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, 2009




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.
      EmployerIncorporation
      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 has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted 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 and post such files).   Yes
 ̈  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.


Large
accelerated filer  ̈               
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
– 20,113,670 shares outstanding as of November 12, 2009.





PART
I


FINANCIAL
INFORMATION





Item
1.                      
Financial Statements




INDEX
TO FINANCIAL STATEMENTS


Page NumberConsolidated
      Balance Sheets at September 30, 2009 (unaudited) and December 31,
      2008
                
                3Consolidated
      Statements of Operations (unaudited) for the three months and nine
      months ended September 30, 2009 and September 30, 2008
                
                4Consolidated
      Statements of Stockholders’ Equity and Comprehensive Income (Loss)
      (unaudited) for the three months and nine months ended September 30, 2009
      and September 30, 2008
                
                5Consolidated
      Statements of Cash Flows (unaudited) for the nine months ended September
      30, 2009 and September 30, 2008
                
                6Notes
      to Consolidated Financial Statements (unaudited)
                
                7


2


Hallmark
Financial Services, Inc. and Subsidiaries


Consolidated
Balance Sheets


($ in
thousands)





September
      30
                                
                                
                                December
      312009
                                
                                
                                2008(unaudited)ASSETSInvestments:Debt
      securities, available-for-sale, at fair value
                                
                                $
                                295,452
                                
                                
                                $
                                268,513Equity
      securities, available-for-sale, at fair value
                                
                                
                                40,959
                                
                                
                                
                                25,003Total
      investments
                                
                                
                                336,411
                                
                                
                                
                                293,516Cash
      and cash equivalents
                                
                                
                                84,422
                                
                                
                                
                                59,134Restricted
      cash and cash equivalents
                                
                                
                                5,918
                                
                                
                                
                                8,033Premiums
      receivable
                                
                                
                                48,794
                                
                                
                                
                                44,032Accounts
      receivable
                                
                                
                                3,729
                                
                                
                                
                                4,531Receivable
      for securities
                                
                                
                                181
                                
                                
                                
                                1,031Prepaid
      reinsurance premiums
                                
                                
                                11,198
                                
                                
                                
                                1,349Reinsurance
      recoverable
                                
                                
                                11,695
                                
                                
                                
                                8,218Deferred
      policy acquisition costs
                                
                                
                                22,629
                                
                                
                                
                                19,524Excess
      of cost over fair value of net assets acquired
                                
                                
                                41,080
                                
                                
                                
                                41,080Intangible
      assets, net
                                
                                
                                29,789
                                
                                
                                
                                28,969Current
      federal income tax recoverable
                                
                                
                                1,080
                                
                                
                                
                                696Deferred
      federal income taxes
                                
                                
                                -
                                
                                
                                
                                6,696Prepaid
      expenses
                                
                                
                                816
                                
                                
                                
                                1,007Other
      assets
                                
                                
                                18,264
                                
                                
                                
                                20,582Total
      assets
                                
                                $
                                616,006
                                
                                
                                $
                                538,398LIABILITIES AND STOCKHOLDERS'
      EQUITYLiabilities:Notes
      payable
                                
                                $
                                59,502
                                
                                
                                $
                                60,919Reserves
      for unpaid losses and loss adjustment expenses
                                
                                
                                180,179
                                
                                
                                
                                156,363Unearned
      premiums
                                
                                
                                130,467
                                
                                
                                
                                102,192Unearned
      revenue
                                
                                
                                266
                                
                                
                                
                                2,037Reinsurance
      balances payable
                                
                                
                                2,680
                                
                                
                                
                                -Accrued
      agent profit sharing
                                
                                
                                1,908
                                
                                
                                
                                2,151Accrued
      ceding commission payable
                                
                                
                                8,600
                                
                                
                                
                                8,605Pension
      liability
                                
                                
                                4,427
                                
                                
                                
                                4,309Deferred
      federal income taxes
                                
                                
                                92
                                
                                
                                
                                -Payable
      for securities
                                
                                
                                688
                                
                                
                                
                                3,606Accounts
      payable and other accrued expenses
                                
                                
                                9,148
                                
                                
                                
                                18,067Total
      liabilities
                                
                                
                                397,957
                                
                                
                                
                                358,249Commitments
      and Contingencies (Note 15)Redeemable
      non-controlling interest
                                
                                
                                1,011
                                
                                
                                
                                737Stockholders'
      equity:Common
      stock, $.18 par value (authorized 33,333,333 shares in 2009 and
      2008;issued
      20,871,498 shares in 2009 and 20,841,782 shares in 2008)
                                
                                
                                3,757
                                
                                
                                
                                3,751Capital
      in excess of par value
                                
                                
                                121,261
                                
                                
                                
                                119,928Retained
      earnings
                                
                                
                                89,186
                                
                                
                                
                                72,242Accumulated
      other comprehensive income (loss)
                                
                                
                                8,161
                                
                                
                                
                                (16,432
                                )Treasury
      stock, at cost (757,828 shares in 2009 and 7,828 in 2008)
                                
                                
                                (5,327
                                )
                                
                                
                                (77
                                )Total
      stockholders' equity
                                
                                
                                217,038
                                
                                
                                
                                179,412$
                                616,006
                                
                                
                                $
                                538,398





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 EndedSeptember 30
                
                
                September 302009
                
                
                2008
                
                
                2009
                
                
                2008Gross
      premiums written
                
                $
                74,013
                
                
                $
                59,005
                
                
                $
                220,545
                
                
                $
                186,357Ceded
      premiums written
                
                
                (11,222
                )
                
                
                (2,493
                )
                
                
                (16,714
                )
                
                
                (6,503
                )Net
      premiums written
                
                
                62,791
                
                
                
                56,512
                
                
                
                203,831
                
                
                
                179,854Change
      in unearned premiums
                
                
                1,447
                
                
                
                2,416
                
                
                
                (17,844
                )
                
                
                (1,918
                )Net
      premiums earned
                
                
                64,238
                
                
                
                58,928
                
                
                
                185,987
                
                
                
                177,936Investment
      income, net of expenses
                
                
                3,467
                
                
                
                4,100
                
                
                
                11,203
                
                
                
                11,682Net
      realized gains (losses)
                
                
                597
                
                
                
                (2,496
                )
                
                
                1,116
                
                
                
                (1,405
                )Finance
      charges
                
                
                1,525
                
                
                
                1,307
                
                
                
                4,324
                
                
                
                3,894Commission
      and fees
                
                
                2,018
                
                
                
                3,127
                
                
                
                10,834
                
                
                
                16,280Processing
      and service fees
                
                
                7
                
                
                
                20
                
                
                
                33
                
                
                
                98Other
      income
                
                
                51
                
                
                
                3
                
                
                
                60
                
                
                
                9Total
      revenues
                
                
                71,903
                
                
                
                64,989
                
                
                
                213,557
                
                
                
                208,494Losses
      and loss adjustment expenses
                
                
                40,579
                
                
                
                38,981
                
                
                
                115,552
                
                
                
                110,514Other
      operating expenses
                
                
                23,428
                
                
                
                24,041
                
                
                
                71,056
                
                
                
                71,114Interest
      expense
                
                
                1,147
                
                
                
                1,186
                
                
                
                3,456
                
                
                
                3,557Amortization
      of intangible assets
                
                
                916
                
                
                
                620
                
                
                
                2,412
                
                
                
                1,766Total
      expenses
                
                
                66,070
                
                
                
                64,828
                
                
                
                192,476
                
                
                
                186,951Income
      before tax
                
                
                5,833
                
                
                
                161
                
                
                
                21,081
                
                
                
                21,543Income
      tax expense (benefit)
                
                
                1,585
                
                
                
                (485
                )
                
                
                5,766
                
                
                
                6,222Net
      income
                
                
                4,248
                
                
                
                646
                
                
                
                15,315
                
                
                
                15,321Less:
      Net income attributable to
    non-controlling  interest
                
                
                34
                
                
                
                15
                
                
                
                36
                
                
                
                15Net
      income attributable to Hallmark Financial Services, Inc.
                
                $
                4,214
                
                
                $
                631
                
                
                $
                15,279
                
                
                $
                15,306Net
      income per share attributable to Hallmark Financial Services, Inc. common
      stockholders:Basic
                
                $
                0.20
                
                
                $
                0.03
                
                
                $
                0.73
                
                
                $
                0.74Diluted
                
                $
                0.20
                
                
                $
                0.03
                
                
                $
                0.73
                
                
                $
                0.73





The
accompanying notes are an integral part


of the
consolidated financial statements


4


Hallmark
Financial Services, Inc. and Subsidiaries


Consolidated
Statements of Stockholders' Equity and Comprehensive Income (Loss)


(Unaudited)


($ in
thousands)





Three
      Months Ended
                    
                    
                    Nine
      Months EndedSeptember
      30,
                    
                    
                    September
      30,2009
                    
                    
                    2008
                    
                    
                    2009
                    
                    
                    2008Common
      StockBalance,
      beginning of period
                    
                    $
                    3,757
                    
                    
                    $
                    3,747
                    
                    
                    $
                    3,751
                    
                    
                    $
                    3,740Issuance
      of common stock upon option exercises
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    6
                    
                    
                    
                    7Balance,
      end of period
                    
                    
                    3,757
                    
                    
                    
                    3,747
                    
                    
                    
                    3,757
                    
                    
                    
                    3,747Additional
      Paid-In CapitalBalance,
      beginning of period
                    
                    
                    120,736
                    
                    
                    
                    119,369
                    
                    
                    
                    119,928
                    
                    
                    
                    118,459Accretion
      of redeemable noncontrolling interest
                    
                    
                    (87
                    )
                    
                    
                    (25
                    )
                    
                    
                    (259
                    )
                    
                    
                    (25
                    )Equity
      based compensation
                    
                    
                    612
                    
                    
                    
                    305
                    
                    
                    
                    1,488
                    
                    
                    
                    1,078Exercise
      of stock options
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    104
                    
                    
                    
                    137Balance,
      end of period
                    
                    
                    121,261
                    
                    
                    
                    119,649
                    
                    
                    
                    121,261
                    
                    
                    
                    119,649Retained
      EarningsBalance,
      beginning of period
                    
                    
                    84,972
                    
                    
                    
                    74,018
                    
                    
                    
                    72,242
                    
                    
                    
                    59,343Adjustment
      to opening balance, net of tax (note 2)
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    1,665
                    
                    
                    
                    -Adjusted
      balance, beginning of period
                    
                    
                    84,972
                    
                    
                    
                    74,018
                    
                    
                    
                    73,907
                    
                    
                    
                    59,343Net
      income attributable to Hallmark Financial Services, Inc.
                    
                    
                    4,214
                    
                    
                    
                    631
                    
                    
                    
                    15,279
                    
                    
                    
                    15,306Balance,
      end of period
                    
                    
                    89,186
                    
                    
                    
                    74,649
                    
                    
                    
                    89,186
                    
                    
                    
                    74,649Accumulated
      Other Comprehensive Income (Loss)Balance,
      beginning of period
                    
                    
                    836
                    
                    
                    
                    (4,756
                    )
                    
                    
                    (16,432
                    )
                    
                    
                    (1,844
                    )Adjustment
      to opening balance, net of tax (note 2)
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    (1,665
                    )
                    
                    
                    -Adjusted
      balance, beginning of period
                    
                    
                    836
                    
                    
                    
                    (4,756
                    )
                    
                    
                    (18,097
                    )
                    
                    
                    (1,844
                    )Additional
      minimun pension liability, net of tax
                    
                    
                    80
                    
                    
                    
                    10
                    
                    
                    
                    239
                    
                    
                    
                    31Net
      unrealized holding gains (losses) arising during period
                    
                    
                    7,881
                    
                    
                    
                    (2,982
                    )
                    
                    
                    27,197
                    
                    
                    
                    (4,340
                    )Reclassification
      adjustment for losses included in net income
                    
                    
                    (636
                    )
                    
                    
                    (734
                    )
                    
                    
                    (1,178
                    )
                    
                    
                    (2,309
                    )Balance,
      end of period
                    
                    
                    8,161
                    
                    
                    
                    (8,462
                    )
                    
                    
                    8,161
                    
                    
                    
                    (8,462
                    )Treasury
      StockBalance,
      beginning of period
                    
                    
                    (77
                    )
                    
                    
                    (77
                    )
                    
                    
                    (77
                    )
                    
                    
                    (77
                    )Acquistion
      of treasury shares
                    
                    
                    (5,250
                    )
                    
                    
                    -
                    
                    
                    
                    (5,250
                    )
                    
                    
                    -Balance,
      end of period
                    
                    
                    (5,327
                    )
                    
                    
                    (77
                    )
                    
                    
                    (5,327
                    )
                    
                    
                    (77
                    )Total
      Stockholders' Equity
                    
                    $
                    217,038
                    
                    
                    $
                    189,506
                    
                    
                    $
                    217,038
                    
                    
                    $
                    189,506Net
      income
                    
                    $
                    4,248
                    
                    
                    $
                    646
                    
                    
                    $
                    15,315
                    
                    
                    $
                    15,321Additional
      minimum pension liablilty, net of tax
                    
                    
                    80
                    
                    
                    
                    10
                    
                    
                    
                    239
                    
                    
                    
                    31Net
      unrealized holding gains (losses) arising during period
                    
                    
                    7,881
                    
                    
                    
                    (2,982
                    )
                    
                    
                    27,197
                    
                    
                    
                    (4,340
                    )Reclassification
      adjustment for losses included in net income
                    
                    
                    (636
                    )
                    
                    
                    (734
                    )
                    
                    
                    (1,178
                    )
                    
                    
                    (2,309
                    )Comprehensive
      income (loss)
                    
                    
                    11,573
                    
                    
                    
                    (3,060
                    )
                    
                    
                    41,573
                    
                    
                    
                    8,703Less:
      Comprehensive income attributable to non-controlling
    interest
                    
                    
                    34
                    
                    
                    
                    15
                    
                    
                    
                    36
                    
                    
                    
                    15Comprehensive
      income (loss) attributable toHallmark
      Financial Services, Inc.
                    
