UNITED
STATES





SECURITIES
AND EXCHANGE COMMISSION





WASHINGTON,
D.C. 20549





FORM
10-Q





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





Securities
Exchange Act of 1934





For the
quarterly period ended June 30, 2009





Commission
file number 001-11252





Hallmark
Financial Services, Inc.





(Exact
name of registrant as specified in its charter)





Nevada
                                
                                87-0447375(State
      or other jurisdiction of
                                
                                (I.R.S.
      EmployerIncorporation
      or organization)
                                
                                Identification
      No.)777 Main Street, Suite 1000, Fort Worth,
      Texas
                                
                                76102(Address
      of principal executive offices)
                                
                                (Zip
      Code)





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





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





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





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


Large
      accelerated filer  ̈
              Accelerated
      filer  ̈Non-accelerated
      filer  ̈
              Smaller
      reporting company  x




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





Indicate
the number of shares outstanding of each of the issuer's classes of common
stock, as of the latest practicable date: Common Stock, par value $.18 per share
– 20,863,670 shares outstanding as of August 13, 2009.





PART
I


FINANCIAL
INFORMATION





Item
1.            Financial
Statements





INDEX
TO FINANCIAL STATEMENTS





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




2





Hallmark
Financial Services, Inc. and Subsidiaries


Consolidated
Balance Sheets


($ in
thousands)





June
      30
                    
                    
                    December
      312009
                    
                    
                    2008(unaudited)ASSETSInvestments:Debt
      securities, available-for-sale, at fair value
                    
                    $
                    274,677
                    
                    
                    $
                    268,513Equity
      securities, available-for-sale, at fair value
                    
                    
                    38,718
                    
                    
                    
                    25,003Total
      investments
                    
                    
                    313,395
                    
                    
                    
                    293,516Cash
      and cash equivalents
                    
                    
                    83,150
                    
                    
                    
                    59,134Restricted
      cash and cash equivalents
                    
                    
                    9,848
                    
                    
                    
                    8,033Premiums
      receivable
                    
                    
                    52,598
                    
                    
                    
                    44,032Accounts
      receivable
                    
                    
                    3,752
                    
                    
                    
                    4,531Receivable
      for securities
                    
                    
                    71
                    
                    
                    
                    1,031Prepaid
      reinsurance premiums
                    
                    
                    6,467
                    
                    
                    
                    1,349Reinsurance
      recoverable
                    
                    
                    14,072
                    
                    
                    
                    8,218Deferred
      policy acquisition costs
                    
                    
                    23,432
                    
                    
                    
                    19,524Excess
      of cost over fair value of net assets acquired
                    
                    
                    41,080
                    
                    
                    
                    41,080Intangible
      assets, net
                    
                    
                    30,705
                    
                    
                    
                    28,969Current
      federal income tax recoverable
                    
                    
                    2,169
                    
                    
                    
                    696Deferred
      federal income taxes
                    
                    
                    3,254
                    
                    
                    
                    6,696Prepaid
      expenses
                    
                    
                    993
                    
                    
                    
                    1,007Other
      assets
                    
                    
                    18,498
                    
                    
                    
                    20,582Total
      assets
                    
                    $
                    603,484
                    
                    
                    $
                    538,398LIABILITIES AND STOCKHOLDERS'
      EQUITYLiabilities:Notes
      payable
                    
                    $
                    59,502
                    
                    
                    $
                    60,919Reserves
      for unpaid losses and loss adjustment expenses
                    
                    
                    180,366
                    
                    
                    
                    156,363Unearned
      premiums
                    
                    
                    126,595
                    
                    
                    
                    102,192Unearned
      revenue
                    
                    
                    605
                    
                    
                    
                    2,037Accrued
      agent profit sharing
                    
                    
                    1,318
                    
                    
                    
                    2,151Accrued
      ceding commission payable
                    
                    
                    8,600
                    
                    
                    
                    8,605Pension
      liability
                    
                    
                    4,388
                    
                    
                    
                    4,309Payable
      for securities
                    
                    
                    4,246
                    
                    
                    
                    3,606Accounts
      payable and other accrued expenses
                    
                    
                    6,749
                    
                    
                    
                    18,067Total
      liabilities
                    
                    
                    392,369
                    
                    
                    
                    358,249Commitments
      and Contingencies (Note 15)Redeemable
      non-controlling interest
                    
                    
                    891
                    
                    
                    
                    737Stockholders'
      equity:Common
      stock, $.18 par value (authorized 33,333,333 shares in 2009 and 2008;
      issued 20,871,498 shares in 2009 and 20,841,782 shares in
      2008)
                    
                    
                    3,757
                    
                    
                    
                    3,751Capital
      in excess of par value
                    
                    
                    120,736
                    
                    
                    
                    119,928Retained
      earnings
                    
                    
                    84,972
                    
                    
                    
                    72,242Accumulated
      other comprehensive income (loss)
                    
                    
                    836
                    
                    
                    
                    (16,432
                    )Treasury
      stock, at cost (7,828 shares in 2009 and 2008)
                    
                    
                    (77
                    )
                    
                    
                    (77
                    )Total
      stockholders’ equity
                    
                    
                    210,224
                    
                    
                    
                    179,412$
                    603,484
                    
                    
                    $
                    538,398





The
accompanying notes are an integral part


of the
consolidated financial statements


3





Hallmark
Financial Services, Inc. and Subsidiaries


Consolidated
Statements of Operations


(Unaudited)


($ in
thousands, except per share amounts)





Three
      Months Ended
                      
                      
                      Six
      Months EndedJune 30
                      
                      
                      June 302009
                      
                      
                      2008
                      
                      
                      2009
                      
                      
                      2008Gross
      premiums written
                      
                      $
                      75,053
                      
                      
                      $
                      63,115
                      
                      
                      $
                      146,532
                      
                      
                      $
                      127,352Ceded
      premiums written
                      
                      
                      (3,260
                      )
                      
                      
                      (2,006
                      )
                      
                      
                      (5,492
                      )
                      
                      
                      (4,010
                      )Net
      premiums written
                      
                      
                      71,793
                      
                      
                      
                      61,109
                      
                      
                      
                      141,040
                      
                      
                      
                      123,342Change
      in unearned premiums
                      
                      
                      (9,474
                      )
                      
                      
                      (1,345
                      )
                      
                      
                      (19,291
                      )
                      
                      
                      (4,334
                      )Net
      premiums earned
                      
                      
                      62,319
                      
                      
                      
                      59,764
                      
                      
                      
                      121,749
                      
                      
                      
                      119,008Investment
      income, net of expenses
                      
                      
                      3,467
                      
                      
                      
                      3,957
                      
                      
                      
                      7,736
                      
                      
                      
                      7,582Net
      realized gains
                      
                      
                      867
                      
                      
                      
                      232
                      
                      
                      
                      519
                      
                      
                      
                      1,091Finance
      charges
                      
                      
                      1,449
                      
                      
                      
                      1,323
                      
                      
                      
                      2,799
                      
                      
                      
                      2,587Commission
      and fees
                      
                      
                      2,627
                      
                      
                      
                      6,669
                      
                      
                      
                      8,816
                      
                      
                      
                      13,153Processing
      and service fees
                      
                      
                      11
                      
                      
                      
                      36
                      
                      
                      
                      26
                      
                      
                      
                      78Other
      income
                      
                      
                      4
                      
                      
                      
                      3
                      
                      
                      
                      9
                      
                      
                      
                      6Total
      revenues
                      
                      
                      70,744
                      
                      
                      
                      71,984
                      
                      
                      
                      141,654
                      
                      
                      
                      143,505Losses
      and loss adjustment expenses
                      
                      
                      38,131
                      
                      
                      
                      36,029
                      
                      
                      
                      74,973
                      
                      
                      
                      71,533Other
      operating expenses
                      
                      
                      23,878
                      
                      
                      
                      23,608
                      
                      
                      
                      47,628
                      
                      
                      
                      47,073Interest
      expense
                      
                      
                      1,150
                      
                      
                      
                      1,186
                      
                      
                      
                      2,309
                      
                      
                      
                      2,371Amortization
      of intangible assets
                      
                      
                      782
                      
                      
                      
                      573
                      
                      
                      
                      1,496
                      
                      
                      
                      1,146Total
      expenses
                      
                      
                      63,941
                      
                      
                      
                      61,396
                      
                      
                      
                      126,406
                      
                      
                      
                      122,123Income
      before tax
                      
                      
                      6,803
                      
                      
                      
                      10,588
                      
                      
                      
                      15,248
                      
                      
                      
                      21,382Income
      tax expense
                      
                      
                      2,519
                      
                      
                      
                      3,178
                      
                      
                      
                      4,181
                      
                      
                      
                      6,707Net
      income
                      
                      
                      4,284
                      
                      
                      
                      7,410
                      
                      
                      
                      11,067
                      
                      
                      
                      14,675Less:
      Net income attributable to
    non-controlling  interest
                      
                      
                      9
                      
                      
                      
                      -
                      
                      
                      
                      2
                      
                      
                      
                      -Net
      income attributable to Hallmark Financial Services, Inc.
                      
                      $
                      4,275
                      
                      
                      $
                      7,410
                      
                      
                      $
                      11,065
                      
                      
                      $
                      14,675Net income per share
      attributable to Hallmark Financial Services,
      Inc. common stockholders:Basic
                      
                      $
                      0.20
                      
                      
                      $
                      0.36
                      
                      
                      $
                      0.53
                      
                      
                      $
                      0.71Diluted
                      
                      $
                      0.20
                      
                      
                      $
                      0.35
                      
                      
                      $
                      0.53
                      
                      
                      $
                      0.70





The
accompanying notes are an integral part


of the
consolidated  financial statements


4





Hallmark
Financial Services, Inc. and Subsidiaries


Consolidated
Statements of Stockholders' Equity and Comprehensive Income


(Unaudited)


($ in
thousands)





Three
      Months Ended
                      
                      
                      Six
      Months EndedJune
      30,
                      
                      
                      June
      30,2009
                      
                      
                      2008
                      
                      
                      2009
                      
                      
                      2008Common
      StockBalance,
      beginning of period
                      
                      $
                      3,757
                      
                      
                      $
                      3,746
                      
                      
                      $
                      3,751
                      
                      
                      $
                      3,740Issuance
      of common stock upon option exercises
                      
                      
                      -
                      
                      
                      
                      1
                      
                      
                      
                      6
                      
                      
                      
                      7Balance,
      end of period
                      
                      
                      3,757
                      
                      
                      
                      3,747
                      
                      
                      
                      3,757
                      
                      
                      
                      3,747Additional
      Paid-In CapitalBalance,
      beginning of period
                      
                      
                      120,200
                      
                      
                      
                      119,120
                      
                      
                      
                      119,928
                      
                      
                      
                      118,459Accretion
      of redeemable noncontrolling interest
                      
                      
                      (78
                      )
                      
                      
                      -
                      
                      
                      
                      (172
                      )
                      
                      
                      -Equity
      based compensation
                      
                      
                      614
                      
                      
                      
                      226
                      
                      
                      
                      876
                      
                      
                      
                      773Exercise
      of stock options
                      
                      
                      -
                      
                      
                      
                      23
                      
                      
                      
                      104
                      
                      
                      
                      137Balance,
      end of period
                      
                      
                      120,736
                      
                      
                      
                      119,369
                      
                      
                      
                      120,736
                      
                      
                      
                      119,369Retained
      EarningsBalance,
      beginning of period
                      
                      
                      79,032
                      
                      
                      
                      66,608
                      
                      
                      
                      72,242
                      
                      
                      
                      59,343Adjustment
      to opening balance, net of tax (note 2)
                      
                      
                      1,665
                      
                      
                      
                      -
                      
                      
                      
                      1,665
                      
                      
                      
                      -Adjusted
      balance, beginning of period
                      
                      
                      80,697
                      
                      
                      
                      66,608
                      
                      
                      
                      73,907
                      
                      
                      
                      59,343Net
      income attributable to Hallmark Financial Services, Inc.
                      
