UNITED STATES

                      SECURITIES AND EXCHANGE COMMISSION

                            WASHINGTON, D.C. 20549

                                  FORM 10-Q

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

                       Securities Exchange Act of 1934

              For the quarterly period ended September 30, 2006

                       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. Employer
     Incorporation or organization)                Identification No.)

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

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

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

 Indicate by check  mark whether the registrant  is an accelerated  filer (as
 defined in Rule 12b-2 of the Exchange Act).   Yes ___  No  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 - 20,759,905 shares outstanding as of November 8, 2006.

<PAGE>

                                      PART I
                               FINANCIAL INFORMATION

 Item 1.   Financial Statements


                      INDEX TO FINANCIAL STATEMENTS

                                                           Page Number
                                                           -----------

 Consolidated Balance Sheets at September 30, 2006               3
 (unaudited) and December 31, 2005

 Consolidated Statements of Operations (unaudited)
 for the three months and nine months ended September 30,
 2006 and September 30, 2005                                     4

 Consolidated Statements of Stockholders' Equity and
 Comprehensive Income (unaudited) for the three months and
 nine months ended September 30, 2006 and September 30, 2005     5

 Consolidated Statements of Cash Flows (unaudited) for the
 nine months ended September 30, 2006 and September 30, 2005     6

 Notes to Consolidated Financial Statements (unaudited)          7

<PAGE>

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

                                                    September 30  December 31
                    ASSETS                              2006          2005
                    ------                           ----------    ----------
                                                     (unaudited)    (audited)
 Investments:
   Debt securities, available-for-sale,
     at market value                                $   125,800   $    79,360
   Equity securities, available-for-sale,
     at market value                                      3,701         3,403
   Short-term investments, available-for-sale,
     at market value                                     40,169        12,281
                                                     ----------    ----------
            Total investments                           169,670        95,044

 Cash and cash equivalents                               39,240        44,528
 Restricted cash and investments                         35,030        13,802
 Premiums receivable                                     61,154        26,530
 Accounts receivable                                     12,276         2,083
 Prepaid reinsurance premium                              1,575           767
 Reinsurance balances receivable                            777             -
 Reinsurance recoverable                                  4,480           444
 Deferred policy acquisition costs                       14,742         9,164
 Excess of cost over fair value
   of net assets acquired                                31,781         4,836
 Intangible assets                                       26,647           459
 Deferred federal income taxes                                -         3,992
 Current federal income tax receivable                    1,010             -
 Other assets                                             9,034         7,257
                                                     ----------    ----------
            Total assets                            $   407,416   $   208,906
                                                     ==========    ==========
     LIABILITIES AND STOCKHOLDERS' EQUITY
 Liabilities:
   Notes payable                                    $    48,529   $    30,928
   Note payable to related party                         12,500             -
   Structured settlements                                24,326             -
   Unpaid losses and loss adjustment expenses            65,604        26,321
   Unearned premiums                                     82,085        36,027
   Unearned revenue                                       7,079         4,055
   Reinsurance balances payable                               -           116
   Accrued agent profit sharing                           1,854         2,173
   Accrued ceding commission payable                     11,534        11,430
   Pension liability                                      2,766         2,932
   Deferred federal income taxes                          4,307             -
   Current federal income tax payable                         -           300
   Accounts payable and other accrued expenses           25,479         9,436
                                                     ----------    ----------
            Total liabilities                           286,063       123,718

 Commitments and Contingencies

 Stockholders' equity:
   Common stock, $.18 par value (authorized
     33,333,333 shares in 2006 and 16,666,667
     shares in 2005; issued 17,767,733 shares
     in 2006 and 14,476,102 shares in 2005)               3,198         2,606
   Additional paid in capital                            93,712        62,907
   Retained earnings                                     26,750        22,289
   Accumulated other comprehensive loss                  (2,230)       (2,597)
   Treasury stock, at cost (7,828 shares in 2006
     and 2,470 in 2005)                                     (77)          (17)
                                                     ----------    ----------
            Total stockholders' equity                  121,353        85,188
                                                     ----------    ----------
                                                    $   407,416   $   208,906
                                                     ==========    ==========

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

<PAGE>
<TABLE>

              Hallmark Financial Services, Inc. and Subsidiaries
                    Consolidated Statements of Operations
                                 (Unaudited)
                 ($ in thousands, except per share amounts)


                                         Three Months Ended           Nine Months Ended
                                            September 30                 September 30
                                        ---------------------       ----------------------
                                          2006         2005           2006          2005
                                        --------     --------       --------      --------
 <S>                                   <C>          <C>            <C>           <C>
 Gross premiums written                $  58,107    $  43,512      $ 153,718      $ 62,985
 Ceded premiums written                   (3,102)        (552)        (7,542)         (552)
                                        --------     --------       --------      --------
   Net premiums written                   55,005       42,960        146,176        62,433
   Change in unearned premiums           (12,811)     (23,936)       (41,289)      (23,706)
                                        --------     --------       --------      --------
   Net premiums earned                    42,194       19,024        104,887        38,727