                    $
                    11,539
                    
                    
                    $
                    (3,075
                    )
                    
                    $
                    41,537
                    
                    
                    $
                    8,688





The
accompanying notes are an integral part


of the
consolidated  financial statements




5
 
  Hallmark
Financial Services, Inc. and Subsidiaries
 Consolidated
Statements of Cash Flows
 (Unaudited)
 ($ in
thousands)
  Nine
      Months EndedSeptember
      302009
                                                        
                                                        
                                                        2008Cash
      flows from operating activities:Net
      income
                                                        
                                                        $
                                                        15,315
                                                        
                                                        
                                                        $
                                                        15,321Adjustments
      to reconcile net income to cash provided by operating
      activities:Depreciation
      and amortization expense
                                                        
                                                        
                                                        2,979
                                                        
                                                        
                                                        
                                                        2,311Deferred
      federal income tax benefit
                                                        
                                                        
                                                        (1,117
                                                        )
                                                        
                                                        
                                                        (1,849
                                                        )Realized
      (gains) losses on investments
                                                        
                                                        
                                                        (1,116
                                                        )
                                                        
                                                        
                                                        1,405Change
      in prepaid reinsurance premiums
                                                        
                                                        
                                                        (5,036
                                                        )
                                                        
                                                        
                                                        (1,694
                                                        )Change
      in premiums receivable
                                                        
                                                        
                                                        (4,787
                                                        )
                                                        
                                                        
                                                        (1,026
                                                        )Change
      in accounts receivable
                                                        
                                                        
                                                        815
                                                        
                                                        
                                                        
                                                        (24
                                                        )Change
      in deferred policy acquisition costs
                                                        
                                                        
                                                        (3,105
                                                        )
                                                        
                                                        
                                                        (392
                                                        )Change
      in reserves for unpaid losses and loss adjustment expenses
                                                        
                                                        
                                                        15,252
                                                        
                                                        
                                                        
                                                        29,950Change
      in unearned premiums
                                                        
                                                        
                                                        23,462
                                                        
                                                        
                                                        
                                                        2,295Change
      in unearned revenue
                                                        
                                                        
                                                        (1,771
                                                        )
                                                        
                                                        
                                                        (823
                                                        )Change
      in accrued agent profit sharing
                                                        
                                                        
                                                        (243
                                                        )
                                                        
                                                        
                                                        (909
                                                        )Change
      in reinsurance recoverable
                                                        
                                                        
                                                        5,087
                                                        
                                                        
                                                        
                                                        (6,573
                                                        )Change
      in reinsurance payable
                                                        
                                                        
                                                        2,680
                                                        
                                                        
                                                        
                                                        -Change
      in current federal income tax recoverable
                                                        
                                                        
                                                        (384
                                                        )
                                                        
                                                        
                                                        (2,451
                                                        )Change
      in accrued ceding commission payable
                                                        
                                                        
                                                        (5
                                                        )
                                                        
                                                        
                                                        94Change
      in all other liabilities
                                                        
                                                        
                                                        (8,094
                                                        )
                                                        
                                                        
                                                        (2,599
                                                        )Change
      in all other assets
                                                        
                                                        
                                                        5,763
                                                        
                                                        
                                                        
                                                        4,122Net
      cash provided by operating activities
                                                        
                                                        
                                                        45,695
                                                        
                                                        
                                                        
                                                        37,158Cash
      flows from investing activities:Purchases
      of property and equipment
                                                        
                                                        
                                                        (907
                                                        )
                                                        
                                                        
                                                        (477
                                                        )Decrease
      in restricted cash and cash equivalents
                                                        
                                                        
                                                        3,470
                                                        
                                                        
                                                        
                                                        7,080Purchases
      of debt and equity securities
                                                        
                                                        
                                                        (74,430
                                                        )
                                                        
                                                        
                                                        (642,260
                                                        )Maturities,
      sales and redemptions of investment securities
                                                        
                                                        
                                                        65,283
                                                        
                                                        
                                                        
                                                        500,516Payment
      for acquisition of subsidiaries
                                                        
                                                        
                                                        (7,246
                                                        )
                                                        
                                                        
                                                        (14,799
                                                        )Net
      cash used in investing activities
                                                        
                                                        
                                                        (13,830
                                                        )
                                                        
                                                        
                                                        (149,940
                                                        )Cash
      flows from financing activities:Proceeds
      from exercise of employee stock options
                                                        
                                                        
                                                        110
                                                        
                                                        
                                                        
                                                        143Net
      borrowings (repayments) of notes payable
                                                        
                                                        
                                                        (1,417
                                                        )
                                                        
                                                        
                                                        946Distribution
      (to) from non-controlling interest
                                                        
                                                        
                                                        (20
                                                        )
                                                        
                                                        
                                                        -Purchase
      of treasury shares
                                                        
                                                        
                                                        (5,250
                                                        )
                                                        
                                                        
                                                        -Repayment
      of structured settlement
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        (10,000
                                                        )Net
      cash used in financing activities
                                                        
                                                        
                                                        (6,577
                                                        )
                                                        
                                                        
                                                        (8,911
                                                        )Increase
      (decrease) in cash and cash equivalents
                                                        
                                                        
                                                        25,288
                                                        
                                                        
                                                        
                                                        (121,693
                                                        )Cash
      and cash equivalents at beginning of period
                                                        
                                                        
                                                        59,134
                                                        
                                                        
                                                        
                                                        145,884Cash
      and cash equivalents at end of period
                                                        
                                                        $
                                                        84,422
                                                        
                                                        
                                                        $
                                                        24,191Supplemental
      cash flow information:Interest
      paid
                                                        
                                                        $
                                                        3,494
                                                        
                                                        
                                                        $
                                                        3,576Taxes
      paid
                                                        
                                                        $
                                                        7,267
                                                        
                                                        
                                                        $
                                                        10,521Supplemental
      schedule of non-cash investing activities:Change
      in receivable for securities related to investment disposals settled after
      the balance sheet date
                                                        
                                                        $
                                                        850
                                                        
                                                        
                                                        $
                                                        27,395Change
      in payable for securities related to investment purchases settled after
      the balance sheet date
                                                        
                                                        $
                                                        (2,918
                                                        )
                                                        
                                                        $
                                                        (85,897
                                                        )
  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, personal 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 and the excess commercial automobile and commercial umbrella
risks produced by our Heath XS Operating Unit which are written on a national
basis.





We pursue our business activities
through subsidiaries whose operations are organized into five operating units
which are supported by four of our insurance company
subsidiaries.  Our AHIS 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. Our Personal
Lines Operating Unit handles non-standard personal automobile insurance and
complementary personal insurance products and services and is comprised of
American Hallmark General Agency, Inc. and Hallmark Claims Services, Inc., both
of which do 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 AHIS Operating Unit and the Personal Segment presently consists solely of
our Personal Lines 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
unaudited consolidated financial statements should be read in conjunction with
our audited consolidated financial statements for the year ended December 31,
2008 included in our Annual Report on Form 10-K filed with the SEC.





The
interim financial data as of September 30, 2009 and 2008 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,
2009 are not necessarily indicative of the operating results to be expected for
the full year.




7





Redeemablenon-controlling
interest





We are accreting the redeemable
non-controlling interest to its redemption value from the date of issuance to
the earliest determinable redemption date, August 29, 2012, using the interest
method.  Changes in redemption value are considered a change in
accounting estimate.  We follow the two class method of computing
earnings per share.  We treat only the portion of the periodic
adjustment to the redeemable non-controlling interest carrying amount that
reflects a redemption in excess of fair value as being akin to an actual
dividend.  (See Note 3, “Business Combinations.”)





Reclassification





Certain previously reported amounts
have been reclassified in order to conform to our current year
presentation.  Such reclassification had no effect on net income or
stockholders’ equity.





Income
taxes





Income taxes are accounted for under
the asset and liability method.  At December 31, 2008, we had recorded
a valuation allowance of $4.5 million primarily attributable to capital losses
from investments, impairments and unrealized losses in excess of
gains.  The valuation allowance was decreased by $4.5 million during
the nine months ended September 30, 2009, due to changes in unrealized and
realized gains and losses on investments.  The changes in valuation
allowance attributable to continuing operations and to accumulated comprehensive
income were approximately $0.5 million and $4.0 million, respectively, for the
nine months ended September 30, 2009.





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.  Actual results could differ materially
from those estimates.





Fair Value of Financial
Instruments





Fair
value estimates are made at a point in time, based on relevant market data as
well as the best information available about the financial
instruments.  Fair value estimates for financial instruments for which
no or limited observable market data is available are based on judgments
regarding current economic conditions, credit and interest rate
risk.  These estimates involve significant uncertainties and judgments
and cannot be determined with precision.  As a result, such calculated
fair value estimates may not be realizable in a current sale or immediate
settlement of the instrument.  In addition, changes in the underlying
assumptions used in the fair value measurement technique, including discount
rate and estimates of future cash flows, could significantly affect these fair
value estimates.





Investment
Securities:  Fair values for debt securities and equity securities are
obtained from an independent pricing service or based on quoted market prices.
(See Notes 4 and 5.)




8





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





Restricted
Cash and Cash Equivalents :  The carrying amount for restricted cash
reported in the balance sheet approximates the fair value.





Notes
Payable:  The carrying value of our bank credit facility of $2.8
million approximates the fair value based on the current interest
rate.  Our trust preferred securities have a carried value of $56.7
million and a fair value of $51.5 million as of September 30,
2009.  The fair value of our trust preferred securities is based on
discounted cash flows using a current yield to maturity of 8.5% based on similar
issues to discount future cash flows.





For
accrued investment income, amounts recoverable from reinsurers, federal income
tax recoverable and other liabilities, the carrying amounts approximate fair
value because of the short maturity of such financial instruments.





Recently Issued Accounting
Standards





In
June 2009, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standards No. 168, “The FASB Accounting
Standards Codification and the Hierarchy of Generally Accepted Accounting
Principles” — a replacement of FASB Statement No. 162 (the
“Codification”).  The Codification reorganized existing U.S. accounting and
reporting standards issued by the FASB and other related private sector standard
setters into a single source of authoritative accounting principles arranged by
topic.  The Codification supersedes all existing U.S. accounting standards.
All other accounting literature not included in the Codification (other than SEC
guidance for publicly-traded companies) is considered non-authoritative. 
The Codification was effective on a prospective basis for interim and annual
reporting periods ending after September 15, 2009.  The adoption of
the Codification changed our references to U.S. GAAP accounting standards but
did not impact our results of operations, financial position or
liquidity.





In
September 2006, FASB issued Statement of Financial Accounting Standards No. 157,
“Fair Value Measurements,” which was codified in the FASB Accounting Standards
Codification (“ASC”) Topic 820, “Fair Value Measurements and Disclosures (“FASB
ASC  820”).  FASB ASC 820 establishes a separate framework
for determining fair values of assets and liabilities that are required by other
authoritative GAAP pronouncements to be measured at fair value.  In
addition, FASB ASC 820 incorporates and clarifies the guidance in FASB Concepts
Statement 7 regarding the use of present value techniques in measuring fair
value.  FASB ASC 820 does not require any new fair value
measurements.  FASB ASC 820 is effective for financial statements
issued for fiscal years beginning after November 15, 2007.  The
adoption of FASB ASC 820 had  no impact on our financial statements or
results of operations but did require additional disclosures.  (See
Note 4, “Fair Value.”)





In February 2007, FASB issued Statement
of Financial Accounting Standards No. 159, “The Fair Value Option for Financial
Assets and Liabilities”, which was codified into FASB ASC Topic 825, “Financial
Instruments” (“FASB ASC 825”).   FASB ASC 825 permits entities to
choose to measure many financial instruments and certain other items at fair
value with changes in fair value included in current earnings.  The
election is made on specified election dates, can be made on an instrument–by-
instrument basis, and is irrevocable.  FASB ASC 825 is effective for
financial statements issued for fiscal years beginning after November 15, 2007.
The adoption of FASB ASC 825 had no impact on our financial statements or
results of operations as we did not elect to apply FASB ASC 825 to any eligible
items.




9





In
December 2007, the FASB issued Revised Statement of Financial Accounting
Standards No. 141R, “Business Combinations”, which was codified into FASB ASC
Topic 805, “Business Combinations”, (“FASB ASC 805”).  FASB ASC 805
provides revised guidance on how an acquirer recognizes and measures in its
financial statements the identifiable assets acquired, the liabilities assumed,
and any noncontrolling interest in the acquired entity. In addition, it provides
revised guidance on the recognition and measurement of goodwill acquired in the
business combination. FASB ASC 805 also provides guidance specific to the
recognition, classification, and measurement of assets and liabilities related
to insurance and reinsurance contracts acquired in a business combination. FASB
ASC 805 applies to business combinations for acquisitions occurring on or after
January 1, 2009. The adoption of FASB ASC 805 did not have a material effect on
our results of operations or liquidity.  However, FASB ASC 805 will
impact the accounting for any future acquisitions.





