plus the difference in percentage points between 60.50% and the actual ratio of losses incurred to premiums earned; d. If the ratio of losses incurred to premiums earned is 51.50% or less, the adjusted commission rate for the period under consideration shale be 40.00%. 9.6 If the ratio of losses incurred to premiums earned for any period is greater than 65.50%, the difference in percentage points between the actual ratio of losses incurred to premiums earned and 65.50% shall be multiplied by premiums earned for the period and the product shall be carried forward to the next adjustment period as a debit to losses incurred. If the ratio of losses incurred to premiums earned for any period is less than 51.50%, the difference in percentage points between 51.50% and the actual ratio of losses incurred to premiums earned shall be multiplied by premiums earned for the period and the product shall be carried forward to the next adjustment period as a credit to losses incurred. 9.7 Within 18 months from the inception of the Underwriting Year, and after the end of each 12 month period thereafter the General Agent shall calculate and report the adjusted commission on premiums earned for the adjustment period. If the adjusted commission on premiums earned is less than commissions previously allowed by the Reinsurer on premiums earned for the adjustment period, the General Agent shall remit the difference to the Reinsurer with its report. If the adjusted commission on premiums earned is greater than commissions previously allowed by the Reinsurer on premiums earned for the adjustment period, the Reinsurer shall remit the difference to the General Agent as promptly as possible after receipt and verification of the Company's report. 9.8 "Losses incurred" as used herein shall mean ceded losses paid as of the effective date of calculation, plus the 10.0% allowance for loss adjustment expense, plus the ceded reserves for losses outstanding as of the same date, plus the debit or minus the credit from the preceding adjustment period, it being understood and agreed that all losses and related loss adjustment expense under policies with effective or renewal dates during an adjustment period shall be charged to that adjustment period, regardless of the date said losses actually occur, unless this Agreement is terminated on a "cutoff" basis, in which event the Reinsurer shall have no liability for losses occurring after the effective date of termination. 9.9 "Premiums earned" as used herein shall mean ceded net written premiums for policies with effective or renewal dates during the adjustment period, less the unearned portion thereof as of the effective date of calculation, it being understood and agreed that all premiums for policies with effective or renewal dates during an adjustment period shall be credited to that adjustment period, unless this Agreement is terminated on a "cutoff" basis, in which event the unearned reinsurance premium (less previously allowed ceding commission) as of the effective date of termination shall be returned by the Reinsurer to the Company. ARTICLE 10 - EXCLUSIONS ----------------------- This Agreement does not apply to and specifically excludes the following: a. Any automobile not classified as private passenger automobile. b. Garagekeepers legal liability. c. Vendors single interest. d. Nuclear risks as defined in the "Nuclear Incident Exclusion Clause - Physical Damage - Reinsurance" and the "Nuclear Incident Exclusion Clause - Liability - Reinsurance" attached to and forming part of this Agreement. e. Liability as a member, subscriber or reinsurer of any Pool, Syndicate or Association, but this exclusion shall not apply to Assigned Risk Plans or similar plans. f. Mobile homes. g. Automobile dealers. h. Automobile Liability with respect to any vehicle used principally as: 1) A Taxicab, public or livery conveyance or bus, it being understood that this exclusion does not apply to school or church buses; 2) An ambulance, fire department or law enforcement vehicle; 3) A racing or exhibition vehicle. i. Loss or damage caused by or resulting from war, invasion, hostilities, acts of foreign enemies, civil war, insurrection, military or usurped power, martial law or confiscation by order of any government of public authority, but not excluding loss or damage which would be covered under a policy or standard form containing a standard war exclusion clause. j. Loss or damage or cost or expenses arising from seepage and/or pollution and/or contamination, other than contamination from smoke damage. Nevertheless, this exclusion does not preclude any payments of the cost of the removal of debris of property damage by a loss otherwise covered hereunder, but subject always to a limit of 25% of the Company's Property Business loss under the original policy. If any business falling within the scope of one or more of the exclusions is assigned to the Company under an Assigned Risk Plan, such exclusion(s) shall not apply, it being understood and agreed that the limits of liability extended by the Company as respects such policies shall not exceed the minimum statutory limits of liability prescribed in such Assigned Risk Plan. If the Company is bound, without the knowledge of and contrary to the instructions of the Company's supervisory underwriting personnel, on any business falling within the scope of one or more of the exclusions set forth in this Article, these exclusions shall be suspended with respect to such business until 30 days after an underwriting supervisor of the Company acquires knowledge of such business. ARTICLE 11 - ERRORS AND OMISSIONS --------------------------------- 11.1 Inadvertent delays, errors or omissions made in connection with this Agreement or any transaction hereunder shall not relieve either party from any liability which would have attached had such delay, error or omission not occurred, provided always that such error or omission is rectified as soon as possible after discovery. ARTICLE 12 - INSPECTION OF RECORDS ---------------------------------- 12.1 All records pertaining to Policies issued on behalf of the Company through or by the Reinsurer or its designated representative subject to this Agreement, shall be deemed to be jointly owned records of the Company and the Reinsurer, and shall be made immediately available to the Company or the Reinsurer or their representative or any duly appointed examiner for any State within the United States; and these records shall be kept in the State of Texas. Notwithstanding the foregoing, the Reinsurer is authorized to maintain duplicate working files of all such records outside the State of Texas. The Company and the Reinsurer agree that neither will destroy any such records in their possession without the prior written approval of the other, except that the Company shall not be required to retain files longer than required by the guidelines set by the Texas Department of Insurance. ARTICLE 13 - OFFSET CLAUSE -------------------------- 13.1 The Company or the Reinsurer shall have the right to offset any balance or amounts due from one party to the other under the terms of this Agreement. The party asserting the right of offset may exercise such right at any time whether the balances due are on account of premiums or losses or otherwise. ARTICLE 14 - ARBITRATION ------------------------ 14.1 Unless both parties mutually agree to waive arbitration with respect to a particular dispute, the parties to this Agreement hereby agree that binding arbitration shall be the sole remedy for any and all dispute(s) arising between them with reference to any transactions, terms or conditions under this Agreement including its formation and validity. Arbitration proceedings brought hereunder shall be referred for final determination to the majority decision of a Panel of three disinterested arbitrators. Notice of demand for arbitration shall be made in writing and shall be served via certified or registered mail, return receipt requested, on the Respondent to the Arbitration at the Respondent's current address. The notice requesting arbitration shall identify the Agreement(s) involved in the dispute, the issues to be resolved in the view of the Petitioner, and the arbitrator selected by the Petitioner. The term "days" as used herein shall mean calendar days. 14.2 The Respondent shall appoint an arbitrator within 30 days of receiving a request by the Petitioner in writing and served via certified or registered mail, return receipt requested, to do so. At the same time as the appointment, the Respondent shall identify in writing any issues which in its view must be resolved in the arbitration proceeding and which were not identified by the Petitioner. If the Respondent fails to appoint its arbitrator within 30 days of being requested to do so, in writing, by the Petitioner, the Petitioner shall have the right to appoint the second arbitrator. Within 30 days after their appointment, the two arbitrators so chosen shall select a third arbitrator to act as umpire. If the two arbitrators do not agree as to the selection of a third arbitrator within 60 days after their appointment, the third arbitrator shall be selected from a list of six individuals (three named by each arbitrator) by a judge of the federal district court in Dallas County, Texas. 14.3 Each arbitrator shall be a disinterested, active or retired official or officer of an insurance or reinsurance company, not under the control or management of either party to this Agreement, and shall have experience in the class and type of business subject to this dispute. 