**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**




**FORM
      10-Q**




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


Securities
      Exchange Act of 1934




For
      the
      quarterly period ended September 30, 2007


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
o




Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
      one):


Large
      accelerated filer o  Accelerated
      filer o Non-accelerated
      filer x




Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act). Yes o 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
      - 20,768,252 shares outstanding as of November 7, 2007.







**PART
      I**


**FINANCIAL
      INFORMATION**





Item
      1.  Financial
      Statements





**INDEX
      TO FINANCIAL STATEMENTS**




Page
                NumberConsolidated
                Balance Sheets at September 30, 2007 (unaudited) and December 31,
                2006
            3Consolidated
                Statements of Operations (unaudited) for the three months and nine
                months
                ended September 30, 2007 and September 30, 2006
            4Consolidated
                Statements of Stockholders’ Equity and Comprehensive Income (unaudited)
                for the three months and nine months ended September 30, 2007 and
                September 30, 2006
            5Consolidated
                Statements of Cash Flows (unaudited) for the nine months ended September
                30, 2007 and September 30, 2006
            6Notes
                to Consolidated Financial Statements (unaudited)
            7


2


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


**Consolidated
      Balance Sheets**


($
      in
      thousands)





**September
                30**
            
            **December
                31****2007**
            
            **2006**(unaudited)
            
            (audited)ASSETSInvestments:Debt
                securities, available-for-sale, at market value
            
            $
            163,054
            
            $
            133,030Equity
                securities, available-for-sale, at market value
            
            
            41,988
            
            
            4,580Short-term
                investments, available-for-sale, at market value
            
            
            56,311
            
            
            25,275Total
                investments
            
            
            261,353
            
            
            162,885Cash
                and cash equivalents
            
            
            61,681
            
            
            81,474Restricted
                cash and cash equivalents
            
            
            15,646
            
            
            24,569Premiums
                receivable
            
            
            53,136
            
            
            44,644Accounts
                receivable
            
            
            18,503
            
            
            13,223Prepaid
                reinsurance premium
            
            
            1,154
            
            
            1,629Reinsurance
                recoverable
            
            
            5,781
            
            
            5,930Deferred
                policy acquisition costs
            
            
            20,776
            
            
            17,145Excess
                of cost over fair value of net assets acquired
            
            
            30,025
            
            
            31,427Intangible
                assets
            
            
            24,354
            
            
            26,074Prepaid
                expenses
            
            
            1,094
            
            
            1,769Other
                assets
            
            
            12,131
            
            
            5,184Total
                assets
            
            $
            505,634
            
            $
            415,953LIABILITIES
                AND STOCKHOLDERS' EQUITYLiabilities:Notes
                payable
            
            $
            60,681
            
            $
            35,763Structured
                settlements
            
            
            9,897
            
            
            24,587Unpaid
                losses and loss adjustment expenses
            
            
            116,136
            
            
            77,564Unearned
                premiums
            
            
            108,365
            
            
            91,606Unearned
                revenue
            
            
            3,356
            
            
            5,734Reinsurance
                balances payable
            
            
            -
            
            
            1,060Accrued
                agent profit sharing
            
            
            1,990
            
            
            1,784Accrued
                ceding commission payable
            
            
            7,052
            
            
            3,956Pension
                liability
            
            
            2,884
            
            
            3,126Deferred
                federal income taxes
            
            
            115
            
            
            2,310Current
                federal income tax payable
            
            
            336
            
            
            2,132Accounts
                payable and other accrued expenses
            
            
            22,736
            
            
            15,600Total
                liabilities
            
            
            333,548
            
            
            265,222Commitments
                and ContingenciesStockholders'
                equity:Common
                stock, $.18 par value (authorized 33,333,333 shares in 2007 and 2006;
                issued 20,776,080 shares in 2007 and 2006)
            
            
            3,740
            
            
            3,740Additional
                paid in capital
            
            
            118,283
            
            
            117,932Retained
                earnings
            
            
            51,847
            
            
            31,480Accumulated
                other comprehensive loss
            
            
            (1,707
            )
            
            (2,344
            )Treasury
                stock, at cost (7,828 shares in 2007 and 2006)
            
            
            (77
            )
            
            (77
            )Total
                stockholders' equity
            
            
            172,086
            
            
            150,731$
            505,634
            
            $
            415,953





The
      accompanying notes are an integral part


of
      the
      consolidated financial statements


3


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


**Consolidated
      Statements of Operations**


(Unaudited)


($
      in
      thousands, except per share amounts)





**Three
                Months Ended**
            
            **Nine
                Months Ended****September
                30**
            
            **September
                30****2007**
            
            **2006**
            
            **2007**
            
            **2006**Gross
                premiums written
            
            $
            62,304
            
            $
            58,107
            
            $
            193,539
            
            $
            153,718Ceded
                premiums written
            
            
            (779
            )
            
            (3,102
            )
            
            (8,947
            )
            
            (7,542
            )Net
                premiums written
            
            
            61,525
            
            
            55,005
            
            
            184,592
            
            
            146,176Change
                in unearned premiums
            
            
            (2,100
            )
            
            (12,811
            )
            
            (18,209
            )
            
            (41,289
            )Net
                premiums earned
            
            
            59,425
            
            
            42,194
            
            
            166,383
            
            
            104,887Investment
                income, net of expenses
            
            
            3,774
            
            
            2,912
            
            
            9,811
            
            
            7,505Gain
                (loss) on investments
            
            
            418
            
            
            (135
            )
            
            1,299
            
            
            (1,501
            )Finance
                charges
            
            
            1,206
            
            
            1,037
            
            
            3,477
            
            
            2,940Commission
                and fees
            
            
            7,280
            
            
            9,943
            
            
            23,344
            
            
            32,223Processing
                and service fees
            
            
            111
            
            
            410
            
            
            586
            
            
            1,994Other
                income
            
            
            4
            
            
            4
            
            
            12
            
            
            24Total
                revenues
            
            
            72,218
            
            
            56,365
            
            
            204,912
            
            
            148,072Losses
                and loss adjustment expenses
            
            
            36,723
            
            
            23,589
            
            
            99,620
            
            
            60,478Other
                operating expenses
            
            
            24,087
            
            
            23,044
            
            
            70,511
            
            
            64,097Interest
                expense
            
            
            1,026
            
            
            1,527
            
            
            2,608
            
            
            4,774Interest
                expense from amortization of discount on convertible notes
            
            
            -
            
            
            -
            
            
            -
            
            
            9,625Amortization
                of intangible asset
            
            
            573
            
            
            573
            
            
            1,719
            
            
            1,719Total
                expenses
            
            
            62,409
            
            
            48,733
            
            
            174,458
            
            
            140,693Income
                before tax
            
            
            9,809
            
            
            7,632
            
            
            30,454
            
            
            7,379Income
                tax expense
            
            
            3,227
            
            
            2,755
            
            
            10,087
            
            
            2,918Net
                income
            
            $
            6,582
            
            $
            4,877
            
            $
            20,367
            
            $
            4,461Common
                stockholders net income per share:Basic
            
            $
            0.32
            
            $
            0.27
            
            $
            0.98
            
            $
            0.28Diluted
            
            $
            0.32
            
            $
            0.27
            
            $
            0.98
            
            $
            0.28





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**
            
            **Nine
                Months Ended****September
                30,**
            
            **September
                30,****2007**
            
            **2006**
            
            **2007**
            
            **2006****Common
                Stock**Balance,
                beginning of period
            
            $
            3,740
            
            $
            3,198
            
            $
            3,740
            
            $
            2,606Conversion
                of note payable to common stock
            
            
            -
            
            
            -
            
            
            -
            
            
            589Issuance
                of common stock upon option exercises
            
            
            -
            
            
            -
            
            
            -
            
            
            3Balance,
                end of period
            
            
            3,740
            
            
            3,198
            
            
            3,740
            
            
            3,198**Additional
                Paid-In Capital**Balance,
                beginning of period
            
            
            118,085
            
            
            93,663
            
            
            117,932
            
            
            62,907Discount
                on convertible notes, net of tax
            
            
            -
            
            
            -
            
            
            -
            
            
            6,066Conversion
                of note payable to common stock
            
            
            -
            
            
            -
            
            
            -
            
            
            24,562Equity
                based compensation
            
            
            198
            
            
            50
            
            
            351
            
            
            107Exercise
                of stock options
            
            
            -
            
            
            (1
            )
            
            -
            
            
            70Balance,
                end of period
            
            
            118,283
            
            
            93,712
            
            
            118,283
            
            
            93,712**Retained
                Earnings**Balance,
                beginning of period
            
            
            45,265
            
            
            21,873
            
            
            31,480
            
            
            22,289Net
                income
            
            
            6,582
            
            
            4,877
            
            
            20,367
            
            
            4,461Balance,
                end of period
            
            
            51,847
            
            
            26,750
            
            
            51,847
            
            
            26,750**Accumulated
                Other Comprehensive Loss**Balance,
                beginning of period
            
            
            (2,746
            )
            
            (3,668
            )
            
            (2,344
            )
            
            (2,597
            )Amortization
                of net actuarial loss, net of tax
            
            
            33
            
            
            -
            
            
            97
            
            
            32Unrealized
                gains on securities, net of tax
            
            
            1,006
            
            
            1,438
            
            
            540
            
            
            335Balance,
                end of period
            
            
            (1,707
            )
            
            (2,230
            )
            
            (1,707
            )
            
            (2,230
            )**Treasury
                Stock**Balance,
                beginning of period
            
            
            (77
            )
            
            (77
            )
            
            (77
            )
            
            (17
            )Acquisition
                of treasury shares
            
            
            -
            
            
            -
            
            
            -
            
            
            (100
            )Exercise
                of stock options
            
            
            -
            
            
            -
            
            
            -
            
            
            40Balance,
                end of period
            
            
            (77
            )
            
            (77
            )
            
            (77
            )
            
            (77
            )**Stockholders'
                Equity**
            
            $
            172,086
            
            $
            121,353
            
            $
            172,086
            
            $
            121,353Net
                income
            
            $
            6,582
            
            $
            4,877
            
            $
            20,367
            
            $
            4,461Amortization
                of net actuarial loss, net of tax
            
            
            33
            
            
            -
            
            
            97
            
            
            32Unrealized
                gains on securities, net of tax
            
            
            1,006
            
            
            1,438
            
            
            540
            
            
            335**Comprehensive
                Income**
            
            $
            7,621
            
            $
            6,315
            
            $
            21,004
            
            $
            4,828





The
      accompanying notes are an integral part


of
      the
      consolidated financial statements


5


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


**Consolidated
      Statement of Cash Flows**


(Unaudited)


($
      in
      thousands)





**Nine
                Months Ended****September
                30****2007**
            
            **2006**Cash
                flows from operating activities:Net
                income
            
            $
            20,367
            
            $
            4,461Adjustments
                to reconcile net income to cash provided by operating
                activities:Depreciation
                and amortization expense
            
            
            2,344
            
            
            2,418Amortization
                of beneficial conversion feature
            
            
            -
            
            
            9,625Amortization
                of discount on structured settlement
            
            
            310
            
            
            784Deferred
                federal income tax benefit
            
            
            (1,170
            )
            
            (4,062
            )(Gain)
                loss on investments
            
            
            (1,299
            )
            
            1,501Change
                in prepaid reinsurance premiums
            
            
            475
            
            
            (808
            )Change
                in prepaid commissions
            
            
            487
            
            
            659Change
                in premiums receivable
            
            
            (8,492
            )
            
            (10,118
            )Change
                in accounts receivable
            
            
            1,604
            
            
            (8,725
            )Change
                in deferred policy acquisition costs
            
            
            (3,631
            )
            
            (5,578
            )Change
                in unpaid losses and loss adjustment expenses
            