                      
                      4,275
                      
                      
                      
                      7,410
                      
                      
                      
                      11,065
                      
                      
                      
                      14,675Balance,
      end of period
                      
                      
                      84,972
                      
                      
                      
                      74,018
                      
                      
                      
                      84,972
                      
                      
                      
                      74,018Accumulated
      Other Comprehensive Income (Loss)Balance,
      beginning of period
                      
                      
                      (12,357
                      )
                      
                      
                      (3,086
                      )
                      
                      
                      (16,432
                      )
                      
                      
                      (1,844
                      )Adjustment
      to opening balance, net of tax (note 2)
                      
                      
                      (1,665
                      )
                      
                      
                      -
                      
                      
                      
                      (1,665
                      )
                      
                      
                      -Adjusted
      balance, beginning of period
                      
                      
                      (14,022
                      )
                      
                      
                      (3,086
                      )
                      
                      
                      (18,097
                      )
                      
                      
                      (1,844
                      )Additional
      minimun pension liability, net of tax
                      
                      
                      79
                      
                      
                      
                      11
                      
                      
                      
                      159
                      
                      
                      
                      21Net
      unrealized holding gains (losses) arising during period
                      
                      
                      15,138
                      
                      
                      
                      (783
                      )
                      
                      
                      19,324
                      
                      
                      
                      (1,905
                      )Reclassification
      adjustment for losses included in net income
                      
                      
                      (359
                      )
                      
                      
                      (898
                      )
                      
                      
                      (550
                      )
                      
                      
                      (1,028
                      )Balance,
      end of period
                      
                      
                      836
                      
                      
                      
                      (4,756
                      )
                      
                      
                      836
                      
                      
                      
                      (4,756
                      )Treasury
      StockBalance,
      beginning and end of period
                      
                      
                      (77
                      )
                      
                      
                      (77
                      )
                      
                      
                      (77
                      )
                      
                      
                      (77
                      )Total
      Stockholders' Equity
                      
                      $
                      210,224
                      
                      
                      $
                      192,301
                      
                      
                      $
                      210,224
                      
                      
                      $
                      192,301Net
      income
                      
                      $
                      4,275
                      
                      
                      $
                      7,410
                      
                      
                      $
                      11,065
                      
                      
                      $
                      14,675Additional
      minimum pension liablilty, net of tax
                      
                      
                      79
                      
                      
                      
                      11
                      
                      
                      
                      159
                      
                      
                      
                      21Net
      unrealized holding gains (losses) arising during period
                      
                      
                      15,138
                      
                      
                      
                      (783
                      )
                      
                      
                      19,324
                      
                      
                      
                      (1,905
                      )Reclassification
      adjustment for losses included in net income
                      
                      
                      (359
                      )
                      
                      
                      (898
                      )
                      
                      
                      (550
                      )
                      
                      
                      (1,028
                      )Comprehensive
      income
                      
                      
                      19,133
                      
                      
                      
                      5,740
                      
                      
                      
                      29,998
                      
                      
                      
                      11,763Less:
      Comprehensive income attributable to non-controlling
    interest
                      
                      
                      9
                      
                      
                      
                      -
                      
                      
                      
                      2
                      
                      
                      
                      -Comprehensive
      income attributable toHallmark
      Financial Services, Inc.
                      
                      $
                      19,124
                      
                      
                      $
                      5,740
                      
                      
                      $
                      29,996
                      
                      
                      $
                      11,763




The
accompanying notes are an integral part


of the
consolidated  financial statements


5





Hallmark
Financial Services, Inc. and Subsidiaries


Consolidated
Statements of Cash Flows


(Unaudited)


($ in
thousands)





Six
      Months EndedJune
      302009
                      
                      
                      2008Cash
      flows from operating activities:Net
      income
                      
                      $
                      11,067
                      
                      
                      $
                      14,675Adjustments
      to reconcile net income to cash provided by operating
      activities:Depreciation
      and amortization expense
                      
                      
                      1,930
                      
                      
                      
                      1,517Deferred
      federal income tax benefit
                      
                      
                      (391
                      )
                      
                      
                      (641
                      )Realized
      gain on investments
                      
                      
                      (519
                      )
                      
                      
                      (1,091
                      )Change
      in prepaid reinsurance premiums
                      
                      
                      (5,118
                      )
                      
                      
                      (1,057
                      )Change
      in premiums receivable
                      
                      
                      (8,591
                      )
                      
                      
                      (1,064
                      )Change
      in accounts receivable
                      
                      
                      791
                      
                      
                      
                      (38
                      )Change
      in deferred policy acquisition costs
                      
                      
                      (3,908
                      )
                      
                      
                      (895
                      )Change
      in reserves for unpaid losses and loss adjustment expenses
                      
                      
                      24,003
                      
                      
                      
                      19,036Change
      in unearned premiums
                      
                      
                      24,403
                      
                      
                      
                      4,371Change
      in unearned revenue
                      
                      
                      (1,432
                      )
                      
                      
                      (696
                      )Change
      in accrued agent profit sharing
                      
                      
                      (833
                      )
                      
                      
                      (1,509
                      )Change
      in reinsurance recoverable
                      
                      
                      (5,854
                      )
                      
                      
                      1,161Change
      in current federal income tax recoverable
                      
                      
                      (1,473
                      )
                      
                      
                      (1,127
                      )Change
      in accrued ceding commission payable
                      
                      
                      (5
                      )
                      
                      
                      90Change
      in all other liabilities
                      
                      
                      (9,197
                      )
                      
                      
                      (4,258
                      )Change
      in all other assets
                      
                      
                      3,909
                      
                      
                      
                      1,275Net
      cash provided by operating activities
                      
                      
                      28,782
                      
                      
                      
                      29,749Cash
      flows from investing activities:Purchases
      of property and equipment
                      
                      
                      (634
                      )
                      
                      
                      (273
                      )Change
      in restricted cash and cash equivalents
                      
                      
                      (460
                      )
                      
                      
                      6,241Purchases
      of debt and equity securities
                      
                      
                      (35,833
                      )
                      
                      
                      (552,067
                      )Maturities,
      sales and redemptions of investment securities
                      
                      
                      40,734
                      
                      
                      
                      414,144Payment
      for acquisition of subsidiaries
                      
                      
                      (7,246
                      )
                      
                      
                      -Net
      cash used in investing activities
                      
                      
                      (3,439
                      )
                      
                      
                      (131,955
                      )Cash
      flows from financing activities:Proceeds
      from exercise of employee stock options
                      
                      
                      110
                      
                      
                      
                      143Repayment
      of notes payable
                      
                      
                      (1,417
                      )
                      
                      
                      (222
                      )Distribution
      of non-controlling interest
                      
                      
                      (20
                      )
                      
                      
                      -Repayment
      of structured settlement
                      
                      
                      -
                      
                      
                      
                      (10,000
                      )Net
      cash used in financing activities
                      
                      
                      (1,327
                      )
                      
                      
                      (10,079
                      )Increase
      (decrease) in cash and cash equivalents
                      
                      
                      24,016
                      
                      
                      
                      (112,285
                      )Cash
      and cash equivalents at beginning of period
                      
                      
                      59,134
                      
                      
                      
                      145,884Cash
      and cash equivalents at end of period
                      
                      $
                      83,150
                      
                      
                      $
                      33,599Supplemental
      cash flow information:Interest
      paid
                      
                      $
                      2,345
                      
                      
                      $
                      2,387Taxes
      paid
                      
                      $
                      6,045
                      
                      
                      $
                      8,402Supplemental
      schedule of non-cash investing activities:Change
      in receivable for securities related to investment disposals settled after
      the balance sheet date
                      
                      $
                      961
                      
                      
                      $
                      27,195Change
      in payable for securities related to investment purchases settled after
      the balance sheet date
                      
                      $
                      (695
                      )
                      
                      $
                      (88,000
                      )





The
accompanying notes are an integral part


of the
consolidated financial statements


6





Hallmark
Financial Services, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements (Unaudited)





1.
General





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





We pursue our business activities
through subsidiaries whose operations are organized into five operating units
which are supported by three of our insurance company
subsidiaries.  Our AHIS Operating Unit handles standard lines
commercial insurance products and services and is comprised of American Hallmark
Insurance Services, Inc. and Effective Claims Management, Inc.  Our
TGA Operating Unit handles primarily excess and surplus lines commercial
insurance products and services and is comprised of TGA Insurance Managers,
Inc., Pan American Acceptance Corporation (“PAAC”) and TGA Special Risk,
Inc.  Our Aerospace Operating Unit handles general aviation insurance
products and services and is comprised of Aerospace Insurance Managers, Inc.,
Aerospace Special Risk, Inc. and Aerospace Claims Management Group,
Inc.  Our Heath XS Operating Unit handles excess commercial automobile
and commercial umbrella risks on both an admitted and non-admitted basis and is
comprised of Heath XS, LLC and Hardscrabble Data Solutions, LLC. Our Personal
Lines Operating Unit handles non-standard personal automobile insurance and
complementary personal insurance products and services and is comprised of
American Hallmark General Agency, Inc. and Hallmark Claims Services, Inc., both
of which do business as Hallmark Insurance Company.





These five operating units are
segregated into three reportable industry segments for financial accounting
purposes.  The Standard Commercial Segment presently consists solely
of the AHIS Operating Unit and the Personal Segment presently consists solely of
our Personal Lines Operating Unit.  The Specialty Commercial Segment
includes our TGA Operating Unit, Aerospace Operating Unit, and Heath XS
Operating Unit.





2.
Basis of Presentation





Our
unaudited consolidated financial statements included herein have been prepared
in accordance with U.S. generally accepted accounting principles (“GAAP”) and
include our accounts and the accounts of our subsidiaries.  All
significant intercompany accounts and transactions have been eliminated in
consolidation.  Certain information and footnote disclosures normally
included in financial statements prepared in accordance with GAAP have been
condensed or omitted pursuant to rules and regulations of the Securities and
Exchange Commission (“SEC”) for interim financial reporting.  These
unaudited consolidated financial statements should be read in conjunction with
our audited consolidated financial statements for the year ended December 31,
2008 included in our Annual Report on Form 10-K filed with the SEC.





The
interim financial data as of June 30, 2009 and 2008 is
unaudited.  However, in the opinion of management, the interim data
includes all adjustments, consisting only of normal recurring adjustments,
necessary for a fair statement of the results for the interim
periods.  The results of operations for the period ended June 30, 2009
are not necessarily indicative of the operating results to be expected for the
full year.


7





Redeemablenon-controlling
interest





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





Reclassification





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





Income
taxes





Income taxes are accounted for under
the asset and liability method.  At December 31, 2008, we had recorded
a valuation allowance of $4.5 million primarily attributable to capital losses
from investments, impairments and unrealized losses in excess of
gains.  The valuation allowance was decreased by $4.5 million during
the six months ended June 30, 2009, due to changes in unrealized and realized
gains and losses on investments.  The changes in valuation allowance
attributable to continuing operations and to accumulated comprehensive income
were approximately $0.4 million and $4.1 million, respectively, for the six
months ended June 30, 2009.





Immaterial Correction of an
Error





We maintain catastrophe
reinsurance for business produced by both our AHIS and TGA Operating
Units.  Prior to July 1, 2007, the premium for our catastrophe
reinsurance contracts was based on all business produced by both operating
units.  The premium for our catastrophe reinsurance contract which
became effective July 1, 2007 is based only on business produced in
Texas.  However in error for the periods between July 1, 2007 to June
30, 2008 we continued to record ceded premium for this coverage as if the
premium was based on all business produced by the AHIS and TGA Operating
Units.  This understated our earned premium for each quarter from July
1, 2007 through June 30, 2008.





We have corrected our prior period’s
financial statements and notes to reflect the reduction of ceded
premium.  Because the error was not material to any prior year
financial statements, the corrections to prior periods will be presented in
future filings, pursuant to SEC Staff Accounting Bulletin No. 108, “Considering
the Effects of Prior Year Misstatements when Quantifying Misstatements in
Current Year Financial Statements.”


8


The following table presents the
effect of the correction on our previously reported consolidated statements of
operations for the three months and six months ended June 30, 2008 (in
thousands, except per share amounts).





