**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 June 30, 2008





Commission
      file number 001-11252





**Hallmark
      Financial Services, Inc.**





(Exact
      name of registrant as specified in its charter)





Nevada
            
            87-0447375(State
                or other jurisdiction of
            
            (I.R.S.
                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 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 companyx




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





Indicate the
      number of shares outstanding of each of the issuer's classes of common stock,
      as
      of the latest practicable date: Common Stock, par value $.18 per share -
      20,808,954 shares outstanding as of August 11, 2008.








**PART
      I**


**FINANCIAL
      INFORMATION**





**Item
      1.**  **Financial
      Statements**





**INDEX
                TO FINANCIAL STATEMENTS**





Page NumberConsolidated Balance
                Sheets at June 30, 2008 (unaudited) and December 31, 2007
            3Consolidated
                Statements of Operations (unaudited) for the three months and six
                months
                ended June 30, 2008 and June 30, 2007
            4Consolidated
                Statements of Stockholders’ Equity and Comprehensive Income (unaudited)
                for the three months and six months ended June 30, 2008 and June
                30,
                2007
            5Consolidated
                Statements of Cash Flows (unaudited) for the six months ended June
                30,
                2008 and June 30, 2007
            6Notes
                to Consolidated Financial Statements (unaudited)
            7


2


**Hallmark
      Financial Services, Inc. and Subsidiaries**


**Consolidated
      Balance Sheets**


($
      in
      thousands)





**June 30**
            
            **December 31****2008**
            
            **2007**(unaudited)ASSETSInvestments:Debt
                securites, available-for-sale, at fair value
            
            $
            164,137
            
            $
            248,069Equity
                securites, available-for-sale, at fair value
            
            
            51,694
            
            
            15,166Short-Term
                investments, available-for-sale, at fair value
            
            
            121,440
            
            
            2,625Total
                investments
            
            
            337,271
            
            
            265,860Cash
                and cash equivalents
            
            
            33,599
            
            
            145,884Restricted
                cash and cash equivalents
            
            
            11,588
            
            
            16,043Premiums
                receivable
            
            
            47,090
            
            
            46,026Accounts
                receivable
            
            
            5,257
            
            
            5,219Receivable
                for securities
            
            
            200
            
            
            27,395Prepaid
                reinsurance premiums
            
            
            682
            
            
            274Reinsurance
                recoverable
            
            
            3,791
            
            
            4,952Deferred
                policy acquisition costs
            
            
            20,652
            
            
            19,757Excess
                of cost over fair value of net assets acquired
            
            
            30,025
            
            
            30,025Intangible
                assets
            
            
            22,634
            
            
            23,781Current
                federal income tax recoverable
            
            
            724
            
            
            -Deferred
                federal income taxes
            
            
            2,413
            
            
            275Prepaid
                expenses
            
            
            1,212
            
            
            1,240Other
                assets
            
            
            21,402
            
            
            19,583Total
                assets
            
            $
            538,540
            
            $
            606,314LIABILITES
                AND STOCKHOLDERS' EQUITYLiabilites:Notes
                payable
            
            $
            60,592
            
            
            60,814Structured
                settlements
            
            
            -
            
            
            10,000Reserves
                for unpaid losses and loss adjustment expenses
            
            
            144,374
            
            
            125,338Unearned
                premiums
            
            
            107,369
            
            
            102,998Unearned
                revenue
            
            
            2,253
            
            
            2,949Accrued
                agent profit sharing
            
            
            1,335
            
            
            2,844Accrued
                ceding commission payable
            
            
            12,189
            
            
            12,099Pension
                liability
            
            
            1,432
            
            
            1,669Current
                federal income tax
            
            
            -
            
            
            630Payable
                for securities
            
            
            3,401
            
            
            91,401Accounts
                payable and other accrued expenses
            
            
            14,150
            
            
            16,385Total
                liabilities
            
            
            347,095
            
            
            427,127Commitments
                and Contingencies (Note 16)Stockholders'
                equity:Common
                stock, $.18 par value (authorized 33,333,333 shares in 2008 and 2007;
                issued 20,816,782 in 2008 and 20,776,080 shares in 2007)
            
            
            3,747
            
            
            3,740Capital
                in excess of par value
            
            
            119,369
            
            
            118,459Retained
                earnings
            
            
            73,162
            
            
            58,909Accumulated
                other comprehensive loss
            
            
            (4,756
            )
            
            (1,844
            )Treasury
                stock, at cost (7,828 shares in 2008 and 2007)
            
            
            (77
            )
            
            (77
            )Total
                stockholders' equity
            
            
            191,445
            
            
            179,187$
            538,540
            
            $
            606,314





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**
            
            **Six Months Ended****June 30**
            
            **June 30****2008**
            
            **2007**
            
            **2008**
            
            **2007**Gross
                premiums written
            
            $
            63,115
            
            $
            66,577
            
            $
            127,352
            
            $
            131,235Ceded
                premiums written
            
            
            (2,327
            )
            
            (4,281
            )
            
            (4,659
            )
            
            (8,168
            )Net
                premiums written
            
            
            60,788
            
            
            62,296
            
            
            122,693
            
            
            123,067Change
                in unearned premiums
            
            
            (1,345
            )
            
            (6,986
            )
            
            (4,334
            )
            
            (16,109
            )Net
                premiums earned
            
            
            59,443
            
            
            55,310
            
            
            118,359
            
            
            106,958Investment
                income, net of expenses
            
            
            3,957
            
            
            3,047
            
            
            7,582
            
            
            6,037Realized
                gain
            
            
            232
            
            
            828
            
            
            1,091
            
            
            881Finance
                charges
            
            
            1,323
            
            
            1,185
            
            
            2,587
            
            
            2,271Commission
                and fees
            
            
            6,669
            
            
            8,159
            
            
            13,153
            
            
            16,064Processing
                and service fees
            
            
            36
            
            
            203
            
            
            78
            
            
            475Other
                income
            
            
            3
            
            
            4
            
            
            6
            
            
            8Total
                revenues
            
            
            71,663
            
            
            68,736
            
            
            142,856
            
            
            132,694Losses
                and loss adjustment expenses
            
            
            36,029
            
            
            30,712
            
            
            71,533
            
            
            62,897Other
                operating expenses
            
            
            23,608
            
            
            23,723
            
            
            47,073
            
            
            46,424Interest
                expense
            
            
            1,186
            
            
            796
            
            
            2,371
            
            
            1,582Amortization
                of intangible assets
            
            
            573
            
            
            573
            
            
            1,146
            
            
            1,146Total
                expenses
            
            
            61,396
            
            
            55,804
            
            
            122,123
            
            
            112,049Income
                before tax
            
            
            10,267
            
            
            12,932
            
            
            20,733
            
            
            20,645Income
                tax expense
            
            
            3,066
            
            
            4,117
            
            
            6,480
            
            
            6,860Net
                income
            
            $
            7,201
            
            $
            8,815
            
            $
            14,253
            
            $
            13,785Common
                stockholders net income per share:Basic
            
            $
            0.35
            
            $
            0.42
            
            $
            0.69
            
            $
            0.66Diluted
            
            $
            0.34
            
            $
            0.42
            
            $
            0.68
            
            $
            0.66





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**


(Unaudited)


($
      in
      thousands)





**Three Months Ended**
            
            **Six Months Ended****June 30,**
            
            **June 30,****2008**
            
            **2007**
            
            **2008**
            
            **2007****Common
                Stock**Balance,
                beginning of period
            
            $
            3,746
            
            $
            3,740
            
            $
            3,740
            
            $
            3,740Issuance
                of common stock upon option exercises
            
            
            1
            
            
            -
            
            
            7
            
            
            -Balance,
                end of period
            
            
            3,747
            
            
            3,740
            
            
            3,747
            
            
            3,740**Additional
                Paid-In Capital**Balance,
                beginning of period
            
            
            119,120
            
            
            117,983
            
            
            118,459
            
            
            117,932Equity
                based compensation
            
            
            226
            
            
            102
            
            
            773
            
            
            153Exercise
                of stock options
            
            
            23
            
            
            -
            
            
            137
            
            
            -Balance,
                end of period
            
            
            119,369
            
            
            118,085
            
            
            119,369
            
            
            118,085**Retained
                Earnings**Balance,
                beginning of period
            