            
            38,572
            
            
            29,793Change
                in unearned premiums
            
            
            16,759
            
            
            42,114Change
                in unearned revenue
            
            
            (2,378
            )
            
            (6,516
            )Change
                in accrued agent profit sharing
            
            
            206
            
            
            (319
            )Change
                in reinsurance recoverable
            
            
            149
            
            
            (3,396
            )Change
                in reinsurance balances payable
            
            
            (1,060
            )
            
            (1,542
            )Change
                in current federal income tax payable
            
            
            (1,796
            )
            
            (2,197
            )Change
                in accrued ceding commission payable
            
            
            3,096
            
            
            104Change
                in all other liabilities
            
            
            3,059
            
            
            (3,556
            )Change
                in all other assets
            
            
            (5,835
            )
            
            854Net
                cash provided by operating activities
            
            
            61,767
            
            
            45,496Cash
                flows from investing activities:Purchases
                of property and equipment
            
            
            (367
            )
            
            (487
            )Premium
                finance notes repaid, net of finance notes originated
            
            
            (856
            )
            
            (2,184
            )Acquisition
                of subsidiaries, net of cash acquired
            
            
            -
            
            
            (25,964
            )Change
                in restricted cash
            
            
            12,244
            
            
            778Purchases
                of debt and equity securities
            
            
            (187,256
            )
            
            (67,795
            )Maturities
                and redemptions of investment securities
            
            
            115,288
            
            
            20,104Net
                purchases of short-term investments
            
            
            (30,713
            )
            
            (27,776
            )Net
                cash used in investing activities
            
            
            (91,660
            )
            
            (103,324
            )Cash
                flows from financing activities:Proceeds
                from exercise of employee stock options
            
            
            -
            
            
            40Payment
                of structured settlement
            
            
            (15,000
            )
            
            -Proceeds
                from issuance of trust preferred securities
            
            
            25,774
            
            
            -Debt
                issuance costs
            
            
            (674
            )
            
            -Proceeds
                from issuance of convertible debt
            
            
            -
            
            
            25,000Proceeds
                from note payable to related party
            
            
            -
            
            
            12,500Proceeds
                from revolving loan on credit facility
            
            
            -
            
            
            15,000Net
                cash provided by financing activities
            
            
            10,100
            
            
            52,540Decrease in
                cash and cash equivalents
            
            
            (19,793
            )
            
            (5,288
            )Cash
                and cash equivalents at beginning of period
            
            
            81,474
            
            
            44,528Cash
                and cash equivalents at end of period
            
            $
            61,681
            
            $
            39,240Supplemental
                Cash Flow Information:Interest
                paid
            
            $
            2,184
            
            $
            3,698Taxes
                paid
            
            $
            13,053
            
            $
            9,084





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 Hallmark General Agency, Inc.
      (“Hallmark General Agency”) and Effective Claims Management, Inc. Our TGA
      Operating Unit handles primarily excess and surplus lines commercial insurance
      products and services and is comprised of Texas General Agency, Inc. (“Texas
      General Agency”), Pan American Acceptance Corporation (“PAAC”) and TGA Special
      Risk, Inc. (“TGASRI”). Our Aerospace Operating Unit handles general aviation
      insurance products and services and is comprised of Aerospace Insurance
      Managers, Inc. (“Aerospace Insurance Managers”), Aerospace Special Risk, Inc.
      (“ASRI”) and Aerospace Claims Management Group, Inc. (“ACMG”). 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, 2006 included in our Annual Report on Form 10-K filed with the
      SEC.





The
      interim financial data as of September 30, 2007 and 2006 is unaudited. However,
      in the opinion of management, the interim data includes all adjustments,
      consisting only of normal recurring adjustments, necessary for a fair statement
      of the results for the interim periods. The results of operations for the period
      ended September 30, 2007 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
      current year presentation. Such reclassification had no effect on net income
      or
      stockholders’ equity. Investment balances that were previously reported in
      Restricted Cash and Investments on the balance sheet have been reclassified
      to
      debt securities, available-for-sale, at market value during the current period.
      The amount reclassified from the December 31, 2006 presentation is $7.2
      million.





***Redesignation
      of Segments***





Each
      of
      our four operating units was reported as a separate segment during the first
      three quarters of 2006. Commencing in the fourth quarter of 2006, our HGA
      Operating Unit was designated as the sole component of the Standard Commercial
      Segment, our TGA Operating Unit and our Aerospace Operating Unit were aggregated
      in the Specialty Commercial Segment, and our Phoenix Operating Unit was
      designated as the sole component of the Personal Segment.




***Reverse
      Stock Split***





All
      share
      and per share amounts have been adjusted to reflect a one-for-six reverse split
      of all issued and unissued shares of our authorized common stock effected July
      31, 2006, and a corresponding increase in the par value of our authorized common
      stock from $0.03 per share to $0.18 per share.





***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.


8





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. We are currently evaluating the impact of adopting SFAS
      157
      on our financial statements.





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.
      We are currently evaluating the impact of adopting SFAS 159 on our financial
      statements.





**3.
      Business Combinations**





We
      account for business combinations using the purchase method of accounting.
      The
      cost of an acquired entity is allocated to the assets acquired (including
      identified intangible assets) and liabilities assumed based on their estimated
      fair values. The excess of the cost of an acquired entity over the net 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.
      While preparing our income tax return during the third quarter of 2007 we
      identified certain tax deductions that were not considered deductible when
      we
      initially recorded the purchase price allocation for the TGA and Aerospace
      Operating Units in 2006. This correction is considered immaterial to the
      purchase price allocation and was corrected on the September 30, 2007 balance
      sheet. The correction reduced total goodwill and total deferred federal income
      tax liability by $1.4 million.


9


**4.
      Supplemental Cash Flow Information**





Effective
      January 1, 2006, we acquired the subsidiaries now comprising our TGA Operating
      Unit and our Aerospace Operating Unit. In conjunction with the acquisitions,
      cash and cash equivalents were used in the acquisitions as follows (in
      thousands):





TGA
            
            AerospaceOperating
                Unit
            
            Operating
                UnitFair
                value of tangible assets excluding cash and cash
                equivalents
            
            $
            52,906
            
            $
            8,391Fair
                value of intangible assets acquired
            
            
            30,531
            
            
            12,356Capitalized
                direct expenses
            
            
            232
            
            
            36Structured
                settlement
            
            
            (23,542
            )
            
            -Liabilities
                assumed
            
            
            (47,468
            )
            
            (7,478
            )Cash
                and cash equivalents used in acquisitions
            
            $
            12,659
            
            $
            13,305





**5.
      Pledged Investments**





We
      have
      certain of our securities pledged for the benefit of various state insurance
      departments, reinsurers and the sellers of our TGA Operating Unit. These
      securities are included with our available-for-sale debt securities as we have
      the ability to trade these securities. We retain the interest earned on these
      securities. These securities had a carrying value of $23.3 million at September
      30, 2007.





**6.
      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 833,333 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.





As
      of
      September 30, 2007, there were incentive stock options to purchase 677,499
      shares of our common stock outstanding and non-qualified stock options to
      purchase 40,000 shares of our common stock outstanding under the 2005 LTIP,
      leaving 115,834 shares reserved for future issuance. As of September 30, 2007,
      there were incentive stock options to purchase 93,001 shares outstanding under
      the 1994 Employee Plan and non-qualified stock options to purchase 23,334 shares
      outstanding under the 1994 Director Plan. In addition, as of September 30,
      2007,
      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.


10





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 vest 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.





A
      summary
      of the status of our stock options as of and changes during the year-to-date
      ended September 30, 2007 is presented below:





Average
            
            Contractual
            
            IntrinsicNumber
                of
            
            Exercise
            
            Term
            
            ValueShares
            
            Price
            
            (Years)
            
            ($000)Outstanding
                at January 1, 2007
            
            
            332,334
            
            $
            7.04Granted
            
            
            520,000
            
            $
            12.52Exercised
            
            
            -
            
            $
            -Forfeited
                or expired
            
            
            (1,834
            )
            $
            5.05Outstanding
                at September 30, 2007
            
            
            850,500
            
            $
            10.40
            
            
            8.1
            
            $
            3,108Exercisable
                at September 30, 2007
            
            
            138,751
            
            $
            4.79
            
            
            3.6
            
            $
            1,285





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





Three
                Months Ended
            
            Nine
                Months EndedSeptember
                30,
            
            September
                30,2007
            
            2006
            
            2007
            
            2006Intrinsic
                value of options exercised
            
            $
            -
            
            $
            -
            
            $
            -
            
            $
            103Cost
                of share-based payments (non-cash)
            
            $
            198
            
            $
            50
            
            $
            351
            
            $
            107Income
                tax benefit of share-based payments recognized in income
            
            $
            69
            
            $
            17
            
            $
            123
            
            $
            37




As
      of
      September 30, 2007 there was $2.7 million of total unrecognized compensation
      cost related to non-vested share-based compensation arrangements granted under
      our plans, of which $0.2 million is expected to be recognized in the remainder
      of 2007, $0.6 million is expected to be recognized in 2008, $0.8 million is
      expected to be recognized in each of 2009 and 2010 and $0.3 million is expected
      to be recognized in 2011.





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
      historical volatility of our common stock. 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.


11





The
      following table details the weighted average grant date fair value and related
      assumptions for the periods indicated (in thousands). There were no options
      granted in the third quarter of 2006.




Three
                Months Ended
            
            Nine
                Months EndedSeptember
                30,
            
            September
                30,2007
            
            2006
            
            2007
            
            2006Grant
                date fair value per share
            
            $
            4.14
            
            
            n/a
            
            $
            4.04
            
            $
            6.26Expected
                term (in years)
            
            
            6.5
            
            
            n/a
            
            
            6.4
            
            
            5.0Expected
                volatility
            
            
            19.0
            %
            
            n/a
            
            
            19.4
            %
            
            59.1
            %Risk
                free interest rate
            
            
            4.8
            %
            
            n/a
            
            
            4.5
            %
            
            4.9
            %




**7.
      Segment Information**





The
      following is business segment information for the three and nine months ended
      September 30, 2007 and 2006 (in thousands):




Three
                Months Ended
            
            Nine
                Months EndedSeptember
                30,
            
            September
                30,2007
            
            2006
            
            2007
            
            2006Revenues:Standard
                Commercial Segment
            
            $
            23,530
            
            $
            20,964
            
            $
            65,300
            
            $
            57,768Specialty
                Commercial Segment
            
            
            32,760
            
            
            22,889
            
            
            93,836
            
            
            56,003Personal
                Segment
            
            
            15,185
            
            
            12,257
            
            
            43,654
            
            
            34,944Corporate
            
            
            743
            
            
            255
            
            
            2,122
            
            
            (643
            )Consolidated
            
            $
            72,218
            
            $
            56,365
            
            $
            204,912
            
            $
            148,072Pre-tax
                income (loss):Standard
                Commercial Segment
            
            $
            3,514
            
            $
            5,112
            
            $
            8,937
            
            $
            11,245Specialty
                Commercial Segment
            
            
            6,350
            
            
            2,867
            
            
            20,477
            
            
            7,925Personal
                Segment
            
            
            1,854
            
            
            2,316
            
            
            6,148
            
            
            6,760Corporate
            
            
            (1,909
            )
            
            (2,663
            )
            
            (5,108
            )
            
            (18,551
            )Consolidated
            
            $
            9,809
            
            $
            7,632
            
            $
            30,454
            
            $
            7,379




12




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





September 30,
              2007
            
            December 31,
              2006AssetsStandard
                Commercial Segment
            
            $
            129,527
            
            $
            130,764Specialty
                Commercial Segment
            
            
            235,335
            
            
            167,675Personal
                Segment
            
            
            96,401
            
            
            85,391Corporate
            
            
            44,371
            
            
            32,123$
            505,634
            
            $
            415,953





**8.
      Reinsurance**





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





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


Three Months Ended
                September 30,
              
              Nine Months Ended
                September 30,2007
              
              2006
              
              2007
              
              2006Ceded
                  earned premiums
              
              $
              2,372
              
              $
              3,112
              
              $
              10,396
              
              $
              6,735Reinsurance
                  recoveries
              
              $
              537
              
              $
              3,130
              
              $
              3,973
              
              $
              4,024




Our
      insurance company subsidiaries presently retain 100% of the risk associated
      with
      all non-standard personal automobile policies marketed by our Phoenix Operating
      Unit. We currently reinsure the following exposures on business generated by
      our
      HGA Operating Unit, our TGA Operating Unit and our Aerospace Operating
      Unit:





·
            **Property****catastrophe**.
                Our property catastrophe reinsurance reduces the financial impact
                a
                catastrophe could have on our commercial property insurance lines.
                Catastrophes might include multiple claims and policyholders. Catastrophes
                include hurricanes, windstorms, earthquakes, hailstorms, explosions,
                severe winter weather and fires. Our property catastrophe reinsurance
                is
                excess-of-loss reinsurance, which provides us reinsurance coverage
                for
                losses in excess of an agreed-upon amount. We utilize catastrophe
                models
                to assist in determining appropriate retention and limits to purchase.
                The
                terms of our property catastrophe reinsurance, effective July 1,
                2007,
                are:





o
            We
                retain the first $2.0 million of property catastrophe losses; and


13





o
            Our
                reinsurers reimburse us 100% for each $1.00 of loss in excess of
                our $2.0
                million retention up to $28.0 million for each catastrophic occurrence,
                subject to a maximum of two events for the contractual
                term.