In
December 2007, the FASB issued Statement of Financial Accounting Standards No.
160, “Noncontrolling Interests in Consolidated Financial Statements—an amendment
of Accounting Research Bulletin No. 51”, which was codified into FASB ASC Topic
810, “Noncontrolling Interests” (“FASB ASC 810”).  FASB ASC 810 amends
Accounting Research Bulletin No. 51 to establish accounting and reporting
standards for the noncontrolling interest in a subsidiary and for the
deconsolidation of a subsidiary.  In addition, it clarifies that a
noncontrolling interest in a subsidiary is an ownership interest in the
consolidated entity that should be reported as a component of equity in the
consolidated financial statements.  FASB ASC 810 is effective on a
prospective basis beginning January 1, 2009, except for the presentation and
disclosure requirements which are applied on a retrospective basis for all
periods presented. The adoption of FASB ASC 810 did not have a significant
impact on our consolidated financial statements.





In
April 2009, FASB issued FASB Staff Position No. FAS 157-4,
“Determining Fair Value When the Volume and Level of Activity for the Asset or
Liability Have Significantly Decreased and Identifying Transactions That Are Not
Orderly”, which was codified into FASB ASC Topic 820. FASB ASC
820  provides guidance for estimating fair value when the volume and
level of activity for the asset or liability have significantly decreased and
identifying circumstances that may indicate that a transaction is not
orderly.  FASB ASC 820 is effective for interim and annual reporting
periods ending after June 15, 2009, and is applied prospectively. The
adoption of this guidance did not have a significant impact on our consolidated
financial statements.





In April
2009, FASB issued FASB Staff Position No. FAS 115-2 and FAS 124-2, “Recognition
and Presentation of Other-Than-Temporary Impairments”,which was codified into
FASB ASC Topic 320, “Investment Securities” (“FASB ASC 320”), amending prior
other-than-temporary impairment guidance for debt in order to make the guidance
more operational and improve the presentation and disclosure of
other-than-temporary impairments in the financial statements. FASB ASC 320
does not amend existing recognition and measurement guidance related to
other-than-temporary impairments of equity securities. The provisions
of  FASB ASC 320 are effective for interim periods ending after
June 15, 2009.  We adopted FASB ASC 320 effective April 1, 2009 which
resulted in a cumulative effect adjustment to the beginning balances of retained
earnings and accumulated other comprehensive income of approximately $2.6
million before tax and $1.7 million net of tax.





In
April 2009, FASB issued FASB Staff Position No. FAS 107-1 and APB Opinion
No. 28-1, “Interim Disclosures about Fair Value of Financial Instruments”,
which was codified into FASB ASC 825.  FASB ASC 825 requires
disclosures about fair value of financial instruments for interim reporting
periods as well as in annual financial statements. This guidance is
effective for interim periods ending after June 15, 2009 but did not impact our
consolidated financial statements.  However, additional footnote
disclosures to our interim and annual financial statements were
required.




10





In May
2009, FASB issued Statement of Financial Accounting Standard No. 165,
“Subsequent Events”, which was codified into FASB ASC Topic 855, “Subsequent
Events” (“FASB ASC 855”), which provides authoritative accounting literature for
a topic previously addressed only in the auditing literature (AICPA AU Section
560, Subsequent Events).  The provisions of FASB ASC 855 are effective
for interim financial periods ending after June 15, 2009. The adoption of FASB
ASC 855 did not have a significant impact on our consolidated financial
statements.





In June
2009, FASB issued Statement of Financial Accounting Standards No. 167,
“Amendments to FASB Interpretation No. 46(R)” (“SFAS 167”), which has not yet
been codified in the Codification.  SFAS 167 addresses the effects of
eliminating the qualifying special-purpose entity concept and responds to
concerns about the application of certain key provisions of FASB Interpretation
No. 46(R), “Consolidation of Variable Interest Entities”, including concerns
over the transparency of enterprises’ involvement with variable interest
entities.  SFAS 167 is effective for calendar year end companies
beginning on January 1, 2010 with earlier application prohibited.  We
do not expect the impact of adopting SFAS 167 to have a material impact on our
consolidated financial statements.





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.





Effective
August 29, 2008, we acquired 80% of the issued and outstanding membership
interests in the subsidiaries now comprising the Heath XS Operating Unit for
consideration of $15.0 million.  In connection with the acquisition of
membership interests in the subsidiaries comprising the Heath XS Operating Unit,
we executed an operating agreement for each subsidiary.  The operating
agreements grant us the right to purchase the remaining 20% membership interests
in the subsidiaries comprising the Heath XS Operating Unit and grant to an
affiliate of the seller the right to require us to purchase such remaining
membership interests (the “Put/Call Option”).  The Put/Call Option
becomes exercisable by either us or the affiliate of the seller upon the earlier
of August 29, 2012, the termination of the employment of the seller by the Heath
XS Operating Unit or a change of control of Hallmark. If the Put/Call Option is
exercised, we will have the right or obligation to purchase the remaining 20%
membership interests in the Heath XS Operating Unit for an amount equal to nine
times the average Pre-Tax Income (as defined in the operating agreements) for
the previous 12 fiscal quarters.  We estimate the ultimate redemption
value of the Put/Call Option to be $2.0 million at September 30,
2009.




11








Tradename
                            
                            $
                            757
                            
                            15
      yearsNon-compete
      agreement
                            
                            $
                            526
                            
                            6
      yearsAgency
      relationships
                            
                            $
                            6,385
                            
                            15
      years




The Heath XS Operating Unit 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.





Effective June 5, 2009, we acquired all
of the issued and outstanding shares of CYR Insurance Management Company
(“CYR”).  CYR has as its primary asset a management agreement with
State and County Mutual Fire Insurance Company (subsequently renamed Hallmark
County Mutual Insurance Company, “HCM”) which provides for CYR to have
management and control of HCM.  We acquired all of the issued and
outstanding shares of CYR for consideration of a base purchase price of $4.0
million paid at closing plus an override commission in an amount equal to 1% of
the net premiums and net policy fees of HCM for the years 2010 and 2011 subject
to a maximum of $1.25 million.  The override commission will be paid
monthly as the subject premiums and policy fees are written.  The fair
value of the management agreement acquired is $3.2 million and will be amortized
over 4 years.  HCM is used to front certain lines of business in our
Specialty Commercial and Personal Segments in Texas where we
previously  produced policies for third party county mutual insurance
companies and reinsured 100% for a fronting fee.





4.
Fair Value





FASBASC 820 defines fair
value, establishes a consistent framework for measuring fair value and expands
disclosure requirements about fair value measurements. FASB 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, FASB 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.





Effective
January 1, 2008, we determine the fair value of our financial instruments based
on the fair value hierarchy established in FASB ASC 820.  In
accordance with FASB ASC 820, 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.




12





Under
FASB ASC 820, we determine fair value based on the price that would be received
for an asset or paid to transfer a liability in an orderly transaction between
market participants on the measurement date.  It is our policy to
maximize the use of observable inputs and minimize the use of unobservable
inputs when developing fair value measurements, in accordance with the fair
value hierarchy described above.  Fair value measurements for assets
and liabilities where there exists limited or no observable market data are
calculated based upon our pricing policy, the economic and competitive
environment, the characteristics of the asset or liability and other factors as
appropriate.  These estimated fair values may not be realized upon
actual sale or immediate settlement of the asset or liability.





Where
quoted prices are available on active exchanges for identical instruments,
investment securities are classified within Level 1 of the valuation
hierarchy.  Level 1 investment securities include common and preferred
stock.  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, 2009 (in
thousands).




Quoted
      Prices in
                    
                    
                    OtherActive
      Markets for
                    
                    
                    Observable
                    
                    
                    UnobservableIdentical
      Assets
                    
                    
                    Inputs
                    
                    
                    Inputs(Level 1)
                    
                    
                    (Level 2)
                    
                    
                    (Level 3)
                    
                    
                    TotalU.S.
      Treasury securities and obligations of U.S. government
                    
                    $
                    -
                    
                    
                    $
                    6,169
                    
                    
                    $
                    -
                    
                    
                    $
                    6,169Corporate
      debt securities
                    
                    
                    -
                    
                    
                    
                    91,427
                    
                    
                    
                    -
                    
                    
                    
                    91,427Municipal
      bonds
                    
                    
                    -
                    
                    
                    
                    168,261
                    
                    
                    
                    28,882
                    
                    
                    
                    197,143Asset
      backed
                    
                    
                    -
                    
                    
                    
                    713
                    
                    
                    
                    -
                    
                    
                    
                    713Total
      debt securities
                    
                    
                    -
                    
                    
                    
                    266,570
                    
                    
                    
                    28,882
                    
                    
                    
                    295,452Financial
      services
                    
                    
                    28,356
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    28,356All
      other
                    
                    
                    12,603
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    12,603Total
      equity securities
                    
                    
                    40,959
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    40,959Total
      debt and equity securities
                    
                    $
                    40,959
                    
                    
                    $
                    266,570
                    
                    
                    $
                    28,882
                    
                    
                    $
                    336,411




Due to
significant unobservable inputs into the valuation model for certain municipal
bonds in illiquid markets, we classified these as level 3 in the fair value
hierarchy.  We used an income approach in order to derive an estimated
fair value of such securities, which included inputs such as expected holding
period, benchmark swap rate, benchmark discount rate and a discount rate premium
for illiquidity.




13





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, 2009 (in
thousands).





Beginning
      balance as of January 1, 2009
                    
                    $
                    46,104Net
      purchases, issuances, sales and settlements
                    
                    
                    (16,450
                    )Total
      realized/unrealized gains included in net income
                    
                    
                    -Net
      gains included in other comprehensive income
                    
                    
                    (772
                    )Transfers
      in and/or out of Level 3
                    
                    
                    -Ending
      balance as of September 30, 2009
                    
                    $
                    28,882





5.
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.  We recognize an
impairment loss when an investment's value declines below cost, adjusted for
accretion, amortization and previous other-than-temporary impairments and it is
determined that the decline is other-than-temporary.




Equity
Investments:  Some of the
factors considered in evaluating whether a decline in fair value for an equity
investment is other-than-temporary include: (1) our ability and intent to
retain the investment for a period of time sufficient to allow for an
anticipated recovery in value; (2) the recoverability of cost; (3) the
length of time and extent to which the fair value has been less than cost; and
(4) the financial condition and near-term and long-term prospects for the
issuer, including the relevant industry conditions and trends, and implications
of rating agency actions and offering prices. When it is determined that an
equity investment is other-than-temporarily impaired, the security is written
down to fair value, and the amount of the impairment is included in earnings as
a realized investment loss. The fair value then becomes the new cost basis of
the investment, and any subsequent recoveries in fair value are recognized at
disposition. We recognize a realized loss when impairment is deemed to be
other-than-temporary even if a decision to sell an equity investment has not
been made. When we decide to sell a temporarily impaired available-for-sale
equity investment and we do not expect the fair value of the equity investment
to fully recover prior to the expected time of sale, the investment is deemed to
be other-than-temporarily impaired in the period in which the decision to sell
is made.




Fixed Maturity
Investments:   We assess whether we intend to sell, or it
is more likely than not that we will be required to sell, a fixed maturity
investment before recovery of its amortized cost basis less any current period
credit losses.  For fixed maturity investments that are considered
other-than-temporarily impaired and that we do not intend to sell and will not
be required to sell, we separate the amount of the impairment into the amount
that is credit related (credit loss component) and the amount due to all other
factors.  The credit loss component is recognized in earnings and is
the difference between the investment’s amortized cost basis and the present
value of its expected future cash flows.  The remaining difference
between the investment’s fair value and the present value of future expected
cash flows is recognized in other comprehensive income.




14




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




Three
      Months Ended
                      
                      
                      Nine
      Months EndedSeptember 30
                      
                      
                      September 302009
                      
                      
                      2008
                      
                      
                      2009
                      
                      
                      2008U.S.
      Treasury securities and obligations of U.S. government
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      1,217Corporate
      debt securities
                      
                      
                      239
                      
                      
                      
                      -
                      
                      
                      
                      1,269
                      
                      
                      
                      -Municipal
      bonds
                      
                      
                      -
                      
                      
                      
                      27
                      
                      
                      
                      (48
                      )
                      
                      
                      204Equity
      securities-financial services
                      
                      
                      58
                      
                      
                      
                      102
                      
                      
                      
                      115
                      
                      
                      
                      142Equity
      securities- all other
                      
                      
                      300
                      
                      
                      
                      527
                      
                      
                      
                      318
                      
                      
                      
                      746Net
      realized gain
                      
                      
                      597
                      
                      
                      
                      656
                      
                      
                      
                      1,654
                      
                      
                      
                      2,309Other-than-temporary
      impairments
                      
                      
                      -
                      
                      
                      
                      (3,152
                      )
                      
                      
                      (538
                      )
                      
                      
                      (3,714
                      )Gain
      (loss) on investments
                      
                      $
                      597
                      
                      
                      $
                      (2,496
                      )
                      
                      $
                      1,116
                      
                      
                      $
                      (1,405
                      )





We
realized gross gains on investments of $0.7 million and $0.7 million during the
three months ended September 30, 2009 and 2008, respectively, and $2.0 million
and $2.8 million for the nine months ended September 30, 2009 and 2008,
respectively. We realized gross losses on investments of $0.1 million and $3.2
million during the three months ended September 30, 2009 and 2008, respectively,
and $0.9 million and $4.2 million for the nine months ended September 30, 2009
and 2008, respectively.  We recorded proceeds from the sale of
investment securities of $25.3 million and $86.9 million during the three months
ended September 30, 2009 and 2008, respectively, and $66.2 million and $475.4
million for the nine months ended September 30, 2009 and 2008, respectively.
Realized investment gains and losses are recognized in operations on the
specific identification method.




