**UNITED
                STATES**
              
              **SECURITIES
                AND EXCHANGE COMMISSION****WASHINGTON,
                D.C. 20549****FORM
                10-Q**Quarterly
                report pursuant to Section 13 or 15(d) of theSecurities
                Exchange Act of 1934For
                the quarterly period ended March 31, 2007Commission
                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) 348-1600Indicate
                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. YesxNo
                oIndicate
                by check mark whether the registrant is a large accelerated filer,
                an
                accelerated filer, or a non-accelerated filer. See definition of
                “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the
                Exchange Act. (Check one):
              
              Large
                accelerated filer oAccelerated
                filer oNon-accelerated
                filer xIndicate
                by check mark whether the registrant is a shell company (as defined
                in
                Rule 12b-2 of the Exchange Act).
              Yes o  
                 NoxIndicate
                the number of shares outstanding of each of the issuer's classes
                of common
                stock, as of the latest practicable date: Common Stock, par value
                $.18 per
                share - 20,768,238 shares outstanding as of May 8,
                2007.








**PART
      I**


**FINANCIAL
      INFORMATION**





Item
      1.  Financial
      Statements




**INDEX
        TO FINANCIAL STATEMENTS**


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





2


**Hallmark
                Financial Services, Inc. and Subsidiaries****Consolidated
                Balance Sheets**($
                in thousands)




March
                31
              2007
            
            December
                31
              2006(unaudited)
            
            (audited)ASSETSInvestments:Debt
                securities, available-for-sale, at market value
            
            $
            133,122
            
            $
            125,784Equity
                securities, available-for-sale, at market value
            
            
            37,448
            
            
            4,580Short-term
                investments, available-for-sale, at market value
            
            
            10,325
            
            
            25,275Total
                investments
            
            
            180,895
            
            
            155,639Cash
                and cash equivalents
            
            
            75,823
            
            
            81,474Restricted
                cash and investments
            
            
            17,013
            
            
            31,815Premiums
                receivable
            
            
            49,497
            
            
            44,644Accounts
                receivable
            
            
            11,425
            
            
            13,223Prepaid
                reinsurance premium
            
            
            1,637
            
            
            1,629Reinsurance
                balances receivable
            
            
            5,083
            
            
            -Reinsurance
                recoverable
            
            
            5,283
            
            
            5,930Deferred
                policy acquisition costs
            
            
            18,929
            
            
            17,145Excess
                of cost over fair value of net assets acquired
            
            
            31,427
            
            
            31,427Intangible
                assets
            
            
            25,501
            
            
            26,074Prepaid
                expenses
            
            
            1,418
            
            
            1,769Other
                assets
            
            
            8,240
            
            
            5,184Total
                assets
            
            $
            432,171
            
            $
            415,953LIABILITIES
                AND STOCKHOLDERS' EQUITYLiabilities:Notes
                payable
            
            $
            36,016
            
            $
            35,763Structured
                settlements
            
            
            9,691
            
            
            24,587Unpaid
                losses and loss adjustment expenses
            
            
            90,840
            
            
            77,564Unearned
                premiums
            
            
            100,581
            
            
            91,606Unearned
                revenue
            
            
            4,508
            
            
            5,734Reinsurance
                balances payable
            
            
            -
            
            
            1,060Accrued
                agent profit sharing
            
            
            594
            
            
            1,784Accrued
                ceding commission payable
            
            
            7,206
            
            
            3,956Pension
                liability
            
            
            3,121
            
            
            3,126Deferred
                federal income taxes
            
            
            3,708
            
            
            2,310Current
                federal income tax payable
            
            
            1,684
            
            
            2,132Accounts
                payable and other accrued expenses
            
            
            18,108
            
            
            15,600Total
                liabilities
            
            
            276,057
            
            
            265,222Commitments
                and ContingenciesStockholders'
                equity:Common
                stock, $.18 par value (authorized 33,333,333 shares in 2007 and
                2006;issued
                20,776,066 shares in 2007 and 2006)
            
            
            3,740
            
            
            3,740Additional
                paid in capital
            
            
            117,983
            
            
            117,932Retained
                earnings
            
            
            36,450
            
            
            31,480Accumulated
                other comprehensive loss
            
            
            (1,982
            )
            
            (2,344
            )Treasury
                stock, at cost (7,828 shares in 2007 and 2006)
            
            
            (77
            )
            
            (77
            )Total
                stockholders' equity
            
            
            156,114
            
            
            150,731$
            432,171
            
            $
            415,953




The
                accompanying notes are an integral partof
                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
              March
                  312007
            
            2006Gross
                premiums written
            
            $
            64,658
            
            $
            47,735Ceded
                premiums written
            
            
            (3,887
            )
            
            (1,956
            )Net
                premiums written
            
            
            60,771
            
            
            45,779Change
                in unearned premiums
            
            
            (9,123
            )
            
            (17,345
            )Net
                premiums earned
            
            
            51,648
            
            
            28,434Investment
                income, net of expenses
            
            
            2,990
            
            
            2,357Realized
                gain (loss)
            
            
            53
            
            
            (83
            )Finance
                charges
            
            
            1,086
            
            
            687Commission
                and fees
            
            
            7,905
            
            
            12,264Processing
                and service fees
            
            
            272
            
            
            857Other
                income
            
            
            4
            
            
            4Total
                revenues
            
            
            63,958
            
            
            44,520Losses
                and loss adjustment expenses
            
            
            32,185
            
            
            16,690Other
                operating costs and expenses
            
            
            22,701
            
            
            21,026Interest
                expense
            
            
            786
            
            
            1,585Interest
                expense from amortization of discount on convertible notes
            
            
            -
            
            
            1,117Amortization
                of intangible asset
            
            
            573
            
            
            573Total
                expenses
            
            
            56,245
            
            
            40,991Income
                before tax
            
            
            7,713
            
            
            3,529Income
                tax expense
            
            
            2,743
            
            
            1,103Net
                income
            
            $
            4,970
            
            $
            2,426Common
                stockholders net income per share:Basic
            
            $
            0.24
            
            $
            0.14Diluted
            
            $
            0.24
            
            $
            0.14Convertible
                noteholders net income per share:Basic
            
            $
            n/a
            
            $
            0.14Diluted
            
            $
            n/a
            
            $
            0.14


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****March
                    31,****2007**
                
                **2006****Common
                    Stock**Balance,
                    beginning of period
                
                $
                3,740
                
                $
                2,606Issuance
                    of common stock upon option exercises
                
                
                -
                
                
                3Balance,
                    end of period
                
                
                3,740
                
                
                2,609**Additional
                    Paid-In Capital**Balance,
                    beginning of period
                
                
                117,932
                
                
                62,907Discount
                    on convertible notes, net of tax
                
                
                -
                
                
                6,032Equity
                    based compensation
                
                
                51
                
                
                24Exercise
                    of stock options
                
                
                -
                
                
                71Balance,
                    end of period
                
                
                117,983
                
                
                69,034**Retained
                    Earnings**Balance,
                    beginning of period
                
                
                31,480
                
                
                22,289Net
                    income
                
                
                4,970
                
                
                2,426Balance,
                    end of period
                
                
                36,450
                
                
                24,715**Accumulated
                    Other Comprehensive Loss**Balance,
                    beginning of period
                
                
                (2,344
                )
                
                (2,597
                )Unrealized
                    gains (losses) on securities, net of tax
                
