Unassociated Document
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

Quarterly report pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934

For the quarterly period ended September 30, 2008

Commission file number 001-11252
 
Hallmark Financial Services, Inc.
(Exact name of registrant as specified in its charter)

Nevada
 
87-0447375
(State or other jurisdiction of
 
(I.R.S. Employer
Incorporation or organization)
 
Identification No.)
 
777 Main Street, Suite 1000, Fort Worth, Texas
 
76102
(Address of principal executive offices)
 
(Zip Code)
 
Registrant's telephone number, including area code: (817) 348-1600
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 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 x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Accelerated filer ¨
Non-accelerated filer ¨
Smaller reporting company x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x 

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: Common Stock, par value $.18 per share - 20,808,954 shares outstanding as of November 12, 2008.



PART I
FINANCIAL INFORMATION

Item 1. Financial Statements

INDEX TO FINANCIAL STATEMENTS
   
Page Number
     
Consolidated Balance Sheets at September 30, 2008 (unaudited) and December 31, 2007
 
3
     
Consolidated Statements of Operations (unaudited) for the three months and nine months ended September 30, 2008 and September 30, 2007
 
4
     
Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss) (unaudited) for the three months and nine months ended September 30, 2008 and September 30, 2007
 
5
     
Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2008 and September 30, 2007
 
6
     
Notes to Consolidated Financial Statements (unaudited)
 
7
 
2

 
Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Balance Sheets
($ in thousands)

   
September 30
 
December 31
 
   
2008
 
2007
 
   
(unaudited)
     
ASSETS
             
               
Investments:
             
Debt securities, available-for-sale, at fair value
 
$
180,954
 
$
248,069
 
Equity securities, available-for-sale, at fair value
   
41,568
   
15,166
 
Short-term investments, available-for-sale, at fair value
   
112,965
   
2,625
 
               
Total investments
   
335,487
   
265,860
 
               
Cash and cash equivalents
   
24,191
   
145,884
 
Restricted cash and cash equivalents
   
8,963
   
16,043
 
Premiums receivable
   
47,052
   
46,026
 
Accounts receivable
   
5,243
   
5,219
 
Receivable for securities
   
-
   
27,395
 
Prepaid reinsurance premiums
   
2,636
   
942
 
Reinsurance recoverable
   
11,525
   
4,952
 
Deferred policy acquisition costs
   
20,149
   
19,757
 
Excess of cost over fair value of net assets acquired
   
37,738
   
30,025
 
Intangible assets
   
29,683
   
23,781
 
Current federal income tax recoverable
   
1,586
   
-
 
Deferred federal income taxes
   
4,371
   
275
 
Prepaid expenses
   
941
   
1,240
 
Other assets
   
20,115
   
19,583
 
               
Total assets
 
$
549,680
 
$
606,982
 
               
LIABILITIES AND STOCKHOLDERS' EQUITY
             
Liabilities:
             
Notes payable
 
$
61,760
 
$
60,814
 
Structured settlements
   
-
   
10,000
 
Reserves for unpaid losses and loss adjustment expenses
   
155,288
   
125,338
 
Unearned premiums
   
105,293
   
102,998
 
Unearned revenue
   
2,126
   
2,949
 
Accrued agent profit sharing
   
1,935
   
2,844
 
Accrued ceding commission payable
   
12,193
   
12,099
 
Pension liability
   
1,017
   
1,669
 
Current federal income tax
   
-
   
864
 
Payable for securities
   
5,504
   
91,401
 
Accounts payable and other accrued expenses
   
14,439
   
16,385
 
               
Total liabilities
   
359,555
   
427,361
 
               
Commitments and Contingencies (Note 17)
             
               
Redeemable minority interest
   
619
   
-
 
               
Stockholders' equity:
             
Common stock, $.18 par value (authorized 33,333,333 shares in 2008 and 2007; issued 20,816,782 in 2008 and 20,776,080 shares in 2007)
   
3,747
   
3,740
 
Capital in excess of par value
   
119,649
   
118,459
 
Retained earnings
   
74,649
   
59,343
 
Accumulated other comprehensive loss
   
(8,462
)
 
(1,844
)
Treasury stock, at cost (7,828 shares in 2008 and 2007)
   
(77
)
 
(77
)
               
Total stockholders' equity
   
189,506
   
179,621
 
               
   
$
549,680
 
$
606,982
 

The accompanying notes are an integral part
of the consolidated financial statements

3


Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Statements of Operations
(Unaudited)
($ in thousands, except per share amounts)

   
Three Months Ended
 
Nine Months Ended
 
 
 
September 30
 
September 30
 
 
 
2008
 
2007
 
2008
 
2007
 
                   
Gross premiums written
 
$
59,005
 
$
62,304
 
$
186,357
 
$
193,539
 
Ceded premiums written
   
(2,493
)
 
(441
)
 
(6,503
)
 
(8,609
)
Net premiums written
   
56,512
   
61,863
   
179,854
   
184,930
 
Change in unearned premiums
   
2,416
   
(2,100
)
 
(1,918
)
 
(18,209
)
Net premiums earned
   
58,928
   
59,763
   
177,936
   
166,721
 
                           
Investment income, net of expenses
   
4,100
   
3,774
   
11,682
   
9,811
 
Net realized gains (impairments and realized losses)
   
(2,496
)
 
418
   
(1,405
)
 
1,299
 
Finance charges
   
1,307
   
1,206
   
3,894
   
3,477
 
Commission and fees
   
3,127
   
7,280
   
16,280
   
23,344
 
Processing and service fees
   
20
   
111
   
98
   
586
 
Other income
   
3
   
4
   
9
   
12
 
                           
Total revenues
   
64,989
   
72,556
   
208,494
   
205,250
 
                           
Losses and loss adjustment expenses
   
38,981
   
36,723
   
110,514
   
99,620
 
Other operating expenses
   
24,041
   
24,087
   
71,114
   
70,511
 
Interest expense
   
1,186
   
1,026
   
3,557
   
2,608
 
Amortization of intangible assets
   
620
   
573
   
1,766
   
1,719
 
                           
Total expenses
   
64,828
   
62,409
   
186,951
   
174,458
 
                           
Income before tax and minority interest
   
161
   
10,147
   
21,543
   
30,792
 
Income tax expense (benefit)
   
