UNITED
STATES





SECURITIES
AND EXCHANGE COMMISSION





WASHINGTON,
D.C. 20549





FORM
10-Q





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





Securities
Exchange Act of 1934





For the
quarterly period ended June 30, 2010





Commission
file number 001-11252





Hallmark
Financial Services, Inc.





(Exact
name of registrant as specified in its charter)





Nevada
                    
                    87-0447375(State
      or other jurisdiction of
                    
                    (I.R.S.
      EmployerIncorporation
      or organization)
                    
                    Identification
      No.)





777 Main Street, Suite
      1000, Fort Worth, Texas
                      
                      76102(Address
      of principal executive offices)
                      
                      (Zip
      Code)





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





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.    Yes x     No
 ̈





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).   Yes
 ̈  No
 ̈





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


Large
accelerated filer  ̈           
 Accelerated filer  ̈


Non-accelerated
filer  ̈               Smaller
reporting company  x





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





Indicate
the number of shares outstanding of each of the issuer's classes of common
stock, as of the latest practicable date: Common Stock, par value $.18 per share
– 20,124,169 shares outstanding as of August 12, 2010.









PART
I


FINANCIAL
INFORMATION





Item
1. Financial Statements





INDEX
TO FINANCIAL STATEMENTS





Page NumberConsolidated
      Balance Sheets at June 30, 2010 (unaudited) and December 31,
      2009
                
                3Consolidated
      Statements of Operations (unaudited) for the three months and six months
      ended June 30, 2010 and June 30, 2009
                
                4Consolidated
      Statements of Stockholders’ Equity and Comprehensive Income (unaudited)
      for the three months and six months ended June 30, 2010 and June 30,
      2009
                
                5Consolidated
      Statements of Cash Flows (unaudited) for the six months ended June 30,
      2010 and June 30, 2009
                
                6Notes
      to Consolidated Financial Statements (unaudited)
                
                7




2




Hallmark
Financial Services, Inc. and Subsidiaries


Consolidated
Balance Sheets


($ in
thousands, except share amounts)





June 30
                        
                        
                        December 312010
                        
                        
                        2009(unaudited)ASSETSInvestments:Debt
      securities, available-for-sale, at fair value (cost; $360,374 in 2010 and
      $287,108 in 2009)
                        
                        $
                        364,694
                        
                        
                        $
                        291,876Equity
      securities, available-for-sale, at fair value (cost; $34,035 in 2010 and
      $27,251 in 2009)
                        
                        
                        40,958
                        
                        
                        
                        35,801Total
      investments
                        
                        
                        405,652
                        
                        
                        
                        327,677Cash
      and cash equivalents
                        
                        
                        75,234
                        
                        
                        
                        112,270Restricted
      cash and cash equivalents
                        
                        
                        9,283
                        
                        
                        
                        5,458Premiums
      receivable
                        
                        
                        54,393
                        
                        
                        
                        46,635Accounts
      receivable
                        
                        
                        3,102
                        
                        
                        
                        3,377Receivable
      for securities
                        
                        
                        17
                        
                        
                        
                        -Ceded
      unearned premiums
                        
                        
                        15,133
                        
                        
                        
                        12,997Reinsurance
      recoverable
                        
                        
                        16,149
                        
                        
                        
                        10,008Deferred
      policy acquisition costs
                        
                        
                        22,736
                        
                        
                        
                        20,792Goodwill
                        
                        
                        41,080
                        
                        
                        
                        41,080Intangible
      assets, net
                        
                        
                        27,040
                        
                        
                        
                        28,873Federal
      income tax recoverable
                        
                        
                        3,242
                        
                        
                        
                        -Deferred
      federal income taxes,net
                        
                        
                        133
                        
                        
                        
                        -Prepaid
      expenses
                        
                        
                        1,669
                        
                        
                        
                        923Other
      assets
                        
                        
                        15,662
                        
                        
                        
                        18,779Total
      assets
                        
                        $
                        690,525
                        
                        
                        $
                        628,869LIABILITIES
      AND STOCKHOLDERS' EQUITYLiabilities:Note
      payable
                        
                        $
                        2,800
                        
                        
                        $
                        2,800Subordinated
      debt securities
                        
                        
                        56,702
                        
                        
                        
                        56,702Reserves
      for unpaid losses and loss adjustment expenses
                        
                        
                        214,448
                        
                        
                        
                        184,662Unearned
      premiums
                        
                        
                        136,190
                        
                        
                        
                        125,089Unearned
      revenue
                        
                        
                        169
                        
                        
                        
                        191Reinsurance
      balances payable
                        
                        
                        2,816
                        
                        
                        
                        3,281Accrued
      agent profit sharing
                        
                        
                        1,232
                        
                        
                        
                        1,790Accrued
      ceding commission payable
                        
                        
                        4,235
                        
                        
                        
                        8,600Pension
      liability
                        
                        
                        2,587
                        
                        
                        
                        2,628Deferred
      federal income taxes, net
                        
                        
                        -
                        
                        
                        
                        942Federal
      income tax payable
                        
                        
                        -
                        
                        
                        
                        1,266Payable
      for securities
                        
                        
                        25,621
                        
                        
                        
                        19Accounts
      payable and other accrued expenses
                        
                        
                        11,302
                        
                        
                        
                        13,258Total
      liabilities
                        
                        
                        458,102
                        
                        
                        
                        401,228Commitments
      and contingencies (Note 17)Redeemable
      non-controlling interest
                        
                        
                        1,179
                        
                        
                        
                        1,124Stockholders'
      equity:Common
      stock, $0.18 par value (authorized 33,333,333 shares in 2010 and 2009;issued
      20,872,831 in 2010 and 2009)
                        
                        
                        3,757
                        
                        
                        
                        3,757Additional
      paid-in capital
                        
                        
                        121,403
                        
                        
                        
                        121,016Retained
      earnings
                        
                        
                        104,380
                        
                        
                        
                        98,482Accumulated
      other comprehensive income
                        
                        
                        6,966
                        
                        
                        
                        8,589Treasury
      stock, at cost (748,662 shares in 2010 and 757,828 in
2009)
                        
                        
                        (5,262
                        )
                        
                        
                        (5,327
                        )Total
      stockholders' equity
                        
                        
                        231,244
                        
                        
                        
                        226,517$
                        690,525
                        
                        
                        $
                        628,869





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




3




Hallmark
Financial Services, Inc. and Subsidiaries


Consolidated
Statements of Operations


(Unaudited)


($ in
thousands, except per share amounts)





Three Months Ended
                  
                  
                  Six Months EndedJune 30
                  
                  
                  June 302010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Gross
      premiums written
                  
                  $
                  83,180
                  
                  
                  $
                  75,053
                  
                  
                  $
                  165,039
                  
                  
                  $
                  146,532Ceded
      premiums written
                  
                  
                  (10,047
                  )
                  
                  
                  (3,260
                  )
                  
                  
                  (19,111
                  )
                  
                  
                  (5,492
                  )Net
      premiums written
                  
                  
                  73,133
                  
                  
                  
                  71,793
                  
                  
                  
                  145,928
                  
                  
                  
                  141,040Change
      in unearned premiums
                  
                  
                  (3,185
                  )
                  
                  
                  (9,474
                  )
                  
                  
                  (8,965
                  )
                  
                  
                  (19,291
                  )Net
      premiums earned
                  
                  
                  69,948
                  
                  
                  
                  62,319
                  
                  
                  
                  136,963
                  
                  
                  
                  121,749Investment
      income, net of expenses
                  
                  
                  3,276
                  
                  
                  
                  3,467
                  
                  
                  
                  6,477
                  
                  
                  
                  7,736Net
      realized gains
                  
                  
                  1,643
                  
                  
                  
                  867
                  
                  
                  
                  5,446
                  
                  
                  
                  519Finance
      charges
                  
                  
                  1,771
                  
                  
                  
                  1,449
                  
                  
                  
                  3,414
                  
                  
                  
                  2,799Commission
      and fees
                  
                  
                  (963
                  )
                  
                  
                  2,627
                  
                  
                  
                  (812
                  )
                  
                  
                  8,816Other
      income
                  
                  
                  12
                  
                  
                  
                  15
                  
                  
                  
                  22
                  
                  
                  
                  35Total
      revenues
                  
                  
                  75,687
                  
                  
                  
                  70,744
                  
                  
                  
                  151,510
                  
                  
                  
                  141,654Losses
      and loss adjustment expenses
                  
                  
                  52,058
                  
                  
                  
                  38,131
                  
                  
                  
                  95,156
                  
                  
                  
                  74,973Other
      operating expenses
                  
                  
                  22,872
                  
                  
                  
                  23,878
                  
                  
                  
                  44,354
                  
                  
                  
                  47,628Interest
      expense
                  
                  
                  1,150
                  
                  
                  
                  1,150
                  
                  
                  
                  2,296
                  
                  
                  
                  2,309Amortization
      of intangible assets
                  
                  
                  916
                  
                  
                  
                  782
                  
                  
                  
                  1,832
                  
                  
                  
                  1,496Total
      expenses
                  
                  
                  76,996
                  
                  
                  
                  63,941
                  
                  
                  
                  143,638
                  
                  
                  
                  126,406Income
      (loss) before tax
                  
                  
                  (1,309
                  )
                  
                  
                  6,803
                  
                  
                  
                  7,872
                  
                  
                  
                  15,248Income
      tax expense (benefit)
                  
                  
                  (953
                  )
                  
                  
                  2,519
                  
                  
                  
                  1,937
                  
                  
                  
                  4,181Net
      income (loss)
                  
                  
                  (356
                  )
                  
                  
                  4,284
                  
                  
                  
                  5,935
                  
                  
                  
                  11,067Less:
      Net income attributable to
    non-controlling  interest
                  
                  
                  32
                  
                  
                  
                  9
                  
                  
                  
                  37
                  
                  
                  
                  2Net
      income (loss) attributable to Hallmark Financial Services,
      Inc.
                  
                  $
                  (388
                  )
                  
                  $
                  4,275
                  
                  
                  $
                  5,898
                  
                  
                  $
                  11,065Net
      income (loss) per share attributable to Hallmark FinancialServices,
      Inc. common stockholders:Basic
                  
                  $
                  (0.02
                  )
                  
                  $
                  0.20
                  
                  
                  $
                  0.29
                  
                  
                  $
                  0.53Diluted
                  
                  $
                  (0.02
                  )
                  
                  $
                  0.20
                  
                  
                  $
                  0.29
                  
                  
                  $
                  0.53





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




4




Hallmark
Financial Services, Inc. and Subsidiaries


Consolidated
Statements of Stockholders' Equity and Comprehensive Income


(Unaudited)


($ in
thousands)





Three Months Ended
                    
                    
                    Six Months EndedJune
      30,
                    
                    
                    June
      30,2010
                    
                    
                    2009
                    
                    
                    2010
                    
                    
                    2009Common
      StockBalance,
      beginning of period
                    
                    $
                    3,757
                    
                    
                    $
                    3,757
                    
                    
                    $
                    3,757
                    
                    
                    $
                    3,751Issuance
      of common stock upon option exercises
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    6Balance,
      end of period
                    
                    
                    3,757
                    
                    
                    
                    3,757
                    
                    
                    
                    3,757
                    
                    
                    
                    3,757Additional
      Paid-In CapitalBalance,
      beginning of period
                    
                    
                    121,196
                    
                    
                    
                    120,200
                    
                    
                    
                    121,016
                    
                    
                    
                    119,928Accretion
      of redeemable noncontrolling interest
                    
                    
                    (84
                    )
                    
                    
                    (78
                    )
                    
                    
                    (162
                    )
                    
                    
                    (172
                    )Equity
      based compensation
                    
                    
                    291
                    
                    
                    
                    614
                    
                    
                    
                    589
                    
                    
                    
                    876Exercise
      of stock options
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    (40
                    )
                    
                    
                    104Balance,
      end of period
                    
                    
                    121,403
                    
                    
                    
                    120,736
                    
                    
                    
                    121,403
                    
                    
                    
                    120,736Retained
      EarningsBalance,
      beginning of period
                    
                    
                    104,768
                    
                    
                    
                    79,032
                    
                    
                    
                    98,482
                    
                    
                    
                    72,242Adjustment
      to opening balance, net of tax (Note 2)
                    
                    
                    -
                    
                    
                    
                    1,665
                    
                    
                    
                    -
                    
                    
                    
                    1,665104,768
                    
                    
                    
                    80,697
                    
                    
                    
                    98,482
                    
                    
                    
                    73,907Net
      income (loss) attributable to Hallmark Financial Services,
      Inc.
                    