·
            **Commercial
                property.**Our
                commercial property reinsurance is excess-of-loss coverage intended
                to
                reduce the financial impact a single-event or catastrophic loss may
                have
                on our results. The terms of the commercial property reinsurance,
                effective July 1, 2007, are:





o
            We
                retain the first $1.0 million of loss for each commercial property
                risk;





o
            Our
                reinsurers reimburse us for the next $5.0 million for each commercial
                property risk; and





o
            Individual
                risk facultative reinsurance is purchased on any commercial property
                with
                limits above $6.0 million.





·
            **Commercial
                casualty.**Our
                commercial casualty reinsurance is excess-of-loss coverage intended
                to
                reduce the financial impact a single-event loss may have on our results.
                The terms of our commercial casualty reinsurance, effective July
                1, 2007,
                are:





o
            We
                retain the first $1.0 million of loss for each commercial casualty
                risk;
                and





o
            Our
                reinsurers reimburse us for the next $5.0 million for each commercial
                casualty risk.





·
            **Aviation**.
                We purchase reinsurance specific to the aviation risks underwritten
                by our
                Aerospace Operating Unit. This reinsurance provides aircraft hull
                and
                liability coverage and airport liability coverage on a per occurrence
                basis on the following terms:





o
            We
                retain the first $350,000 of each aircraft hull or liability or airport
                liability loss;





o
            Our
                reinsurers reimburse us for the next $1.15 million of each aircraft
                hull
                or liability loss and for the next $650,000 of each airport liability
                loss; and





o
            Our
                reinsurers provide additional reimbursement of $4.0 million for each
                airport liability loss and aircraft liability loss, excluding passenger
                liability.





Refer
      to
      Note 6 to the consolidated financial statements in our Annual Report on Form
      10-K for the year ended December 31, 2006, for reinsurance coverages in effect
      prior to the current treaties.


14





**9.
      Notes Payable**




On
      June
      21, 2005, an unconsolidated trust subsidiary, Hallmark Statutory Trust I,
      completed a private placement of $30.0 million of 30-year floating rate trust
      preferred securities. Simultaneously, we borrowed $30.9 million from the trust
      subsidiary and contributed $30.0 million to one of our insurance company
      subsidiaries in order to increase policyholder surplus. The note bears an
      initial interest rate of 7.725% until June 15, 2015, at which time interest
      will
      adjust quarterly to the three-month LIBOR rate plus 3.25 percentage points.
      As
      of September 30, 2007, the note balance was $30.9 million.





On
      August
      23, 2007, a newly formed unconsolidated trust subsidiary, Hallmark Statutory
      Trust II, completed a private placement of $25.0 million of 30 year floating
      rate trust preferred securities. Simultaneously, we borrowed $25.8 million
      from
      the trust subsidiary for working capital and general corporate purposes. The
      note bears an initial interest rate at 8.28% until September 15, 2017, at which
      time interest will adjust quarterly to the three-month LIBOR rate plus 2.90
      percentage points. As of September 30, 2007 the note balance was $25.8
      million.





On
      January 27, 2006, we borrowed $15.0 million under our revolving credit facility
      to fund the cash required to close the acquisition of the subsidiaries
      comprising our TGA Operating Unit. As of September 30, 2007, the balance on
      the
      revolving note was $2.8 million, which currently bears interest at 7.23% per
      annum. Also included in notes payable is $1.2 million outstanding under PAAC’s
      revolving credit sub-facility, which also currently bears interest at 7.23%
      per
      annum. (See Note 11, “Credit Facilities”). ****





**10.
      Structured Settlements**





In
      connection with the acquisition of the subsidiaries comprising our TGA Operating
      Unit, we recorded a payable for future guaranteed payments of $25.0 million
      discounted at 4.4%, the rate of two-year U.S. Treasuries (the only investment
      permitted on the trust account securing such future payments). As of September
      30, 2007, the balance of the structured settlements was $9.9
      million.





**11.
      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.
      Principal outstanding under the revolving credit facility generally bears
      interest at the three month Eurodollar rate plus 2.00%, 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. The amended and restated
      credit agreement terminates on January 27, 2008. The new premium finance
      sub-facility terminates May 31, 2009. As of September 30, 2007, we were in
      compliance with all of our covenants.





PAAC
      had
      a $5.0 million revolving credit facility with JPMorgan Chase Bank which
      terminated June 30, 2007. This facility was replaced with the new $5.0 million
      premium finance sub-facility with The Frost National Bank as discussed
      above.


15


**11.
      Deferred Policy Acquisition Costs**





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





Three Months Ended
              September 30,
            
            Nine Months Ended
              September 30,2007
            
            2006
            
            2007
            
            2006Deferred
            
            $
            (12,197
            )
            $
            (10,709
            )
            $
            (37,163
            )
            $
            (28,299
            )Amortized
            
            
            11,635
            
            
            8,531
            
            
            33,532
            
            
            22,721Net
            
            $
            (562
            )
            $
            (2,178
            )
            $
            (3,631
            )
            $
            (5,578
            )











**12.
      Earnings per Share**





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





Three Months Ended
              September 30,
            
            Nine Months Ended
              September 30,2007
            
            2006
            
            2007
            
            2006Weighted
                average shares - basic
            
            
            20,768
            
            
            17,760
            
            
            20,768
            
            
            16,019Effect
                of dilutive securities
            
            
            -
            
            
            26
            
            
            -
            
            
            19Weighted
                average shares - assuming dilution
            
            
            20,768
            
            
            17,786
            
            
            20,768
            
            
            16,038





For
      the
      three and nine months ended September 30, 2007, 520,000 shares attributable
      to
      outstanding stock options were excluded from the calculation of diluted earnings
      per share because the exercise prices of the stock options were greater than
      the
      average price of the common shares and, therefore, their inclusion would have
      been anti-dilutive. For the three and nine months ended September 30, 2006,
      109,166 shares attributable to outstanding stock options were excluded from
      the
      calculation of diluted earnings per share because the exercise prices of the
      stock options were greater than the average price of the common shares and,
      therefore, their inclusion would have been anti-dilutive.


16


**13.
      Net Periodic Pension Cost**





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





Three
                  Months Ended
              September
                30,
            
            Nine
                  Months Ended
              September
                30,2007
            
            2006
            
            2007
            
            2006Interest
                cost
            
            $
            180
            
            $
            172
            
            $
            540
            
            $
            515Amortization
                of net loss
            
            
            50
            
            
            40
            
            
            150
            
            
            121Expected
                return on plan assets
            
            
            (161
            )
            
            (157
            )
            
            (482
            )
            
            (472
            )Net
                periodic pension cost
            
            $
            69
            
            $
            55
            
            $
            208
            
            $
            164




We
      contributed $31 thousand and $0.2 million to our frozen defined benefit cash
      balance plan (“Cash Balance Plan”) during each of the three months ended
      September 30, 2007 and 2006, respectively. We contributed $0.3 million to our
      Cash Balance Plan during each of the nine months ended September 30, 2007 and
      2006. Refer to Note 14 to the consolidated financial statements in our Annual
      Report on Form 10-K for the year ended December 31, 2006 for more discussion
      of
      our retirement plans.





**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” and “Item 1A. Risk Factors” 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 Hallmark General Agency,
                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 Texas General Agency, Inc., Pan American Acceptance
                Corporation 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.


17




·
            ***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, 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.





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





·
            ***Phoenix
                Indemnity Insurance Company******(“PIIC”)***presently
                assumes all 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, PIIC retains 34% of our total net premiums written and GSIC retains
      20%
      of our total net premiums written.




All
      share
      and per share amounts have been adjusted to reflect a one-for-six reverse split
      of all issued and unissued shares of our authorized common stock effected July
      31, 2006.




Each
      of
      our four operating units was reported as a separate segment during the first
      three quarters of 2006. Commencing in the fourth quarter of 2006, our HGA
      Operating Unit was designated as the sole component of the Standard Commercial
      Segment, our TGA Operating Unit and our Aerospace Operating Unit were aggregated
      in the Specialty Commercial Segment and our Phoenix Operating Unit was
      designated as the sole component of the Personal Segment.


18




**Results
      of Operations**





**Management
      Overview.** During
      the three months and nine months ended September 30, 2007, our total revenues
      were $72.2 million and $204.9 million, respectively representing a 28% and
      38%
      increase over the $56.4 million and $148.1 million in total revenues,
      respectively, for the same periods of 2006. 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. Specialty
      Commercial Segment revenues increased $9.9 million and $37.8 million, or 43%
      and
      68%, during the three months and nine months ended September 30, 2007,
      respectively, as compared to the same periods of 2006. Revenues from our
      Personal Segment increased $2.9 million and $8.7 million, or 24% and 25%, during
      the three and nine months ended September 30, 2007, due largely to geographic
      expansion into new states. Increased retention of business was also the primary
      reason for the Standard Commercial Segment’s $2.6 million and $7.5 million
      increases in revenue for the three months and nine months ended September 30,
      2007, respectively. Net gain on investments of $0.4 million and
      $1.3 million for the three months and nine months ended September 30, 2007,
      respectively, as compared to net losses on investments of $0.1 million and
      $1.5
      million recognized for the same periods the prior year, were the primary reason
      for an increase in revenue for Corporate.





We
      reported net income of $6.6 million and $20.4 million for the three months
      and
      nine months ended September 30, 2007, respectively, as compared to net income
      of
      $4.9 million and $4.5 million reported for the three and nine months ended
      September 30, 2006, respectively. On a diluted per share basis, net income
      was
      $0.32 and $0.98 for the three months and nine months ended September 30, 2007,
      respectively, as compared to net income per share of $0.27 and $0.28 for the
      same periods in 2006. During the nine months ended September 30, 2006, we
      recorded $9.6 million of interest expense from amortization attributable to
      the
      deemed discount on convertible promissory notes issued in January, 2006 and
      subsequently converted to common stock during the second quarter of 2006. The
      increase in net income was also attributable to increased revenue as discussed
      above and to prior year favorable loss reserve development of $2.9 million
      for
      the nine months ended September 30, 2007 as compared to $2.0 million of prior
      year favorable development recognized during the same period of 2006. Lower
      interest expense and additional investment income from a larger investment
      portfolio resulting from increased retention of premiums also contributed to
      the
      increase in net income.


