Notes
to Consolidated Financial Statements (Unaudited)
1.
General
Hallmark
Financial Services, Inc. (“Hallmark” and, together with subsidiaries, “we,” “us”
or “our”) is an insurance holding company engaged in the sale of
property/casualty insurance products to businesses and
individuals. Our business involves marketing, distributing,
underwriting and servicing our insurance products, as well as providing other
insurance related services.
We pursue
our business activities through subsidiaries whose operations are organized into
five business units, which are supported by our four insurance company
subsidiaries. Our Standard Commercial business unit (formerly known
as our AHIS Operating Unit) handles commercial insurance products and services
in the standard market. Our E&S Commercial business unit
(formerly known as our TGA Operating Unit) handles primarily commercial
insurance products and services in the excess and surplus lines
market. Our General Aviation business unit (formerly known as our
Aerospace Operating Unit) handles general aviation insurance products and
services. Our Excess & Umbrella business unit (formerly known as
our Heath XS Operating Unit) offers low and middle market commercial umbrella
and excess liability insurance on both an admitted and non-admitted basis
focusing primarily on trucking, specialty automobile and non-fleet automobile
coverage. Our Personal Lines business unit (formerly known as our Personal Lines
Operating Unit) handles personal insurance products and services. Our
insurance company subsidiaries supporting these business units are American
Hallmark Insurance Company of Texas (“AHIC”), Hallmark Insurance Company
(“HIC”), Hallmark Specialty Insurance Company (“HSIC”) and Hallmark County
Mutual Insurance Company (“HCM”).
These
five business units are segregated into three reportable industry segments for
financial accounting purposes. The Standard Commercial Segment
presently consists solely of the Standard Commercial business unit and the
Personal Segment presently consists solely of the Personal Lines business
unit. The Specialty Commercial Segment includes the E&S
Commercial, General Aviation and Excess & Umbrella business
units.
2.
Basis of Presentation
Our
unaudited consolidated financial statements included herein have been prepared
in accordance with U.S. generally accepted accounting principles (“GAAP”) and
include our accounts and the accounts of our subsidiaries. All
significant intercompany accounts and transactions have been eliminated in
consolidation. Certain information and footnote disclosures normally
included in financial statements prepared in accordance with GAAP have been
condensed or omitted pursuant to rules and regulations of the Securities and
Exchange Commission (“SEC”) for interim financial reporting. These
unaudited consolidated financial statements should be read in conjunction with
our audited consolidated financial statements for the year ended December 31,
2009 included in our Annual Report on Form 10-K filed with the SEC.
The
interim financial data as of June 30, 2010 and 2009 is
unaudited. However, in the opinion of management, the interim data
includes all adjustments, consisting of normal recurring adjustments, necessary
for a fair statement of the results for the interim periods. The
results of operations for the period ended June 30, 2010 are not necessarily
indicative of the operating results to be expected for the full
year.
Redeemable
non-controlling
interest
We are accreting the redeemable
non-controlling interest to its redemption value from the date of issuance to
the earliest determinable redemption date, August 29, 2012, using the interest
method. Changes in redemption value are considered a change in
accounting estimate. We follow the two class method of computing
earnings per share. We treat only the portion of the periodic
adjustment to the redeemable non-controlling interest carrying amount that
reflects a redemption in excess of fair value as being akin to an actual
dividend. (See Note 3, “Business Combinations.”)
Reclassification
Certain previously reported amounts
have been reclassified in order to conform to our current year
presentation. Such reclassification had no effect on net income or
stockholders’ equity.
Income
Taxes
We file 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.
Use of Estimates in the
Preparation of the Financial Statements
Our preparation of
financial statements in conformity with GAAP requires us to make estimates and
assumptions that affect our reported amounts of assets and liabilities and our
disclosure of contingent assets and liabilities at the date of our consolidated
financial statements, as well as our reported amounts of revenues and expenses
during the reporting period. Refer to “Critical Accounting Estimates
and Judgments” in our Annual Report on Form 10-K for the year ended December 31,
2009 for information on accounting policies that we consider critical in
preparing our consolidated financial statements. Actual results could differ
materially from those estimates.