14.4 Within 30 days after notice of appointment of all arbitrators, the Petitioner and the Respondent shall each submit a statement of position to the Panel. 14.5 Within 60 days after notice of appointment of all arbitrators, each party shall provide the other with its relevant books, records, and/or other papers not protected from disclosure by either the work-product or attorney client privilege. Other than the exchange of relevant documents, both parties shall refrain from engaging in any type of discovery including, but not limited to, depositions and interrogatories. 14.6 Within 30 days following the exchange of documents, the Petitioner and the Respondent shall submit re-hearing briefs to the Panel. 14.7 Unless some other location is mutually agreeable to the parties, arbitration proceedings shall take place within the municipality wherein the Home Office of the Company is located. Arbitration shall commence as soon as practicable but in no event longer than 120 days after selection of the third arbitrator with notice thereof to the parties. The specific time and site of arbitration shall be promptly agreed to by the parties, or if no Contract is reached, then determined by the Panel. 14.8 The Panel shall be relieved from applying the strict rules of evidence and/or procedure and shall make its decision based on the custom and practice of the insurance and reinsurance business with a view toward effecting this Agreement in a reasonable manner. Should either party fail to appear at an arbitration hearing and/or fail to furnish the Panel with any subpoenaed papers or information, the Panel is empowered to proceed ex parte. The Panel shall make its award within 60 days following the close of the hearing. The majority decision of the Panel shall be final and binding upon the parties and shall be reduced to a written award, which may include factual findings, and shall be signed by any two of the three arbitrators, dated and delivered overnight to the parties. The Panel may award pre- judgment and post-judgment interest, but in no case shall the authority of the Panel extend to awarding punitive or exemplary damages. Judgment may be entered upon the award by any court having jurisdiction. 14.9 The expense of its own arbitrator, but shall equally share with the other the expense of the third arbitrator. In the event that the two arbitrators are chosen by one party, as above provided, the expense of the two arbitrators, the third arbitrator and the arbitration shall be equally divided between the Petitioner and the Respondent. Unless mutually agreed other wise, a court reporter transcript shall be taken of the hearing with costs to be divided equally between the parties. The remaining costs of arbitration shall be allocated by the Panel. 14.10 The Arbitration proceeding brought hereunder, any or all provisions contained herein, and arbitration awards entered pursuant to this Article are specifically governed by, subject to and enforceable under the Federal Arbitration Act (Title 9, United States Code, Sections 1-14, as amended.) 14.11 Each party agrees that time is of the essence with respect to all terms and conditions referenced in this Article. All deadlines contained in this Article may be extended by mutual Contract of the parties, and if the Panel has been selected, the Panel's Contract must also be obtained. 14.12 Each party agrees that any arbitration award entered pursuant to and governed by this Article shall not have any precedential or collateral estoppel effect on future arbitrations, proceedings, or controversies, if any, between the parties. Any claim of res judicata or claim preclusion shall itself be subject to arbitration. 14.13 This Article shall survive the termination of this Agreement. ARTICLE 15 - HONORABLE UNDERTAKING ---------------------------------- 15.1 The purposes of this Agreement are not to be defeated by narrow or technical legal interpretations of its provisions. This Agreement shall be construed as an honorable undertaking and should be interpreted for the purpose of giving effect to the intentions of the parties hereto. ARTICLE 16 - ASSESSMENTS AND ASSIGNMENTS ---------------------------------------- 16.1 The Reinsurer hereby assumes liability for its fifty-five percent (55%) quota share reinsurance participation with respect to any and all costs, assessments or assignments imposed as a result of Policies reinsured hereunder (whether before or after the termination of this Agreement) levied or made by a guaranty fund, insolvency fund, plan, pool, association, or other arrangement created by statute or regulation including, but not limited to, assessments levied by the Texas Property & Casualty Insurance Guaranty Association. The Company shall account to the Reinsurer for any recovery or any credit allowed to the Company against its premium taxes, and return to the Reinsurer its share of any recovery or credit. ARTICLE 17 - CONSERVATION, LIQUIDATION OR INSOLVENCY ---------------------------------------------------- 17.1 In the event of the insolvency of the Company, the Reinsurance afforded by this Agreement shall be payable directly by the Reinsurer to the Company or its liquidator, receiver or statutory successor on the basis of the liability of the Company under the Policies, without diminution because of the insolvency of the Company, in accordance with the provisions of any State Law which may be involved except: a. where the Agreement specifically provides another payee of such reinsurance in the event of the insolvency of the Company; or b. where the Reinsurer with the consent of the direct insured(s) has assumed such Policy obligations of the Company as direct obligations of the Reinsurer to the payees under such policies and in substitution for the obligations of the Company to the payees. 17.2 In the event of the insolvency of the Company, the liquidator, receiver or statutory successor of the Company shall give written notice to the Reinsurer of the pendency of a claim against the insolvent Company on a Policy within a reasonable time after such claim is filed in the insolvency proceedings. During the pendency of such claim, the Reinsurer may investigate such claim and interpose at its own expense, in the proceeding where such claim is to be adjudicated, any defense or defenses which it may deem available to the Company or its liquidator, receiver or statutory successor. The expense thus incurred by the Reinsurer shall be chargeable, subject to court approval, against the insolvent Company as part of the expense of liquidation to the extent of the proportionate share of the benefits which may accrue to the Company solely as a result of the defense undertaken by the Reinsurer. 17.3 If two (2) or more reinsurers are involved in the same claim and a majority in interest elects to interpose defense to such claim, the expense shall be apportioned in accordance with the terms of this Agreement as though such expense had been incurred by the Company. 17.4 As respects subject business assumed as reinsurance under this Agreement, the parties agree that if the Company has a conservator, liquidator, or receiver appointed for it, or becomes the subject of any conservation, liquidation or insolvency proceeding, and the Company is permitted to have all its liabilities under the Policies reinsured hereunder assumed by another licensed insurer, such assuming insurer shall be substituted for the Company as payee of any reinsurance recoverable hereunder in respect of losses under Policies subject hereto, and the Reinsurer shall make payments thereof directly to the substituted insurer. 17.5 In the event the foregoing provisions apply, all the other provisions of this Agreement shall apply to the substituted insurer in the same manner as if said insurer were substituted for the Company as the reinsured party hereunder, and to the extent this Agreement reinsures such substituted insurer, coverage hereunder shall be excluded as respects the Company. ARTICLE 18 - LOSS IN EXCESS OF POLICY LIMITS/EXTRA CONTRACTUAL OBLIGATIONS -------------------------------------------------------------------------- 18.1 This Agreement shall protect the Company for fifty-five percent (55%) of any loss in excess of Policy limits (XPL) and/or fifty-five percent (55%) of the extra contractual obligations (ECO) and shall be deemed to be a loss under the Policy involved and shall be subject to this Agreement. However, the maximum ECO/XPL loss the Reinsurer shall be liable for is subject to $550,000 for any one occurrence. 18.2 Notwithstanding anything stated herein, this Agreement shall not apply to any extra contractual obligation (ECO) incurred by the Company as a result of any fraudulent and/or criminal act by any officer or director of the Company acting individually or collectively or in collusion with any individual or corporation or any other organization or party involved in the presentation, defense or settlement of any claim covered hereunder. 