19


**Third
      Quarter 2007 as Compared to Third Quarter 2006**





The
      following is additional business segment information for the three months ended
      September 30, 2007 and 2006 (in thousands):





**Hallmark
      Financial Services, Inc.**


**Consolidated
      Segment Data**





**Three Months Ended September 30, 2007****Standard**
              **Commercial**
              **Segment**
            
            **Specialty**
              **Commercial**
              **Segment**
            
            **Personal**
              **Segment**
            
            **Corporate**
            
            **Consolidated**Produced
                premium
            
            $
            21,945
            
            $
            37,919
            
            $
            14,854
            
            $
            -
            
            $
            74,718Gross
                premiums written
            
            
            21,918
            
            
            25,531
            
            
            14,855
            
            
            -
            
            
            62,304Ceded
                premiums written
            
            
            198
            
            
            (977
            )
            
            -
            
            
            -
            
            
            (779
            )Net
                premiums written
            
            
            22,116
            
            
            24,554
            
            
            14,855
            
            
            -
            
            
            61,525Change
                in unearned premiums
            
            
            (311
            )
            
            (870
            )
            
            (919
            )
            
            -
            
            
            (2,100
            )Net
                premiums earned
            
            
            21,805
            
            
            23,684
            
            
            13,936
            
            
            -
            
            
            59,425Total
                revenues
            
            
            23,530
            
            
            32,760
            
            
            15,185
            
            
            743
            
            
            72,218Losses
                and loss adjustment expenses
            
            
            13,513
            
            
            13,682
            
            
            9,532
            
            
            (4
            )
            
            36,723Pre-tax
                income (loss)
            
            
            3,514
            
            
            6,350
            
            
            1,854
            
            
            (1,909
            )
            
            9,809Net
                loss ratio (1)
            
            
            62.0
            %
            
            57.8
            %
            
            68.4
            %
            
            
            
            
            61.8
            %Net
                expense ratio (1)
            
            
            27.3
            %
            
            30.8
            %
            
            22.9
            %
            
            
            
            
            27.7
            %Net
                combined ratio (1)
            
            
            89.3
            %
            
            88.6
            %
            
            91.3
            %
            
            
            
            
            89.5
            %**Three
                Months Ended September 30, 2006****Standard**
              **Commercial**
              **Segment**
            
            
            **Specialty**
              **Commercial**
              **Segment**
            
            
            **Personal**
              **Segment**
            
            
            **Corporate**
            
            
            **Consolidated**Produced
                premium
            
            $
            22,206
            
            $
            41,320
            
            $
            12,278
            
            $
            -
            
            $
            75,804Gross
                premiums written
            
            
            21,967
            
            
            23,862
            
            
            12,278
            
            
            -
            
            
            58,107Ceded
                premiums written
            
            
            (2,270
            )
            
            (832
            )
            
            -
            
            
            -
            
            
            (3,102
            )Net
                premiums written
            
            
            19,697
            
            
            23,030
            
            
            12,278
            
            
            -
            
            
            55,005Change
                in unearned premiums
            
            
            (497
            )
            
            (11,256
            )
            
            (1,058
            )
            
            -
            
            
            (12,811
            )Net
                premiums earned
            
            
            19,200
            
            
            11,774
            
            
            11,220
            
            
            -
            
            
            42,194Total
                revenues
            
            
            20,964
            
            
            22,889
            
            
            12,257
            
            
            255
            
            
            56,365Losses
                and loss adjustment expenses
            
            
            9,347
            
            
            7,450
            
            
            6,800
            
            
            (8
            )
            
            23,589Pre-tax
                income (loss)
            
            
            5,112
            
            
            2,867
            
            
            2,316
            
            
            (2,663
            )
            
            7,632Net
                loss ratio (1)
            
            
            48.7
            %
            
            63.3
            %
            
            60.6
            %
            
            
            
            
            55.9
            %Net
                expense ratio (1)
            
            
            28.1
            %
            
            30.7
            %
            
            24.3
            %
            
            
            
            
            27.8
            %Net
                combined ratio (1)
            
            
            76.8
            %
            
            94.0
            %
            
            84.9
            %
            
            
            
            
            83.7
            %





(1)
      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.


20


***Standard
      Commercial Segment***





Gross
      premiums written for the Standard Commercial Segment were $21.9 million for
      the
      three months ended September 30, 2007 as compared to $22.0 million for the
      three
      months ended September 30, 2006. Net premiums written were $22.1 million for
      the
      three months ended September 30, 2007, or 12% more than the $19.7 million
      reported for the same period in 2006. Increased competition has kept premium
      produced by the Standard Commercial Segment relatively flat for the third
      quarter of 2007 compared to the same period in 2006. The increase in net written
      premium is primarily attributable to increased retention of business and a
      more
      cost-effective structure for reinsurance.





Total
      revenue for the Standard Commercial Segment of $23.5 million for the third
      quarter of 2007 was $2.5 million more than the $21.0 million reported in the
      third quarter of 2006. This 12% increase in total revenue was primarily due
      to
      increased net premiums earned of $2.6 million for the quarter due to increased
      retention of business and increased net investment income of $0.4 million.
      These
      increases in revenue were partially offset by lower ceding commission revenue
      and processing fees of $0.5 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 $3.5 million for the third quarter
      of 2007 decreased $1.6 million, or 31%, from the $5.1 million reported for
      the
      third quarter of 2006. This decrease in pre-tax income was primarily
      attributable to higher net loss results as evidenced by a net loss ratio of
      62.0% for the three months ended September 30, 2007 as compared to 48.7% for
      the
      same period of 2006.





The
      higher net loss ratio was impacted by lower ceded losses of $0.3 million for
      the
      three months ended September 30, 2007 as compared to $3.2 million for the same
      period in 2006. The gross loss ratio before reinsurance was 59.6% for the three
      months ended September 30, 2007 as compared to 58.2% for the same period the
      prior year. The gross loss results for the three months ended September 30,
      2007
      included $0.1 million of favorable prior year development as compared to
      favorable prior year development of $0.5 million recognized during the same
      period of 2006. Absent prior year development, the gross incurred losses and
      loss adjustment expense before reinsurance for the Standard Commercial Segment
      were lower by $0.2 million.





The
      Standard Commercial Segment reported net expense ratios of 27.3% and 28.1%
      for
      the third quarters of 2007 and 2006, respectively. The net expense ratio for
      2006 was higher primarily due to costs to assume from Clarendon National
      Insurance Company the unearned premium previously produced by the Standard
      Commercial Segment.





***Specialty
      Commercial Segment***





Gross
      premiums written for the Specialty Commercial Segment for the third quarter
      of
      2007 were $25.5 million, or 7%, more than the $23.9 million reported for the
      same period in 2006. Net premiums written for the third quarter of 2007 were
      $24.6 million, or 7%, more than the $23.0 million reported for the same period
      in 2006. The increase in premium volume was due to the increased retention
      of
      business produced by our TGA Operating Unit from 50% in 2006 to 60% in
      2007.





Total
      revenue for the Specialty Commercial Segment of $32.8 million for the third
      quarter of 2007 was $9.9 million more than the $22.9 million reported in the
      third quarter of 2006. This 43% increase in revenue was largely due to increased
      net premiums earned of $11.9 million for the quarter as a result of the
      increased retention of business. The Specialty Commercial Segment also
      recognized $1.1 million of contingent ceding commission under quota share
      agreements for treaties effective 2006 and prior, due to improved underwriting
      results. Increased net investment income contributed an additional $0.4 million
      to the increase in revenue for the quarter. These increases in revenue were
      partially offset by lower ceding commission revenue of $3.6 million due to
      the
      shift from a third party agency structure to an insurance underwriting
      structure.


21





Pre-tax
      income for the Specialty Commercial Segment of $6.4 million for the third
      quarter of 2007 increased $3.5 million, or 121%, from the $2.9 million reported
      for the same period in 2006. Increased revenue, discussed above, was the primary
      reason for the increase in pre-tax income, partially offset by increased losses
      and loss adjustment expenses of $6.2 million and increased operating expenses
      of
      $0.2 million due mostly to production related expenses that are directly related
      to increased earned premium.





The
      Specialty Commercial Segment reported a net loss ratio of 57.8% for the third
      quarter of 2007 as compared to 63.3% for the third quarter of 2006. The initial
      actuarial loss estimates at the time of the acquisition of the subsidiaries
      comprising the Specialty Commercial Segment have proven to be high as positive
      indicators have emerged in these operations. As a result, the Specialty
      Commercial Segment experienced favorable prior year development of $0.5 million
      for the three months ended September 30, 2007, as compared to no prior year
      development in the third quarter of 2006. The Specialty Commercial Segment
      reported a net expense ratio of 30.8% for the third quarter of 2007 as compared
      to 30.7% for the third quarter of 2006.





***Personal
      Segment***





Net
      premium written for our Personal Segment increased $2.6 million during the
      third
      quarter of 2007 to $14.9 million compared to $12.3 million in the third quarter
      of 2006. The increase in premium was due mostly to continued geographic
      expansion that began in 2006.





Total
      revenue for the Personal Segment increased 24% to $15.2 million for the third
      quarter of 2007 from $12.3 million for the same period in 2006. Higher earned
      premium of $2.7 million and increased finance charges of $0.2 million were
      the
      primary factors for the increase in revenue for the period.





Pre-tax
      income for the Personal Segment was $1.9 million for the three months ended
      September 30, 2007 as compared to $2.3 million for the same period in 2006.
      The
      increased revenue, as discussed above, was offset by increased losses and loss
      adjustment expenses of $2.7 million and increased operating expenses of $0.7
      million due mostly to production related expenses attributable to the increased
      earned premium. The Personal Segment reported a net loss ratio of 68.4% for
      the
      third quarter of 2007 as compared to 60.6% for the same period in 2006. 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 $0.1 million of favorable prior accident year development
      in the third quarter 2007 as compared to $0.7 million of favorable prior year
      development in the third quarter of 2006. The Personal Segment reported a net
      expense ratio of 22.9% for the third quarter of 2007 as compared to 24.3% for
      the third quarter of 2006. 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 to PIIC in each period.


22





***Corporate***





Corporate
      revenue increased $0.5 million for the third quarter of 2007 as compared to
      the
      same period in 2006. The increase was primarily due to $0.4 million of net
      gains
      on our investment portfolio during the third quarter of 2007, as compared to
      $0.1 million of net losses recognized during the third quarter of
      2006.




Corporate
      pre-tax loss was $1.9 million for the third quarter of 2007 as compared to
      $2.7
      million for the same period in 2006. Contributing to the decreased loss were
      the gains discussed above and lower interest expense of $0.5 million due to
      the permanent financing of debt used to acquire the subsidiaries comprising
      the
      Specialty Commercial Segment in 2006. Most of this debt was either converted
      to
      equity in the second quarter of 2006 or repaid with proceeds from our public
      equity offering in the fourth quarter of 2006. Partially offsetting these
      improvements were increased operating expenses of $0.2 million for the third
      quarter 2007 due mostly to increased consulting costs related to compliance
      with
      Sarbanes-Oxley Section 404 requirements and new employees.