            
            65,961
            
            
            36,450
            
            
            58,909
            
            
            31,480Net
                income
            
            
            7,201
            
            
            8,815
            
            
            14,253
            
            
            13,785Balance,
                end of period
            
            
            73,162
            
            
            45,265
            
            
            73,162
            
            
            45,265**Accumulated
                Other Comprehensive Loss**Balance,
                beginning of period
            
            
            (3,086
            )
            
            (1,982
            )
            
            (1,844
            )
            
            (2,344
            )Additional
                minimum pension liability, net of tax
            
            
            11
            
            
            64
            
            
            21
            
            
            64Unrealized
                losses on securities, net of tax
            
            
            (1,681
            )
            
            (828
            )
            
            (2,933
            )
            
            (466
            )Balance,
                end of period
            
            
            (4,756
            )
            
            (2,746
            )
            
            (4,756
            )
            
            (2,746
            )**Treasury
                Stock**Balance,
                beginning of period
            
            
            (77
            )
            
            (77
            )
            
            (77
            )
            
            (77
            )Acquisition
                of treasury shares
            
            
            -
            
            
            -
            
            
            -
            
            
            -Exercise
                of stock options
            
            
            -
            
            
            -
            
            
            -
            
            
            -Balance,
                end of period
            
            
            (77
            )
            
            (77
            )
            
            (77
            )
            
            (77
            )**Stockholders'
                Equity**
            
            $
            191,445
            
            $
            164,267
            
            $
            191,445
            
            $
            164,267Net
                income
            
            $
            7,201
            
            $
            8,815
            
            $
            14,253
            
            $
            13,785Additional
                minimum pension liability, net of tax
            
            
            11
            
            
            64
            
            
            21
            
            
            64Unrealized
                losses on securities, net of tax
            
            
            (1,681
            )
            
            (828
            )
            
            (2,933
            )
            
            (466
            )**Comprehensive
                Income**
            
            $
            5,531
            
            $
            8,051
            
            $
            11,341
            
            $
            13,383





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)





**Six Months Ended****June 30****2008**
            
            **2007**Cash
                flows from operating activities:Net
                income
            
            $
            14,253
            
            $
            13,785Adjustments
                to reconcile net income to cash provided by operating
                activities:Depreciation
                and amortization expense
            
            
            1,517
            
            
            1,564Amortization
                of discount on structured settlement
            
            
            -
            
            
            207Deferred
                federal income tax benefit
            
            
            (641
            )
            
            (916
            )Realized
                gain on investments
            
            
            (1,091
            )
            
            (881
            )Change
                in prepaid reinsurance premiums
            
            
            (408
            )
            
            (144
            )Change
                in premiums receivable
            
            
            (1,064
            )
            
            (9,925
            )Change
                in accounts receivable
            
            
            (38
            )
            
            796Change
                in deferred policy acquisition costs
            
            
            (895
            )
            
            (3,069
            )Change
                in unpaid losses and loss adjustment expenses
            
            
            19,036
            
            
            26,824Change
                in unearned premiums
            
            
            4,371
            
            
            16,253Change
                in unearned revenue
            
            
            (696
            )
            
            (1,957
            )Change
                in accrued agent profit sharing
            
            
            (1,509
            )
            
            (528
            )Change
                in reinsurance recoverable
            
            
            1,161
            
            
            (575
            )Change
                in current federal income tax payable
            
            
            (1,354
            )
            
            2,520Change
                in accrued ceding commission payable
            
            
            90
            
            
            3,103Change
                in all other liabilities
            
            
            (4,258
            )
            
            2,059Change
                in all other assets
            
            
            1,275
            
            
            (4,522
            )Net
                cash provided by operating activities
            
            
            29,749
            
            
            44,594Cash
                flows from investing activities:Purchases
                of property and equipment
            
            
            (273
            )
            
            (269
            )Change
                in restricted cash
            
            
            6,241
            
            
            14,527Purchases
                of debt and equity securities
            
            
            (218,022
            )
            
            (106,636
            )Maturities
                and redemptions of investment securities
            
            
            198,914
            
            
            62,506Net
                purchases of short-term investments
            
            
            (118,815
            )
            
            (38,771
            )Net
                cash used in investing activities
            
            
            (131,955
            )
            
            (68,643
            )Cash
                flows from financing activities:Proceeds
                from exercise of employee stock options
            
            
            143
            
            
            -Note
                payable
            
            
            (222
            )
            
            (633
            )Payment
                of structured settlement
            
            
            (10,000
            )
            
            (15,000
            )Net
                cash used by financing activities
            
            
            (10,079
            )
            
            (15,633
            )Decrease
                in cash and cash equivalents
            
            
            (112,285
            )
            
            (39,682
            )Cash
                and cash equivalents at beginning of period
            
            
            145,884
            
            
            81,474Cash
                and cash equivalents at end of period
            
            $
            33,599
            
            $
            41,792Supplemental
                cash flow information:Interest
                paid
            
            $
            2,387
            
            $
            1,372Taxes
                paid
            
            $
            8,402
            
            $
            5,256Supplemental
                schedule of non cash investing activities:Change
                in receivable for securities for investment disposals that settled
                after
                the balance sheet date
            
            $
            27,195
            
            $
            (14
            )Change
                in payable for securities for investment purchases that settled after
                the
                balance sheet date
            
            $
            (88,000
            )
            $
            8,878





The
      accompanying notes are an integral part


of
      the
      consolidated financial statements


6


**Hallmark
      Financial Services, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements (Unaudited)**





**1.
      General**




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





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





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





**2.
      Basis of Presentation**





Our
      unaudited consolidated financial statements included herein have been prepared
      in accordance with U.S. generally accepted accounting principles (“GAAP”) and
      include our accounts and the accounts of our subsidiaries. All significant
      intercompany accounts and transactions have been eliminated in consolidation.
      Certain information and footnote disclosures normally included in financial
      statements prepared in accordance with GAAP have been condensed or omitted
      pursuant to rules and regulations of the Securities and Exchange Commission
      (“SEC”) for interim financial reporting. These financial statements should be
      read in conjunction with our audited financial statements for the year ended
      December 31, 2007 included in our Annual Report on Form 10-K filed with the
      SEC.





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


7


***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.





***Use
      of Estimates in the Preparation of the Financial
      Statements***





Our
      preparation of financial statements in conformity with GAAP requires us to
      make
      estimates and assumptions that affect our reported amounts of assets and
      liabilities and our disclosure of contingent assets and liabilities at the
      date
      of our financial statements, as well as our reported amounts of revenues and
      expenses during the reporting period. Actual results could differ materially
      from those estimates.





***Recently
      Issued Accounting Standards***





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





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





In
      September 2006, FASB issued Statement of Financial Accounting Standards No.
      157,
“Fair Value Measurements” (“SFAS 157”). SFAS 157 establishes a separate
      framework for determining fair values of assets and liabilities that are
      required by other authoritative GAAP pronouncements to be measured at fair
      value. In addition, SFAS 157 incorporates and clarifies the guidance in FASB
      Concepts Statement 7 regarding the use of present value techniques in measuring
      fair value. SFAS 157 does not require any new fair value measurements. SFAS
      157
      is effective for financial statements issued for fiscal years beginning after
      November 15, 2007. The adoption of SFAS 157 had no impact on our financial
      statements or results of operations but did require additional disclosures.
      (See
      Note 3, “Fair Value”).


8


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




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





In
      December 2007, the FASB issued Statement of Financial Accounting Standards
      No.
      160, “Noncontrolling Interests in Consolidated Financial Statements—an amendment
      of Accounting Research Bulletin No. 51” (“SFAS 160”). SFAS 160 amends Accounting
      Research Bulletin No. 51 to establish accounting and reporting standards for
      the
      noncontrolling interest in a subsidiary and for the deconsolidation of a
      subsidiary. In addition, it clarifies that a noncontrolling interest in a
      subsidiary is an ownership interest in the consolidated entity that should
      be
      reported as a component of equity in the consolidated financial statements.
      SFAS
      160 is effective on a prospective basis beginning January 1, 2009, except for
      the presentation and disclosure requirements which are applied on a
      retrospective basis for all periods presented. We do not expect the provisions
      of SFAS 160 to have a material effect on our results of operations, financial
      position or liquidity.