                
                362
                
                
                (820
                )Balance,
                    end of period
                
                
                (1,982
                )
                
                (3,417
                )**Treasury
                    Stock**Balance,
                    beginning of period
                
                
                (77
                )
                
                (17
                )Acquisition
                    of treasury shares
                
                
                -
                
                
                (100
                )Exercise
                    of stock options
                
                
                -
                
                
                40Balance,
                    end of period
                
                
                (77
                )
                
                (77
                )**Stockholders'
                    Equity**
                
                $
                156,114
                
                $
                92,864Net
                    income
                
                $
                4,970
                
                $
                2,426Unrealized
                    gains (losses) on securities, net of tax
                
                
                362
                
                
                (820
                )**Comprehensive
                    Income**
                
                $
                5,332
                
                $
                1,606
 The
            accompanying notes are an integral part
 of
          the
          consolidated financial statements




5


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




Three
                  Months EndedMarch
                312007
            
            2006Cash
                flows from operating activities:Net
                income
            
            $
            4,970
            
            $
            2,426Adjustments
                to reconcile net income to cash provided by operating
                activities:Depreciation
                and amortization expense
            
            
            781
            
            
            800Amortization
                of beneficial conversion feature
            
            
            -
            
            
            1,117Amortization
                of discount on structured settlement
            
            
            104
            
            
            262Deferred
                federal income tax expense (benefit)
            
            
            1,200
            
            
            (1,756
            )Realized
                (gain) loss on investments
            
            
            (53
            )
            
            83Change
                in prepaid reinsurance premiums
            
            
            (8
            )
            
            (547
            )Change
                in premiums receivable
            
            
            (4,853
            )
            
            (17,430
            )Change
                in accounts receivable
            
            
            1,798
            
            
            (4,230
            )Change
                in deferred policy acquisition costs
            
            
            (1,784
            )
            
            (1,927
            )Change
                in unpaid losses and loss adjustment expenses
            
            
            13,276
            
            
            7,861Change
                in unearned premiums
            
            
            8,975
            
            
            17,882Change
                in unearned revenue
            
            
            (1,226
            )
            
            (2,230
            )Change
                in accrued agent profit sharing
            
            
            (1,190
            )
            
            (1,654
            )Change
                in reinsurance recoverable
            
            
            647
            
            
            (493
            )Change
                in reinsurance balances payable
            
            
            (6,143
            )
            
            (455
            )Change
                in current federal income tax payable/recoverable
            
            
            (449
            )
            
            1,008Change
                in accrued ceding commission payable
            
            
            3,250
            
            
            220Excess
                tax benefits from share-based payments
            
            
            -
            
            
            25Change
                in all other liabilities
            
            
            2,503
            
            
            7,644Change
                in all other assets
            
            
            (2,823
            )
            
            976Net
                cash provided by operating activities
            
            
            18,975
            
            
            9,582Cash
                flows from investing activities:Purchases
                of property and equipment
            
            
            (72
            )
            
            (106
            )Premium
                finance notes repaid, net of finance notes originated
            
            
            252
            
            
            (1,745
            )Acquisition
                of subsidiaries, net of cash acquired
            
            
            -
            
            
            (25,964
            )Change
                in restricted cash and investments
            
            
            14,802
            
            
            (25,138
            )Purchases
                of debt and equity securities
            
            
            (48,251
            )
            
            (4,532
            )Maturities
                and redemptions of investment securities
            
            
            8,643
            
            
            3,923Net
                redemptions of short-term investments
            
            
            15,000
            
            
            11,946Net
                cash used in investing activities
            
            
            (9,626
            )
            
            (41,616
            )Cash
                flows from financing activities:Proceeds
                from exercise of employee stock options
            
            
            -
            
            
            40Payment
                of structured settlement
            
            
            (15,000
            )
            
            -Proceeds
                from issuance of convertible debt
            
            
            -
            
            
            25,000Proceeds
                from note payable to related party
            
            
            -
            
            
            12,500Proceeds
                from revolving loan on credit facility
            
            
            -
            
            
            15,000Net
                cash (used in) provided by financing activities
            
            
            (15,000
            )
            
            52,540Increase
                (decrease) in cash and cash equivalents
            
            
            (5,651
            )
            
            20,506Cash
                and cash equivalents at beginning of period
            
            
            81,474
            
            
            44,528Cash
                and cash equivalents at end of period
            
            $
            75,823
            
            $
            65,034Supplemental
                Cash Flow Information:Interest
                paid
            
            $
            687
            
            $
            983Taxes
                paid
            
            $
            1,992
            
            $
            1,800




The
                accompanying notes are an integral partof
                the consolidated financial statements





6


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


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





**1.
      General**




Hallmark
      Financial Services, Inc. (“Hallmark” and, together with subsidiaries, “we,” “us”
or “our”) is an insurance holding company which, through its subsidiaries,
      engages in the sale of property/casualty insurance products to businesses and
      individuals. Our business involves marketing, distributing, underwriting and
      servicing commercial insurance in Texas, New Mexico, Idaho, Oregon, Montana,
      Louisiana, Oklahoma, Arkansas and Washington; marketing, distributing,
      underwriting and servicing non-standard personal automobile insurance in Texas,
      New Mexico, Arizona, Oklahoma, Arkansas, Idaho, Oregon and Washington;
      marketing, distributing, underwriting and servicing general aviation insurance
      in 47 states; and providing other insurance related services.





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





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





**2.
      Basis of Presentation**





Our
      unaudited consolidated financial statements included herein have been prepared
      in accordance with U.S. generally accepted accounting principles (“GAAP”) and
      include our accounts and the accounts of our subsidiaries. All significant
      intercompany accounts and transactions have been eliminated in consolidation.
      Certain information and footnote disclosures normally included in financial
      statements prepared in accordance with GAAP have been condensed or omitted
      pursuant to rules and regulations of the Securities and Exchange Commission
      (“SEC”) for interim financial reporting. These financial statements should be
      read in conjunction with our audited financial statements for the year ended
      December 31, 2006 included in our Annual Report on Form 10-K filed with the
      SEC.





The
      interim financial data as of March 31, 2007 and 2006 is unaudited. However,
      in
      the opinion of management, the interim data includes all adjustments, consisting
      only of normal recurring adjustments, necessary for a fair statement of the
      results for the interim periods. The results of operations for the period ended
      March 31, 2007 are not necessarily indicative of the operating results to be
      expected for the full year.




7





***Reclassification***





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





***Redesignation
      of Segments***





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




***Reverse
      Stock Split***





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





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





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





***Recently
      Issued Accounting Standards***





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





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




8





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





In
      February 2007, FASB issued Statement of Financial Accounting Standards No.
      159,
“The Fair Value Option for Financial Assets and Liabilities” (“SFAS 159”). SFAS
      159 permits entities to choose to measure many financial instruments and certain
      other items at fair value with changes in fair value included in current
      earnings. The election is made on specified election dates, can be made on
      an
      instrument-by- instrument basis, and is irrevocable. SFAS 159 is effective
      for
      financial statements issued for fiscal years beginning after November 15, 2007.
      We are currently evaluating the impact of adopting SFAS 159 on our financial
      statements.





**3.
      Business Combinations**





We
      account for business combinations using the purchase method of accounting.
      The
      cost of an acquired entity is allocated to the assets acquired (including
      identified intangible assets) and liabilities assumed based on their estimated
      fair values. The excess of the cost of an acquired entity over the net of the
      amounts assigned to assets acquired and liabilities assumed is an asset referred
      to as “excess of cost over net assets acquired” or “goodwill.” Indirect and
      general expenses related to business combinations are expensed as
      incurred.





