HALLMARK FINANCIAL SERVICES INC - Quarter Report: 2023 March (Form 10-Q)

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UNITED STATES

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SECURITIES AND EXCHANGE COMMISSION

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WASHINGTON, D.C. 20549

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FORM 10-Q

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Quarterly report pursuant to Section 13 or 15(d) of the

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(Mark One) Securities Exchange Act of 1934

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☒ Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

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For the quarterly period ended March 31, 2023

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☐ Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

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Commission file number 001-11252

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Hallmark Financial Services, Inc.

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(Exact name of registrant as specified in its charter)

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Registrant’s telephone number, including area code: (817) 348-1600

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Securities registered pursuant to Section 12(b) of the Act:

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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  ☒      No ☐

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Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).  Yes ☒  No ☐

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Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer,  a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,”  “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

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If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 15(a) of the Exchange Act. ☐

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Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes ☐ No ☒

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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 $1.00 per share –1,818,482 shares outstanding as of May 15, 2023.

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Table of Contents

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PART I

FINANCIAL INFORMATION

Item 1.   Financial Statements

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INDEX TO FINANCIAL STATEMENTS

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Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Balance Sheets

($ in thousands, except par value)

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

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Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Statements of Operations

(Unaudited)

($ in thousands, except per share amounts)

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

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Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Statements of Comprehensive (Loss) Income

(Unaudited)

($ in thousands)

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

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Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Statements of Stockholders’ Equity

(Unaudited)

($ in thousands)

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

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Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

($ in thousands)

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

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Hallmark Financial Services, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

1. General

Hallmark Financial Services, Inc. (“Hallmark” and, together with subsidiaries, the “Company”, “we,” “us” or “our”) is an insurance holding company that, through its subsidiaries, engages 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 market, distribute, underwrite and service our property/casualty insurance products primarily through business units organized by products and distribution channels. Our business units are supported by our insurance company subsidiaries.  

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Our Commercial Accounts business unit offers package and monoline property/casualty and, until exited in 2016, occupational accident insurance products and services.  Our Aviation business unit offers general aviation insurance. Our former Workers Compensation operating unit specialized in small and middle market workers compensation business until discontinued during 2015. Our Specialty Personal Lines business unit offers non-standard personal automobile and renters insurance products and services.  Our Specialty Runoff business unit consists of the senior care facilities professional liability insurance and services previously reported as part of our Professional Liability business unit; the contract binding line of the primary automobile insurance products and services previously reported as part of our Commercial Auto business unit; and the satellite launch property/casualty insurance products and services, as well as certain specialty programs, previously reported as part of our Aerospace & Programs business unit.  The lines of business comprising the Specialty Runoff business unit were discontinued at various times during 2020 through 2022 and are presently in runoff.

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These business units are segregated into three reportable industry segments for financial accounting purposes. The Commercial Lines Segment consists of the Commercial Accounts business unit, the Aviation business unit, and the runoff from our former Workers Compensation operating unit. The Personal Segment consists solely of our Specialty Personal Lines business unit and the Runoff Segment consists solely of the Specialty Runoff business unit.  The Runoff Segment was previously reported as part of our former Specialty Commercial Segment.

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Our discontinued operations consist of our Commercial Auto business unit (excluding the exited contract binding line) which offered primary and excess commercial vehicle insurance products and services; our E&S Casualty business unit which offered primary and excess liability, excess public entity liability, E&S package and garage liability insurance products and services; our E&S Property business unit which offered primary and excess commercial property insurance for both catastrophe and non-catastrophe exposures; and our Professional Liability business unit (excluding the exited senior care facilities line) which offered healthcare and financial lines professional liability insurance products and services primarily for businesses, medical professionals and medical facilities.  Our Discontinued Operations business units, which were sold in October 2022, were previously reported as part of our former Specialty Commercial Segment.  (See, Note 3.)  

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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”), Hallmark County Mutual Insurance Company (“HCM”), Hallmark National Insurance Company (“HNIC”) and Texas Builders Insurance Company (“TBIC”).

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2. Basis of Presentation

Our unaudited consolidated financial statements included herein have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and include our accounts and the accounts of our subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. Certain 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, 2022 included in our Annual Report on Form 10-K filed with the SEC.

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The interim financial data as of March 31, 2023 and 2022 is unaudited. However, in the opinion of management, the interim financial 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 periods ended March 31, 2023 are not necessarily indicative of the operating results to be expected for the full year.