                    
                    (388
                    )
                    
                    
                    4,275
                    
                    
                    
                    5,898
                    
                    
                    
                    11,065Balance,
      end of period
                    
                    
                    104,380
                    
                    
                    
                    84,972
                    
                    
                    
                    104,380
                    
                    
                    
                    84,972Accumulated
      Other Comprehensive Income (Loss)Balance,
      beginning of period
                    
                    
                    11,083
                    
                    
                    
                    (12,357
                    )
                    
                    
                    8,589
                    
                    
                    
                    (16,432
                    )Adjustment
      to open ing balance, net of tax (Note 2)
                    
                    
                    -
                    
                    
                    
                    (1,665
                    )
                    
                    
                    -
                    
                    
                    
                    (1,665
                    )Adjusted
      balance, beginning of period
                    
                    
                    11,083
                    
                    
                    
                    (14,022
                    )
                    
                    
                    8,589
                    
                    
                    
                    (18,097
                    )Additional
      minimum pension liability, net of tax
                    
                    
                    37
                    
                    
                    
                    79
                    
                    
                    
                    73
                    
                    
                    
                    159Net
      unrealized holding gains (losses) arising during period
                    
                    
                    (2,511
                    )
                    
                    
                    15,138
                    
                    
                    
                    3,750
                    
                    
                    
                    19,324Reclassification
      adjustment for losses included in net income
                    
                    
                    (1,643
                    )
                    
                    
                    (359
                    )
                    
                    
                    (5,446
                    )
                    
                    
                    (550
                    )Balance,
      end of period
                    
                    
                    6,966
                    
                    
                    
                    836
                    
                    
                    
                    6,966
                    
                    
                    
                    836Treasury
      StockBalance,
      beginning of period
                    
                    
                    (5,268
                    )
                    
                    
                    (77
                    )
                    
                    
                    (5,327
                    )
                    
                    
                    (77
                    )Issuance
      of treasury stock upon option exercises
                    
                    
                    6
                    
                    
                    
                    -
                    
                    
                    
                    65
                    
                    
                    
                    -Balance,
      end of period
                    
                    
                    (5,262
                    )
                    
                    
                    (77
                    )
                    
                    
                    (5,262
                    )
                    
                    
                    (77
                    )Total
      Stockholders' Equity
                    
                    $
                    231,244
                    
                    
                    $
                    210,224
                    
                    
                    $
                    231,244
                    
                    
                    $
                    210,224Net
      income (loss)
                    
                    $
                    (356
                    )
                    
                    $
                    4,284
                    
                    
                    $
                    5,935
                    
                    
                    $
                    11,067Additional
      minimum pension liability, net of tax
                    
                    
                    37
                    
                    
                    
                    79
                    
                    
                    
                    73
                    
                    
                    
                    159Net
      unrealized holding gains (losses) arising during period
                    
                    
                    (2,511
                    )
                    
                    
                    15,138
                    
                    
                    
                    3,750
                    
                    
                    
                    19,324Reclassification
      adjustment for losses included in net income
                    
                    
                    (1,643
                    )
                    
                    
                    (359
                    )
                    
                    
                    (5,446
                    )
                    
                    
                    (550
                    )Comprehensive
      income (loss)
                    
                    
                    (4,473
                    )
                    
                    
                    19,142
                    
                    
                    
                    4,312
                    
                    
                    
                    30,000Less:
      Comprehensive income attributable to non-controlling
    interest
                    
                    
                    32
                    
                    
                    
                    9
                    
                    
                    
                    37
                    
                    
                    
                    2Comprehensive
      income (loss) attributable toHallmark
      Financial Services, Inc.
                    
                    $
                    (4,505
                    )
                    
                    $
                    19,133
                    
                    
                    $
                    4,275
                    
                    
                    $
                    29,998





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




5




Hallmark
Financial Services, Inc. and Subsidiaries
 Consolidated
Statements of Cash Flows
 (Unaudited)
 ($ in
thousands)




Six Months EndedJune 302010
                            
                            
                            2009Cash
      flows from operating activities:Net
      income
                            
                            $
                            5,935
                            
                            
                            $
                            11,067Adjustments
      to reconcile net income to cash provided by operating
      activities:Depreciation
      and amortization expense
                            
                            
                            2,326
                            
                            
                            
                            1,930Deferred
      federal income taxes
                            
                            
                            (734
                            )
                            
                            
                            (391
                            )Realized
      gains on investments
                            
                            
                            (5,446
                            )
                            
                            
                            (519
                            )Change
      in ceded unearned premiums
                            
                            
                            (2,136
                            )
                            
                            
                            (5,118
                            )Change
      in premiums receivable
                            
                            
                            (7,758
                            )
                            
                            
                            (8,591
                            )Change
      in accounts receivable
                            
                            
                            244
                            
                            
                            
                            791Change
      in deferred policy acquisition costs
                            
                            
                            (1,944
                            )
                            
                            
                            (3,908
                            )Change
      in reserves for unpaid losses and loss adjustment expenses
                            
                            
                            29,786
                            
                            
                            
                            24,003Change
      in unearned premiums
                            
                            
                            11,101
                            
                            
                            
                            24,403Change
      in unearned revenue
                            
                            
                            (22
                            )
                            
                            
                            (1,432
                            )Change
      in accrued agent profit sharing
                            
                            
                            (558
                            )
                            
                            
                            (833
                            )Change
      in reinsurance recoverable
                            
                            
                            (6,141
                            )
                            
                            
                            (5,854
                            )Change
      in reinsurance balances payable
                            
                            
                            (465
                            )
                            
                            
                            -Change
      in current federal income tax recoverable/payable
                            
                            
                            (4,508
                            )
                            
                            
                            (1,473
                            )Change
      in accrued ceding commission payable
                            
                            
                            (4,365
                            )
                            
                            
                            (5
                            )Change
      in all other liabilities
                            
                            
                            (1,996
                            )
                            
                            
                            (9,197
                            )Change
      in all other assets
                            
                            
                            4,130
                            
                            
                            
                            3,909Net
      cash provided by operating activities
                            
                            
                            17,449
                            
                            
                            
                            28,782Cash
      flows from investing activities:Purchases
      of property and equipment
                            
                            
                            (841
                            )
                            
                            
                            (634
                            )Net
      transfers into restricted cash and cash equivalents
                            
                            
                            (3,825
                            )
                            
                            
                            (460
                            )Purchases
      of investment securities
                            
                            
                            (123,337
                            )
                            
                            
                            (35,833
                            )Maturities,
      sales and redemptions of investment securities
                            
                            
                            73,637
                            
                            
                            
                            40,734Payment
      for acquisition of subsidiaries
                            
                            
                            -
                            
                            
                            
                            (7,246
                            )Net
      cash used in investing activities
                            
                            
                            (54,366
                            )
                            
                            
                            (3,439
                            )Cash
      flows from financing activities:Proceeds
      from exercise of employee stock options
                            
                            
                            25
                            
                            
                            
                            110Net
      repayments of notes payable
                            
                            
                            -
                            
                            
                            
                            (1,417
                            )Distribution
      to non-controlling interest
                            
                            
                            (144
                            )
                            
                            
                            (20
                            )Net
      cash used in financing activities
                            
                            
                            (119
                            )
                            
                            
                            (1,327
                            )Increase
      (Decrease) in cash and cash equivalents
                            
                            
                            (37,036
                            )
                            
                            
                            24,016Cash
      and cash equivalents at beginning of period
                            
                            
                            112,270
                            
                            
                            
                            59,134Cash
      and cash equivalents at end of period
                            
                            $
                            75,234
                            
                            
                            $
                            83,150Supplemental
      cash flow information:Interest
      paid
                            
                            $
                            2,303
                            
                            
                            $
                            2,345Taxes
      paid
                            
                            $
                            7,179
                            
                            
                            $
                            6,045Supplemental
      schedule of non-cash investing activities:Change
      in receivable for securities related to investment disposals settled after
      the balance sheet date
                            
                            $
                            31
                            
                            
                            $
                            961Change
      in payable for securities related to investment purchases settled after
      the balance sheet date
                            
                            $
                            25,601
                            
                            
                            $
                            (695
                            )




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 engaged in the sale of
property/casualty insurance products to businesses and
individuals.  Our business involves marketing, distributing,
underwriting and servicing our insurance products, as well as providing other
insurance related services.





We pursue
our business activities through subsidiaries whose operations are organized into
five business units, which are supported by our four insurance company
subsidiaries.  Our Standard Commercial business unit (formerly known
as our AHIS Operating Unit) handles commercial insurance products and services
in the standard market.  Our E&S Commercial business unit
(formerly known as our TGA Operating Unit) handles primarily commercial
insurance products and services in the excess and surplus lines
market.  Our General Aviation business unit (formerly known as our
Aerospace Operating Unit) handles general aviation insurance products and
services.  Our Excess & Umbrella business unit (formerly known as
our Heath XS Operating Unit) offers low and middle market commercial umbrella
and excess liability insurance on both an admitted and non-admitted basis
focusing primarily on trucking, specialty automobile and non-fleet automobile
coverage. Our Personal Lines business unit (formerly known as our Personal Lines
Operating Unit) handles personal insurance products and services.  Our
insurance company subsidiaries supporting these business units are American
Hallmark Insurance Company of Texas (“AHIC”), Hallmark Insurance Company
(“HIC”), Hallmark Specialty Insurance Company (“HSIC”) and Hallmark County
Mutual Insurance Company (“HCM”).





These
five business units are segregated into three reportable industry segments for
financial accounting purposes.  The Standard Commercial Segment
presently consists solely of the Standard Commercial business unit and the
Personal Segment presently consists solely of the Personal Lines business
unit.  The Specialty Commercial Segment includes the E&S
Commercial, General Aviation and Excess & Umbrella business
units.





2.
Basis of Presentation





Our
unaudited consolidated financial statements included herein have been prepared
in accordance with U.S. generally accepted accounting principles (“GAAP”) and
include our accounts and the accounts of our subsidiaries.  All
significant intercompany accounts and transactions have been eliminated in
consolidation.  Certain information and footnote disclosures normally
included in financial statements prepared in accordance with GAAP have been
condensed or omitted pursuant to rules and regulations of the Securities and
Exchange Commission (“SEC”) for interim financial reporting.  These
unaudited consolidated financial statements should be read in conjunction with
our audited consolidated financial statements for the year ended December 31,
2009 included in our Annual Report on Form 10-K filed with the SEC.





The
interim financial data as of June 30, 2010 and 2009 is
unaudited.  However, in the opinion of management, the interim data
includes all adjustments, consisting of normal recurring adjustments, necessary
for a fair statement of the results for the interim periods.  The
results of operations for the period ended June 30, 2010 are not necessarily
indicative of the operating results to be expected for the full
year.




7




Redeemablenon-controlling
interest





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





Reclassification





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





Income
Taxes





We file a consolidated federal income
tax return.  Deferred federal income taxes reflect the future tax
consequences of differences between the tax bases of assets and liabilities and
their financial reporting amounts at each year end.  Deferred taxes
are recognized using the liability method, whereby tax rates are applied to
cumulative temporary differences based on when and how they are expected to
affect the tax return. Deferred tax assets and liabilities are adjusted for tax
rate changes in effect for the year in which these temporary differences are
expected to be recovered or settled.





Use of Estimates in the
Preparation of the Financial Statements





Our preparation of
financial statements in conformity with GAAP requires us to make estimates and
assumptions that affect our reported amounts of assets and liabilities and our
disclosure of contingent assets and liabilities at the date of our consolidated
financial statements, as well as our reported amounts of revenues and expenses
during the reporting period.  Refer to “Critical Accounting Estimates
and Judgments” in our Annual Report on Form 10-K for the year ended December 31,
2009 for information on accounting policies that we consider critical in
preparing our consolidated financial statements. Actual results could differ
materially from those estimates.





Fair Value of Financial
Instruments





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





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




8




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





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





Notes
Payable:  The carrying value of our bank credit facility of $2.8
million approximates the fair value based on the current interest
rate.





Subordinated
Debt Securities:  Our trust preferred securities have a carried value
of $56.7 million and a fair value of $54.6 million as of June 30,
2010.  The fair value of our trust preferred securities is based on
discounted cash flows using a current yield to maturity of 8.25% based on
similar issues to discount future cash flows.





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





Variable Interest
Entities





On June 21, 2005, we formed Hallmark
Statutory Trust I (“Trust I”), an unconsolidated trust subsidiary, for the sole
purpose of issuing $30.0 million in trust preferred securities.  Trust
I used the proceeds from the sale of these securities and our initial capital
contribution to purchase $30.9 million of subordinated debt securities from
Hallmark.  The debt securities are the sole assets of Trust I, and the
payments under the debt securities are the sole revenues of Trust
I.





On August
23, 2007, we formed Hallmark Statutory Trust II (“Trust II”), an unconsolidated
trust subsidiary, for the sole purpose of issuing $25.0 million in trust
preferred securities.  Trust II used the proceeds from the sale of
these securities and our initial capital contribution to purchase $25.8 million
of subordinated debt securities from Hallmark.  The debt securities
are the sole assets of Trust II, and the payments under the debt securities are
the sole revenues of Trust II.





In 2009, the Financial Accounting
Standards Board (“FASB”) issued revised accounting standards regarding
consolidation of variable interest entities, which was effective for us on
January 1, 2010.  Accordingly, we reevaluated our investments in Trust
I and II (collectively the “Trusts”) and determined that, while the Trusts
continue to be variable interest entities, we are not the primary
beneficiary.  Therefore, the Trusts are not included in our
consolidated financial statements.