 Investment income, net of expenses        2,912        1,412          7,505         2,274
 Realized gain (loss)                       (135)          93         (1,501)           52
 Finance charges                           1,037          487          2,940         1,536
 Commission and fees                       9,943        3,094         32,223        13,534
 Processing and service fees                 410        1,048          1,994         4,252
 Other income                                  4            9             24            22
                                        --------     --------       --------      --------
   Total revenues                         56,365       25,167        148,072        60,397

 Losses and loss adjustment expenses      23,589       11,043         60,478        22,584
 Other operating costs and expenses       23,044        9,897         64,097        27,752
 Interest expense                          1,527          559          4,774           664
 Interest expense from amortization
   of discount on convertible notes            -            -          9,625             -
 Amortization of intangible asset            573           17          1,719            31
                                        --------     --------       --------      --------
   Total expenses                         48,733       21,516        140,693        51,031

 Income before tax                         7,632        3,651          7,379         9,366

 Income tax expense                        2,755        1,178          2,918         3,074
                                        --------     --------       --------      --------
 Net income                            $   4,877    $   2,473      $   4,461     $   6,292
                                        ========     ========       ========      ========

 Common stockholders net income
   per share:
     Basic                             $    0.27    $    0.17      $    0.28     $    0.58
                                        ========     ========       ========      ========
     Diluted                           $    0.27    $    0.17      $    0.28     $    0.58
                                        ========     ========       ========      ========


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

</TABLE>
<PAGE>
<TABLE>

              Hallmark Financial Services, Inc. and Subsidiaries
    Consolidated Statements of Stockholders' Equity and Comprehensive Income
                                (Unaudited)
                             ($ in thousands)

                                         Three Months Ended           Nine Months Ended
                                            September 30,               September 30,
                                        ---------------------       ----------------------
                                          2006         2005           2006          2005
                                        --------     --------       --------      --------
 <S>                                   <C>          <C>            <C>           <C>
 Common Stock
 Balance, beginning of period          $   3,198    $   2,606      $   2,606     $   1,106
 Conversion of note payable
   to common stock                             -            -            589             -
 Issuance of common stock
   in rights offering                          -            -              -         1,500
 Issuance of common stock
   upon option exercises                       -            -              3             -
                                        --------     --------       --------      --------
 Balance, end of period                    3,198        2,606          3,198         2,606

 Additional Paid-In Capital
 Balance, beginning of period             93,663       62,898         62,907        19,647
 Discount on convertible notes,
   net of tax                                  -            -          6,066             -
 Conversion of note payable
   to common stock                             -            -         24,562             -
 Issuance of common stock
   in rights offering                          -          (31)             -        43,391
 Equity based compensation                    50           20            107            43
 Exercise of stock options                    (1)           -             70          (194)
                                        --------     --------       --------      --------
 Balance, end of period                   93,712       62,887         93,712        62,887

 Retained Earnings
 Balance, beginning of period             21,873       16,922         22,289        13,103
 Net income                                4,877        2,473          4,461         6,292
                                        --------     --------       --------      --------
 Balance, end of period                   26,750       19,395         26,750        19,395

 Accumulated Other Comprehensive Loss
 Balance, beginning of period             (3,668)        (964)        (2,597)         (759)
 Additional minimum pension liability,
   net of tax                                  -            -             32            30
 Unrealized gains (losses) on
   securities, net of tax                  1,438         (832)           335        (1,067)
                                        --------     --------       --------      --------
 Balance, end of period                   (2,230)      (1,796)        (2,230)       (1,796)

 Treasury Stock
 Balance, beginning of period                (77)         (17)           (17)         (441)
 Acquisition of treasury shares                -            -           (100)            -
 Exercise of stock options                     -            -             40           424
                                        --------     --------       --------      --------
 Balance, end of period                      (77)         (17)           (77)          (17)

                                        --------     --------       --------      --------
 Stockholders' Equity                  $ 121,353    $  83,075      $ 121,353     $  83,075
                                        ========     ========       ========      ========

 Net income                            $   4,877    $   2,473      $   4,461     $   6,292
 Additional minimum pension
   liability, net of tax                       -            -             32            30
 Unrealized gains (losses)
  on securities, net of tax                1,438         (832)           335        (1,067)
                                        --------     --------       --------      --------
 Comprehensive Income                  $   6,315    $   1,641      $   4,828     $   5,255
                                        ========     ========       ========      ========