(485
)
 
3,345
   
6,222
   
10,205
 
Income before minority interest
   
646
   
6,802
   
15,321
   
20,587
 
Minority interest
   
15
   
-
   
15
   
-
 
                           
                           
Net income
 
$
631
 
$
6,802
 
$
15,306
 
$
20,587
 
                           
Common stockholders net income per share:
                         
Basic
 
$
0.03
 
$
0.33
 
$
0.74
 
$
0.99
 
Diluted
 
$
0.03
 
$
0.33
 
$
0.73
 
$
0.99
 

The accompanying notes are an integral part
of the consolidated financial statements

4


Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Statement of Stockholders' Equity and Comprehensive Income (Loss)
(Unaudited)
($ in thousands)
 
   
Three Months Ended
 
Nine Months Ended
 
   
September 30,
 
September 30,
 
   
2008
 
2007
 
2008
 
2007
 
                   
Common Stock
                         
Balance, beginning of period
 
$
3,747
 
$
3,740
 
$
3,740
 
$
3,740
 
Issuance of common stock upon option exercises
   
-
   
-
   
7
   
-
 
Balance, end of period
   
3,747
   
3,740
   
3,747
   
3,740
 
                           
Additional Paid-In Capital
                         
Balance, beginning of period
   
119,369
   
118,085
   
118,459
   
117,932
 
Accretion of redeemable minority interest to redemption value
   
(25
)
 
-
   
(25
)
 
-
 
Equity based compenstion
   
305
   
198
   
1,078
   
351
 
Exercise of stock options
   
-
   
-
   
137
   
-
 
                           
Balance, end of period
   
119,649
   
118,283
   
119,649
   
118,283
 
                           
Retained Earnings
                         
Balance, beginning of period
   
74,018
   
45,265
   
59,343
   
31,480
 
Net income
   
631
   
6,802
   
15,306
   
20,587
 
                           
Balance, end of period
   
74,649
   
52,067
   
74,649
   
52,067
 
                           
Accumulated Other Comprehensive Loss
                         
Balance, beginning of period
   
(4,756
)
 
(2,746
)
 
(1,844
)
 
(2,344
)
Additional minimun pension liability, net of tax
   
10
   
33
   
31
   
97
 
Unrealized gains (losses) on securities, net of tax
   
(3,716
)
 
1,006
   
(6,649
)
 
540
 
Balance, end of period
   
(8,462
)
 
(1,707
)
 
(8,462
)
 
(1,707
)
                           
Treasury Stock
                         
Balance, beginning of period
   
(77
)
 
(77
)
 
(77
)
 
(77
)
Acquisition of treasury shares
   
-
   
-
   
-
   
-
 
                           
Balance, end of period
   
(77
)
 
(77
)
 
(77
)
 
(77
)
                       
Stockholders' Equity
 
$
189,506
 
$
172,306
 
$
189,506
 
$
172,306
 
                           
Net income
 
$
631
 
$
6,802
 
$
15,306
 
$
20,587
 
Additional minimum pension liablilty, net of tax
   
10
   
33
   
31
   
97
 
Unrealized gains (losses) on securities, net of tax
   
(3,716
)
 
1,006
   
(6,649
)
 
540
 
Comprehensive Income (Loss)
 
$
(3,075
)
$
7,841
 
$
8,688
 
$
21,224
 

The accompanying notes are an integral part
of the consolidated financial statements

5


Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Statement of Cash Flows
(Unaudited)
($ in thousands)
 
   
Nine Months Ended
 
   
September 30
 
   
2008
 
2007
 
Cash flows from operating activities:
             
Net income
 
$
15,306
 
$
20,587
 
               
Adjustments to reconcile net income to cash provided by operating activites:
             
Depreciation and amortization expense
   
2,311
   
2,344
 
Minority interest
   
15
   
-
 
Amortization of discount on structured settlement
   
-
   
310
 
Deferred federal income tax benefit
   
(1,849
)
 
(1,170
)
Realized (gain) loss on investments and impairment losses
   
1,405
   
(1,299
)
Change in prepaid reinsurance premiums
   
(1,694
)
 
137
 
Change in prepaid commissions
   
-
   
487
 
Change in premiums receivable
   
(1,026
)
 
(8,492
)
Change in accounts receivable
   
(24
)
 
1,604
 
Change in deferred policy acquisition costs
   
(392
)
 
(3,631
)
Change in unpaid losses and loss adjustment expenses
   
29,950
   
38,572
 
Change in unearned premiums
   
2,295
   
16,759
 
Change in unearned revenue
   
(823
)
 
(2,378
)
Change in accrued agent profit sharing
   
(909
)
 
206
 
Change in reinsurance recoverable
   
(6,573
)
 
149
 
Change in reinsurance payable
   
-
   
(1,060
)
Change in current federal income tax payable
   
(2,451
)
 
(1,678
)
Change in accrued ceding commission payable
   
94
   
3,096
 
Change in all other liabilities
   
(2,599
)
 
3,059
 
Change in all other assets
   
4,122
   
(5,835
)
               
Net cash provided by operating activities
   
37,158
   
61,767
 
               
Cash flows from investing activities:
             
Purchases of property and equipment
   
(477
)
 
(367
)
Acquisition of subsidiaries, net of cash acquired
   
(14,799
)
 
-
 
Change in restricted cash
   
7,080
   
12,244
 
Purchases of debt and equity securities
   
(258,465
)
 
(187,256
)
Maturities and redemptions of investment securities
   
227,061
   
115,288
 
Net purchases of short-term investments
   
(110,340
)
 
(30,713
)
               
Net cash (used in) investing activities
   
(149,940
)
 
(90,804
)
               
Cash flows from financing activities:
             
Proceeds from exercise of employee stock options
   
143
   
-
 
Net borrowings (repayment) of notes payable
   
946
   
(856
)
Payment of structured settlement
   
(10,000
)
 
(15,000
)
Proceeds from issuance of trust preferred securities
   
-
   
25,774
 
Debt issuance costs
   
-
   
(674
)
               
Net cash (used in) provided by financing activities
   
(8,911
)
 