23


**Nine
      Months Ended September 30, 2007 as Compared to Nine Months Ended September
      30,
      2006**





The
      following is additional business segment information for the nine months ended
      September 30, 2007 and 2006 (in thousands):





**Hallmark
      Financial Services, Inc.**


**Consolidated
      Segment Data**





**Nine
                Months Ended September 30, 2007****Standard
                Commercial Segment**
            
            **Specialty
                Commercial Segment**
            
            **Personal
                Segment**
            
            **Corporate**
            
            **Consolidated**Produced
                premium
            
            $
            70,246
            
            $
            118,232
            
            $
            43,228
            
            $
            -
            
            $
            231,706Gross
                premiums written
            
            
            70,139
            
            
            80,172
            
            
            43,228
            
            
            -
            
            
            193,539Ceded
                premiums written
            
            
            (5,241
            )
            
            (3,706
            )
            
            -
            
            
            -
            
            
            (8,947
            )Net
                premiums written
            
            
            64,898
            
            
            76,466
            
            
            43,228
            
            
            -
            
            
            184,592Change
                in unearned premiums
            
            
            (2,966
            )
            
            (12,100
            )
            
            (3,143
            )
            
            -
            
            
            (18,209
            )Net
                premiums earned
            
            
            61,932
            
            
            64,366
            
            
            40,085
            
            
            -
            
            
            166,383Total
                revenues
            
            
            65,300
            
            
            93,836
            
            
            43,654
            
            
            2,122
            
            
            204,912Losses
                and loss adjustment expenses
            
            
            37,621
            
            
            35,398
            
            
            26,612
            
            
            (11
            )
            
            99,620Pre-tax
                income (loss)
            
            
            8,937
            
            
            20,477
            
            
            6,148
            
            
            (5,108
            )
            
            30,454Net
                loss ratio (1)
            
            
            60.7
            %
            
            55.0
            %
            
            66.4
            %
            
            
            
            
            59.9
            %Net
                expense ratio (1)
            
            
            27.4
            %
            
            31.4
            %
            
            23.1
            %
            
            
            
            
            27.9
            %Net
                combined ratio (1)
            
            
            88.1
            %
            
            86.4
            %
            
            89.5
            %
            
            
            
            
            87.8
            %**Nine
                Months Ended September 30, 2006****Standard
                Commercial Segment**
            
            
            **Specialty
                Commercial Segment**
            
            
            **Personal
                Segment**
            
            
            **Corporate**
            
            
            **Consolidated**Produced
                premium
            
            $
            69,357
            
            $
            115,610
            
            $
            34,116
            
            $
            -
            
            $
            219,083Gross
                premiums written
            
            
            68,884
            
            
            50,718
            
            
            34,116
            
            
            -
            
            
            153,718Ceded
                premiums written
            
            
            (6,122
            )
            
            (1,420
            )
            
            -
            
            
            -
            
            
            (7,542
            )Net
                premiums written
            
            
            62,762
            
            
            49,298
            
            
            34,116
            
            
            -
            
            
            146,176Change
                in unearned premiums
            
            
            (12,396
            )
            
            (26,136
            )
            
            (2,757
            )
            
            -
            
            
            (41,289
            )Net
                premiums earned
            
            
            50,366
            
            
            23,162
            
            
            31,359
            
            
            -
            
            
            104,887Total
                revenues
            
            
            57,768
            
            
            56,003
            
            
            34,944
            
            
            (643
            )
            
            148,072Losses
                and loss adjustment expenses
            
            
            27,165
            
            
            13,969
            
            
            19,369
            
            
            (25
            )
            
            60,478Pre-tax
                income (loss)
            
            
            11,245
            
            
            7,925
            
            
            6,760
            
            
            (18,551
            )
            
            7,379Net
                loss ratio (1)
            
            
            53.9
            %
            
            60.3
            %
            
            61.8
            %
            
            
            
            
            57.7
            %Net
                expense ratio (1)
            
            
            29.1
            %
            
            27.6
            %
            
            25.7
            %
            
            
            
            
            27.8
            %Net
                combined ratio (1)
            
            
            83.0
            %
            
            87.9
            %
            
            87.5
            %
            
            
            
            
            85.5
            %





(1)
      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.


24





***Standard
      Commercial Segment***





Gross
      premiums written for the Standard Commercial Segment were $70.1 million for
      the
      nine months ended September 30, 2007, or 2% more than the $68.9 million reported
      for the same period in 2006. Net premiums written were $64.9 million for the
      nine months ended September 30, 2007 as compared to $62.8 million reported
      for
      the same period in 2006. Increased competition and rate pressure have challenged
      premium volume growth by the Standard Commercial Segment throughout 2007.




Total
      revenue for the Standard Commercial Segment of $65.3 million for the nine months
      ended September 30, 2007 was $7.5 million more than the $57.8 million reported
      during the nine months ended September 30, 2006. This 13% increase in total
      revenue was primarily due to increased net premiums earned of $11.6 million
      and
      increased net investment income of $1.1 million. These increases in revenue
      were
      partially offset by contingent commission adjustments related to adverse
      development on prior accident years of $1.5 million, as well as lower ceding
      commission revenue of $2.4 million and lower processing and service fees of
      $1.3
      million, in both cases due to the shift from a third party agency structure
      to
      an insurance underwriting structure.





Pre-tax
      income for our Standard Commercial Segment of $8.9 million for the nine months
      ended September 30, 2007 decreased $2.3 million, or 21%, from the $11.2 million
      reported for the same period of 2006. This decrease in pre-tax income was
      primarily attributable to the contingent commission adjustment discussed above,
      as well as higher net loss results.





The
      net
      loss ratio for the nine months ended September 30, 2007 was 60.7% as compared
      to
      the 53.9% reported for the same period of 2006. The net loss ratio was
      unfavorably impacted by lower ceded losses of $2.3 million for the nine months
      ended September 30, 2007 as compared to $3.8 million for the same period in
      2006. The gross loss ratio before reinsurance was 58.2% for the nine months
      ended September 30, 2007 as compared to 55.6% for the same period the prior
      year. The gross loss results for the nine months ended September 30, 2007 and
      September 30, 2006 both included $0.8 million of favorable prior year
      development. Absent prior year development, the gross incurred losses and loss
      adjustment expense before reinsurance for the Standard Commercial Segment were
      higher by $2.7 million primarily due to competitive market conditions in the
      current accident year.





The
      Standard Commercial Segment reported net expense ratios of 27.4% and 29.1%
      for
      the nine months ended September 30, 2007 and 2006, respectively. The net expense
      ratio for 2006 was higher primarily due to costs to assume from Clarendon
      National Insurance Company the unearned premium previously produced by the
      Standard Commercial Segment.


25




***Specialty
      Commercial Segment***





Gross
      premiums written for the Specialty Commercial Segment for the first nine months
      of 2007 were $80.2 million or 58% more than the $50.7 million reported for
      the
      same period in 2006. Net premiums written for the first nine months of 2007
      were
      $76.5 million or 55% more than the $49.3 million reported for the same period
      in
      2006. The increase in premium volume was due to the increased retention of
      business produced by our TGA Operating Unit from 50% in 2006 to 60% in 2007,
      as
      well as the retention of the business produced by our Aerospace Operating Unit
      beginning in the third quarter of 2006.





Total
      revenue for the Specialty Commercial Segment of $93.8 million for the first
      nine
      months of 2007 was $37.8 million more than the $56.0 million reported in the
      first nine months of 2006. This 68% increase in revenue was largely due to
      increased net premiums earned of $41.2 million for the first nine months of
      2007
      as a result of the increased retention of business. The Specialty Commercial
      Segment recognized $4.4 million of contingent ceding commission under quota
      share agreements for treaties effective 2006 and prior due to improved
      underwriting results. Increased net investment income contributed an additional
      $1.8 million to the increase in revenue for the quarter. These increases in
      revenue were partially offset by lower ceding commission and fee revenue of
      $9.4
      million due to the shift from a third party agency structure to an insurance
      underwriting structure.




Pre-tax
      income for the Specialty Commercial Segment of $20.5 million for the first
      nine
      months of 2007 increased $12.6 million, or 158%, from the $7.9 million reported
      for the same period in 2006. Increased revenue, discussed above, was the primary
      reason for the increase in pre-tax income, partially offset by increased losses
      and loss adjustment expenses of $21.4 million and increased operating expenses
      of $3.9 million due mostly to production related expenses that are directly
      related to increased earned premium.





The
      Specialty Commercial Segment reported a net loss ratio of 55.0% for the first
      nine months of 2007 as compared to 60.3% for the first six months of 2006.
      The
      initial actuarial loss estimates at the time of the acquisition of the
      subsidiaries comprising the Specialty Commercial Segment have proven to be
      high
      as positive indicators have emerged in these operations. As a result, the
      Specialty Commercial Segment experienced favorable prior year development of
      $1.9 million for the nine months ended September 30, 2007, as compared to
      favorable prior year development of $0.5 million for the same period of 2006,
      was the primary cause for the decrease in the net loss ratio. The Specialty
      Commercial Segment reported a net expense ratio of 31.4% for the first nine
      months of 2007 as compared to 27.6% for the first nine months of 2006. The
      increase in the net expense ratio was primarily due to the 2006 net expense
      ratio being depressed by the amortization of the fair value adjustment of the
      deferred policy acquisition cost asset, which was recognized in the application
      of SFAS No. 141 in the 2006 acquisition of the TGA Operating Unit. This
      favorably impacted the reported operating expenses during the first nine months
      of 2006. In addition, amortization of the fair value adjustment of the unearned
      premium reserve, also recognized pursuant to SFAS No. 141, reduced the reported
      net premiums earned during the first nine months of 2006.




***Personal
      Segment***





Net
      premium written for our Personal Segment increased $9.1 million during the
      first
      nine months of 2007 to $43.2 million compared to $34.1 million in the first
      nine
      months of 2006. The increase in premium was due mostly to continued geographic
      expansion that began in 2006.




26




Total
      revenue for the Personal Segment increased 25% to $43.7 million for the first
      nine months of 2007 from $34.9 million for the same period in 2006. Higher
      earned premium of $8.7 million was the primary reason for the increase in
      revenue for the period. Increased finance charges of $0.7 million were offset
      by
      lower investment income of $0.5 million due to the reallocation of capital
      to
      other segments for their increased retention of premium and lower third party
      commission revenue of $0.2 million.





Pre-tax
      income for the Personal Segment was $6.1 million for the nine months ended
      September 30, 2007 as compared to $6.8 million for the same period in 2006.
      The
      increased revenue, as discussed above, was offset by increased losses and loss
      adjustment expenses of $7.3 million and increased operating expenses of $2.1
      million due mostly to production related expenses attributable to the increased
      earned premium. The Personal Segment reported a net loss ratio of 66.4% for
      the
      first nine months of 2007 as compared to 61.8% for the same period in 2006.
      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 $0.3 million of favorable prior accident year development
      during the first nine months of 2007 as compared to $0.7 million of favorable
      prior year development during the first nine months of 2006. The Personal
      Segment reported a net expense ratio of 23.1% for the first nine months of
      2007
      as compared to 25.7% for the first nine months of 2006. 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 to PIIC in each
      period.





***Corporate***





Corporate
      revenue increased $2.8 million for the first nine months of 2007 as compared
      to
      the same period in 2006. The increase was primarily due to $1.3 million of
      net
      gains on our investment portfolio during the first nine months of 2007 as
      compared to $1.5 million of net losses recognized during the same period of
      2006.





Corporate
      pre-tax loss was $5.1 million for the first nine months of 2007 as compared
      to
      $18.6 million for the same period in 2006. The decreased loss was mostly due
      to
      the absence of the $9.6 million of interest expense incurred in the first six
      months of 2006 from amortization attributable to the deemed discount on
      convertible promissory notes issued in January, 2006. These notes were converted
      to common stock during the second quarter of 2006. Also contributing to the
      decreased loss were the gains discussed above and lower interest expense of
      $2.1 million due to the permanent financing of debt used to acquire the
      subsidiaries comprising the Specialty Commercial Segment in 2006. Most of this
      debt was either converted to equity in the second quarter of 2006 or repaid
      with
      proceeds from our public equity offering in the fourth quarter of 2006.
      Partially offsetting these improvements were increased operating expenses of
      $1.0 million for the first nine months of 2007 due mostly to increased
      consulting costs related to compliance with Sarbanes-Oxley Section 404
      requirements and new employees.