**3.
      Fair Value**





SFAS 157
      defines fair value, establishes a consistent framework for measuring fair value
      and expands disclosure requirements about fair value measurements.
      SFAS 157, among other things, requires us to maximize the use of observable
      inputs and minimize the use of unobservable inputs when measuring fair value.
      In
      addition, SFAS 157 precludes the use of block discounts when measuring the
      fair value of instruments traded in an active market, which were previously
      applied to large holdings of publicly traded equity securities. It also requires
      recognition of trade-date gains related to certain derivative transactions
      whose
      fair value has been determined using unobservable market inputs. This guidance
      supersedes the guidance in Emerging Issues Task Force Issue No. 02-3,
”Issues Involved in Accounting for Derivative Contracts Held for Trading
      Purposes and Contracts Involved in Energy Trading and Risk Management
      Activities”, which prohibited the recognition of trade-date gains for such
      derivative transactions when determining the fair value of instruments not
      traded in an active market.


9


***Assets
      and Liabilities Recorded at Fair Value on a Recurring
      Basis***





Effective
      January 1, 2008, we determine the fair value of our financial instruments based
      on the fair value hierarchy established in SFAS 157 which requires an entity
      to
      maximize the use of observable inputs and minimize the use of unobservable
      inputs. Observable inputs reflect market data obtained from independent sources,
      while unobservable inputs reflect our market assumptions. In accordance with
      SFAS 157, these two types of inputs have created 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 are unobservable for the asset
                or
                liability.





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





Under
      SFAS 157, we determine fair value based on the price that would be received
      for
      an asset or paid to transfer a liability in an orderly transaction between
      market participants on the measurement date. It is our policy to maximize the
      use of observable inputs and minimize the use of unobservable inputs when
      developing fair value measurements, in accordance with the fair value hierarchy
      described above. Fair value measurements for assets and liabilities where there
      exists limited or no observable market data are calculated based upon our
      pricing policy, the economic and competitive environment, the characteristics
      of
      the asset or liability and other factors as appropriate. These estimated fair
      values may not be realized upon actual sale or immediate settlement of the
      asset
      or liability.





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.


10


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 June 30, 2008 (in
      thousands).




Quoted Prices in
            
            OtherActive Markets for
            
            Observable
            
            UnobservableIdentical Assets
            
            Inputs
            
            Inputs(Level 1)
            
            (Level 2)
            
            (Level 3)
            
            TotalDebt
                securities
            
            $
            -
            
            $
            164,137
            
            $
            -
            
            $
            164,137Equity
                securities
            
            
            51,694
            
            
            -
            
            
            -
            
            
            51,694Short-term
                investments
            
            
            -
            
            
            121,440
            
            
            -
            
            
            121,440Total
            
            $
            51,694
            
            $
            285,577
            
            $
            -
            
            $
            337,271





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 six months ended June 30, 2008 (in thousands).





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





**4.
      Investments**





We
      complete a detailed analysis each quarter to assess whether any decline in
      the
      fair value of any investment below cost is deemed other-than-temporary. All
      securities with an unrealized loss are reviewed. Unless other factors cause
      us
      to reach a contrary conclusion, investments with a fair market value
      significantly less than cost for more than 180 days are deemed to have a decline
      in value that is other-than-temporary. A decline in value that is considered
      to
      be other-than-temporary is charged to earnings based on the fair value of the
      security at the time of assessment, resulting in a new cost basis for the
      security.




11




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 June 30, 2008 and December 31, 2007:


As
                  of June 30, 2008Less than 12 months
              
              12 months or longer
              
              TotalUnrealized
              
              
              
              Unrealized
              
              
              
              UnrealizedFair Value
              
              Losses
              
              Fair Value
              
              Losses
              
              Fair Value
              
              LossesCorporate
                  debt securities
              
              $
              18,036
              
              $
              708
              
              $
              21,958
              
              $
              1,775
              
              $
              39,994
              
              $
              2,483Municipal
                  bonds
              
              
              74,537
              
              
              1,589
              
              
              4,508
              
              
              89
              
              
              79,045
              
              
              1,678Equity
                  securities
              
              
              29,569
              
              
              3,044
              
              
              -
              
              
              -
              
              
              29,569
              
              
              3,044Short
                  term securities
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Total
              
              $
              122,142
              
              $
              5,341
              
              $
              26,466
              
              $
              1,864
              
              $
              148,608
              
              $
              7,205
 
 As
                  of December 31, 2007Less than 12 months
              
              12 months or longer
              
              TotalUnrealized
              
              
              
              Unrealized
              
              
              
              UnrealizedFair
                  Value
              
              Losses
              
              Fair
                  Value
              
              Losses
              
              Fair
                  Value
              
              LossesCorporate
                  debt securities
              
              $
              19,021
              
              $
              840
              
              $
              18,329
              
              $
              896
              
              $
              37,350
              
              $
              1,736Municipal
                  bonds
              
              
              24,392
              
              
              122
              
              
              7,780
              
              
              130
              
              
              32,172
              
              
              252Equity
                  securities
              
              
              6,954
              
              
              318
              
              
              -
              
              
              -
              
              
              6,954
              
              
              318Short
                  term securities
              
              
              352
              
              
              1
              
              
              -
              
              
              -
              
              
              352
              
              
              1Total
              
              $
              50,719
              
              $
              1,281
              
              $
              26,109
              
              $
              1,026
              
              $
              76,828
              
              $
              2,307





Of
      the
      gross unrealized loss at June 30, 2008, $1.9 million is more than twelve months
      old, consisting of 16 bond positions. Of the gross unrealized loss at December
      31, 2007, $1.0 million is more than twelve months old, consisting of 22 bond
      positions. We consider these losses as a temporary decline in value as they
      are
      predominately on bonds where we believe we have the ability to hold our
      positions until maturity and whose decline in fair value is driven by interest
      rate increases. We see no other indications that the decline in values of these
      securities is other than temporary.





**5.
      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 of the
      amounts assigned to assets acquired and liabilities assumed is an asset referred
      to as “excess of cost over net assets acquired” or “goodwill.” Indirect and
      general expenses related to business combinations are expensed as incurred.




**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 $17.5 million at June 30, 2008 and a carrying value
      of
      $18.5 million at December 31, 2007.


12


**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 approved by the shareholders
      on
      May 26, 2005. There are 1,500,000 shares authorized for issuance under the
      2005
      LTIP. Our 1994 Key Employee Long Term Incentive Plan (the “1994 Employee Plan”)
      and 1994 Non-Employee Director Stock Option Plan (the “1994 Director Plan”) both
      expired in 2004 but have unexercised options outstanding.





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





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





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


13


A
      summary
      of the status of our stock options as of and changes during the year-to-date
      ended June 30, 2008 is presented below:





Average
            
            Contractual
            
            IntrinsicNumber of
            
            Exercise
            
            Term
            
            ValueShares
            
            Price
            
            (Years)
            
            ($000)Outstanding
                at January 1, 2008
            
            
            848,000
            
            $
            10.41Granted
            
            
            270,000
            
            $
            11.46Exercised
            
            
            (40,702
            )
            $
            3.54Forfeited
                or expired
            
            
            -
            
            $
            -Outstanding
                at June 30, 2008
            
            
            1,077,298
            
            $
            11.20
            
            
            8.3
            
            $
            786Exercisable
                at June 30, 2008
            
            
            261,549
            
            $
            8.15
            
            
            5.8
            
            $
            696





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
            
            Six Months EndedJune 30,
            
            June 30,2008
            
            2007
            
            2008
            
            2007Intrinsic
                value of options exercised
            
            $
            59
            
            $
            -
            
            $
            337
            
            $
            -Cost
                of share-based payments (non-cash)
            
            $
            226
            
            $
            102
            
            $
            773
            
            $
            153Income
                tax benefit of share-basedpayments
                recognized in income
            
            $
            79
            
            $
            36
            
            $
            270
            
            $
            54





As
      of
      June 30, 2008 there was $3.1 million of total unrecognized compensation cost
      related to non-vested share-based compensation arrangements granted under our
      plans, of which $0.6 million is expected to be recognized in the remainder
      of
      2008, $1.0 million is expected to be recognized in 2009, $0.9 million is
      expected to be recognized in 2010, $0.5 million is expected to be recognized
      in
      2011 and $0.1 million is expected to be recognized in 2012.





