| HALLMARK FINANCIAL SERVICES INC Item 1A Risk Factors |
| Our results may fluctuate as a result of cyclical changes in the property and casualty insurance industry |
| All of our revenue is attributable to property and casualty insurance, which as an industry is cyclical in nature and has historically been characterized by soft markets followed by hard markets |
| A soft market is a period of relatively high levels of price competition, less restrictive underwriting standards and generally low premium rates |
| A hard market is a period of capital shortages resulting in lack of insurance availability, relatively low levels of competition, more selective underwriting of risks and relatively high premium rates |
| Our industry is very competitive, which may unfavorably impact our results of operations |
| The property and casualty insurance market, our primary source of revenue, is highly competitive and, except for regulatory considerations, has very few barriers to entry |
| According to AM Best Company, Inc, there were 3cmam120 property and casualty insurance companies and 2cmam019 property and casualty insurance groups operating in North America as of July 22, 2005 |
| Our Commercial Insurance Operation competes with a variety of large national standard commercial lines carriers such as Hartford, Zurich, St |
| Paul Travelers and Safeco, as well as numerous smaller regional companies |
| Although our Personal Insurance Operation competes with large national insurers such as Allstate, State Farm and Progressive, as a participant in the non-standard personal automobile marketplace our competition is most directly associated with numerous regional companies and managing general agencies |
| Our competitors include entities which have, or are affiliated with entities which have, greater financial and other resources than we have |
| Estimating reserves is inherently uncertain |
| If our loss reserves are not adequate, it will have an unfavorable impact on our results |
| We maintain loss reserves to cover estimated liability for unpaid losses and LAE, for reported and unreported claims incurred as of the end of each accounting period |
| Reserves represent managementapstas estimates of what the ultimate settlement and administration of claims will cost |
| These estimates, which generally involve actuarial projections, are based on managementapstas assessment of facts and circumstances then known, as well as estimates of future trends in claim severity and frequency, judicial theories of liability, and other factors |
| These variables are affected by both internal and external events, such as changes in claim handling procedures, inflation, judicial trends and legislative changes |
| Additionally, there may be a significant reporting lag between the occurrence of an event and the time it is reported to us |
| The inherent uncertainties of estimating reserves are greater for certain types of liabilities, particularly those in which the various considerations affecting the type of claim are subject to change and in which long periods of time may elapse before a definitive determination of liability is made |
| Reserve estimates are continually refined in a regular and ongoing process as experience develops and further claims are reported and settled |
| Adjustments to reserves are reflected in the results of the periods in which such estimates are changed |
| Because setting reserves is inherently uncertain, there can be no assurance that the current reserves will prove adequate |
| Our results may be unfavorably impacted if we are unable to obtain adequate reinsurance |
| If we are unable to obtain adequate reinsurance protection for the risks we have underwritten, we will either be exposed to greater losses from these risks or we will reduce the level of business that we underwrite, which will reduce our revenue |
| The amount, availability and cost of reinsurance are subject to prevailing market conditions beyond our control, and may affect our ability to write additional premiums as well as our profitability |
| We purchase reinsurance by transferring, or ceding, part of the risk we have assumed to a reinsurance company in exchange for part of the premium we receive in connection with the risk |
| Although reinsurance makes the reinsurer liable to us to the extent the risk is transferred or ceded to the reinsurer, it does not relieve us of our liability to our policyholders |
| Accordingly, we bear credit risk with respect to our reinsurers |
| We cannot assure that our reinsurers will pay all of our reinsurance claims, or that they will pay our claims on a timely basis |
| Catastrophic losses may adversely affect our results of operations, liquidity and financial condition |
| Property and casualty insurance companies are subject to claims arising out of catastrophes that may have a significant affect on their results of operations, liquidity and financial condition |
| Catastrophes can be caused by various events, including hurricanes, windstorms, earthquakes, hail storms, explosions, severe winter weather and fires, and may include man-made events, such as the September 11, 2001 terrorist attacks on the World Trade Center |
| The incidence, frequency, and severity of catastrophes are inherently unpredictable |
| The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event |
| We are subject to comprehensive regulation, and our results may be unfavorably impacted by these regulations |
| We are subject to comprehensive governmental regulation and supervision |
| Most insurance regulations are designed to protect the interests of policyholders rather than of the stockholders and other investors of the insurance companies |