**4.
      Supplemental Cash Flow Information**





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


TGA
              
              AerospaceOperating
                  Unit
              
              Operating
                  UnitFair
                  value of tangible assets excluding cashand
                  cash equivalents
              
              $
              52,906
              
              $
              8,391Fair
                  value of intangible assets acquired
              
              
              31,585
              
              
              12,575Capitalized
                  direct expenses
              
              
              232
              
              
              36Structured
                  settlement
              
              
              (23,542
              )
              
              -Liabilities
                  assumed
              
              
              (48,522
              )
              
              (7,697
              )Cash
                  and cash equivalents used in acquisitions
              
              $
              12,659
              
              $
              13,305




9




**5.
      Share-Based Payment Arrangements**





Our
      2005
      Long Term Incentive Plan (“2005 LTIP”) is a stock compensation plan for key
      employees and non-employee directors that was approved by the shareholders
      on
      May 26, 2005. There are 833,333 shares authorized for issuance under the 2005
      LTIP. Our 1994 Key Employee Long Term Incentive Plan (the “1994 Employee Plan”)
      and 1994 Non-Employee Director Stock Option Plan (the “1994 Director Plan”) both
      expired in 2004.





As
      of
      March 31, 2007, there were incentive stock options to purchase 197,499 shares
      of
      our common stock outstanding under the 2005 LTIP, leaving 635,834 shares
      reserved for future issuance. As of March 31, 2007, there were incentive stock
      options to purchase 93,168 shares outstanding under the 1994 Employee Plan
      and
      non-qualified stock options to purchase 23,334 shares outstanding under the
      1994
      Director Plan. In addition, as of March 31, 2007, there were outstanding
      non-qualified stock options to purchase 16,666 shares of our common stock
      granted to certain non-employee directors outside the 1994 Director Plan in
      lieu
      of fees for service on our board of directors in 1999. The exercise price of
      all
      such outstanding stock options is equal to the fair market value of our common
      stock on the date of grant.





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





A
      summary
      of the status of our stock options as of and changes during the year-to-date
      ended March 31, 2007 is presented below:





Average
              
              Contractual
              
              IntrinsicNumber
                  of
              
              Exercise
              
              Term
              
              ValueShares
              
              Price
              
              (Years)
              
              ($000)Outstanding
                  at January 1, 2007
              
              
              332,334
              
              $
              7.04Granted
              
              
              -
              
              $
              -Exercised
              
              
              -
              
              $
              -Forfeited
                  or expired
              
              
              (1,667
              )
              $
              5.10Outstanding
                  at March 31, 2007
              
              
              330,667
              
              $
              7.05
              
              
              6.1
              
              $
              1,649Exercisable
                  at March 31, 2007
              
              
              82,418
              
              $
              3.82
              
              
              3.2
              
              $
              678


10





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 EndedMarch
                  31,2007
              
              2006Intrinsic
                  value of options exercised
              
              $
              -
              
              $
              103Cost
                  of share-based payments (non-cash)
              
              $
              51
              
              $
              24Income
                  tax benefit of share-basedpayments
                  recognized in income
              
              $
              18
              
              $
              8





As
      of
      March 31, 2007 there was $0.9 million of total unrecognized compensation cost
      related to non-vested share-based compensation arrangements granted under our
      plans, of which $0.2 million is expected to be recognized in the remainder
      of
      2007, $0.3 million is expected to be recognized in each of 2008 and 2009 and
      $0.1 million is expected to be recognized in 2010.





The
      fair
      value of each stock option granted is estimated on the date of grant using
      the
      Black-Scholes option pricing model. Expected volatilities are based on
      historical volatility of our common stock. The risk- free interest rates
      for periods within the contractual term of the options are based on rates for
      U.S. Treasury Notes with maturity dates corresponding to the options expected
      lives on the dates of grant. There were no options granted in either the first
      quarters of 2007 or 2006.




**6.
      Segment Information**





The
      following is business segment information for the three months ended March
      31,
      2007 and 2006 (in thousands):


Three
                  Months EndedMarch
                  31,2007
              
              2006Revenues:Standard
                  Commercial Segment
              
              $
              21,767
              
              $
              17,540Specialty
                  Commercial Segment
              
              
              28,098
              
              
              15,968Personal
                  Segment
              
              
              13,773
              
              
              10,797Corporate
              
              
              320
              
              
              215Consolidated
              
              $
              63,958
              
              $
              44,520Pre-tax
                  income (loss):Standard
                  Commercial Segment
              
              $
              2,759
              
              $
              3,360Specialty
                  Commercial Segment
              
              
              4,686
              
              
              1,619Personal
                  Segment
              
              
              2,118
              
              
              2,051Corporate
              
              
              (1,850
              )
              
              (3,501
              )Consolidated
              
              $
              7,713
              
              $
              3,529





11




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





March
                31, 2007
            
            December
                31, 2006AssetsStandard
                Commercial Segment
            
            $
            126,369
            
            $
            130,764Specialty
                Commercial Segment
            
            
            199,855
            
            
            167,675Personal
                Segment
            
            
            90,183
            
            
            85,391Corporate
            
            
            15,764
            
            
            32,123$
            432,171
            
            $
            415,953





**7.
      Reinsurance**





We
      reinsure a portion of the risk we underwrite in order to control the exposure
      to
      losses and to protect capital resources. We cede to reinsurers a portion of
      these risks and pay premiums based upon the risk and exposure of the policies
      subject to such reinsurance. Ceded reinsurance involves credit risk and is
      generally subject to aggregate loss limits. Although the reinsurer is liable
      to
      us to the extent of the reinsurance ceded, we are ultimately liable as the
      direct insurer on all risks reinsured. Reinsurance recoverables are reported
      after allowances for uncollectible amounts. We monitor the financial condition
      of reinsurers on an ongoing basis and review our reinsurance arrangements
      periodically. Reinsurers are selected based on their financial condition,
      business practices and the price of their product offerings. Refer to Note
      6 of
      our Form 10-K for the year ended December 31, 2006 for more discussion of our
      reinsurance.





12




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




Three
                Months Ended
              March
                  31,2007
            
            2006Ceded
                earned premiums
            
            $
            3,879
            
            $
            1,397Reinsurance
                recoveries
            
            $
            1,095
            
            $
            776





**8.
      Notes Payable**





On
      June
      21, 2005, our newly formed trust entity completed a private placement of $30.0
      million of 30-year floating rate trust preferred securities. Simultaneously,
      we
      borrowed $30.9 million from the trust subsidiary and contributed $30.0 million
      to one of our insurance company subsidiaries in order to increase policyholder
      surplus. The note bears an initial interest rate of 7.725% until June 15, 2015,
      at which time interest will adjust quarterly to the three month LIBOR rate
      plus
      3.25 percentage points. As of March 31, 2007, the note balance was $30.9
      million.