For
      the Three
                                
                                
                                For
      the SixMonths
      Ended
                                
                                
                                Months
      EndedJune
      30,
                                
                                
                                June
      30,2008
                                
                                
                                2008As previously reported:Ceded
      premiums written
                                
                                $
                                (2,327
                                )
                                
                                $
                                (4,659
                                )Net
      premiums written
                                
                                
                                60,788
                                
                                
                                
                                122,693Net
      premiums earned
                                
                                
                                59,443
                                
                                
                                
                                118,359Total
      revenues
                                
                                
                                71,663
                                
                                
                                
                                142,856Income
      before tax
                                
                                
                                10,267
                                
                                
                                
                                20,733Income
      tax expense
                                
                                
                                3,066
                                
                                
                                
                                6,480Net
      income
                                
                                $
                                7,201
                                
                                
                                $
                                14,253Common
      stockholders net income per share:Basic
                                
                                $
                                0.35
                                
                                
                                $
                                0.69Diluted
                                
                                $
                                0.34
                                
                                
                                $
                                0.68Adjustments:Ceded
      premiums written
                                
                                $
                                321
                                
                                
                                $
                                649Income
      tax expense
                                
                                
                                112
                                
                                
                                
                                227Net
      income impact
                                
                                $
                                209
                                
                                
                                $
                                422As revised:Ceded
      premiums written
                                
                                $
                                (2,006
                                )
                                
                                $
                                (4,010
                                )Net
      premiums written
                                
                                
                                61,109
                                
                                
                                
                                123,342Net
      premiums earned
                                
                                
                                59,764
                                
                                
                                
                                119,008Total
      revenues
                                
                                
                                71,984
                                
                                
                                
                                143,505Income
      before tax
                                
                                
                                10,588
                                
                                
                                
                                21,382Income
      tax expense
                                
                                
                                3,178
                                
                                
                                
                                6,707Net
      income
                                
                                $
                                7,410
                                
                                
                                $
                                14,675Common
      stockholders net income per share:Basic
                                
                                $
                                0.36
                                
                                
                                $
                                0.71Diluted
                                
                                $
                                0.35
                                
                                
                                $
                                0.70




9





The
following table presents the effect of the correction on our previously reported
consolidated balance sheet as of June 30, 2008 (in thousands).





As
      previouslyreported
                    
                    
                    Adjustment
                    
                    
                    As
      revisedBalances as of June 30,
2008Prepaid
      reinsurance premiums
                    
                    $
                    682
                    
                    
                    $
                    1,317
                    
                    
                    $
                    1,999Current
      federal income tax recoverable
                    
                    
                    724
                    
                    
                    
                    (461
                    )
                    
                    
                    263Total
      assets
                    
                    
                    538,540
                    
                    
                    
                    856
                    
                    
                    
                    539,396Total
      liabilities
                    
                    
                    347,095
                    
                    
                    
                    -
                    
                    
                    
                    347,095Retained
      earnings
                    
                    
                    73,162
                    
                    
                    
                    856
                    
                    
                    
                    74,018Total
      stockholders' equity
                    
                    
                    191,445
                    
                    
                    
                    856
                    
                    
                    
                    192,301





The following table presents the
effect of the correction on our previously reported consolidated statements of
cash flows for the six months ended June 30, 2008 (in thousands).





For
      the SixMonths
      EndedJune
      30,2008As previously reported:Net
      income
                        
                        $
                        14,253Change
      in prepaid reinsurance premiums
                        
                        
                        (408
                        )Change
      in current federal income tax payable
                        
                        
                        (1,354
                        )Net
      cash provided by operating activities
                        
                        
                        29,749Adjustments:Net
      income
                        
                        $
                        422Change
      in prepaid reinsurance premiums
                        
                        
                        (649
                        )Change
      in current federal income tax payable
                        
                        
                        227Net
      cash provided by operating activities
                        
                        
                        -As revised:Net
      income
                        
                        $
                        14,675Change
      in prepaid reinsurance premiums
                        
                        
                        (1,057
                        )Change
      in current federal income tax payable
                        
                        
                        (1,127
                        )Net
      cash provided by operating activities
                        
                        
                        29,749





Use of Estimates in the
Preparation of the Financial Statements





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


10





Fair Value of Financial
Instruments





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





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





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





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





Notes
Payable:  The carrying value of our bank credit facility of $2.8
million approximates the fair value based on the current interest
rate.  Our trust preferred securities have a carried value of $56.7
million and a fair value of $48.4 million as of June 30, 2009.  The
fair value of our trust preferred securities is based on discounted cash flows
using a current yield to maturity of 9.5% based on similar issues to discount
future cash flows.





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





Recently Issued Accounting
Standards





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





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


11





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





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





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





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





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


12


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





In June
2009, FASB issued Statement of Financial Accounting Standards No. 167,
“Amendments to FASB Interpretation No. 46(R)” (“SFAS 167”).  SFAS 167
addresses the effects of eliminating the qualifying special-purpose entity
concept and responds to concerns about the application of certain key provisions
of FASB Interpretation No. 46(R), “Consolidation of Variable Interest Entities”,
including concerns over the transparency of enterprises’ involvement with
variable interest entities.  SFAS 167 is effective for calendar year
end companies beginning on January 1, 2010 with earlier application
prohibited.  We are evaluating the impact of adopting SFAS 167 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
amounts assigned to assets acquired and liabilities assumed is an asset referred
to as “Excess of cost over fair value of net assets
acquired.”  Indirect and general expenses related to business
combinations are expensed as incurred.





Effective
August 29, 2008, we acquired 80% of the issued and outstanding membership
interests in the subsidiaries now comprising the Heath XS Operating Unit for
consideration of $15.0 million.  In connection with the acquisition of
membership interests in the subsidiaries comprising the Heath XS Operating Unit,
we executed an operating agreement for each subsidiary.  The operating
agreements grant us the right to purchase the remaining 20% membership interests
in the subsidiaries comprising the Heath XS Operating Unit and grant to an
affiliate of the seller the right to require us to purchase such remaining
membership interests (the “Put/Call Option”).  The Put/Call Option
becomes exercisable by either us or the affiliate of the seller upon the earlier
of August 29, 2012, the termination of the employment of the seller by the Heath
XS Operating Unit or a change of control of Hallmark. If the Put/Call Option is
exercised, we will have the right or obligation to purchase the remaining 20%
membership interests in the Heath XS Operating Unit for an amount equal to nine
times the average Pre-Tax Income (as defined in the operating agreements) for
the previous 12 fiscal quarters.  We estimate the ultimate redemption
value of the Put/Call Option to be $2.9 million at June 30, 2009.





The fair
value of the amortizable intangible assets acquired and respective amortization
periods are as follows ($ in thousands):





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




13





The Heath XS Operating Unit is an
underwriting organization that produces lower hazard, middle market, excess
commercial automobile and commercial umbrella insurance policies on both an
admitted and non-admitted basis through a network of independent wholesale
agencies throughout the United States.





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





4.
Fair Value





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





Effective
January 1, 2008, we determine the fair value of our financial instruments based
on the fair value hierarchy established in SFAS 157.  In accordance
with SFAS 157, we utilize the following fair value hierarchy:





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





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





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





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


14





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





Where
quoted prices are available on active exchanges for identical instruments,
investment securities are classified within Level 1 of the valuation
hierarchy.  Level 1 investment securities include common and preferred
stock.  If quoted prices are not available from active exchanges for
identical instruments, then fair values are estimated using quoted prices from
less active markets, quoted prices of securities with similar characteristics or
by pricing models utilizing other significant observable
inputs.  Examples of such instruments, which would generally be
classified within Level 2 of the valuation hierarchy, include corporate bonds,
municipal bonds and U.S. Treasury securities.  In cases where there is
limited activity or less transparency around inputs to the valuation, investment
securities are classified within Level 3 of the valuation
hierarchy.  Level 3 investments are valued based on the best available
data in order to approximate fair value.  This data may be internally
developed and consider risk premiums that a market participant would
require.  Investment securities classified within Level 3 include
other less liquid investment securities.







The
following table presents for each of the fair value hierarchy levels, our assets
that are measured at fair value on a recurring basis at June 30, 2009 (in
thousands).




Quoted
      Prices in
                    
                    
                    OtherActive
      Markets for
                    
                    
                    Observable
                    
                    
                    UnobservableIdentical
      Assets
                    
                    
                    Inputs
                    
                    
                    Inputs(Level
      1)
                    
                    
                    (Level
      2)
                    
                    
                    (Level
      3)
                    
                    
                    TotalU.S.
      Treasury securities and obligations of U.S. government
                    
                    $
                    -
                    
                    
                    $
                    6,199
                    
                    
                    $
                    -
                    
                    
                    $
                    6,199Corporate
      debt securities
                    
                    
                    -
                    
                    
                    
                    72,850
                    
                    
                    
                    -
                    
                    
                    
                    72,850Municipal
      bonds
                    
                    
                    -
                    
                    
                    
                    161,232
                    
                    
                    
                    34,014
                    
                    
                    
                    195,246Asset
      backed
                    
                    
                    -
                    
                    
                    
                    382
                    
                    
                    
                    -
                    
                    
                    
                    382Total
      debt securities
                    
                    
                    -
                    
                    
                    
                    240,663
                    
                    
                    
                    34,014
                    
                    
                    
                    274,677Financial
      services
                    
                    
                    27,152
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    27,152All
      other
                    
                    
                    11,566
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    11,566Total
      equity securities
                    
                    
                    38,718
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    38,718Total
      debt and equity securities
                    
                    $
                    38,718
                    
                    
                    $
                    240,663
                    
                    
                    $
                    34,014
                    
                    
                    $
                    313,395




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


15





The
following table summarizes the changes in fair value for all financial assets
measured at fair value on a recurring basis using significant unobservable
inputs (Level 3) during the six months ended June 30, 2009 (in
thousands).





Beginning
      balance as of January 1, 2009
                      
                      $
                      46,104Net
      purchases, issuances, sales and settlements
                      
                      
                      (12,000
                      )Total
      realized/unrealized gains included in net income
                      
                      
                      -Net
      gains included in other comprehensive income
                      
                      
                      (90
                      )Transfers
      in and/or out of Level 3
                      
                      
                      -Ending
      balance as of June 30, 2009
                      
                      $
                      34,014





5.
Investments





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




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




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


16




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




Three
      Months Ended
                                              
                                              
                                              Six
      Months EndedJune
      30
                                              
                                              
                                              June
      302009
                                              
                                              
                                              2008
                                              
                                              
                                              2009
                                              
                                              
                                              2008U.S.
      Treasury securities and obligations of U.S.
government
                                              
                                              $
                                              -
                                              
                                              
                                              $
                                              -
                                              
                                              
                                              $
                                              -
                                              
                                              
                                              $
                                              1,217Corporate
      debt securities
                                              
                                              
                                              894
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              1,022
                                              
                                              
                                              
                                              -Municipal
      bonds
                                              
                                              
                                              (44
                                              )
                                              
                                              
                                              177
                                              
                                              
                                              
                                              (40
                                              )
                                              
                                              
                                              178Equity
      securities-financial services
                                              
                                              
                                              (23
                                              )
                                              
                                              
                                              320
                                              
                                              
                                              
                                              27
                                              
                                              
                                              
                                              99Equity
      securities- all other
                                              
                                              
                                              40
                                              
                                              
                                              
                                              195
                                              
                                              
                                              
                                              48
                                              
                                              
                                              
                                              160Net
      realized gain
                                              
                                              
                                              867
                                              
                                              
                                              
                                              692
                                              
                                              
                                              
                                              1,057
                                              
                                              
                                              
                                              1,654Other-than-temporary
      impairments
                                              
                                              
                                              -
                                              
                                              
                                              
                                              (460
                                              )
                                              
                                              
                                              (538
                                              )
                                              
                                              
                                              (563
                                              )Gain
      on investments
                                              
                                              $
                                              867
                                              
                                              
                                              $
                                              232
                                              
                                              
                                              $
                                              519
                                              
                                              
                                              $
                                              1,091




We
realized gross gains on investments of $1.1 million and $1.0 million during the
three months ended June 30, 2009
and 2008, respectively, and $1.3 million and $2.2 million for the six months
ended June 30, 2009 and 2008, respectively. We realized gross losses on
investments of $0.2 million and $0.8 million during the three months ended June
30, 2009 and 2008, respectively, and $0.8 million and $1.1 million for the six
months ended June 30, 2009 and 2008, respectively.  We recorded
proceeds from the sale of investment securities of $28.2 million and $257.9
million during the three months ended June 30, 2009 and 2008, respectively, and
$40.9 million and $388.5 million for the six months ended June 30, 2009 and
2008, respectively. Realized investment gains and losses are recognized in
operations on the specific identification method.