                 The accompanying notes are an integral part
                  of the consolidated financial statements
</TABLE>
<PAGE>

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

                                                       Nine Months Ended
                                                          September 30
                                                     ------------------------
                                                        2006          2005
                                                     ----------    ----------
 Cash flows from operating activities:
   Net income                                       $     4,461   $     6,292

 Adjustments to reconcile net income to cash
   provided by operating activities:
    Depreciation and amortization expense                 3,202           289
    Interest expense related to amortization
      of discount on convertible notes                    9,625             -
    Deferred federal income tax (benefit) expense        (4,062)        2,051
    Realized (gain) loss on investments                   1,501           (52)
    Change in prepaid reinsurance premiums                 (808)         (297)
    Change in premiums receivable                       (10,118)      (30,193)
    Change in accounts receivable                        (8,725)        1,253
    Change in deferred policy acquisition costs          (5,578)       (6,130)
    Change in unpaid losses and loss adjustment
      expenses                                           29,793         2,537
    Change in unearned premiums                          42,114        24,003
    Change in unearned revenue                           (6,516)       (1,685)
    Change in accrued agent profit sharing                 (319)         (496)
    Change in reinsurance recoverable                    (3,396)        2,037
    Change in reinsurance balances payable               (1,542)            -
    Change in current federal income tax
      payable/recoverable                                (2,197)       (2,121)
    Change in accrued ceding commission payable             104         9,678
    Change in all other liabilities                      (3,556)          812
    Change in all other assets                            1,651        (2,354)
                                                     ----------    ----------
      Net cash provided by operating activities          45,634         5,624
                                                     ----------    ----------
 Cash flows from investing activities:
   Purchases of property and equipment                     (487)         (275)
   Premium finance notes repaid,
     net of finance notes originated                     (2,184)            -
   Acquisition of subsidiaries, net of cash acquired    (25,964)            -
   Change in restricted cash and investments            (24,089)       (2,080)
   Purchases of debt and equity securities              (41,091)      (57,901)
   Maturities and redemptions of investment
     securities                                          18,129         1,237
   Net redemptions (purchases) of short-term
     investments                                        (27,776)            2
                                                     ----------    ----------
   Net cash used in investing activities               (103,462)      (59,017)
                                                     ----------    ----------

 Cash flows from financing activities:
    Proceeds from exercise of employee stock options         40           230
    Proceeds from stockholder rights offering                 -        44,891
    Proceeds from issuance of trust preferred
      securities                                              -        30,928
    Debt issuance costs                                       -          (907)
    Proceeds from issuance of convertible debt           25,000             -
    Proceeds from note payable to related party          12,500             -
    Proceeds from revolving loan on credit facility      15,000             -
                                                     ----------    ----------
        Net cash provided by financing activities        52,540        75,142
                                                     ----------    ----------

 Increase (decrease) in cash and cash equivalents        (5,288)       21,749
 Cash and cash equivalents at beginning of period        44,528        12,901
                                                     ----------    ----------
 Cash and cash equivalents at end of period         $    39,240   $    34,650
                                                     ==========    ==========
 Supplemental Cash Flow Information:
   Interest paid                                    $     3,698    $      567
                                                     ----------    ----------
   Taxes paid                                       $     9,084   $     3,144
                                                     ----------    ----------

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

<PAGE>

              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",  "our")   is  a  diversified   property/casualty
 insurance group  that serves businesses  and  individuals in  specialty  and
 niche markets.  We market, distribute, underwrite and service our commercial
 and personal  property/casualty insurance  products through  four  operating
 units,  each  of  which  has  a  specific focus.   Our  HGA  Operating  Unit
 primarily handles  standard commercial  insurance,  our TGA  Operating  Unit
 concentrates on excess and surplus  lines commercial insurance, our  Phoenix
 Operating Unit focuses on non-standard personal automobile insurance and our
 Aerospace Operating Unit  specializes  in  general aviation  insurance.  The
 subsidiaries comprising our TGA Operating  Unit and our Aerospace  Operating
 Unit  were  acquired  effective  January 1, 2006.   The  insurance  policies
 produced by our  four operating units  are  written by  our three  insurance
 company  subsidiaries  as  well  as  unaffiliated  insurers.   Our insurance
 company subsidiaries  are  American  Hallmark  Insurance  Company  of  Texas
 ("AHIC"), Phoenix  Indemnity  Insurance  Company ("PIIC")  and  Gulf  States
 Insurance Company ("GSIC").