9,244
 
               
Decrease in cash and cash equivalents
   
(121,693
)
 
(19,793
)
Cash and cash equivalents at beginning of period
   
145,884
   
81,474
 
Cash and cash equivalents at end of period
 
$
24,191
 
$
61,681
 
               
Supplemental Cash Flow Information:
             
               
Interest paid
 
$
3,576
 
$
2,184
 
Taxes paid
 
$
10,521
 
$
13,053
 
               
Supplemental schedule of non-cash investing activities:
             
               
Change in receivable for securities related to investment disposals that settled after the balance sheet date
 
$
27,395
 
$
(14
)
               
Change in payable for securities related to investment purchases that settled after the balance sheet date
 
$
(85,897
)
$
8,878
 

The accompanying notes are an integral part
of the consolidated financial statements

6

 
Hallmark Financial Services, Inc. and Subsidiaries
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 which, through its subsidiaries, engages in the sale of property/casualty insurance products to businesses and individuals. Our business involves marketing, distributing, underwriting and servicing commercial insurance, non-standard automobile insurance and general aviation insurance, as well as providing other insurance related services. Our business is geographically concentrated in the south central and northwest regions of the United States, except for our general aviation business which is written on a national basis.

We pursue our business activities through subsidiaries whose operations are organized into five operating units which are supported by our three insurance company subsidiaries. Our HGA Operating Unit handles standard lines commercial insurance products and services and is comprised of American Hallmark Insurance Services, Inc. and Effective Claims Management, Inc. Our TGA Operating Unit handles primarily excess and surplus lines commercial insurance products and services and is comprised of TGA Insurance Managers, Inc., Pan American Acceptance Corporation (“PAAC”) and TGA Special Risk, Inc. Our Aerospace Operating Unit handles general aviation insurance products and services and is comprised of Aerospace Insurance Managers, Inc., Aerospace Special Risk, Inc. and Aerospace Claims Management Group, Inc. Our Heath XS Operating Unit handles excess commercial automobile and commercial umbrella risks on both an admitted and non-admitted basis and is comprised of Heath XS, LLC and Hardscrabble Data Solutions, LLC (collectively, “Heath Group”). Our Phoenix Operating Unit handles non-standard personal automobile insurance products and services and is comprised solely of American Hallmark General Agency, Inc. (which does business as Hallmark Insurance Company).

These five operating units are segregated into three reportable industry segments for financial accounting purposes. The Standard Commercial Segment presently consists solely of the HGA Operating Unit and the Personal Segment presently consists solely of our Phoenix Operating Unit. The Specialty Commercial Segment includes our TGA Operating Unit, Aerospace Operating Unit, and Heath XS Operating Unit.

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 financial statements should be read in conjunction with our audited financial statements for the year ended December 31, 2007 included in our Annual Report on Form 10-K filed with the SEC.

The interim financial data as of September 30, 2008 and 2007 is unaudited. However, in the opinion of management, the interim data includes all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the results for the interim periods. The results of operations for the period ended September 30, 2008 are not necessarily indicative of the operating results to be expected for the full year.

7


Redeemable minority interest

We are accreting the redeemable minority 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 minority 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.

Immaterial Correction of an Error

We maintain catastrophe reinsurance for business produced by both our HGA and TGA Operating Units. Prior to July 1, 2007, the premium for our catastrophe reinsurance was based on all business produced by both operating units. Effective July 1, 2007, the premium for our catastrophe reinsurance is based only on business produced in Texas. However, in error we continued to record ceded premium for this coverage based on all business produced by the HGA and TGA Operating Units. This understated our earned premium for each quarter since July 1, 2007 through June 30, 2008.

We are correcting our prior period’s financial statements and notes to reflect the reduction of ceded premium. Because the error was not material to any prior year financial statements, the corrections to prior periods will be presented in future filings, pursuant to SEC Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” Financial statements for the year ended December 31, 2007 will be revised in the December 31, 2008 Annual Report on Form 10-K.

The following table presents the effect of the correction on our previously reported consolidated statements of operations for the three months ended September 30, 2007, December 31, 2007, March 31, 2008 and June 30, 2008.
 
8

 
   
For the Three Months Ended
 
   
September 30,
 
December 31,
 
March 31,
 
June 30,
 
   
2007
 
2007
 
2008
 
2008
 
As previously reported:
                         
Ceded premiums written
 
$
(779
)
$
(2,382
)
$
(2,332
)
$
(2,327
)
Net premiums written
   
61,525
   
53,551
   
61,905
   
60,788
 
Net premiums earned
   
59,425
   
58,920
   
58,916
   
59,443
 
Total revenues
   
72,218
   
69,586
   
71,193
   
71,663
 
                           
Income before tax
   
9,809
   
10,647
   
10,466
   
10,267
 
Income tax expense
   
3,227
   
3,585
   
3,414
   
3,066
 
Net income
 
$
6,582
 
$
7,062
 
$
7,052
 
$
7,201
 
                           
Common stockholders net income per share:
                         
Basic
 
$
0.32
 
$
0.34
 
$
0.34
 
$
0.35
 
Diluted
 
$
0.32
 
$
0.34
 
$
0.34
 
$
0.34
 
                           
Adjustments:
                         
Ceded premiums written
 
$
338
 
$
330
 
$
328
 
$
321
 
Income tax expense
   
118
   
116
   
115
   
112
 
Net income impact
 
$
220
 
$
214
 
$
213
 
$
209
 
                           
As revised:
                         
Ceded premiums written
 
$
(441
)
$
(2,052
)
$
(2,004
)
$
(2,006
)
Net premiums written
   
61,863
   
53,881
   
62,233
   
61,109
 
Net premiums earned
   
59,763
   
59,250
   
59,244
   
59,764
 
Total revenues
   
72,556
   
69,916
   
71,521
   
71,984
 
                           
Income before tax
   
10,147
   
10,977
   
10,794
   
10,588
 
Income tax expense
   
3,345
   
3,701
   
3,529
   
3,178
 
Net income
 
$
6,802
 
$
7,276
 
$
7,265
 
$
7,410
 
                           
Common stockholders net income per share:
                         
Basic
 
$
0.33
 
$
0.35
 
$
0.35
 
$
0.36
 
Diluted
 
$
0.33
 
$
0.35
 
$
0.35
 
$
0.35
 
 
The following table presents the effect of the correction on our previously reported consolidated statements of operations for the nine months ended September 30, 2007, the year ended December 31, 2007, and the six months ended June 30, 2008.