Subsequent Event

AHIC, HIC, HSIC, HCM and HNIC (collectively, the “Hallmark Insurers”) are parties to a Loss Portfolio Transfer Reinsurance Contract (the “LPT Contract”) and related agreements with DARAG Bermuda Ltd. (“DARAG Bermuda”) and DARAG Insurance (Guernsey) Limited (“DARAG Guernsey” and, collectively, the “Reinsurers”). The Reinsurers and the Hallmark Insurers agreed to submit to binding arbitration a dispute regarding the rights and obligations of the parties under the LPT Contract. The Company established a receivable of $58.9 million pending a resolution of the matter. An interim binding arbitration award was declared by the arbitration panel on May 4, 2023. In accordance with GAAP, the Company recognized in the current reporting period a write-off to bad debt expense of $32.9 million of the receivable established by the Company. As of March 31, 2023, our consolidated balance sheet included $4.0 million of account receivable from DARAG related to cost incurred in which we contend we have right of reimbursement. A definitive binding award is expected to be forthcoming in the near future which may increase or decrease our total write-off.

On May 5, 2023 AM Best downgraded the Long-Term Issuer Credit Rating (Long-Term ICR) to “bb” (Fair) from “bbb-” (Good) and associated Long-Term Issue Ratings (Long-Term IRs) of the Hallmark insurance subsidiaries. Concurrently, AM Best  downgraded the Financial Strength Rating (FSR) to B++ (Good) from A- (Excellent) and the Long-Term ICRs to “bbb” (Good) from “a-” (Excellent). The B++ rating applied to AHIC, HIC, HSIC, HNIC and HCM. In addition, AM Best maintained the under review with negative implications status of all Credit Ratings (ratings).

On May 9, 2023 AM Best further downgraded, due to the outcome of the DARAG arbitration, the Long-Term ICR to “ccc-” (Weak) from “bb” (Fair) and associated Long-Term IRs of the Hallmark insurance subisidiares. Concurrently, AM Best further downgraded the  FSR to C++ (Marginal) from B++ (Good) and the Long-Term ICRs to “b+” (Marginal) from “bbb” (Good). The C++ rating applies to AHIC, HIC, HSIC, HNIC and HCM. A.M. Best has indicated a negative outlook for each of the ratings assigned to these insurance company subsidiaries.

On May 14, 2023 the Company submitted notice to AM Best to withdraw from AM Best’s interactive rating process.  We will be assigned a Non-Rating Designation of NR by AM Best, which are assigned to insurance companies that are not rated.

On May 5, 2023, the Company entered into an agreement  with an A.M. Best rated “A” insurance company to continue to write new business in circumstances that require an A.M. Best financial strength rating higher than our own. The cost structure of the remaining business is negatively impacted by the additional expense associated with the aforementioned agreement  Further, certain terms of the agreement are variable based on the amount of Company surplus. Such adjustments may cause the rated “A” insurance company to terminate the agreement or Hallmark to determine it is not in its best interest to continue to write new business pursuant to the agreement.  The Company could be obligated to incur minimum costs of $250,000 plus assessments and state premium taxes in the event it were to elect to discontinue writing new business pursuant to the agreement .

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” under Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2022 for information on accounting policies that we consider critical in preparing our consolidated financial statements. Actual results could differ materially from those estimates.

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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.

Cash and Cash Equivalents:  The carrying amounts reported in the consolidated balance sheets for these instruments approximate their fair values.

Restricted Cash:  The carrying amount for restricted cash reported in the consolidated balance sheets approximates the fair value.

Senior Unsecured Notes Due 2029:  Our senior unsecured notes payable due in 2029 had a carrying value of $49.4 million and a fair value of $45.6 million as of March 31, 2023.   Our senior unsecured notes payable would be included in Level 3 of the fair value hierarchy if they were reported at fair value.

Subordinated Debt Securities:  Our trust preferred securities had a carrying value of $56.0 million and a fair value of $35.9 million as of March 31, 2023. Our trust preferred securities would be included in Level 3 of the fair value hierarchy if they were reported at fair value.

For accounts receivable, reinsurance balances, premiums receivable, federal income tax recoverable and other assets, the carrying amounts are held at net realizable value which approximates 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.

We evaluate on an ongoing basis our investments in Trust I and Trust II (collectively the “Trusts”) and have determined that we do not have a variable interest in the Trusts. Therefore, the Trusts are not included in our consolidated financial statements.