 2. Basis of Presentation

     Our  unaudited consolidated  financial statements  included herein  have
 been  prepared  in  accordance  with  U.S.  generally  accepted   accounting
 principles ("GAAP")  and  include  our accounts  and  the  accounts  of  our
 subsidiaries.  All significant  intercompany accounts and transactions  have
 been  eliminated  in  consolidation.   Certain  information   and   footnote
 disclosures normally included in financial statements prepared in accordance
 with GAAP have been condensed or omitted pursuant to rules  and  regulations
 of the  Securities and  Exchange Commission  ("SEC") for  interim  financial
 reporting.  These financial  statements should be  read in conjunction  with
 our  audited  financial  statements  for  the  year ended  December 31, 2005
 included in our Annual Report on Form 10-K filed with the SEC.

     The  interim  financial data  as  of  September 30,  2006  and  2005  is
 unaudited.  However, in the opinion of management, the interim data includes
 all adjustments, consisting only of normal recurring adjustments,  necessary
 for a fair statement of the results for the interim periods.  The results of
 operations for  the period  ended September  30,  2006 are  not  necessarily
 indicative of the operating results to be expected for the full year.

 Reclassification
 ----------------

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

 Redesignation of Segments
 -------------------------

     Effective January 1, 2006,  our Commercial Insurance Operation has  been
 redesignated as our HGA Operating Unit and our Personal Insurance  Operation
 has been redesignated as  our Phoenix Operating Unit,  in each case  without
 change in the composition of the reporting segment.

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

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

 Recently Issued Accounting Standards
 ------------------------------------
     In  December 2002,  the Financial  Accounting Standards  Board  ("FASB")
 issued Statement of Financial Accounting Standards No. 148, "Accounting  for
 Stock-Based Compensation  -  Transition and Disclosure"  ("SFAS 148").  SFAS
 148 amended  FASB  Statement  of Financial  Accounting  Standards  No.  123,
 "Accounting  for   Stock-Based  Compensation"   ("SFAS  123")   to   provide
 alternative methods of  transition for voluntary  change to  the fair  value
 based  method  of  accounting  for  stock-based  employee  compensation.  In
 addition, SFAS  148  amended the  disclosure  requirements of  SFAS  123  to
 require  prominent  disclosures  in   both  annual  and  interim   financial
 statements  about  the  method   of  accounting  for  stock-based   employee
 compensation  and  the  effect of  the  method  used  on  reported  results.
 Effective January 1, 2003, we adopted  the prospective method provisions  of
 SFAS 148.   Under the  prospective method, we  have applied  the fair  value
 based method of accounting  for our stock-based  payments for option  grants
 after December 31, 2002.

     In  December  2004,  FASB  issued  Statement  of  Financial   Accounting
 Standards No. 123R "Share-Based Payment"  ("SFAS 123R"), which revises  SFAS
 123 and supersedes Accounting Principles Board ("APB") Opinion No. 25  ("APB
 25").   SFAS 123R eliminates an entity's ability to account for  share-based
 payments using APB 25 and requires  that all such transactions be  accounted
 for using a fair value based  method.  In April  2005, the SEC deferred  the
 effective date  of  SFAS  123R  from the  first  interim  or  annual  period
 beginning after June 15, 2005 to  the next fiscal year beginning after  June
 15, 2005.  We  adopted  SFAS 123R  on  January 1, 2006  using the  modified-
 prospective  transition method.  Under  the modified-prospective  transition
 method, compensation  cost  recognized  during  the  period  should  include
 compensation cost  for all  share-based payments  granted  to, but  not  yet
 vested as  of January 1, 2006, based on grant  date fair value estimates  in
 accordance with the original  provisions of SFAS  123 and compensation  cost
 for all share-based  payments granted after  January 1, 2006  in  accordance
 with SFAS 123R.  Since we  adopted the fair value  method of SFAS 123  under
 the prospective method provision of SFAS  148 beginning January 1, 2003,  we
 have a  small  amount of  unvested  share-based payments  granted  prior  to
 January 1, 2003.   During the  first  nine months  of  2006,  we  recognized
 approximately $8  thousand of  additional  compensation expense  under  SFAS
 123R.  SFAS 123R also requires the  benefits of tax deductions in excess  of
 recognized stock compensation cost to be reported as a financing cash  flow,
 rather than as an operating cash flow as previously required.  (See Note  5,
 "Share-Based Payment Arrangements.")

     Had  compensation cost  for all  of our  stock option  grants under  our
 stock compensation plans been  determined based on fair  value at the  grant
 date in  accordance with  the fair  value provisions  of SFAS  123, our  net
 income and earnings per share for the three and nine months ended  September
 30, 2005 would  have been  the pro forma  amounts  indicated  below.  Actual
 results for the  three and nine  months ended  September 30, 2006  have been
 determined in accordance with  the fair value provisions  of SFAS 123R  and,
 therefore, pro forma results for such period are not necessary.