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


14


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





Three
                Months Ended
            
            Six
                Months EndedJune
                30,
            
            June
                30,2008
            
            2007
            
            2008
            
            2007Grant
                date fair value per share
            
            $
            4.74
            
            $
            4.04
            
            $
            4.74
            
            $
            4.04Expected
                term (in years)
            
            
            6.4
            
            
            6.4
            
            
            6.4
            
            
            6.4Expected
                volatility
            
            
            35.0
            %
            
            19.4
            %
            
            35.0
            %
            
            19.4
            %Risk
                free interest rate
            
            
            3.4
            %
            
            4.5
            %
            
            3.4
            %
            
            4.5
            %





**8.
      Segment Information**





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





Three Months Ended
            
            Six Months EndedJune 30,
            
            June 30,2008
            
            2007
            
            2008
            
            2007Revenues:Standard
                Commercial Segment
            
            $
            22,157
            
            $
            20,003
            
            $
            43,986
            
            $
            41,770Specialty
                Commercial Segment
            
            
            31,988
            
            
            32,978
            
            
            64,075
            
            
            61,076Personal
                Segment
            
            
            16,498
            
            
            14,696
            
            
            32,224
            
            
            28,469Corporate
            
            
            1,020
            
            
            1,059
            
            
            2,571
            
            
            1,379Consolidated
            
            $
            71,663
            
            $
            68,736
            
            $
            142,856
            
            $
            132,694Pre-tax
                income (loss):Standard
                Commercial Segment
            
            $
            3,984
            
            $
            2,664
            
            $
            7,865
            
            $
            5,423Specialty
                Commercial Segment
            
            
            6,265
            
            
            9,441
            
            
            11,558
            
            
            14,127Personal
                Segment
            
            
            1,913
            
            
            2,176
            
            
            4,503
            
            
            4,294Corporate
            
            
            (1,895
            )
            
            (1,349
            )
            
            (3,193
            )
            
            (3,199
            )Consolidated
            
            $
            10,267
            
            $
            12,932
            
            $
            20,733
            
            $
            20,645


15


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





June 30,
            
            December 31,2008
            
            2007AssetsStandard
                Commercial Segment
            
            $
            163,521
            
            $
            211,428Specialty
                Commercial Segment
            
            
            202,692
            
            
            229,138Personal
                Segment
            
            
            75,710
            
            
            100,986Corporate
            
            
            96,617
            
            
            64,762$
            538,540
            
            $
            606,314





**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. Refer to Note
      5 of
      our Annual Report on Form 10-K for the year ended December 31, 2007 for more
      discussion of our reinsurance.





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




Three Months Ended
            
            Six Months EndedJune 30,
            
            June 30,2008
            
            2007
            
            2008
            
            2007Ceded
                earned premiums
            
            $
            2,312
            
            $
            4,144
            
            $
            4,622
            
            $
            8,024Reinsurance
                recoveries
            
            $
            1,156
            
            $
            2,349
            
            $
            1,263
            
            $
            3,433





**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 June 30, 2008, the note balance was $30.9 million.


16


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 June 30, 2008, the balance on the
      revolving note was $2.8 million, which currently bears interest at 4.69% per
      annum. Also included in notes payable is $1.1 million outstanding as of June
      30,
      2008 under PAAC’s revolving credit sub-facility, which also currently bears
      interest at 4.69% per annum. (See Note 12, “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
      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. Under the terms
      of
      the note, we pay interest only each quarter and the principal of the note at
      maturity. As of June 30, 2008 the note balance was $25.8 million.




**11.
      Structured Settlements**





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





**12.
      Credit Facilities**





On
      June
      29, 2005, we entered into a credit facility with The Frost National Bank. The
      credit facility was amended and restated on January 27, 2006 to a $20.0 million
      revolving credit facility, with a $5.0 million letter of credit sub-facility.
      The credit facility was further amended effective May 31, 2007 to increase
      the
      revolving credit facility to $25.0 million and establish a new $5.0 million
      revolving credit sub-facility for the premium finance operations of PAAC. The
      credit agreement was again amended effective February 20, 2008 to extend the
      termination to January 27, 2010, revise various affirmative and negative
      covenants and decrease the interest rate in most instances to the three month
      Eurodollar rate plus 1.90 percentage points, payable quarterly in arrears.
      We
      pay letter of credit fees at the rate of 1.00% per annum. Our obligations under
      the revolving credit facility are secured by a security interest in the capital
      stock of all of our subsidiaries, guaranties of all of our subsidiaries and
      the
      pledge of substantially all of our assets. The revolving credit facility
      contains covenants which, among other things, require us to maintain certain
      financial and operating ratios and restrict certain distributions, transactions
      and organizational changes. As of June 30, 2008, we were in compliance with
      all
      of our covenants. (See Note 10, “Notes Payable”).





17


**13.
      Deferred Policy Acquisition Costs**





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




Three Months Ended
            
            Six Months EndedJune 30,
            
            June 30,2008
            
            2007
            
            2008
            
            2007Deferred
            
            $
            (13,613
            )
            $
            (12,606
            )
            $
            (28,018
            )
            $
            (24,966
            )Amortized
            
            
            13,377
            
            
            11,321
            
            
            27,123
            
            
            21,897Net
            
            $
            (236
            )
            $
            (1,285
            )
            $
            (895
            )
            $
            (3,069
            )





**14.
      Earnings per Share**





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





Three Months Ended
            
            Six Months EndedJune 30,
            
            June 30,2008
            
            2007
            
            2008
            
            2007Weighted
                average shares - basic
            
            
            20,806
            
            
            20,768
            
            
            20,794
            
            
            20,768Effect
                of dilutive securities
            
            
            78
            
            
            -
            
            
            91
            
            
            -Weighted
                average shares - assuming dilution
            
            
            20,884
            
            
            20,768
            
            
            20,885
            
            
            20,768





For
      the
      three and six months ended June 30, 2008 , 899,167 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. For the three and
      six
      months ended June 30, 2007, 500,000 shares of common stock potentially issuable
      upon 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.





**15.
      Net Periodic Pension Cost**





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





Three Months Ended
            
            Six Months EndedJune 30,
            
            June 30,2008
            
            2007
            
            2008
            
            2007Interest
                cost
            
            $
            167
            
            $
            180
            
            $
            334
            
            $
            360Amortization
                of net (gain) loss
            
            
            (167
            )
            
            50
            
            
            (335
            )
            
            100Expected
                return on plan assets
            
            
            16
            
            
            (160
            )
            
            32
            
            
            (321
            )Net
                periodic pension cost
            
            $
            16
            
            $
            70
            
            $
            31
            
            $
            139


18





We
      contributed $152 thousand and $196 thousand to our frozen defined benefit cash
      balance plan (“Cash Balance Plan”) during the three months ended June 30, 2008
      and 2007, respectively. We contributed $236 thousand and $270 thousand to our
      Cash Balance Plan during the six months ended June 30, 2008 and 2007,
      respectively. Refer to Note 13 to the consolidated financial statements in
      our
      Annual Report on Form 10-K for the year ended December 31, 2007 for more
      discussion of our retirement plans.





**16.
      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.





**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, non-standard automobile insurance and general
      aviation insurance, as well as providing other insurance related services.
      Our
      business is geographically concentrated in the south central and northwest
      regions of the United States, except for our general aviation business which
      is
      written on a national basis. We
      pursue
      our business activities through subsidiaries whose operations are organized
      into
      four operating units which are supported by 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
                HGA
                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 and the general aviation insurance products
                and
                services handled by our Aerospace 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.