9


   
For the Nine
 
For the Year
 
For the Six
 
   
Months Ended
 
Ended
 
Months Ended
 
   
September 30,
 
December 31,
 
June 30,
 
   
2007
 
2007
 
2008
 
As previously reported:
                   
Ceded premiums written
 
$
(8,947
)
$
(11,329
)
$
(4,659
)
Net premiums written
   
184,592
   
238,143
   
122,693
 
Net premiums earned
   
166,383
   
225,303
   
118,359
 
Total revenues
   
204,912
   
274,498
   
142,856
 
                     
Income before tax
   
30,454
   
41,101
   
20,733
 
Income tax expense
   
10,087
   
13,672
   
6,480
 
Net income
 
$
20,367
 
$
27,429
 
$
14,253
 
                     
Common stockholders net income per share:
                   
Basic
 
$
0.98
 
$
1.32
 
$
0.69
 
Diluted
 
$
0.98
 
$
1.32
 
$
0.68
 
                     
Adjustments:
                   
Ceded premiums written
 
$
338
 
$
668
 
$
649
 
Income tax expense
   
118
   
234
   
227
 
Net income impact
 
$
220
 
$
434
 
$
422
 
                     
As revised:
                   
Ceded premiums written
 
$
(8,609
)
$
(10,661
)
$
(4,010
)
Net premiums written
   
184,930
   
238,811
   
123,342
 
Net premiums earned
   
166,721
   
225,971
   
119,008
 
Total revenues
   
205,250
   
275,166
   
143,505
 
                     
Income before tax
   
30,792
   
41,769
   
21,382
 
Income tax expense
   
10,205
   
13,906
   
6,707
 
Net income
 
$
20,587
 
$
27,863
 
$
14,675
 
                     
Common stockholders net income per share:
                   
Basic
 
$
0.99
 
$
1.34
 
$
0.71
 
Diluted
 
$
0.99
 
$
1.34
 
$
0.70
 

The following table presents the effect of the correction on our previously reported consolidated balance sheet as of December 31, 2007.

   
As previously
         
   
reported
 
Adjustment
 
As revised
 
Balances as of December 31, 2007
                   
Prepaid reinsurance premiums
 
$
274
 
$
668
 
$
942
 
Total assets
   
606,314
   
668
   
606,982
 
Current federal income tax payable
   
630
   
234
   
864
 
Total liabilities
   
427,127
   
234
   
427,361
 
Retained earnings
   
58,909
   
434
   
59,343
 
Total stockholders' equity
   
179,187
   
434
   
179,621
 
 
10


The following table presents the effect of the correction on our previously reported consolidated statements of cash flows for the nine months ended September 30, 2007, the year ended December 31, 2007, the three months ended March 31, 2008, and the six months ended June 30, 2008.

   
For the Nine
 
For the Year
 
For the Three
 
For the Six
 
   
Months Ended
 
Ended
 
Months Ended
 
Months Ended
 
   
September 30,
 
December 31,
 
March 31, 
 
June 30,
 
   
2007
 
2007
 
2008
 
2008
 
As previously reported:
                         
Net income
 
$
20,367
 
$
27,429
 
$
7,052
 
$
14,253
 
Change in prepaid reinsurance premiums
   
475
   
1,355
   
(1,923
)
 
(408
)
Change in current federal income tax payable
   
(1,796
)
 
(1,502
)
 
2,788
   
(1,354
)
Net cash provided by operating activities
   
61,767
   
80,337
   
12,388
   
29,749
 
                           
Adjustments:
                         
Net income
 
$
220
 
$
434
 
$
213
 
$
422
 
Change in prepaid reinsurance premiums
   
(338
)
 
(668
)
 
(328
)
 
(649
)
Change in current federal income tax payable
   
118
   
234
   
115
   
227
 
Net cash provided by operating activities
   
-
   
-
   
-
   
-
 
                           
As revised:
                         
Net income
 
$
20,587
 
$
27,863
 
$
7,265
 
$
14,675
 
Change in prepaid reinsurance premiums
   
137
   
687
   
(2,251
)
 
(1,057
)
Change in current federal income tax payable
   
(1,678
)
 
(1,268
)
 
2,903
   
(1,127
)
Net cash provided by operating activities
   
61,767
   
80,337
   
12,388
   
29,749
 


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 financial statements, as well as our reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates.

Recently Issued Accounting Standards

In September 2005, the American Institute of Certified Public Accountants issued Statement of Position 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts” (“SOP 05-01”). This Statement provides guidance on accounting for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in Statement of Financial Accounting Standards No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments,” previously issued by the Financial Accounting Standards Board (“FASB”). SOP 05-01 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006. The adoption of SOP 05-01 had no material impact on our financial condition or results of operations.

11


In June 2006, FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109” (“FIN 48”), was issued. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with FASB Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes”. FIN 48 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, as well as providing guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006 with earlier application permitted as long as the company has not yet issued financial statements, including interim financial statements, in the period of adoption. We adopted the provisions of FIN 48 on January 1, 2007. Since we had no unrecognized tax benefits, we recognized no additional liability or reduction in deferred tax asset as a result of the adoption of FIN 48. We are no longer subject to U. S. federal, state, local or non-U.S. income tax examinations by tax authorities for years prior to 2003.

In September 2006, FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 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, SFAS 157 incorporates and clarifies the guidance in FASB Concepts Statement 7 regarding the use of present value techniques in measuring fair value. SFAS 157 does not require any new fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The adoption of SFAS 157 had no impact on our financial statements or results of operations but did require additional disclosures. (See Note 5, “Fair Value”).

In February 2007, FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Liabilities” (“SFAS 159”). SFAS 159 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. SFAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The adoption of SFAS 159 had no impact on our financial statements or results of operations as we did not elect to apply SFAS 159 to any eligible items.
 