Recently Issued Accounting
Standards





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




9




In
September 2006, FASB issued Statement of Financial Accounting Standards No. 157,
“Fair Value Measurements,” which was codified into FASB Accounting Standards
Codification (“ASC”) Topic 820, “Fair Value Measurements and Disclosures” (“ASC
820”).  ASC 820 establishes a separate framework for determining fair
values of assets and liabilities that are required by other authoritative GAAP
pronouncements to be measured at fair value.  In addition, ASC 820
incorporates and clarifies the guidance in FASB Concepts Statement 7 regarding
the use of present value techniques in measuring fair value.  ASC 820
does not require any new fair value measurements. ASC 820 is effective for
financial statements issued for fiscal years beginning after November 15,
2007.  In January 2010, the FASB updated ASC 820 requiring additional
disclosures about fair value measurements regarding transfers between fair value
categories as well as purchases, sales, issuances and settlements related to
fair value measurements of financial instruments with non-observable
inputs.  This update was effective for interim and annual periods
beginning after December 15, 2009 except for disclosures about purchases, sales,
issuances and settlements of financial instruments with non-observable inputs,
which are effective for years beginning after December 15, 2010. The adoption of
ASC 820 had no impact on our financial position or results of operations but did
require additional disclosures.  (See Note 4, “Fair
Value.”)





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





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





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




10




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





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





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





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





In June
2009, FASB issued Statement of Financial Accounting Standards No. 167,
“Amendments to FASB Interpretation No. 46(R)” (“SFAS 167”), which was codified
into ASC 810.  ASC 810 addresses the effects of eliminating the
qualifying special-purpose entity concept and responds to concerns about the
application of certain key provisions of FASB Interpretation No. 46(R),
“Consolidation of Variable Interest Entities,” including concerns over the
transparency of enterprises’ involvement with variable interest
entities.  SFAS 167 is effective for calendar year end companies
beginning on January 1, 2010 with earlier application prohibited.  The
adoption of ASC Topic 810 did not have a material impact on our financial
position or results of operations.




11




3.
Business Combinations





We account for business combinations
using the purchase method of accounting pursuant to ASC 805. 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 “goodwill.” Indirect and general expenses related to business
combinations are expensed as incurred for acquisitions in 2009 and
after.  Prior to 2009, indirect and general expenses were
capitalized.





Effective
August 29, 2008, we acquired 80% of the issued and outstanding membership
interests in the subsidiaries now comprising our Excess & Umbrella business
unit for consideration of $15.0 million.  In connection with the
acquisition, we executed an operating agreement for each
subsidiary.  The operating agreements grant us the right to purchase
the remaining 20% membership interests in the subsidiaries and grant to an
affiliate of the seller the right to require us to purchase such remaining
membership interests (the “Put/Call Option”).  The Put/Call Option
becomes exercisable by either us or the affiliate of the seller upon the earlier
of August 29, 2012, the termination of the employment of the seller by the
Excess & Umbrella business unit or a change of control of Hallmark. If the
Put/Call Option is exercised, we will have the right or obligation to purchase
the remaining 20% membership interests in the Excess & Umbrella business
unit  for an amount equal to nine times the average Pre-Tax Income (as
defined in the operating agreements) for the previous 12 fiscal
quarters.  We estimate the ultimate redemption value of the Put/Call
Option to be $2.2 million at June 30, 2010.


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





4.
Fair Value





ASC
820 defines fair value, establishes a consistent framework for measuring fair
value and expands disclosure requirements about fair value measurements. ASC
820, among other things, requires us to maximize the use of observable inputs
and minimize the use of unobservable inputs when measuring fair value. In
addition, ASC 820 precludes the use of block discounts when measuring the fair
value of instruments traded in an active market, which were previously applied
to large holdings of publicly traded equity securities.





We
determine the fair value of our financial instruments based on the fair value
hierarchy established in ASC 820.  In accordance with ASC 820, we
utilize the following fair value hierarchy:





·
            Level
      1: quoted prices in active markets for identical
  assets;





·
            Level
      2: inputs to the valuation methodology include quoted prices for similar
      assets and liabilities in active markets, inputs of identical assets for
      less active markets, and inputs that are observable for the asset or
      liability, either directly or indirectly, for substantially the full term
      of the instrument; and




12




·
            Level
      3: inputs to the valuation methodology that are unobservable for the asset
      or liability.





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





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





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





Level 2
investment securities include corporate bonds, municipal bonds and U.S. Treasury
securities for which quoted prices are not available on active exchanges for
identical instruments.  We use a third party pricing service to
determine fair values for each Level 2 investment security in all asset
classes.  Since quoted prices in active markets for identical assets
are not available, these prices are determined by the pricing service using
observable market information such as quotes from less active markets and/or
quoted prices of securities with similar characteristics, among other things. We
have reviewed the processes used by the pricing service and have determined that
they result in fair values consistent with the requirements of  ASC
820 for Level 2 investment securities.





In cases where there is limited
activity or less transparency around inputs to the valuation, investment
securities are classified within Level 3 of the valuation
hierarchy.  Level 3 investments are valued based on the best available
data in order to approximate fair value.  This data may be internally
developed and consider risk premiums that a market participant would
require.  Investment securities classified within Level 3 include
other less liquid investment securities.




The
following table presents for each of the fair value hierarchy levels, our assets
that are measured at fair value on a recurring basis at June 30, 2010 (in
thousands):




13




Quoted Prices in
                  
                  
                  OtherActive Markets for
                  
                  
                  Observable
                  
                  
                  UnobservableIdentical Assets
                  
                  
                  Inputs
                  
                  
                  Inputs(Level 1)
                  
                  
                  (Level 2)
                  
                  
                  (Level 3)
                  
                  
                  TotalU.S.
      Treasury securities and obligations of U.S. Government
                  
                  $
                  -
                  
                  
                  $
                  6,540
                  
                  
                  $
                  -
                  
                  
                  $
                  6,540Corporate
      debt securities
                  
                  
                  -
                  
                  
                  
                  198,551
                  
                  
                  
                  -
                  
                  
                  
                  198,551Municipal
      bonds
                  
                  
                  -
                  
                  
                  
                  135,493
                  
                  
                  
                  23,500
                  
                  
                  
                  158,993Asset
      backed
                  
                  
                  -
                  
                  
                  
                  610
                  
                  
                  
                  -
                  
                  
                  
                  610Total
      debt securities
                  
                  
                  -
                  
                  
                  
                  341,194
                  
                  
                  
                  23,500
                  
                  
                  
                  364,694Financial
      services
                  
                  
                  20,067
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  20,067All
      other
                  
                  
                  20,891
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  20,891Total
      equity securities
                  
                  
                  40,958
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  40,958Total
      debt and equity securities
                  
                  $
                  40,958
                  
                  
                  $
                  341,194
                  
                  
                  $
                  23,500
                  
                  
                  $
                  405,652




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





The
following table summarizes the changes in fair value for all financial assets
measured at fair value on a recurring basis using significant unobservable
inputs (Level 3) during the six months ended June 30, 2010 (in
thousands):





Beginning
      balance as of January 1, 2010
                    
                    $
                    25,272Net
      purchases, issuances, sales and settlements
                    
                    
                    (2,125
                    )Total
      realized/unrealized gains included in net income
                    
                    
                    -Net
      gains included in other comprehensive income
                    
                    
                    353Transfers
      in and/or out of Level 3
                    
                    
                    -Ending
      balance as of June 30, 2010
                    
                    $
                    23,500





5.
Investments





We
complete a detailed analysis each quarter to assess whether any decline in the
fair value of any investment below cost is deemed other-than-temporary. All
securities with an unrealized loss are reviewed.  We recognize an
impairment loss when an investment’s value declines below cost, adjusted for
accretion, amortization and previous other-than-temporary impairments and it is
determined that the decline is other-than-temporary.




14




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




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




15




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




Three Months Ended
                              
                              
                              Six Months EndedJune 30
                              
                              
                              June 302010
                              
                              
                              2009
                              
                              
                              2010
                              
                              
                              2009U.S.
      Treasury securities and obligations of U.S. Government
                              
                              $
                              -
                              
                              
                              $
                              -
                              
                              
                              $
                              -
                              
                              
                              $
                              -Corporate
      debt securities
                              
                              
                              74
                              
                              
                              
                              894
                              
                              
                              
                              3,368
                              
                              
                              
                              1,022Municipal
      bonds
                              
                              
                              24
                              
                              
                              
                              (44
                              )
                              
                              
                              (72
                              )
                              
                              
                              (40
                              )Equity
      securities-financial services
                              
                              
                              1,201
                              
                              
                              
                              (23
                              )
                              
                              
                              1,767
                              
                              
                              
                              27Equity
      securities-all other
                              
                              
                              344
                              
                              
                              
                              40
                              
                              
                              
                              383
                              
                              
                              
                              48Net
      realized gain before other-than-temporary impairments
                              
                              
                              1,643
                              
                              
                              
                              867
                              
                              
                              
                              5,446
                              
                              
                              
                              1,057Other-than-temporary
      impairments
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              (538
                              )Net
      realized gain
                              
                              $
                              1,643
                              
                              
                              $
                              867
                              
                              
                              $
                              5,446
                              
                              
                              $
                              519




We
realized gross gains on investments of $1.6 million and $1.1 million during the
three months ended June 30, 2010 and 2009, respectively, and $5.5 and $1.3
million for the six months ended June 30, 2010 and 2009, respectively. We did
not realize any gross losses on investments for the three months ended June 30,
2010 and realized gross losses of $0.2 million during the three months ended
June 30, 2009 and $0.1 million and $0.8 million for the six months ended June
30, 2010 and 2009, respectively. We recorded proceeds from the sale of
investment securities of $26.5 million and $28.2 million during the three months
ended June 30, 2010 and 2009, respectively, and $73.6 million and $40.9 million
for the six months ended June 30, 2010 and 2009, respectively. Realized
investment gains and losses are recognized in operations on the specific
identification method.




16




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




Gross
                      
                      
                      GrossAmortized
                      
                      
                      Unrealized
                      
                      
                      Unrealized
                      
                      
                      FairCost
                      
                      
                      Gains
                      
                      
                      Losses
                      
                      
                      ValueAs of June 30, 2010U.S.
      Treasury securities and obligations of U.S. Government
                      
                      $
                      6,510
                      
                      
                      $
                      29
                      
                      
                      $
                      -
                      
                      
                      $
                      6,539Corporate
      debt securities
                      
                      
                      195,796
                      
                      
                      
                      4,475
                      
                      
                      
                      (1,720
                      )
                      
                      
                      198,551Municipal
      bonds
                      
                      
                      157,483
                      
                      
                      
                      3,170
                      
                      
                      
                      (1,659
                      )
                      
                      
                      158,994Asset
      backed
                      
                      
                      585
                      
                      
                      
                      25
                      
                      
                      
                      -
                      
                      
                      
                      610Total
      debt securities
                      
                      
                      360,374
                      
                      
                      
                      7,699
                      
                      
                      
                      (3,379
                      )
                      
                      
                      364,694Financial
      services
                      
                      
                      16,530
                      
                      
                      
                      3,765
                      
                      
                      
                      (228
                      )
                      
                      
                      20,067All
      other
                      
                      
                      17,505
                      
                      
                      
                      4,178
                      
                      
                      
                      (792
                      )
                      
                      
                      20,891Total
      equity securities
                      
                      
                      34,035
                      
                      
                      
                      7,943
                      
                      
                      
                      (1,020
                      )
                      
                      
                      40,958Total
      debt and equity securities
                      
                      $
                      394,409
                      
                      
                      $
                      15,642
                      
                      
                      $
                      (4,399
                      )
                      
                      $
                      405,652As of December 31, 2009U.S.
      Treasury securities and obligations of U.S. Government
                      
                      $
                      6,830
                      
                      
                      $
                      23
                      
                      
                      $
                      (17
                      )
                      
                      $
                      6,836Corporate
      debt securities
                      
                      
                      94,560
                      
                      
                      
                      7,190
                      
                      
                      
                      (2,201
                      )
                      
                      
                      99,549Municipal
      bonds
                      
                      
                      185,036
                      
                      
                      
                      2,543
                      
                      
                      
                      (2,786
                      )
                      
                      
                      184,793Asset
      backed
                      
                      
                      682
                      
                      
                      
                      17
                      
                      
                      
                      (1
                      )
                      
                      
                      698Total
      debt securities
                      
                      
                      287,108
                      
                      
                      
                      9,773
                      
                      
                      
                      (5,005
                      )
                      
                      
                      291,876Financial
      services
                      
                      
                      17,156
                      
                      
                      
                      5,008
                      
                      
                      
                      (232
                      )
                      
                      
                      21,932All
      other
                      
                      
                      10,095
                      
                      
                      
                      3,790
                      
                      
                      
                      (16
                      )
                      
                      
                      13,869Total
      equity securities
                      
                      
                      27,251
                      
                      
                      
                      8,798
                      
                      
                      
                      (248
                      )
                      