On
      January 27, 2006, we borrowed $15.0 million under our revolving credit facility
      to fund the cash required to close the acquisition of the subsidiaries
      comprising our TGA Operating Unit. As of March 31, 2007, the balance on the
      revolving note was $2.8 million, which currently bears interest at 7.34% per
      annum. Also included in notes payable is $2.3 million outstanding under PAAC’s
      revolving credit facility, which currently bears 8.25% interest. (See Note
      10,
“Credit Facilities”). ****





**9.
      Structured Settlements**





In
      connection with the acquisition of the subsidiaries comprising our TGA Operating
      Unit, we recorded a payable for future guaranteed payments of $25.0 million
      discounted at 4.4%, the rate of two-year U.S. Treasuries (the only investment
      permitted on the trust account securing such future payments and which is
      classified in restricted cash and investments on our balance sheet). As of
      March
      31, 2007, the balance of the structured settlements was $9.7
      million.





**10.
      Credit Facilities**





On
      June
      29, 2005, we entered into a credit facility with The Frost National Bank. The
      credit facility was amended and restated on January 27, 2006 to a $20.0 million
      revolving credit facility, with a $5.0 million letter of credit sub-facility.
      Principal outstanding under the revolving credit facility generally bears
      interest at the three month Eurodollar rate plus 2.00%, payable quarterly in
      arrears. We pay letter of credit fees at the rate of 1.00% per annum. Our
      obligations under the revolving credit facility are secured by a security
      interest in the capital stock of all of our subsidiaries, guaranties of all
      of
      our subsidiaries and the pledge of substantially all of our assets. The
      revolving credit facility contains covenants which, among other things, require
      us to maintain certain financial and operating ratios and restrict certain
      distributions, transactions and organizational changes. The amended and restated
      credit agreement terminates on January 27, 2008. As of March 31, 2007, we were
      in compliance with all of our covenants. In the third quarter of 2005, we issued
      a $4.0 million letter of credit under this facility to collateralize certain
      obligations under the agency agreement between our HGA Operating Unit and
      Clarendon National Insurance Company effective July 1, 2004.




13




PAAC
      has
      a $5.0 million revolving credit facility with JPMorgan Chase Bank which
      terminates June 30, 2007. Principal outstanding under this revolving credit
      facility generally bears interest at 1% above the prime rate. PAAC’s obligations
      under this revolving credit facility are secured by its premium finance notes
      receivables. This revolving credit facility contains various restrictive
      covenants which, among other things, require PAAC to maintain minimum amounts
      of
      tangible net worth and working capital. As of March 31, 2007, PAAC was in
      compliance with of all of its covenants.





**11.
      Deferred Policy Acquisition Costs**





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


Three
                  Months EndedMarch
                  31,2007
              
              2006Deferred
              
              $
              (12,360
              )
              $
              (8,720
              )Amortized
              
              
              10,576
              
              
              6,793Net
              
              $
              (1,784
              )
              $
              (1,927
              )


**12.
      Earnings per Share**





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


Three
                  Months EndedMarch
                  31,2007
              
              2006Common
                  Stockholders:Weighted
                  average shares - basic
              
              
              20,768
              
              
              14,479Effect
                  of dilutive securities
              
              
              23
              
              
              131Weighted
                  average shares - assuming dilution
              
              
              20,791
              
              
              14,610Convertible
                  Noteholders:Weighted
                  average shares - basic and assuming dilution
              
              
              -
              
              
              3,255




For
      the
      three months ended March 31, 2007, 109,166 shares attributable to outstanding
      stock options were excluded from the calculation of diluted earnings per share
      because the exercise prices of the stock options were greater than the average
      price of the common shares and, therefore, their inclusion would have been
      anti-dilutive. For the three months ended March 31, 2006 no shares attributable
      to outstanding stock options were excluded from the calculation of diluted
      earnings per share. For the basic and diluted earnings per share calculation
      for
      the three months ended March 31, 2006, net income was allocated $2.0 million
      to
      common stockholders and $0.4 million to holders of convertible
      notes.





14




**13.
      Net Periodic Pension Cost**





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


Three
                  Months EndedMarch
                  31,2007
              
              2006Interest
                  cost
              
              $
              180
              
              $
              171Amortization
                  of net loss
              
              
              50
              
              
              40Expected
                  return on plan assets
              
              
              (161
              )
              
              (157
              )Net
                  periodic pension cost
              
              $
              69
              
              $
              54


We
      contributed $74 thousand and $32 thousand to our frozen defined benefit cash
      balance plan during the three months ended March 31, 2007 and 2006,
      respectively. Refer to Note 14 of our Form 10-K for the year ended December
      31,
      2006 for more discussion of our retirement plans.





15




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





*The
      following discussion should be read together with our consolidated financial
      statements and the notes thereto. This discussion contains forward-looking
      statements. Please see “Risks Associated with Forward-Looking Statements in this
      Form 10-Q” and “Item 1A. Risk Factors” for a discussion of some of the
      uncertainties, risks and assumptions associated with these
      statements.*





**Introduction**





Hallmark
      Financial Services, Inc. (“Hallmark” and, together with subsidiaries, “we”,
“us”, “our”) is an insurance holding company which, through its subsidiaries,
      engages in the sale of property/casualty insurance products to businesses and
      individuals. Our business involves marketing, distributing, underwriting and
      servicing commercial insurance in Texas, New Mexico, Idaho, Oregon, Montana,
      Louisiana, Oklahoma, Arkansas and Washington; marketing, distributing,
      underwriting and servicing non-standard personal automobile insurance in Texas,
      New Mexico, Arizona, Oklahoma, Arkansas, Idaho, Oregon and Washington;
      marketing, distributing, underwriting and servicing general aviation insurance
      in 47 states; and providing other insurance related services. We pursue our
      business activities through subsidiaries whose operations are organized into
      four operating units which are supported by our insurance company
      subsidiaries.




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




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





·
            ***Specialty
                Commercial Segment.***Our Specialty Commercial Segment includes the excess and surplus
                lines
                commercial property/casualty insurance products and services handled
                by
                our TGA Operating Unit and the general aviation insurance products
                and
                services handled by our Aerospace Operating Unit. Our TGA Operating
                Unit
                is comprised of our Texas General Agency, Inc., Pan American Acceptance
                Corporation and TGA Special Risk, Inc. subsidiaries. Our Aerospace
                Operating Unit is comprised of our Aerospace Insurance Managers,
                Inc.,
                Aerospace Special Risk, Inc. and Aerospace Claims Management Group,
                Inc.
                subsidiaries.





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





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





·
            ***American
                Hallmark Insurance Company of Texas********(“AHIC”)*******presently
                retains all of the risks on the commercial property/casualty policies
                marketed by our HGA Operating Unit and assumes a portion of the risks
                on
                the commercial property/casualty policies marketed by our TGA Operating
                Unit.




16




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





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





Effective
      January 1, 2006, our insurance company subsidiaries entered into a pooling
      arrangement, which was subsequently amended on December 15, 2006, pursuant
      to
      which AHIC retains 46% of the total net premiums written by all of our operating
      units, PIIC retains 34% of our total net premiums written and GSIC retains
      20%
      of our total net premiums written.




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




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





**Results
      of Operations**





**Management
      Overview.** During
      the three months ended March 31, 2007, our total revenues were $64.0 million,
      representing a 44% increase over the $44.5 million in total revenues for the
      same period of 2006. Increased retention of business produced by our Specialty
      Commercial Segment was the primary cause of the increase in revenue. Specialty
      Commercial Segment revenues increased $12.1 million, or 76% during the three
      months ended March 31, 2007 as compared to the same period of 2006. The
      retention of business produced by the Standard Commercial Segment that was
      previously retained by third parties was the primary reason for that segment’s
      $4.2 million increase in revenue for the three months ended March 31, 2007.
      Earned premiums from our Personal Segment contributed $2.9 million to the
      increase in revenue for the three months ended March 31, 2007.