18.3 It is warranted that the Managing General Agent or its appointed claims handler will maintain Errors and Omissions Insurance coverage requiring a minimum of $3,000,000. It is further warranted that, in the event of XPL and/or ECO loss hereunder, the Managing General Agent's Errors and Omissions Insurance coverage will inure to the benefit of this contract, and any coverage under this agreement shall be excess to the coverage afforded under the Managing General Agent's Errors and Omissions Insurance coverage. Any possible recovery shall not diminish or delay payment of any obligations from the Reinsurer to the company. ARTICLE 19 - SAVINGS CLAUSE --------------------------- 19.1 If any law or regulation of any Federal, State or Local Government of the United States of America, or the ruling of officials having supervision over insurance companies, should prohibit or render illegal this Agreement or any portion thereof, as to risks or properties located in the jurisdiction of such authority, either the Company or the Reinsurer may, upon written notice to the other, suspend or abrogate this Agreement insofar as it relates to risks or properties located within such jurisdiction to such extent as may be necessary to comply with such law, regulation or ruling. Such illegality shall in no way affect any other portion thereof, provided, however, that the Reinsurer or the Company may terminate or suspend this Agreement insofar as it relates to the Business to which such law or regulation may apply. 19.2 Should any portion of this Agreement be held to be unenforceable by Arbitration or any court of competent jurisdiction, the remainder of such Agreement shall be construed as if originally written without the unenforceable portion thereof, giving effect to the extent possible of the original intent of the parties hereto as expressed in such Agreement as originally written. ARTICLE 20 - UNAUTHORIZED (NON-ADMITTED) REINSURANCE ---------------------------------------------------- 20.1 In the event the Company is unable to take reserve credit under this Agreement or the Reinsurers A.M. Best rating is below "A-", the Reinsurer hereby agrees to secure delivery to the Company, prior to the effective date of this Agreement, a clean, irrevocable, evergreen, unconditional letter of credit drawn on a bank that is a member of the Federal Reserve System and approved by the National Association of Insurance Commissioners, and in accordance with the rules and regulations as set forth by the Texas Department of Insurance or any other regulatory authority having jurisdiction, for an amount equal to the Reinsurer's share of the reserves for unearned premium and outstanding losses and loss expenses, including incurred but not reported losses. The Company agrees to furnish the Reinsurer with necessary accounting data to establish the amount of such letter of credit. 20.2 In the event the Reinsurer and the Company mutually agree, the Reinsurer may, instead of complying with Article 20.1, enter into a trust agreement and establish a trust account for the benefit of the Company in a bank that is a member of the Federal Reserve System, approved by the National Association of Insurance Commissioners and in accordance with the rules and regulations as set forth by the Texas Department of Insurance or any other regulatory authority having jurisdiction. Such amount shall be determined in accordance with Article 20.1 above. 20.3 The assets deposited in the trust account shall be valued, according to their current fair market value, and shall consist only of cash, certificates of deposit, and/or investments of the types permitted by the Texas Insurance Code, Article 5.75-1 (d), provided that such investments are issued by an institution that is not the parent, subsidiary, or affiliate of either the guarantor or the beneficiary. 20.4 The trust agreement shall further require that all settlements of account between the Company and the Reinsurer be made in cash or its equivalent. 20.5 The Reinsurer and the Company hereby agree that the Letter of Credit or the assets in the trust account established pursuant to this Agreement may be withdrawn by the Company at any time, notwithstanding any other provisions in this Agreement. Such withdrawals shall be utilized and applied by the Company or its successors in interest by operation of law, including without limitation any liquidator, rehabilitator, receiver, or conservator of such Company, without diminution because of insolvency on the part of the Company or the Reinsurer, only for the following purposes: a. to reimburse the Company for the Reinsurer's share of premiums returned to the owners of Policies reinsured under this Agreement on account of cancellations of such Policies; or b. to reimburse the Company for the Reinsurer's share of surrenders and benefits or losses paid by the Company pursuant to the provisions of the Policies reinsured under this Agreement; or c. in the event of notice of termination of the trust, to fund an account with the Company in an amount at least equal to the reinsurers share of reserves described in Article 20.1 above; or d. to pay any other amounts due the Company under this Agreement. ARTICLE 21 - PROGRAM REVIEW --------------------------- 21.1 The Reinsurer acknowledges that it has been afforded the opportunity to review the records of the Managing General Agent including but not limited to rate levels, rate filings, underwriting guidelines and claims handling. Although the Company may perform reviews as well, it is understood that the participation of the Reinsurer on this Agreement is based upon its continuing due diligence and not based upon due diligence performed by the Company. ARTICLE 22 - MISCELLANEOUS -------------------------- 22.1 This Agreement has been made and entered into in the State of Texas. 22.2 All notices required to be given hereunder shall be deemed to have been duly given by personally delivering such notice in writing or by mailing it, Certified Mail, return receipt requested, with postage prepaid. Any party may change the address to which notices and other communications hereunder are to be sent to such party by giving the other party written notice thereof in accordance with this provision. 22.3 This Agreement shall be binding upon the parties hereto, together with their respective executors, administrators, personal representatives, heirs and assigns. 22.4 This Agreement may be executed in one or more counterparts, each of which shall be deemed an original, but all of which together shall constitute one and the same instrument. 22.5 This Agreement may be amended, modified or supplemented only by a written instrument executed by all parties hereto. 22.6 This Agreement is the entire Agreement between the parties and supersedes one and all previous agreements, written or oral, and amendments thereto. 22.7 A waiver by the Company, the Reinsurer or its designated representative of any breach or default by the other party under this Agreement shall not constitute a continuing waiver or a waiver by the Company, the Reinsurer or its designated representative of any subsequent act in breach or of default hereunder. 22.8 Headings used in this agreement are for reference purposes only and shall not be deemed a part of this Agreement. ARTICLE 23 - INTERMEDIARY ------------------------- Benfield Inc. is hereby recognized as the Intermediary negotiating this Agreement for all business hereunder. All communications (including but not limited to notices, statements, premium, return premium, commissions, taxes, losses, loss adjustment expense, salvages and loss settlements) relating thereto shall be transmitted to the Company or the Reinsurer through the Intermediary located at 3600 West 80th Street, Minneapolis, Minnesota 55431. Payments by the Company to the Intermediary shall be deemed to constitute payment to the Reinsurer. Payments by the Reinsurer to the Intermediary shall be deemed to constitute payment to the Company only to the extent that such payments are actually received by the Company. SCHEDULE OF BUSINESS The Company, the Reinsurer and the Managing General Agent agree that the Managing General Agent has the authority to accept, on forms approved by the Company, any Policy, endorsement, binder, certificate, or proposal for insurance. The Managing General Agent's authority is limited by this Schedule of Business. Overall: Projected premium volume $40,000,000 Territory Texas only Maximum policy term Twelve months Lines of business and maximum limits of liability Coverage Maximum Limits Bodily Injury Liability $ 25,027 each person $ 50,027 each accident Property Damage Liability $ 25,027 each accident Uninsured/Underinsured Motorists Bodily Injury $ 25,027 each person $ 50,027 each accident Property Damage $ 25,027 each accident Personal Injury Protection $ 2,527 each person Medical payments $ 527 each person Physical Damage $ 50,000 each automobile This Agreement does not apply to and specifically excludes the following: a. Any business not produced by AMERICAN HALLMARK GENERAL AGENCY, INC., or b. Any business not classified as private passenger automobile liability or physical damage, or c. Exclusions specified within the Quota Share Reinsurance Agreement Number HFS-03-002. IN WITNESS WHEREOF, the Company and Reinsurer hereto by their respective duly authorized representatives have executed this Agreement as of the date first above written. DORINCO REINSURANCE COMPANY BY:_____________________________________ ITS:____________________________________ OLD AMERICAN COUNTY MUTUAL FIRE INSURANCE COMPANY BY:_____________________________________ ITS:____________________________________ EX-10.CR 9 exh10cr.txt BLANKET RETROCESSION AGREEMENT EXHIBIT 10(cr) Blanket Retrocession Agreement Effective: October 1, 2003 issued to Dorinco Reinsurance Company Midland, Michigan by American Hallmark Insurance Company of Texas Dallas, Texas Table of Contents Article Page I Business Reinsured 1 II Commencement and Termination 1 III Territory 2 IV Exclusions 2 V Concurrency of Conditions 3 VI Retention and Limit 3 VII Definitions 5 VIII Loss Notices and Settlements 5 IX Salvage and Subrogation 6 X Reinsurance Premium 