                                                   Three Months   Nine Months
                                                       Ended         Ended
                                                   September 30,  September 30,
      (in thousands)                                     2005         2005
                                                       ---------------------
      Net income as reported                          $  2,473     $  6,292

      Add:  Stock-based compensation expenses
      included in reported net income, net of
      related tax effects                                   13           28

      Deduct:  Total stock-based employee
      compensation expense determined under
      fair value based method for all awards,
      net of related tax effects                           (16)         (37)
                                                       --------------------
      Pro forma net income                            $  2,470     $  6,283
                                                       ====================
      Earnings per share:
        Basic-as reported                             $   0.17     $   0.58
                                                       ====================
        Basic-pro forma                               $   0.17     $   0.58
                                                       ====================
        Diluted-as reported                           $   0.17     $   0.58
                                                       ====================
        Diluted-pro forma                             $   0.17     $   0.57
                                                       ====================


      In May 2005,  FASB issued Statement  of Financial Accounting  Standards
 No. 154, "Accounting  Changes and Error  Corrections, a  replacement of  APB
 Opinion No.  20 and  FASB Statement  No. 3"  ("SFAS  154").  This  Statement
 requires retrospective application to prior periods' financial statements of
 a change in accounting principle.  It applies both to voluntary changes  and
 to changes required by an accounting pronouncement if the pronouncement does
 not include specific transition provisions.  APB 20 previously required that
 most voluntary changes in accounting  principles be recognized by  recording
 the cumulative effect  of  a  change in accounting  principle.  SFAS 154  is
 effective for fiscal  years beginning  after  December 15, 2005.  We do  not
 expect the adoption of SFAS 154 to have a material impact on our results  of
 operations or financial condition.

      In November 2005, FASB issued Staff Position ("FSP") No. FAS 115-1  and
 FAS  124-1,  "The  Meaning   of  Other-Than-Temporary  Impairment  and   Its
 Application to Certain Investments."   This FSP addresses the  determination
 as to when an investment is  considered impaired, whether the impairment  is
 other than temporary,  and  the measurement of an impaired  loss.  This  FSP
 also includes accounting considerations subsequent to the recognition of  an
 other-than-temporary  impairment  and  requires  certain  disclosures  about
 unrealized losses  that have  not  been recognized  as  other-than-temporary
 impairments.  FSP  No. FAS 115-1  and  FAS 124-1 is effective for  reporting
 periods beginning after December 15, 2005.  The adoption of this FSP did not
 have a material impact on our results of operations or financial condition.

      In  February  2006,  FASB  issued  Statement  of  Financial  Accounting
 Standards No.  155, "Accounting  for Certain  Hybrid Financial  Instruments"
 ("SFAS 155").   Under  current  GAAP,  an  entity  that  holds  a  financial
 instrument  with  an  embedded  derivative  must  bifurcate  the   financial
 instrument,  resulting  in  the  host  and  the  embedded  derivative  being
 accounted for separately.  SFAS 155 permits, but does not require,  entities
 to account for  financial instruments with  an embedded  derivative at  fair
 value thus negating the  need to bifurcate the  instrument between its  host
 and  the  embedded derivative.  SFAS  155 is  effective for  fiscal  periods
 beginning after  September 15, 2006.  We  do not expect  that SFAS 155  will
 have a material impact on our results of operations or financial condition.

      In March 2006, FASB issued Statement of Financial Accounting  Standards
 No. 156, "Accounting for Servicing of Financial Assets" ("SFAS 156").   SFAS
 156  amends  FASB  Statement  of  Financial  Accounting  Standards  No. 140,
 "Accounting  for   Transfers  and   Servicing   of  Financial   Assets   and
 Extinguishments of Liabilities," to  require that all separately  recognized
 servicing assets  and  servicing liabilities  be initially  measured at fair
 value,  if  practicable.  SFAS  156  permits,  but  does  not  require,  the
 subsequent  measurement  of  separately  recognized  servicing  assets   and
 servicing  liabilities  at  fair  value.  An  entity  that  uses  derivative
 instruments to mitigate the risks inherent in servicing assets and servicing
 liabilities is required to account for those derivative instruments at  fair
 value.  We do not expect  that SFAS 156 will have  a material impact on  our
 results of operations or financial condition.