15




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




Gross
                    
                    
                    GrossAmortized
                    
                    
                    Unrealized
                    
                    
                    Unrealized
                    
                    
                    FairAs of September 30, 2009
                    
                    Cost
                    
                    
                    Gains
                    
                    
                    Losses
                    
                    
                    ValueU.S.
      Treasury securities and obligations of U.S. government
                    
                    $
                    6,104
                    
                    
                    $
                    65
                    
                    
                    $
                    -
                    
                    
                    $
                    6,169Corporate
      debt securities
                    
                    
                    87,349
                    
                    
                    
                    6,488
                    
                    
                    
                    (2,410
                    )
                    
                    
                    91,427Municipal
      bonds
                    
                    
                    197,746
                    
                    
                    
                    2,793
                    
                    
                    
                    (3,396
                    )
                    
                    
                    197,143Asset
      backed
                    
                    
                    699
                    
                    
                    
                    14
                    
                    
                    
                    -
                    
                    
                    
                    713Total
      debt securities
                    
                    
                    291,898
                    
                    
                    
                    9,360
                    
                    
                    
                    (5,806
                    )
                    
                    
                    295,452Financial
      services
                    
                    
                    21,770
                    
                    
                    
                    6,598
                    
                    
                    
                    (12
                    )
                    
                    
                    28,356All
      other
                    
                    
                    9,294
                    
                    
                    
                    3,644
                    
                    
                    
                    (335
                    )
                    
                    
                    12,603Total
      equity securities
                    
                    
                    31,064
                    
                    
                    
                    10,242
                    
                    
                    
                    (347
                    )
                    
                    
                    40,959Total
      debt and equity securities
                    
                    $
                    322,962
                    
                    
                    $
                    19,602
                    
                    
                    $
                    (6,153
                    )
                    
                    $
                    336,411As of December 31, 2008U.S.
      Treasury securities and obligations of U.S. government
                    
                    $
                    3,996
                    
                    
                    $
                    179
                    
                    
                    $
                    -
                    
                    
                    $
                    4,175Corporate
      debt securities
                    
                    
                    67,157
                    
                    
                    
                    395
                    
                    
                    
                    (7,005
                    )
                    
                    
                    60,547Municipal
      bonds
                    
                    
                    211,083
                    
                    
                    
                    631
                    
                    
                    
                    (7,923
                    )
                    
                    
                    203,791Total
      debt securities
                    
                    
                    282,236
                    
                    
                    
                    1,205
                    
                    
                    
                    (14,928
                    )
                    
                    
                    268,513Financial
      services
                    
                    
                    24,761
                    
                    
                    
                    332
                    
                    
                    
                    (3,618
                    )
                    
                    
                    21,475All
      other
                    
                    
                    4,292
                    
                    
                    
                    29
                    
                    
                    
                    (793
                    )
                    
                    
                    3,528Total
      equity securities
                    
                    
                    29,053
                    
                    
                    
                    361
                    
                    
                    
                    (4,411
                    )
                    
                    
                    25,003Total
      debt and equity securities
                    
                    $
                    311,289
                    
                    
                    $
                    1,566
                    
                    
                    $
                    (19,339
                    )
                    
                    $
                    293,516




16




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, 2009 and December 31, 2008 (in thousands):





As of September 30, 200912 months or less
                      
                      
                      Longer than 12 months
                      
                      
                      TotalUnrealized
                      
                      
                      
                      
                      
                      Unrealized
                      
                      
                      
                      
                      
                      UnrealizedFair Value
                      
                      
                      Losses
                      
                      
                      Fair Value
                      
                      
                      Losses
                      
                      
                      Fair Value
                      
                      
                      LossesCorporate
      debt securities
                      
                      $
                      14,081
                      
                      
                      $
                      (1,527
                      )
                      
                      $
                      9,169
                      
                      
                      $
                      (883
                      )
                      
                      $
                      23,250
                      
                      
                      $
                      (2,410
                      )Municipal
      bonds
                      
                      
                      33,282
                      
                      
                      
                      (1,995
                      )
                      
                      
                      41,220
                      
                      
                      
                      (1,401
                      )
                      
                      
                      74,502
                      
                      
                      
                      (3,396
                      )Total
      debt securities
                      
                      
                      47,363
                      
                      
                      
                      (3,522
                      )
                      
                      
                      50,389
                      
                      
                      
                      (2,284
                      )
                      
                      
                      97,752
                      
                      
                      
                      (5,806
                      )Financial
      services
                      
                      
                      1,638
                      
                      
                      
                      (12
                      )
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1,638
                      
                      
                      
                      (12
                      )All
      other
                      
                      
                      2,362
                      
                      
                      
                      (335
                      )
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      2,362
                      
                      
                      
                      (335
                      )Total
      equity securities
                      
                      
                      4,000
                      
                      
                      
                      (347
                      )
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      4,000
                      
                      
                      
                      (347
                      )Total
      debt and equity securities
                      
                      $
                      51,363
                      
                      
                      $
                      (3,869
                      )
                      
                      $
                      50,389
                      
                      
                      $
                      (2,284
                      )
                      
                      $
                      101,752
                      
                      
                      $
                      (6,153
                      )





As of December 31,
200812 months or less
                    
                    
                    Longer than 12 months
                    
                    
                    TotalUnrealized
                    
                    
                    
                    
                    
                    Unrealized
                    
                    
                    
                    
                    
                    UnrealizedFair Value
                    
                    
                    Losses
                    
                    
                    Fair Value
                    
                    
                    Losses
                    
                    
                    Fair Value
                    
                    
                    LossesCorporate
      debt securities
                    
                    $
                    34,314
                    
                    
                    $
                    (5,175
                    )
                    
                    $
                    9,786
                    
                    
                    $
                    (1,830
                    )
                    
                    $
                    44,100
                    
                    
                    $
                    (7,005
                    )Municipal
      bonds
                    
                    
                    106,175
                    
                    
                    
                    (7,258
                    )
                    
                    
                    10,295
                    
                    
                    
                    (665
                    )
                    
                    
                    116,470
                    
                    
                    
                    (7,923
                    )Total
      debt securities
                    
                    
                    140,489
                    
                    
                    
                    (12,433
                    )
                    
                    
                    20,081
                    
                    
                    
                    (2,495
                    )
                    
                    
                    160,570
                    
                    
                    
                    (14,928
                    )Financial
      services
                    
                    
                    7,110
                    
                    
                    
                    (3,618
                    )
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    7,110
                    
                    
                    
                    (3,618
                    )All
      other
                    
                    
                    1,822
                    
                    
                    
                    (793
                    )
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    1,822
                    
                    
                    
                    (793
                    )Equity
      securities
                    
                    
                    8,932
                    
                    
                    
                    (4,411
                    )
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    8,932
                    
                    
                    
                    (4,411
                    )Total
      debt and equity securities
                    
                    $
                    149,421
                    
                    
                    $
                    (16,844
                    )
                    
                    $
                    20,081
                    
                    
                    $
                    (2,495
                    )
                    
                    $
                    169,502
                    
                    
                    $
                    (19,339
                    )





At
September 30, 2009, the gross unrealized losses more than twelve months old were
attributable to 39 bond positions.  At December 31, 2008, the gross
unrealized losses more than twelve months old were attributable to 15 bond
positions.  We consider these losses as a temporary decline in value
as they are predominately on bonds that we do not intend to sell and do not
believe we will be required to sell prior to recovery of our amortized cost
basis.  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 evaluation 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.




17





Also, as
a result of the challenging market conditions, we expect the volatility in the
valuation of our equity securities to continue in the foreseeable future. This
volatility may lead to additional impairments on our equity securities portfolio
or changes regarding retention strategies for certain equity
securities.





The
amortized cost and estimated fair value of debt securities at September 30, 2009
by contractual maturity are as follows. Expected maturities may differ from
contractual maturities because certain borrowers may have the right to call or
prepay obligations with or without penalties.





Amortized
                    
                    
                    FairCost
                    
                    
                    Value(in
      thousands)Due
      in one year or less
                    
                    $
                    36,343
                    
                    
                    $
                    37,237Due
      after one year through five years
                    
                    
                    126,983
                    
                    
                    
                    132,249Due
      after five years through ten years
                    
                    
                    52,526
                    
                    
                    
                    51,749Due
      after ten years
                    
                    
                    75,347
                    
                    
                    
                    73,504Asset
      backed
                    
                    
                    699
                    
                    
                    
                    713$
                    291,898
                    
                    
                    $
                    295,452





Activity related to the credit
component recognized in earnings on debt securities held by us for which a
portion of other-than-temporary impairment was recognized in other comprehensive
income for the nine months ended September 30, 2009 is as follows (in
thousands):





Balance,
      January 1, 2009
                    
                    $
                    -Credit
      componment of other-than-temporary impairment not reclassified to OCI in
      conjuction with the cumulative effect transition adjustment
      (1)
                    
                    
                    1,168Additions
      for the credit component on debt securities in which other-than-temporary
      impairment was not previously recognized
                    
                    
                    -Balance,
      September 30, 2009
                    
                    $
                    1,168





(1) As of
April 1, 2009, the Company had securities with $3.7 million of
other-than-temporary impairment previously recognized in earnings of which $1.1
million represented the credit component and $2.6 million represented the
noncredit component which was reclassified back to accumulated other
comprehensive income through a cumulative-effect adjustment.





Accumulated
other comprehensive income includes $0.7 million, net of tax, of noncredit
related impairments as of September 30, 2009.




18





6.
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 $22.5 million at
September 30, 2009 and a carrying value of $26.4 million at December 31,
2008.





7.
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 initially approved by the
shareholders on May 26, 2005.  There are 2,000,000 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, 2009, there were incentive stock options to purchase 1,262,499
shares of our common stock outstanding and non-qualified stock options to
purchase 320,000 shares of our common stock outstanding under the 2005 LTIP,
leaving 417,501 shares reserved for future issuance.  As of September
30, 2009, there were incentive stock options to purchase 3,833 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, 2009, there were outstanding non-qualified stock
options to purchase 8,333 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 prior to
2009 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.  Incentive stock options granted in 2009 under the 2005 LTIP
vest in equal annual increments on each of the first seven anniversary dates and
terminate 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.




19





A summary
of the status of our stock options as of and changes during the year-to-date
ended September 30, 2009 is presented below:





Average
                    
                    
                    Contractual
                    
                    
                    IntrinsicNumber
      of
                    
                    
                    Exercise
                    
                    
                    Term
                    
                    
                    ValueShares
                    
                    
                    Price
                    
                    
                    (Years)
                    
                    
                    ($000)Outstanding
      at January 1, 2009
                    
                    
                    1,052,298
                    
                    
                    $
                    11.12Granted
                    
                    
                    595,000
                    
                    
                    $
                    6.62Exercised
                    
                    
                    (29,716
                    )
                    
                    $
                    3.66Forfeited
      or expired
                    
                    
                    (2,083
                    )
                    
                    $
                    2.63Outstanding
      at September 30, 2009
                    
                    
                    1,615,499
                    
                    
                    $
                    9.61
                    
                    
                    
                    8.2
                    
                    
                    $
                    1,083Exercisable
      at September 30, 2009
                    
                    
                    415,833
                    
                    
                    $
                    10.36
                    
                    
                    
                    6.7
                    
                    
                    $
                    230





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 EndedSeptember 30,
                      
                      
                      September 30,2009
                      
                      
                      2008
                      
                      
                      2009
                      
                      
                      2008Intrinsic
      value of options exercised
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      107
                      
                      
                      $
                      337Cost
      of share-based payments (non-cash)
                      
                      $
                      612
                      
                      
                      $
                      305
                      
                      
                      $
                      1,488
                      
                      
                      $
                      1,078Income
      tax benefit of share-basedpayments
      recognized in income
                      
                      $
                      118
                      
                      
                      $
                      15
                      
                      
                      $
                      231
                      
                      
                      $
                      20





As of
September 30, 2009 there was $2.7 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 during the
remainder of 2009, $1.0 million is expected to be recognized in 2010, $0.7
million is expected to be recognized in 2011, $0.3 million is expected to be
recognized in 2012, $0.1 million is expected to be recognized each year from
2013 through 2016.





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 base on the
simplified method as we do not have sufficient historical exercise data to
provide a basis for estimating the expected term.




20





The
following table details the weighted average grant date fair value and related
assumptions for the periods indicated.  No options were granted in the
third quarter of 2009 or 2008.