19


·
            ***Personal
                Segment.***Our Personal Segment includes the non-standard personal automobile
                insurance products and services handled by our Phoenix Operating
                Unit
                which is comprised solely of American Hallmark General Agency, Inc.,
                which
                does business as Phoenix Indemnity 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 by our HGA Operating Unit, retains a portion of the risks
                on the
                non-standard personal automobile policies marketed by our Phoenix
                Operating Unit, assumes a portion of the risks on the commercial
                property/casualty policies marketed by our TGA Operating Unit and
                assumes
                a portion of the risks on the aviation property/casualty products
                marketed
                by our Aerospace Operating Unit.





·
            ***Hallmark
                Specialty Insurance Company (“HSIC”)***presently
                assumes a portion of the risks on the commercial property/casualty
                policies marketed by our TGA Operating
                Unit.





·
            ***Hallmark
                Insurance Company (“HIC”) (formerly known as Phoenix Indemnity Insurance
                Company)***presently assumes a portion of the risks on the non-standard personal
                automobile policies marketed by our Phoenix Operating Unit and assumes
                a
                portion of the risks on the aviation property/casualty products marketed
                by our Aerospace Operating Unit.





Effective
      January 1, 2006, our insurance company subsidiaries entered into a pooling
      arrangement, which was subsequently amended on December 15, 2006, pursuant
      to
      which AHIC retains 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 had no impact on our
      consolidated financial statements under GAAP.




**Results
      of Operations**





**Management
      Overview.** During
      the three and six months ended June 30, 2008, our total revenues were $71.7
      and
      $142.9 million, representing a 4% and 8% increase over the $68.7 million and
      $132.7 in total revenues, respectively, for the same periods of 2007. Increased
      earned premium due to increased retention of business produced by our Specialty
      Commercial Segment, and increased production by our Personal Segment were the
      primary causes of the increase in revenue. Standard Commercial Segment revenues
      increased $2.2 million, or 11% and 5%, during the three and six months ended
      June 30, 2008 as compared to the same periods during 2007, due primarily to
      increased contingent commissions related to favorable loss development on prior
      accident years. Specialty Commercial Segment revenues decreased $1.0 million
      and
      increased $3.0 million, during the three months and six months ended June 30,
      2008 as compared to the same periods of 2007, due to lower commission income
      primarily as a result of the continued shift from a third-party agency model
      to
      an underwriting model, partially offset by increased net premiums earned as
      a
      result of the increased retention of business. Revenues from our Personal
      Segment increased $1.8 million and $3.8 million, or 12% and 13%, during the
      three and six months ended June 30, 2008 as compared to the same periods during
      2007, due largely to geographic expansion into new states. Corporate revenue
      of
      $1.0 million remained relatively unchanged for the second quarter of 2008 as
      compared to the same period in 2007. Corporate revenue increased $1.2 million
      for the six months ended June 30, 2008 primarily due to increased recognized
      gains on our investment portfolio of $0.2 million and increased investment
      income of $1.0 million due to changes in capital allocation.


20


We
      reported net income of $7.2 million and $14.3 million for the three and six
      months ended June 30, 2008, which was $1.6 million lower and $0.5 million higher
      than the $8.8 million and $13.8 million reported for the same periods in 2007.
      On a diluted basis per share, net income was $0.34 and $0.68 per share,
      respectively, for the three months and six months ended June 30, 2008 as
      compared to $0.42 and $0.66 per share for the same periods in 2007. The decrease
      in net income for the three months was primarily attributable to favorable
      loss
      development on prior accident years during the second quarter of 2008 of $0.3
      million as compared to $1.9 million for the same period during 2007. The year
      to
      date increase in net income was primarily attributable to a lower effective
      tax
      rate from a higher amount of tax exempt bonds in our investment portfolio in
      2008 than we held in 2007. Year to date 2008 pre tax income increased $0.1
      million to $20.7 million from the prior year. Increased revenue, as discussed
      above, was partially offset by increased incurred loss and loss adjustment
      expense of $8.6 million, increased interest expense of $0.8 million from our
      issuance of trust preferred securities in the third quarter of 2007 and
      increased operating expense of $0.6 million.


21




**Second
      Quarter 2008 as Compared to Second Quarter 2007**





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





**Hallmark
      Financial Services, Inc.**


**Consolidated
      Segment Data**





**Three Months Ended June 30, 2008****Standard**
            
            **Specialty****Commercial**
            
            **Commercial**
            
            **Personal****Segment**
            
            **Segment**
            
            **Segment**
            
            **Corporate**
            
            **Consolidated**Produced
                premium (1)
            
            $
            21,624
            
            $
            35,986
            
            $
            14,153
            
            $
            -
            
            $
            71,763Gross
                premiums written
            
            
            21,624
            
            
            27,338
            
            
            14,153
            
            
            -
            
            
            63,115Ceded
                premiums written
            
            
            (1,382
            )
            
            (945
            )
            
            -
            
            
            -
            
            
            (2,327
            )Net
                premiums written
            
            
            20,242
            
            
            26,393
            
            
            14,153
            
            
            -
            
            
            60,788Change
                in unearned premiums
            
            
            36
            
            
            (2,395
            )
            
            1,014
            
            
            -
            
            
            (1,345
            )Net
                premiums earned
            
            
            20,278
            
            
            23,998
            
            
            15,167
            
            
            -
            
            
            59,443Total
                revenues
            
            
            22,157
            
            
            31,988
            
            
            16,498
            
            
            1,020
            
            
            71,663Losses
                and loss adjustment expenses
            
            
            11,669
            
            
            13,976
            
            
            10,384
            
            
            -
            
            
            36,029Pre-tax
                income (loss)
            
            
            3,984
            
            
            6,265
            
            
            1,913
            
            
            (1,895
            )
            
            10,267Net
                loss ratio (2)
            
            
            57.5
            %
            
            58.2
            %
            
            68.5
            %
            
            
            
            
            60.6
            %Net
                expense ratio (2)
            
            
            27.3
            %
            
            30.7
            %
            
            21.6
            %
            
            
            
            
            29.2
            %Net
                combined ratio (2)
            
            
            84.8
            %
            
            88.9
            %
            
            90.1
            %
            
            
            
            
            89.8
            %





**Three Months Ended June 30, 2007****Standard**
            
            **Specialty****Commercial**
            
            **Commercial**
            
            **Personal****Segment**
            
            **Segment**
            
            **Segment**
            
            **Corporate**
            
            **Consolidated**Produced
                premium (1)
            
            $
            24,751
            
            $
            40,956
            
            $
            13,298
            
            $
            -
            
            $
            79,005Gross
                premiums written
            
            
            24,740
            
            
            28,540
            
            
            13,297
            
            
            -
            
            
            66,577Ceded
                premiums written
            
            
            (2,804
            )
            
            (1,477
            )
            
            -
            
            
            -
            
            
            (4,281
            )Net
                premiums written
            
            
            21,936
            
            
            27,063
            
            
            13,297
            
            
            -
            
            
            62,296Change
                in unearned premiums
            
            
            (1,731
            )
            
            (5,474
            )
            
            219
            
            
            -
            
            
            (6,986
            )Net
                premiums earned
            
            
            20,205
            
            
            21,589
            
            
            13,516
            
            
            -
            
            
            55,310Total
                revenues
            
            
            20,003
            
            
            32,978
            
            
            14,696
            
            
            1,059
            
            
            68,736Losses
                and loss adjustment expenses
            
            
            11,267
            
            
            10,635
            
            
            8,813
            
            
            (3
            )
            
            30,712Pre-tax
                income (loss)
            
            
            2,664
            
            
            9,441
            
            
            2,176
            
            
            (1,349
            )
            
            12,932Net
                loss ratio (2)
            
            
            55.8
            %
            
            49.3
            %
            
            65.2
            %
            
            
            
            
            55.5
            %Net
                expense ratio (2)
            
            
            27.0
            %
            
            32.0
            %
            
            22.8
            %
            
            
            
            
            27.9
            %Net
                combined ratio (2)
            
            
            82.8
            %
            
            81.3
            %
            
            88.0
            %
            
            
            
            
            83.4
            %




(1)
            Produced
                premium is a non-GAAP measurement that management uses to track total
                controlled premium produced by our operations. We believe this is
                a usefultool
                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 where we receive commission
                revenue.