6 XI Offset (BRMA 36C) 6 XII Access to Records (BRMA 1D) 6 XIII Liability of the Retrocessionaire 6 XIV Net Retained Lines (BRMA 32B) 7 XV Errors and Omissions (BRMA 14F) 7 XVI Taxes (BRMA 50B) 7 XVII Currency (BRMA 12A) 7 XVIII Unauthorized Retrocessionaires 7 XIX Insolvency 9 XX Arbitration 9 XXI Service of Suit (BRMA 49D) 10 XXII Governing Law (BRMA 71B) 10 XXIII Entire Agreement 11 XXIV Intermediary (BRMA 23A) 11 Blanket Retrocession Agreement Effective: October 1, 2003 issued to Dorinco Reinsurance Company Midland, Michigan (hereinafter referred to as the "Reinsurer") by American Hallmark Insurance Company of Texas Dallas, Texas (hereinafter referred to as the "Retrocessionaire") Article I - Business Reinsured A. By this Agreement the Reinsurer obligates itself to retrocede to the Retrocessionaire and the Retrocessionaire obligates itself to accept a part of the Reinsurer's share in the interests and liabilities of the "Reinsurer" as respects subject business (as hereinafter defined) under the Quota Share Reinsurance Agreement, effective October 1, 2003, (hereinafter referred to as the "Original Agreement") made and entered into by and among the Reinsurer, Old American County Mutual Fire Insurance Company (hereinafter referred to as the "Issuing Company") and American Hallmark General Agency, Inc., Dallas, Texas (hereinafter referred to as the "General Agent"). A copy of the Original Agreement is attached to and forms part of this Agreement. B. "Subject business" as used herein shall mean the losses retroceded hereunder as respects the "loss corridor" provisions set forth in paragraph A of Article VI. Article II - Commencement and Termination A. This Agreement shall become effective at 12:01 a.m., Central Standard Time, October 1, 2003, with respect to losses under policies allocated to underwriting years commencing at or after that time and date, and shall continue in force thereafter until the Original Agreement is terminated. This Agreement shall terminate automatically upon termination of the Original Agreement. B. Unless otherwise mutually agreed, reinsurance hereunder on subject business in force on the effective date of termination shall remain in full force and effect until expiration, cancellation or next premium anniversary of such subject business, whichever first occurs, but in no event beyond 12 months following the effective date of termination, subject, however, to regulatory requirements regarding policy cancellations and non-renewals. C. "Underwriting year" as used in this Agreement shall mean the period from 12:01 a.m., Central Standard Time, October 1, 2003 until 12:01 a.m., Central Standard Time, October 1, 2004, and each subsequent 12-month period (or portion thereof if the Original Agreement terminates prior to the end of a 12-month underwriting year) shall be a separate underwriting year. All premiums and losses from policies ceded under the Original Agreement and allocated to an underwriting year shall be credited or charged, respectively, to such underwriting year, regardless of the date said premiums earn or such losses occur. It is understood that a policy will be allocated to the underwriting year which is in effect as of: 1. The effective date of such policies, with respect to all new policies; and 2. The renewal date of such policies, with respect to term policies with renewals of one year or less. Such policies shall remain in the same underwriting year, as originally allocated, until the next renewal date or premium anniversary date, at which time such policies shall be allocated to the underwriting year in effect as of the date provided above. The term of any policy issued with respect to subject business hereunder shall not exceed 12 months. Article III - Territory The territorial limits of this Agreement shall be identical with those of the Original Agreement. Article IV - Exclusions A. This Agreement does not apply to and specifically excludes the following: 1. Any Automobile business not classified as a Private Passenger Automobile. 2. Garagekeepers Legal Liability. 3. Vendors Single Interest. 4. Nuclear risks as defined in the "Nuclear Incident Exclusion Clause - Physical Damage - Reinsurance" and the "Nuclear Incident Exclusion Clause - Liability - Reinsurance" attached to and forming part of this Agreement. 5. Liability as a member, subscriber or reinsurer of any Pool, Syndicate or Association, but this exclusion shall not apply to Assigned Risk Plans or similar plans. 6. Mobile homes. 7. Automobile dealers. 8. Automobile Liability with respect to any vehicle used principally as: a. A taxicab, public or livery conveyance or bus, it being understood that this exclusion does not apply to school or church buses; b. An ambulance, fire department or law enforcement vehicle; c. A racing or exhibition vehicle. 9. Loss or damage caused by or resulting from war, invasion, hostilities, acts of foreign enemies, civil war, insurrection, military or usurped power, martial law or confiscation by order of any government of public authority, but not excluding loss or damage which would be covered under a policy or standard form containing a standard War Exclusion Clause. 10. Loss or damage or cost or expenses arising from seepage and/or pollution and/or contamination, other than contamination from smoke damage. Nevertheless, this exclusion does not preclude any payments of the cost of the removal of debris of property damage by a loss otherwise covered hereunder, but subject always to a limit of 25.0% of the Issuing Company's Property business loss under the original policy. B. If any subject business falling within the scope of one or more of the exclusions is assigned to the Issuing Company under an Assigned Risk Plan, such exclusion(s) shall not apply, it being understood and agreed that the limits of liability extended by the Issuing Company as respects such policies shall not exceed the minimum statutory limits of liability prescribed in such Assigned Risk Plan. C. If the Reinsurer is bound, without the knowledge and contrary to the instructions of the Reinsurer's supervisory underwriting personnel, on any subject business falling within the scope of one or more of the exclusions set forth in this Article, these exclusions shall be suspended with respect to such subject business until 30 days after an underwriting supervisor of the Reinsurer acquires knowledge of such subject business. Article V - Concurrency of Conditions This Agreement shall follow in all respects the terms and conditions of the Original Agreement (including addenda thereto when accepted by the Retrocessionaire), provided the terms and conditions of the Original Agreement are not inconsistent with the terms and conditions of this Agreement. The Reinsurer agrees to transmit all notices and information pertaining to the subject matter of this Agreement as promptly as possible after receipt thereof. Article VI - Retention and Limit A. The Retrocessionaire shall be liable for 100% of the amount by which losses incurred exceed 65.5% of premiums earned under the Original Agreement for each underwriting year hereunder. However, the Retrocessionaire's liability under this paragraph shall not exceed 17.5% of premiums earned for each underwriting year hereunder and shall hereinafter be referred as the "loss corridor." The Reinsurer shall calculate, report and make any adjustments to the loss corridor in conjunction with the provisions under the Premium and Commission Article under the Original Agreement. B. As respects the liability of the Retrocessionaire for ultimate net loss under the loss corridor, including incurred but not reported loss reserves (hereinafter referred to as "IBNR"), the Retrocessionaire or the General Agent, on behalf of the Retrocessionaire, agree to fund the foregoing amounts by securing an irrevocable letter of credit containing an "evergreen clause" from a federally chartered or mutually acceptable bank, or other securities subject to the approval of the Reinsurer. C. Any funding requirements as respects the loss corridor will be completed within 45 days after the end of each underwriting year. D. In the event the Retrocessionaire's policyholders' surplus drops to the levels shown below, in addition to the funding requirements set forth in paragraph B above, the Retrocessionaire or the General Agent, on behalf of the Retrocessionaire, will secure additional funding (based on percentages as set forth below of the Retrocessionaire's limit of liability under the loss corridor), by an irrevocable letter of credit containing an "evergreen clause" from a federally chartered or mutually acceptable bank, or other securities subject to the approval of the Reinsurer: Reinsurer's Policyholders' Additional Surplus Funding $7,500,000 to $6,500,000 5.0% $6,500,000 to $5,500,000 10.0% $5,500,000 and below 17.5% Such additional funding shall be required to be secured immediately, notwithstanding the Retrocessionaire's liability under the loss corridor, and shall be the greater of the Retrocessionaire's liability under the loss corridor or the funding requirements set forth in this paragraph D. E. "Losses incurred" as used herein shall mean the balance of the following, all as respects losses and loss adjustment expenses ceded under the Original Agreement: 1. Ceded losses paid and the allowance for loss adjustment expenses as of the effective date of calculation; plus 2. The ceded reserves for losses outstanding as of the effective date of calculation; plus 3. As respects the second and each subsequent agreement year under the Original Agreement, plus the