Fair Value of Financial
Instruments
Fair
value estimates are made at a point in time, based on relevant market data as
well as the best information available about the financial
instruments. Fair value estimates for financial instruments for which
no or limited observable market data is available are based on judgments
regarding current economic conditions, credit and interest rate
risk. These estimates involve significant uncertainties and judgments
and cannot be determined with precision. As a result, such calculated
fair value estimates may not be realizable in a current sale or immediate
settlement of the instrument. In addition, changes in the underlying
assumptions used in the fair value measurement technique, including discount
rate and estimates of future cash flows, could significantly affect these fair
value estimates.
Investment
Securities: Fair values for debt securities and equity securities are
obtained from an independent pricing service or based on quoted market prices.
(See Note 4, “Fair Values” and Note 5, “Investments.”)
Cash and
Cash Equivalents: The carrying amounts reported in the balance sheet
for these instruments approximate their fair values.
Restricted
Cash and Cash Equivalents: The carrying amount for restricted cash
reported in the balance sheet approximates the fair value.
Notes
Payable: The carrying value of our bank credit facility of $2.8
million approximates the fair value based on the current interest
rate.
Subordinated
Debt Securities: Our trust preferred securities have a carried value
of $56.7 million and a fair value of $54.6 million as of June 30,
2010. The fair value of our trust preferred securities is based on
discounted cash flows using a current yield to maturity of 8.25% based on
similar issues to discount future cash flows.
For
accrued investment income, amounts recoverable from reinsurers, federal income
tax recoverable/payable and other liabilities, the carrying amounts approximate
fair value because of the short maturity of such financial
instruments.
Variable Interest
Entities
On June 21, 2005, we formed Hallmark
Statutory Trust I (“Trust I”), an unconsolidated trust subsidiary, for the sole
purpose of issuing $30.0 million in trust preferred securities. Trust
I used the proceeds from the sale of these securities and our initial capital
contribution to purchase $30.9 million of subordinated debt securities from
Hallmark. The debt securities are the sole assets of Trust I, and the
payments under the debt securities are the sole revenues of Trust
I.
On August
23, 2007, we formed Hallmark Statutory Trust II (“Trust II”), an unconsolidated
trust subsidiary, for the sole purpose of issuing $25.0 million in trust
preferred securities. Trust II used the proceeds from the sale of
these securities and our initial capital contribution to purchase $25.8 million
of subordinated debt securities from Hallmark. The debt securities
are the sole assets of Trust II, and the payments under the debt securities are
the sole revenues of Trust II.
In 2009, the Financial Accounting
Standards Board (“FASB”) issued revised accounting standards regarding
consolidation of variable interest entities, which was effective for us on
January 1, 2010. Accordingly, we reevaluated our investments in Trust
I and II (collectively the “Trusts”) and determined that, while the Trusts
continue to be variable interest entities, we are not the primary
beneficiary. Therefore, the Trusts are not included in our
consolidated financial statements.
Recently Issued Accounting
Standards
In
June 2009, the FASB issued Statement of Financial Accounting Standards
No. 168, “The FASB Accounting Standards Codification and the Hierarchy of
Generally Accepted Accounting Principles — a replacement of FASB Statement
No. 162” (the “Codification”). The Codification reorganized existing
U.S. accounting and reporting standards issued by the FASB and other related
private sector standard setters into a single source of authoritative accounting
principles arranged by topic. The Codification supersedes all existing
U.S. accounting standards. All other accounting literature not included in the
Codification (other than SEC guidance for publicly-traded companies) is
considered non-authoritative. The Codification was effective on a
prospective basis for interim and annual reporting periods ending after
September 15, 2009. The adoption of the Codification changed our
references to GAAP accounting standards but did not impact our financial
position or results of operations.