                      
                      35,801Total
      debt and equity securities
                      
                      $
                      314,359
                      
                      
                      $
                      18,571
                      
                      
                      $
                      (5,253
                      )
                      
                      $
                      327,677




17




The
following schedules summarize the gross unrealized losses showing the length of
time that investments have been continuously in an unrealized loss position as
of June 30, 2010 and December 31, 2009 (in thousands):





As of June 30, 201012 months or less
                  
                  
                  Longer than 12 months
                  
                  
                  TotalUnrealized
                  
                  
                  
                  
                  
                  Unrealized
                  
                  
                  
                  
                  
                  UnrealizedFair Value
                  
                  
                  Losses
                  
                  
                  Fair Value
                  
                  
                  Losses
                  
                  
                  Fair Value
                  
                  
                  LossesU.S.
      Treasury securities and obligations of U.S. Government
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -Corporate
      debt securities
                  
                  
                  73,817
                  
                  
                  
                  (788
                  )
                  
                  
                  5,412
                  
                  
                  
                  (932
                  )
                  
                  
                  79,229
                  
                  
                  
                  (1,720
                  )Municipal
      bonds
                  
                  
                  27,371
                  
                  
                  
                  (1,059
                  )
                  
                  
                  37,740
                  
                  
                  
                  (600
                  )
                  
                  
                  65,111
                  
                  
                  
                  (1,659
                  )Total
      debt securities
                  
                  
                  101,188
                  
                  
                  
                  (1,847
                  )
                  
                  
                  43,152
                  
                  
                  
                  (1,532
                  )
                  
                  
                  144,340
                  
                  
                  
                  (3,379
                  )Financial
      services
                  
                  
                  2,489
                  
                  
                  
                  (228
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2,489
                  
                  
                  
                  (228
                  )All
      other
                  
                  
                  10,104
                  
                  
                  
                  (792
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  10,104
                  
                  
                  
                  (792
                  )Total
      equity securities
                  
                  
                  12,593
                  
                  
                  
                  (1,020
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  12,593
                  
                  
                  
                  (1,020
                  )Total
      debt and equity securities
                  
                  $
                  113,781
                  
                  
                  $
                  (2,867
                  )
                  
                  $
                  43,152
                  
                  
                  $
                  (1,532
                  )
                  
                  $
                  156,933
                  
                  
                  $
                  (4,399
                  )





As of December 31,
200912 months or less
                  
                  
                  Longer than 12 months
                  
                  
                  TotalUnrealized
                  
                  
                  
                  
                  
                  Unrealized
                  
                  
                  
                  
                  
                  UnrealizedFair Value
                  
                  
                  Losses
                  
                  
                  Fair Value
                  
                  
                  Losses
                  
                  
                  Fair Value
                  
                  
                  LossesU.S.
      Treasury securities and obligations of U.S. Government
                  
                  $
                  3,202
                  
                  
                  $
                  (17
                  )
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  3,202
                  
                  
                  $
                  (17
                  )Corporate
      debt securities
                  
                  
                  18,924
                  
                  
                  
                  (166
                  )
                  
                  
                  9,642
                  
                  
                  
                  (2,035
                  )
                  
                  
                  28,566
                  
                  
                  
                  (2,201
                  )Municipal
      bonds
                  
                  
                  28,940
                  
                  
                  
                  (1,524
                  )
                  
                  
                  42,183
                  
                  
                  
                  (1,262
                  )
                  
                  
                  71,123
                  
                  
                  
                  (2,786
                  )Asset
      backed
                  
                  
                  51
                  
                  
                  
                  (1
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  51
                  
                  
                  
                  (1
                  )Total
      debt securities
                  
                  
                  51,117
                  
                  
                  
                  (1,708
                  )
                  
                  
                  51,825
                  
                  
                  
                  (3,297
                  )
                  
                  
                  102,942
                  
                  
                  
                  (5,005
                  )Financial
      services
                  
                  
                  1,417
                  
                  
                  
                  (232
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1,417
                  
                  
                  
                  (232
                  )All
      other
                  
                  
                  658
                  
                  
                  
                  (16
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  658
                  
                  
                  
                  (16
                  )Equity
      securities
                  
                  
                  2,075
                  
                  
                  
                  (248
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2,075
                  
                  
                  
                  (248
                  )Total
      debt and equity securities
                  
                  $
                  53,192
                  
                  
                  $
                  (1,956
                  )
                  
                  $
                  51,825
                  
                  
                  $
                  (3,297
                  )
                  
                  $
                  105,017
                  
                  
                  $
                  (5,253
                  )





At
June 30, 2010, the gross unrealized losses more than twelve months old were
attributable to 33 bond positions.  At December 31, 2009, the gross
unrealized losses more than twelve months old were attributable to 60 bond
positions.  We consider these losses as a temporary decline in value
as they are predominately on bonds that we do not intend to sell and do not
believe we will be required to sell prior to recovery of our amortized cost
basis.  We see no other indications that the decline in values of
these securities is other-than-temporary.




18




Based on
evidence gathered through our normal credit evaluation process, we presently
expect that all debt securities held in our investment portfolio will be paid in
accordance with their contractual terms.  Nonetheless, it is at least
reasonably possible that the performance of certain issuers of these debt
securities will be worse than currently expected resulting in additional future
write-downs within our portfolio of debt securities.





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





The
amortized cost and estimated fair value of debt securities at June 30, 2010 by
contractual maturity are as follows. Expected maturities may differ from
contractual maturities because certain borrowers may have the right to call or
prepay obligations with or without penalties.





Amortized
                  
                  
                  FairCost
                  
                  
                  Value(in
      thousands)Due
      in one year or less
                  
                  $
                  38,209
                  
                  
                  $
                  38,728Due
      after one year through five years
                  
                  
                  193,268
                  
                  
                  
                  197,738Due
      after five years through ten years
                  
                  
                  82,786
                  
                  
                  
                  82,532Due
      after ten years
                  
                  
                  45,526
                  
                  
                  
                  45,086Asset
      backed
                  
                  
                  585
                  
                  
                  
                  610$
                  360,374
                  
                  
                  $
                  364,694





Activity
related to the credit component recognized in earnings for the six months ended
June 30, 2010, on debt securities held by us for which a portion of
other-than-temporary impairment was previously recognized in other comprehensive
income is as follows (in thousands):





Balance,
      January 1, 2010
                    
                    $
                    1,168Reductions
      for securities sold or matured during the period
                    
                    
                    (1,168
                    )Balance,
      June 30, 2010
                    
                    $
                    -




19




6.
Pledged Investments





We have certain of our securities
pledged for the benefit of various state insurance departments and
reinsurers.  These securities are included with our available-for-sale
debt securities because we have the ability to trade these
securities.  We retain the interest earned on these
securities.  These securities had a carrying value of $31.8 million at
June 30, 2010 and a carrying value of $29.7 million at December 31,
2009.





7.
Share-Based Payment Arrangements





Our 2005
Long Term Incentive Plan (“2005 LTIP”) is a stock compensation plan for key
employees and non-employee directors that was approved by the shareholders on
May 26, 2005.  There are 2,000,000 shares authorized for issuance
under the 2005 LTIP.  Our 1994 Key Employee Long Term Incentive Plan
(the “1994 Employee Plan”) and 1994 Non-Employee Director Stock Option Plan (the
“1994 Director Plan”) both expired in 2004 but have unexercised options
outstanding.





As of
June 30, 2010, there were incentive stock options to purchase 1,286,666 shares
of our common stock outstanding and non-qualified stock options to purchase
320,000 shares of our common stock outstanding and there were 392,501 shares
reserved for future issuance under the 2005 LTIP.  As of June 30,
2010, there were incentive stock options to purchase 2,500 shares outstanding
under the 1994 Employee Plan and non-qualified stock options to purchase 20,834
shares outstanding under the 1994 Director Plan.  The exercise price
of all such outstanding stock options is equal to the fair market value of our
common stock on the date of grant.





Options
granted under the 1994 Employee Plan prior to October 31, 2003, vest 40% six
months from the date of grant and an additional 20% on each of the first three
anniversary dates of the grant and terminate ten years from the date of
grant.  Incentive stock options granted under the 2005 LTIP prior to
2009 and the 1994 Employee Plan after October 31, 2003, vest 10%, 20%, 30% and
40% on the first, second, third and fourth anniversary dates of the grant,
respectively, and terminate five to ten years from the date of
grant.  Incentive stock options granted in 2009 under the 2005 LTIP
vest in equal annual increments on each of the first seven anniversary dates and
terminate ten years from the date of grant.  There was one grant of
25,000 incentive stock options in 2010 under the 2005 LTIP that vests in equal
annual increments on each of the first three anniversary dates and terminates
ten years from the date of grant.  Non-qualified stock options granted
under the 2005 LTIP generally vest 100% six months after the date of grant and
terminate ten years from the date of grant.  There was one grant of
200,000 non-qualified stock options in 2009 under the 2005 LTIP that vests in
equal annual increments on each of the first seven anniversary dates and
terminates ten years from the date of grant.  All non-qualified stock
options granted under the 1994 Director Plan vested 40% six months from the date
of grant and an additional 10% on each of the first six anniversary dates of the
grant and terminate ten years from the date of grant.




20




A summary
of the status of our stock options as of and changes during the six months ended
June 30, 2010 is presented below:





Average
                                  
                                  
                                  Contractual
                                  
                                  
                                  IntrinsicNumber of
                                  
                                  
                                  Exercise
                                  
                                  
                                  Term
                                  
                                  
                                  ValueShares
                                  
                                  
                                  Price
                                  
                                  
                                  (Years)
                                  
                                  
                                  ($000)Outstanding
      at January 1, 2010
                                  
                                  
                                  1,614,166
                                  
                                  
                                  $
                                  9.62Granted
                                  
                                  
                                  25,000
                                  
                                  
                                  $
                                  9.12Exercised
                                  
                                  
                                  (9,166
                                  )
                                  
                                  $
                                  2.69Forfeited
      or expired
                                  
                                  
                                  -
                                  
                                  
                                  $
                                  -Outstanding
      at June 30, 2010
                                  
                                  
                                  1,630,000
                                  
                                  
                                  $
                                  9.65
                                  
                                  
                                  
                                  7.5
                                  
                                  
                                  $
                                  2,390Exercisable
      at June 30, 2010
                                  
                                  
                                  773,427
                                  
                                  
                                  $
                                  10.32
                                  
                                  
                                  
                                  6.8
                                  
                                  
                                  $
                                  837





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





Three Months Ended
                  
                  
                  Six Months EndedJune 30,
                  
                  
                  June 30,2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Intrinsic
      value of options exercised
                  
                  $
                  3
                  
                  
                  $
                  -
                  
                  
                  $
                  47
                  
                  
                  $
                  107Cost
      of share-based payments (non-cash)
                  
                  $
                  291
                  
                  
                  $
                  614
                  
                  
                  $
                  589
                  
                  
                  $
                  876Income
      tax benefit of share-based payments recognized in income
                  
                  $
                  7
                  
                  
                  $
                  30
                  
                  
                  $
                  15
                  
                  
                  $
                  30





As of
June 30, 2010, there was $2.4 million of total unrecognized compensation cost
related to non-vested share-based compensation arrangements granted under our
plans, of which $0.5 million is expected to be recognized during the remainder
of 2010, $0.8 million is expected to be recognized in 2011, $0.4 million is
expected to be recognized in 2012, $0.2 million is expected to be recognized
each year from 2013 through 2015 and $0.1 million is expected to be recognized
in 2016.