Income Taxes

We file a consolidated federal income tax return. Deferred federal income taxes reflect the future tax consequences of differences between the tax basis of assets and liabilities and their financial reporting amounts at each year end. We account for income taxes under the asset and liability method, which requires the recognition of deferred taxes for temporary differences between the financial statement and tax return basis of assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in future years for which we have already recorded the tax benefit in our income statement. Deferred tax liabilities generally represent tax expense recognized in our financial statements for which payment has been deferred or expenditures for which we have already taken a deduction in our tax return but have not yet been recognized in our financial statements.

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Under GAAP, we are required to evaluate the recoverability of our deferred tax assets and establish a valuation allowance if necessary to reduce our deferred tax assets to an amount that is more likely than not to be realized. Significant judgment is required in determining whether valuation allowances should be established, as well as the amount of such allowances.  We establish or adjust valuation allowances for deferred tax assets when we estimate that it is more likely than not that future taxable income will be insufficient to realize the value of the deferred tax assets. We evaluate all significant available positive and negative evidence as part of our analysis. Negative evidence includes the existence of losses in recent years. Positive evidence includes the forecast of future taxable income and tax-planning strategies that would result in the realization of deferred tax assets. The underlying assumptions we use in forecasting future taxable income require significant judgment and take into account our recent performance. The ultimate realization of deferred tax assets depends on the generation of future taxable income during the periods in which temporary differences are deductible or creditable. If actual experience differs from these estimates and assumptions, the recognized deferred tax asset value may not be fully realized, resulting in an increase to income tax expense in our results of operations.  

As of March 31, 2023, the Company maintained  a full valuation allowance of $39.0 million against its deferred tax assets because we determined that it is more likely than not that these assets will not be recoverable. If, in the future, we determine we can support the recoverability of all or a portion of the deferred tax assets under the guidance, the tax benefits relating to any reversal of the valuation allowance on deferred tax assets will be accounted for as a reduction of income tax expense and result in an increase in equity.  Changes in tax laws and rates may affect recorded deferred tax assets and liabilities and our effective tax rate in the future.

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The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. There were no uncertain tax positions at March 31, 2023.

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Reverse Stock Split

On November 29, 2022, we filed a Certificate of Change to our Articles of Incorporation to affect a reverse split of our issued and outstanding common stock on a one-for-ten reverse split of all issued and unissued shares of the Company.  The reverse stock split was effective on January 1, 2023. The Certificate of Change effected a one-for-ten reverse split of all issued and unissued shares of the Company’s common stock and adjusted the post-split par value of the common stock to $1.00 per share. As a result, the Company’s total authorized capital stock consists of 3,333,333 shares of common stock, $1.00 par value per share. No fractional shares were issued in connection with the reverse stock split and all fractions of a share were rounded up to the next whole share. The reverse stock split did not otherwise alter any of the voting powers, designations, preferences, limitations, restrictions, or relative rights of the capital stock of the Company. Accordingly, as required in accordance with U.S. GAAP, all common share and per share data are retrospectively restated to give effect of the Reverse Stock Split for all periods presented herein.

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Recently Issued Accounting Pronouncements

In March 2020, the FASB issued ASU 2020-04, Reference Rate Reform ("ASU 2020-04"). ASU 2020-04 provides optional guidance for a limited period of time to ease potential accounting impact associated with transitioning away from reference rates that are expected to be discontinued, such as the London Interbank Offered Rate ("LIBOR"). The amendments in this ASU apply only to contracts, hedging relationships, and other transactions that reference LIBOR or another reference rate expected to be discontinued. The amendments in ASU 2020-04 could be adopted as of March 12, 2020 and are effective through December 31, 2024. We do not currently have any contracts that have been changed to a new reference rate and do not expect the adoption of this guidance to have a material effect on the Company’s results of operations, financial position or liquidity.