Nine
      Months EndedSeptember 30,2009
                  
                  
                  2008Grant
      date fair value per share
                  
                  $
                  2.84
                  
                  
                  $
                  4.74Expected
      term (in years)
                  
                  
                  6.2
                  
                  
                  
                  6.4Expected
      volatility
                  
                  
                  40.0
                  %
                  
                  
                  35.0
                  %Risk
      free interest rate
                  
                  
                  2.5
                  %
                  
                  
                  3.4
                  %





8.
Segment Information





The
following is business segment information for the three and nine months ended
September 30, 2009 and 2008 (in thousands):





Three
      Months Ended
                    
                    
                    Nine
      Months EndedSeptember 30,
                    
                    
                    September 30,2009
                    
                    
                    2008
                    
                    
                    2009
                    
                    
                    2008Revenues:Standard
      Commercial Segment
                    
                    $
                    19,569
                    
                    
                    $
                    20,280
                    
                    
                    $
                    57,783
                    
                    
                    $
                    64,617Specialty
      Commercial Segment
                    
                    
                    32,346
                    
                    
                    
                    30,245
                    
                    
                    
                    97,601
                    
                    
                    
                    94,617Personal
      Segment
                    
                    
                    18,735
                    
                    
                    
                    16,053
                    
                    
                    
                    54,971
                    
                    
                    
                    48,277Corporate
                    
                    
                    1,253
                    
                    
                    
                    (1,589
                    )
                    
                    
                    3,202
                    
                    
                    
                    983Consolidated
                    
                    $
                    71,903
                    
                    
                    $
                    64,989
                    
                    
                    $
                    213,557
                    
                    
                    $
                    208,494Pre-tax income (loss), net of non-controlling
      interest:Standard
      Commercial Segment
                    
                    $
                    2,164
                    
                    
                    $
                    887
                    
                    
                    $
                    5,987
                    
                    
                    $
                    9,104Specialty
      Commercial Segment
                    
                    
                    3,588
                    
                    
                    
                    745
                    
                    
                    
                    14,280
                    
                    
                    
                    12,601Personal
      Segment
                    
                    
                    2,225
                    
                    
                    
                    2,544
                    
                    
                    
                    7,738
                    
                    
                    
                    7,047Corporate
                    
                    
                    (2,178
                    )
                    
                    
                    (4,030
                    )
                    
                    
                    (6,960
                    )
                    
                    
                    (7,224
                    )Consolidated
                    
                    $
                    5,799
                    
                    
                    $
                    146
                    
                    
                    $
                    21,045
                    
                    
                    $
                    21,528


21


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




September
      30,
                      
                      
                      December
      31,2009
                      
                      
                      2008AssetsStandard
      Commercial Segment
                      
                      $
                      139,923
                      
                      
                      $
                      146,415Specialty
      Commercial Segment
                      
                      
                      271,301
                      
                      
                      
                      230,130Personal
      Segment
                      
                      
                      103,113
                      
                      
                      
                      84,456Corporate
                      
                      
                      101,669
                      
                      
                      
                      77,397$
                      616,006
                      
                      
                      $
                      538,398





9.
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 EndedSeptember 30,
                    
                    
                    September 30,2009
                    
                    
                    2008
                    
                    
                    2009
                    
                    
                    2008Ceded
      earned premiums
                    
                    $
                    7,137
                    
                    
                    $
                    2,153
                    
                    
                    $
                    12,331
                    
                    
                    $
                    6,126Reinsurance
      recoveries
                    
                    $
                    4,166
                    
                    
                    $
                    8,211
                    
                    
                    $
                    7,388
                    
                    
                    $
                    9,474





We
presently retain 100% of the risk associated with all policies marketed by our
Personal Lines Operating Unit. We currently reinsure the following exposures on
business generated by our AHIS Operating Unit, our TGA Operating Unit, our Heath
XS Operating Unit, and our Aerospace Operating Unit:




·
            Property
      catastrophe.  Our property catastrophe reinsurance
      reduces the financial impact a catastrophe could have on our commercial
      and personal 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 are:




o
            We
      retain the first $3.0 million of property catastrophe losses;
      and




22




o
            Our
      reinsurers reimburse us 100% for any loss in excess of our $3.0 million
      retention up to $35.0 million for each catastrophic occurrence, subject to
      an aggregate limit of $64.0
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
  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 $10.0 million for all commercial property risk involved
      in any one occurrence, in all cases subject to an aggregate limit of $30.0
      million for all commercial property losses occurring during the treaty
      period; and




o
            Individual
      risk facultative reinsurance is purchased on any commercial property with
      limits above $6.0 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
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 combined
      aircraft hull and liability loss and for the next $650,000 of each airport
      liability loss; and




o
            Other
      risks with liability limits greater than $1.0 million are placed in a
      quota share treaty where we retain 20% of incurred
  losses.





·
            Heath
      XS.  Effective July 1, 2009, in states where we are
      admitted, we directly insure policies written by our Heath XS Operating
      Unit and reinsure a portion of the risk with third party carriers. 
      In states where we are not admitted, our Heath XS Operating Unit writes
      policies under fronting arrangements pursuant to which we assume all of
      the risk and then retrocede a portion of the risk to third party
      reinsurers.  We reinsure or retrocede 79% of the risk on policies
      written by our Heath XS Operating Unit.  Through June 30, 2009,
      our Heath XS Operating Unit wrote policies under a fronting arrangement
      pursuant to which we assumed 35% of the
risk.





·
            Hallmark County
      Mutual.  HCM is used to front certain lines of business
      in our Specialty Commercial and Personal Segments in Texas where we
      previously produced policies for third party county mutual insurance
      companies and reinsured 100% for a fronting fee.  In addition
      HCM is used to front business produced by unaffiliated third parties. HCM
      does not retain any business.


23


10.
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,
2009, the note balance was $30.9 million.





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, 2009, the
balance on the revolving note was $2.8 million, which currently bears interest
at 2.18% per annum. (See Note 11, “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, 2009 the
note balance was $25.8 million.





11.
Credit Facilities





We have a credit facility with The
Frost National Bank which was amended and restated on January 27, 2006 to
provide 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 all of our non-insurance company 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, 2009, we were in compliance with all of our
covenants.  As of September 30, 2009 we had $2.8 million outstanding
under this facility.





24




12.
Deferred Policy Acquisition Costs





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


Three Months Ended
                  
                  
                  Nine Months EndedSeptember 30,
                  
                  
                  September 30,2009
                  
                  
                  2008
                  
                  
                  2009
                  
                  
                  2008Deferred
                  
                  $
                  (7,454
                  )
                  
                  $
                  (13,700
                  )
                  
                  $
                  (38,539
                  )
                  
                  $
                  (41,718
                  )Amortized
                  
                  
                  8,257
                  
                  
                  
                  14,204
                  
                  
                  
                  35,434
                  
                  
                  
                  41,326Net
                  
                  $
                  803
                  
                  
                  $
                  504
                  
                  
                  $
                  (3,105
                  )
                  
                  $
                  (392
                  )





13.
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 EndedSeptember 30,
                    
                    
                    September 30,2009
                    
                    
                    2008
                    
                    
                    2009
                    
                    
                    2008Weighted
      average shares - basic
                    
                    
                    20,652
                    
                    
                    
                    20,809
                    
                    
                    
                    20,790
                    
                    
                    
                    20,799Effect
      of dilutive securities
                    
                    
                    14
                    
                    
                    
                    62
                    
                    
                    
                    32
                    
                    
                    
                    82Weighted
      average shares - assuming dilution
                    
                    
                    20,666
                    
                    
                    
                    20,871
                    
                    
                    
                    20,822
                    
                    
                    
                    20,881





For the three and nine months ended
September 30, 2009 and 2008, 899,166 shares of common stock potentially issuable
upon the exercise of employee stock options were excluded from the weighted
average number of shares outstanding on a diluted basis because the effect of
such options would be anti-dilutive.





14.
Net Periodic Pension Cost





The
following table details the net periodic pension cost incurred by period (in
thousands):





Three
      Months Ended
                    
                    
                    Nine
      Months EndedSeptember
      30,
                    
                    
                    September
      30,2009
                    
                    
                    2008
                    
                    
                    2009
                    
                    
                    2008Interest
      cost
                    
                    $
                    160
                    
                    
                    $
                    167
                    
                    
                    $
                    482
                    
                    
                    $
                    501Amortization
      of net loss
                    
                    
                    122
                    
                    
                    
                    16
                    
                    
                    
                    366
                    
                    
                    
                    48Expected
      return on plan assets
                    
                    
                    (121
                    )
                    
                    
                    (167
                    )
                    
                    
                    (363
                    )
                    
                    
                    (502
                    )Net
      periodic pension cost
                    
                    $
                    161
                    
                    
                    $
                    16
                    
                    
                    $
                    485
                    
                    
                    $
                    47





We did not make any contributions to
our frozen defined benefit cash balance plan (“Cash Balance Plan”) during the
three or nine months ended September 30, 2009.  We contributed
$414,000 and $650,000  to the Cash Balance Plan during the three and
nine months ended September 30, 2008, respectively.  Refer to Note 14
to the consolidated financial statements in our Annual Report on Form 10-K for
the year ended December 31, 2008 for more discussion of our retirement
plans.





25




15.
Contingencies





We are engaged in legal proceedings
in the ordinary course of business, none of which, either individually or in the
aggregate, are believed likely to have a material adverse effect on our
consolidated financial position or results of operations, in the opinion of
management.  The various legal proceedings to which we are a party are
routine in nature and incidental to our business.





We have evaluated subsequent events
through November 12, 2009, the date the financial statements were
issued.





Item
2.  Management's Discussion and Analysis of Financial Condition and
Results of Operations.





The
following discussion should be read together with our consolidated financial
statements and the notes thereto.  This discussion contains
forward-looking statements.  Please see “Risks Associated with
Forward-Looking Statements in this Form 10-Q”  for a discussion of
some of the uncertainties, risks and assumptions associated with these
statements.





Introduction





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, personal 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 and the excess
commercial automobile and commercial umbrella risks produced by our Heath XS
Operating Unit which are written on a national basis.  We pursue our business
activities through subsidiaries whose operations are organized into five
operating units which are supported by four of our insurance company
subsidiaries.




Our
non-carrier insurance activities are segregated by operating units into the
following reportable segments:




·
            Standard
      Commercial Segment.  Our Standard Commercial Segment
      includes the standard lines commercial property/casualty insurance
      products and services handled by our AHIS Operating Unit which is
      comprised of our American Hallmark Insurance Services, Inc. and Effective
      Claims Management, Inc.
subsidiaries.





·
            Specialty
      Commercial Segment.  Our Specialty Commercial Segment
      includes the excess and surplus lines commercial property/casualty
      insurance products and services handled by our TGA Operating Unit, the
      general aviation insurance products and services handled by our Aerospace
      Operating Unit, and the excess commercial automobile and commercial
      umbrella insurance products handled by our Heath XS Operating
      Unit.  Our TGA Operating Unit is comprised of our TGA Insurance
      Managers, Inc., Pan American Acceptance Corporation (“PAAC”) and TGA
      Special Risk, Inc. subsidiaries.  Our Aerospace Operating Unit
      is comprised of our Aerospace Insurance Managers, Inc., Aerospace Special
      Risk, Inc. and Aerospace Claims Management Group, Inc.
      subsidiaries.  Our Heath XS Operating Unit is compromised of our
      Heath XS, LLC and Hardscrabble Data Solutions, LLC
      subsidiaries.




26




·
            Personal
      Segment.  Our Personal Segment includes the non-standard
      personal automobile insurance and complementary personal insurance
      products and services handled by our Personal Lines Operating Unit which
      is comprised of American Hallmark General Agency, Inc. and Hallmark Claims
      Services, Inc., both of which do business as Hallmark Insurance
      Company.





The retained premium produced by our
operating units is supported by the following insurance company
subsidiaries:





·
            American
      Hallmark Insurance Company of Texas(“AHIC”)presently retains
      all of the risks on the commercial property/casualty policies marketed
      within the Standard Commercial Segment and assumes a portion of the risks
      on the commercial and aviation property/casualty policies marketed within
      the Specialty Commercial Segment.





·
            Hallmark
      Specialty Insurance Company (“HSIC”) presently retains a portion of
      the risks on the commercial property/casualty policies marketed within the
      Specialty Commercial Segment.





·
            Hallmark
      Insurance Company (“HIC”)presently assumes all of the risks on the
      personal property/casualty policies marketed by our Personal Lines
      Operating Unit and assumes a portion of the risks on the aviation
      property/casualty products marketed within the Specialty Commercial
      Segment.





·
            Hallmark
      County Mutual Insurance Company (“HCM”)control and
      management was acquired effective June 5, 2009 through the acquisition of
      all of the issued and outstanding shares of CYR Insurance Management
      Company (“CYR”).  CYR has as its primary asseta
      management agreement with HCM which provides for CYR to have management
      and control of HCM.  HCM is used to front certain lines of
      business in our Specialty Commercial and Personal Segments in Texas where
      we previously produced policies for third party county mutual insurance
      companies and reinsured 100% for a fronting fee.  HCM does not
      retain any business.





AHIC, HSIC, and HIC have
entered into a pooling arrangement  pursuant to which AHICretains 46% of the total net premiums written by all of our operating
units, HIC retains 34% of our total net premiums written and HSIC retains 20% of
our total net premiums written.   This pooling arrangement has no
impact on our consolidated financial statements under GAAP.




Results
of Operations





Management
Overview.During the three and nine months ended September 30,
2009, our total revenues were $71.9 million and $213.6 million, representing a
11% and 2% increase from the $65.0 million and $208.5 million in total revenues
for the same periods of 2008.  This increase in revenue was primarily
attributable to increased earned premium due to increased retention of business
in our Specialty Commercial Segment, the acquisition of our Heath XS Operating
Unit in the third quarter of 2008 and increased production by our Personal Lines
Segment. Increased revenue was partially offset by reduced earned premium in our
Standard Commercial Segment due to the deterioration of the general economic
environment in our major markets and by lower commission and fee income in our
Specialty Commercial Segment due to profit sharing commission adjustments
related to adverse loss development on prior accident years as well as the shift
from a third party agency structure to an insurance underwriting
structure.