In December 2007, the FASB issued Revised Statement of Financial Accounting Standards No. 141R, “Business Combinations” (“SFAS 141R”), a replacement of Statement of Financial Accounting Standards No. 141, “Business Combinations”. SFAS 141R 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 acquiree. In addition, it provides revised guidance on the recognition and measurement of goodwill acquired in the business combination. SFAS 141R 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. SFAS 141R applies to business combinations for acquisitions occurring on or after January 1, 2009. We do not expect the provisions of SFAS 141R to have a material effect on our results of operations or liquidity. However, SFAS 141R 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” (“SFAS 160”). SFAS 160 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. SFAS 160 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. We are currently assessing the impact of SFAS 160 on our consolidated financial statements.

12


3. Business Combinations

We account 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 amounts assigned to assets acquired and liabilities assumed is an asset referred to as “Excess of cost over fair value of net assets acquired.” Indirect and general expenses related to business combinations are expensed as incurred.

On August 29, 2008, we acquired 80% of the issued and outstanding membership interests in Heath Group for cash consideration of $15 million plus fair value of a put option of $539 thousand included as redeemable minority interest. (See Note 1, “General - Redeemable Minority Interest.”) We have the right to purchase the remaining 20% membership interests in Heath Group and have granted to an affiliate of the seller the right to require us to purchase such remaining interests (the “Put/Call Option”). The Put/Call Option becomes exercisable by either party upon the earlier of August 29, 2012, the termination of the employment of the seller by the Heath Group or a change in control of Hallmark. The Put/Call option expires on August 29, 2018. If the Put/Call Option is exercised, we will have the right or obligation to purchase the remaining membership interests in the Heath Group for an amount equal to 20% of nine times the average pre-tax income for the previous 12 fiscal quarters. We estimate the ultimate redemption value of the Put/Call option to be $4.8 million at September 30, 2008.

The fair value of the amortizable intangible assets acquired and respective amortization periods are as follows ($ in thousands):

Tradename
 
$
757
   
15 years
 
Non-compete agreement
 
$
526
   
6 years
 
Agency relationships
 
$
6,385
   
15 years
 

The Heath Group is an underwriting organization that produces lower hazard, middle market, excess commercial automobile and commercial umbrella insurance policies on both an admitted and non-admitted basis through a network of independent wholesale agencies throughout the United States.

4. Supplemental Cash Flow Information

Effective August 29, 2008, we acquired the Heath Group. (See Note 3, “Business Combinations.”) In conjunction with the acquisition, cash and cash equivalents were used in the acquisitions as follows (in thousands):

13


Fair value of tangible assets excluding cash and cash equivalents
 
$
(3
)
Fair value of intangible assets acquired
   
15,381
 
Redeemable minority interest assumed
   
(579
)
Cash and cash equivalents used in acquisitions,
       
net of $201 thousand cash and cash equivalents acquired
 
$
14,799
 

The purchase price was preliminarily allocated to the assets acquired and the liabilities assumed based on their estimated fair values at the purchase date as summarized above. The final allocation of the purchase price will be finalized in the fourth quarter of 2008 upon completing certain Heath Group tax filings impacting the tax basis of assets and liabilities acquired.

5. Fair Value

         SFAS 157 defines fair value, establishes a consistent framework for measuring fair value and expands disclosure requirements about fair value measurements. SFAS 157, 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, SFAS 157 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. It also requires recognition of trade-date gains related to certain derivative transactions whose fair value has been determined using unobservable market inputs. This guidance supersedes the guidance in Emerging Issues Task Force Issue No. 02-3, ”Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities”, which prohibited the recognition of trade-date gains for such derivative transactions when determining the fair value of instruments not traded in an active market.

Effective January 1, 2008, we determine the fair value of our financial instruments based on the fair value hierarchy established in SFAS 157. In accordance with SFAS 157, we utilize the following fair value hierarchy:
 
 
·
Level 1: quoted prices in active markets for identical assets;

 
·
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

 
·
Level 3: inputs to the valuation methodology that are unobservable for the asset or liability.

This hierarchy requires the use of observable market data when available.

Under SFAS 157, 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.

14


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. If quoted prices are not available from active exchanges for identical instruments, then fair values are estimated using quoted prices from less active markets, quoted prices of securities with similar characteristics or by pricing models utilizing other significant observable inputs. Examples of such instruments, which would generally be classified within Level 2 of the valuation hierarchy, include corporate bonds, municipal bonds and U.S. Treasury 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 September 30, 2008 (in thousands).
 
   
Quoted Prices in
 
Other
         
   
Active Markets for
 
Observable
 
Unobservable
     
   
Identical Assets
 
Inputs
 
Inputs
     
   
(Level 1)
 
(Level 2)
 
(Level 3)
 
Total
 
                   
Debt securities
 
$
-
 
$
180,954
 
$
-
 
$
180,954
 
Equity securities
   
41,568
   
-
   
-
   
41,568
 
Short-term investments
   
335
   
112,630
   
-
   
112,965
 
Total
 
$
41,903
 
$
293,584
 
$
-
 
$
335,487
 
 
The following table summarizes the changes in fair value for all financial assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the nine months ended September 30, 2008 (in thousands).

Beginning balance as of January 1, 2008
 
$
4,000
 
         
Purchases, issuances, sales and settlements
   
(4,000
)
Total realized/unrealized gains/(losses) included in net income
   
-
 
Net gains/(losses) included on other comprehensive income
   
-
 
Transfers in and/or out of Level 3
   
-
 
         
Ending balance as of September 30, 2008
 
$
-
 
 
15


6. Investments

We complete a detailed analysis each quarter to assess whether any decline in the fair value of any investment below cost is deemed other-than-temporary. All securities with an unrealized loss are reviewed. Unless other factors cause us to reach a contrary conclusion, investments with a fair market value significantly less than cost for more than 180 days are deemed to have a decline in value that is other-than-temporary. A decline in value that is considered to be other-than-temporary is charged to earnings based on the fair value of the security at the time of assessment, resulting in a new cost basis for the security. For the three and nine months ended September 30, 2008, we recognized approximately $3.2 million and $3.7 million of other than temporary impairments on investments.
 