debit or minus the credit from the preceeding agreement year under the Original Agreement. As respects the funding requirements for the loss corridor set forth above, losses incurred shall include: 1. As respects the first calculation of the loss corridor for the underwriting year, an amount representing IBNR equal to 7.5% of the premiums earned for policies allocated to the underwriting year; 2. As respects the second calculation of the loss corridor for the underwriting year, an amount representing IBNR equal to 3.0% of the premiums earned for policies allocated to the underwriting year; 3. As respects the third and each subsequent calculation of the loss corridor for the underwriting year, no IBNR shall be included. F. "Premiums earned" as used herein shall mean ceded net written premiums allocated to the underwriting year (i.e., net of cancellations and return premiums), less the unearned portion thereof as of the effective date of calculation, all as respects premiums ceded under the Original Agreement. Article VII - Definitions A. "Ultimate net loss" as used herein is defined as the sum or sums (including the allowance for loss adjustment expense, as hereinafter defined) paid or payable by the Reinsurer in settlement of claims and in satisfaction of judgments rendered on account of claims, after the deduction of all recoveries and all claims on inuring insurance or reinsurance, whether collectible or not. Nothing herein shall be construed to mean that losses under this Agreement are not recoverable until the Reinsurer's ultimate net loss has been ascertained. B. "Loss adjustment expense" as used herein shall mean expenses allocable to the investigation, defense and/or settlement of specific claims, including litigation expenses, interest on judgments and costs, expenses and fees resulting from a declaratory judgment or injunctive action brought by an insured or other person, but not including office expenses or salaries of the Reinsurer's regular employees. The liability of the Retrocessionaire for loss adjustment expense hereunder shall equal 10.0% of premiums earned for the underwriting year. Article VIII - Loss Notices and Settlements A. Whenever a loss sustained by the Reinsurer appears likely to result in a claim hereunder, the Reinsurer shall notify the Retrocessionaire, and the Retrocessionaire shall have the right to participate in the adjustment of the loss at its own expense. B. All loss settlements made by the Reinsurer, provided they are within the terms of this Agreement, shall be binding upon the Retrocessionaire, and the Retrocessionaire agrees to pay all amounts for which it may be liable upon receipt of reasonable evidence of the amount paid (or scheduled to be paid) by the Reinsurer. Article IX - Salvage and Subrogation The Retrocessionaire shall be credited with salvage (i.e., reimbursement obtained or recovery made by the Reinsurer, less the actual cost, excluding salaries of officials and employees of the Reinsurer and sums paid to attorneys as retainer, of obtaining such reimbursement or making such recovery) on account of claims and settlements involving reinsurance hereunder. Salvage thereon shall always be used to reimburse the excess carriers in the reverse order of their priority according to their participation before being used in any way to reimburse the Reinsurer for its primary loss. Article X - Reinsurance Premium A. As premium for the reinsurance provided hereunder for each underwriting year, the Reinsurer shall pay the Retrocessionaire 2.0% of the premium's earned under the Original Agreement for policies allocated to the underwriting year. B. Within 60 days after the end of each month, the Reinsurer shall report the premiums earned under the Original Agreement for the month. The premium due the Retrocessionaire, at the rate shown in paragraph A, shall be paid by the Reinsurer with its report. Any adjustments to the premium paid to the Retrocessionaire for each underwriting year shall be made within 45 days after 12 months following the end of the underwriting year. Article XI - Offset (BRMA 36C) The Reinsurer and the Retrocessionaire shall have the right to offset any balance or amounts due from one party to the other under the terms of this Agreement. The party asserting the right of offset may exercise such right any time whether the balances due are on account of premiums or losses or otherwise. Article XII - Access to Records (BRMA 1D) The Retrocessionaire or its designated representatives shall have access at any reasonable time to all records of the Reinsurer which pertain in any way to this reinsurance. Article XIII - Liability of the Retrocessionaire A. The liability of the Retrocessionaire shall follow that of the Reinsurer in every case and be subject in all respects to all the general and specific stipulations, clauses, waivers and modifications of the Issuing Company's policies and any endorsements thereon. However, in no event shall this be construed in any way to provide coverage outside the terms and conditions set forth in this Agreement. B. Nothing herein shall in any manner create any obligations or establish any rights against the Retrocessionaire in favor of any third party or any person or persons not party to this Agreement. Article XIV - Net Retained Lines (BRMA 32B) A. This Agreement applies only to that portion of any policy which the Reinsurer retains net for its own account, and in calculating the amount of any loss hereunder and also in computing the amount or amounts in excess of which this Agreement attaches, only loss or losses in respect of that portion of any policy which the Reinsurer retains net for its own account shall be included. B. The amount of the Retrocessionaire's liability hereunder in respect of any loss or losses shall not be increased by reason of the inability of the Reinsurer to collect from any other retrocessionaire(s), whether specific or general, any amounts which may have become due from such retrocessionaire(s), whether such inability arises from the insolvency of such other retrocessionaire(s) or otherwise. Article XV - Errors and Omissions (BRMA 14F) Inadvertent delays, errors or omissions made in connection with this Agreement or any transaction hereunder shall not relieve either party from any liability which would have attached had such delay, error or omission not occurred, provided always that such error or omission is rectified as soon as possible after discovery. Article XVI - Taxes (BRMA 50B) In consideration of the terms under which this Agreement is issued, the Reinsurer will not claim a deduction in respect of the premium hereon when making tax returns, other than income or profits tax returns, to any state or territory of the United States of America or the District of Columbia. Article XVII - Currency (BRMA 12A) A. Whenever the word "Dollars" or the "$" sign appears in this Agreement, they shall be construed to mean United States Dollars and all transactions under this Agreement shall be in United States Dollars. B. Amounts paid or received by the Reinsurer in any other currency shall be converted to United States Dollars at the rate of exchange at the date such transaction is entered on the books of the Reinsurer. Article XVIII - Unauthorized Retrocessionaires A. If the Retrocessionaire is unauthorized in any state of the United States of America or the District of Columbia, the Retrocessionaire agrees to fund its share of the Reinsurer's outstanding loss and loss adjustment expense reserves (including IBNR) by: 1. Clean, irrevocable and unconditional letters of credit issued and confirmed, if confirmation is required by the insurance regulatory authorities involved, by a bank or banks meeting the NAIC Securities Valuation Office credit standards for issuers of letters of credit and acceptable to said insurance regulatory authorities; and/or 2. Cash advances; and/or 3. Other securities subject to prior approval by the Reinsurer; if, without such funding, a penalty would accrue to the Reinsurer on any financial statement it is required to file with the insurance regulatory authorities involved. The Retrocessionaire, at its sole option, may fund in other than cash if its method and form of funding are acceptable to the insurance regulatory authorities involved and to the Reinsurer. B. With regard to funding in whole or in part by letters of credit, it is agreed that each letter of credit will be in a form acceptable to insurance regulatory authorities involved, will be issued for a term of at least one year and will include an "evergreen clause," which automatically extends the term for at least one additional year at each expiration date unless written notice of non-renewal is given to the Reinsurer not less than 30 days prior to said expiration date. The Reinsurer and the Retrocessionaire further agree, notwithstanding anything to the contrary in this Agreement, that said letters of credit may be drawn upon by the Reinsurer or its successors in interest at any time, without diminution because of the insolvency of the Reinsurer or the Retrocessionaire, but only for one or more of the following purposes: 1. To reimburse itself for the Retrocessionaire's share of losses and/or loss adjustment expense paid under the terms of the subject business reinsured hereunder, unless paid in cash by the Retrocessionaire; 2. To reimburse itself for the Retrocessionaire's share of any other amounts claimed to be due hereunder, unless paid in cash by the Retrocessionaire; 3. To fund a cash account in an amount equal to the Retrocessionaire's share of any ceded