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




21




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





Three Months Ended
                              
                              
                              Six Months EndedJune 30,
                              
                              
                              June 30,2010
                              
                              
                              2009
                              
                              
                              2010
                              
                              
                              2009Grant
      date fair value per share
                              
                              $
                              3.62
                              
                              
                              $
                              2.84
                              
                              
                              $
                              3.62
                              
                              
                              $
                              2.84Expected
      term (in years)
                              
                              
                              6.0
                              
                              
                              
                              6.2
                              
                              
                              
                              6.0
                              
                              
                              
                              6.2Expected
      volatility
                              
                              
                              35.0
                              %
                              
                              
                              40.0
                              %
                              
                              
                              35.0
                              %
                              
                              
                              40.0
                              %Risk
      free interest rate
                              
                              
                              3.2
                              %
                              
                              
                              2.5
                              %
                              
                              
                              3.2
                              %
                              
                              
                              2.5
                              %





8.
Segment Information





The following is business segment
information for the three and six months ended June 30, 2010 and 2009 (in
thousands):


Three Months Ended
                      
                      
                      Six Months EndedJune 30,
                      
                      
                      June 30,2010
                      
                      
                      2009
                      
                      
                      2010
                      
                      
                      2009Revenues:Standard
      Commercial Segment
                      
                      $
                      17,265
                      
                      
                      $
                      18,194
                      
                      
                      $
                      35,299
                      
                      
                      $
                      38,214Specialty
      Commercial Segment
                      
                      
                      32,124
                      
                      
                      
                      32,430
                      
                      
                      
                      64,611
                      
                      
                      
                      65,255Personal
      Segment
                      
                      
                      24,754
                      
                      
                      
                      18,701
                      
                      
                      
                      45,968
                      
                      
                      
                      36,236Corporate
                      
                      
                      1,544
                      
                      
                      
                      1,419
                      
                      
                      
                      5,632
                      
                      
                      
                      1,949Consolidated
                      
                      $
                      75,687
                      
                      
                      $
                      70,744
                      
                      
                      $
                      151,510
                      
                      
                      $
                      141,654Pre-tax income (loss), net of non-controlling
      interest:Standard
      Commercial Segment
                      
                      $
                      (1,870
                      )
                      
                      $
                      1,247
                      
                      
                      $
                      (2,809
                      )
                      
                      $
                      3,823Specialty
      Commercial Segment
                      
                      
                      967
                      
                      
                      
                      5,010
                      
                      
                      
                      7,314
                      
                      
                      
                      10,692Personal
      Segment
                      
                      
                      1,132
                      
                      
                      
                      2,894
                      
                      
                      
                      3,782
                      
                      
                      
                      5,513Corporate
                      
                      
                      (1,570
                      )
                      
                      
                      (2,357
                      )
                      
                      
                      (452
                      )
                      
                      
                      (4,782
                      )Consolidated
                      
                      $
                      (1,341
                      )
                      
                      $
                      6,794
                      
                      
                      $
                      7,835
                      
                      
                      $
                      15,246




22




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





June 30,
                        
                        
                        December 31,2010
                        
                        
                        2009AssetsStandard
      Commercial Segment
                        
                        $
                        132,292
                        
                        
                        $
                        136,745Specialty
      Commercial Segment
                        
                        
                        304,109
                        
                        
                        
                        280,970Personal
      Segment
                        
                        
                        149,232
                        
                        
                        
                        109,844Corporate
                        
                        
                        104,892
                        
                        
                        
                        101,310$
                        690,525
                        
                        
                        $
                        628,869





9.
Reinsurance





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





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




Three Months Ended
                  
                  
                  Six Months EndedJune 30,
                  
                  
                  June 30,2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Ceded
      earned premiums
                  
                  $
                  9,432
                  
                  
                  $
                  3,136
                  
                  
                  $
                  17,257
                  
                  
                  $
                  5,194Reinsurance
      recoveries
                  
                  $
                  6,842
                  
                  
                  $
                  1,890
                  
                  
                  $
                  10,578
                  
                  
                  $
                  3,222





We
presently retain 100% of the risk associated with all policies marketed by our
Personal Lines business unit. We currently reinsure the following exposures on
business generated by our Standard Commercial, E&S Commercial, Excess &
Umbrella, and General Aviation business units:




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




23




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




o
            Our
      reinsurers reimburse us 100% for any loss in excess of our $3.0 million
      retention up to $35.0 million for each catastrophic occurrence, subject to
      an aggregate limit of $64.0
million.




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




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




o
            Our
      reinsurers reimburse us for the next $5.0 million for each commercial
      property risk, and $10.0 million for all commercial property risk involved
      in any one occurrence, in all cases subject to an aggregate limit of $30.0
      million for all commercial property losses occurring during the treaty
      period; and




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




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




o
            We
      retain the first $1.0 million of any commercial liability risk;
      and




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




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




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




o
            Our
      reinsurers reimburse us for the next $3.3 million of each combined
      aircraft hull and liability loss and for the next $650,000 of each airport
      liability loss; and




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





·
            Excess &
      Umbrella.  Effective July 1, 2009, in states where we
      offer admitted policies, we directly insure policies written by our Excess
      & Umbrella business unit and reinsure a portion of the risk with third
      party carriers.  In states where we offer non-admitted policies, our
      Excess & Umbrella business unit writes policies under fronting
      arrangements pursuant to which we assume all of the risk and then
      retrocede a portion of the risk to third party reinsurers.  We
      reinsure or retrocede 79% of the risk on policies written by our Excess
      & Umbrella business unit.  Through June 30, 2009, our Excess
      & Umbrella business unit wrote policies under a fronting arrangement
      pursuant to which we assumed 35% of the
risk.





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




24




10.
Note Payable





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 E&S Commercial
business unit.  As of June 30, 2010, the balance on the
revolving note was $2.8 million, which currently bears interest at 3.03% per
annum. (See Note 12, “Credit Facilities.”)





11.  Subordinated
Debt Securities





On June
21, 2005, we entered into a trust preferred securities transaction pursuant to
which we issued $30.9 million aggregate principal amount of subordinated debt
securities due in 2035.  To effect the transaction, we formed Trust I
as a Delaware statutory trust.  Trust I issued $30.0 million of
preferred securities to investors and $0.9 million of common securities to
us.  Trust I used the proceeds from these issuances to purchase the
subordinated debt securities.  Our Trust I subordinated debt
securities bear 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.  Trust I pays dividends on its preferred securities
at the same rate.  Under the terms of our Trust I subordinated debt
securities, we pay interest only each quarter and the principal of the note at
maturity.  The subordinated debt securities are uncollaterized and do
not require maintenance of minimum financial covenants. As of June 30, 2010, the
balance of our Trust I subordinated debt was $30.9 million.





On August
23, 2007, we entered into a trust preferred securities transaction pursuant to
which we issued $25.8 million aggregate principal amount of subordinated debt
securities due in 2037.  To effect the transaction, we formed Trust II
as a Delaware statutory trust.  Trust II issued $25.0 million of
preferred securities to investors and $0.8 million of common securities to
us.  Trust II used the proceeds from these issuances to purchase the
subordinated debt securities.  Our Trust II subordinated debt
securities bear an initial interest rate of 8.28% until September 15, 2017, at
which time interest will adjust quarterly to the three-month LIBOR rate plus
2.90 percentage points.  Trust II pays dividends on its preferred
securities at the same rate.  Under the terms of our Trust II
subordinated debt securities, we pay interest only each quarter and the
principal of the note at maturity.  The subordinated debt securities
are uncollaterized and do not require maintenance of minimum financial
covenants. As of June 30, 2010, the balance of our Trust II subordinated debt
was $25.8 million.





12.
Credit Facilities





Our First
Restated Credit Agreement with The Frost National Bank dated January 27, 2006
was most recently amended effective May 27, 2010 to extend the term of the
facility until May 27, 2012, provide for the repayment of all amounts
outstanding at termination on or before April 30, 2015, reduce the revolving
commitment to $5.0 million from $25.0 million and eliminate the credit
sub-facility for premium finance operations. This amendment further revised
various affirmative and negative covenants and changed the interest rate, at our
election, to either the prime rate or LIBOR plus 2.5%. We pay an annual average
fee of 0.25% of the average daily unused balance of the credit facility. 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, guarantees of all of our subsidiaries
and the pledge of all of our non-insurance company assets.  The
revolving credit facility contains covenants that, among other things, require
us to maintain certain financial and operating ratios and restrict certain
distributions, transactions and organizational changes.  As of June
30, 2010, we were in compliance with or had obtained waivers of all of our
covenants.  As of June 30, 2010, we had $2.8 million outstanding under
this facility.





25





13.
Deferred Policy Acquisition Costs





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





Three Months Ended
                      
                      
                      Six Months EndedJune 30,
                      
                      
                      June 30,2010
                      
                      
                      2009
                      
                      
                      2010
                      
                      
                      2009Deferred
                      
                      $
                      (11,842
                      )
                      
                      $
                      (15,559
                      )
                      
                      $
                      (27,697
                      )
                      
                      $
                      (31,085
                      )Amortized
                      
                      
                      11,304
                      
                      
                      
                      13,129
                      
                      
                      
                      25,753
                      
                      
                      
                      27,177Net
                      
                      $
                      (538
                      )
                      
                      $
                      (2,430
                      )
                      
                      $
                      (1,944
                      )
                      
                      $
                      (3,908
                      )




14.
Earnings per Share





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


Three Months Ended
                    
                    
                    Six Months EndedJune 30,
                    
                    
                    June 30,2010
                    
                    
                    2009
                    
                    
                    2010
                    
                    
                    2009Weighted
      average shares - basic
                    
                    
                    20,124
                    
                    
                    
                    20,864
                    
                    
                    
                    20,122
                    
                    
                    
                    20,860Effect
      of dilutive securities
                    
                    
                    132
                    
                    
                    
                    12
                    
                    
                    
                    52
                    
                    
                    
                    15Weighted
      average shares - assuming dilution
                    
                    
                    20,256
                    
                    
                    
                    20,876
                    
                    
                    
                    20,174
                    
                    
                    
                    20,875





For the
three months and six months ended June 30, 2010, 899,166 shares of common stock
potentially issuable upon the exercise of employee stock options were excluded
from the weighted average number of shares outstanding on a diluted basis
because the effect of such options would be anti-dilutive.  For the
three months and six months ended June 30, 2009, 987,499 shares of common stock
potentially issuable upon the exercise of employee stock options were excluded
from the weighted average number of shares outstanding on a diluted basis
because the effect of such options would be anti-dilutive.





26




15.
Net Periodic Pension Cost





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





Three Months Ended
                    
                    
                    Six Months EndedJune 30,
                    
                    
                    June 30,2010
                    
                    
                    2009
                    
                    
                    2010
                    
                    
                    2009Interest
      cost
                    
                    $
                    163
                    
                    
                    $
                    161
                    
                    
                    $
                    325
                    
                    
                    $
                    322Amortization
      of net loss
                    
                    
                    56
                    
                    
                    
                    122
                    
                    
                    
                    112
                    
                    
                    
                    244Expected
      return on plan assets
                    
                    
                    (137
                    )
                    
                    
                    (121
                    )
                    
                    
                    (273
                    )
                    
                    
                    (242
                    )Net
      periodic pension cost
                    
                    $
                    82
                    
                    
                    $
                    162
                    
                    
                    $
                    164
                    
                    
                    $
                    324





We contributed $94 thousand to
our frozen defined benefit cash balance plan (“Cash Balance Plan”) during the
three months and six months ended June 30, 2010.  We did not make any
contributions to the Cash Balance Plan during the three months and six months
ended June 30, 2009.  Refer to Note 13 to the consolidated financial
statements in our Annual Report on Form 10-K for the year ended December 31,
2009 for more discussion of our retirement plans.





16.   Income
Taxes





Our
effective income tax rate for the six months ended June 30, 2010 was 24.6%,
which varied from the statutory income tax rate utilized primarily due to the
increase in the tax exempt income effect relative to lower pre-tax income and
the recognition of a tax benefit related to the disposal of certain
securities.  Our effective income tax rate for the six months ended
June 30, 2009 was 27.4%, which varied from the statutory income tax rate
utilized primarily because of our investments in tax exempt securities and a
reduction in the valuation allowance.





17.
Commitments and Contingencies





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





18.  Subsequent
Event





On August
9, 2010 we announced the execution of an agreement for our wholly-owned
subsidiary, HIC, to acquire State Auto National Insurance Company (“SAN”) from
State Auto Financial Corporation.  SAN is an Ohio domiciled insurance
company which writes non-standard personal automobile policies through
independent agents in 21 states.  Closing of the acquisition is subject to
regulatory approval and other customary closing conditions.





The
purchase price for the acquisition will be $14.0 million cash at closing plus an
earn-out of up to $2.0 million.  We expect to fund the acquisition out
of working capital.  The cash portion of the purchase price is subject to
post-closing adjustment to the extent the statutory capital and surplus of SAN
is greater or less than $10.0 million.  The earn-out is payable quarterly
in an amount equal to 2% of gross collected premiums on new or renewal personal
lines insurance policies written by SAN agents during the three years following
closing.  In connection with the closing, SAN will enter into reinsurance
agreements with an affiliate of the seller pursuant to which the affiliate will
handle all claims and assume all liabilities arising under policies issued by
SAN prior to the closing and during a transition period of up to six months
following the closing.




27




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





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





Introduction





Hallmark
Financial Services, Inc. (“Hallmark” and, together with subsidiaries, “we,” “us”
or “our”) is an insurance holding company that, through its subsidiaries,
engages in the sale of property/casualty insurance products to businesses and
individuals. Our business involves marketing, distributing, underwriting and
servicing commercial insurance, personal insurance and general aviation
insurance, as well as providing other insurance related services.  Our
business is geographically concentrated in the southcentral and northwest
regions of the United States, except for our General Aviation and Excess &
Umbrella business, which is written on a national basis.  We pursue our business
activities through subsidiaries whose operations are organized into five
business units, which are supported by our four insurance company
subsidiaries.




Our
non-carrier insurance activities are segregated by business 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 Standard Commercial business unit
      (formerly known as our AHIS Operating
Unit).





·
            Specialty
      Commercial Segment.  Our Specialty Commercial Segment
      includes the excess and surplus lines commercial property/casualty
      insurance products and services handled by our E&S Commercial business
      unit (formerly known as our TGA Operating Unit), the general aviation
      insurance products and services handled by our General Aviation business
      unit (formerly known as our Aerospace Operating Unit), and the low and
      middle market commercial umbrella and excess liability insurance products
      handled by our Excess & Umbrella business unit (formerly known as our
      Heath XS Operating Unit).