27




**Financial
      Condition and Liquidity**





***Sources
      and Uses of Funds***





Our
      sources of funds are from insurance-related operations, financing activities
      and
      investing activities. Major sources of funds from operations include premiums
      collected (net of policy cancellations and premiums ceded), commissions, and
      processing and service fees. As a holding company, Hallmark is dependent on
      dividend payments and management fees from its subsidiaries to meet operating
      expenses and debt obligations. As of September 30, 2007, Hallmark had $36.6
      million in unrestricted cash and invested assets. Unrestricted cash and invested
      assets of our non-insurance subsidiaries were $6.9 million as of September
      30,
      2007.





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. PIIC, 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. GSIC, 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 2007, our insurance company subsidiaries’ ordinary dividend capacity is
      $12.4 million. None of our insurance company subsidiaries paid a dividend to
      Hallmark during the first nine months of 2007 or the 2006 fiscal
      year.





***Comparison
      of September 30, 2007 to December 31, 2006***





On
      a
      consolidated basis, our cash and investments (excluding restricted cash) at
      September 30, 2007 were $323.0 million compared to $244.4 million at December
      31, 2006. Net cash provided by our operating activities and the issuance of
      trust preferred securities during the third quarter of 2007 contributed to
      this
      increase in our cash and investments for the nine months ended September 30,
      2007.




***Comparison
      of Nine Months Ended September 30, 2007 and September 30,
      2006***





Net
      cash
      provided by our consolidated operating activities was $61.8 million for the
      first nine months of 2007 compared to $45.5 million for the first nine months
      of
      2006. The increase in operating cash flow was primarily due to increased
      collected premiums resulting from increased retained premium volume, partially
      offset by additional retained paid losses and loss adjustment expenses and
      additional paid operating expenses.





Cash
      used
      in investing activities during the first nine months of 2007 was $91.7 million
      as compared to $103.3 million for the same period in 2006. The higher cash
      used
      in investing activities during the first nine months of 2006 was mostly due
      to
      the acquisitions of the subsidiaries comprising our Specialty Commercial Segment
      which used $26.0 million, net of cash acquired. The withdrawal of $15.0 million
      from a trust account securing the future guaranteed payments to the sellers
      of
      the subsidiaries comprising our TGA Operating Unit to make the first installment
      payment in the first quarter of 2007 contributed to the reduction in cash used
      by investing activities during the first nine months of 2007. Also contributing
      to the reduction in cash used by investing activities was an increase of $95.2
      million from maturities and redemptions of investment securities. Net premium
      finance notes repaid of $0.9 million during the first nine months of 2007 versus
      net premium finance notes repaid of $2.2 million during the first nine months
      of
      2006 also contributed to the reduction in cash used in investing activities.
      Partially offsetting these reductions was a $119.5 million increase in purchase
      of debt and equity securities and a $2.9 million increase in net purchase of
      short-term investments.




28




Cash
      provided in financing activities during the first nine months of 2007 was $10.1
      million as compared to $52.5 million provided by financing activities for the
      same period of 2006. The cash provided in 2007 was from the issuance of trust
      preferred securities less debt issuance costs, offset by the payment of a
      portion of the structured settlement to the sellers of the subsidiaries
      comprising our TGA Operating Unit. The cash provided in 2006 was primarily
      from
      the issuance of three debt instruments in January. The first was a promissory
      note payable to Newcastle Partners, L.P. (“Newcastle Partners”) in the amount of
      $12.5 million to fund the cash required to close the acquisition of the
      subsidiaries now comprising our Aerospace Operating Unit. The second debt
      instrument was $25.0 million in subordinated convertible promissory notes to
      the
      Newcastle Special Opportunity Fund I, L.P. and Newcastle Special Opportunity
      Fund II, L.P. (the “Opportunity Funds”). The principal and accrued interest on
      the convertible notes was converted to 3.3 million shares of our common stock
      during the second quarter of 2006. The $25.0 million raised with these notes
      was
      used to fund a trust account securing future guaranteed payments to the sellers
      of the subsidiaries now comprising our TGA Operating Unit. The third debt
      instrument was $15.0 million borrowed under our revolving credit facility to
      fund the cash required to close the acquisition of the subsidiaries now
      comprising our TGA Operating Unit. In October 2006, we repaid the promissory
      note to Newcastle Partners and repaid $12.2 million of the outstanding principal
      balance of our revolving credit facility, in each case with proceeds received
      from our public equity offering. Newcastle Partners and the Opportunity Funds
      are each an affiliate of our Executive Chairman, Mark E. Schwarz.





***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.
      Principal outstanding under the revolving credit facility generally bears
      interest at the three month Eurodollar rate plus 2.00%, 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. The amended and restated
      credit agreement terminates on January 27, 2008. The new premium finance
      sub-facility terminates May 31, 2009. As of September 30, 2007, we were in
      compliance with all of our covenants.





PAAC
      had
      a $5.0 million revolving credit facility with JPMorgan Chase Bank which
      terminated June 30, 2007. This facility was replaced with the new $5.0 million
      premium finance sub-facility with The Frost National Bank as discussed
      above.





29




***Trust
      Preferred Securities***





On
      June
      21, 2005, an unconsolidated trust subsidiary, Hallmark Statutory Trust I,
      completed a private placement of $30.0 million of 30-year floating rate trust
      preferred securities. Simultaneously, we borrowed $30.9 million from the trust
      subsidiary and contributed $30.0 million to one of our insurance company
      subsidiaries in order to increase policyholder surplus. The note bears an
      initial interest rate of 7.725% until June 15, 2015, at which time interest
      will
      adjust quarterly to the three-month LIBOR rate plus 3.25 percentage points.
      As
      of September 30, 2007, the note balance was $30.9 million.





On
      August
      23, 2007, a newly formed unconsolidated trust subsidiary, Hallmark Statutory
      Trust II, completed a private placement of $25.0 million of 30 year floating
      rate trust preferred securities. Simultaneously, we borrowed $25.8 million
      from
      the trust subsidiary for working capital and general corporate purposes. The
      note bears an initial interest rate at 8.28% until September 15, 2017, at which
      time interest will adjust quarterly to the three-month LIBOR rate plus 2.90
      percentage points. As of September 30, 2007 the note balance was $25.8
      million.





***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 is due on or before January 1, 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 is due on
      or
      before January 1, 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 future 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 September 30, 2007, the balance of the structured settlements
      was $9.9 million.





***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
      September 30, 2007, 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,
      2006.





**Item
      4T. Controls and Procedures.**





The
      principal executive officer and principal financial officer of the Company
      have
      evaluated the Company’s 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 the Company in the reports that it files or submits 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 the Company in the reports
      that it files or submits under such Act is accumulated and communicated to
      the
      Company’s management, including its 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
      the Company’s internal controls over financial reporting that have materially
      affected, or are reasonably likely to materially affect, the Company’s internal
      control over financial reporting.




30




**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 the
      Company's 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 the control of the Company. Although
      the
      Company believes 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 the Company
      or
      any other person that the objectives and plans of the Company will be
      achieved.





31




**PART
      II**


**OTHER
      INFORMATION**





**Item
      1.**  **Legal
      Proceedings.**





The
      Company is 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 the consolidated financial position of the Company
      or
      the results of operations, in the opinion of management. The various legal
      proceedings to which the Company is a party are routine in nature and incidental
      to the Company’s business.





**Item
      1A.**  **Risk
      Factors.**





In
      addition to the other information set forth in this report, you should carefully
      consider the following risk factors:





***Our
      success depends on our ability to price accurately the risks we
      underwrite*** .





Our
      results of operations and financial condition depend on our ability to
      underwrite and set premium rates accurately for a wide variety of risks.
      Adequate rates are necessary to generate premiums sufficient to pay losses,
      loss
      settlement expenses and underwriting expenses and to earn a profit. To price
      our
      products accurately, we must collect and properly analyze a substantial amount
      of data; develop, test and apply appropriate pricing techniques; closely monitor
      and timely recognize changes in trends; and project both severity and frequency
      of losses with reasonable accuracy. Our ability to undertake these efforts
      successfully, and as a result price our products accurately, is subject to
      a
      number of risks and uncertainties, some of which are outside our control,
      including:





Ÿ
              the
                  availability of sufficient reliable data and our ability to properly
                  analyze available data;




Ÿ
            the
                uncertainties that inherently characterize estimates and
                assumptions;




Ÿ
              our
                  selection and application of appropriate pricing techniques;
                  and




Ÿ
              changes
                  in applicable legal liability standards and in the civil litigation
                  system
                  generally.





Consequently,
      we could under-price risks, which would adversely affect our profit margins,
      or
      we could overprice risks, which could reduce our sales volume and
      competitiveness. In either case, our profitability could be materially and
      adversely affected.





***Our
      results may fluctuate as a result of cyclical changes in the property/casualty
      insurance industry.***





Our
      revenue is primarily attributable to property/casualty insurance, which as
      an
      industry is cyclical in nature and has historically been characterized by soft
      markets followed by hard markets. A soft market is a period of relatively high
      levels of price competition, less restrictive underwriting standards and
      generally low premium rates. A hard market is a period of capital shortages
      resulting in lack of insurance availability, relatively low levels of
      competition, more selective underwriting of risks and relatively high premium
      rates. If we find it necessary to reduce premiums or limit premium increases
      due
      to competitive pressures on pricing in a softening market, we may experience
      a
      reduction in our premiums written and in our profit margins and revenues, which
      could adversely affect our financial results.




32




***Estimating
      reserves is inherently uncertain. If our loss reserves are not adequate, it
      will
      have an unfavorable impact on our results.***





We
      maintain loss reserves to cover our estimated ultimate liability for unpaid
      losses and loss adjustment expenses for reported and unreported claims incurred
      as of the end of each accounting period. Reserves represent management’s
      estimates of what the ultimate settlement and administration of claims will
      cost
      and are not reviewed by an independent actuary. These estimates, which generally
      involve actuarial projections, are based on management’s assessment of facts and
      circumstances then known, as well as estimates of future trends in claim
      severity and frequency, judicial theories of liability, and other factors.
      These
      variables are affected by both internal and external events, such as changes
      in
      claims handling procedures, inflation, judicial trends and legislative changes.
      Many of these factors are not quantifiable. Additionally, there may be a
      significant reporting lag between the occurrence of an event and the time it
      is
      reported to us. The inherent uncertainties of estimating reserves are greater
      for certain types of liabilities, particularly those in which the various
      considerations affecting the type of claim are subject to change and in which
      long periods of time may elapse before a definitive determination of liability
      is made. Reserve estimates are continually refined in a regular and ongoing
      process as experience develops and further claims are reported and settled.
      Adjustments to reserves are reflected in the results of the periods in which
      such estimates are changed. For example, a 1% change in September 30, 2007
      unpaid losses and loss adjustment expenses would have produced a $1.2 million
      change to pretax earnings. Our gross loss and loss adjustment expense reserves
      totaled $116.1 million at September 30, 2007. Our loss and loss adjustment
      expense reserves, net of reinsurance recoverables, were $110.3 million at that
      date. Because setting reserves is inherently uncertain, there can be no
      assurance that the current reserves will prove adequate.





***Our
      failure to maintain favorable financial strength ratings could negatively impact
      our ability to compete successfully.***





Third-party
      rating agencies assess and rate the claims-paying ability of insurers based
      upon
      criteria established by the agencies. During 2005, A.M. Best, a nationally
      recognized insurance industry rating service and publisher, upgraded the
      financial strength rating of PIIC, from “B” (Fair) to “B+” (Very Good), and
      upgraded the financial strength rating of AHIC, from “B” (Fair) to “A-”
(Excellent). Our insurance company subsidiaries have historically been rated
      on
      an individual basis. However, effective January 1, 2006, our insurance company
      subsidiaries entered into a pooling arrangement, which was subsequently amended
      December 15, 2006, whereby AHIC would retain 46% of the net premiums written,
      PIIC would retain 34% of the net premiums written and GSIC would retain 20%
      of
      the net premiums written. As a result, in June 2006, A.M. Best notified us
      that
      our insurance company subsidiaries would be rated on a pooled basis and assigned
      a rating of “A-” (Excellent) to each of our individual insurance company
      subsidiaries and to the pool formed by our insurance company
      subsidiaries.




