On October 6, 2006, the shares of the company began trading under the ticker symbol "HALL" on NASDAQ. The company began operating as a publicly traded entity on September 19, 2005, with shares previously traded under the ticker symbol "HAF" on the American Stock Exchange. Formed in 1987, Hallmark Financial Services, headquartered in Fort Worth, Texas, initially operated a small chain of retail outlets specializing in providing financing for eyeglasses and contact lenses. The focus changed to insurance products following the 1990 acquisitions of American Hallmark Insurance Company (AHIC) and American Hallmark General Agency (AHGA). Today, the company has evolved into a holding company for a group of diversified property and casualty insurance subsidiaries that retain low-severity (low losses) and short-tailed risks (one year). The company's product structure focuses on marketing, distributing, underwriting, and servicing commercial and personal property and casualty insurance to underserved niche markets. The company provides commercial insurance in eight southern and western states (Texas, New Mexico, Idaho, Oregon, Montana, Louisiana, Oklahoma and Washington non-standard personal automobile insurance in five western states (Texas, New Mexico, Arizona, Oklahoma and Idaho) general aviation insurance in nearly every state (excluding Alaska, Massachusetts, and Washington D.C.) as well as providing other insurance related services. On December 21, 2006, Hallmark Financial Services restructured its four operating units into three operating segments: Personal Insurance segment (which consists solely of the Phoenix Operating Unit), the Standard Commercial segment (which consists solely of the HGA Operating Unit), and the Commercial Specialty Segment (which is a combination of the TGA Operating Unit and the Aerospace Operating Unit).
Hallmark General Agency (HGA)
The focus is on package policies (general liability, property, auto, multi-peril, umbrella, fire, and theft) for small to medium businesses (such as office mercantile, light manufacturing, and artisan contractors). This grouping typically has relatively stable loss results, with low severity and short-tailed liability.
The company focuses on the recruiting and the retaining of agents that closely match the company's culture. These agents are given a degree of non-contractual geographic exclusivity within which to operate. During 2006, 190 independent agents had a relationship with the company for nearly 17 years, each agent accounting for more than $1.0 million in premium production. The top 10 agents accounted for 38% of the premium production (no agent produced more than 8% of the premium production for HGA). Of the 109 independent agents distributing HGA products, most are located in non-urban markets in Texas, New Mexico, Oregon, Idaho, Montana, and Washington
Phoenix General Agency (PGA)
It provides liability coverage for drivers desiring the minimum automobile insurance mandated by state law. These policies are requested by individuals who typically do not conform to standard carrier underwriting guidelines, but not limited to driving record, age of driver, claims history, age of vehicle, or limited financial resources.
While this is a niche insurance line of business, non-standard personal automobile insurance is more of a commodity product than others in Hallmark's stable. National and larger regional players have benefited from back-office cost saves (i.e. centralized claims handling), advances in technology, and underwriting via multivariate modeling. The results are likely to create downward profitability pressures if somewhat irrational pricing were to seep into the market during the softer segments of the cycle.
However, given the potential for increased competition, we think the company would be proactive with respect to product evolution and taking advantage of market opportunities to stave off at least some of the potential market pressure, vis- -vis add-on products or services that match its insured's needs. For example, with most non-standard automobile insurance purchasers, the client is typically unable to pay the whole premium initially. PGA effectively offers a direct bill program ($3 9 per payment or installment).
This non-standard personal auto insurance is marketed and serviced by PGA through 1155 independent agents in Texas, New Mexico, Arizona, Arkansas, Oklahoma, Oregon, and Idaho, with three main premium producing states (Texas, Arizona, and New Mexico). The company underwrites both personal automobile liability and physical damage insurance to the tune of 78% and 22%, respectively, of total premium.
In December 2006, Hallmark's two operating segments (Texas General Agency and Aerospace Insurance Managers) were merged into one segment and renamed the Commercial Specialty Segment. During 2006, Texas General Agency accounted for approximately 80.7% of the aggregate premiums produced by the Commercial Specialty Segment, with the remaining 19.3% coming from Aerospace operating unit.
Commercial Specialty Segment
Texas General Agency (TGA)
Predominately provides mono-line commercial automobile, excess and surplus insurance for general liability and property, as well as, some non-standard auto and low value personal property products. Currently policies are being issued in Texas, Louisiana and Oklahoma. The major attributes for this low premium policy product stem from the defensive and profitability nature of this business line as the risks are short-tailed and low hazard by nature. If a risk fails to meet the underwriting criteria for a standard market risk, the coverage would be written under an excess and surplus policy. Justification for writing a risk under this type of policy could be limited if a business entity had a limited number of years of operation, a defined minimum premium sized, and or had an adverse loss history.
Nearly 93.0% of TGA's premiums come from commercial automobile and general liability coverage. Focus Commercial Automobile risk is for coverage of 10 or less vehicles used for business or light-to-medium service. Generally these vehicles are used for short-hauls of 200 miles or less (i.e. delivery services, artisans, cement mixers, and dump trucks). General liability coverage is for small business owners (i.e. apartments/retail dwellings, artisan contractors, convenience stores, restaurants, and sales and service entities). The remaining 7.5% of TGA's premiums comes from a group of risks (commercial property, dwelling fire, homeowners, and non-standard automobile coverage).