We
      reported net income of $5.0 million for the three months ended March 31, 2007,
      representing a 105% increase over net income of $2.4 million in the same period
      of 2006. On a diluted basis, net income to the common stockholders was $0.24
      per
      share for the three months ended March 31, 2007 as compared to $0.14 per share
      for the same period in 2006. During the three months ended March 31, 2006,
      we
      recorded $1.1 million of interest expense from amortization attributable to
      the
      deemed discount on convertible promissory notes issued in January, 2006 and
      subsequently converted to common stock during the second quarter of 2006. The
      increase in net income was also attributable to the results of our Specialty
      Commercial Segment, as well as additional investment income from a larger
      investment portfolio resulting from increased retention of premiums. These
      increases were partially offset by lower results from our Standard Commercial
      Segment.


17


**First
      Quarter 2007 as Compared to First Quarter 2006**





The
      following is additional business segment information for the three months ended
      March 31, 2007 and 2006 (in thousands):


**Three
                  Months Ended March 31, 2007****Standard**
              
              **Specialty****Commercial**
              
              **Commercial**
              
              **Personal****Segment**
              
              **Segment**
              
              **Segment**
              
              **Corporate**
              
              **Consolidated**Produced
                  premium
              
              
              23,550
              
              
              39,357
              
              
              15,076
              
              
              -
              
              
              77,983Gross
                  premiums written
              
              
              23,481
              
              
              26,101
              
              
              15,076
              
              
              -
              
              
              64,658Ceded
                  premiums written
              
              
              (2,635
              )
              
              (1,252
              )
              
              -
              
              
              -
              
              
              (3,887
              )Net
                  premiums written
              
              
              20,846
              
              
              24,849
              
              
              15,076
              
              
              -
              
              
              60,771Change
                  in unearned premiums
              
              
              (924
              )
              
              (5,756
              )
              
              (2,443
              )
              
              
              
              
              (9,123
              )Net
                  premiums earned
              
              
              19,922
              
              
              19,093
              
              
              12,633
              
              
              -
              
              
              51,648Total
                  revenues
              
              
              21,767
              
              
              28,098
              
              
              13,773
              
              
              320
              
              
              63,958Losses
                  and loss adjustment expenses
              
              
              12,841
              
              
              11,081
              
              
              8,267
              
              
              (4
              )
              
              32,185Pre-tax
                  income
              
              
              2,759
              
              
              4,686
              
              
              2,118
              
              
              (1,850
              )
              
              7,713Net
                  loss ratio (1)
              
              
              64.5
              %
              
              58.0
              %
              
              65.4
              %
              
              
              
              
              62.3
              %Net
                  expense ratio (1)
              
              
              28.0
              %
              
              31.5
              %
              
              23.6
              %
              
              
              
              
              28.2
              %Net
                  combined ratio(1)
              
              
              92.5
              %
              
              89.5
              %
              
              89.0
              %
              
              
              
              
              90.5
              %
  **Three
                  Months Ended March 31, 2006****Standard**
              
              **Specialty****Commercial**
              
              **Commercial**
              
              **Personal****Segment**
              
              **Segment**
              
              **Segment**
              
              **Corporate**
              
              **Consolidated**Produced
                  premium
              
              
              23,664
              
              
              39,005
              
              
              11,099
              
              
              -
              
              
              73,768Gross
                  premiums written
              
              
              23,464
              
              
              13,172
              
              
              11,099
              
              
              -
              
              
              47,735Ceded
                  premiums written
              
              
              (1,785
              )
              
              (171
              )
              
              -
              
              
              -
              
              
              (1,956
              )Net
                  premiums written
              
              
              21,679
              
              
              13,001
              
              
              11,099
              
              
              -
              
              
              45,779Change
                  in unearned premiums
              
              
              (7,367
              )
              
              (8,622
              )
              
              (1,356
              )
              
              -
              
              
              (17,345
              )Net
                  premiums earned
              
              
              14,312
              
              
              4,379
              
              
              9,743
              
              
              -
              
              
              28,434Total
                  revenues
              
              
              17,540
              
              
              15,968
              
              
              10,797
              
              
              215
              
              
              44,520Losses
                  and loss adjustment expenses
              
              
              7,800
              
              
              2,812
              
              
              6,086
              
              
              (8
              )
              
              16,690Pre-tax
                  income
              
              
              3,360
              
              
              1,619
              
              
              2,051
              
              
              (3,501
              )
              
              3,529Net
                  loss ratio (1)
              
              
              54.5
              %
              
              64.2
              %
              
              62.5
              %
              
              
              
              
              58.7
              %Net
                  expense ratio (1)
              
              
              30.8
              %
              
              27.3
              %
              
              26.7
              %
              
              
              
              
              28.8
              %Net
                  combined ratio(1)
              
              
              85.3
              %
              
              91.5
              %
              
              89.2
              %
              
              
              
              
              87.5
              %




(1)
      The
      net loss ratio is calculated as incurred losses and loss adjustment expenses
      divided by net premiums earned, each determined in accordance with GAAP. The
      net
      expense ratio is calculated as total underwriting expenses of our insurance
      company subsidiaries, including allocated overhead expenses and offset by agency
      fee income, divided by net premiums earned, each determined in accordance with
      GAAP. Net combined ratio is calculated as the sum of the net loss ratio and
      the
      net expense ratio.


18


***Standard
      Commercial Segment***





Gross
      premiums written for the Standard Commercial Segment were $23.5 million for
      the
      three months ended March 31, 2007 and 2006. Net premiums written were $20.8
      million for the three months ended March 31, 2007 as compared to $21.7 million
      for the same period in 2006. Increased competition and rate pressure kept
      premium volume by the Standard Commercial Segment relatively flat during the
      first quarter of 2007 in comparison to the same period the prior year.





Total
      revenue for the Standard Commercial Segment of $21.8 million for the first
      quarter of 2007 was $4.2 million more than the $17.5 million reported in the
      first quarter of 2006. This 24% increase in total revenue was primarily due
      to
      increased net premiums earned of $5.6 million for the quarter. Increased net
      investment income contributed an additional $0.3 million to the increase in
      revenue for the quarter. These increases in revenue were partially offset by
      lower ceding commission revenue of $1.2 million and lower processing and service
      fees of $0.5 million, in both cases due to the shift from a third party agency
      structure to an insurance underwriting structure.





Pre-tax
      income for our Standard Commercial Segment of $2.8 million for the first quarter
      of 2007 decreased $0.6 million, or 18%, from the $3.4 million reported for
      the
      first quarter of 2006. This decrease in pre-tax income was primarily
      attributable to an increase in the net loss ratio to 64.5% for the first quarter
      of 2007 as compared to 54.5% for the same period of 2006. Two factors driving
      this increase in the net loss ratio were: (1) a decrease in incurred losses
      inuring to our reinsurance coverage, and (2) an increase in our estimate of
      the
      gross incurred loss ratio for the current accident year to reflect a softening
      rate environment in the standard commercial property/casualty marketplace.
      We
      did not recognize any prior accident year development in the first quarter
      of
      either 2007 or 2006. The Standard Commercial Segment reported net expense ratios
      of 28.0% and 30.8% for the first quarters of 2007 and 2006, respectively. The
      net expense ratio for 2006 was higher primarily due to costs to assume from
      Clarendon National Insurance Company the unearned premium previously produced
      by
      the Standard Commercial Segment.