·
            Personal
      Segment.  Our Personal Segment includes the non-standard
      personal automobile insurance and complementary personal insurance
      products and services handled by our Personal Lines business unit
      (formerly known as our Personal Lines Operating
  Unit).





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




28




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





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





·
            Hallmark
      Insurance Company (“HIC”)presently retains a portion of the risks
      on both the personal policies marketed within the Personal Segment and
      commercial and aviation property/casualty products marketed within the
      Specialty Commercial Segment.





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





AHIC, HSIC, and HIC have
entered into a pooling arrangement pursuant to which AHICretains 46% of
the total net premiums written by all of our business units, HIC retains 34% of
our total net premiums written and HSIC retains 20% of our total net premiums
written.  This pooling arrangement has no impact on our consolidated
financial statements reported in accordance with U.S. generally accepted
accounting principles (“GAAP”).





Results
of Operations





Management
Overview.During the three and six months ended June 30, 2010,
our total revenues were $75.7 million and $151.5 million, representing a 7%
increase from the $70.7 million and $141.7 million in total revenues for the
same periods of 2009.  This increase in revenue was primarily attributable
to increased earned premium due to increased production by our Personal Segment
and gains realized on our investment portfolio. These increases in revenue were
partially offset by reduced earned premium in our Standard Commercial Segment
due to the deterioration of the general economic environment in our major
markets.





We
reported a net loss attributable to Hallmark of $0.4 million and net income
attributable to Hallmark of $5.9 million for the three and six months ended June
30, 2010, respectively, which was $4.7 million and $5.2 million lower than the
$4.3 million and $11.1 million net income attributable to Hallmark reported for
the same periods of 2009.  On a diluted basis per share, net loss was $0.02
per share and net income was $0.29 per share for the three and six months ended
June 30, 2010, respectively, as compared to net income of $0.20 and $0.53 per
share for the same periods in 2009.    The decrease in net
income for the three and six months ending June 30, 2010 was primarily due to
increased loss and loss adjustment expenses (“LAE”), including unfavorable prior
year loss development of $4.3 million and $6.5 million recognized during the
three and six months ended June 30, 2010, respectively, as compared to $1.8
million unfavorable development recognized for the three and six months ended
June 30, 2009.  Partially offsetting the increased loss and LAE was
the increase in revenue for the three and six months ending June 30, 2010, as
well as lower operating expenses due to lower production related expenses in our
E&S Commercial  and  General Aviation business units and
lower information technology costs in our Standard Commercial
Segment.  The Company’s effective income tax rate for the six months
ending June 30, 2010 was 24.6% as compared to the 27.4% effective income tax
rate for the same period during 2009.  The decrease in the effective
tax rate was primarily due to the increase in the tax exempt income effect
relative to lower pre-tax income and the recognition of a tax benefit related to
the disposal of certain securities.




29




Second
Quarter 2010 as Compared to Second Quarter 2009





The
following is additional business segment information for the three months ended
June 30, 2010 and 2009 (in thousands):





Hallmark Financial Services, Inc.


Consolidated
Segment Data





Three
      Months Ended June 30, 2010Standard
                          
                          
                          SpecialtyCommercial
                          
                          
                          Commercial
                          
                          
                          PersonalSegment
                          
                          
                          Segment
                          
                          
                          Segment
                          
                          
                          Corporate
                          
                          
                          ConsolidatedProduced
      premium (1)
                          
                          $
                          18,804
                          
                          
                          $
                          40,351
                          
                          
                          $
                          22,613
                          
                          
                          $
                          -
                          
                          
                          $
                          81,768Gross
      premiums written
                          
                          
                          18,792
                          
                          
                          
                          41,775
                          
                          
                          
                          22,613
                          
                          
                          
                          -
                          
                          
                          
                          83,180Ceded
      premiums written
                          
                          
                          (909
                          )
                          
                          
                          (9,123
                          )
                          
                          
                          (15
                          )
                          
                          
                          -
                          
                          
                          
                          (10,047
                          )Net
      premiums written
                          
                          
                          17,883
                          
                          
                          
                          32,652
                          
                          
                          
                          22,598
                          
                          
                          
                          -
                          
                          
                          
                          73,133Change
      in unearned premiums
                          
                          
                          (1,246
                          )
                          
                          
                          (2,036
                          )
                          
                          
                          97
                          
                          
                          
                          -
                          
                          
                          
                          (3,185
                          )Net
      premiums earned
                          
                          
                          16,637
                          
                          
                          
                          30,616
                          
                          
                          
                          22,695
                          
                          
                          
                          -
                          
                          
                          
                          69,948Total
      revenues
                          
                          
                          17,265
                          
                          
                          
                          32,124
                          
                          
                          
                          24,754
                          
                          
                          
                          1,544
                          
                          
                          
                          75,687Losses
      and loss adjustment expenses
                          
                          
                          13,652
                          
                          
                          
                          21,231
                          
                          
                          
                          17,175
                          
                          
                          
                          -
                          
                          
                          
                          52,058Pre-tax  income
      (loss), net ofnon-controlling
      interest
                          
                          
                          (1,870
                          )
                          
                          
                          967
                          
                          
                          
                          1,132
                          
                          
                          
                          (1,570
                          )
                          
                          
                          (1,341
                          )Net
      loss ratio (2)
                          
                          
                          82.1
                          %
                          
                          
                          69.3
                          %
                          
                          
                          75.7
                          %
                          
                          
                          
                          
                          
                          
                          74.4
                          %Net
      expense ratio (2)
                          
                          
                          32.5
                          %
                          
                          
                          29.5
                          %
                          
                          
                          22.5
                          %
                          
                          
                          
                          
                          
                          
                          30.1
                          %Net
      combined ratio (2)
                          
                          
                          114.6
                          %
                          
                          
                          98.8
                          %
                          
                          
                          98.2
                          %
                          
                          
                          
                          
                          
                          
                          104.5
                          %





Three
      Months Ended June 30, 2009Standard
                          
                          
                          SpecialtyCommercial
                          
                          
                          Commercial
                          
                          
                          PersonalSegment
                          
                          
                          Segment
                          
                          
                          Segment
                          
                          
                          Corporate
                          
                          
                          ConsolidatedProduced
      premium (1)
                          
                          $
                          20,425
                          
                          
                          $
                          40,252
                          
                          
                          $
                          16,918
                          
                          
                          $
                          -
                          
                          
                          $
                          77,595Gross
      premiums written
                          
                          
                          20,425
                          
                          
                          
                          37,710
                          
                          
                          
                          16,918
                          
                          
                          
                          -
                          
                          
                          
                          75,053Ceded
      premiums written
                          
                          
                          (1,084
                          )
                          
                          
                          (2,176
                          )
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          (3,260
                          )Net
      premiums written
                          
                          
                          19,341
                          
                          
                          
                          35,534
                          
                          
                          
                          16,918
                          
                          
                          
                          -
                          
                          
                          
                          71,793Change
      in unearned premiums
                          
                          
                          (1,614
                          )
                          
                          
                          (8,158
                          )
                          
                          
                          298
                          
                          
                          
                          -
                          
                          
                          
                          (9,474
                          )Net
      premiums earned
                          
                          
                          17,727
                          
                          
                          
                          27,376
                          
                          
                          
                          17,216
                          
                          
                          
                          -
                          
                          
                          
                          62,319Total
      revenues
                          
                          
                          18,194
                          
                          
                          
                          32,430
                          
                          
                          
                          18,701
                          
                          
                          
                          1,419
                          
                          
                          
                          70,744Losses
      and loss adjustment expenses
                          
                          
                          11,119
                          
                          
                          
                          15,848
                          
                          
                          
                          11,164
                          
                          
                          
                          -
                          
                          
                          
                          38,131Pre-tax income
      (loss), net ofnon-controlling
      interest
                          
                          
                          1,247
                          
                          
                          
                          5,010
                          
                          
                          
                          2,894
                          
                          
                          
                          (2,357
                          )
                          
                          
                          6,794Net
      loss ratio (2)
                          
                          
                          62.7
                          %
                          
                          
                          57.9
                          %
                          
                          
                          64.8
                          %
                          
                          
                          
                          
                          
                          
                          61.2
                          %Net
      expense ratio (2)
                          
                          
                          32.1
                          %
                          
                          
                          30.2
                          %
                          
                          
                          20.7
                          %
                          
                          
                          
                          
                          
                          
                          30.5
                          %Net
      combined ratio (2)
                          
                          
                          94.8
                          %
                          
                          
                          88.1
                          %
                          
                          
                          85.5
                          %
                          
                          
                          
                          
                          
                          
                          91.7
                          %





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


(2)  The
net loss ratio is calculated as incurred losses and LAE divided by net premiums
earned, each determined in accordance  with GAAP.  The
net  expense ratio is now calculated for our business units that
retain 100% of produced premium as total operating expenses  for the
unit offset by agency fee income divided by net premiums earned, each determined
in accordance with GAAP.  For the business units that do not retain
100% of the produced premium, the net expense ratio is calculated as
underwriting expenses of the insurance company subsidiaries for the unit offset
by agency fee income, divided by net premiums earned, each determined in
accordance with GAAP.  Net combined ratio is calculated as the sum of
the net loss ratio and the net expense ratio.


30


Standard
Commercial Segment





Gross
premiums written for the Standard Commercial Segment were $18.8 million for the
three months ended June 30, 2010, which was $1.6 million, or 8%, less than the
$20.4 million reported for the same period in 2009.  Net premiums
written were $17.9 million for the three months ended June 30, 2010 as compared
to $19.3 million reported for the same period in 2009.  The decrease
in premium volume was predominately due to the deterioration of the general
economic environment, particularly in the construction industry, reducing the
available insured exposures.





Total
revenue for the Standard Commercial Segment of $17.3 million for the three
months ended June 30, 2010 was $0.9 million less than the $18.2 million reported
during the same period in 2009.  This 5% decrease in total revenue was
mostly due to decreased net premiums earned of $1.1 million.





Our
Standard Commercial Segment reported a pre-tax loss of $1.9 million for the
three months ended June 30, 2010 as compared to pre-tax income of $1.2 million
for the same period of 2009. Higher loss and LAE expenses of $2.5 million,
primarily as a result of weather related losses and unfavorable prior year
development, and decreased revenue were the primary drivers of the pre-tax loss
for the three months ended June 30, 2010. Partially offsetting the decline in
pre-tax results were lower operating expenses of $0.3 million driven by lower
information technology costs and lower production related expenses.





The
Standard Commercial Segment reported a net loss ratio of 82.1% for the three
months ended June 30, 2010 as compared to 62.7% for 2009. The gross loss ratio
before reinsurance for the three months ended June 30, 2010 was 91.4% as
compared to the 59.6% reported for the same period of 2009.  The
higher gross and net loss ratio for the three months ended June 30, 2010 was
impacted by an increased number of large property losses including weather
related losses. The loss and LAE during the three months ended June 30, 2010 for
the Standard Commercial Segment included unfavorable loss reserve development of
$1.1 million as compared to favorable development of $0.5 million for the same
period in 2009.





Specialty
Commercial Segment





The $32.1
million of total revenue for the Specialty Commercial Segment during the three
months ended June 30, 2010 was $0.3 million lower than the $32.4 million
reported for the same period in 2009. This decrease in revenue was primarily
comprised of lower commission and fee income of $3.8 million primarily related
to the shift from a third party agency structure to an insurance underwriting
structure. This decrease was partially offset by increased net premiums earned
of $3.2 million as a result of the increased retention of business in our
E&S Commercial business unit and increased earned premium in our Excess
& Umbrella business unit, as well as increased net investment income of $0.4
million.





Pre-tax
income for the Specialty Commercial Segment of $1.0 million for the second
quarter of 2010 was $4.0 million lower than the $5.0 million reported for the
same period in 2009.  The decrease in pre-tax income was primarily due
to higher loss and LAE expenses of $5.4 million primarily as a result of
unfavorable prior loss development as well as higher current accident year loss
estimates and decreased revenue.  This increase in loss and LAE was
partially offset by lower operating expenses of $1.7 million.  The
decrease in operating expense was the combined result of (i) increased quota
share ceding commission of $1.6 million in our Excess & Umbrella business
unit, (ii) lower other production related expenses of $0.3 million, partially
offset by (iii) higher salary related expenses of $0.1 million, and (iv)
increased amortization of intangible assets of $0.2 million related to our
acquisition of CYR on June 5, 2009.





31


The Specialty Commercial Segment
reported a net loss ratio of 69.3% for the three months ended June 30, 2010 as
compared to 57.9% for the same period during 2009. The gross loss ratio before
reinsurance was 67.0% for the three months ended June 30, 2010 as compared to
59.2% for the same period during 2009. The higher gross and net loss ratio was
impacted by (i) late emerging general liability claims and
(ii) increased volatility in large liability losses and weather related
commercial automobile claims in the current accident year. During the three
months ended June 30, 2010 the Specialty Commercial Segment also reported $2.5
million of unfavorable prior year loss development as compared to $2.7 million
for the same period during 2009.