17




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




Gross
                                          
                                          
                                          GrossAmortized
                                          
                                          
                                          Unrealized
                                          
                                          
                                          Unrealized
                                          
                                          
                                          FairCost
                                          
                                          
                                          Gains
                                          
                                          
                                          Losses
                                          
                                          
                                          ValueAs of June 30, 2009U.S.
      Treasury securities andobligations
      of U.S. government
                                          
                                          $
                                          6,100
                                          
                                          
                                          $
                                          99
                                          
                                          
                                          $
                                          -
                                          
                                          
                                          $
                                          6,199Corporate
      debt securities
                                          
                                          
                                          73,818
                                          
                                          
                                          
                                          3,779
                                          
                                          
                                          
                                          4,747
                                          
                                          
                                          
                                          72,850Municipal
      bonds
                                          
                                          
                                          198,128
                                          
                                          
                                          
                                          1,108
                                          
                                          
                                          
                                          3,990
                                          
                                          
                                          
                                          195,246Asset
      backed
                                          
                                          
                                          379
                                          
                                          
                                          
                                          12
                                          
                                          
                                          
                                          9
                                          
                                          
                                          
                                          382Total
      debt securities
                                          
                                          
                                          278,425
                                          
                                          
                                          
                                          4,998
                                          
                                          
                                          
                                          8,746
                                          
                                          
                                          
                                          274,677Financial
      services
                                          
                                          
                                          23,041
                                          
                                          
                                          
                                          4,423
                                          
                                          
                                          
                                          312
                                          
                                          
                                          
                                          27,152All
      other
                                          
                                          
                                          9,755
                                          
                                          
                                          
                                          2,224
                                          
                                          
                                          
                                          413
                                          
                                          
                                          
                                          11,566Total
      equity securities
                                          
                                          
                                          32,796
                                          
                                          
                                          
                                          6,647
                                          
                                          
                                          
                                          725
                                          
                                          
                                          
                                          38,718Total
      debt and equity securities
                                          
                                          $
                                          311,221
                                          
                                          
                                          $
                                          11,645
                                          
                                          
                                          $
                                          9,471
                                          
                                          
                                          $
                                          313,395As of December 31, 2008U.S.
      Treasury securities and obligations of U.S.
government
                                          
                                          $
                                          3,996
                                          
                                          
                                          $
                                          179
                                          
                                          
                                          $
                                          -
                                          
                                          
                                          $
                                          4,175Corporate
      debt securities
                                          
                                          
                                          67,157
                                          
                                          
                                          
                                          395
                                          
                                          
                                          
                                          7,005
                                          
                                          
                                          
                                          60,547Municipal
      bonds
                                          
                                          
                                          211,083
                                          
                                          
                                          
                                          631
                                          
                                          
                                          
                                          7,923
                                          
                                          
                                          
                                          203,791Total
      debt securities
                                          
                                          
                                          282,236
                                          
                                          
                                          
                                          1,205
                                          
                                          
                                          
                                          14,928
                                          
                                          
                                          
                                          268,513Financial
      services
                                          
                                          
                                          24,761
                                          
                                          
                                          
                                          332
                                          
                                          
                                          
                                          3,618
                                          
                                          
                                          
                                          21,475All
      other
                                          
                                          
                                          4,292
                                          
                                          
                                          
                                          29
                                          
                                          
                                          
                                          793
                                          
                                          
                                          
                                          3,528Total
      equity securities
                                          
                                          
                                          29,053
                                          
                                          
                                          
                                          361
                                          
                                          
                                          
                                          4,411
                                          
                                          
                                          
                                          25,003Total
      debt and equity securities
                                          
                                          $
                                          311,289
                                          
                                          
                                          $
                                          1,566
                                          
                                          
                                          $
                                          19,339
                                          
                                          
                                          $
                                          293,516


18





The
following schedules summarize the gross unrealized losses showing the length of
time that investments have been continuously in an unrealized loss position as
of June 30, 2009 and December 31, 2008 (in thousands):





As
      of June 30, 200912
      months or less
                                                                  
                                                                  
                                                                  Longer
      than 12 months
                                                                  
                                                                  
                                                                  TotalUnrealized
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  Unrealized
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  UnrealizedFair
      Value
                                                                  
                                                                  
                                                                  Losses
                                                                  
                                                                  
                                                                  Fair
      Value
                                                                  
                                                                  
                                                                  Losses
                                                                  
                                                                  
                                                                  Fair
      Value
                                                                  
                                                                  
                                                                  LossesCorporate
      debt securities
                                                                  
                                                                  $
                                                                  12,915
                                                                  
                                                                  
                                                                  $
                                                                  (2,444
                                                                  )
                                                                  
                                                                  $
                                                                  20,226
                                                                  
                                                                  
                                                                  $
                                                                  (2,303
                                                                  )
                                                                  
                                                                  $
                                                                  33,141
                                                                  
                                                                  
                                                                  $
                                                                  (4,747
                                                                  )Municipal
      bonds
                                                                  
                                                                  
                                                                  66,287
                                                                  
                                                                  
                                                                  
                                                                  (1,588
                                                                  )
                                                                  
                                                                  
                                                                  43,022
                                                                  
                                                                  
                                                                  
                                                                  (2,402
                                                                  )
                                                                  
                                                                  
                                                                  109,309
                                                                  
                                                                  
                                                                  
                                                                  (3,990
                                                                  )Asset
      backed
                                                                  
                                                                  
                                                                  84
                                                                  
                                                                  
                                                                  
                                                                  (9
                                                                  )
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  84
                                                                  
                                                                  
                                                                  
                                                                  (9
                                                                  )Total
      debt securities
                                                                  
                                                                  
                                                                  79,286
                                                                  
                                                                  
                                                                  
                                                                  (4,041
                                                                  )
                                                                  
                                                                  
                                                                  63,248
                                                                  
                                                                  
                                                                  
                                                                  (4,705
                                                                  )
                                                                  
                                                                  
                                                                  142,534
                                                                  
                                                                  
                                                                  
                                                                  (8,746
                                                                  )Financial
      services
                                                                  
                                                                  
                                                                  1,586
                                                                  
                                                                  
                                                                  
                                                                  (312
                                                                  )
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  1,586
                                                                  
                                                                  
                                                                  
                                                                  (312
                                                                  )All
      other
                                                                  
                                                                  
                                                                  1,624
                                                                  
                                                                  
                                                                  
                                                                  (390
                                                                  )
                                                                  
                                                                  
                                                                  956
                                                                  
                                                                  
                                                                  
                                                                  (23
                                                                  )
                                                                  
                                                                  
                                                                  2,580
                                                                  
                                                                  
                                                                  
                                                                  (413
                                                                  )Total
      equity securities
                                                                  
                                                                  
                                                                  3,210
                                                                  
                                                                  
                                                                  
                                                                  (702
                                                                  )
                                                                  
                                                                  
                                                                  956
                                                                  
                                                                  
                                                                  
                                                                  (23
                                                                  )
                                                                  
                                                                  
                                                                  4,166
                                                                  
                                                                  
                                                                  
                                                                  (725
                                                                  )Total
      debt and equity securities
                                                                  
                                                                  $
                                                                  82,496
                                                                  
                                                                  
                                                                  $
                                                                  (4,743
                                                                  )
                                                                  
                                                                  $
                                                                  64,204
                                                                  
                                                                  
                                                                  $
                                                                  (4,728
                                                                  )
                                                                  
                                                                  $
                                                                  146,700
                                                                  
                                                                  
                                                                  $
                                                                  (9,471
                                                                  )As
      of December 31, 200812
      months or less
                                                                  
                                                                  
                                                                  Longer
      than 12 months
                                                                  
                                                                  
                                                                  TotalUnrealized
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  Unrealized
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  
                                                                  UnrealizedFair
      Value
                                                                  
                                                                  
                                                                  Losses
                                                                  
                                                                  
                                                                  Fair
      Value
                                                                  
                                                                  
                                                                  Losses
                                                                  
                                                                  
                                                                  Fair
      Value
                                                                  
                                                                  
                                                                  LossesCorporate
      debt securities
                                                                  
                                                                  $
                                                                  34,314
                                                                  
                                                                  
                                                                  $
                                                                  (5,175
                                                                  )
                                                                  
                                                                  $
                                                                  9,786
                                                                  
                                                                  
                                                                  $
                                                                  (1,830
                                                                  )
                                                                  
                                                                  $
                                                                  44,100
                                                                  
                                                                  
                                                                  $
                                                                  (7,005
                                                                  )Municipal
      bonds
                                                                  
                                                                  
                                                                  106,175
                                                                  
                                                                  
                                                                  
                                                                  (7,258
                                                                  )
                                                                  
                                                                  
                                                                  10,295
                                                                  
                                                                  
                                                                  
                                                                  (665
                                                                  )
                                                                  
                                                                  
                                                                  116,470
                                                                  
                                                                  
                                                                  
                                                                  (7,923
                                                                  )Total
      debt securities
                                                                  
                                                                  
                                                                  140,489
                                                                  
                                                                  
                                                                  
                                                                  (12,433
                                                                  )
                                                                  
                                                                  
                                                                  20,081
                                                                  
                                                                  
                                                                  
                                                                  (2,495
                                                                  )
                                                                  
                                                                  
                                                                  160,570
                                                                  
                                                                  
                                                                  
                                                                  (14,928
                                                                  )Financial
      services
                                                                  
                                                                  
                                                                  7,110
                                                                  
                                                                  
                                                                  
                                                                  (3,618
                                                                  )
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  7,110
                                                                  
                                                                  
                                                                  
                                                                  (3,618
                                                                  )All
      other
                                                                  
                                                                  
                                                                  1,822
                                                                  
                                                                  
                                                                  
                                                                  (793
                                                                  )
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  1,822
                                                                  
                                                                  
                                                                  
                                                                  (793
                                                                  )Equity
      securities
                                                                  
                                                                  
                                                                  8,932
                                                                  
                                                                  
                                                                  
                                                                  (4,411
                                                                  )
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  8,932
                                                                  
                                                                  
                                                                  
                                                                  (4,411
                                                                  )Total
                                                                  
                                                                  $
                                                                  149,421
                                                                  
                                                                  
                                                                  $
                                                                  (16,844
                                                                  )
                                                                  
                                                                  $
                                                                  20,081
                                                                  
                                                                  
                                                                  $
                                                                  (2,495
                                                                  )
                                                                  
                                                                  $
                                                                  169,502
                                                                  
                                                                  
                                                                  $
                                                                  (19,339
                                                                  )





At
June 30, 2009, the gross unrealized losses more than twelve months old were
attributable to 41 bond positions and 1 equity position.  At December
31, 2008, the gross unrealized losses more than twelve months old were
attributable to 15 bond positions.  We consider these losses as a
temporary decline in value as they are predominately on bonds that we do not
intend to sell and do not believe we will be required to sell prior to recovery
of our amortized cost basis.  We see no other indications that the
decline in values of these securities is other-than-temporary.





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


19





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





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





Amortized
                  
                  
                  FairCost
                  
                  
                  Value(in
      thousands)Due
      in one year or less
                  
                  $
                  31,533
                  
                  
                  $
                  31,545Due
      after one year through five years
                  
                  
                  99,828
                  
                  
                  
                  100,966Due
      after five years through ten years
                  
                  
                  59,426
                  
                  
                  
                  56,813Due
      after ten years
                  
                  
                  87,259
                  
                  
                  
                  84,971Asset
      backed
                  
                  
                  379
                  
                  
                  
                  382$
                  278,425
                  
                  
                  $
                  274,677





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





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





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





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


20





6.
Pledged Investments





We have certain of our securities
pledged for the benefit of various state insurance departments and
reinsurers.  These securities are included with our available-for-sale
debt securities because we have the ability to trade these
securities.  We retain the interest earned on these
securities.  These securities had a carrying value of $24.2 million at
June 30, 2009 and a carrying value of $26.4 million at December 31,
2008.