      In June 2006, FASB  issued FASB Interpretation  No. 48 "Accounting  for
 Uncertainty in Income Taxes" ("FIN 48").  This Interpretation clarifies  the
 accounting for  uncertainty  in  income  taxes  recognized  in  a  company's
 financial statements in  accordance with Statement  of Financial  Accounting
 Standards No.  109, "Accounting  for Income  Taxes."   FIN 48  prescribes  a
 recognition threshold and measurement attribute for the financial statements
 recognition  and  measurement  of  a  tax  position  taken or expected to be
 taken in  a tax return.  FIN  48 also provides  guidance  on  derecognition,
 classification, interest  and  penalties,  accounting  in  interim  periods,
 disclosure, and transition.  FIN 48  requires that only income tax  benefits
 that meet the "more likely than not" recognition threshold be recognized  or
 continue to  be recognized  on the  effective date.   Initial  derecognition
 amounts would be reported as a  cumulative effect of a change in  accounting
 principle, as  an adjustment  to  the opening  balance  sheet   of  retained
 earnings for the 2007 fiscal year.   The provisions of FIN 48 are  effective
 for fiscal years ending after December 15, 2006.  We do not contemplate  any
 adjustments  and,  accordingly,  do  not   believe  the  adoption  of   this
 Interpretation will have  a material affect  on our  financial condition  or
 results of operations.

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

      In  September 2006,  FASB  issued  Statement  of  Financial  Accounting
 Standards No. 158,  "Employers' Accounting for  Defined Benefit Pension  and
 Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106,
 and 132(R)" ("SFAS 158").  SFAS  158 requires (1) balance sheet  recognition
 of the funded  status of  defined benefit  plans, (2)  recognition in  other
 comprehensive income of various items before they are recognized in periodic
 benefit cost,  (3) the  measurement date  for plan  assets  and  the benefit
 obligation  to be the balance  sheet  date,  and  (4) additional disclosure.
 Requirements (1), (2), and (4) of  SFAS 158 are effective  as of the  end of
 the first fiscal year  ending after December 15,  2006.  Requirement (3)  of
 SFAS 158 is effective for fiscal years  ending after December 15, 2008.   We
 currently recognize the  funded status of  our frozen  defined benefit  cash
 balance plan in our balance sheet and, therefore, we do not expect that  the
 adoption of  SFAS  158  will  have  a material  impact  on  our  results  of
 operations or financial condition.

      In September 2006, the SEC staff issued Staff Accounting Bulletin Topic
 1N,   Financial  Statements  -  Considering  the   Effects  of  Prior   Year
 Misstatements when  Quantifying  Misstatements  in  Current  Year  Financial
 Statements ("SAB  108").  SAB  108  provides  guidance  on  how  prior  year
 misstatements should  be  evaluated  when  determining  the  materiality  of
 misstatements in the  current year  financial statements.  SAB 108  requires
 materiality to  be  determined  by considering  the  effect  of  prior  year
 misstatements on both the current year  balance sheet and income  statement,
 with consideration of their  carryover and reversing  effects. SAB 108  also
 addresses how to correct material misstatements.  The provisions of SAB  108
 are effective for financial statements issued for fiscal years ending  after
 November 15, 2006. The effect of  adopting SAB 108 has not been  determined,
 but it  is  not  expected to  have  a  significant effect  on  our  reported
 financial condition or results of operations.


 3. Business Combinations

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

      Effective  January  1,  2006,  we  acquired  all  of  the  issued   and
 outstanding capital  stock  of  the  subsidiaries  now  comprising  the  TGA
 Operating Unit for an aggregate cash purchase price of up to $45.6  million,
 consisting of unconditional  consideration of $37.6 million  and  contingent
 consideration of $8.0  million.  Of  the unconditional consideration,  $13.9
 million was paid  at closing and  $14.3 million will  be paid  on or  before
 January 1, 2007 and $9.5 million will be paid on or before  January 1, 2008.
 The payment of any contingent consideration  is conditioned on  the  sellers
 complying with  certain restrictive  covenants  and  the TGA  Operating Unit
 achieving certain operational objectives  related to premium production  and
 loss ratios.  The  contingent consideration, if any,  will be payable on  or
 before March 30, 2009, unless the sellers elect to defer payment until March
 30 of any subsequent year in order to permit further development of the loss
 ratios.  In addition to the purchase price, we will pay $2.0 million to  the
 sellers in  consideration  of  their  compliance  with  certain  restrictive
 covenants, including a covenant  not to compete for  a period of five  years
 after  closing.  Of  this  additional  amount,  $750 thousand  was  paid  at
 closing, $750 thousand will be  paid on or before January 1, 2007  and  $500
 thousand will be paid on or before January 1, 2008.