Personal
Segment





Net
premiums written for our Personal Segment increased $5.7 million during the
second quarter of 2010 to $22.6 million as compared to $16.9 million for the
second quarter of 2009.  The increase in premium was due mostly to
continued geographic expansion.





Total
revenue for the Personal Segment increased 32% to $24.8 million for the second
quarter of 2010 from $18.7 million for the second quarter of
2009.  Higher earned premium of $5.5 million was the primary reason
for the increase in revenue for the period.  Increased finance charges
and net investment income of $0.4 million and $0.1 million, respectively,
further contributed to the increase in revenue during the second quarter of
2010.





Pre-tax
income for the Personal Segment was $1.1 million for the three months ended June
30, 2010 as compared to $2.9 million for the same period of
2009.  Increased revenue was offset by increased losses and LAE of
$6.0 million and increased operating expenses of $1.8 million due mostly to
increased production and salary expense related to continued geographic
expansion.





The
Personal Segment reported a net loss ratio of 75.7% for the three months ended
June 30, 2010 as compared to 64.8% for the second quarter of
2009.  The increase in the net loss ratio was due primarily to
continued geographic expansion as the resulting growth has created a larger
portion of new and maturing business as compared to our mature legacy
business.  Our current accident year loss ratio reflects the near term
loss ratio penalty associated with this change in mix of seasoned versus less
seasoned business.  During the three months ended June 30, 2010, the
Personal Segment reported $0.7 million of unfavorable prior loss development
driven mostly by legal expense related to a 2001 bad faith claim as
compared to $0.3 million favorable prior year development reported for the same
period in 2009.





Corporate





Total
revenue for Corporate increased by $0.1 million for the three months ended June
30, 2010 as compared to the same period the prior year.  This increase
in total revenue was due primarily to gains of $1.6 million recognized on our
investment portfolio for the three months ended June 30, 2010 as compared to
gains of $0.9 million recognized during the same period in 2009.  This
increase in revenue was offset by lower net investment income of $0.6 million
for the three months ended June 30, 2010 as compared to the same period of the
prior year.





Corporate
pre-tax loss was $1.6 million for the three months ended June 30, 2010 as
compared to a $2.4 million pre-tax loss for the same period the prior
year.  The decrease in pre-tax loss was the result of the increased
revenue as well as lower operating expenses of $0.7 million due predominately to
lower non-cash compensation expense of $0.4 million related to lower stock
option expense to directors and lower pension costs.  Also
contributing to the lower operating expenses was $0.4 million related to
advances for a cancelled start-up program during the second quarter of
2009.




32




Six
Months Ended June 30, 2010 as Compared to Six Months Ended June 30,
2009





The
following is additional business segment information for the six months ended
June 30, 2010 and 2009 (in thousands):





Hallmark
Financial Services, Inc.


Consolidated
Segment Data





Six
      Months Ended June 30, 2010Standard
                          
                          
                          SpecialtyCommercial
                          
                          
                          Commercial
                          
                          
                          PersonalSegment
                          
                          
                          Segment
                          
                          
                          Segment
                          
                          
                          Corporate
                          
                          
                          ConsolidatedProduced
      premium (1)
                          
                          $
                          36,901
                          
                          
                          $
                          75,633
                          
                          
                          $
                          49,744
                          
                          
                          $
                          -
                          
                          
                          $
                          162,278Gross
      premiums written
                          
                          
                          36,889
                          
                          
                          
                          78,406
                          
                          
                          
                          49,744
                          
                          
                          
                          -
                          
                          
                          
                          165,039Ceded
      premiums written
                          
                          
                          (1,945
                          )
                          
                          
                          (17,147
                          )
                          
                          
                          (19
                          )
                          
                          
                          -
                          
                          
                          
                          (19,111
                          )Net
      premiums written
                          
                          
                          34,944
                          
                          
                          
                          61,259
                          
                          
                          
                          49,725
                          
                          
                          
                          -
                          
                          
                          
                          145,928Change
      in unearned premiums
                          
                          
                          (1,426
                          )
                          
                          
                          80
                          
                          
                          
                          (7,619
                          )
                          
                          
                          -
                          
                          
                          
                          (8,965
                          )Net
      premiums earned
                          
                          
                          33,518
                          
                          
                          
                          61,339
                          
                          
                          
                          42,106
                          
                          
                          
                          -
                          
                          
                          
                          136,963Total
      revenues
                          
                          
                          35,299
                          
                          
                          
                          64,611
                          
                          
                          
                          45,968
                          
                          
                          
                          5,632
                          
                          
                          
                          151,510Losses
      and loss adjustment expenses
                          
                          
                          27,268
                          
                          
                          
                          37,627
                          
                          
                          
                          30,261
                          
                          
                          
                          -
                          
                          
                          
                          95,156Pre-tax
      income (loss), net ofnon-controlling
      interest
                          
                          
                          (2,809
                          )
                          
                          
                          7,314
                          
                          
                          
                          3,782
                          
                          
                          
                          (452
                          )
                          
                          
                          7,835Net
      loss ratio (2)
                          
                          
                          81.4
                          %
                          
                          
                          61.3
                          %
                          
                          
                          71.9
                          %
                          
                          
                          
                          
                          
                          
                          69.5
                          %Net
      expense ratio (2)
                          
                          
                          31.7
                          %
                          
                          
                          28.8
                          %
                          
                          
                          22.1
                          %
                          
                          
                          
                          
                          
                          
                          29.5
                          %Net
      combined ratio (2)
                          
                          
                          113.1
                          %
                          
                          
                          90.1
                          %
                          
                          
                          94.0
                          %
                          
                          
                          
                          
                          
                          
                          99.0
                          %





Six
      Months Ended June 30, 2009Standard
                          
                          
                          SpecialtyCommercial
                          
                          
                          Commercial
                          
                          
                          PersonalSegment
                          
                          
                          Segment
                          
                          
                          Segment
                          
                          
                          Corporate
                          
                          
                          ConsolidatedProduced
      premium (1)
                          
                          $
                          39,572
                          
                          
                          $
                          74,534
                          
                          
                          $
                          37,544
                          
                          
                          $
                          -
                          
                          
                          $
                          151,650Gross
      premiums written
                          
                          
                          39,572
                          
                          
                          
                          69,416
                          
                          
                          
                          37,544
                          
                          
                          
                          -
                          
                          
                          
                          146,532Ceded
      premiums written
                          
                          
                          (2,187
                          )
                          
                          
                          (3,305
                          )
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          (5,492
                          )Net
      premiums written
                          
                          
                          37,385
                          
                          
                          
                          66,111
                          
                          
                          
                          37,544
                          
                          
                          
                          -
                          
                          
                          
                          141,040Change
      in unearned premiums
                          
                          
                          (1,208
                          )
                          
                          
                          (13,784
                          )
                          
                          
                          (4,299
                          )
                          
                          
                          -
                          
                          
                          
                          (19,291
                          )Net
      premiums earned
                          
                          
                          36,177
                          
                          
                          
                          52,327
                          
                          
                          
                          33,245
                          
                          
                          
                          -
                          
                          
                          
                          121,749Total
      revenues
                          
                          
                          38,214
                          
                          
                          
                          65,255
                          
                          
                          
                          36,236
                          
                          
                          
                          1,949
                          
                          
                          
                          141,654Losses
      and loss adjustment expenses
                          
                          
                          22,465
                          
                          
                          
                          30,781
                          
                          
                          
                          21,727
                          
                          
                          
                          -
                          
                          
                          
                          74,973Pre-tax
      income (loss), net ofnon-controlling
      interest
                          
                          
                          3,823
                          
                          
                          
                          10,692
                          
                          
                          
                          5,513
                          
                          
                          
                          (4,782
                          )
                          
                          
                          15,246Net
      loss ratio (2)
                          
                          
                          62.1
                          %
                          
                          
                          58.8
                          %
                          
                          
                          65.4
                          %
                          
                          
                          
                          
                          
                          
                          61.6
                          %Net
      expense ratio (2)
                          
                          
                          32.2
                          %
                          
                          
                          30.1
                          %
                          
                          
                          20.9
                          %
                          
                          
                          
                          
                          
                          
                          30.6
                          %Net
      combined ratio (2)
                          
                          
                          94.3
                          %
                          
                          
                          88.9
                          %
                          
                          
                          86.3
                          %
                          
                          
                          
                          
                          
                          
                          92.2
                          %





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


(2)  The
net loss ratio is calculated as incurred losses and LAE divided by net premiums
earned, each determined in accordance  with GAAP.  The
net  expense ratio is calculated for our business units that retain
100% of produced premium as total operating expenses  for the unit
offset by agency fee income divided by net premiums earned, each determined in
accordance with GAAP.  For the business units that do not retain 100%
of the produced premium, the net expense ratio is calculated as underwriting
expenses of the insurance company subsidiaries for the unit offset by agency fee
income, divided by net premiums earned, each determined in accordance with
GAAP.  Net combined ratio is calculated as the sum of the net loss
ratio and the net expense ratio.





33




Standard
Commercial Segment





Gross
premiums written for the Standard Commercial Segment were $36.9 million for the
six months ended June 30, 2010, which was $2.7 million, or 7%, less than the
$39.6 million reported for the same period in 2009.  Net premiums
written were $34.9 million for the six months ended June 30, 2010 as compared to
$37.4 million reported for the same period in 2009.  The decrease in
premium volume was predominately due to the deterioration of the general
economic environment, particularly in the construction industry, reducing the
available insured exposures.





Total
revenue for the Standard Commercial Segment of $35.3 million for the six months
ended June 30, 2010 was $2.9 million less than the $38.2 million reported during
the same period in 2009.  This 8% decrease in total revenue was mostly
due to decreased net premiums earned of $2.7 million.





Our
Standard Commercial Segment reported a pre-tax loss of $2.8 million for the six
months ended June 30, 2010 as compared to pre-tax income of $3.8 million for the
same period of 2009. Higher loss and LAE expenses of $4.8 million, primarily as
a result of weather related losses and unfavorable prior year development, and
decreased revenue contributed to this pre-tax loss reported for the six months
ended June 30, 2010. Partially offsetting the decline in results were lower
operating expenses of $1.1 million driven by lower information technology costs
and lower production related expenses.





The
Standard Commercial Segment reported a net loss ratio of 81.4% for the six
months ended June 30, 2010 as compared to 62.1% for 2009. The gross loss ratio
before reinsurance for the six months ended June 30, 2010 was 84.7% as compared
to the 61.0% reported for the same period of 2009.  The higher gross
and net loss ratio for the six months ended June 30, 2010 was impacted by an
increased number of large property losses including weather related
losses.  Further contributing to the higher gross and net loss ratio
during the six months ended June 30, 2010 was unfavorable loss reserve
development of $3.3 million, as compared to favorable development of $0.5
million for the same period during 2009.





Specialty
Commercial Segment





The $64.6
million of total revenue for the Specialty Commercial Segment during the six
months ended June 30, 2010 was $0.7 million lower than the $65.3 million
reported for the same period in 2009. This decrease in revenue was primarily
comprised of lower commission and fee income of $9.9 million primarily related
to the shift from a third party agency structure to an insurance underwriting
structure. Decreased finance charges of $0.2 million further contributed to this
decrease in revenue. This decrease in revenue was partially offset by increased
net premiums earned of $9.0 million as a result of the increased retention of
business in our E&S Commercial business unit and increased earned premium in
our Excess & Umbrella business unit and increased net investment income of
$0.4 million.





Pre-tax
income for the Specialty Commercial Segment of $7.3 million for the first six
months of 2010 was $3.4 million lower than the $10.7 million reported for the
same period in 2009. The decrease in pre-tax income was primarily due to
decreased revenue and higher loss and LAE expenses of $6.8 million. The decrease
in pre-tax income was partially offset by lower operating expenses of $4.3
million. The decrease in operating expense was the combined result of (i)
increased quota share ceding commission of $3.0 million in our Excess &
Umbrella business unit, (ii) lower other production related expenses of $1.3
million, and (iii) lower salary related expenses of $0.2 million, partially
offset by (iv) increased amortization of intangible assets of $0.2 million
related to our acquisition of CYR on June 5, 2009.





34


The Specialty Commercial Segment
reported a net loss ratio of 61.3% for the six months ended June 30, 2010 as
compared to 58.8% for the same period during 2009.  The higher net
loss ratio was impacted by (i) late emerging general liability claims and (ii)
increased volatility in large liability losses and weather related commercial
automobile claims in the current accident year. The Specialty Commercial Segment
reported $2.5 million of unfavorable prior year development for the six months
ended June 30, 2010 as compared to $2.7 million of unfavorable development for
the same period during 2009.





Personal
Segment





Net
premiums written for our Personal Segment increased $12.2 million during the
first six months of 2010 to $49.7 million compared to $37.5 million for the
first six months of 2009.  The increase in premium was due mostly to
continued geographic expansion.





Total
revenue for the Personal Segment increased 27% to $46.0 million for the first
six months of 2010 from $36.2 million for the first six months of
2009.  Higher earned premium of $8.9 million was the primary reason
for the increase in revenue for the period.  Increased finance charges
of $0.8 million further contributed to the increase in revenue during the first
six months of 2010.