27




We
reported net earnings of $4.2 million and $15.3 million for the three and nine
months ended September 30, 2009, which were $3.6 million higher than the $0.6
million reported for the third quarter 2008 and the same as reported for the
nine months ended September 30, 2008.  On a diluted basis per share, net
earnings were $0.20 and $0.73 per share for the three months and nine months
ended September 30, 2009, as compared to $0.03 and $0.73 per share for the same
periods in 2008.   The increase in net earnings for the three months
ended September 30, 2009 was primarily attributable to increased revenue,
partially offset by higher loss and loss adjustment expense (“LAE”) due mostly
to unfavorable prior year loss development of $1.7 million recognized in the
three months ending September 30, 2009 as compared to favorable development of
$0.1 million recognized during the three months ending September 30, 2008. 
The increase in revenue for the nine months ending September 30, 2009 was offset
by increased loss and LAE due mostly to unfavorable prior year loss development
of $3.5 million recognized during the nine months ending September 30, 2009 as
compared to favorable development of $1.9 million recognized during the nine
months ending September 30, 2008.








28




Third
Quarter 2009 as Compared to Third Quarter 2008





The
following is additional business segment information for the three months ended
September 30, 2009 and 2008 (in thousands):





Hallmark
Financial Services, Inc


Consolidated
Segment Data





Three Months Ended September 30, 2009Standard
                            
                            
                            SpecialtyCommercial
                            
                            
                            Commercial
                            
                            
                            PersonalSegment
                            
                            
                            Segment
                            
                            
                            Segment
                            
                            
                            Corporate
                            
                            
                            ConsolidatedProduced
      premium (1)
                            
                            $
                            17,309
                            
                            
                            $
                            36,064
                            
                            
                            $
                            17,424
                            
                            
                            $
                            -
                            
                            
                            $
                            70,797Gross
      premiums written
                            
                            
                            17,309
                            
                            
                            
                            39,280
                            
                            
                            
                            17,424
                            
                            
                            
                            -
                            
                            
                            
                            74,013Ceded
      premiums written
                            
                            
                            (1,144
                            )
                            
                            
                            (10,078
                            )
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            (11,222
                            )Net
      premiums written
                            
                            
                            16,165
                            
                            
                            
                            29,202
                            
                            
                            
                            17,424
                            
                            
                            
                            -
                            
                            
                            
                            62,791Change
      in unearned premiums
                            
                            
                            1,627
                            
                            
                            
                            92
                            
                            
                            
                            (272
                            )
                            
                            
                            -
                            
                            
                            
                            1,447Net
      premiums earned
                            
                            
                            17,792
                            
                            
                            
                            29,294
                            
                            
                            
                            17,152
                            
                            
                            
                            -
                            
                            
                            
                            64,238Total
      revenues
                            
                            
                            19,569
                            
                            
                            
                            32,346
                            
                            
                            
                            18,735
                            
                            
                            
                            1,253
                            
                            
                            
                            71,903Losses
      and loss adjustment expenses
                            
                            
                            11,425
                            
                            
                            
                            17,641
                            
                            
                            
                            11,513
                            
                            
                            
                            -
                            
                            
                            
                            40,579Pre-tax  income
      (loss), net ofnon-controlling
      interest
                            
                            
                            2,164
                            
                            
                            
                            3,588
                            
                            
                            
                            2,225
                            
                            
                            
                            (2,178
                            )
                            
                            
                            5,799Net
      loss ratio (2)
                            
                            
                            64.2
                            %
                            
                            
                            60.2
                            %
                            
                            
                            67.1
                            %
                            
                            
                            
                            
                            
                            
                            63.2
                            %Net
      expense ratio (2)
                            
                            
                            32.8
                            %
                            
                            
                            29.8
                            %
                            
                            
                            22.4
                            %
                            
                            
                            
                            
                            
                            
                            31.0
                            %Net
      combined ratio (2)
                            
                            
                            97.0
                            %
                            
                            
                            90.0
                            %
                            
                            
                            89.5
                            %
                            
                            
                            
                            
                            
                            
                            94.2
                            %





Three
      Months Ended September 30, 2008Standard
                      
                      
                      SpecialtyCommercial
                      
                      
                      Commercial
                      
                      
                      PersonalSegment
                      
                      
                      Segment
                      
                      
                      Segment
                      
                      
                      Corporate
                      
                      
                      ConsolidatedProduced
      premium (1)
                      
                      $
                      18,957
                      
                      
                      $
                      36,295
                      
                      
                      $
                      14,763
                      
                      
                      $
                      -
                      
                      
                      $
                      70,015Gross
      premiums written
                      
                      
                      18,954
                      
                      
                      
                      25,288
                      
                      
                      
                      14,763
                      
                      
                      
                      -
                      
                      
                      
                      59,005Ceded
      premiums written
                      
                      
                      (1,274
                      )
                      
                      
                      (1,219
                      )
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (2,493
                      )Net
      premiums written
                      
                      
                      17,680
                      
                      
                      
                      24,069
                      
                      
                      
                      14,763
                      
                      
                      
                      -
                      
                      
                      
                      56,512Change
      in unearned premiums
                      
                      
                      1,784
                      
                      
                      
                      650
                      
                      
                      
                      (18
                      )
                      
                      
                      -
                      
                      
                      
                      2,416Net
      premiums earned
                      
                      
                      19,464
                      
                      
                      
                      24,719
                      
                      
                      
                      14,745
                      
                      
                      
                      -
                      
                      
                      
                      58,928Total
      revenues
                      
                      
                      20,280
                      
                      
                      
                      30,245
                      
                      
                      
                      16,053
                      
                      
                      
                      (1,589
                      )
                      
                      
                      64,989Losses
      and loss adjustment expenses
                      
                      
                      13,239
                      
                      
                      
                      16,287
                      
                      
                      
                      9,455
                      
                      
                      
                      -
                      
                      
                      
                      38,981Pre-tax  income
      (loss), net ofnon-controlling
      interest
                      
                      
                      887
                      
                      
                      
                      745
                      
                      
                      
                      2,544
                      
                      
                      
                      (4,030
                      )
                      
                      
                      146Net
      loss ratio (2)
                      
                      
                      68.0
                      %
                      
                      
                      65.9
                      %
                      
                      
                      64.1
                      %
                      
                      
                      
                      
                      
                      
                      66.2
                      %Net
      expense ratio (2)
                      
                      
                      30.9
                      %
                      
                      
                      30.8
                      %
                      
                      
                      21.5
                      %
                      
                      
                      
                      
                      
                      
                      30.1
                      %Net
      combined ratio (2)
                      
                      
                      98.9
                      %
                      
                      
                      96.7
                      %
                      
                      
                      85.6
                      %
                      
                      
                      
                      
                      
                      
                      96.3
                      %





(1)  Produced
premium is a non-GAAP measurement that management uses to track total premium
produced by our operations. Produced premium excludes unaffiliated third party
premium fronted on our recently acquired HCM subsidiary. We believe this is a
useful tool for users of our financial statements to measure our premium
production whether retained by our insurance company subsidiaries or assumed by
third party insurance carriers who pay us commission
revenue.


(2)  The
net loss ratio is calculated as incurred losses and LAE divided by net premiums
earned, each determined in accordance  with GAAP.  During
the second quarter of 2009 we changed the method in which the net expense ratio
is calculated.  The net  expense ratio is now calculated for
our operating units that retain 100% of produced premium as total operating
expenses  for the unit offset by agency fee income divided by net
premiums earned, each determined in accordance with GAAP.  For the
operating units that do not retain 100% of the produced premium, the net expense
ratio is calculated as underwriting expenses of the insurance company
subsidiaries for the unit offset by agency fee income, divided by net premiums
earned, each determined in accordance with GAAP.  Net combined ratio
is calculated as the sum of the net loss ratio and the net expense
ratio.  All prior periods have been restated to conform to the new
method, resulting in an increase to the consolidated net expense ratio of 1.3%
for the three months ended September 30, 2008.


29


Standard
Commercial Segment





Gross
premiums written for the Standard Commercial Segment were $17.3 million for the
three months ended September 30, 2009, which was $1.7 million, or 9%, less than
the $19.0 million reported for the same period in 2008.  Net premiums
written were $16.2 million for the three months ended September 30, 2009 as
compared to $17.7 million reported for the same period in 2008.  The
decrease in premium volume was predominately due to the deterioration of the
general economic environment, particularly in the construction industry,
reducing the available insured exposures.





Total
revenue for the Standard Commercial Segment of $19.6 million for the three
months ended September 30, 2009 was $0.7 million less than the $20.3 million
reported during the same period in 2008.  This 4% decrease in total
revenue was mostly due to decreased net premiums earned of $1.7 million, offset
by increased profit sharing commissions of $1.3 million related to favorable
loss development on prior treaty years during 2009 compared to unfavorable loss
development on prior treaty years for the same period in 2008. Decreased net
investment income of $0.3 million during the three months ended September 30,
2009 as compared to the same period during 2008 also contributed to the decrease
in total revenue.





Pre-tax
income for our Standard Commercial Segment of $2.2 million for the three months
ended September 30, 2009 increased $1.3 million, or 144%, from the $0.9 million
reported for the same period of 2008. Decreased revenue was offset by lower loss
and LAE expenses of $1.8 million primarily as a result of hurricane related
losses recorded in the third quarter of 2008 and by lower operating expenses of
$0.2 million mostly due to lower premium volume.





The
Standard Commercial Segment reported a net loss ratio of 64.2% for the three
months ended September 30, 2009 as compared to 68.0% for 2008. The gross loss
ratio before reinsurance for the three months ended September 30, 2009 was 66.2%
as compared to the 89.7% reported for the same period of 2008.  The
gross loss results for the three months ended September 30, 2008 included $8.8
million of hurricane related losses partially offset by $0.4 million of
favorable development on prior accident years.  Hurricane related
losses accounted for 42.3% of the gross loss ratio and 17.1% of the net loss
ratio for the third quarter of 2008. During the three months ended September 30,
2009, the Standard Commercial Segment reported unfavorable development of $0.4
million. The Standard Commercial Segment reported a higher net expense ratio of
32.8% for the three months ended September 30, 2009 as compared to 30.9% for the
same period in 2008 due mostly to lower earned premium.





Specialty
Commercial Segment





The $32.3 million of total revenue
for the three months ended September 30, 2009 was $2.1 million higher than the
$30.2 million reported for the same period in 2008. This increase in revenue was
largely due to increased net premiums earned of $4.6 million as a result of the
increased retention of business and the acquisition of the Heath XS Operating
Unit during the third quarter of 2008. These increases were partially offset by
lower commission and fee income of $2.4 million primarily related to profit
sharing commission adjustments related to adverse loss development on prior
accident years as well as the shift from a third party agency structure to an
insurance underwriting structure.








Pre-tax income for the Specialty
Commercial Segment of $3.6 million was $2.9 million higher than the $0.7 million
reported for the same period in 2008. Increased revenue was complemented by
lower operating expenses of $2.2 million. These lower operating expenses in the
third quarter of 2009 were primarily the result of a $1.2 million premium
receivable write-off due to the default of a producer in our TGA Operating Unit
during the third quarter of 2008 and lower production related expenses of $1.0
million due to lower produced premium and lower operating expenses of $0.1
million in our Aerospace Operating Unit and TGA Operating Unit partially offset
by increased operating expenses of $0.3 million due primarily to the acquisition
of the  Heath XS Operating Unit effective August 29,
2008.  The increase in pre-tax income was further offset by higher
loss and LAE expenses of $1.3 million.




The Specialty Commercial Segment
reported a net loss ratio of 60.2% for the three months ended September 30, 2009
as compared to 65.9% for the same period during 2008.  Hurricane
related losses accounted for 10.8% of the net loss ratio for the third quarter
of 2008, offset by unfavorable prior year loss development of $1.2 million
during the third quarter of 2009 as compared to $0.4 million during the same
period of 2008.   The Specialty Commercial Segment reported a net
expense ratio of 29.8% for the third quarter of 2009 as compared to 30.8% for
the same period the prior year.





Personal
Segment





Net premiums written for our Personal
Segment increased $2.6 million during the third quarter of 2009 to $17.4 million
compared to $14.8 million for the third quarter of 2008.  The increase
in premium was due mostly to continued geographic expansion.





Total revenue for the Personal
Segment increased 17% to $18.7 million for the third quarter of 2009 from $16.1
million for the third quarter of 2008.  Higher earned premium of $2.4
million was the primary reason for the increase in revenue for the
period.  Increased finance charges of $0.3 million further contributed
to the increase in revenue during the third quarter of 2009.




Pre-tax income for the Personal
Segment was $2.2 million for the three months ended September 30, 2009 compared
to $2.5 million for the same period during 2008.  Increased revenue
was offset by increased losses and LAE of $2.1 million and increased operating
expenses of $0.9 million due mostly to increased production and salary expense
related to continued geographic expansion.





The Personal Segment reported a net
loss ratio of 67.1% for the three months ended September 30, 2009 as compared to
64.1% for the third quarter of 2008.  The increase in the net loss
ratio was primarily a result of higher current accident year loss experience as
compared to the prior year due in part to hail storm related losses. We
recognized $0.1 million of unfavorable prior accident year development for the
three months ended September 30, 2009 as compared to $0.2 million of favorable
prior accident year development for the same period during 2008. The Personal
Segment reported a net expense ratio of 22.4% for the three months ended
September 30, 2009 as compared to 21.5% for the second quarter of
2008.





Corporate





Total revenue for corporate increased
by $2.8 million for the three months ended September 30, 2009 as compared to the
same period the prior year.  This increase in total revenue was due
primarily to recognized gains of $0.6 million on our investment portfolio for
the three months ended September 30, 2009 as compared to recognized losses of
$2.5 million during the same period in 2008.  This increase in revenue
was offset by lower net investment income of $0.3 million for the three months
ended September 30, 2009 as compared to the same period of the prior
year.