33




These
      financial strength ratings are used by policyholders, insurers, reinsurers
      and
      insurance and reinsurance intermediaries as an important means of assessing
      the
      financial strength and quality of insurers. These ratings are not evaluations
      directed to potential purchasers of our common stock and are not recommendations
      to buy, sell or hold our common stock. Our ratings are subject to change at
      any
      time and could be revised downward or revoked at the sole discretion of the
      rating agencies. We believe that the ratings assigned by A.M. Best are an
      important factor in marketing our products. Our ability to retain our existing
      business and to attract new business in our insurance operations depends largely
      on these ratings. Our failure to maintain our ratings, or any other adverse
      development with respect to our ratings, could cause our current and future
      independent agents and insureds to choose to transact their business with more
      highly rated competitors. If A.M. Best downgrades our ratings or publicly
      indicates that our ratings are under review, it is likely that we would not
      be
      able to compete as effectively with our competitors, and our ability to sell
      insurance policies could decline. If that happens, our sales and earnings would
      decrease. For example, many of our agencies and insureds have guidelines that
      require us to have an A.M. Best financial strength rating of “A-” or higher. A
      reduction of our A.M. Best rating below “A-” would prevent us from issuing
      policies to insureds or potential insureds with such ratings requirements.
      Because lenders and reinsurers will use our A.M. Best ratings as a factor in
      deciding whether to transact business with us, the failure of our insurance
      company subsidiaries to maintain their current ratings could dissuade a lender
      or reinsurance company from conducting business with us or might increase our
      interest or reinsurance costs. In addition, a ratings downgrade by A.M. Best
      below “A-” would require us to post collateral in support of our obligations
      under certain of our reinsurance agreements pursuant to which we assume
      business.





***The
      loss of key executives could disrupt our business.***





Our
      success will depend in part upon the continued service of certain key
      executives. Our success will also depend on our ability to attract and retain
      additional executives and personnel. We do not have employment agreements with
      our Chief Executive Officer or any other of our executive officers other than
      employment agreements entered into in connection with the acquisitions of the
      subsidiaries now comprising our TGA Operating Unit and our Aerospace Operating
      Unit. The loss of key personnel, or our inability to recruit and retain
      additional qualified personnel, could cause disruption in our business and
      could
      prevent us from fully implementing our business strategies, which could
      materially and adversely affect our business, growth and
      profitability.





***Our
      industry is very competitive, which may unfavorably impact our results of
      operations.***





The
      property/casualty insurance market, our primary source of revenue, is highly
      competitive and, except for regulatory considerations, has very few barriers
      to
      entry. According to A.M. Best, there were 3,141 property/casualty insurance
      companies and 2,017 property/casualty insurance groups operating in North
      America as of July 23, 2007. Our HGA Operating Unit competes with a variety
      of
      large national standard commercial lines carriers such as The Hartford, Zurich
      North America, St. Paul Travelers and Safeco, as well as numerous smaller
      regional companies. The primary competition for our TGA Operating Unit’s excess
      and surplus lines products includes such carriers as Atlantic Casualty Insurance
      Company, Colony Insurance Company, Burlington Insurance Company, Penn America
      Insurance Group and, to a lesser extent, a number of national standard lines
      carriers such as Zurich North America and The Hartford. Our Aerospace Operating
      Unit considers its primary competitors to be Houston Casualty Corp., Phoenix
      Aviation, W. Brown & Company, AIG and London Aviation Underwriters. Although
      our Phoenix Operating Unit competes with large national insurers such as
      Allstate, State Farm and Progressive, as a participant in the non-standard
      personal automobile marketplace its competition is most directly associated
      with
      numerous regional companies and managing general agencies. Our competitors
      include entities which have, or are affiliated with entities which have, greater
      financial and other resources than we have. In addition, competitors may attempt
      to increase market share by lowering rates. In that case, we could experience
      reductions in our underwriting margins, or sales of our insurance policies
      could
      decline as customers purchase lower-priced products from our competitors. Losing
      business to competitors offering similar products at lower prices, or having
      other competitive advantages, could adversely affect our results of
      operations.




34




***Our
      results may be unfavorably impacted if we are unable to obtain adequate
      reinsurance*** .





As
      part
      of our overall risk and capacity management strategy, we purchase reinsurance
      for significant amounts of risk, especially catastrophe risks that we and our
      insurance company subsidiaries underwrite. Our catastrophe and non-catastrophe
      reinsurance facilities are subject to annual renewal. We may be unable to
      maintain our current reinsurance facilities or to obtain other reinsurance
      facilities in adequate amounts and at favorable rates. The amount, availability
      and cost of reinsurance are subject to prevailing market conditions beyond
      our
      control and may affect our ability to write additional premiums as well as
      our
      profitability. If we are unable to obtain adequate reinsurance protection for
      the risks we have underwritten, we will either be exposed to greater losses
      from
      these risks or we will reduce the level of business that we underwrite, which
      will reduce our revenue.





***If
      the companies that provide our reinsurance do not pay our claims in a timely
      manner, we could incur severe losses.***





We
      purchase reinsurance by transferring, or ceding, part of the risk we have
      assumed to a reinsurance company in exchange for part of the premium we receive
      in connection with the risk. Although reinsurance makes the reinsurer liable
      to
      us to the extent the risk is transferred or ceded to the reinsurer, it does
      not
      relieve us of our liability to our policyholders. Accordingly, we bear credit
      risk with respect to our reinsurers. We cannot assure that our reinsurers will
      pay all of our reinsurance claims, or that they will pay our claims on a timely
      basis. At September 30, 2007, we had a total of $5.8 million due us from
      reinsurers for recovery of losses. The largest amount due us from a single
      reinsurer as of September 30, 2007 was $1.4 million from QBE Reinsurance
      Corporation. If any of our reinsurers are unable or unwilling to pay amounts
      they owe us in a timely fashion, we could suffer a significant loss or a
      shortage of liquidity, which would have a material adverse effect on our
      business and results of operations.





***Catastrophic
      losses are unpredictable and may adversely affect our results of operations,
      liquidity and financial condition*** .





Property/casualty
      insurance companies are subject to claims arising out of catastrophes that
      may
      have a significant effect on their results of operations, liquidity and
      financial condition. Catastrophes can be caused by various events, including
      hurricanes, windstorms, earthquakes, hail storms, explosions, severe winter
      weather and fires, and may include man-made events, such as the September 11,
      2001 terrorist attacks on the World Trade Center. The incidence, frequency,
      and
      severity of catastrophes are inherently unpredictable. The extent of losses
      from
      a catastrophe is a function of both the total amount of insured exposure in
      the
      area affected by the event and the severity of the event. Claims from
      catastrophic events could reduce our net income, cause substantial volatility
      in
      our financial results for any fiscal quarter or year or otherwise adversely
      affect our financial condition, liquidity or results of operations. Catastrophes
      may also negatively affect our ability to write new business. Increases in
      the
      value and geographic concentration of insured property and the effects of
      inflation could increase the severity of claims from catastrophic events in
      the
      future.




***Catastrophe
      models may not accurately predict future losses*** .





Along
      with other insurers in the industry, we use models developed by third-party
      vendors in assessing our exposure to catastrophe losses that assume various
      conditions and probability scenarios. However, these models do not necessarily
      accurately predict future losses or accurately measure losses currently
      incurred. Catastrophe models, which have been evolving since the early 1990s,
      use historical information about various catastrophes and detailed information
      about our in-force business. While we use this information in connection with
      our pricing and risk management activities, there are limitations with respect
      to their usefulness in predicting losses in any reporting period. Examples
      of
      these limitations are significant variations in estimates between models and
      modelers and material increases and decreases in model results due to changes
      and refinements of the underlying data elements and assumptions. Such
      limitations lead to questionable predictive capability and post-event
      measurements that have not been well understood or proven to be sufficiently
      reliable. In addition, the models are not necessarily reflective of company
      or
      state-specific policy language, demand surge for labor and materials or loss
      settlement expenses, all of which are subject to wide variation by catastrophe.
      Because the occurrence and severity of catastrophes are inherently unpredictable
      and may vary significantly from year to year, historical results of operations
      may not be indicative of future results of operations.




35




***We
      are subject to comprehensive regulation, and our results may be unfavorably
      impacted by these regulations.***





We
      are
      subject to comprehensive governmental regulation and supervision. Most insurance
      regulations are designed to protect the interests of policyholders rather than
      of the stockholders and other investors of the insurance companies. These
      regulations, generally administered by the department of insurance in each
      state
      in which we do business, relate to, among other things:


Ÿ approval
        of policy forms and rates;


Ÿ standards
        of solvency, including risk-based capital measurements, which are a measure
        developed by the National Association of Insurance Commissioners and used
        by the
        state insurance regulators to identify insurance companies that potentially
        are
        inadequately capitalized;


Ÿ licensing
        of insurers and their agents;


Ÿ restrictions
        on the nature, quality and concentration of investments;


Ÿ restrictions
        on the ability of insurance company subsidiaries to pay
        dividends;


Ÿ restrictions
        on transactions between insurance company subsidiaries and their
        affiliates;


Ÿ requiring
        certain methods of accounting;


Ÿ periodic
        examinations of operations and finances;


Ÿ the
        use
        of non-public consumer information and related privacy
        issues;


Ÿ the
        use
        of credit history in underwriting and rating;


Ÿ limitations
        on the ability to charge policy fees;


Ÿ the
        acquisition or disposition of an insurance company or of any company controlling
        an insurance company;




36


Ÿ involuntary
        assignments of high-risk policies, participation in reinsurance facilities
        and
        underwriting associations, assessments and other governmental
        charges;


Ÿ restrictions
        on the cancellation or non-renewal of policies and, in certain jurisdictions,
        withdrawal from writing certain lines of business;


Ÿ prescribing
        the form and content of records of financial condition to be
        filed;


Ÿ requiring
        reserves for unearned premium, losses and other purposes; and


Ÿ with
        respect to premium finance business, the federal Truth-in-Lending Act and
        similar state statutes. In states where specific statutes have not been enacted,
        premium finance is generally subject to state usury laws that are applicable
        to
        consumer loans.





State
      insurance departments also conduct periodic examinations of the affairs of
      insurance companies and require filing of annual and other reports relating
      to
      the financial condition of insurance companies, holding company issues and
      other
      matters. Our business depends on compliance with applicable laws and regulations
      and our ability to maintain valid licenses and approvals for our operations.
      Regulatory authorities may deny or revoke licenses for various reasons,
      including violations of regulations. Changes in the level of regulation of
      the
      insurance industry or changes in laws or regulations themselves or
      interpretations by regulatory authorities could have a material adverse affect
      on our operations. In addition, we could face individual, group and class-action
      lawsuits by our policyholders and others for alleged violations of certain
      state
      laws and regulations. Each of these regulatory risks could have an adverse
      effect on our profitability.