7.
Share-Based Payment Arrangements





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





As of
June 30, 2009, there were incentive stock options to purchase 1,262,499 shares
of our common stock outstanding and non-qualified stock options to purchase
320,000 shares of our common stock outstanding under the 2005 LTIP, leaving
417,501 shares reserved for future issuance.  As of June 30, 2009,
there were incentive stock options to purchase 5,916 shares outstanding under
the 1994 Employee Plan and non-qualified stock options to purchase 20,834 shares
outstanding under the 1994 Director Plan.  In addition, as of June 30,
2009, there were outstanding non-qualified stock options to purchase 8,333
shares of our common stock granted to certain non-employee directors outside the
1994 Director Plan in lieu of fees for service on our board of directors in
1999.  The exercise price of all such outstanding stock options is
equal to the fair market value of our common stock on the date of
grant.





Options
granted under the 1994 Employee Plan prior to October 31, 2003, vest 40% six
months from the date of grant and an additional 20% on each of the first three
anniversary dates of the grant and terminate ten years from the date of
grant.  Incentive stock options granted under the 2005 LTIP prior to
2009 and the 1994 Employee Plan after October 31, 2003, vest 10%, 20%, 30% and
40% on the first, second, third and fourth anniversary dates of the grant,
respectively, and terminate five to ten years from the date of
grant.  Incentive stock options granted in 2009 under the 2005 LTIP
vest in equal annual increments on each of the first seven anniversary dates and
terminate ten years from the date of grant.  Non-qualified stock
options granted under the 2005 LTIP vest 100% six months after the date of grant
and terminate ten years from the date of grant.  All non-qualified
stock options granted under the 1994 Director Plan vested 40% six months from
the date of grant and an additional 10% on each of the first six anniversary
dates of the grant and terminate ten years from the date of
grant.  The options granted to non-employee directors outside the 1994
Director Plan fully vested six months after the date of grant and terminate ten
years from the date of grant.





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


21





Average
                        
                        
                        Contractual
                        
                        
                        IntrinsicNumber
      of
                        
                        
                        Exercise
                        
                        
                        Term
                        
                        
                        ValueShares
                        
                        
                        Price
                        
                        
                        (Years)
                        
                        
                        ($000)Outstanding
      at January 1, 2009
                        
                        
                        1,052,298
                        
                        
                        $
                        11.12Granted
                        
                        
                        595,000
                        
                        
                        $
                        6.62Exercised
                        
                        
                        (29,716
                        )
                        
                        $
                        3.66Forfeited
      or expired
                        
                        
                        -
                        
                        
                        $
                        -Outstanding
      at June 30, 2009
                        
                        
                        1,617,582
                        
                        
                        $
                        9.60
                        
                        
                        
                        8.4
                        
                        
                        $
                        448Exercisable
      at June 30, 2009
                        
                        
                        417,916
                        
                        
                        $
                        10.32
                        
                        
                        
                        6.9
                        
                        
                        $
                        130





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





Three
      Months Ended
                  
                  
                  Six
      Months EndedJune
      30,
                  
                  
                  June
      30,2009
                  
                  
                  2008
                  
                  
                  2009
                  
                  
                  2008Intrinsic
      value of options exercised
                  
                  $
                  -
                  
                  
                  $
                  59
                  
                  
                  $
                  107
                  
                  
                  $
                  337Cost
      of share-based payments (non-cash)
                  
                  $
                  614
                  
                  
                  $
                  226
                  
                  
                  $
                  876
                  
                  
                  $
                  773Income
      tax benefit of share-based payments recognized in income
                  
                  $
                  215
                  
                  
                  $
                  79
                  
                  
                  $
                  307
                  
                  
                  $
                  270





As of
June 30, 2009 there was $3.3 million of total unrecognized compensation cost
related to non-vested share-based compensation arrangements granted under our
plans, of which $0.9 million is expected to be recognized during the remainder
of 2009, $1.0 million is expected to be recognized in 2010, $0.7 million is
expected to be recognized in 2011, $0.3 million is expected to be recognized in
2012, $0.1 million is expected to be recognized each year from 2013 through
2016.





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


22





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





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





8.
Segment Information





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





Three
      Months Ended
                    
                    
                    Six
      Months EndedJune
      30,
                    
                    
                    June
      30,2009
                    
                    
                    2008
                    
                    
                    2009
                    
                    
                    2008Revenues:Standard
      Commercial Segment
                    
                    $
                    18,194
                    
                    
                    $
                    22,332
                    
                    
                    $
                    38,214
                    
                    
                    $
                    44,338Specialty
      Commercial Segment
                    
                    
                    32,430
                    
                    
                    
                    32,134
                    
                    
                    
                    65,255
                    
                    
                    
                    64,372Personal
      Segment
                    
                    
                    18,701
                    
                    
                    
                    16,498
                    
                    
                    
                    36,236
                    
                    
                    
                    32,224Corporate
                    
                    
                    1,419
                    
                    
                    
                    1,020
                    
                    
                    
                    1,949
                    
                    
                    
                    2,571Consolidated
                    
                    $
                    70,744
                    
                    
                    $
                    71,984
                    
                    
                    $
                    141,654
                    
                    
                    $
                    143,505Pre-tax income (loss), net of non-controlling
      interest:Standard
      Commercial Segment
                    
                    $
                    1,247
                    
                    
                    $
                    4,159
                    
                    
                    $
                    3,823
                    
                    
                    $
                    8,217Specialty
      Commercial Segment
                    
                    
                    5,010
                    
                    
                    
                    6,411
                    
                    
                    
                    10,692
                    
                    
                    
                    11,855Personal
      Segment
                    
                    
                    2,894
                    
                    
                    
                    1,913
                    
                    
                    
                    5,513
                    
                    
                    
                    4,503Corporate
                    
                    
                    (2,357
                    )
                    
                    
                    (1,895
                    )
                    
                    
                    (4,782
                    )
                    
                    
                    (3,193
                    )Consolidated
                    
                    $
                    6,794
                    
                    
                    $
                    10,588
                    
                    
                    $
                    15,246
                    
                    
                    $
                    21,382


23





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





June
      30,
                          
                          
                          December
      31,2009
                          
                          
                          2008AssetsStandard
      Commercial Segment
                          
                          $
                          153,430
                          
                          
                          $
                          146,415Specialty
      Commercial Segment
                          
                          
                          273,437
                          
                          
                          
                          230,130Personal
      Segment
                          
                          
                          108,716
                          
                          
                          
                          84,456Corporate
                          
                          
                          67,901
                          
                          
                          
                          77,397$
                          603,484
                          
                          
                          $
                          538,398





9.
Reinsurance





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





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





Three
      Months Ended
                      
                      
                      Six
      Months EndedJune
      30,
                      
                      
                      June
      30,2009
                      
                      
                      2008
                      
                      
                      2009
                      
                      
                      2008Ceded
      earned premiums
                      
                      $
                      3,136
                      
                      
                      $
                      1,991
                      
                      
                      $
                      5,194
                      
                      
                      $
                      3,972Reinsurance
      recoveries
                      
                      $
                      1,890
                      
                      
                      $
                      1,156
                      
                      
                      $
                      3,222
                      
                      
                      $
                      1,263





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




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


24




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




o
            Our
      reinsurers reimburse us 100% for any loss in excess of our $3.0 million
      retention up to $10.0 million for each catastrophic occurrence, subject to
      an aggregate limit of $14.0 million.  As a result of hurricane
      losses, we have ceded to our reinsurers losses of approximately $8.3
      million and have approximately $5.7 million of coverage remaining under
      this layer of catastrophe reinsurance at June 30,
  2009.




o
            Our
      reinsurers reimburse us 100% for any loss in excess of $10.0 million up to
      $25.0 million for each catastrophic occurrence subject to an aggregate
      limit of $50.0 million.




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




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




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




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




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




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




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




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




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




o
            Our
      reinsurers reimburse us for the next $2.15 million of each combined
      aircraft hull and liability loss and for the next $650,000 of each airport
      liability loss; and




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





·
            Heath
      XS.  Effective July 1, 2009, in states where we are
      admitted, we directly insure policies written by our Heath XS Operating
      Unit and reinsure a portion of the risk with third party carriers. 
      In states where we are not admitted, our Heath XS Operating Unit writes
      policies under fronting arrangements pursuant to which we assume all of
      the risk and then retrocede a portion of the risk to third party
      reinsurers.  We reinsure or retrocede 80% of the risk on policies
      written by our Heath XS Operating Unit.  Through June 30, 2009,
      our Heath XS Operating Unit wrote policies under a fronting arrangement
      pursuant to which we assumed 35% of the
risk.


25





10.
Notes Payable





On June
21, 2005, an unconsolidated trust subsidiary completed a private placement of
$30.0 million of 30-year floating rate trust preferred
securities.  Simultaneously, we borrowed $30.9 million from the trust
subsidiary and contributed $30.0 million to one of our insurance company
subsidiaries in order to increase policyholder surplus.  The note
bears an initial interest rate of 7.725% until June 15, 2015, at which time
interest will adjust quarterly to the three-month LIBOR rate plus 3.25
percentage points.  Under the terms of the note, we pay interest only
each quarter and the principal of the note at maturity. As of June 30, 2009, the
note balance was $30.9 million.





On
January 27, 2006, we borrowed $15.0 million under our revolving credit facility
to fund the cash required to close the acquisition of the subsidiaries
comprising our TGA Operating Unit.  As of June 30, 2009, the balance
on the revolving note was $2.8 million, which currently bears interest at 2.50%
per annum. (See Note 11, “Credit Facilities.”)





On August
23, 2007, an unconsolidated trust subsidiary completed a private placement of
$25.0 million of 30-year floating rate trust preferred
securities.  Simultaneously, we borrowed $25.8 million from the trust
subsidiary for working capital and general corporate purposes. The note bears an
initial interest rate of 8.28% until September 15, 2017, at which time interest
will adjust quarterly to the three-month LIBOR rate plus 2.90 percentage
points.  Under the terms of the note, we pay interest only each
quarter and the principal of the note at maturity. As of June 30, 2009 the note
balance was $25.8 million.





11.
Credit Facilities





We have a credit facility with The
Frost National Bank which was amended and restated on January 27, 2006 to
provide a $20.0 million revolving credit facility with a $5.0 million letter of
credit sub-facility.  The credit facility was further amended
effective May 31, 2007 to increase the revolving credit facility to $25.0
million and establish a new $5.0 million revolving credit sub-facility for the
premium finance operations of PAAC.  The credit agreement was again
amended effective February 20, 2008 to extend the termination to January 27,
2010, revise various affirmative and negative covenants and decrease the
interest rate in most instances to the three month Eurodollar rate plus 1.90
percentage points, payable quarterly in arrears.  We pay letter of
credit fees at the rate of 1.00% per annum.  Our obligations under the
revolving credit facility are secured by a security interest in the capital
stock of all of our subsidiaries, guaranties of all of our subsidiaries and the
pledge of all of our non-insurance company assets.  The revolving
credit facility contains covenants which, among other things, require us to
maintain certain financial and operating ratios and restrict certain
distributions, transactions and organizational changes.  As of June
30, 2009, we were in compliance with all of our covenants.  As of June
30, 2009 we had $2.8 million outstanding under this facility.


26





12.
Deferred Policy Acquisition Costs





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





Three
      Months Ended
                    
                    
                    Six
      Months EndedJune
      30,
                    
                    
                    June
      30,2009
                    
                    
                    2008
                    
                    
                    2009
                    
                    
                    2008Deferred
                    
                    $
                    (15,559
                    )
                    
                    $
                    (13,613
                    )
                    
                    $
                    (31,085
                    )
                    
                    $
                    (28,018
                    )Amortized
                    
                    
                    13,129
                    
                    
                    
                    13,377
                    
                    
                    
                    27,177
                    
                    
                    
                    27,123Net
                    
                    $
                    (2,430
                    )
                    
                    $
                    (236
                    )
                    
                    $
                    (3,908
                    )
                    
                    $
                    (895
                    )





13.
Earnings per Share





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





Three
      Months Ended
                          
                          
                          Six
      Months EndedJune
      30,
                          
                          
                          June
      30,2009
                          
                          
                          2008
                          
                          
                          2009
                          
                          
                          2008Weighted
      average shares - basic
                          
                          
                          20,864
                          
                          
                          
                          20,806
                          
                          
                          
                          20,860
                          
                          
                          
                          20,794Effect
      of dilutive securities
                          
                          
                          12
                          
                          
                          
                          78
                          
                          
                          
                          15
                          
                          
                          
                          91Weighted
      average shares - assuming dilution
                          
                          
                          20,876
                          
                          
                          
                          20,884
                          
                          
                          
                          20,875
                          
                          
                          
                          20,885





For the three and six months ended
June 30, 2009, there were 987,499 shares of common stock potentially issuable
upon the exercise of employee stock options that were excluded from the weighted
average number of shares outstanding on a diluted basis because the effect of
such options would be anti-dilutive. For the three and six months ended June 30,
2008, there were 899,167 shares of common stock potentially issuable upon
exercise of employee stock options that were excluded from the weighted average
number of shares outstanding on a diluted basis because the effect of such
options would be anti-dilutive.