The following schedules summarize the gross unrealized losses showing the length of time that investments have been continuously in an unrealized loss position as of September 30, 2008 and December 31, 2007:

   
As of September 30, 2008
 
   
Less than 12 months
 
12 months or longer
 
Total
 
       
Unrealized
     
Unrealized
     
Unrealized
 
   
Fair Value
 
Losses
 
Fair Value
 
Losses
 
Fair Value
 
Losses
 
                           
Corporate debt securities
 
$
25,169
 
$
(1,063
)
$
16,860
 
$
(2,778
)
$
42,029
 
$
(3,841
)
Municipal bonds
   
79,655
   
(3,216
)
 
7,488
   
(232
)
 
87,143
   
(3,448
)
Equity securities
   
29,181
   
(3,976
)
 
-
   
-
   
29,181
   
(3,976
)
Short term securities
   
354
   
-
   
-
   
-
   
354
   
-
 
Total
 
$
134,359
 
$
(8,255
)
$
24,348
 
$
(3,010
)
$
158,707
 
$
(11,265
)

   
As of December 31, 2007
 
   
Less than 12 months
 
12 months or longer
 
Total
 
       
Unrealized
     
Unrealized
     
Unrealized
 
   
Fair Value
 
Losses
 
Fair Value
 
Losses
 
Fair Value
 
Losses
 
                           
Corporate debt securities
 
$
19,021
 
$
(840
)
$
18,329
 
$
(896
)
$
37,350
 
$
(1,736
)
Municipal bonds
   
24,392
   
(122
)
 
7,780
   
(130
)
 
32,172
   
(252
)
Equity securities
   
6,954
   
(318
)
 
-
   
-
   
6,954
   
(318
)
Short term securities
   
352
   
(1
)
 
-
   
-
   
352
   
(1
)
Total
 
$
50,719
 
$
(1,281
)
$
26,109
 
$
(1,026
)
$
76,828
 
$
(2,307
)

Of the gross unrealized loss at September 30, 2008, $3.0 million is more than twelve months old, consisting of 17 bond positions. Of the gross unrealized loss at December 31, 2007, $1.0 million is more than twelve months old, consisting of 22 bond positions. We consider these losses as a temporary decline in value as they are predominately on bonds where we believe we have the ability to hold our positions until maturity and the debt issuers have the ability to make all contractual payments. We see no other indications that the decline in values of these securities is other than temporary.
 
Based on evidence gathered through our normal credit surveillance process, we presently expect that all debt securities held in our investment portfolio will be paid in accordance with their contractual terms. Nonetheless, it is at least reasonably possible that the performance of certain issuers of these debt securities will be worse than currently expected resulting in additional future write-downs within our portfolio of debt securities.
 
Also, as a result of the challenging market conditions, including expected further weakening in the economic environment subsequent to September 30, 2008, we have experienced continued volatility in the valuation of our equity securities including increases in our unrealized investment losses. We expect the volatility in the valuation of our equity securities to continue in the foreseable future. This volatility may lead to additional impairments on our equity securities portfolio or changes regarding retention strategies for certain equity securities.
16

 
7. Pledged Investments

We have certain of our securities pledged for the benefit of various state insurance departments and reinsurers. These securities are included with our available-for-sale debt securities because we have the ability to trade these securities. We retain the interest earned on these securities. These securities had a carrying value of $13.9 million at September 30, 2008 and a carrying value of $18.5 million at December 31, 2007.

8. Share-Based Payment Arrangements

Our 2005 Long Term Incentive Plan (“2005 LTIP”) is a stock compensation plan for key employees and non-employee directors that was approved by the shareholders on May 26, 2005. There are 1,500,000 shares authorized for issuance under the 2005 LTIP. Our 1994 Key Employee Long Term Incentive Plan (the “1994 Employee Plan”) and 1994 Non-Employee Director Stock Option Plan (the “1994 Director Plan”) both expired in 2004 but have unexercised options outstanding.

As of September 30, 2008, there were incentive stock options to purchase 927,499 shares of our common stock outstanding and non-qualified stock options to purchase 60,000 shares of our common stock outstanding under the 2005 LTIP, leaving 512,501 shares reserved for future issuance. As of September 30, 2008, there were incentive stock options to purchase 52,299 shares outstanding under the 1994 Employee Plan and non-qualified stock options to purchase 20,834 shares outstanding under the 1994 Director Plan. In addition, as of September 30, 2008, there were outstanding non-qualified stock options to purchase 16,666 shares of our common stock granted to certain non-employee directors outside the 1994 Director Plan in lieu of fees for service on our board of directors in 1999. The exercise price of all such outstanding stock options is equal to the fair market value of our common stock on the date of grant.

Options granted under the 1994 Employee Plan prior to October 31, 2003, vest 40% six months from the date of grant and an additional 20% on each of the first three anniversary dates of the grant and terminate ten years from the date of grant. Incentive stock options granted under the 2005 LTIP and the 1994 Employee Plan after October 31, 2003, vest 10%, 20%, 30% and 40% on the first, second, third and fourth anniversary dates of the grant, respectively, and terminate five to ten years from the date of grant. Non-qualified stock options granted under the 2005 LTIP vest 100% six months after the date of grant and terminate ten years from the date of grant. All non-qualified stock options granted under the 1994 Director Plan vested 40% six months from the date of grant and an additional 10% on each of the first six anniversary dates of the grant and terminate ten years from the date of grant. The options granted to non-employee directors outside the 1994 Director Plan fully vested six months after the date of grant and terminate ten years from the date of grant.

During the first quarter of 2008, we determined our previous recognition of compensation expense on share based arrangements did not conform to GAAP. As a result, we corrected our calculation to properly record compensation expense on a straight line basis over the requisite service period for the entire award in accordance with SFAS No. 123R “Share-Based Payment”. The cumulative impact of this correction was recorded during the first quarter of 2008 resulting in additional compensation expense of approximately $354 thousand which is not considered to have a material impact on our financial position or results of operations.