      Texas General  Agency,  Inc. ("Texas  General  Agency") is  a  managing
 general  agency  involved in  the marketing,  underwriting and servicing  of
 property  and  casualty insurance  products, with  a particular  emphasis on
 commercial automobile and general liability risks produced on an excess  and
 surplus lines basis.  The  other affiliated companies  in the TGA  Operating
 Unit are Texas  General Agency's  wholly owned  insurance subsidiary,  GSIC,
 which reinsures a portion of the  business written by Texas General  Agency;
 TGA Special Risk, Inc. ("TGASRI"), which brokers mobile home insurance;  and
 Pan American  Acceptance Corporation  ("PAAC"), which  finances premiums  on
 property and casualty  insurance products marketed  by Texas General  Agency
 and  TGASRI.  Interim  GAAP financial  statements for  the subsidiaries  now
 comprising the TGA Operating Unit are not available for 2005 and, therefore,
 quarterly supplemental  pro  forma  disclosures are  not  included  in  this
 report.

      Effective  January 1, 2006,  we also  acquired all  of the  issued  and
 outstanding membership  interests in  the  subsidiaries now  comprising  the
 Aerospace Operating  Unit, for  an aggregate  consideration of  up to  $15.0
 million, consisting of unconditional consideration  of $12.5 million due  in
 cash at closing  and  contingent consideration  of up to  $2.5 million.  The
 unconditional consideration of $12.5 million  is allocated $11.9 million  to
 the purchase price and $0.6 million to the seller's compliance with  certain
 restrictive covenants, including a covenant not  to compete for a period  of
 five  years  after  closing.  The  payment of  contingent  consideration  is
 conditioned on the seller complying with  its restrictive covenants and  the
 Aerospace Operating Unit achieving certain operational objectives related to
 premium production  and  loss ratios.  The contingent consideration, if any,
 will  be payable  in cash  on or before March 30, 2009,  unless  the  seller
 elects to  defer  a  portion of  the  payment  in order  to  permit  further
 development of loss ratios.

      Our Aerospace Operating Unit is involved in the marketing and servicing
 of  general  aviation  property  and  casualty  insurance  products  with  a
 particular emphasis on private and small commercial  aircraft.  Interim GAAP
 financial statements  for  the  subsidiaries now  comprising  our  Aerospace
 Operating  Unit  are  not  available  for  2005  and,  therefore,  quarterly
 supplemental pro forma disclosures are not included in this report.


 4. Supplemental Cash Flow Information

      Effective January 1, 2006, we acquired the subsidiaries now  comprising
 our TGA  Operating Unit  and  our Aerospace  Operating  Unit. (See  Note  3,
 "Business Combinations.")   In conjunction with  the acquisitions, cash  and
 cash equivalents were used in the acquisitions as follows (in thousands):

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


 5. Share-Based Payment Arrangements

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

      As of  September  30,  2006, there  were  incentive  stock  options  to
 purchase 197,499 shares of our common stock outstanding under the 2005 LTIP,
 leaving 635,834 shares reserved  for future issuance.  As  of  September 30,
 2006,  there  were  incentive  stock  options  to  purchase  101,918  shares
 outstanding under  the  Employee Plan  and  non-qualified stock  options  to
 purchase 25,001 shares outstanding under the Director Plan.  In addition, as
 of September 30, 2006, there were outstanding non-qualified stock options to
 purchase 16,666 shares of our common  stock granted to certain  non-employee
 directors outside the 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 Employee Plan prior to October 31, 2003, vest
 40% six months from the date of grant and  an additional 20% on each of  the
 first three anniversary dates of the grant and terminate ten years from  the
 date of grant.  Options  granted under the 2005  LTIP and the Employee  Plan
 after October 31, 2003,  vest 10%, 20%,  30% and 40%  on the first,  second,
 third and fourth anniversary dates of the grant, respectively, and terminate
 five to ten years  from the date of  grant.  All  options granted under  the
 Director Plan vest 40% six months from  the date of grant and an  additional
 10% on each of the  first six anniversary dates  of the grant and  terminate
 ten years  from the  date of  grant.  The options  granted  to  non-employee
 directors outside the Director Plan fully  vested six months after the  date
 of grant and terminate ten years from the date of grant.

      A summary of the status of our  stock options as of and changes  during
 the year-to-date ended September 30, 2006 is presented below:

                                                        Weighted
                                                        Average
                                             Weighted   Remaining   Aggregate
                                             Average   Contractual  Intrinsic
                                 Number of   Exercise     Term        Value
                                  Shares      Price      (Years)     ($000)
                                 --------------------------------------------
 Outstanding at January 1, 2006    252,750   $   4.92         -            -
 Granted                           109,166   $  11.34         -            -
 Exercised                         (20,832)  $   5.50         -            -
 Forfeited or expired                    -   $      -         -            -
                                 ---------
 Outstanding at
   September 30, 2006              341,084   $   6.93       6.6     $  1,497
 Exercisable at
   September 30, 2006               90,834   $   3.70       3.7     $    691


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

                                  Three Months Ended       Nine Months Ended
                                     September 30,           September 30,
                                   2006         2005       2006         2005
                                  ------       ------     -------     -------
 Intrinsic value of options
   exercised                     $     -      $     -    $    103    $    260

 Cost of share-based payments    $    50      $    20    $    107    $     43

 Income tax benefit of
   share-based payments
   recognized in income          $    17      $     7    $     37    $     15


      As of September 30, 2006, there was $1.0 million of total  unrecognized
 compensation   cost   related   to   non-vested   share-based   compensation
 arrangements granted under our plans, of  which $47 thousand is expected  to
 be recognized  in the  remainder of  2006, $0.3  million is  expected  to be
 recognized in each of 2007, 2008 and 2009 and $0.1 million is expected to be
 recognized in 2010.