14.
Net Periodic Pension Cost





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





Three
      Months Ended
                          
                          
                          Six
      Months EndedJune
      30,
                          
                          
                          June
      30,2009
                          
                          
                          2008
                          
                          
                          2009
                          
                          
                          2008Interest
      cost
                          
                          $
                          161
                          
                          
                          $
                          167
                          
                          
                          $
                          322
                          
                          
                          $
                          334Amortization
      of net (gain) loss
                          
                          
                          122
                          
                          
                          
                          16
                          
                          
                          
                          244
                          
                          
                          
                          32Expected
      return on plan assets
                          
                          
                          (121
                          )
                          
                          
                          (167
                          )
                          
                          
                          (242
                          )
                          
                          
                          (335
                          )Net
      periodic pension cost
                          
                          $
                          162
                          
                          
                          $
                          16
                          
                          
                          $
                          324
                          
                          
                          $
                          31


27


We did not make any contributions to
our frozen defined benefit cash balance plan (“Cash Balance Plan”) during the
three or six months ended June 30, 2009.  We contributed $152 thousand
and $236 thousand to the Cash Balance Plan during the three and six months ended
June 30, 2008, respectively.  Refer to Note 14 to the consolidated
financial statements in our Annual Report on Form 10-K for the year ended
December 31, 2008 for more discussion of our retirement plans.





15.
Contingencies





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





We have evaluated subsequent events
through August 13, 2009, the date the financial statements were
issued.





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





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





Introduction





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




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




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





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


28





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





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





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





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





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





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





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


29


Results
of Operations





Management
Overview.During the three and six months ended June 30, 2009,
our total revenues were $70.7 million and $141.7 million, representing a 2% and
1% decrease from the $72.0 million and $143.5 million in total revenues for
the same periods of 2008.  This decrease in revenue was primarily
attributable to lower commission and fee income in our Standard Commercial and
Specialty Commercial Segments due to  profit sharing commission
adjustments related to adverse loss development on prior accident years as well
as a shift in our Specialty Commercial Segment from a third party agency
structure to an insurance underwriting structure. This decrease in revenue was
partially offset by increased earned premium due to increased retention of
business in our Specialty Commercial Segment, the acquisition of our Heath XS
Operating Unit in the third quarter of 2008 and increased production by our
Personal Lines Segment, partially offset by reduced earned premium in our
Standard Commercial Segment due to the deterioration of the general economic
environment in our major markets.





We reported net income attributable to
Hallmark of $4.3 million and $11.1 million for the three and six months ended
June 30, 2009, which was $3.1 million and $3.6 million lower than the $7.4
million and $14.7 million reported for the same periods in 2008.  On a
diluted basis per share, net income was $0.20 and $0.53 per share for the three
months and six months ended June 30, 2009, as compared to $0.35 and $0.70 per
share for the same periods in 2008.   The decrease in net income
attributable to Hallmark for the three and six months ended June 30, 2009 was
primarily attributable to decreased revenue as discussed above and higher loss
and loss adjustment expense (“LAE”) due mostly to unfavorable prior year loss
development of $1.8 million recognized in both the three months and six months
ending June 30, 2009 as compared to favorable development of $0.3 million and
$1.8 million recognized during the three months and six months ending June 30,
2008.





Second
Quarter 2009 as Compared to Second Quarter 2008


30





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





Three
      Months Ended June 30, 2009Standard
                                                                      
                                                                      
                                                                      SpecialtyCommercial
                                                                      
                                                                      
                                                                      Commercial
                                                                      
                                                                      
                                                                      PersonalSegment
                                                                      
                                                                      
                                                                      Segment
                                                                      
                                                                      
                                                                      Segment
                                                                      
                                                                      
                                                                      Corporate
                                                                      
                                                                      
                                                                      ConsolidatedProduced
      premium (1)
                                                                      
                                                                      $
                                                                      20,425
                                                                      
                                                                      
                                                                      $
                                                                      40,252
                                                                      
                                                                      
                                                                      $
                                                                      16,918
                                                                      
                                                                      
                                                                      $
                                                                      -
                                                                      
                                                                      
                                                                      $
                                                                      77,595Gross
      premiums written
                                                                      
                                                                      
                                                                      20,425
                                                                      
                                                                      
                                                                      
                                                                      37,710
                                                                      
                                                                      
                                                                      
                                                                      16,918
                                                                      
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      
                                                                      75,053Ceded
      premiums written
                                                                      
                                                                      
                                                                      (1,084
                                                                      )
                                                                      
                                                                      
                                                                      (2,176
                                                                      )
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      
                                                                      (3,260
                                                                      )Net
      premiums written
                                                                      
                                                                      
                                                                      19,341
                                                                      
                                                                      
                                                                      
                                                                      35,534
                                                                      
                                                                      
                                                                      
                                                                      16,918
                                                                      
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      
                                                                      71,793Change
      in unearned premiums
                                                                      
                                                                      
                                                                      (1,614
                                                                      )
                                                                      
                                                                      
                                                                      (8,158
                                                                      )
                                                                      
                                                                      
                                                                      298
                                                                      
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      
                                                                      (9,474
                                                                      )Net
      premiums earned
                                                                      
                                                                      
                                                                      17,727
                                                                      
                                                                      
                                                                      
                                                                      27,376
                                                                      
                                                                      
                                                                      
                                                                      17,216
                                                                      
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      
                                                                      62,319Total
      revenues
                                                                      
                                                                      
                                                                      18,194
                                                                      
                                                                      
                                                                      
                                                                      32,430
                                                                      
                                                                      
                                                                      
                                                                      18,701
                                                                      
                                                                      
                                                                      
                                                                      1,419
                                                                      
                                                                      
                                                                      
                                                                      70,744Losses
      and loss adjustment expenses
                                                                      
                                                                      
                                                                      11,119
                                                                      
                                                                      
                                                                      
                                                                      15,848
                                                                      
                                                                      
                                                                      
                                                                      11,164
                                                                      
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      
                                                                      38,131Pre-tax  income
      (loss), net ofnon-controlling
      interest
                                                                      
                                                                      
                                                                      1,247
                                                                      
                                                                      
                                                                      
                                                                      5,010
                                                                      
                                                                      
                                                                      
                                                                      2,894
                                                                      
                                                                      
                                                                      
                                                                      (2,357
                                                                      )
                                                                      
                                                                      
                                                                      6,794Net
      loss ratio (2)
                                                                      
                                                                      
                                                                      62.7
                                                                      %
                                                                      
                                                                      
                                                                      57.9
                                                                      %
                                                                      
                                                                      
                                                                      64.8
                                                                      %
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      61.2
                                                                      %Net
      expense ratio (2)
                                                                      
                                                                      
                                                                      32.1
                                                                      %
                                                                      
                                                                      
                                                                      30.2
                                                                      %
                                                                      
                                                                      
                                                                      20.7
                                                                      %
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      30.5
                                                                      %Net
      combined ratio (2)
                                                                      
                                                                      
                                                                      94.8
                                                                      %
                                                                      
                                                                      
                                                                      88.1
                                                                      %
                                                                      
                                                                      
                                                                      85.5
                                                                      %
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      91.7
                                                                      %Three
      Months Ended June 30, 2008Standard
                                                                      
                                                                      
                                                                      SpecialtyCommercial
                                                                      
                                                                      
                                                                      Commercial
                                                                      
                                                                      
                                                                      PersonalSegment
                                                                      
                                                                      
                                                                      Segment
                                                                      
                                                                      
                                                                      Segment
                                                                      
                                                                      
                                                                      Corporate
                                                                      
                                                                      
                                                                      ConsolidatedProduced
      premium (1)
                                                                      
                                                                      $
                                                                      21,624
                                                                      
                                                                      
                                                                      $
                                                                      35,986
                                                                      
                                                                      
                                                                      $
                                                                      14,153
                                                                      
                                                                      
                                                                      $
                                                                      -
                                                                      
                                                                      
                                                                      $
                                                                      71,763Gross
      premiums written
                                                                      
                                                                      
                                                                      21,624
                                                                      
                                                                      
                                                                      
                                                                      27,338
                                                                      
                                                                      
                                                                      
                                                                      14,153
                                                                      
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      
                                                                      63,115Ceded
      premiums written
                                                                      
                                                                      
                                                                      (1,207
                                                                      )
                                                                      
                                                                      
                                                                      (799
                                                                      )
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      
                                                                      (2,006
                                                                      )Net
      premiums written
                                                                      
                                                                      
                                                                      20,417
                                                                      
                                                                      
                                                                      
                                                                      26,539
                                                                      
                                                                      
                                                                      
                                                                      14,153
                                                                      
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      
                                                                      61,109Change
      in unearned premiums
                                                                      
                                                                      
                                                                      36
                                                                      
                                                                      
                                                                      
                                                                      (2,395
                                                                      )
                                                                      
                                                                      
                                                                      1,014
                                                                      
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      
                                                                      (1,345
                                                                      )Net
      premiums earned
                                                                      
                                                                      
                                                                      20,453
                                                                      
                                                                      
                                                                      
                                                                      24,144
                                                                      
                                                                      
                                                                      
                                                                      15,167
                                                                      
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      
                                                                      59,764Total
      revenues
                                                                      
                                                                      
                                                                      22,332
                                                                      
                                                                      
                                                                      
                                                                      32,134
                                                                      
                                                                      
                                                                      
                                                                      16,498
                                                                      
                                                                      
                                                                      
                                                                      1,020
                                                                      
                                                                      
                                                                      
                                                                      71,984Losses
      and loss adjustment expenses
                                                                      
                                                                      
                                                                      11,669
                                                                      
                                                                      
                                                                      
                                                                      13,976
                                                                      
                                                                      
                                                                      
                                                                      10,384
                                                                      
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      
                                                                      36,029Pre-tax  income
      (loss)
                                                                      
                                                                      
                                                                      4,159
                                                                      
                                                                      
                                                                      
                                                                      6,411
                                                                      
                                                                      
                                                                      
                                                                      1,913
                                                                      
                                                                      
                                                                      
                                                                      (1,895
                                                                      )
                                                                      
                                                                      
                                                                      10,588Net
      loss ratio (2)
                                                                      
                                                                      
                                                                      57.1
                                                                      %
                                                                      
                                                                      
                                                                      57.9
                                                                      %
                                                                      
                                                                      
                                                                      68.5
                                                                      %
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      60.3
                                                                      %Net
      expense ratio (2)
                                                                      
                                                                      
                                                                      31.2
                                                                      %
                                                                      
                                                                      
                                                                      30.3
                                                                      %
                                                                      
                                                                      
                                                                      21.8
                                                                      %
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      31.0
                                                                      %Net
      combined ratio (2)
                                                                      
                                                                      
                                                                      88.3
                                                                      %
                                                                      
                                                                      
                                                                      88.2
                                                                      %
                                                                      
                                                                      
                                                                      90.3
                                                                      %
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      91.3
                                                                      %





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





(2)  The
net loss ratio is calculated as incurred losses and LAE divided by net premiums
earned, each determined in accordance  with GAAP.  During
the second quarter of 2009 we changed the method in which the net expense ratio
is calculated.  The net  expense ratio is now calculated for
our operating units that retain 100% of produced premium, as total operating
expenses  for the unit offset by agency fee income divided by net
premiums earned, each determined in accordance with GAAP.  For the
operating units that do not retain 100% of the produced premium, the net expense
ratio is calculated as underwriting expenses of the insurance company
subsidiaries for the unit offset by agency fee income, divided by net premiums
earned, each determined in accordance with GAAP.  Net combined ratio
is calculated as the sum of the net loss ratio and the net expense
ratio.  All prior periods have been restated to conform to the new
method, resulting in an increase to the consolidated net expense ratio of 1.9%
for the three months ended June 30, 2008.