***Specialty
      Commercial Segment***





Gross
      premiums written for the Specialty Commercial Segment for the first quarter
      of
      2007 were $26.1 million or 98% more than the $13.2 million reported for the
      same
      period in 2006. Net premiums written for the first quarter of 2007 were $24.8
      million or 91% more than the $13.0 million reported for the same period in
      2006.
      The increase in premium volume was due to the increased retention of business
      produced by our TGA Operating Unit from 50% in 2006 to 60% in 2007, as well
      as
      the retention of the business produced by our Aerospace Operating Unit beginning
      in the third quarter of 2006.





Total
      revenue for the Specialty Commercial Segment of $28.1 million for the first
      quarter of 2007 was $12.1 million more than the $16.0 million reported in the
      first quarter of 2006. This 76% increase in revenue was largely due to increased
      net premiums earned of $14.7 million for the quarter as a result of the
      increased retention of business. Increased net investment income contributed
      an
      additional $0.7 million to the increase in revenue for the quarter. These
      increases in revenue were partially offset by lower ceding commission revenue
      of
      $3.2 million due to the shift from a third party agency structure to an
      insurance underwriting structure.




Pre-tax
      income for the Specialty Commercial Segment of $4.7 million for the first
      quarter of 2007 increased $3.1 million, or 189%, from the $1.6 million reported
      for the same period in 2006. Increased revenue, discussed above, was the primary
      reason for the increase in pre-tax income, partially offset by increased losses
      and loss adjustment expenses of $8.3 million and increased operating expenses
      of
      $0.8 million due mostly to production related expenses that are directly related
      to increased earned premium. The Specialty Commercial Segment reported a net
      loss ratio of 58.0% for the first quarter of 2007 as compared to 64.2% for
      the
      first quarter of 2006. Better than anticipated development of the 2006 accident
      year was the primary cause for the decrease. The
      Specialty Commercial Segment reported a net expense ratio of 31.5% for the
      first
      quarter of 2007 as compared to 27.3% for the first quarter of 2006. The increase
      in the net expense ratio was primarily due to the recognition of runoff premium
      in GSIC during the first quarter of 2006 that was produced prior to our
      acquisition of the subsidiaries now comprising our TGA Operating Unit. This
      had
      the effect of depressing the first quarter 2006 expense ratio.




19





***Personal
      Segment***





Net
      premium written for our Personal Segment increased $4.0 million during the
      first
      quarter of 2007 to $15.1 million compared to $11.1 million in the first quarter
      of 2006. The increase in premium was due mostly to geographic expansion that
      began in 2006.





Total
      revenue for the Personal Segment increased 27.6% to $13.8 million for the first
      quarter of 2007 from $10.8 million for the same period in 2006. Higher earned
      premium of $2.9 million was the primary reason for the increase in revenue
      for
      the period. Increased finance charges were offset by lower investment income
      due
      to the reallocation of capital to other segments for their increased retention
      of premium.





Pre-tax
      income for the Personal Segment was $2.1 million for the first quarters of
      both
      2007 and 2006. The increased revenue, as discussed above, was offset by
      increased losses and loss adjustment expenses of $2.2 million and increased
      operating expenses of $0.7 million due mostly to production related expenses
      directly related to the increased earned premium. The Personal Segment reported
      a net loss ratio of 65.4% for the first quarter of 2007 as compared to 62.5%
      for
      the same period in 2006. A competitive pricing environment and the new business
      impact associated with geographic expansion were the primary reasons for the
      increase in the net loss ratio. We did not recognize any prior accident year
      development in either the first quarter 2007 or 2006. The Personal Segment
      reported a net expense ratio of 23.6% for the first quarter of 2007 as compared
      to 26.7% for the first quarter of 2006. The decrease in the expense ratio was
      mainly due to increased finance charges in relation to earned premium, as well
      as fixed overhead allocations to PIIC in each period.





***Corporate***





Corporate
      revenue increased $0.1 million for the first quarter of 2007 as compared to
      the
      same period in 2006. The increase was primarily due to gains realized on our
      investment portfolio.





Corporate
      pre-tax loss was $1.9 million for the first quarter of 2007 as compared to
      $3.5
      million for the same period in 2006. The decreased loss was mostly due to the
      absence of the $1.1 million of interest expense incurred in the first quarter
      of
      2006 from amortization attributable to the deemed discount on convertible
      promissory notes issued in January, 2006. Also contributing to the decreased
      loss was lower interest expense of $0.8 million due to the permanent financing
      of debt used to acquire the subsidiaries comprising the Specialty Commercial
      Segment in 2006. Most of this debt was either converted to equity in the second
      quarter of 2006 or repaid with proceeds from our public equity offering in
      the
      fourth quarter of 2006.


20


**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 March 31, 2007, Hallmark had $2.4 million
      in unrestricted cash and invested assets. Unrestricted cash and invested assets
      of our non-insurance subsidiaries were $4.9 million as of March 31, 2007.





AHIC,
      domiciled in Texas, is limited in the payment of dividends in any 12-month
      period, without the prior written consent of the Texas Department of Insurance,
      to the greater of statutory net income for the prior calendar year or 10% of
      statutory surplus as of the prior year end. Dividends may only be paid from
      unassigned surplus funds. PIIC, domiciled in Arizona, is limited in the payment
      of dividends to the lesser of 10% of prior year surplus or prior year’s net
      investment income, without prior written approval from the Arizona Department
      of
      Insurance. GSIC, domiciled in Oklahoma, is limited in the payment of dividends
      to the greater of 10% of prior year surplus or prior year’s statutory net
      income, without prior written approval from the Oklahoma Insurance Department.
      During 2007, our insurance company subsidiaries’ ordinary dividend capacity is
      $12.4 million. None of our insurance company subsidiaries paid a dividend to
      Hallmark during the first three months of 2007 or the 2006 fiscal
      year.





***Comparison
      of March 31, 2007 to December 31, 2006***





On
      a
      consolidated basis, our cash and investments (excluding restricted cash and
      investments) at March 31, 2007 were $256.7 million compared to $237.1 million
      at
      December 31, 2006. Net cash provided by our operating activities was the primary
      driver of the increase in our cash and investments for the three months ended
      March 31, 2007.




***Comparison
      of Three Months Ended March 31, 2007 and March 31,
      2006***





Net
      cash
      provided by our consolidated operating activities was $19.0 million for the
      first three months of 2007 compared to $9.6 million for the first three months
      of 2006. The increase in operating cash flow was primarily due to increased
      collected premiums resulting from increased retained premium volume, partially
      offset by additional retained paid losses and loss adjustment expenses and
      additional paid operating expenses.





Cash
      used
      in investing activities during the first three months of 2007 was $9.6 million
      as compared to $41.6 million for the same period in 2006. The higher cash used
      in investing activities during the first quarter of 2006 was mostly due to
      the
      acquisitions of the subsidiaries comprising our Specialty Commercial Segment
      which used $26.0 million, net of cash acquired. Also contributing to the higher
      cash used by investing activities during the first quarter of 2006 was the
      funding of $25.0 million to a trust account securing the future guaranteed
      payments to the sellers of the subsidiaries comprising our TGA Operating Unit,
      of which $15.0 million was withdrawn to make the first installment payment
      in
      the first quarter of 2007. Increases in maturities and redemptions of investment
      securities of $4.7 million and net redemptions of short-term investments of
      $3.1
      million, as well as net premium finance notes originated of $0.3 million during
      the first quarter of 2007 versus net premium finance notes repaid of $1.7
      million during the first quarter of 2006, also contributed to the reduction
      in
      cash used in investing activities. Partially offsetting these reductions was
      a
      $43.7 million increase in purchases of debt and equity securities.