(2)
            The
                net loss ratio is calculated as incurred losses and loss adjustment
                expenses divided by net premiums earned, each determined in accordance
                with GAAP. The net expense ratio is calculated as total underwriting
                expenses of our insurance company subsidiaries, including allocated
                overhead expenses and 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.


22


***Standard
      Commercial Segment***




Gross
      premiums written for the Standard Commercial Segment were $21.6 million for
      the
      three months ended June 30, 2008, which was $3.1 million less than the $24.7
      million for the three months ended June 30, 2007. Net premiums written were
      $20.2 million for the three months ended June 30, 2008 as compared to the $21.9
      million reported for the same period in 2007. The primary reasons for the
      decline in premiums were increased competition and rate pressure in the standard
      commercial markets.





Total
      revenue for the Standard Commercial Segment was $22.2 million for the three
      months ended June 30, 2008 as compared to $20.0 million for the same period
      in
      2007. This $2.2 million increase was due primarily to increased contingent
      commissions of $2.1 million related to favorable loss development on prior
      accident years during the second quarter of 2008 as compared to the same period
      for 2007. Net premiums earned increased $0.1 million for the quarter due to
      the
      upward trend of net premium written in 2007 as compared to the flat net written
      premium trend in 2008.





Pre-tax
      income for our Standard Commercial Segment of $4.0 million for the second
      quarter of 2008 increased $1.3 million from the $2.7 million reported for the
      second quarter of 2007. Increased revenue as discussed above was the primary
      reason for the increase in pre-tax income, partially offset by higher losses
      and
      loss adjustment expense of $0.4 million for the quarter and increased operating
      expenses of $0.5 million due to production related costs as well as new hires.
      The higher losses and loss adjustment expense is evidenced by a net loss ratio
      of 57.5% for the three months ended June 30, 2008 as compared to 55.8% for
      the
      same period of 2007.





The
      net
      loss ratio was unfavorably impacted by lower ceded losses of $0.9 for the three
      months ended June 30, 2008, as compared to $1.8 million for the same period
      the
      prior year. The gross loss ratio before reinsurance was 58.1% for the three
      months ended June 30, 2008 as compared to 57.3% for the same period the prior
      year. The gross loss results for the three months ended June 30, 2008 included
      $0.4 million of favorable prior year development as compared to favorable loss
      development on prior accident years of $0.6 million recognized during the same
      period of 2007. The Standard Commercial Segment reported net expense ratios
      of
      27.3% and 27.0% for the second quarters of 2008 and 2007,
      respectively.





***Specialty
      Commercial Segment***





Gross
      premiums written for the Specialty Commercial Segment for the second quarter
      of
      2008 were $27.3 million, which was $1.2 million less than the $28.5 million
      reported for the same period in 2007. Net premiums written for the second
      quarter of 2008 were $26.4 million, which was $0.7 million less than the $27.1
      million reported for the same period in 2007. The decrease in premium volume
      was
      due to increased competition and rate pressure in both the excess and surplus
      and general aviation markets.




Total
      revenue for the Specialty Commercial Segment of $32.0 million for the second
      quarter of 2008 was $1.0 million less than the $33.0 million reported in the
      first quarter of 2007. This 3% decrease in revenue was largely due to lower
      commission income of $3.5 million for the quarter primarily as a result of
      the
      shift from a third party agency structure to an insurance underwriting structure
      partially offset by increased net premiums earned of $2.4 million for the
      quarter as a result of the increased retention of business and increased net
      investment income of $0.1 million.


23





Pre-tax
      income for the Specialty Commercial Segment of $6.3 million for the second
      quarter of 2008 decreased $3.1 million from the $9.4 million reported for the
      same period in 2007. Decreased revenue, discussed above, as well as increased
      losses and loss adjustment expenses of $3.3 million were the primary reasons
      for
      the decrease in pre-tax income, partially offset by lower other operating
      expenses of $1.1 million.





The
      Specialty Commercial Segment reported a net loss ratio of 58.2% for the second
      quarter of 2008 as compared to 49.3% for the second quarter of 2007. Unfavorable
      prior accident year development of $0.5 million for the second quarter of 2008
      as compared to favorable prior accident year development of $1.4 million during
      the same period of 2007 were the primary cause for the increase in net loss
      ratio. Absent prior year development, the gross incurred losses and loss
      adjustment expense before reinsurance were higher by $1.2 million primarily
      due
      to increased pricing pressure reflected in our current accident year loss
      estimates. The Specialty Commercial Segment reported a net expense ratio of
      30.7% for the second quarter of 2008, as compared to 32.0% for the second
      quarter of 2007. The decrease in the net expense ratio was primarily due to
      increased retention on our catastrophe reinsurance and commercial property
      per
      risk reinsurance programs during the second quarter of 2008 as compared to
      the
      second quarter of 2007.





***Personal
      Segment***





Net
      premium written for our Personal Segment increased $0.9 million during the
      second quarter of 2008 to $14.2 million compared to $13.3 million in the second
      quarter of 2007. The increase in net premium was due mostly to continued
      geographic expansion.





Total
      revenue for the Personal Segment increased 12% to $16.5 million for the second
      quarter of 2008 from $14.7 million for the same period in 2007. The primary
      reason for the increase was higher earned premium of $1.7 million.





Pre-tax
      income for the Personal Segment was $1.9 million for the three months ended
      June
      30, 2008 as compared to $2.2 million for the same period in 2007. The increased
      revenue, as discussed above, was partially offset by increased losses and loss
      adjustment expenses of $1.6 million and increased operating expenses of $0.5
      million due mostly to production related expenses attributable to the increased
      earned premium.





The
      Personal Segment reported a net loss ratio of 68.5% for the second quarter
      of
      2008 as compared to 65.2% for the same period in 2007. A competitive pricing
      environment and the new business impact associated with geographic expansion
      were the primary reasons for the increase in net loss ratio. We recognized
      $0.3
      million of favorable prior accident year development in the second quarter
      2008
      as compared to $0.1 million of unfavorable prior accident year development
      in
      the second quarter of 2007. The Personal Segment reported a net expense ratio
      of
      21.6% for the second quarter of 2008 as compared to 22.8% for the second quarter
      of 2007. The decrease in the net expense ratio was mainly due to increased
      finance charges and fixed overhead allocations in relation to earned
      premium.


24


***Corporate***





Corporate
      revenue of $1.0 million for the three months ended June 30, 2008 remained
      relatively unchanged from the $1.1 million reported for the same period in
      2007.
      Recognized gains on our investment portfolio decreased $0.6 million and
      investment income increased $0.6 million due to changes in capital
      allocation.





Corporate
      pre-tax loss was $1.9 million for the second quarter of 2008 as compared to
      $1.3
      million for the same period in 2007. Contributing to the increased loss was
      increased interest expense of $0.4 million due primarily to the issuance of
      trust preferred securities in August 2007 and increased operating expense of
      $0.1 million.