17


A summary of the status of our stock options as of September 30, 2008 and changes during the nine-months then ended is presented below:

       
Average
 
Contractual
 
Intrinsic
 
   
Number of
 
Exercise
 
Term
 
Value
 
   
Shares
 
Price
 
(Years)
 
($000)
 
                   
Outstanding at January 1, 2008
   
848,000
 
$
10.41
             
Granted
   
270,000
 
$
11.46
             
Exercised
   
(40,702
)
$
3.54
             
Forfeited or expired
   
-
 
$
-
             
Outstanding at September 30, 2008
   
1,077,298
 
$
10.93
   
8.0
 
$
682
 
Exercisable at September 30, 2008
   
263,549
 
$
8.19
   
5.5
 
$
614
 

The following table details the intrinsic value of options exercised, total cost of share-based payments charged against income before income tax benefit and the amount of related income tax benefit recognized in income for the periods indicated (in thousands):

   
Three Months Ended
 
Nine Months Ended
 
   
September 30,
 
September 30,
 
   
2008
 
2007
 
2008
 
2007
 
                   
Intrinsic value of options exercised
 
$
-
 
$
-
 
$
337
 
$
-
 
                           
Cost of share-based payments (non-cash)
 
$
305
 
$
198
 
$
1,078
 
$
351
 
                           
Income tax benefit of share-based payments recognized in income
 
$
107
 
$
69
 
$
377
 
$
123
 

As of September 30, 2008 there was $2.8 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under our plans, of which $0.3 million is expected to be recognized in the remainder of 2008, $1.0 million is expected to be recognized in 2009, $0.9 million is expected to be recognized in 2010, $0.5 million is expected to be recognized in 2011 and $0.1 million is expected to be recognized in 2012.

The fair value of each stock option granted is estimated on the date of grant using the Black-Scholes option pricing model. Expected volatilities are based on the historical volatility of similar companies’ common stock for a period equal to the expected term. The risk- free interest rates for periods within the contractual term of the options are based on rates for U.S. Treasury Notes with maturity dates corresponding to the options’ expected lives on the dates of grant. Expected term is determined based on the simplified method as we do not have sufficient historical exercise data to provide a basis for estimating the expected term.

18


The following table details the weighted average grant date fair value and related assumptions for the periods indicated:

   
Three Months Ended
 
Nine Months Ended
 
   
September 30,
 
September 30,
 
   
2008
 
2007
 
2008
 
2007
 
                   
Grant date fair value per share
   
n/a
 
$
4.14
 
$
4.74
 
$
4.04
 
                           
Expected term (in years)
   
n/a
   
6.5
   
6.4
   
6.4
 
Expected volatility
   
n/a
   
19.0
%
 
35.0
%
 
19.4
%
Risk free interest rate
   
n/a
   
4.8
%
 
3.4
%
 
4.5
%

9. Segment Information

The following is business segment information for the three and nine months ended September 30, 2008 and 2007 (in thousands):

   
Three Months Ended
 
Nine Months Ended
 
   
September 30,
 
September  30,
 
   
2008
 
2007
 
2008
 
2007
 
Revenues:
                         
Standard Commercial Segment
 
$
20,280
 
$
23,718
 
$
64,617
 
$
65,488
 
Specialty Commercial Segment
   
30,245
   
32,910
   
94,617
   
93,986
 
Personal Segment
   
16,053
   
15,185
   
48,277
   
43,654
 
Corporate
   
(1,589
)
 
743
   
983
   
2,122
 
Consolidated
 
$
64,989
 
$
72,556
 
$
208,494
 
$
205,250
 
                           
Pre-tax income (loss), net of minority interest:
                         
Standard Commercial Segment
 
$
887
 
$
3,702
 
$
9,104
 
$
9,125
 
Specialty Commercial Segment
   
745
   
6,500
   
12,601
   
20,627
 
Personal Segment
   
2,544
   
1,854
   
7,047
   
6,148
 
Corporate
   
(4,030
)
 
(1,909
)
 
(7,224
)
 
(5,108
)
Consolidated
 
$
146
 
$
10,147
 
$
21,528
 
$
30,792
 

19


The following is additional business segment information as of the dates indicated (in thousands):

   
September 30,
 
December 31,
 
   
2008
 
2007
 
Assets
             
               
Standard Commercial Segment
 
$
157,105
 
$
211,761
 
Specialty Commercial Segment
   
219,124
   
229,473
 
Personal Segment
   
78,143
   
100,986
 
Corporate
   
95,308
   
64,762
 
   
$
549,680
 
$
606,982
 

10. Reinsurance

We reinsure a portion of the risk we underwrite in order to control the exposure to losses and to protect capital resources. We cede to reinsurers a portion of these risks and pay premiums based upon the risk and exposure of the policies subject to such reinsurance. Ceded reinsurance involves credit risk and is generally subject to aggregate loss limits. Although the reinsurer is liable to us to the extent of the reinsurance ceded, we are ultimately liable as the direct insurer on all risks reinsured. Reinsurance recoverables are reported after allowances for uncollectible amounts. We monitor the financial condition of reinsurers on an ongoing basis and review our reinsurance arrangements periodically. Reinsurers are selected based on their financial condition, business practices and the price of their product offerings.

The following table shows earned premiums ceded and reinsurance loss recoveries by period (in thousands):

   
Three Months Ended
 
Nine Months Ended
 
   
September 30,
 
September 30,
 
   
2008
 
2007
 
2008
 
2007
 
                   
Ceded earned premiums
 
$
2,153
 
$
2,035
 
$
6,126
 
$
10,059
 
Reinsurance recoveries
 
$
8,211
 
$
537
 
$
9,474
 
$
3,973
 

Our insurance company subsidiaries presently retain 100% of the risk associated with all non-standard personal automobile policies marketed by our Phoenix Operating Unit. We currently reinsure the following exposures on business generated by our HGA Operating Unit, our TGA Operating Unit and our Aerospace Operating Unit:
 
 
·
Property catastrophe. Our property catastrophe reinsurance reduces the financial impact a catastrophe could have on our commercial property insurance lines. Catastrophes might include multiple claims and policyholders. Catastrophes include hurricanes, windstorms, earthquakes, hailstorms, explosions, severe winter weather and fires. Our property catastrophe reinsurance is excess-of-loss reinsurance, which provides us reinsurance coverage for losses in excess of an agreed-upon amount. We utilize catastrophe models to assist in determining appropriate retention and limits to purchase. The terms of our property catastrophe reinsurance, effective July 1, 2008, are:

20


 
o
We retain the first $3.0 million of property catastrophe losses; and
 
 
o
Our reinsurers reimburse us 100% for each $1.00 of loss in excess of our $3.0 million retention up to $10.0 million for each catastrophic occurrence, subject to an aggregate limit of $14 million. As a result of hurricane losses we have ceded to our reinsurers losses of approximately $7.0 million and have approximately $7.0 million of coverage remaining under this layer of catastrophe reinsurance at September 30, 2008.
 
 
o
Our reinsurers reimburse us 100% for each $1.00 of loss in excess of $10.0 million up to $35.0 million for each catastrophic occurrence subject to an aggregate limit of $50.0 million.
 