In
September 2006, FASB issued Statement of Financial Accounting Standards No. 157,
“Fair Value Measurements,” which was codified into FASB Accounting Standards
Codification (“ASC”) Topic 820, “Fair Value Measurements and Disclosures” (“ASC
820”). ASC 820 establishes a separate framework for determining fair
values of assets and liabilities that are required by other authoritative GAAP
pronouncements to be measured at fair value. In addition, ASC 820
incorporates and clarifies the guidance in FASB Concepts Statement 7 regarding
the use of present value techniques in measuring fair value. ASC 820
does not require any new fair value measurements. ASC 820 is effective for
financial statements issued for fiscal years beginning after November 15,
2007. In January 2010, the FASB updated ASC 820 requiring additional
disclosures about fair value measurements regarding transfers between fair value
categories as well as purchases, sales, issuances and settlements related to
fair value measurements of financial instruments with non-observable
inputs. This update was effective for interim and annual periods
beginning after December 15, 2009 except for disclosures about purchases, sales,
issuances and settlements of financial instruments with non-observable inputs,
which are effective for years beginning after December 15, 2010. The adoption of
ASC 820 had no impact on our financial position or results of operations but did
require additional disclosures. (See Note 4, “Fair
Value.”)
In February 2007, FASB issued Statement
of Financial Accounting Standards No. 159, “The Fair Value Option for Financial
Assets and Liabilities,” which was codified into FASB ASC Topic 825, “Financial
Instruments” (“ASC 825”). ASC 825 permits entities to choose to
measure many financial instruments and certain other items at fair value with
changes in fair value included in current earnings. The election is
made on specified election dates, can be made on an instrument–by–instrument
basis, and is irrevocable. ASC 825 is effective for financial
statements issued for fiscal years beginning after November 15, 2007. The
adoption of ASC 825 had no impact on our financial position or results of
operations as we did not elect to apply ASC 825 to any eligible
items.
In
December 2007, the FASB issued Revised Statement of Financial Accounting
Standards No. 141R, “Business Combinations,” which was codified into FASB ASC
Topic 805, “Business Combinations” (“ ASC 805”). ASC 805 provides
revised guidance on how an acquirer recognizes and measures in its financial
statements the identifiable assets acquired, the liabilities assumed, and any
noncontrolling interest in the acquired entity. In addition, it provides revised
guidance on the recognition and measurement of goodwill acquired in the business
combination. ASC 805 also provides guidance specific to the recognition,
classification, and measurement of assets and liabilities related to insurance
and reinsurance contracts acquired in a business combination. ASC 805 applies to
business combinations for acquisitions occurring on or after January 1, 2009.
The adoption of ASC 805 did not have a material effect on our financial position
or results of operations. However, ASC 805 will impact the accounting
for any future acquisitions.
In
December 2007, the FASB issued Statement of Financial Accounting Standards No.
160, “Noncontrolling Interests in Consolidated Financial Statements—an amendment
of Accounting Research Bulletin No. 51,” which was codified into FASB ASC Topic
810, “Noncontrolling Interests” (“ASC 810”). ASC 810 amends
Accounting Research Bulletin No. 51 to establish accounting and reporting
standards for the noncontrolling interest in a subsidiary and for the
deconsolidation of a subsidiary. In addition, it clarifies that a
noncontrolling interest in a subsidiary is an ownership interest in the
consolidated entity that should be reported as a component of equity in the
consolidated financial statements. ASC 810 is effective on a
prospective basis beginning January 1, 2009, except for the presentation and
disclosure requirements which are applied on a retrospective basis for all
periods presented. The adoption of ASC 810 did not have a significant impact on
our financial position or results of operations.
In
April 2009, FASB issued FASB Staff Position No. FAS 157-4,
“Determining Fair Value When the Volume and Level of Activity for the Asset or
Liability Have Significantly Decreased and Identifying Transactions That Are Not
Orderly,” which was codified into ASC 820. ASC 820 provides guidance
for estimating fair value when the volume and level of activity for the asset or
liability have significantly decreased and identifying circumstances that may
indicate that a transaction is not orderly. ASC 820 is
effective for interim and annual reporting periods ending after June 15,
2009, and is applied prospectively. The adoption of this guidance did not have a
significant impact on our financial position or results of
operations.