21





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




***Credit
      Facilities***





****  On
      June
      29, 2005, we entered into a credit facility with The Frost National Bank. The
      credit facility was amended and restated on January 27, 2006 to a $20.0 million
      revolving credit facility, with a $5.0 million letter of credit sub-facility.
      Principal outstanding under the revolving credit facility generally bears
      interest at the three month Eurodollar rate plus 2.00%, payable quarterly in
      arrears. We pay letter of credit fees at the rate of 1.00% per annum. Our
      obligations under the revolving credit facility are secured by a security
      interest in the capital stock of all of our subsidiaries, guaranties of all
      of
      our subsidiaries and the pledge of substantially all of our assets. The
      revolving credit facility contains covenants which, among other things, require
      us to maintain certain financial and operating ratios and restrict certain
      distributions, transactions and organizational changes. The amended and restated
      credit agreement terminates on January 27, 2008. As of March 31, 2007, there
      was
      $2.8 million outstanding under our revolving credit facility, and we were in
      compliance with all of our covenants. In the third quarter of 2005, we issued
      a
      $4.0 million letter of credit under this facility to collateralize certain
      obligations under the agency agreement between our HGA Operating Unit and
      Clarendon National Insurance Company effective July 1, 2004.




PAAC
      has
      a $5.0 million revolving credit facility with JPMorgan Chase Bank which
      terminates June 30, 2007. Principal outstanding under this revolving credit
      facility generally bears interest at 1% above the prime rate. PAAC’s obligations
      under this revolving credit facility are secured by its premium finance notes
      receivables. This revolving credit facility contains various restrictive
      covenants which, among other things, require PAAC to maintain minimum amounts
      of
      tangible net worth and working capital. As of March 31, 2007, $2.3 million
      was
      outstanding under this revolving credit facility and PAAC was in compliance
      with
      or had obtained waivers of all of its covenants.




22





***Trust
      Preferred Securities***





On
      June
      21, 2005, our newly formed trust entity completed a private placement of $30.0
      million of 30-year floating rate trust preferred securities. Simultaneously,
      we
      borrowed $30.9 million from the trust subsidiary and contributed $30.0 million
      to AHIC in order to increase policyholder surplus. The note bears an initial
      interest rate of 7.725% until June 15, 2015, at which time interest will adjust
      quarterly to the three month LIBOR rate plus 3.25 percentage points. As of
      March
      31, 2007, the note balance was $30.9 million.





***Structured
      Settlements***





In
      connection with our acquisition of the subsidiaries now comprising our TGA
      Operating Unit, we issued to the sellers promissory notes in the aggregate
      principal amount of $23.7 million, of which $14.2 million was paid on January
      2,
      2007, and $9.5 million is due on or before January 1, 2008. We are also
      obligated to pay to the sellers an additional $1.3 million, of which $0.8
      million was paid on January 2, 2007 and an additional $0.5 million is due on
      or
      before January 1, 2008, in consideration of the sellers’ compliance with certain
      restrictive covenants, including a covenant not to compete for a period of
      five
      years after closing. We secured payment of these future installments of purchase
      price and restrictive covenant consideration by depositing $25.0 million in
      a
      trust account for the benefit of the sellers. We recorded a payable for future
      guaranteed payments to the sellers of $25.0 million discounted at 4.4%, the
      rate
      of two-year U.S. Treasuries purchased as the only permitted investment of the
      trust account. The trust account is classified in restricted cash and
      investments on our balance sheet. As of March 31, 2007, the balance of the
      structured settlements was $9.7 million.





***Conclusion***





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




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





As
      of
      March 31, 2007, there had been no material changes in the market risks described
      in the Company’s Form 10-K for the year ended December 31, 2006.





**Item
      4. Controls and Procedures.**





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




23





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





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





24


**PART
      II**


**OTHER
      INFORMATION**





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





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





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





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





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





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





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





·
            the
                uncertainties that inherently characterize estimates and
                assumptions;





·
            our
                selection and application of appropriate pricing techniques;
                and





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





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





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





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




25





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





We
      maintain loss reserves to cover our estimated ultimate liability for unpaid
      losses and loss adjustment expenses for reported and unreported claims incurred
      as of the end of each accounting period. Reserves represent management’s
      estimates of what the ultimate settlement and administration of claims will
      cost
      and are not reviewed by an independent actuary. These estimates, which generally
      involve actuarial projections, are based on management’s assessment of facts and
      circumstances then known, as well as estimates of future trends in claim
      severity and frequency, judicial theories of liability, and other factors.
      These
      variables are affected by both internal and external events, such as changes
      in
      claims handling procedures, inflation, judicial trends and legislative changes.
      Many of these factors are not quantifiable. Additionally, there may be a
      significant reporting lag between the occurrence of an event and the time it
      is
      reported to us. The inherent uncertainties of estimating reserves are greater
      for certain types of liabilities, particularly those in which the various
      considerations affecting the type of claim are subject to change and in which
      long periods of time may elapse before a definitive determination of liability
      is made. Reserve estimates are continually refined in a regular and ongoing
      process as experience develops and further claims are reported and settled.
      Adjustments to reserves are reflected in the results of the periods in which
      such estimates are changed. For example, a 1% change in March 31, 2007 unpaid
      losses and loss adjustment expenses would have produced a $0.9 million change
      to
      pretax earnings. Our gross loss and loss adjustment expense reserves totaled
      $90.8 million at March 31, 2007. Our loss and loss adjustment expense reserves,
      net of reinsurance recoverables, were $85.6 million at that date. Because
      setting reserves is inherently uncertain, there can be no assurance that the
      current reserves will prove adequate.





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





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





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




26





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





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





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





The
      property/casualty insurance market, our primary source of revenue, is highly
      competitive and, except for regulatory considerations, has very few barriers
      to
      entry. According to A.M. Best, there were 3,173 property/casualty insurance
      companies and 2,065 property/casualty insurance groups operating in North
      America as of July 24, 2006. Our HGA Operating Unit competes with a variety
      of
      large national standard commercial lines carriers such as The Hartford, Zurich
      North America, St. Paul Travelers and Safeco, as well as numerous smaller
      regional companies. The primary competition for our TGA Operating Unit’s excess
      and surplus lines products includes such carriers as Atlantic Casualty Insurance
      Company, Colony Insurance Company, Burlington Insurance Company, Penn America
      Insurance Group and, to a lesser extent, a number of national standard lines
      carriers such as Zurich North America and The Hartford. Our Aerospace Operating
      Unit considers its primary competitors to be Houston Casualty Corp., Phoenix
      Aviation, W. Brown & Company, AIG and London Aviation Underwriters. Although
      our Phoenix Operating Unit competes with large national insurers such as
      Allstate, State Farm and Progressive, as a participant in the non-standard
      personal automobile marketplace its competition is most directly associated
      with
      numerous regional companies and managing general agencies. Our competitors
      include entities which have, or are affiliated with entities which have, greater
      financial and other resources than we have. In addition, competitors may attempt
      to increase market share by lowering rates. In that case, we could experience
      reductions in our underwriting margins, or sales of our insurance policies
      could
      decline as customers purchase lower-priced products from our competitors. Losing
      business to competitors offering similar products at lower prices, or having
      other competitive advantages, could adversely affect our results of
      operations.