Pre-tax
income for the Personal Segment was $3.8 million for the six months ended June
30, 2010 as compared to $5.5 million for the same period of
2009.  Increased revenue was offset by increased losses and LAE of
$8.5 million and increased operating expenses of $2.9 million due mostly to
increased production and salary expense related to continued geographic
expansion.





The
Personal Segment reported a net loss ratio of 71.9% for the six months ended
June 30, 2010 as compared to 65.4% for the same period of 2009.  The
increase in the net loss ratio was due primarily to continued geographic
expansion as the resulting growth has created a larger portion of new and
maturing business as compared to our mature legacy business.  Our
current accident year loss ratio reflects the near term loss ratio penalty
associated with this change in mix of seasoned versus less seasoned
business.  During the six months ended June 30, 2010, the Personal
Segment reported $0.7 million of unfavorable prior loss development driven
mostly by legal expense related to a 2001 bad faith claim as compared to $0.3
million favorable prior year development reported for the same period in
2009.





Corporate





Total
revenue for Corporate increased by $3.7 million for the six months ended June
30, 2010 as compared to the same period the prior year.  This increase
in total revenue was due primarily to gains of $5.4 million recognized on our
investment portfolio for the six months ended June 30, 2010 as compared to $0.5
million of gains recognized during the same period in 2009.  This
increase in revenue was offset by lower net investment income of $1.2 million
for the six months ended June 30, 2010 as compared to the same period of the
prior year.





Corporate
pre-tax loss was $0.5 million for the six months ended June 30, 2010 as compared
to a $4.8 million pre-tax loss for the same period the prior
year.  The decrease in pre-tax loss was the result
of  increased revenue, as well as lower operating expenses of $0.7
million due predominately to lower non-cash compensation expense of $0.5 million
related to lower stock option expense to directors and lower pension
costs.  Also contributing to the lower operating expenses were $0.4
million related to advances for a cancelled start up program during the first
six months of 2009.





35




Financial
Condition and Liquidity





Sources
and Uses of Funds





Our
sources of funds are from insurance-related operations, financing activities and
investing activities.  Major sources of funds from operations include
premiums collected (net of policy cancellations and premiums ceded),
commissions, and processing and service fees.  As a holding company,
Hallmark is dependent on dividend payments and management fees from its
subsidiaries to meet operating expenses and debt obligations.  As of
June 30, 2010, Hallmark had $13.5 million in unrestricted cash and invested
assets at the holding company. Unrestricted cash and invested assets of our
non-insurance subsidiaries were $1.3 million as of June 30, 2010.





AHIC,
domiciled in Texas, is limited in the payment of dividends in any 12-month
period, without the prior written consent of the Texas Department of Insurance,
to the greater of statutory net income for the prior calendar year or 10% of
statutory surplus as of the prior year end. Dividends may only be paid from
unassigned surplus funds.  HIC, domiciled in Arizona, is limited in
the payment of dividends to the lesser of 10% of prior year surplus or prior
year’s net investment income, without prior written approval from the Arizona
Department of Insurance.  HSIC, domiciled in Oklahoma, is limited in
the payment of dividends to the greater of 10% of prior year surplus or prior
year’s statutory net income, not including realized capital gains, without prior
written approval from the Oklahoma Insurance Department.  During 2010,
our insurance company subsidiaries’ ordinary dividend capacity is $19.4 million,
of which $15.9 million is available to Hallmark.  As a county mutual,
dividends from HCM are payable to policyholders. None of our insurance company
subsidiaries paid a dividend to Hallmark during the first six months of 2010 or
the 2009 fiscal year.





Comparison
of June 30, 2010 to December 31, 2009





On a
consolidated basis, our cash and investments (excluding restricted cash) at June
30, 2010 were $480.9 million compared to $439.9 million at December 31,
2009.  An increase in the fair market value of our investment
portfolio for the period and cash from operating activities were the primary
reasons for this increase.





Comparison of Six Months Ended June
30, 2010 and June 30, 2009





Net cash
provided by our consolidated operating activities was $17.4 million for the
first six months of 2010 compared to $28.8 million for the first six months of
2009.  The decrease in operating cash flow was primarily due to higher
paid losses and lower collected ceding commissions, partially offset by more
collected premiums.





Net cash
used in investing activities during the first six months of 2010 was $54.4
million as compared to $3.4 million for the same period in
2009.  Contributing to the increase in cash used in investing
activities were an increase of $87.5 million in purchases of debt and equity
securities, a $0.2 million increase  in purchases of property and
equipment and a higher net transfer into restricted cash of $3.4 million,
partially offset by (i) a $32.9 million increase in maturities, sales and
redemptions of investment securities during 2010, (ii) a $3.3 million payment of
contingent consideration during the first quarter 2009 to the sellers of the
subsidiaries comprising our E&S Commercial business unit,
and  (iii) a cash payment of $3.9 million during the second quarter of
2009, net of cash acquired, for the acquisition of a management agreement
controlling HCM.





36


Cash used
in financing activities during the first six months of 2010 was $0.1 million as
compared to $1.3 million for the same period of 2009.  The cash used
during the first six months of 2009 was primarily for the payment of a note
payable by our premium finance operation.





Credit
Facilities





Our First
Restated Credit Agreement with The Frost National Bank was most recently amended
effective May 27, 2010 to extend the term of the facility until May 27, 2012,
provide for the repayment of all amounts outstanding at termination on or before
April 30, 2015, reduce the revolving commitment to $5.0 million from $25.0
million and eliminate the credit sub-facility for premium finance operations.
This amendment further revised various affirmative and negative covenants and
changed the interest rate, at our election, to either the prime rate or LIBOR
plus 2.5%. We pay an annual average fee of 0.25% of the average daily unused
balance of the credit facility. 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, guarantees of all of our subsidiaries and the pledge of all of our
non-insurance company assets.  The revolving credit facility contains
covenants that, among other things, require us to maintain certain financial and
operating ratios and restrict certain distributions, transactions and
organizational changes.  As of June 30, 2010, we were in compliance
with or had obtained waivers of all of our covenants.  As of June 30,
2010, we had $2.8 million outstanding under this facility.





Trust
Preferred Securities





On June
21, 2005, we entered into a trust preferred securities transaction pursuant to
which we issued $30.9 million aggregate principal amount of subordinated debt
securities due in 2035.  To effect the transaction, we formed a
Delaware statutory trust, Hallmark Statutory Trust I (“Trust
I”).  Trust I issued $30.0 million of preferred securities to
investors and $0.9 million of common securities to us.  Trust I used
the proceeds from these issuances to purchase the subordinated debt
securities.  Our Trust I subordinated debt securities bear 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.  Trust I pays dividends on its preferred securities at the
same rate.  Under the terms of our Trust I subordinated debt
securities, we pay interest only each quarter and the principal of the note at
maturity.  The subordinated debt securities are uncollaterized and do
not require maintenance of minimum financial covenants. As of June 30, 2010, the
balance of our Trust I subordinated debt was $30.9 million.





On August
23, 2007, we entered into a trust preferred securities transaction pursuant to
which we issued $25.8 million aggregate principal amount of subordinated debt
securities due in 2037.  To effect the transaction, we formed a
Delaware statutory trust, Hallmark Statutory Trust II (“Trust
II”).  Trust II issued $25.0 million of preferred securities to
investors and $0.8 million of common securities to us.  Trust II used
the proceeds from these issuances to purchase the subordinated debt
securities.  Our Trust II subordinated debt securities bear an initial
interest rate of 8.28% until September 15, 2017, at which time interest will
adjust quarterly to the three-month LIBOR rate plus 2.90 percentage
points.  Trust II pays dividends on its preferred securities at the
same rate.  Under the terms of our Trust II subordinated debt
securities, we pay interest only each quarter and the principal of the note at
maturity.  The subordinated debt securities are uncollaterized and do
not require maintenance of minimum financial covenants. As of June 30, 2010, the
balance of our Trust II subordinated debt was $25.8 million.










Item
3.  Quantitative and Qualitative Disclosures About Market
Risk.





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





Item
4T.  Controls and Procedures.





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





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





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


37


PART
II


OTHER
INFORMATION





Item
      1.
            Legal
      Proceedings.





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





Item
      1A.
            Risk
      Factors.





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





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





None.





Item
      3.
            Defaults
      Upon Senior Securities.





None.





Item
      4.
            (Removed
      and Reserved.)





Item
      5.
            Other
      Information.





None.





Item
      6.
            Exhibits.





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





Exhibit
                Number
              
              Description3(a)
              
              Restated
      Articles of Incorporation of the registrant, as amended (incorporated by
      reference to Exhibit 3.1 to the registrant’s Registration Statement on
      Form S-1 [Registration No. 333-136414] filed September 8,
      2006).3(b)
              
              Amended
      and Restated By-Laws of the registrant (incorporated by reference to
      Exhibit 3.1 to the registrant’s Current Report on Form 8-K filed October
      1, 2007).4(a)
              
              Specimen
      certificate for Common Stock, $0.18 par value per share, of the registrant
      (incorporated by reference to Exhibit 4.1 to Amendment No. 1 to the
      registrant’s Registration Statement on Form S-1 [Registration No.
      333-136414] filed September 8,
2006).


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Exhibit
                        Number
                      
                      Description4(b)
                      
                      Indenture
      dated as of June 21, 2005, between Hallmark Financial Services, Inc. and
      JPMorgan Chase Bank, National Association (incorporated by reference to
      Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed June 27,
      2005).4(c)
                      
                      Amended
      and Restated Declaration of Trust of Hallmark Statutory Trust I dated as
      of June 21, 2005, among Hallmark Financial Services, Inc., as sponsor,
      Chase Bank USA, National Association, as Delaware trustee, and JPMorgan
      Chase Bank, National Association, as institutional trustee, and Mark
      Schwarz and Mark Morrison, as administrators (incorporated by reference to
      Exhibit 4.2 to the registrant’s Current Report on Form 8-K filed June 27,
      2005).4(d)
                      
                      Form
      of Junior Subordinated Debt Security Due 2035 (incorporated by reference
      to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed June
      27, 2005).4(e)
                      
                      Form
      of Capital Security Certificate (incorporated by reference to Exhibit 4.2
      to the registrant’s Current Report on Form 8-K filed June 27,
      2005).4(f)
                      
                      First
      Restated Credit Agreement dated January 27, 2006, between Hallmark
      Financial Services, Inc. and The Frost National Bank (incorporated by
      reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K
      filed February 2, 2006).4(g)
                      
                      Form
      of Registration Rights Agreement dated January 27, 2006, between Hallmark
      Financial Services, Inc. and Newcastle Special Opportunity Fund I, L.P.
      and Newcastle Special Opportunity Fund II, L.P. (incorporated by reference
      to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed
      February 2, 2006).4(h)
                      
                      Indenture
      dated as of August 23, 2007, between Hallmark Financial Services, Inc. and
      The Bank of New York Trust Company, National Association (incorporated by
      reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K
      filed August 24, 2007).4(i)
                      
                      Amended
      and Restated Declaration of Trust of Hallmark Statutory Trust II dated as
      of August 23, 2007, among Hallmark Financial Services, Inc., as sponsor,
      The Bank of New York (Delaware), as Delaware trustee, and The Bank of New
      York Trust Company, National Association, as institutional trustee, and
      Mark Schwarz and Mark Morrison, as administrators (incorporated by
      reference to Exhibit 4.2 to the registrant’s Current Report on Form 8-K
      filed August 24, 2007).4(j)
                      
                      Form
      of Junior Subordinated Debt Security Due 2037 (incorporated by reference
      to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed August
      24, 2007).4(k)
                      
                      Form
      of Capital Security Certificate (incorporated by reference to Exhibit 4.2
      to the registrant’s Current Report on Form 8-K filed August 24,
      2007).4(l)
                      
                      Seventh
      Restated Credit Agreement dated May 27, 2010, between Hallmark Financial
      Services, Inc. and The Frost National Bank (incorporated by reference to
      Exhibit 10.1 to the registrant’s Current Report on Form 8-K filed June 17,
      2010).31(a)
                      
                      Certification
      of principal executive officer required by Rule 13a-14(a) or Rule
      15d-14(a).31(b)
                      
                      Certification
      of principal financial officer required by Rule 13a-14(a) or Rule
      15d-14(a).




39




Exhibit
                  Number
                
                Description32(a)
                
                Certification
      of principal executive officer Pursuant to 18 U.S.C.
  1350.32(b)
                
                Certification
      of principal financial officer Pursuant to 18 U.S.C.
  1350.




SIGNATURES





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





HALLMARK
      FINANCIAL SERVICES, INC.
                    (Registrant)Date:  August
      16, 2010
                  
                  /s/ Mark J. MorrisonMark
      J. Morrison, Chief Executive Officer and President(Principal
      Executive Officer)Date:  August
      16, 2010
                  
                  /s/ Jeffrey R. PassmoreJeffrey
      R. Passmore, Chief Accounting Officer and Senior Vice
                    President(Principal
      Financial
Officer)


40