outstanding loss and loss adjustment expense reserves (including IBNR) funded by means of a letter of credit which is under non-renewal notice, if said letter of credit has not been renewed or replaced by the Retrocessionaire 10 days prior to its expiration date; 4. To refund to the Retrocessionaire any sum in excess of the actual amount required to fund the Retrocessionaire's share of the Reinsurer's ceded outstanding loss and loss adjustment expense reserves (including IBNR), if so requested by the Retrocessionaire. In the event the amount drawn by the Reinsurer on any letter of credit is in excess of the actual amount required for B(1), or B(3), or in the case of B(2), the actual amount determined to be due, the Reinsurer shall promptly return to the Retrocessionaire the excess amount so drawn. Article XIX - Insolvency A. In the event of the insolvency of the Reinsurer, this reinsurance shall be payable directly to the Reinsurer or to its liquidator, receiver, conservator or statutory successor on the basis of the liability of the Reinsurer without diminution because of the insolvency of the Reinsurer or because the liquidator, receiver, conservator or statutory successor of the Reinsurer has failed to pay all or a portion of any claim. It is agreed, however, that the liquidator, receiver, conservator or statutory successor of the Reinsurer shall give written notice to the Retrocessionaire of the pendency of a claim against the Reinsurer indicating the reinsurance contract reinsured which claim would involve a possible liability on the part of the Retrocessionaire within a reasonable time after such claim is filed in the conservation or liquidation proceeding or in the receivership, and that during the pendency of such claim, the Retrocessionaire may investigate such claim and interpose, at its own expense, in the proceeding where such claim is to be adjudicated, any defense or defenses that it may deem available to the Reinsurer or its liquidator, receiver, conservator or statutory successor. The expense thus incurred by the Retrocessionaire shall be chargeable, subject to the approval of the Court, against the Reinsurer as part of the expense of conservation or liquidation to the extent of a pro rata share of the benefit which may accrue to the Reinsurer solely as a result of the defense undertaken by the Retrocessionaire. B. It is further understood and agreed that, in the event of the insolvency of the Reinsurer, the reinsurance under this Agreement shall be payable directly by the Retrocessionaire to the Reinsurer or to its liquidator, receiver or statutory successor, except as provided by Section 4118(a) of the New York Insurance Law or except (1) where this Agreement specifically provides another payee of such reinsurance in the event of the insolvency of the Reinsurer or (2) where the Retrocessionaire with the consent of the original reinsured or reinsureds has assumed such contract obligations of the Reinsurer as direct obligations of the Retrocessionaire to the payees under such contracts and in substitution for the obligations of the Reinsurer to such payees. Article XX - Arbitration A. As a condition precedent to any right of action hereunder, in the event of any dispute or difference of opinion hereafter arising with respect to this Agreement, it is hereby mutually agreed that such dispute or difference of opinion shall be submitted to arbitration. One Arbiter shall be chosen by the Reinsurer, the other by the Retrocessionaire, and an Umpire shall be chosen by the two Arbiters before they enter upon arbitration, all of whom shall be active or retired disinterested executive officers of insurance or reinsurance companies or Lloyd's London Underwriters. In the event that either party should fail to choose an Arbiter within 30 days following a written request by the other party to do so, the requesting party may choose two Arbiters who shall in turn choose an Umpire before entering upon arbitration. If the two Arbiters fail to agree upon the selection of an Umpire within 30 days following their appointment, each Arbiter shall nominate three candidates within 10 days thereafter, two of whom the other shall decline, and the decision shall be made by drawing lots. B. Each party shall present its case to the Arbiters within 30 days following the date of appointment of the Umpire. The Arbiters shall consider this Agreement as an honorable engagement rather than merely as a legal obligation and they are relieved of all judicial formalities and may abstain from following the strict rules of law. The decision of the Arbiters shall be final and binding on both parties; but failing to agree, they shall call in the Umpire and the decision of the majority shall be final and binding upon both parties. Judgment upon the final decision of the Arbiters may be entered in any court of competent jurisdiction. C. Each party shall bear the expense of its own Arbiter, and shall jointly and equally bear with the other the expense of the Umpire and of the arbitration. In the event that the two Arbiters are chosen by one party, as above provided, the expense of the Arbiters, the Umpire and the arbitration shall be equally divided between the two parties. D. Any arbitration proceedings shall take place at a location mutually agreed upon by the parties to this Agreement, but notwithstanding the location of the arbitration, all proceedings pursuant hereto shall be governed by the law of the state in which the Reinsurer has its principal office. Article XXI - Service of Suit (BRMA 49D) (Applicable if the Retrocessionaire is not domiciled in the United States of America, and/or is not authorized in any State, Territory or District of the United States where authorization is required by insurance regulatory authorities) A. It is agreed that in the event the Retrocessionaire fails to pay any amount claimed to be due hereunder, the Retrocessionaire, at the request of the Reinsurer, will submit to the jurisdiction of a court of competent jurisdiction within the United States. Nothing in this Article constitutes or should be understood to constitute a waiver of the Retrocessionaire's rights to commence an action in any court of competent jurisdiction in the United States, to remove an action to a United States District Court, or to seek a transfer of a case to another court as permitted by the laws of the United States or of any state in the United States. B. Further, pursuant to any statute of any state, territory or district of the United States which makes provision therefor, the Retrocessionaire hereby designates the Superintendent, Commissioner or Director of Insurance or other officer specified for that purpose in the statute, or his successor or successors in office, as its true and lawful attorney upon whom may be served any lawful process in any action, suit or proceeding instituted by or on behalf of the Reinsurer or any beneficiary hereunder arising out of this Agreement. Article XXII - Governing Law (BRMA 71B) This Agreement shall be governed by and construed in accordance with the laws of the State of Texas. Article XXIII - Entire Agreement This Agreement contains the entire agreement between the parties as to the subject matter hereof. No waiver, modification, variation, change or amendment to this Agreement shall be binding on either party unless reduced to writing and signed by a duly authorized officer of each party. Article XXIV - Intermediary (BRMA 23A) Benfield Inc. is hereby recognized as the Intermediary negotiating this Agreement for all business hereunder. All communications (including but not limited to notices, statements, premium, return premium, commissions, taxes, losses, loss adjustment expense, salvages and loss settlements) relating thereto shall be transmitted to the Reinsurer or the Retrocessionaire through Benfield Inc., 3600 West 80th Street, Minneapolis, Minnesota 55431. Payments by the Reinsurer to the Intermediary shall be deemed to constitute payment to the Retrocessionaire. Payments by the Retrocessionaire to the Intermediary shall be deemed to constitute payment to the Reinsurer only to the extent that such payments are actually received by the Reinsurer. In Witness Whereof, the parties by their duly authorized representatives have executed this Agreement as of the dates undermentioned at: Midland, Michigan,this ______ day of ________________ in the year ________. __________________________________________________________ Dorinco Reinsurance Company Dallas, Texas,this ______ day of ___________________ in the year _________. __________________________________________________________ American Hallmark General Agency, Inc. Dallas, Texas,this ______ day of ___________________ in the year _________. __________________________________________________________ American Hallmark Insurance Company of Texas Nuclear Incident Exclusion Clause - Physical Damage - Reinsurance (U.S.A.) 1. This Reinsurance does not cover any loss or liability accruing to the Reassured, directly or indirectly and whether as Insurer or Reinsurer, from any Pool of Insurers or Reinsurers formed for the purpose of covering Atomic or Nuclear Energy risks. 