25


**Six
      Months Ended June 30, 2008 as Compared to Six Months Ended June 30,
      2007**





The
      following is additional business segment information for the six months ended
      June 30, 2008 and 2007 (in thousands):





**Hallmark
      Financial Services, Inc.**


**Consolidated
      Segment Data**





**Six Months Ended June 30, 2008****Standard**
            
            **Specialty****Commercial**
            
            **Commercial**
            
            **Personal****Segment**
            
            **Segment**
            
            **Segment**
            
            **Corporate**
            
            **Consolidated**Produced
                premium (1)
            
            
            43,373
            
            
            68,006
            
            
            31,880
            
            
            -
            
            
            143,259Gross
                premiums written
            
            
            43,373
            
            
            52,099
            
            
            31,880
            
            
            -
            
            
            127,352Ceded
                premiums written
            
            
            (2,746
            )
            
            (1,913
            )
            
            -
            
            
            -
            
            
            (4,659
            )Net
                premiums written
            
            
            40,627
            
            
            50,186
            
            
            31,880
            
            
            -
            
            
            122,693Change
                in unearned premiums
            
            
            440
            
            
            (2,550
            )
            
            (2,224
            )
            
            
            
            
            (4,334
            )Net
                premiums earned
            
            
            41,067
            
            
            47,636
            
            
            29,656
            
            
            -
            
            
            118,359Total
                revenues
            
            
            43,986
            
            
            64,075
            
            
            32,224
            
            
            2,571
            
            
            142,856Losses
                and loss adjustment expenses
            
            
            22,979
            
            
            28,979
            
            
            19,575
            
            
            -
            
            
            71,533Pre-tax
                income (loss)
            
            
            7,865
            
            
            11,558
            
            
            4,503
            
            
            (3,193
            )
            
            20,733Net
                loss ratio (2)
            
            
            56.0
            %
            
            60.8
            %
            
            66.0
            %
            
            
            
            
            60.4
            %Net
                expense ratio (2)
            
            
            27.3
            %
            
            30.7
            %
            
            22.0
            %
            
            
            
            
            29.1
            %Net
                combined ratio (2)
            
            
            83.3
            %
            
            91.5
            %
            
            88.0
            %
            
            
            
            
            89.5
            %





**Six Months Ended June 30, 2007****Standard**
            
            **Specialty****Commercial**
            
            **Commercial**
            
            **Personal****Segment**
            
            **Segment**
            
            **Segment**
            
            **Corporate**
            
            **Consolidated**Produced
                premium (1)
            
            
            48,301
            
            
            80,313
            
            
            28,374
            
            
            -
            
            
            156,988Gross
                premiums written
            
            
            48,221
            
            
            54,641
            
            
            28,373
            
            
            -
            
            
            131,235Ceded
                premiums written
            
            
            (5,439
            )
            
            (2,729
            )
            
            -
            
            
            -
            
            
            (8,168
            )Net
                premiums written
            
            
            42,782
            
            
            51,912
            
            
            28,373
            
            
            -
            
            
            123,067Change
                in unearned premiums
            
            
            (2,655
            )
            
            (11,230
            )
            
            (2,224
            )
            
            -
            
            
            (16,109
            )Net
                premiums earned
            
            
            40,127
            
            
            40,682
            
            
            26,149
            
            
            -
            
            
            106,958Total
                revenues
            
            
            41,770
            
            
            61,076
            
            
            28,469
            
            
            1,379
            
            
            132,694Losses
                and loss adjustment expenses
            
            
            24,108
            
            
            21,716
            
            
            17,080
            
            
            (7
            )
            
            62,897Pre-tax
                income (loss)
            
            
            5,423
            
            
            14,127
            
            
            4,294
            
            
            (3,199
            )
            
            20,645Net
                loss ratio (2)
            
            
            60.1
            %
            
            53.4
            %
            
            65.3
            %
            
            
            
            
            58.8
            %Net
                expense ratio (2)
            
            
            27.5
            %
            
            31.8
            %
            
            23.2
            %
            
            
            
            
            28.1
            %Net
                combined ratio (2)
            
            
            87.6
            %
            
            85.2
            %
            
            88.5
            %
            
            
            
            
            86.9
            %





(1)
            Produced
                premium is a non-GAAP measurement that management uses to track total
                controlled premium produced by our operations. 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 where we receive commission
                revenue.




(2)
            The
                net loss ratio is calculated as incurred losses and loss adjustment
                expenses divided by net premiums earned, each determined in accordance
                with GAAP. The net expense ratio is calculated as total underwriting
                expenses of our insurance company subsidiaries, including allocated
                overhead expenses and 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.




26


***Standard
      Commercial Segment***





Gross
      premiums written for the Standard Commercial Segment were $43.4 million for
      the
      six months ended June 30, 2008, or 10% less than the $48.2 million reported
      for
      the same period in 2007. Net premiums written were $40.6 million for the six
      months ended June 30, 2008 as compared to $42.8 million reported for the same
      period in 2007. Increased competition and rate pressure continue to challenge
      premium volume growth in the Standard Commercial Segment.





Total
      revenue for the Standard Commercial Segment of $44.0 million for the six months
      ended June 30, 2008 was $2.2 million more than the $41.8 million reported during
      the six months ended June 30, 2007. This 5% increase in total revenue was
      primarily due to increased contingent commissions of $1.4 million related to
      favorable loss development on prior accident years during 2008 compared to
      the
      same period for 2007. Also contributing to this increase in revenues was
      increased net premiums earned of $0.9 million and increased net investment
      income of $0.2 million. These increases in revenue were partially offset by
      lower processing and service fees of $0.3 million, due to the shift from a
      third
      party agency structure to an insurance underwriting structure.





Pre-tax
      income for our Standard Commercial Segment of $7.9 million for the six months
      ended June 30, 2008 increased $2.5 million, or 45%, from the $5.4 million
      reported for the same period of 2007. This increase in pre-tax income was
      primarily attributable to increased revenue discussed above as well as lower
      loss and loss adjustment expenses of $1.1 million. These increases were
      partially offset by higher operating expenses of $0.9 million primarily due
      to
      production related expenses related to higher earned premium and new
      hires.





The
      net
      loss ratio for the six months ended June 30, 2008 was 56.0% as compared to
      the
      60.1% reported for the same period of 2007. The gross loss ratio before
      reinsurance was 54.2% for the six months ended June 30, 2008 as compared to
      57.5% for the same period the prior year. The gross loss results for the six
      months ended June 30, 2008 included $2.2 million of favorable prior year
      development as compared to favorable prior year development of $0.6 million
      recognized during the same period of 2007. Absent prior year development, the
      gross incurred losses and loss adjustment expense before reinsurance for the
      Standard Commercial Segment were lower by $0.9 million due to better gross
      loss
      experience.





The
      Standard Commercial Segment reported net expense ratios of 27.3% and 27.5%
      for
      the six months ended June 30, 2008 and 2007, respectively.





***Specialty
      Commercial Segment***





Gross
      premiums written for the Specialty Commercial Segment for the first six months
      of 2008 were $52.1 million, or 5% less than the $54.6 million reported for
      the
      same period in 2007. Net premiums written for the first six months of 2008
      were
      $50.2 million or 3% less than the $51.9 million reported for the same period
      in
      2007. The decrease in premium volume was due to the increased competition and
      rate pressure in both the excess and surplus and general aviation markets.





Total
      revenue for the Specialty Commercial Segment of $64.1 million for the first
      six
      months of 2008 was $3.0 million more than the $61.1 million reported in the
      first six months of 2007. This 5% increase in revenue was largely due to
      increased net premiums earned of $7.0 million for the first six months of 2008
      as a result of the increased retention of business. Increased net investment
      income contributed an additional $0.3 million to the increase in revenue for
      the
      quarter. These increases in revenue were partially offset by lower ceding
      commission and fee revenue of $4.2 million due primarily to the shift from
      a
      third party agency structure to an insurance underwriting structure.


27





Pre-tax
      income for the Specialty Commercial Segment of $11.6 million for the first
      six
      months of 2008 decreased $2.6 million, or 18%, from the $14.1 million reported
      for the same period in 2007. Increased losses and loss adjustment expenses
      of
      $7.3 million, partially offset by the increased revenue discussed above and
      lower operating expenses of $1.7 million due mostly to production related
      expenses.





The
      Specialty Commercial Segment reported a net loss ratio of 60.8% for the first
      six months of 2008 as compared to 53.4% for the first six months of 2007.
      Unfavorable prior year development of $1.0 million for the six months ended
      June
      30, 2008 as compared to favorable prior year development of $1.4 million for
      the
      same period of 2007 was the primary cause for the increase in the net loss
      ratio. Absent prior year development, the gross incurred losses and loss
      adjustment expense before reinsurance were higher by $4.0 million primarily
      due
      to increased pricing pressure reflected in our current accident year loss
      estimates.





The
      Specialty Commercial Segment reported a net expense ratio of 30.7% for the
      first
      six months of 2008 as compared to 31.8% for the first six months of 2007. The
      decrease in the net expense ratio was primarily due to increased retention
      on
      our catastrophe reinsurance and commercial property per risk reinsurance
      programs during the first six months of 2008 as compared to the same period
      in
      2007.