31


Standard
Commercial Segment





Gross
premiums written for the Standard Commercial Segment were $20.4 million for the
three months ended June 30, 2009, which was $1.2 million, or 6%, less than the
$21.6 million reported for the same period in 2008.  Net premiums
written were $19.3 million for the three months ended June 30, 2009 as compared
to $20.4 million reported for the same period in 2008.  The decrease
in premium volume was predominately due to the deterioration of the general
economic environment, particularly in the construction industry, reducing the
available insured exposures.





Total
revenue for the Standard Commercial Segment of $18.2 million for the three
months ended June 30, 2009 was $4.1 million less than the $22.3 million reported
during the same period in 2008.  This 19% decrease in total revenue
was mostly due to decreased net premiums earned of $2.7 million and $1.2 million
reduced commission and fees due to a profit sharing commission adjustment
related to adverse loss development on prior accident years. Decreased net
investment income of $0.2 million during the three months ended June 30, 2009 as
compared to the same period during 2008 also contributed to the decrease in
total revenue.





Pre-tax
income for our Standard Commercial Segment of $1.2 million for the three months
ended June 30, 2009 decreased $3.0 million, or 70%, from the $4.2 million
reported for the same period of 2008.  Decreased revenue as discussed
above was the primary reason for the decrease in pre-tax income, offset by lower
loss and LAE of $0.5 million and lower operating expenses of $0.7 million,
mostly due to lower premium volume during the three months ended June 30, 2009
as compared to the same period during 2008.





The
Standard Commercial Segment reported a net loss ratio of 62.7% for the three
months ended June 30, 2009 as compared to 57.1% for 2008. The gross loss ratio
before reinsurance for the three months ended June 30, 2009 was 59.6% as
compared to the 58.1% reported for the same period of 2008.  The
higher net loss ratio for the second quarter of fiscal 2009 as compared to the
same period in fiscal 2008 was unfavorably impacted by lower ceded losses of
$0.1 for the three months ended June 30, 2009, as compared to $0.9 for the same
period the prior year.  The Standard Commercial Segment reported a
higher net expense ratio of 32.1% for the three months ended June 30, 2009 as
compared to 31.2% for the same period in 2008 due mostly to lower earned
premium.





Specialty
Commercial Segment





The $32.4 million of total revenue
for the three months ended June 30, 2009 was $0.3 million higher than the $32.1
million reported for the same period in 2008. This increase in revenue was
largely due to increased net premiums earned of $3.2 million as a result of the
increased retention of business and the acquisition of the Heath XS Operating
Unit during the third quarter of 2008. These increases were offset by lower
commission and fee income of $2.8 million primarily related to the shift in our
TGA Operating Unit from a third party agency structure to an insurance
underwriting structure partially offset by increased commission income in our
newly acquired Heath XS Operating Unit.





Pre-tax income for the Specialty
Commercial Segment of $5.0 million was $1.4 million lower than the $6.4 million
reported for the same period in 2008. The decrease in pre-tax income was mostly
due to increased loss and LAE of $1.9 million and increased amortization of
intangible assets of $0.2 million related to the acquisitions of Heath XS
Operating Unit during the third quarter of 2008 and CYR Insurance Management
Company during the second quarter of 2009.  These were partially
offset by increased revenue, discussed above, as well as lower than prior year
operating expenses of $0.4 million, mostly due to lower production related
expenses.


32




The
Specialty Commercial Segment reported a net loss ratio of 57.9% for the three
months ended June 30, 2009 and 2008. The gross loss ratio before reinsurance was
59.2% for the three months ended June 30, 2009 as compared to 57.1% for the same
period the prior year.  The gross loss results for the three months
ended June 30, 2009 were unfavorably impacted by $2.7 million of adverse prior
year development as compared to $0.5 million of adverse prior year development
for the same period the prior year.  This unfavorable prior year loss
development was offset by lower current accident year loss experience as
compared to the prior year. The Specialty Commercial Segment reported a net
expense ratio of 30.2% for the second quarter of 2009 as compared to 30.3% for
the same period the prior year.




Personal
Segment





Net
premiums written for our Personal Segment increased $2.8 million during the
second quarter of 2009 to $16.9 million compared to $14.1 million for the second
quarter of 2008.  The increase in premium was due mostly to continued
geographic expansion.





Total
revenue for the Personal Segment increased 13% to $18.7 million for the second
quarter of 2009 from $16.5 million for the second quarter of
2008.  Higher earned premium of $2.0 million was the primary reason
for the increase in revenue for the period.  Increased finance charges
of $0.2 million further contributed to the increase in revenue during the second
quarter of 2009.





Pre-tax
income for the Personal Segment was $2.9 million for the three months ended June
30, 2009 compared to $1.9 million for the same period during
2008.  The increased revenue, as discussed above, was partially offset
by increased losses and LAE of $0.8 million and increased operating expenses of
$0.4 million due mostly to continued geographic expansion.





The
Personal Segment reported a net loss ratio of 64.8% for the three months ended
June 30, 2009 as compared to 68.5% for the second quarter of
2008.  The decline in the net loss ratio was primarily a result of the
maturing of the new business associated with geographic expansion. We recognized
$0.3 million of favorable prior accident year development for the three months
ended June 30, 2009 and June 30, 2008. The Personal Segment reported a net
expense ratio of 20.7% for the three months ended June 30, 2009 as compared to
21.8% for the second quarter of 2008.  This lower expense ratio was
primarily a result of higher earned premium and finance charges during the three
months ended June 30, 2009 as compared to the same period during
2008.





Corporate





Total
revenue for corporate increased by $0.4 million for the three months ended June
30, 2009 as compared to the same period the prior year.  This increase
in total revenue was due primarily to recognized gains of $0.8 million on our
investment portfolio for the three months ended June 30, 2009 as compared to
recognized gains of $0.2 million during the same period in 2008.  This
increase in revenue was offset by lower net investment income of $0.2 million
for the three months ended June 30, 2009 as compared to the same period of the
prior year.





Corporate
pre-tax loss was $2.4 million for the three months ended June 30, 2009 as
compared to $1.9 million for the same period the prior year.  The
increased loss was mostly due to increased operating expenses of $0.9 million
due predominately to increased non-cash compensation expense of $0.5 million
related to stock option grants to directors and employees and periodic pension
costs.  Also contributing to the increase in operating expenses was
$0.4 million related to advances for a cancelled start-up
program.  These higher operating expenses were partially offset by the
increased revenue discussed above.


33


Six
Months Ended June 30, 2009 as Compared to Six Months Ended June 30,
2008





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


Hallmark
Financial Services, Inc.


Consolidated
Segment Data





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





Six Months Ended June 30,
    2008Standard
                  
                  
                  SpecialtyCommercial
                  
                  
                  Commercial
                  
                  
                  PersonalSegment
                  
                  
                  Segment
                  
                  
                  Segment
                  
                  
                  Corporate
                  
                  
                  ConsolidatedProduced
      premium (1)
                  
                  $
                  43,373
                  
                  
                  $
                  68,006
                  
                  
                  $
                  31,880
                  
                  
                  $
                  -
                  
                  
                  $
                  143,259Gross
      premiums written
                  
                  
                  43,373
                  
                  
                  
                  52,099
                  
                  
                  
                  31,880
                  
                  
                  
                  -
                  
                  
                  
                  127,352Ceded
      premiums written
                  
                  
                  (2,394
                  )
                  
                  
                  (1,616
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (4,010
                  )Net
      premiums written
                  
                  
                  40,979
                  
                  
                  
                  50,483
                  
                  
                  
                  31,880
                  
                  
                  
                  -
                  
                  
                  
                  123,342Change
      in unearned premiums
                  
                  
                  440
                  
                  
                  
                  (2,550
                  )
                  
                  
                  (2,224
                  )
                  
                  
                  -
                  
                  
                  
                  (4,334
                  )Net
      premiums earned
                  
                  
                  41,419
                  
                  
                  
                  47,933
                  
                  
                  
                  29,656
                  
                  
                  
                  -
                  
                  
                  
                  119,008Total
      revenues
                  
                  
                  44,338
                  
                  
                  
                  64,372
                  
                  
                  
                  32,224
                  
                  
                  
                  2,571
                  
                  
                  
                  143,505Losses
      and loss adjustment expenses
                  
                  
                  22,979
                  
                  
                  
                  28,979
                  
                  
                  
                  19,575
                  
                  
                  
                  -
                  
                  
                  
                  71,533Pre-tax
      income (loss)
                  
                  
                  8,217
                  
                  
                  
                  11,855
                  
                  
                  
                  4,503
                  
                  
                  
                  (3,193
                  )
                  
                  
                  21,382Net
      loss ratio (2)
                  
                  
                  55.5
                  %
                  
                  
                  60.5
                  %
                  
                  
                  66.0
                  %
                  
                  
                  
                  
                  
                  
                  60.1
                  %Net
      expense ratio (2)
                  
                  
                  31.1
                  %
                  
                  
                  30.5
                  %
                  
                  
                  21.6
                  %
                  
                  
                  
                  
                  
                  
                  30.7
                  %Net
      combined ratio (2)
                  
                  
                  86.6
                  %
                  
                  
                  91.0
                  %
                  
                  
                  87.6
                  %
                  
                  
                  
                  
                  
                  
                  90.8
                  %





(1)    Produced
premium is a non-GAAP measurement that management uses to track total controlled
premium produced by our operations.  We believe this is a useful tool
for users of our financial statements to measure our premium production whether
retained by our insurance company subsidiaries or retained by third party
insurance carriers where we receive commission revenue.





(2) The
net loss ratio is calculated as incurred losses and LAE divided by net premiums
earned, each determined in accordance with GAAP.  During the second
quarter of 2009 we changed the method in which the net expense ratio is
calculated. The net expense ratio is now calculated for our operating units that
retain 100% of produced premium, as total operating expenses for the unit offset
by agency fee income divided by net premiums earned, each determined in
accordance with GAAP.  For the operating units that do not retain 100%
of the produced premium, the net expense ratio is calculated as underwriting
expenses of the insurance company subsidiaries for the unit offset by agency fee
income, divided by net premiums earned, each determined in accordance with GAAP.
Net combined ratio is calculated as the sum of the net loss ratio and the net
expense ratio.  All prior periods have been restated to conform to the
new method, resulting in an increase to the consolidated net expense ratio of
1.7% for the six months ended June 30, 2008.




34


Standard
Commercial Segment





Gross
premiums written for the Standard Commercial Segment were $39.6 million for the
six months ended June 30, 2009, or 9% less than the $43.4 million reported for
the same period in 2008.  Net premiums written were $37.4 million for
the six months ended June 30, 2009 as compared to $41.0 million reported for the
same period in 2008.  The decrease in premium volume was predominately
due to the deterioration of the general economic environment, particularly in
the construction industry, reducing the available insured
exposures.





Total
revenue for the Standard Commercial Segment of $38.2 million for the six months
ended June 30, 2009 was $6.1 million less than the $44.3 million reported during
the six months ended June 30, 2008.  This 14% decrease in total
revenue was primarily due to lower net earned premiums of $5.2 million and
decreased profit sharing commissions of $0.7 million related to unfavorable loss
development on prior accident years during 2009 compared to the same period for
2008. Also contributing to this decrease in revenues was lower net investment
income of $0.1 million.





Pre-tax
income for our Standard Commercial Segment of $3.8 million for the six months
ended June 30, 2009 decreased $4.4 million, or 53%, from the $8.2 million
reported for the same period of 2008.  This decrease in pre-tax income
was primarily attributable to decreased revenue discussed above partially offset
by lower loss and LAE expenses of $0.5 million and lower operating expenses of
$1.2 million primarily due to lower production related expenses.