2. Without in any way restricting the operation of paragraph (1) of this Clause, this Reinsurance does not cover any loss or liability accruing to the Reassured, directly or indirectly and whether as Insurer or Reinsurer, from any insurance against Physical Damage (including business interruption or consequential loss arising out of such Physical Damage) to: I. Nuclear reactor power plants including all auxiliary property on the site, or II. Any other nuclear reactor installation, including laboratories handling radioactive materials in connection with reactor installations, and "critical facilities" as such, or III. Installations for fabricating complete fuel elements or for processing substantial quantities of "special nuclear material," and for reprocessing, salvaging, chemically separating, storing or disposing of "spent" nuclear fuel or waste materials, or IV. Installations other than those listed in paragraph (2) III above using substantial quantities of radioactive isotopes or other products of nuclear fission. 3. Without in any way restricting the operations of paragraphs (1) and (2) hereof, this Reinsurance does not cover any loss or liability by radioactive contamination accruing to the Reassured, directly or indirectly, and whether as Insurer or Reinsurer, from any insurance on property which is on the same site as a nuclear reactor power plant or other nuclear installation and which normally would be insured therewith except that this paragraph (3) shall not operate (a) where Reassured does not have knowledge of such nuclear reactor power plant or nuclear installation, or (b) where said insurance contains a provision excluding coverage for damage to property caused by or resulting from radioactive contamination, however caused. However on and after 1st January 1960 this sub-paragraph (b) shall only apply provided the said radioactive contamination exclusion provision has been approved by the Governmental Authority having jurisdiction thereof. 4. Without in any way restricting the operations of paragraphs (1), (2) and (3) hereof, this Reinsurance does not cover any loss or liability by radioactive contamination accruing to the Reassured, directly or indirectly, and whether as Insurer or Reinsurer, when such radioactive contamination is a named hazard specifically insured against. 5. It is understood and agreed that this Clause shall not extend to risks using radioactive isotopes in any form where the nuclear exposure is not considered by the Reassured to be the primary hazard. 6. The term "special nuclear material" shall have the meaning given it in the Atomic Energy Act of 1954 or by any law amendatory thereof. 7. Reassured to be sole judge of what constitutes: (a) substantial quantities, and (b) the extent of installation, plant or site. Note.-Without in any way restricting the operation of paragraph (1) hereof, it is understood and agreed that (a) all policies issued by the Reassured on or before 31st December 1957 shall be free from the application of the other provisions of this Clause until expiry date or 31st December 1960 whichever first occurs whereupon all the provisions of this Clause shall apply. (b) with respect to any risk located in Canada policies issued by the Reassured on or before 31st December 1958 shall be free from the application of the other provisions of this Clause until expiry date or 31st December 1960 whichever first occurs whereupon all the provisions of this Clause shall apply. 12/12/57 N.M.A. 1119 BRMA 35B Nuclear Incident Exclusion Clause - Liability - Reinsurance (U.S.A.) (Approved by Lloyd's Underwriters' Fire and Non-Marine Association) (1) This reinsurance does not cover any loss or liability accruing to the Reassured as a member of, or subscriber to, any association of insurers or reinsurers formed for the purpose of covering nuclear energy risks or as a direct or indirect reinsurer of any such member, subscriber or association. (2) Without in any way restricting the operation of paragraph (1) of this Clause it is understood and agreed that for all purposes of this reinsurance all the original policies of the Reassured (new, renewal and replacement) of the classes specified in Clause II of this paragraph (2) from the time specified in Clause III in this paragraph (2) shall be deemed to include the following provision (specified as the Limited Exclusion Provision): Limited Exclusion Provision.* I. It is agreed that the policy does not apply under any liability coverage, to (injury, sickness, disease, death or destruction (bodily injury or property damage with respect to which an insured under the policy is also an insured under a nuclear energy liability policy issued by Nuclear Energy Liability Insurance Association, Mutual Atomic Energy Liability Underwriters or Nuclear Insurance Association of Canada, or would be an insured under any such policy but for its termination upon exhaustion of its limit of liability. II. Family Automobile Policies (liability only), Special Automobile Policies (private passenger automobiles, liability only), Farmers Comprehensive Personal Liability Policies (liability only), Comprehensive Personal Liability Policies (liability only) or policies of a similar nature; and the liability portion of combination forms related to the four classes of policies stated above, such as the Comprehensive Dwelling Policy and the applicable types of Homeowners Policies. III. The inception dates and thereafter of all original policies as described in II above, whether new, renewal or replacement, being policies which either (a) become effective on or after 1st May, 1960, or (b) become effective before that date and contain the Limited Exclusion Provision set out above; provided this paragraph (2) shall not be applicable to Family Automobile Policies, Special Automobile Policies, or policies or combination policies of a similar nature, issued by the Reassured on New York risks, until 90 days following approval of the Limited Exclusion Provision by the Governmental Authority having jurisdiction thereof. (3) Except for those classes of policies specified in Clause II of paragraph (2) and without in any way restricting the operation of paragraph (1) of this Clause, it is understood and agreed that for all purposes of this reinsurance the original liability policies of the Reassured (new, renewal and replacement) affording the following coverages: Owners, Landlords and Tenants Liability, Contractual Liability, Elevator Liability, Owners or Contractors (including railroad) Protective Liability, Manufacturers and Contractors Liability, Product Liability, Professional and Malpractice Liability, Storekeepers Liability, Garage Liability, Automobile Liability (including Massachusetts Motor Vehicle or Garage Liability) shall be deemed to include, with respect to such coverages, from the time specified in Clause V of this paragraph (3), the following provision (specified as the Broad Exclusion Provision): Broad Exclusion Provision.* It is agreed that the policy does not apply: I. Under any Liability Coverage to (injury, sickness, disease, death or destruction (bodily injury or property damage (a) with respect to which an insured under the policy is also an insured under a nuclear energy liability policy issued by Nuclear Energy Liability Insurance Association, Mutual Atomic Energy Liability Underwriters or Nuclear Insurance Association of Canada, or would be an insured under any such policy but for its termination upon exhaustion of its limit of liability; or (b) resulting from the hazardous properties of nuclear material and with respect to which (1) any person or organization is required to maintain financial protection pursuant to the Atomic Energy Act of 1954, or any law amendatory thereof, or (2) the insured is, or had this policy not been issued would be, entitled to indemnity from the United States of America, or any agency thereof, under any agreement entered into by the United States of America, or any agency thereof, with any person or organization. II. Under any Medical Payments Coverage, or under any Supplementary Payments Provision relating to (immediate medical or surgical relief (first aid, to expenses incurred with respect to (bodily injury, sickness, disease or death (bodily injury resulting from the hazardous properties of nuclear material and arising out of the operation of a nuclear facility by any person or organization. III. Under any Liability Coverage to (injury, sickness, disease, death or destruction (bodily injury or property damage resulting from the hazardous properties of nuclear material, if (a) the nuclear material (1) is at any nuclear facility owned by, or operated by or on behalf of, an insured or (2) has been discharged or dispersed therefrom; (b) the nuclear material is contained in spent fuel or waste at any time possessed, handled, used, processed, stored, transported or disposed of by or on behalf of an insured; or (c) the (injury, sickness, disease, death or destruction (bodily injury or property damage arises out of the furnishing by an insured of services, materials, parts or equipment in connection with the planning, construction, maintenance, operation or use of any nuclear facility, but if such facility is located within the United States of America, its territories, or possessions or Canada, this exclusion (c) applies only to (injury to or destruction of property at such nuclear facility (property damage to such nuclear facility and any property thereat. IV. As used in this endorsement: "hazardous properties" include radioactive, toxic or explosive properties; "nuclear material" means source material, special nuclear material or byproduct material; "source material", "special nuclear material", and "byproduct material" have the meanings given them in the Atomic Energy Act of 1954 or in any law amendatory thereof; "spent fuel" means any fuel element or fuel component, solid or liquid, which has been used or exposed to radiation in a nuclear reactor; "waste" means any waste material (1) containing