TGA distributes its products though 38 general agents, in addition to the 751 retail agents in Texas. For FY06, 77.9% of TGA's total premium production is attributable to general agents with the remainder coming from retail agents. During 2006, the top 10 general agents and top 10 retail agents produced 43.9% and 4.1% of the premiums, respectively. In addition, no single general agent or retail agent produced more than 9% or 1% of the total premiums, respectively.
Aerospace Insurance Managers (AIM)
Hall's AIM unit's is one of only a handful of operations in the U.S. that has developed a niche focus of providing aircraft liability, aircraft hull, and airport liability covering smaller aircrafts, nonstandard aircrafts (such as a Cherokee Six i.e. a six seat aircraft) older aircrafts, airports, non-standard pilots (retiring, new, or between crafts), and aviation-related business. AIM markets excess and surplus coverage through its affiliate Aerospace Special Risk Inc. and its claims management practice through Aerospace Claims Management Corp.
This unit's property-casualty insurance business is about a 60%-to-40% mix, respectively, short-tailed. AIM currently has 10 underwriters with 3-to-40 years of aviation experience, which include former pilots and air traffic controllers (i.e. a substantial intellectual property base upon which to draw). While the underwriters control the liability limits, about 99% of the business is restricted to $1.0 million per occurrence limit and $100,000 per person limits. About 80% of the covered aircraft are single engine (about half with engines of 200 horsepower or less), with $127,869 in average hull value coverage, and a modest $6,000 annual premium.
AIM distributes its products through 215 aviation specialty brokers (no binding authority). In FY06, the top 10 agencies produced 47% of AIM's premium production, the largest broker producing 15% of the volume, and others producing less than 6% of the volume.
Major Business Segments
Existing Business Segments
% 2006 Revenue
% 2006 Pre-tax income
POTENTIAL FOR GEOGRAPHIC EXPANSION
Even though the company markets its products through more than 2,100 brokers, independent agents, general agents, and retail agents, its primary footprint only extends to nine states five in the Southwest and four in the Northwest. Excluding AIM (which operates throughout the country, with the exception of Alaska, Massachusetts, and the District of Columbia) with over 210 agents, Hallmark has the ability to organically expand its existing footprint. For example, over 90% of TGA's business is based in Texas with the remainder contributed by Oklahoma and Louisiana. We would expect TGA products to be extended to existing agency relationships within other key states that Hallmark operates. Over the next year, we would expect TGA products to be sold first in the states of Arizona, New Mexico, and Oregon, and at some point there after added to remaining states were appropriate.
While we anticipate Hallmark will first look to organically leverage the franchise base, expansion into new states of operation should not be discounted. Logically we would anticipate the company to expand into contiguous markets. These new market states (Nevada, Utah, Wyoming, and Colorado) would link the existing franchise states beyond the current definition for the company as either Northwestern and Southwestern regional franchise but a Western insurance entity. Once Hallmark links the existing sections of the company, we would anticipate Eastern movement into similar contiguous markets at some million in Personal Segment during point in the future. Based on this initiative, sales of this segment increased by $2.8 million during 2Q07.
Over the years, first with the American Hallmark acquisitions and now most recently with TGA and AIM, Hallmark has proven itself as a capable acquirer. While we do not see any glaring product void currently, we do think management will be opportunistic in the coming years. However, we would not expect management to acquire just for the sake of expanding the product base. We would expect any new acquisition would need be additive to Hallmark's niche product franchise and be transferable across the geographic footprint.
As of December 31, 2006, the company had $268.9 million in invested assets and cash and cash equivalents (including $31.8 million in restricted cash and cash equivalent). With 97.2% of the portfolio in fixed-income securities and 2.8% of the portfolio in equity investments, Hallmark continues to internally manage the investment portfolio under a more conservative investment strategy. The fixed income securities portion continues to carry a rating of AA based on a weighed average basis, with about three-quarters of the portfolio being A rated and less than 10% BB or below. We would not anticipate any major changes to the current make-up of the portfolio at this time.
As of 3Q07, the company had no exposure in its investment portfolio to sub-prime mortgages and only $4,000 total exposure in mortgage backed securities.
The company raised $24.6 million in net proceeds from the recently completed 3.0 million-share secondary common stock offering. As a result, the company used the proceeds to pay down lines of credit, thereby adjusting to 19.9% the debt-to-total capital compared to 33.5% reported at 3Q06. Based on trends for production and improvements in the retention of net premiums over the next couple of years, we would expect the company to be a net generator of capital at some point during 2007. Thus, we do not anticipate the company needing to access the equity capital markets for several years. However, we would anticipate if any additional acquisitions were to materialize, that the company would look to access the debt markets based on its current leverage ratios. We expect that with cash and cash equivalents of about $41.8 million, the company has sufficient liquidity to meet its projected insurance obligations, operational expenses requirements for the next twelve months.
During June 2006, A.M. Best assigned a rating of "A-"to each of the company's insurance subsidiaries, enhancing the investment potential for investors of this company. The rating was affirmed in May 2007.