In June 2016, the FASB issued ASU 2016-13, “Measurement of Credit Losses on Financial Instruments” (Topic 326). ASU 2016-13 replaces the existing incurred loss impairment model with an expected credit loss impairment model. The expected credit loss impairment model requires the entity to recognize its estimate of expected credit losses for affected financial assets using an allowance for credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. The amendments in this ASU require a financial asset (or a group of financial assets) measured at amortized cost basis to be presented at the net amount expected to be collected. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial asset(s) to

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present the net carrying value at the amount expected to be collected. The income statement includes the measurement of credit losses for newly recognized financial assets, as well as the expected increases or decreases of expected credit losses that have occurred during the period. Credit losses on available-for-sale debt securities are measured in a manner similar to current GAAP, although ASU 2016-13 requires that they be presented as an allowance rather than as a write-down of the amortized cost. In situations where the estimate of credit loss on an available-for-sale debt security declines, entities will be able to record a reversal of the allowance to income in the current period, which was prohibited prior to the adoption of ASU 2016-13. The expected loss approach will require entities to incorporate considerations of historical information, current information and reasonable and supportable forecasts. The standard also requires expanded disclosures related to credit losses and credit quality indicators. As a smaller reporting company, ASU 2016-13 is effective for fiscal years of the Company beginning after December 15, 2022, including interim periods within those fiscal years. ASU 2016-13 requires a modified retrospective transition method and early adoption is permitted. Application of the standard to our applicable assets, including debt securities, cash, premium receivable, accounts receivable, reinsurance recoverables and prepaid expenses, did not have a material impact on our financial results. After consideration of risk and qualitative factors for each asset type in scope, an allowance for expected credit losses of $200 thousand was established in regards to reinsurance recoverables. See ‘Note 5. Investments” for a discussion regarding expected credit loss on our debt security assets. For determination of the  reinsurance recoverables expected credit loss allowance, our Company relies on external ratings of credit worthiness from A.M. Best and collectability of recorded amounts considering letters of credit pledged by reinsurance partners. The ratings at March 31, 2023 of our reinsurance recoverables not offset by our liabilities for amounts owed to reinsurers and pledged letters of credit are 96% rated A- or better, 1% rated B++ or B+ and 3% all other lower ratings.

3. Discontinued Operations Classification

On October 7, 2022 the Company consummated the sale of substantially all of its excess and surplus lines operations to Core Specialty Insurance Holdings, Inc. (“Core Specialty”) for $40.0 million cash consideration, plus an estimated $19.9 million consideration for the acquisition costs associated with certain net unearned premium reserves.  The Company retained the related loss and loss adjustment expenses (“LAE”) reserves of its excess and surplus lines businesses and will experience future cash outflows and change in estimates for these reserves until all claims have been settled. The transaction was comprised of substantially all of nine business units within the Company’s former Specialty Commercial Segment, certain related assets and liabilities, and the immediate transition to Core Specialty of approximately 200 employees who produce and support these lines of businesses. This transaction met the criteria for discontinued operations accounting. As a result, the results of operations for the affected excess and surplus lines are included in discontinued operations in our Consolidated Statement of Operations for all periods shown. The following table summarizes income (loss) from discontinued operations (in thousands):

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4. Fair Value

ASC 820 defines fair value, establishes a consistent framework for measuring fair value and requires disclosure 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:

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 equity securities.

Level 2 investment securities include corporate bonds, collateralized corporate bank loans, municipal bonds, U.S. Treasury securities, other obligations of the U.S. Government and mortgage-backed securities for which quoted prices are not available on active exchanges for identical instruments. We use third-party pricing services 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 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 services and have determined that they result in fair values consistent with the requirements of ASC 820 for Level 2 investment securities. We have not adjusted any prices received from third-party pricing sources. There were no transfers between Level 1 and Level 2 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.

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The following table presents, for each of the fair value hierarchy levels, assets that are measured at fair value on a recurring basis at March 31, 2023 and December 31, 2022 (in thousands):

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There were no investments classified as Level 3 as of March 31, 2023 and 2022.

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5. Investments

The amortized cost/carrying value and estimated fair value of investments in debt and equity securities by category is as follows (in thousands):

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As of March 31, 2023, the Company had  investments in 52 issuers that represented more than 10% of stockholders’ equity. Of the investments in the 52 issuers, 94% was in debt securities with the remaining amount in equity securities. Of the debt securities invested in the 52 issuers, 89% was considered investment grade.

Major categories of net investment gains (losses) on investments are summarized as follows (in thousands):

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We realized gross gains on investments of $1.5 million and $152 thousand during the three months ended March 31, 2023 and 2022, respectively. We realized gross losses on investments of $2.1 million and $6 thousand for the three months ended March 31, 2023 and 2022, respectively. We recorded proceeds from the sale of investment securities of $50.4 million and $0.5 million during the three months ended March 31, 2023 and 2022, respectively. Realized investment gains and losses are recognized in operations on the first in-first out method.

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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 March 31, 2023 and December 31, 2022 (in thousands):

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