In April
2009, FASB issued FASB Staff Position No. FAS 115-2 and FAS 124-2, “Recognition
and Presentation of Other-Than-Temporary Impairments,” which was codified into
FASB ASC Topic 320, “Investment Securities” (“ASC 320”), amending prior
other-than-temporary impairment guidance for debt in order to make the guidance
more operational and improve the presentation and disclosure of
other-than-temporary impairments in the financial statements. ASC 320 did
not amend existing recognition and measurement guidance related to
other-than-temporary impairments of equity securities. The provisions
of ASC 320 are effective for interim periods ending after
June 15, 2009. We adopted ASC 320 effective April 1, 2009 which
resulted in a cumulative effect adjustment to the beginning balances of retained
earnings and accumulated other comprehensive income of approximately $2.6
million before tax and $1.7 million net of tax.
In
April 2009, FASB issued FASB Staff Position No. FAS 107-1 and APB Opinion
No. 28-1, “Interim Disclosures about Fair Value of Financial Instruments,”
which was codified into ASC 825. ASC 825 requires disclosures
about fair value of financial instruments for interim reporting periods as well
as in annual financial statements. This guidance is effective for interim
periods ending after June 15, 2009 but did not impact our financial position or
results of operations. However, additional footnote disclosures to
our interim and annual financial statements were required.
In May
2009, FASB issued Statement of Financial Accounting Standard No. 165,
“Subsequent Events,” which was codified into FASB ASC Topic 855, “Subsequent
Events” (“ASC 855”), which provides authoritative accounting literature for a
topic previously addressed only in the auditing literature. The
provisions of ASC 855 are effective for interim financial periods ending after
June 15, 2009. The adoption of ASC 855 did not have a significant impact on our
financial position or results of operations.
In June
2009, FASB issued Statement of Financial Accounting Standards No. 167,
“Amendments to FASB Interpretation No. 46(R)” (“SFAS 167”), which was codified
into ASC 810. ASC 810 addresses the effects of eliminating the
qualifying special-purpose entity concept and responds to concerns about the
application of certain key provisions of FASB Interpretation No. 46(R),
“Consolidation of Variable Interest Entities,” including concerns over the
transparency of enterprises’ involvement with variable interest
entities. SFAS 167 is effective for calendar year end companies
beginning on January 1, 2010 with earlier application prohibited. The
adoption of ASC Topic 810 did not have a material impact on our financial
position or results of operations.
3.
Business Combinations
We account for business combinations
using the purchase method of accounting pursuant to ASC 805. 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 “goodwill.” Indirect and general expenses related to business
combinations are expensed as incurred for acquisitions in 2009 and
after. Prior to 2009, indirect and general expenses were
capitalized.
Effective
August 29, 2008, we acquired 80% of the issued and outstanding membership
interests in the subsidiaries now comprising our Excess & Umbrella business
unit for consideration of $15.0 million. In connection with the
acquisition, we executed an operating agreement for each
subsidiary. The operating agreements grant us the right to purchase
the remaining 20% membership interests in the subsidiaries and grant to an
affiliate of the seller the right to require us to purchase such remaining
membership interests (the “Put/Call Option”). The Put/Call Option
becomes exercisable by either us or the affiliate of the seller upon the earlier
of August 29, 2012, the termination of the employment of the seller by the
Excess & Umbrella business unit or a change of control of Hallmark. If the
Put/Call Option is exercised, we will have the right or obligation to purchase
the remaining 20% membership interests in the Excess & Umbrella business
unit for an amount equal to nine times the average Pre-Tax Income (as
defined in the operating agreements) for the previous 12 fiscal
quarters. We estimate the ultimate redemption value of the Put/Call
Option to be $2.2 million at June 30, 2010.