byproduct material and (2) resulting from the operation by any person or organization of any nuclear facility included within the definition of nuclear facility under paragraph (a) or (b) thereof; "nuclear facility" means (a) any nuclear reactor, (b) any equipment or device designed or used for (1) separating the isotopes of uranium or plutonium, (2) processing or utilizing spent fuel, or (3) handling processing or packaging waste, (c) any equipment or device used for the processing, fabricating or alloying of special nuclear material if at any time the total amount of such material in the custody of the insured at the premises where such equipment or device is located consists of or contains more than 25 grams of plutonium or uranium 233 or any combination thereof, or more than 250 grams of uranium 235, (d) any structure, basin, excavation, premises or place prepared or used for the storage or disposal of waste, and includes the site on which any of the foregoing is located, all operations conducted on such site and all premises used for such operations; "nuclear reactor" means any apparatus designed or used to sustain nuclear fission in a self-supporting chain reaction or to contain a critical mass of fissionable material; (With respect to injury to or destruction of property, the word "injury" or "destruction," ("property damage" includes all forms of radioactive contamination of property, (includes all forms of radioactive contamination of property. V. The inception dates and thereafter of all original policies affording coverages specified in this paragraph (3), whether new, renewal or replacement, being policies which become effective on or after 1st May, 1960, provided this paragraph (3) shall not be applicable to (i) Garage and Automobile Policies issued by the Reassured on New York risks, or (ii) statutory liability insurance required under Chapter 90, General Laws of Massachusetts, until 90 days following approval of the Broad Exclusion Provision by the Governmental Authority having jurisdiction thereof. (4) Without in any way restricting the operation of paragraph (1) of this Clause, it is understood and agreed that paragraphs (2) and (3) above are not applicable to original liability policies of the Reassured in Canada and that with respect to such policies this Clause shall be deemed to include the Nuclear Energy Liability Exclusion Provisions adopted by the Canadian Underwriters' Association or the Independent Insurance Conference of Canada. *NOTE. The words printed in italics in the Limited Exclusion Provision and in the Broad Exclusion Provision shall apply only in relation to original liability policies which include a Limited Exclusion Provision or a Broad Exclusion Provision containing those words. EX-10.CS 10 exh10cs.txt LETTER OF TERMINATION EXHIBIT 10(cs) November 2, 2003 Ms. Pat Hemley Chief Financial Officer FPF, Inc. 600 Seventeenth Street, Suite 1900S Denver Colorado 80202 RE: Sale and Assignment Agreement dated November 18, 1999 by and among Hallmark Finance Corporation (the "Seller" and, herein, "Hallmark") and FPF, Inc. ("FPF" and, herein, "Flatiron"), as amended or modified (the "Agreement") Dear Ms. Hemley: This letter will serve as formal notification of termination with respect to the above referenced agreement. Cancellation shall be effective 60 days from the date of this letter on December 31, 2003. Please contact me directly if you have any questions. Yours truly, Brookland F. Davis President EX-21 11 exh21.txt LIST OF SUBSIDIARIES EXHIBIT 21 Subsidiaries of Hallmark Financial Services, Inc. ------------------------------------------------- Name of Subsidiary* State of Incorporation ------------------- ---------------------- American Hallmark Insurance Company of Texas Texas Hallmark Finance Corporation Texas ACO Holdings, Inc. Texas Hallmark Claims Service, Inc. Texas American Hallmark General Agency, Inc. Texas Hallmark Underwriters, Inc. Texas American Hallmark Agencies, Inc. Texas Allrisk Insurance Agency, Inc. Texas Phoenix Indemnity Insurance Company Arizona Hallmark General Agency, Inc. Texas Effective Claims Management, Inc. Texas * All subsidiaries conduct business under their corporate name. EX-23.1 12 exh23-1.txt INDEPENDENT AUDITORS' CONSENT Exhibit 23.1 INDEPENDENT AUDITORS' CONSENT The Board of Directors Hallmark Financial Services, Inc.: We consent to incorporation by reference in the registration statement on Form S-8 (File No. 333 41220) of Hallmark Financial Services, Inc. and subsidiaries of our report dated March 24, 2004, relating to the consolidated balance sheet of Hallmark Financial Services, Inc. and subsidiaries as of December 31, 2003, and the related consolidated statements of operations, stockholders' equity and comprehensive income and cash flows for the year ended December 31, 2003, which report appears in the December 31, 2003 annual report on Form 10-KSB of Hallmark Financial Service, Inc. Our report refers to the adoption of the prospective method provisions for stock-based employee compensation. /s/ KPMG LLP ------------- KPMG LLP Dallas, Texas March 24, 2004 EX-23.2 13 exh23-2.txt CONSENT OF INDEPENDENT ACCOUNTANTS Exhibit 23.2 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (File No. 333-41220) of Hallmark Financial Services, Inc. of our report dated March 16, 2003 relating to the financial statements, which appears in this Form 10-KSB. /s/ PricewaterhouseCoopers LLP ------------------------------ PricewaterhouseCoopers LLP Dallas, Texas March 30, 2004 EX-31.A 14 exh31a.txt CERTIFICATION OF CHIEF EXECUTIVE OFFICER Exhibit 31(a) CERTIFICATIONS I, Mark E. Schwarz, Chief Executive Officer of Hallmark Financial Services, Inc. (the "Company"), certify that: 1. I have reviewed this annual report on Form 10-KSB of the Company; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the Company as of, and for, the periods presented in this report; 4. The Company's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures [as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)] for the Company and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) evaluated the effectiveness of the Company's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) disclosed in this report any change in the Company's internal control over financial reporting that occurred during the Company's most recent fiscal quarter (the Company's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting; and 5. The Company's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Company's auditors and the audit committee of the Company's board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Company's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Company's internal control over financial reporting. Date: March 30, 2004 /s/ Mark E. Schwarz ---------------------------------------- Mark E. Schwarz, Chief Executive Officer EX-31.B 15 exh31b.txt CERTIFICATION OF CHIEF FINANCIAL OFFICER Exhibit 31(b) CERTIFICATIONS I, Mark J. Morrison, Chief Financial Officer of Hallmark Financial Services, Inc. (the "Company"), certify that: 1. I have reviewed this annual report on Form 10-KSB of the Company; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the Company as of, and for, the periods presented in this report; 4. The Company's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures [as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)] for the Company and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) evaluated the effectiveness of the Company's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) disclosed in this report any change in the Company's internal control over financial reporting that occurred during the Company's most recent fiscal quarter (the Company's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting; and 5. The Company's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Company's auditors and the audit committee of the Company's board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Company's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Company's internal control over financial reporting. Date: March 30, 2004 /s/ Mark J. Morrison ----------------------------------------- Mark J. Morrison, Chief Financial Officer EX-32.A 16 exh32a.txt CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO 18 U.S.C. 1350 Exhibit 32(a) CERTIFICATION PURSUANT TO 18 U.S.C. S 1350 I, Mark E. Schwarz, Chief Executive Officer of Hallmark Financial Services, Inc. (the "Company"), hereby certify that the accompanying annual report on Form 10-KSB for the fiscal year ended December 31, 2003, and filed with the Securities and Exchange Commission on the date hereof (the "Report"), fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934, as amended. I further certify that the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. Date: March 30, 2004 /s/ Mark E. Schwarz ----------------------- Mark E. Schwarz, Chief Executive Officer CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO 18 U.S.C. 1350 Exhibit 32(b) CERTIFICATION PURSUANT TO 18 U.S.C. S 1350 I, Mark J. Morrison, Chief Financial Officer of Hallmark Financial Services, Inc. (the "Company"), hereby certify that the accompanying annual report on Form 10-KSB for the fiscal year ended December 31, 2003, and filed with the Securities and Exchange Commission on the date hereof (the "Report"), fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934, as amended. I further certify that the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. Date: March 30, 2004 /s/ Mark J. Morrison ----------------------- Mark J. Morrison, Chief Financial Officer