| These regulations, generally administered by the department of insurance in each state in which we do business, relate to, among other things; * Approval of policy forms and rates, * Standards of solvency, including risk based capital measurements (which are a measure developed by the National Association of Insurance Commissioners and used by the state insurance regulators to identify insurance companies that potentially are inadequately capitalized), * Licensing of insurers and their agents, * Restrictions on the nature, quality and concentration of investments, * Restrictions on the ability of our insurance company subsidiaries to pay dividends, * Restrictions on transactions between the insurance company subsidiaries and their affiliates, * Requiring certain methods of accounting, * Periodic examinations of operations and finances, * Prescribing the form and content of records of financial condition to be filed, and * Requiring reserves for unearned premium, losses and other purposes |
| State insurance departments also conduct periodic examinations of the affairs of insurance companies and require filing of annual and other reports relating to the financial condition of insurance companies, holding company issues and other matters |
| Our business depends on compliance with applicable laws and regulations and our ability to maintain valid licenses and approvals for our operations |
| Regulatory authorities may deny or revoke licenses for various reasons, including violations of regulations |
| Changes in the level of regulation of the insurance industry or changes in laws or regulations themselves or interpretations by regulatory authorities could have a material adverse affect on our operations |
| State statutes limit the aggregate amount of dividends that our subsidiaries may pay Hallmark, thereby limiting its funds to pay expenses and dividends |
| Hallmark is a holding company and a legal entity separate and distinct from its subsidiaries |
| As a holding company without significant operations of its own, Hallmarkapstas principal sources of funds are dividends and other sources of funds from its subsidiaries |
| State insurance laws limit the ability of Hallmarkapstas insurance company subsidiaries to pay dividends and require the insurance companies to maintain specified levels of statutory capital and surplus |
| These restrictions affect the ability of our insurance company subsidiaries to pay dividends and use their capital in other ways |
| Hallmarkapstas right to participate in any distribution of assets of the insurance company subsidiaries is subject to prior claims of policyholders and creditors (except to the extent that its rights, if any, as a creditor are recognized) |
| Consequently, Hallmarkapstas ability to pay debts, expenses and cash dividends to our stockholders may be limited |
| Our insurance company subsidiaries are subject to minimum capital and surplus requirements |
| Failure to meet these requirements could subject us to regulatory action |
| Our insurance company subsidiaries are subject to minimum capital and surplus requirements imposed under the laws of Texas and Arizona |
| Any failure by one of our insurance company subsidiaries to meet minimum capital and surplus requirements imposed by applicable state law will subject it to corrective action, which may include requiring adoption of a comprehensive financial plan, revocation of its license to sell insurance products or placing the subsidiary under state regulatory control |
| Any new minimum capital and surplus requirements adopted in the future may require us to increase the capital and surplus of our insurance company subsidiaries, which we may not be able to do |
| The loss of key executives could disrupt our business |
| Our success will depend in part upon the continued service of certain key executives |
| Our success will also depend on our ability to attract and retain additional executives and personnel |
| The loss of key personnel could cause disruption in our business |
| Adverse securities market conditions can have a significant and negative impact on our investment portfolio |
| Our results of operations depend in part on the performance of our invested assets |
| As of December 31, 2005, 84dtta8prca of our investment portfolio was invested in fixed maturity securities |
| Certain risks are inherent in connection with fixed maturity securities, including loss upon default and price volatility in reaction to changes in interest rates and general market factors |
| In general, the fair market value of a portfolio of fixed income securities increases or decreases inversely with changes in the market interest rates, while net investment income realized from future investments in fixed income securities increases or decreases along with interest rates |
| In addition, some of our fixed income securities have call or prepayment options |
| This could subject us to reinvestment risk should interest rates fall or issuers call their securities and we reinvest proceeds at lower interest rates |
| We attempt to mitigate this risk by investing in securities with varied maturity dates, so that only a portion of the portfolio will mature at any point in time |
| Furthermore, actual net investment income and/or cash flows from investments that carry prepayment risk (such as mortgage-backed and other asset-backed securities) may differ from those anticipated at the time of investment as a result of interest rate fluctuations |
| An investment has prepayment risk when there is a risk that cash flows from the repayment of principal might occur earlier than anticipated because of declining interest rates or later than anticipated because of rising interest rates |
| The fair value of our fixed income securities as of December 31, 2005 was dlra87dtta3 million |
| If market interest rates were to change 1prca, (eg from 5prca to 6prca), the fair value of our fixed income securities would change approximately dlra3dtta6 million as of December 31, 2005 |
| The change in fair value was determined using duration modeling assuming no prepayments |
| In addition to the general risks described above, although we maintain an investment grade portfolio, our fixed income securities are also subject to credit risk |
| If any of the issuers of our fixed income securities suffer financial set backs, the ratings on the fixed income securities could fall (with a concurrent fall in market value) and, in a worst case scenario, the issuer could default on its obligations |