Effective June 5, 2009, we acquired all
of the issued and outstanding shares of CYR Insurance Management Company
(“CYR”). CYR has as its primary asset a management agreement with
Hallmark County Mutual Insurance Company, (“HCM”), which provides for CYR to
have management and control of HCM. We acquired all of the issued and
outstanding shares of CYR for consideration of a base purchase price of $4.0
million paid at closing plus an override commission in an amount equal to 1% of
the net premiums and net policy fees of HCM for the years 2010 and 2011 subject
to a maximum of $1.25 million. The override commission is paid
monthly as the subject premiums and policy fees are written. The fair
value of the management agreement acquired is $3.2 million and is being
amortized over four years. HCM is used to front certain lines of
business in our Specialty Commercial and Personal Segments in Texas where we
previously produced policies for third party county mutual insurance companies
and reinsured 100% for a fronting fee.
4.
Fair Value
ASC
820 defines fair value, establishes a consistent framework for measuring fair
value and expands disclosure requirements about fair value measurements. ASC
820, among other things, requires us to maximize the use of observable inputs
and minimize the use of unobservable inputs when measuring fair value. In
addition, ASC 820 precludes the use of block discounts when measuring the fair
value of instruments traded in an active market, which were previously applied
to large holdings of publicly traded equity securities.
We
determine the fair value of our financial instruments based on the fair value
hierarchy established in ASC 820. In accordance with ASC 820, we
utilize the following fair value hierarchy:
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·
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Level
1: quoted prices in active markets for identical
assets;
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·
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Level
2: inputs to the valuation methodology include quoted prices for similar
assets and liabilities in active markets, inputs of identical assets for
less active markets, and inputs that are observable for the asset or
liability, either directly or indirectly, for substantially the full term
of the instrument; and
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·
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Level
3: inputs to the valuation methodology that are unobservable for the asset
or liability.
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This
hierarchy requires the use of observable market data when
available.
Under ASC
820, we determine fair value based on the price that would be received for an
asset or paid to transfer a liability in an orderly transaction between market
participants on the measurement date. It is our policy to maximize
the use of observable inputs and minimize the use of unobservable inputs when
developing fair value measurements, in accordance with the fair value hierarchy
described above. Fair value measurements for assets and liabilities
where there exists limited or no observable market data are calculated based
upon our pricing policy, the economic and competitive environment, the
characteristics of the asset or liability and other factors as
appropriate. These estimated fair values may not be realized upon
actual sale or immediate settlement of the asset or liability.
Where
quoted prices are available on active exchanges for identical instruments,
investment securities are classified within Level 1 of the valuation
hierarchy. Level 1 investment securities include common and preferred
stock.
Level 2
investment securities include corporate bonds, municipal bonds and U.S. Treasury
securities for which quoted prices are not available on active exchanges for
identical instruments. We use a third party pricing service to
determine fair values for each Level 2 investment security in all asset
classes. Since quoted prices in active markets for identical assets
are not available, these prices are determined by the pricing service using
observable market information such as quotes from less active markets and/or
quoted prices of securities with similar characteristics, among other things. We
have reviewed the processes used by the pricing service and have determined that
they result in fair values consistent with the requirements of ASC
820 for Level 2 investment securities.
In cases where there is limited
activity or less transparency around inputs to the valuation, investment
securities are classified within Level 3 of the valuation
hierarchy. Level 3 investments are valued based on the best available
data in order to approximate fair value. This data may be internally
developed and consider risk premiums that a market participant would
require. Investment securities classified within Level 3 include
other less liquid investment securities.
The
following table presents for each of the fair value hierarchy levels, our assets
that are measured at fair value on a recurring basis at June 30, 2010 (in
thousands):
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Quoted Prices in
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Other
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Active Markets for
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Observable
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Unobservable
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Identical Assets
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Inputs
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Inputs
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(Level 1)
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(Level 2)
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(Level 3)
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Total
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U.S.
Treasury securities and obligations of U.S. Government
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$
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-
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$
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6,540
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$
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-
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$
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6,540
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Corporate
debt securities
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-
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198,551
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-
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198,551
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Municipal
bonds
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-
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135,493
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23,500
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158,993
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Asset
backed
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-
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610
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-
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610
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Total
debt securities
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-
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341,194
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23,500
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364,694
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