31


Corporate pre-tax loss was $2.2
million for the three months ended September 30, 2009 as compared to $4.0
million for the same period the prior year.  The decreased loss was
mostly due to increased revenue  partially offset by increased
operating expenses of $0.4 million related to stock option grants to directors
and employees and periodic pension costs, other compensation expense of $0.4
million, and other operating expenses of $0.3 million. These increases in
operating expenses were offset by a $0.4 million subsequent recovery related to
a receivable for a cancelled start-up program.  In addition, increased
intangible amortization of $0.3 million related to our acquisition of CYR during
the second quarter of 2009 further offset the increased revenue.





32




Nine
Months Ended September 30, 2009 as Compared to Nine Months Ended September 30,
2008





The following is additional business
segment information for the nine months ended September 30, 2009 and 2008 (in
thousands):





Hallmark
Financial Services, Inc.


Consolidated
Segment Data





Nine
      Months Ended September 30, 2009Standard
                            
                            
                            SpecialtyCommercial
                            
                            
                            Commercial
                            
                            
                            PersonalSegment
                            
                            
                            Segment
                            
                            
                            Segment
                            
                            
                            Corporate
                            
                            
                            ConsolidatedProduced
      premium (1)
                            
                            $
                            56,881
                            
                            
                            $
                            110,598
                            
                            
                            $
                            54,968
                            
                            
                            $
                            -
                            
                            
                            $
                            222,447Gross
      premiums written
                            
                            
                            56,881
                            
                            
                            
                            108,696
                            
                            
                            
                            54,968
                            
                            
                            
                            -
                            
                            
                            
                            220,545Ceded
      premiums written
                            
                            
                            (3,331
                            )
                            
                            
                            (13,383
                            )
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            (16,714
                            )Net
      premiums written
                            
                            
                            53,550
                            
                            
                            
                            95,313
                            
                            
                            
                            54,968
                            
                            
                            
                            -
                            
                            
                            
                            203,831Change
      in unearned premiums
                            
                            
                            419
                            
                            
                            
                            (13,692
                            )
                            
                            
                            (4,571
                            )
                            
                            
                            -
                            
                            
                            
                            (17,844
                            )Net
      premiums earned
                            
                            
                            53,969
                            
                            
                            
                            81,621
                            
                            
                            
                            50,397
                            
                            
                            
                            -
                            
                            
                            
                            185,987Total
      revenues
                            
                            
                            57,783
                            
                            
                            
                            97,601
                            
                            
                            
                            54,971
                            
                            
                            
                            3,202
                            
                            
                            
                            213,557Losses
      and loss adjustment expenses
                            
                            
                            33,890
                            
                            
                            
                            48,422
                            
                            
                            
                            33,240
                            
                            
                            
                            -
                            
                            
                            
                            115,552Pre-tax
      income (loss), net ofnon-controlling
      interest
                            
                            
                            5,987
                            
                            
                            
                            14,280
                            
                            
                            
                            7,738
                            
                            
                            
                            (6,960
                            )
                            
                            
                            21,045Net
      loss ratio (2)
                            
                            
                            62.8
                            %
                            
                            
                            59.3
                            %
                            
                            
                            66.0
                            %
                            
                            
                            
                            
                            
                            
                            62.1
                            %Net
      expense ratio (2)
                            
                            
                            32.4
                            %
                            
                            
                            30.0
                            %
                            
                            
                            21.4
                            %
                            
                            
                            
                            
                            
                            
                            30.8
                            %Net
      combined ratio (2)
                            
                            
                            95.2
                            %
                            
                            
                            89.3
                            %
                            
                            
                            87.4
                            %
                            
                            
                            
                            
                            
                            
                            92.9
                            %





Nine
      Months Ended September 30, 2008Standard
                        
                        
                        SpecialtyCommercial
                        
                        
                        Commercial
                        
                        
                        PersonalSegment
                        
                        
                        Segment
                        
                        
                        Segment
                        
                        
                        Corporate
                        
                        
                        ConsolidatedProduced
      premium (1)
                        
                        $
                        62,330
                        
                        
                        $
                        104,302
                        
                        
                        $
                        46,643
                        
                        
                        $
                        -
                        
                        
                        $
                        213,275Gross
      premiums written
                        
                        
                        62,327
                        
                        
                        
                        77,387
                        
                        
                        
                        46,643
                        
                        
                        
                        -
                        
                        
                        
                        186,357Ceded
      premiums written
                        
                        
                        (3,667
                        )
                        
                        
                        (2,836
                        )
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        (6,503
                        )Net
      premiums written
                        
                        
                        58,660
                        
                        
                        
                        74,551
                        
                        
                        
                        46,643
                        
                        
                        
                        -
                        
                        
                        
                        179,854Change
      in unearned premiums
                        
                        
                        2,224
                        
                        
                        
                        (1,900
                        )
                        
                        
                        (2,242
                        )
                        
                        
                        -
                        
                        
                        
                        (1,918
                        )Net
      premiums earned
                        
                        
                        60,884
                        
                        
                        
                        72,651
                        
                        
                        
                        44,401
                        
                        
                        
                        -
                        
                        
                        
                        177,936Total
      revenues
                        
                        
                        64,617
                        
                        
                        
                        94,617
                        
                        
                        
                        48,277
                        
                        
                        
                        983
                        
                        
                        
                        208,494Losses
      and loss adjustment expenses
                        
                        
                        36,218
                        
                        
                        
                        45,266
                        
                        
                        
                        29,030
                        
                        
                        
                        -
                        
                        
                        
                        110,514Pre-tax
      income (loss)
                        
                        
                        9,104
                        
                        
                        
                        12,601
                        
                        
                        
                        7,047
                        
                        
                        
                        (7,224
                        )
                        
                        
                        21,528Net
      loss ratio (2)
                        
                        
                        59.5
                        %
                        
                        
                        62.3
                        %
                        
                        
                        65.4
                        %
                        
                        
                        
                        
                        
                        
                        62.1
                        %Net
      expense ratio (2)
                        
                        
                        31.0
                        %
                        
                        
                        30.6
                        %
                        
                        
                        21.6
                        %
                        
                        
                        
                        
                        
                        
                        30.5
                        %Net
      combined ratio (2)
                        
                        
                        90.5
                        %
                        
                        
                        92.9
                        %
                        
                        
                        87.0
                        %
                        
                        
                        
                        
                        
                        
                        92.6
                        %





(1)    Produced
premium is a non-GAAP measurement that management uses to track total premium
produced by our operations. Produced premium excludes unaffiliated third party
premium fronted on our recently acquired HCM subsidiary. We believe this is a
useful tool for users of our financial statements to measure our premium
production whether retained by our insurance company subsidiaries or retained by
third party insurance carriers who pay us commission revenue.





(2) The
net loss ratio is calculated as incurred losses and LAE divided by net premiums
earned, each determined in accordance with GAAP.  During the second
quarter of 2009 we changed the method in which the net expense ratio is
calculated. The net expense ratio is now calculated for our operating units that
retain 100% of produced premium as total operating expenses for the unit offset
by agency fee income divided by net premiums earned, each determined in
accordance with GAAP.  For the operating units that do not retain 100%
of the produced premium, the net expense ratio is calculated as underwriting
expenses of the insurance company subsidiaries for the unit offset by agency fee
income, divided by net premiums earned, each determined in accordance with GAAP.
Net combined ratio is calculated as the sum of the net loss ratio and the net
expense ratio.  All prior periods have been restated to conform to the
new method, resulting in an increase to the consolidated net expense ratio of
1.6% for the nine months ended September 30, 2008.


33


Standard
Commercial Segment





Gross
premiums written for the Standard Commercial Segment were $56.9 million for the
nine months ended September 30, 2009, or 9% less than the $62.3 million reported
for the same period in 2008.  Net premiums written were $53.6 million
for the nine months ended September 30, 2009 as compared to $58.7 million
reported for the same period in 2008.  The decrease in premium volume
was predominately due to the deterioration of the general economic environment,
particularly in the construction industry, reducing the available insured
exposures.





Total
revenue for the Standard Commercial Segment of $57.8 million for the nine months
ended September 30, 2009 was $6.8 million less than the $64.6 million reported
during the nine months ended September 30, 2008.  This 11% decrease in
total revenue was primarily due to lower net earned premiums of $6.9 million and
lower net investment income of $0.4 million partially offset by increased profit
sharing commissions of $0.5 million related to favorable loss development on
prior treaty years.





Pre-tax
income for our Standard Commercial Segment of $6.0 million for the nine months
ended September 30, 2009 decreased $3.1 million, or 34%, from the $9.1 million
reported for the same period of 2008.  This decrease in pre-tax income
was primarily attributable to decreased revenue partially offset by lower loss
and LAE expenses of $2.3 million and lower operating expenses of $1.4 million
primarily due to lower production related expenses.





The net
loss ratio for the nine months ended September 30, 2009 was 62.8% as compared to
the 59.5% reported for the same period of 2008.  The gross loss ratio
before reinsurance was 62.7% for the nine months ended September 30, 2009 as
compared to 65.6% for the same period the prior year.  The gross loss
results for the nine months ended September 30, 2008 included $8.8 million of
hurricane related losses partially offset by $2.6 million of favorable
development on prior accident years. The Standard Commercial Segment reported
$0.2 million of favorable prior year development for the nine months ended
September 30, 2009. The Standard Commercial Segment reported net expense ratios
of 32.4% and 31.0% for the nine months ended September 30, 2009 and 2008,
respectively.  The increase in the net expense ratio was due mostly to
lower earned premium.





Specialty
Commercial Segment





Gross premiums written for the
Specialty Commercial Segment for the first nine months of 2009 were $108.7
million, or 40% more than the $77.4 million reported for the same period in
2008.  Net premiums written for the first nine months of 2009 of $95.3
million were 28% more than the $74.6 million reported for the same period in
2008.  The increase in premium volume was due to increased retention
of business and the acquisition of the Heath XS Operating Unit during the third
quarter of 2008.





Total revenue for the Specialty
Commercial Segment of $97.6 million for the first nine months of 2009 was $3.0
million more than the $94.6 million reported in the first nine months of
2008.  This 3% increase in revenue was largely due to increased net
premiums earned of $9.0 million for the first nine months of 2009 as a result of
the increased retention of business and the acquisition of Heath XS Operating
Unit during the third quarter of 2008.  Increased net investment
income contributed an additional $0.2 million to the increase in revenue for the
quarter.  These increases in revenue were partially offset by (a)
lower commission and fee revenue of $6.0 million primarily related to the shift
from a third party agency structure to an insurance underwriting structure and
profit sharing adjustments related to adverse loss development on prior accident
years, and (b) reduced finance charges of $0.2 million in excess of increased
commission income in our newly acquired Heath XS Operating Unit.





34


Pre-tax income for the Specialty
Commercial Segment of $14.3 million for the first nine months of 2009 increased
$1.7 million, or 13%, from the $12.6 million reported for the same period in
2008.   Increased revenue was complemented by lower expenses of
$1.8 million. These lower expenses for the first nine months of 2009 were
primarily the result of (a) a $1.2 million premium receivable write-off due to
the default of a producer in our TGA Operating Unit during the third quarter of
2008  and lower production related expenses of $2.8 million due to
lower produced premium and lower operating expenses of $0.8 million in our
Aerospace Operating Unit and TGA Operating Unit partially offset by (b)
increased operating expenses of $2.6 million and increased amortization of
intangible assets of $0.4 million, in both cases related to the acquisition
of  Heath XS Operating Unit effective August 29, 2008.  The
increase in pre-tax income was reduced by higher loss and LAE expenses of $3.1
million.





The Specialty Commercial Segment
reported a net loss ratio of 59.3% for the first nine months of 2009 as compared
to 62.3% for the same period during 2008.  The net loss ratio for the
first nine months of 2008 includes $2.7 million of incurred losses net of
reinsurance attributable to hurricane damage during the third quarter of 2008,
and $1.4 million of unfavorable prior accident year loss reserve development.
Incurred losses for the first nine months of 2009 included $3.9 million of
unfavorable prior accident year loss reserve development. The Specialty
Commercial Segment reported a net expense ratio of 30.0% for the first nine
months of 2009 as compared to 30.6% for the first nine months of
2008.





Personal
Segment





Net premium written for our Personal
Segment increased $8.4 million during the first nine months of 2009 to $55.0
million compared to $46.6 million in the first nine months of
2008.  The increase in premium was due mostly to continued geographic
expansion.





Total revenue for the Personal
Segment increased 14% to $55.0 million for the first nine months of 2009 from
$48.3 million for the same period in 2008.  Higher earned premium of
$6.0 million was the primary reason for the increase in revenue for the
period.  Increased finance charges of $0.6 million and net investment
income of $0.1 million further contributed to this increase in
revenue.





Pre-tax income for the Personal
Segment was $7.7 million for the nine months ended September 30, 2009 as
compared to $7.0 million for the same period in 2008.  Increased
revenue was offset by increased losses and LAE of $4.2 million and increased
operating expenses of $1.8 million due mostly to production expenses related to
continued geographic expansion.





The Personal Segment reported a net
loss ratio of 66.0% for the first nine months of 2009 as compared to 65.4% for
the same period in 2008.  We recognized $0.2 million of favorable
prior accident year development during the first nine months 2009 as compared to
$0.8 million of favorable prior year development during the first nine months of
2008.  The Personal Segment reported a net expense ratio of 21.4% for
the first nine months of 2009 as compared to 21.6% for the first nine months of
2008.