| Future changes in the fair market value of our available-for-sale securities will be reflected in other comprehensive income |
| Similar treatment is not available for liabilities |
| Therefore, interest rate fluctuations could adversely affect our shareholders &apos equity, total comprehensive income and/or our cash flows |
| We are reliant on independent agents to market our products and their failure to do so would have a material adverse effect on our results of operations |
| We principally market our insurance programs through independent insurance agents |
| As a result, our business depends in large part on the marketing efforts of these agents and on our ability to offer insurance products and services that meet the requirements of the agents and their customers |
| The agents, however, are not obligated to sell or promote our products and many sell or promote competitors &apos insurance products in addition to our products |
| The failure or inability of insurance agents to market our insurance products successfully could have a material adverse impact on our business, financial condition and results of operations |
| We may experience difficulty in integrating recent acquisitions into our operations |
| We completed the acquisitions of both Aerospace and TGA during January, 2006 |
| The successful integration of these newly acquired businesses into our operations will require, among other things, the retention and assimilation of their key management, sales and other personnel; the coordination of their lines of insurance products and services; the adaptation of their technology, information systems and other processes; and the retention and transition of their customers |
| Unexpected difficulties in integrating these acquisitions could result in increased expenses and the diversion of management time and resources |
| If we do not successfully integrate these acquired businesses into our operations, we may not realize the anticipated benefits of one or both of the acquisitions, which could have a material adverse impact on our financial condition and results of operations |
| Mark E Schwarz, our Chairman and Chief Executive Officer, through his affiliation with Newcastle Partners, LP, and the Opportunity Funds, has the ability to exert significant influence over our operations and may have interests that differ from those of our other stockholders |
| Newcastle Partners, LP ( "e Newcastle "e ) beneficially owns approximately 78prca of our common stock |
| In addition, the Opportunity Funds hold convertible promissory notes which, subject to shareholder approval and certain anti- dilution provisions, are convertible into approximately 19dtta5 million shares of our common stock |
| Mark E Schwarz has sole investment and voting control over the shares beneficially owned by Newcastle and the Opportunity Funds and thus has the ability to exert significant influence over our policies and affairs, including the election of our board of directors and the approval of any action requiring stockholder vote |
| Schwarz, Newcastle and the Opportunity Funds may differ from the interests of our other stockholders in some respects |
| Schwarz, Newcastle and the Opportunity Funds may take action adverse to our other stockholders |
| If we are unable to raise additional capital or restructure our indebtedness to Newcastle, we may have difficulty satisfying current liquidity requirements |
| We funded the acquisition of Aerospace by borrowing dlra12dtta5 million from Newcastle on January 3, 2006 |
| The principal and accrued interest of this bridge loan are payable on demand at any time after June 30, 2006 |
| We have previously announced our intention to retire this debt through a rights offering of our common stock to existing shareholders during 2006 |
| However, if we are unable to complete the rights offering or restructure the payment schedule of the bridge loan, we may be unable to repay the bridge loan when demand is made |
| Any default under the bridge loan to Newcastle would also be an event of default under our primary secured credit facility and, therefore, could have a material adverse effect on our liquidity and operations |
| If our shareholders do not approve the conversion of the convertible promissory notes issued to the Opportunity Funds, we may be unable to satisfy future liquidity requirements |
| In connection with the acquisition of TGA, we issued dlra25dtta0 million in convertible promissory notes to the Opportunity Funds, the principal of which becomes due on July 27, 2007 |
| If conversion is approved by our shareholders, these convertible notes will be automatically converted to shares of our common stock at their maturity to the extent not previously converted by the holders |
| Newcastle owns sufficient shares of our common stock to assure shareholder approval and has an agreement with the Opportunity Funds to vote its shares in favor of such approval |
| Nonetheless, if we do not obtain such shareholder approval, we may be unable to repay the convertible notes at maturity |
| Any default under the convertible notes would also be an event of default under our primary secured credit facility and, therefore, could have a material adverse effect on our liquidity and operations |
| Conversion of the convertible promissory notes issued to the Opportunity Funds will dilute the percentage ownership of our other shareholders |
| Subject to shareholder approval, the convertible notes issued to the Opportunity Funds will become convertible by the holders into approximately 19dtta5 million shares of our common stock (subject to certain anti-dilution provisions), and will be automatically converted to such common stock at their maturity in July, 2007 |
| Upon such conversion, the proportionate voting and ownership interest of all other shareholders will be reduced and the percentage of our equity attributable to previously issued shares of our common stock will be diluted |