***Personal
      Segment***





Net
      premium written for our Personal Segment increased $3.5 million during the
      first
      six months of 2008 to $31.9 million compared to $28.4 million in the first
      six
      months of 2007. The increase in premium was due mostly to continued geographic
      expansion that began in 2007.





Total
      revenue for the Personal Segment increased 13% to $32.2 million for the first
      six months of 2008 from $28.5 million for the same period in 2007. Higher earned
      premium of $3.5 million was the primary reason for the increase in revenue
      for
      the period. Increased finance charges of $0.3 million were partially offset
      by
      lower third party commission revenue of $0.1 million.





Pre-tax
      income for the Personal Segment was $4.5 million for the six months ended June
      30, 2008 as compared to $4.3 million for the same period in 2007. The increased
      revenue, as discussed above, was offset by increased losses and loss adjustment
      expenses of $2.5 million and increased operating expenses of $1.0 million due
      mostly to production related expenses attributable to the increased earned
      premium.





The
      Personal Segment reported a net loss ratio of 66.0% for the first six months
      of
      2008 as compared to 65.3% for the same period in 2007. A competitive pricing
      environment and the new business impact associated with geographic expansion
      were the primary reasons for the increase in the net loss ratio. We recognized
      $0.6 million of favorable prior accident year development during the first
      six
      months 2008 as compared to $0.1 million of favorable prior year development
      during the first six months of 2007.





The
      Personal Segment reported a net expense ratio of 22.0% for the first six months
      of 2008 as compared to 23.2% for the first six months of 2007. The decrease
      in
      the net expense ratio was mainly due to increased finance charges in relation
      to
      earned premium, as well as fixed overhead allocations in relation to earned
      premium.


28





***Corporate***





Corporate
      revenue increased $1.2 million for the first six months of 2008 as compared
      to
      the same period in 2007. The increase was primarily due to increased investment
      income of $1.0 million due primarily to changes in capital allocation and $1.1
      million of net gains recognized on our investment portfolio during the first
      six
      months of 2008 as compared to $0.9 million of net gains recognized during the
      same period of 2007.





Corporate
      pre-tax loss was $3.2 million for the first six months of 2008 and 2007. The
      increase in revenue discussed above was offset by increased interest expense
      of
      $0.8 million due primarily to the issuance of trust preferred securities in
      August 2007 and increased operating expenses of $0.4 million.




**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 June 30, 2008, Hallmark had $26.6 million
      in unrestricted cash and invested assets at the holding company. Unrestricted
      cash and invested assets of our non-insurance subsidiaries were $3.5 million
      as
      of June 30, 2008.





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 2008, our insurance company subsidiaries’ ordinary dividend capacity is
      $16.3 million. None of our insurance company subsidiaries paid a dividend to
      Hallmark during the first six months of 2008 or the 2007 fiscal
      year.





***Comparison
      of June 30, 2008 to December 31, 2007***





On
      a
      consolidated basis, our cash and investments (excluding restricted cash) at
      June
      30, 2008 were $370.9 million compared to $411.7 million at December 31, 2007.
      Settlement of receivables and payables for securities during the first quarter
      of 2008 as well as a decline in market value for the period, contributed to
      this
      decrease in our cash and investments. At June 30, 2008, 88% of the Company’s
      investments were rated investment grade and had an average duration of 2.9
      years, including approximately 36% that were held in short-term investments.
      The
      Company classifies its bond securities as available for sale. The net unrealized
      loss associated with the investment portfolio was $4.7 million (net of tax
      effects) at June 30, 2008 (see Note 4 of Notes to Condensed Consolidated
      Financial Statements which appears in Item 1 of this Report).




29


***Comparison
      of Six Months Ended June 30, 2008 and June 30, 2007***





Net
      cash
      provided by our consolidated operating activities was $29.7 million for the
      first six months of 2008 compared to $44.6 million for the first six months
      of
      2007. The decrease in operating cash flow was primarily due to increased paid
      losses from the maturing of retained business growth that began in late 2005.





Net
      cash
      used in investing activities during the first six months of 2008 was $132.0
      million as compared to $68.6 million for the same period in 2007. Contributing
      to the increase in cash used in investing activities was an increase of $111.4
      million in purchases of debt and equity securities, a $80.0 million increase
      in
      net purchases of short-term investments, and a $8.3 million reduction in
      restricted cash, partially offset by a $136.4 million increase in maturities
      and
      redemptions of investment securities.




Cash
      used
      in financing activities during the first six months of 2008 was $10.1 million
      as
      compared to $15.6 million used by financing activities for the same period
      of
      2007. The cash used in both periods was primarily for the payment of deferred
      guaranteed consideration to the sellers of the subsidiaries comprising our
      TGA
      Operating Unit. As of June 30, 2008 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 substantially all of our assets. The revolving credit facility
      contains covenants which, among other things, require us to maintain certain
      financial and operating ratios and restrict certain distributions, transactions
      and organizational changes. As of June 30, 2008, we were in compliance with
      all
      of our covenants. As of June 30, 2008, we had $3.9 million outstanding under
      this credit facility.





***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 June 30, 2008, 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 June 30, 2008,
      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.


30





***Structured
      Settlements***





In
      connection with our acquisition of the subsidiaries now comprising our TGA
      Operating Unit, we issued to the sellers promissory notes in the aggregate
      principal amount of $23.7 million, of which $14.2 million was paid on January
      2,
      2007, and $9.5 million was paid on January 2, 2008. We were also obligated
      to
      pay to the sellers an additional $1.3 million, of which $0.8 million was paid
      on
      January 2, 2007 and an additional $0.5 million was paid on January 2, 2008,
      in
      consideration of the sellers’ compliance with certain restrictive covenants,
      including a covenant not to compete for a period of five years after closing.
      We
      secured payment of these installments of purchase price and restrictive covenant
      consideration by depositing $25.0 million in a trust account for the benefit
      of
      the sellers. We recorded a payable for future guaranteed payments to the sellers
      of $25.0 million discounted at 4.4%, the rate of two-year U.S. Treasuries (the
      only permitted investment of the trust account). As of June 30, 2008 we had
      fully repaid our obligation to the sellers.





***Conclusion***





Based
      on
      budgeted and year-to-date cash flow information, we believe that we have
      sufficient liquidity to meet our projected insurance obligations, operational
      expenses and capital expenditure requirements for the next 12 months.





**Item
      3. Quantitative and Qualitative Disclosures About Market
      Risk.**





As
      of
      June 30, 2008, there had been no material changes in the market risks described
      in our Annual Report on Form 10-K for the year ended December 31,
      2007.





**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.


31





**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.


32


**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
      Securities and Exchange Commission).


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





None.





**Item
      3.**  **Defaults
      Upon Senior Securities.**





None.





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




Hallmark’s
      Annual Meeting of Shareholders was held on May 22, 2008. Of the 20,801,587
      shares of common stock of Hallmark entitled to vote at the meeting, 16,666,751
      shares were present in person or by proxy.




At
      the
      Annual Meeting, the following individuals were elected to serve as directors
      of
      Hallmark and received the number of votes set forth opposite their respective
      names:




Director
            
            Votes For
            
            Votes WithheldMark
                E. Schwarz
            
            
            15,212,726
            
            
            281,287Scott
                T. Berlin
            
            
            16,258,362
            
            
            281,287James
                H. Graves
            
            
            16,385,389
            
            
            281,287George
                R. Manser
            
            
            16,169,427
            
            
            281,287




At
      the
      Annual Meeting, Hallmark stockholders approved an increase in the number of
      shares of common stock authorized for issuance under the 2005 Long Term
      Incentive Plan. Votes were cast 14,443,821 in favor of such proposal, with
      11,865 votes abstaining.





**Item
      5.**  **Other
      Information.**





None.


33





**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).




34





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.




35


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:
                  August 11, 2008
              
              /s/
                Mark J. MorrisonMark
                  J. Morrison, Chief Executive Officer and President
                (Principal
                  Executive Officer)Date:
                  August 11, 2008
              
              /s/
                Jeffrey R. PassmoreJeffrey
                  R. Passmore, Chief Accounting Officer and Senior Vice
                  President(Principal
                  Financial Officer)


36