Corporate





Corporate revenue increased $2.2
million for the first nine months of 2009 as compared to the same period in
2008. This increase in total revenue was due primarily to recognized gains of
$1.1 million on our investment portfolio for the nine months ended September 30,
2009 as compared to recognized losses of $1.4 million during the same period in
2008.  This increase in revenue was offset by lower net investment
income of $0.3 million for the nine months ended September 30, 2009 as compared
to the same period of the prior year.





Corporate pre-tax loss was $7.0
million for the nine months ended September 30, 2009 as compared to $7.2 million
for the same period the prior year.  The decreased loss was mostly due
to increased revenue partially offset by increased non-cash operating expenses
of $0.9 million related to stock option grants to directors and employees and
periodic pension costs, other compensation expense of $0.4 million, and other
operating expenses of $0.4 million.  In addition, increased intangible
amortization of $0.3 million related to our acquisition of CYR during the second
quarter of 2009 further offset the increased revenue.





Financial
Condition and Liquidity





Sources
and Uses of Funds





Our
sources of funds are from insurance-related operations, financing activities and
investing activities.  Major sources of funds from operations include
premiums collected (net of policy cancellations and premiums ceded),
commissions, and processing and service fees.  As a holding company,
Hallmark is dependent on dividend payments and management fees from its
subsidiaries to meet operating expenses and debt obligations.  As of
September 30, 2009, Hallmark had $10.9 million in unrestricted cash and invested
assets at the holding company. Unrestricted cash and invested assets of our
non-insurance subsidiaries were $6.7 million as of September 30,
2009.





AHIC,
domiciled in Texas, is limited in the payment of dividends in any 12-month
period, without the prior written consent of the Texas Department of Insurance,
to the greater of statutory net income for the prior calendar year or 10% of
statutory surplus as of the prior year end. Dividends may only be paid from
unassigned surplus funds.  HIC, domiciled in Arizona, is limited in
the payment of dividends to the lesser of 10% of prior year surplus or prior
year’s net investment income, without prior written approval from the Arizona
Department of Insurance.  HSIC, domiciled in Oklahoma, is limited in
the payment of dividends to the greater of 10% of prior year surplus or prior
year’s statutory net income, without prior written approval from the Oklahoma
Insurance Department.  During 2009, our insurance company
subsidiaries’ ordinary dividend capacity is $18.4 million, of which $13.8
million is available to Hallmark.  None of our insurance company
subsidiaries paid a dividend to Hallmark during the first nine months of 2009 or
the 2008 fiscal year.





Comparison of September 30, 2009 to
December 31, 2008





On a
consolidated basis, our cash and investments (excluding restricted cash) at
September 30, 2009 were $420.8 million compared to $352.7 million at December
31, 2008.  An increase in market value of our investment portfolio for
the period and cash from operating activities were the primary reasons for this
increase.





35


Comparison of Nine Months Ended
September 30, 2009 and September 30, 2008





Net cash
provided by our consolidated operating activities was $45.7 million for the
first nine months of 2009 compared to $37.1 million for the first nine months of
2008.  The increase in operating cash flow was primarily due to
increased retention of business and the timing of premium settlements with third
party insurance carriers.





Net cash used in investing activities
during the first nine months of 2009 was $13.8 million as compared to $149.9
million for the same period in 2008.  Contributing to the decrease in
cash used in investing activities was a decrease of $567.8 million in purchases
of debt and equity securities, partially offset by (i) a $3.6 million reduction
in the change in restricted cash, (ii) a $435.2 million reduction in maturities,
sales and redemptions of investment securities, (iii) a $0.4 million increase in
purchases of property and equipment, (iv) a net cash payment of $3.9 million,
net of cash acquired, for the acquisition of a management agreement
controlling  Hallmark County Mutual Insurance Company and (v) a $3.3
million payment of contingent consideration to the sellers of the subsidiaries
comprising our TGA Operating Unit.  The net cash paid for acquisitions
was partially offset by a net cash payment of $14.8 million, net of cash
acquired for the acquisition of our Heath XS Operating Unit during the third
quarter of 2008.





Cash used in financing activities
during the first nine months of 2009 was $6.6 million as compared to $8.9
million for the same period of 2008.  The cash used during the first
nine months of 2009 was primarily for the repurchase of the Company’s common
stock during the third quarter of 2009. The cash used during the first nine
months of 2008 was primarily for the payment of consideration to the sellers of
the subsidiaries comprising our TGA Operating Unit.  As of September
30, 2009 we had fully repaid our obligation to the sellers.





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 all of our non-insurance company 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, 2009 we were in compliance with all of our
covenants.  As of September 30, 2009, we had $2.8 million outstanding
under this credit facility.





36




Trust
Preferred Securities





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.  As of September 30, 2009, the note
balance was $30.9 million.  Under the terms of the note, we pay
interest only each quarter and the principal of the note at
maturity.





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 at 8.28% until September 15, 2017, at which time interest
will adjust quarterly to the three-month LIBOR rate plus 2.90 percentage
points.  As of September 30, 2009, the note balance was $25.8
million.  Under the terms of the note, we pay interest only each
quarter and the principal of the note at maturity.





Item
3.  Quantitative and Qualitative Disclosures About Market
Risk.





This Item is omitted as permitted for a
“smaller reporting company” (as defined by the SEC).





Item
4T.  Controls and Procedures.





The principal executive officer and
principal financial officer of Hallmark have evaluated our disclosure controls
and procedures and have concluded that, as of the end of the period covered by
this report, such disclosure controls and procedures were effective in ensuring
that information required to be disclosed by us in the reports that we file or
submit under the Securities Exchange Act of 1934 is timely recorded, processed,
summarized and reported. The principal executive officer and principal financial
officer also concluded that such disclosure controls and procedures were
effective in ensuring that information required to be disclosed by us in the
reports that we file or submit under such Act is accumulated and communicated to
our management, including our principal executive officer and principal
financial officer, as appropriate, to allow timely decisions regarding required
disclosure.  During the most recent fiscal quarter, there have been no
changes in our internal controls over financial reporting that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.





Risks Associated with Forward-Looking
Statements Included in this Form 10-Q





This Form
10-Q contains certain forward-looking statements within the meaning of Section
27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act
of 1934, which are intended to be covered by the safe harbors created
thereby.  These statements include the plans and objectives of
management for future operations, including plans and objectives relating to
future growth of our business activities and availability of
funds.  The forward-looking statements included herein are based on
current expectations that involve numerous risks and
uncertainties.  Assumptions relating to the foregoing involve
judgments with respect to, among other things, future economic, competitive and
market conditions, regulatory framework, weather-related events and future
business decisions, all of which are difficult or impossible to predict
accurately and many of which are beyond our control.  Although we
believe that the assumptions underlying the forward-looking statements are
reasonable, any of the assumptions could be inaccurate and, therefore, there can
be no assurance that the forward-looking statements included in this Form 10-Q
will prove to be accurate.  In light of the significant uncertainties
inherent in the forward-looking statements included herein, the inclusion of
such information should not be regarded as a representation by us or any other
person that our objectives and plans will be achieved.


37


PART
II


OTHER
INFORMATION





Item
1.            Legal
Proceedings.





We are engaged in legal proceedings
in the ordinary course of business, none of which, either individually or in the
aggregate, are believed likely to have a material adverse effect on our
consolidated financial position or results of operations, in the opinion of
management.  The various legal proceedings to which we are a party are
routine in nature and incidental to our business.





Item
1A.         Risk
Factors.





This Item is omitted as permitted for
a “smaller reporting company” (as defined by the SEC).





Item
2.            Unregistered
Sales of Equity Securities and Use of Proceeds.





On April 18, 2008, we announced a
plan to repurchase up to 1,000,000 shares of our common stock in the open market
or in privately negotiated transactions (the “Stock Repurchase
Plan”).  The first repurchases under the Stock Repurchase Plan were
made during the third quarter of fiscal 2009.  The Stock Repurchase
Plan does not have an expiration date.





The following table furnishes
information for purchases made pursuant to the Stock Repurchase Plan during the
quarter ended September 30, 2009:





Issuer Purchases of Equity SecuritiesCumulative Number
                    
                    
                    Maximum Number ofAverage
                    
                    
                    of Shares Purchased
                    
                    
                    Shares that May YetTotal Number of
                    
                    
                    Price Paid
                    
                    
                    as Part of Publicly
                    
                    
                    Be Purchased UnderPeriod
                    
                    Shares Purchased
                    
                    
                    Per Share
                    
                    
                    Announced Plan
                    
                    
                    the PlanJuly
      1- 31, 2009
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    1,000,000August
      1 - 30, 2009
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    1,000,000September
      1 - 30, 2009
                    
                    
                    750,000
                    
                    
                    $
                    7.00
                    
                    
                    
                    750,000
                    
                    
                    
                    250,000





Item
3.            Defaults
Upon Senior Securities.





None.





Item
4.            Submission
of Matters to a Vote of Security Holders.







None.





Item
5.            Other
Information.





None.





38




Item
6.            Exhibits.





The
following exhibits are filed herewith or incorporated herein by
reference:





Exhibit
                                                Number
                                              
                                              Description3(a)
                                              
                                              Restated
      Articles of Incorporation of the registrant, as amended (incorporated by
      reference to Exhibit 3.1 to the registrant’s Registration Statement on
      Form S-1 [Registration No. 333-136414] filed September 8,
      2006).3(b)
                                              
                                              Amended
      and Restated By-Laws of the registrant (incorporated by reference to
      Exhibit 3.1 to the registrant’s Current Report on Form 8-K filed October
      1, 2007).4(a)
                                              
                                              Specimen
      certificate for Common Stock, $0.18 par value per share, of the registrant
      (incorporated by reference to Exhibit 4.1 to Amendment No. 1 to the
      registrant’s Registration Statement on Form S-1 [Registration No.
      333-136414] filed September 8, 2006).4(b)
                                              
                                              Indenture
      dated as of June 21, 2005, between Hallmark Financial Services, Inc. and
      JPMorgan Chase Bank, National Association (incorporated by reference to
      Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed June 27,
      2005).4(c)
                                              
                                              Amended
      and Restated Declaration of Trust of Hallmark Statutory Trust I dated as
      of June 21, 2005, among Hallmark Financial Services, Inc., as sponsor,
      Chase Bank USA, National Association, as Delaware trustee, and JPMorgan
      Chase Bank, National Association, as institutional trustee, and Mark
      Schwarz and Mark Morrison, as administrators (incorporated by reference to
      Exhibit 4.2 to the registrant’s Current Report on Form 8-K filed June 27,
      2005).4(d)
                                              
                                              Form
      of Junior Subordinated Debt Security Due 2035 (incorporated by reference
      to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed June
      27, 2005).4(e)
                                              
                                              Form
      of Capital Security Certificate (incorporated by reference to Exhibit 4.2
      to the registrant’s Current Report on Form 8-K filed June 27,
      2005).4(f)
                                              
                                              First
      Restated Credit Agreement dated January 27, 2006, between Hallmark
      Financial Services, Inc. and The Frost National Bank (incorporated by
      reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K
      filed February 2, 2006).4(g)
                                              
                                              Form
      of Registration Rights Agreement dated January 27, 2006, between Hallmark
      Financial Services, Inc. and Newcastle Special Opportunity Fund I, L.P.
      and Newcastle Special Opportunity Fund II, L.P. (incorporated by reference
      to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed
      February 2, 2006).4(h)
                                              
                                              Indenture
      dated as of August 23, 2007, between Hallmark Financial Services, Inc. and
      The Bank of New York Trust Company, National Association (incorporated by
      reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K
      filed August 24, 2007).4(i)
                                              
                                              Amended
      and Restated Declaration of Trust of Hallmark Statutory Trust II dated as
      of August 23, 2007, among Hallmark Financial Services, Inc., as sponsor,
      The Bank of New York (Delaware), as Delaware trustee, and The Bank of New
      York Trust Company, National Association, as institutional trustee, and
      Mark Schwarz and Mark Morrison, as administrators (incorporated by
      reference to Exhibit 4.2 to the registrant’s Current Report on Form 8-K
      filed August 24,
2007).




39




Exhibit
              Number
            
            Description4(j)
            
            Form
      of Junior Subordinated Debt Security Due 2037 (incorporated by reference
      to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed August
      24, 2007).4(k)
            
            Form
      of Capital Security Certificate (incorporated by reference to Exhibit 4.2
      to the registrant’s Current Report on Form 8-K filed August 24,
      2007).31(a)
            
            Certification
      of principal executive officer required by Rule 13a-14(a) or
              Rule
      15d-14(a).31(b)
            
            Certification
      of principal financial officer required by Rule 13a-14(a) or
              Rule
      15d-14(a).32(a)
            
            Certification
      of principal executive officer Pursuant to 18 U.S.C.
  1350.32(b)
            
            Certification
      of principal financial officer Pursuant to 18 U.S.C.
  1350.




SIGNATURES





In
accordance with the requirements of the Exchange Act, the registrant has caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.





HALLMARK
FINANCIAL SERVICES, INC.


(Registrant)




Date:
      November 12, 2009
                                      
                                      /s/ Mark J. MorrisonMark
      J. Morrison, Chief Executive Officer and President(Principal
      Executive Officer)Date:
      November 12, 2009
                                      
                                      /s/ Jeffrey R. PassmoreJeffrey
      R. Passmore, Chief Accounting Officer and Senior Vice
      President(Principal
      Financial
Officer)


40