 
·
Commercial property. Our commercial property reinsurance is excess-of-loss coverage intended to reduce the financial impact a single-event or catastrophic loss may have on our results. The terms of our commercial property reinsurance, effective July 1, 2008, are:
 
 
o
We retain the first $1.0 million of loss for each commercial property risk;
 
 
o
Our reinsurers reimburse us for the next $5.0 million for each commercial property risk; and
 
 
o
Individual risk facultative reinsurance is purchased on any commercial property with limits above $5.0 million.
 
 
·
Commercial casualty. Our commercial casualty reinsurance is excess-of-loss coverage intended to reduce the financial impact a single-event loss may have on our results. The terms of our commercial casualty reinsurance, effective July 1, 2008, are:
 
 
o
We retain the first $1.0 million of any commercial liability risk: and
 
 
o
Our reinsurers reimburse us for the next $5.0 million for each commercial liability risk.
 
 
·
Aviation. We purchase reinsurance specific to the aviation risks underwritten by our Aerospace Operating Unit. This reinsurance provides aircraft hull and liability coverage and airport liability coverage on a per occurrence basis on the following terms:
 
 
o
We retain the first $350,000 of each aircraft hull or liability loss or airport liability loss;
 
 
o
Our reinsurers reimburse us for the next $2.15 million of each aircraft hull loss and for the next $650,000 of each aircraft or airport liability loss; and
 
 
o
Risks with liability limits greater than $1.0 million are placed in a quota share treaty where we retain 20% of incurred losses.

11. Notes Payable
 
On June 21, 2005, an unconsolidated trust subsidiary completed a private placement of $30.0 million of 30-year floating rate trust preferred securities. Simultaneously, we borrowed $30.9 million from the trust subsidiary and contributed $30.0 million to one of our insurance company subsidiaries in order to increase policyholder surplus. The note bears an initial interest rate of 7.725% until June 15, 2015, at which time interest will adjust quarterly to the three-month LIBOR rate plus 3.25 percentage points. Under the terms of the note, we pay interest only each quarter and the principal of the note at maturity. As of September 30, 2008, the note balance was $30.9 million.

21


On January 27, 2006, we borrowed $15.0 million under our revolving credit facility to fund the cash required to close the acquisition of the subsidiaries comprising our TGA Operating Unit. As of September 30, 2008, the balance on the revolving note was $2.8 million, which currently bears interest at 5.78% per annum. Also included in notes payable is $2.3 million outstanding as of September 30, 2008 under PAAC’s revolving credit sub-facility, which also currently bears interest at 5.78% per annum. (See Note 13, “Credit Facilities.”) 

On August 23, 2007, an unconsolidated trust subsidiary completed a private placement of $25.0 million of 30-year floating rate trust preferred securities. Simultaneously, we borrowed $25.8 million from the trust subsidiary for working capital and general corporate purposes. The note bears an initial interest rate of 8.28% until September 15, 2017, at which time interest will adjust quarterly to the three-month LIBOR rate plus 2.90 percentage points. Under the terms of the note, we pay interest only each quarter and the principal of the note at maturity. As of September 30, 2008 the note balance was $25.8 million.
 
12. Structured Settlements

In connection with the acquisition of the subsidiaries comprising our TGA Operating Unit, we recorded a payable for future guaranteed payments of $25.0 million discounted at 4.4%, the rate of two-year U.S. Treasuries (the only investment permitted on the trust account securing such future payments). As of September 30, 2008 we had fully repaid our obligation to the sellers.

13. Credit Facilities

On June 29, 2005, we entered into a credit facility with The Frost National Bank. The credit facility was amended and restated on January 27, 2006 to a $20.0 million revolving credit facility, with a $5.0 million letter of credit sub-facility. The credit facility was further amended effective May 31, 2007 to increase the revolving credit facility to $25.0 million and establish a new $5.0 million revolving credit sub-facility for the premium finance operations of PAAC. The credit agreement was again amended effective February 20, 2008 to extend the termination to January 27, 2010, revise various affirmative and negative covenants and decrease the interest rate in most instances to the three month Eurodollar rate plus 1.90 percentage points, payable quarterly in arrears. We pay letter of credit fees at the rate of 1.00% per annum. Our obligations under the revolving credit facility are secured by a security interest in the capital stock of all of our subsidiaries, guaranties of all of our subsidiaries and the pledge of substantially all of our assets. The revolving credit facility contains covenants which, among other things, require us to maintain certain financial and operating ratios and restrict certain distributions, transactions and organizational changes. As of September 30, 2008, we were in compliance with all of our financial and non-financial covenants under this credit facility. (See Note 11, “Notes Payable.”)

22


14. Deferred Policy Acquisition Costs

The following table shows total deferred and amortized policy acquisition costs by period (in thousands):

   
Three Months Ended
 
Nine Months Ended
 
   
September 30,
 
September 30,
 
   
2008
 
2007
 
2008
 
2007
 
                   
Deferred
 
$
(13,700
)
$
(12,197
)
$
(41,718
)
$
(37,163
)
Amortized
   
14,204
   
11,635
   
41,326
   
33,532
 
                           
Net
 
$
504
 
$
(562
)
$
(392
)
$
(3,631
)

15. Earnings per Share

The following table sets forth basic and diluted weighted average shares outstanding for the periods indicated (in thousands):

   
Three Months Ended
 
Nine Months Ended
 
   
September 30,
 
September 30,