27





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





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





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





We
      purchase reinsurance by transferring, or ceding, part of the risk we have
      assumed to a reinsurance company in exchange for part of the premium we receive
      in connection with the risk. Although reinsurance makes the reinsurer liable
      to
      us to the extent the risk is transferred or ceded to the reinsurer, it does
      not
      relieve us of our liability to our policyholders. Accordingly, we bear credit
      risk with respect to our reinsurers. We cannot assure that our reinsurers will
      pay all of our reinsurance claims, or that they will pay our claims on a timely
      basis. At March 31, 2007, we had a total of $5.3 million due us from reinsurers
      for recovery of losses. The largest amount due us from a single reinsurer as
      of
      March 31, 2007 was $0.8 million from GE Reinsurance Corp. If any of our
      reinsurers are unable or unwilling to pay amounts they owe us in a timely
      fashion, we could suffer a significant loss or a shortage of liquidity, which
      would have a material adverse effect on our business and results of
      operations.





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





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





28




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





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





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





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





· approval
        of policy forms and rates;





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





·     
licensing
      of
      insurers and their agents;





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





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





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





·     
requiring
      certain methods of accounting;





·     
periodic
      examinations of operations and finances;





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





·     
the
      use of
      credit history in underwriting and rating;




29





·     
limitations
      on the ability to charge policy fees;





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





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





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





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





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





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





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





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





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




30





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





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





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





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





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





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





Our
      results of operations depend in part on the performance of our invested assets.
      As of March 31, 2007, 80% of our investment portfolio was invested in
      fixed-income securities. Certain risks are inherent in connection with
      fixed-income securities, including loss upon default and price volatility in
      reaction to changes in interest rates and general market factors. In general,
      the fair market value of a portfolio of fixed-income securities increases or
      decreases inversely with changes in the market interest rates, while net
      investment income realized from future investments in fixed-income securities
      increases or decreases along with interest rates. In addition, 9% of our
      fixed-income securities have call or prepayment options. This subjects us to
      reinvestment risk should interest rates fall and issuers call their securities.
      Furthermore, actual net investment income and/or cash flows from investments
      that carry prepayment risk, such as mortgage-backed and other asset-backed
      securities, may differ from those anticipated at the time of investment as
      a
      result of interest rate fluctuations. An investment has prepayment risk when
      there is a risk that cash flows from the repayment of principal might occur
      earlier than anticipated because of declining interest rates or later than
      anticipated because of rising interest rates.




31





In
      addition to the general risks described above, although 85% of our fixed-income
      portfolio is investment-grade, our fixed-income securities are nonetheless
      subject to credit risk. If any of the issuers of our fixed-income securities
      suffer financial setbacks, the ratings on the fixed-income securities could
      fall
      (with a concurrent fall in market value) and, in a worst case scenario, the
      issuer could default on its obligations. Future changes in the fair market
      value
      of our available-for-sale securities will be reflected in other comprehensive
      income. Similar treatment is not available for liabilities. Therefore, interest
      rate fluctuations could adversely affect our stockholders’ equity, total
      comprehensive income and/or our cash flows.





As
      of
      March 31, 2007, 20% of our investment portfolio was invested in equity
      securities. The equity securities that we hold are subject to economic loss
      from
      a decline in share price. As a result, the values of these equity securities
      are
      heavily influenced by the specific financial prospects of each issuer. In
      addition, general economic conditions, stock market conditions and other factors
      may adversely affect the value of our equity investments. As a result, we may
      not realize the desired returns on our equity investments, may incur losses
      on
      sales of our equity securities or may be required to write down the value of
      our
      equity securities.





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





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





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





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




32




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





The
      following five states accounted for 80% of our gross written premiums for the
      three months ended March 31, 2007: Texas (43%), Oregon (14%), New Mexico (10%),
      Idaho (7%) and Arizona (6%). Our revenues and profitability are subject to
      the
      prevailing regulatory, legal, economic, political, demographic, competitive,
      weather and other conditions in the principal states in which we do business.
      Changes in any of these conditions could make it less attractive for us to
      do
      business in such states and would have a more pronounced effect on us compared
      to companies that are more geographically diversified. In addition, our exposure
      to severe losses from localized natural perils, such as windstorms or
      hailstorms, is increased in those areas where we have written significant
      numbers of property/casualty insurance policies.





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





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





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





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





33




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





None.





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





None.





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





None.





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





None.





34




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





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




Exhibit
              Number
            
            Description3(a)
            
            Articles
                of Incorporation of the registrant, as amended (incorporated by reference
                to Exhibit 3(a) to the registrant’s Annual Report on Form 10-KSB for the
                fiscal year ended December 31, 1993).3(b)
            
            Restated
                By-Laws of the registrant, as amended (incorporated by reference
                to
                Exhibit 3.2 to the registrant’s Registration Statement on Form S-1 filed
                August 8, 2006).4(a)
            
            Specimen
                certificate for Common Stock, $0.18 par value per share, of the registrant
                (incorporated by reference to Exhibit 4.1 to the registrant’s
                Post-Effective Amendment No. 1 to Registration Statement on Form
                S-1 filed
                October 3, 2006).4(b)
            
            Indenture
                dated as of June 21, 2005, between Hallmark Financial Services, Inc.
                and
                JPMorgan Chase Bank, National Association (incorporated by reference
                to
                Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed June 27,
                2005).4(c)
            
            Amended
                and Restated Declaration of Trust of Hallmark Statutory Trust I dated
                as
                of June 21, 2005, among Hallmark Financial Services, Inc., as sponsor,
                Chase Bank USA, National Association, as Delaware trustee, and JPMorgan
                Chase Bank, National Association, as institutional trustee, and Mark
                Schwarz and Mark Morrison, as administrators (incorporated by reference
                to
                Exhibit 4.2 to the registrant’s Current Report on Form 8-K filed June 27,
                2005).4(d)
            
            Form
                of Junior Subordinated Debt Security Due 2035 (incorporated by reference
                to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed June
                27, 2005).4(e)
            
            Form
                of Capital Security Certificate (incorporated by reference to Exhibit
                4.2
                to the registrant’s Current Report on Form 8-K filed June 27,
                2005).




35




Exhibit
              Number
            
            Description4(f)
            
            Form
                of Registration Rights Agreement dated January 27, 2006, between
                Hallmark
                Financial Services, Inc. and Newcastle Special Opportunity Fund I,
                L.P.
                and Newcastle Special Opportunity Fund II, L.P. (incorporated by
                reference
                to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed
                February 2, 2006).31(a)
            
            Certification
                of principal executive officer required by Rule 13a-14(a) orRule
                15d-14(a).31(b)
            
            Certification
                of principal financial officer required by Rule 13a-14(a) orRule
                15d-14(a).32(a)
            
            Certification
                of principal executive officer Pursuant to 18 U.S.C.
                1350.32(b)
            
            Certification
                of principal financial officer Pursuant to 18 U.S.C. 1350.





36


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:
                May 10, 2007
            
            /s/
                Mark J. MorrisonMark
                J. Morrison, Chief Executive Officer and President
              (Principal
                Executive Officer)




Date:
                May 10, 2007
            
            /s/
                  Jeffrey R. PassmoreJeffrey
                  R. Passmore, Chief Accounting Officer and Senior Vice
                  President(Principal Financial
                Officer)




37