***State
      statutes limit the aggregate amount of dividends that our subsidiaries may
      pay
      Hallmark, thereby limiting its funds to pay expenses and
      dividends.***





Hallmark
      is a holding company and a legal entity separate and distinct from its
      subsidiaries. As a holding company without significant operations of its own,
      Hallmark’s principal sources of funds are dividends and other sources of funds
      from its subsidiaries. State insurance laws limit the ability of Hallmark’s
      insurance company subsidiaries to pay dividends and require our insurance
      company subsidiaries to maintain specified minimum levels of statutory capital
      and surplus. The aggregate maximum amount of dividends permitted by law to
      be
      paid by an insurance company does not necessarily define an insurance company’s
      actual ability to pay dividends. The actual ability to pay dividends may be
      further constrained by business and regulatory considerations, such as the
      impact of dividends on surplus, by our competitive position and by the amount
      of
      premiums that we can write. Without regulatory approval, the aggregate maximum
      amount of dividends that could be paid to Hallmark in 2007 by our insurance
      company subsidiaries is $12.4 million. State insurance regulators have broad
      discretion to limit the payment of dividends by insurance companies and
      Hallmark’s right to participate in any distribution of assets of one of our
      insurance company subsidiaries is subject to prior claims of policyholders
      and
      creditors except to the extent that its rights, if any, as a creditor are
      recognized. Consequently, Hallmark’s ability to pay debts, expenses and cash
      dividends to our stockholders may be limited.




37




***Our
      insurance company subsidiaries are subject to minimum capital and surplus
      requirements. Failure to meet these requirements could subject us to regulatory
      action.***





Our
      insurance company subsidiaries are subject to minimum capital and surplus
      requirements imposed under the laws of their respective states of domicile
      and
      each state in which they issue policies. Any failure by one of our insurance
      company subsidiaries to meet minimum capital and surplus requirements imposed
      by
      applicable state law will subject it to corrective action, which may include
      requiring adoption of a comprehensive financial plan, revocation of its license
      to sell insurance products or placing the subsidiary under state regulatory
      control. Any new minimum capital and surplus requirements adopted in the future
      may require us to increase the capital and surplus of our insurance company
      subsidiaries, which we may not be able to do.





***We
      are subject to assessments and other surcharges from state guaranty funds,
      mandatory reinsurance arrangements and state insurance facilities, which may
      reduce our profitability.***





Virtually
      all states require insurers licensed to do business therein to bear a portion
      of
      the unfunded obligations of impaired or insolvent insurance companies. These
      obligations are funded by assessments, which are levied by guaranty associations
      within the state, up to prescribed limits, on all member insurers in the state
      on the basis of the proportionate share of the premiums written by member
      insurers in the lines of business in which the impaired, insolvent or failed
      insurer was engaged. Accordingly, the assessments levied on us by the states
      in
      which we are licensed to write insurance may increase as we increase our
      premiums written. In addition, as a condition to the ability to conduct business
      in certain states, insurance companies are required to participate in mandatory
      reinsurance funds. The effect of these assessments and mandatory reinsurance
      arrangements, or changes in them, could reduce our profitability in any given
      period or limit our ability to grow our business.





We
      are
      currently monitoring developments with respect to various state facilities,
      such
      as the Texas FAIR Plan and the Texas Windstorm Insurance Association, and the
      various guaranty funds in which we participate. The ultimate impact of recent
      catastrophe experience on these facilities is currently uncertain but could
      result in the facilities recognizing a financial deficit or a financial deficit
      greater than the level currently estimated. They may, in turn, have the ability
      to assess participating insurers when financial deficits occur, adversely
      affecting our results of operations. While these facilities are generally
      designed so that the ultimate cost is borne by policyholders, the exposure
      to
      assessments and the availability of recoupments or premium rate increases from
      these facilities may not offset each other in our financial statements.
      Moreover, even if they do offset each other, they may not offset each other
      in
      financial statements for the same fiscal period due to the ultimate timing
      of
      the assessments and recoupments or premium rate increases, as well as the
      possibility of policies not being renewed in subsequent years.





***Adverse
      securities market conditions can have a significant and negative impact on
      our
      investment portfolio*** .





Our
      results of operations depend in part on the performance of our invested assets.
      As of September 30, 2007, 84% of our investment portfolio was invested in
      fixed-income securities. Certain risks are inherent in connection with
      fixed-income securities, including loss upon default and price volatility in
      reaction to changes in interest rates and general market factors. In general,
      the fair market value of a portfolio of fixed-income securities increases or
      decreases inversely with changes in the market interest rates, while net
      investment income realized from future investments in fixed-income securities
      increases or decreases along with interest rates. In addition, 20% of our
      fixed-income securities have call or prepayment options. This subjects us to
      reinvestment risk should interest rates fall and issuers call their securities.
      Furthermore, actual net investment income and/or cash flows from investments
      that carry prepayment risk, such as mortgage-backed and other asset-backed
      securities, may differ from those anticipated at the time of investment as
      a
      result of interest rate fluctuations. An investment has prepayment risk when
      there is a risk that cash flows from the repayment of principal might occur
      earlier than anticipated because of declining interest rates or later than
      anticipated because of rising interest rates.




38




In
      addition to the general risks described above, although 90% of our fixed-income
      portfolio is investment-grade, our fixed-income securities are nonetheless
      subject to credit risk. If any of the issuers of our fixed-income securities
      suffer financial setbacks, the ratings on the fixed-income securities could
      fall
      (with a concurrent fall in market value) and, in a worst case scenario, the
      issuer could default on its obligations. Hallmark has no exposure in its
      investment portfolio to sub-prime mortgages and $4 thousand total exposure
      in
      mortgage backed securities. Future changes in the fair market value of our
      available-for-sale securities will be reflected in other comprehensive income.
      Similar treatment is not available for liabilities. Therefore, interest rate
      fluctuations could adversely affect our stockholders’ equity, total
      comprehensive income and/or our cash flows.





As
      of
      September 30, 2007, 16% of our investment portfolio was invested in equity
      securities. The equity securities that we hold are subject to economic loss
      from
      a decline in share price. As a result, the values of these equity securities
      are
      heavily influenced by the specific financial prospects of each issuer. In
      addition, general economic conditions, stock market conditions and other factors
      may adversely affect the value of our equity investments. As a result, we may
      not realize the desired returns on our equity investments, may incur losses
      on
      sales of our equity securities or may be required to write down the value of
      our
      equity securities.





***We
      rely on independent agents and specialty brokers to market our products and
      their failure to do so would have a material adverse effect on our results
      of
      operations.***





We
      market
      and distribute our insurance programs exclusively through independent insurance
      agents and specialty insurance brokers. As a result, our business depends in
      large part on the marketing efforts of these agents and brokers and on our
      ability to offer insurance products and services that meet the requirements
      of
      the agents, the brokers and their customers. However, these agents and brokers
      are not obligated to sell or promote our products and many sell or promote
      competitors’ insurance products in addition to our products. Some of our
      competitors have higher financial strength ratings, offer a larger variety
      of
      products, set lower prices for insurance coverage and/or offer higher
      commissions than we do. Therefore, we may not be able to continue to attract
      and
      retain independent agents and brokers to sell our insurance products. The
      failure or inability of independent agents and brokers to market our insurance
      products successfully could have a material adverse impact on our business,
      financial condition and results of operations.





***We
      may experience difficulty in integrating recent or future acquisitions into
      our
      operations.***





We
      completed the acquisitions of the subsidiaries now comprising both our TGA
      Operating Unit and our Aerospace Operating Unit during January 2006. We may
      pursue additional acquisitions in the future. The successful integration of
      newly acquired businesses into our operations will require, among other things,
      the retention and assimilation of their key management, sales and other
      personnel; the coordination of their lines of insurance products and services;
      the adaptation of their technology, information systems and other processes;
      and
      the retention and transition of their customers. Unexpected difficulties in
      integrating any acquisition could result in increased expenses and the diversion
      of management time and resources. If we do not successfully integrate any
      acquired business into our operations, we may not realize the anticipated
      benefits of the acquisition, which could have a material adverse impact on
      our
      financial condition and results of operations. Further, any potential
      acquisitions may require significant capital outlays and, if we issue equity
      or
      convertible debt securities to pay for an acquisition, the issuance may be
      dilutive to our existing stockholders.




39




***Our
      geographic concentration ties our performance to the business, weather, economic
      and regulatory conditions of certain states*** .





The
      following five states accounted for 79% of our gross written premiums for the
      nine months ended September 30, 2007: Texas (44%), Oregon (14%), New Mexico
      (9%), Idaho (7%) and Arizona (5%). Our revenues and profitability are subject
      to
      the prevailing regulatory, legal, economic, political, demographic, competitive,
      weather and other conditions in the principal states in which we do business.
      Changes in any of these conditions could make it less attractive for us to
      do
      business in such states and would have a more pronounced effect on us compared
      to companies that are more geographically diversified. In addition, our exposure
      to severe losses from localized natural perils, such as windstorms or
      hailstorms, is increased in those areas where we have written significant
      numbers of property/casualty insurance policies.





***The
      exclusions and limitations in our policies may not be
      enforceable.***





Many
      of
      the policies we issue include exclusions or other conditions that define and
      limit coverage, which exclusions and conditions are designed to manage our
      exposure to certain types of risks and expanding theories of legal liability.
      In
      addition, many of our policies limit the period during which a policyholder
      may
      bring a claim under the policy, which period in many cases is shorter than
      the
      statutory period under which these claims can be brought by our policyholders.
      While these exclusions and limitations help us assess and control our loss
      exposure, it is possible that a court or regulatory authority could nullify
      or
      void an exclusion or limitation, or legislation could be enacted modifying
      or
      barring the use of these exclusions and limitations. This could result in higher
      than anticipated losses and loss adjustment expenses by extending coverage
      beyond our underwriting intent or increasing the number or size of claims,
      which
      could have a material adverse effect on our operating results. In some
      instances, these changes may not become apparent until some time after we have
      issued the insurance policies that are affected by the changes. As a result,
      the
      full extent of liability under our insurance contracts may not be known for
      many
      years after a policy is issued.





***We
      rely on our information technology and telecommunications systems and the
      failure or disruption of these systems could disrupt our operations and
      adversely affect our results of operations*** .





Our
      business is highly dependent upon the successful and uninterrupted functioning
      of our information technology and telecommunications systems. We rely on these
      systems to process new and renewal business, provide customer service, make
      claims payments and facilitate collections and cancellations, as well as to
      perform actuarial and other analytical functions necessary for pricing and
      product development. Our systems could fail of their own accord or might be
      disrupted by factors such as natural disasters, power disruptions or surges,
      computer hackers or terrorist attacks. Failure or disruption of these systems
      for any reason could interrupt our business and adversely affect our results
      of
      operations.




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





None.




40




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





None.




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




None.




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





None.




41


**Item
      6.**  **Exhibits.**





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





ExhibitNumber
            
            Description3(a)
            
            Articles
                of Incorporation of the registrant, as amended (incorporated by reference
                to Exhibit 3(a) to the registrant’s Annual Report on Form 10-KSB for the
                fiscal year ended December 31, 1993).3(b)
            
            Restated
                By-Laws of the registrant, as amended (incorporated by reference
                to
                Exhibit 3.1 to the registrant’s Current Report on Form 8K 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 the registrant’s
                Post-Effective Amendment No. 1 to Registration Statement on Form
                S-1 filed
                October 3, 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)
            
            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(g)
            
            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(h)
            
            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).4(i)
            
            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(j)
            
            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).




42




ExhibitNumber
              
              Description


31(a)
            
            Certification
                of principal executive officer required by Rule 13a-14(a) orRule
                15d-14(a).31(b)
            
            Certification
                of principal financial officer required by Rule 13a-14(a) orRule
                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.




43


SIGNATURES





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





HALLMARK
      FINANCIAL SERVICES, INC.


(Registrant)




Date:
                  November 7, 2007
              
              /s/
                  Mark J. MorrisonMark
                  J. Morrison, Chief Executive Officer and President
                (Principal
                  Executive Officer)Date:
                  November 7, 2007
              
              /s/
                  Jeffrey R. PassmoreJeffrey
                  R. Passmore, Chief Accounting Officer and Senior Vice
                  President(Principal
                  Financial Officer)


44