The net
loss ratio for the six months ended June 30, 2009 was 62.1% as compared to the
55.5% reported for the same period of 2008.  The gross loss ratio
before reinsurance was 61.0% for the six months ended June 30, 2009 as compared
to 54.2% for the same period the prior year.  The gross loss results
for the six months ended June 30, 2009 included $0.5 million of favorable prior
year development as compared to favorable prior year development of $2.2 million
recognized during the same period of 2008.  The Standard Commercial
Segment reported net expense ratios of 32.2% and 31.1% for the six months ended
June 30, 2009 and 2008, respectively.  The increase in the net expense
ratio was due mostly to lower earned premium.





Specialty
Commercial Segment





Gross premiums written for the
Specialty Commercial Segment for the first six months of 2009 were $69.4
million, or 33% more than the $52.1 million reported for the same period in
2008.  Net premiums written for the first six months of 2009 of $66.1
million were 31% more than the $50.5 million reported for the same period in
2008.  The increase in premium volume was due to increased retention
of business and the acquisition of the Heath XS Operating Unit during the third
quarter of 2008.





Total revenue for the Specialty
Commercial Segment of $65.3 million for the first six months of 2009 was $0.9
million more than the $64.4 million reported in the first six months of
2008.  This 1% increase in revenue was largely due to increased net
premiums earned of $4.4 million for the first six months of 2009 as a result of
the increased retention of business and the acquisition of Heath XS Operating
Unit during the third quarter of 2008.  Increased net investment
income contributed an additional $0.2 million to the increase in revenue for the
quarter.  These increases in revenue were partially offset by lower
commission and fee revenue of $3.6 million primarily related to the shift from a
third party agency structure to an insurance underwriting structure partially
offset by increased commission income in our newly acquired Heath XS Operating
Unit.


35


Pre-tax income for the Specialty
Commercial Segment of $10.7 million for the first six months of 2009 decreased
$1.2 million, or 10%, from the $11.9 million reported for the same period in
2008.  Increased losses and LAE of $1.8 million and increased
amortization of intangible assets of $0.3 million primarily related to our
acquisition of the Heath XS Operating Unit during 2008 more than offset the
increased revenues discussed above.




The Specialty Commercial Segment
reported a net loss ratio of 58.8% for the first six months of 2009 as compared
to 60.5% for the first six months of 2008.  The gross loss ratio
before reinsurance was 59.4% for the three months ended June 30, 2009 as
compared to 59.5% for the same period the prior year.  The gross loss
results for the three months ended June 30, 2009 were unfavorably impacted by
$2.7 million of adverse prior year development as compared to $1.0 million of
adverse prior year development for the same period the prior
year.  This unfavorable prior year loss development was offset by
lower current accident year loss experience as compared to the prior year. The
Specialty Commercial Segment reported a net expense ratio of 30.1% for the first
six months of 2009 as compared to 30.5% for the first six months of
2008.




Personal
Segment





Net premium written for our Personal
Segment increased $5.6 million during the first six months of 2009 to $37.5
million compared to $31.9 million in the first six months of
2008.  The increase in premium was due mostly to continued geographic
expansion.





Total revenue for the Personal
Segment increased 12% to $36.2 million for the first six months of 2009 from
$32.2 million for the same period in 2008.  Higher earned premium of
$3.6 million was the primary reason for the increase in revenue for the
period.  Increased finance charges of $0.3 million and net investment
income of $0.1 million further contributed to this increase in
revenue.





Pre-tax income for the Personal
Segment was $5.5 million for the six months ended June 30, 2009 as compared to
$4.5 million for the same period in 2008.  The increased revenue, as
discussed above, was offset by increased losses and LAE of $2.2 million and
increased operating expenses of $0.8 million due mostly to continued geographic
expansion.





The Personal Segment reported a net
loss ratio of 65.4% for the first six months of 2009 as compared to 66.0% for
the same period in 2008.  The decline in the net loss ratio was
primarily a result of the maturing of the new business associated with
geographic expansion. We recognized $0.3 million of favorable prior accident
year development during the first six months 2009 as compared to $0.6 million of
favorable prior year development during the first six months of
2008.  The Personal Segment reported a net expense ratio of 20.9% for
the first six months of 2009 as compared to 21.6% for the first six months of
2008.  This lower expense ratio was primarily the result of higher
earned premium and finance charges during the three months ended June 30, 2009
as compared to the same period during 2008.


36


Corporate





Corporate
revenue decreased $0.6 million for the first six months of 2009 as compared to
the same period in 2008. This decrease in total revenue was due primarily to
recognized gains of $0.5 million on our investment portfolio for the six months
ended June 30, 2009 as compared to recognized gains of $1.1 million during the
same period in 2008.





Corporate
pre-tax loss was $4.8 million for the six months ended June 30, 2009 as compared
to $3.2 million for the same period the prior year.  The increased
loss was mostly due to the decreased revenues discussed above as well as
increased operating expenses of $1.0 million due predominately to increased
non-cash compensation expense of $0.5 million related to stock option grants to
directors and employees and periodic pension costs.  Also contributing
to the increase in operating expenses was $0.4 million related to advances for a
cancelled start-up program.





Financial
Condition and Liquidity





Sources
and Uses of Funds





Our
sources of funds are from insurance-related operations, financing activities and
investing activities.  Major sources of funds from operations include
premiums collected (net of policy cancellations and premiums ceded),
commissions, and processing and service fees.  As a holding company,
Hallmark is dependent on dividend payments and management fees from its
subsidiaries to meet operating expenses and debt obligations.  As of
June 30, 2009, Hallmark had $14.5 million in unrestricted cash and invested
assets at the holding company. Unrestricted cash and invested assets of our
non-insurance subsidiaries were $5.6 million as of June 30, 2009.





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





Comparison
of June 30, 2009 to December 31, 2008





On a
consolidated basis, our cash and investments (excluding restricted cash) at June
30, 2009 were $396.5 million compared to $352.7 million at December 31,
2008.  An increase in market value of our investment portfolio for the
period and cash from operating activities was the primary reason for this
increase.


37


Comparison
of Six Months Ended June 30, 2009 and June 30, 2008





Net cash
provided by our consolidated operating activities was $28.8 million for the
first six months of 2009 compared to $29.7 million for the first six months of
2008.  The decrease in operating cash flow was primarily due to the
timing of premium settlements with third party insurance carriers.





Net cash
used in investing activities during the first six months of 2009 was $3.4
million as compared to $132.0 million for the same period in
2008.  Contributing to the decrease in cash used in investing
activities was a decrease of $516.2 million in purchases of debt and equity
securities, partially offset by (i) a $6.7 million reduction in the change in
restricted cash, (ii) a $373.4 million reduction in maturities, sales and
redemptions of investment securities, (iii) a $0.4 million increase in purchases
of property and equipment, (iv) a net cash payment of $3.9 million, net of cash
acquired, for the acquisition of a management agreement
controlling  State and County Mutual Insurance Company and (v) a $3.3
million payment of contingent consideration to the sellers of the subsidiaries
comprising our TGA Operating Unit.





Cash used
in financing activities during the first six months of 2009 was $1.3 million as
compared to $10.1 million for the same period of 2008.  The cash used
during the first six months of 2008 was primarily for the payment of
consideration to the sellers of the subsidiaries comprising our TGA Operating
Unit.  As of June 30, 2009 we had fully repaid our obligation to the
sellers.





Credit
Facilities





On June
29, 2005, we entered into a credit facility with The Frost National
Bank.  The credit facility was amended and restated on January 27,
2006 to a $20.0 million revolving credit facility, with a $5.0 million letter of
credit sub-facility.  The credit facility was further amended
effective May 31, 2007 to increase the revolving credit facility to $25.0
million and establish a new $5.0 million revolving credit sub-facility for the
premium finance operations of PAAC.  The credit agreement was again
amended effective February 20, 2008 to extend the termination to January 27,
2010, revise various affirmative and negative covenants and decrease the
interest rate in most instances to the three month Eurodollar rate plus 1.90
percentage points, payable quarterly in arrears.  We pay letter of
credit fees at the rate of 1.00% per annum.  Our obligations under the
revolving credit facility are secured by a security interest in the capital
stock of all of our subsidiaries, guaranties of all of our subsidiaries and the
pledge of all of our non-insurance company assets.  The revolving
credit facility contains covenants which, among other things, require us to
maintain certain financial and operating ratios and restrict certain
distributions, transactions and organizational changes.  As of June
30, 2009 we were in compliance with all of our covenants.  As of June
30, 2009, we had $2.8 million outstanding under this credit
facility.





Trust
Preferred Securities





On June
21, 2005, an unconsolidated trust subsidiary completed a private placement of
$30.0 million of 30-year floating rate trust preferred
securities.  Simultaneously, we borrowed $30.9 million from the trust
subsidiary and contributed $30.0 million to one of our insurance company
subsidiaries in order to increase policyholder surplus.  The note
bears an initial interest rate of 7.725% until June 15, 2015, at which time
interest will adjust quarterly to the three-month LIBOR rate plus 3.25
percentage points.  As of June 30, 2009, the note balance was $30.9
million.  Under the terms of the note, we pay interest only each
quarter and the principal of the note at maturity.


38


On August
23, 2007, an unconsolidated trust subsidiary completed a private placement of
$25.0 million of 30-year floating rate trust preferred
securities.  Simultaneously, we borrowed $25.8 million from the trust
subsidiary for working capital and general corporate purposes. The note bears an
initial interest rate at 8.28% until September 15, 2017, at which time interest
will adjust quarterly to the three-month LIBOR rate plus 2.90 percentage
points.  As of June 30, 2009, the note balance was $25.8
million.  Under the terms of the note, we pay interest only each
quarter and the principal of the note at maturity.





Item
3.  Quantitative and Qualitative Disclosures About Market
Risk.





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





Item
4T.  Controls and Procedures.





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





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





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


39


PART
II


OTHER
INFORMATION





Item
1.            Legal
Proceedings.





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





Item
1A.         Risk
Factors.





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





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





None.




Item
3.            Defaults
Upon Senior Securities.





None.





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




Hallmark’s Annual Meeting of
Shareholders was held on May 28, 2009.  Of the 20,871,498 shares of
common stock of Hallmark entitled to vote at the meeting, 19,576,025 shares were
present in person or by proxy.





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





Director
                          
                          Votes
      For
                          
                          
                          Votes Withheld
                          
                          
                          AbstainedMark
      E. Schwarz
                          
                          
                          15,993,266
                          
                          
                          
                          3,339,685
                          
                          
                          
                          243,074Scott
      T. Berlin
                          
                          
                          17,677,866
                          
                          
                          
                          1,655,085
                          
                          
                          
                          243,074James
      H. Graves
                          
                          
                          18,969,026
                          
                          
                          
                          363,925
                          
                          
                          
                          243,074Jim
      W. Henderson
                          
                          
                          19,141,111
                          
                          
                          
                          191,840
                          
                          
                          
                          243,074George
      R. Manser
                          
                          
                          17,666,989
                          
                          
                          
                          1,665,962
                          
                          
                          
                          243,074





At the
Annual Meeting, Hallmark stockholders approved an increase in the number of
shares of common stock authorized for issuance under the 2005 Long Term
Incentive Plan.  Votes were cast 15,843,322 in favor of such proposal,
782,794 votes opposed and 5,737 votes abstaining.


40


Item
5.            Other
Information.





None.





Item
6.            Exhibits.





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





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




41





Exhibit
                      Number
                    
                    Description4(j)
                    
                    Form
      of Junior Subordinated Debt Security Due 2037 (incorporated by reference
      to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed August
      24, 2007).4(k)
                    
                    Form
      of Capital Security Certificate (incorporated by reference to Exhibit 4.2
      to the registrant’s Current Report on Form 8-K filed August 24,
      2007).31(a)
                    
                    Certification
      of principal executive officer required by Rule 13a-14(a) 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.





SIGNATURES





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





HALLMARK
FINANCIAL SERVICES, INC.


(Registrant)





Date:
      August 13, 2009
              
              /s/ Mark J. MorrisonMark
      J. Morrison, Chief Executive Officer and President(Principal
      Executive Officer)Date:
      August 13, 2009
              
              /s/ Jeffrey R. PassmoreJeffrey
      R. Passmore, Chief Accounting Officer and Senior Vice
      President(Principal
      Financial Officer)


42