      The fair value of each stock option granted is estimated on the date of
 grant using the Black-Scholes option  pricing model.  Expected  volatilities
 are based on  historical volatility of  Hallmark's  shares.   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.

      The following  table details  the grant  date  fair value  and  related
 assumptions for the periods indicated (in thousands).  There were no options
 granted in either of the first or third quarters of 2006 or 2005.

                                  Three Months Ended       Nine Months Ended
                                     September 30,           September 30,
                                   2006         2005       2006         2005
                                  ------       ------     -------     -------
 Grant date fair value per share     n/a          n/a    $   6.26    $   4.01

 Expected term                       n/a          n/a           5           5
 Expected volatility                 n/a          n/a        59.1%       62.5%
 Risk free interest rate             n/a          n/a         4.9%        3.9%


 For the  nine  months  ended September 30, 2006  and  2005,  we had non-cash
 stock-based  compensation  expense  of  $107  thousand  and  $43   thousand,
 respectively.


 6. Segment Information

     The following is business  segment information for the three months  and
 nine months ended September 30, 2006 and 2005 (in thousands):

                                  Three Months Ended      Nine Months Ended
                                     September 30,           September 30,
                                  -------------------     -------------------
                                   2006         2005       2006         2005
                                  -------     -------     -------     -------
 Revenues:
 ---------
 HGA Operating Unit              $ 20,964    $ 14,339    $ 57,768    $ 27,194
 TGA Operating Unit                19,403           -      48,686           -
 Phoenix Operating Unit            12,257      10,814      34,944      33,169
 Aerospace Operating Unit           3,486           -       7,317           -
 Corporate                            255          14        (643)         34
                                  -------     -------     -------     -------
   Consolidated                  $ 56,365    $ 25,167    $148,072    $ 60,397
                                  =======     =======     =======     =======

 Pre-tax income (loss):
 ----------------------
 HGA Operating Unit              $  5,112    $  2,196    $ 11,245    $  4,761
 TGA Operating Unit                 1,998           -       7,152           -
 Phoenix Operating Unit             2,316       2,790       6,760       7,666
 Aerospace Operating Unit             869           -         773           -
 Corporate                         (2,663)     (1,335)    (18,551)     (3,061)
                                  -------     -------     -------     -------
   Consolidated                  $  7,632    $  3,651    $  7,379    $  9,366
                                  =======     =======     =======     =======

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

                                           Sept. 30,     Dec. 31,
                                             2006          2005
                                           --------      --------
                  Assets
                  ------
        HGA Operating Unit                $ 143,304    $  136,220
        TGA Operating Unit                  121,695             -
        Phoenix Operating Unit               80,767        68,264
        Aerospace Operating Unit             29,424             -
        Corporate                            32,226         4,422
                                           --------      --------
          Consolidated                    $ 407,416     $ 208,906
                                           ========      ========


 7. Reinsurance

     We reinsure a portion of the risk we underwrite in order to control  the
 exposure to losses and to protect capital resources.  We cede to  reinsurers
 a portion of these risks and pay  premiums based upon the risk and  exposure
 of  the policies  subject to such  reinsurance.  Ceded reinsurance  involves
 credit risk and is generally subject to aggregate loss limits.  Although the
 reinsurer is liable to  us to the  extent of the  reinsurance ceded, we  are
 ultimately liable as the direct insurer on all risks reinsured.  Reinsurance
 recoverables are reported  after allowances for  uncollectible amounts.   We
 monitor the financial condition of reinsurers on an ongoing basis and review
 our reinsurance arrangements periodically.  Reinsurers are selected based on
 their financial condition, business practices and the price of their product
 offerings.  Refer to Note 6 of our Form 10-K for the year ended December 31,
 2005 for more discussion of our reinsurance.

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

                                  Three Months Ended      Nine Months Ended
                                     September 30,           September 30,
                                  -------------------     -------------------
                                   2006         2005       2006         2005
                                 -------     -------     -------     -------
        Ceded earned premiums   $  3,099    $    255    $  6,696    $    255
        Reinsurance recoveries  $  3,130    $   (118)   $  4,024    $   (499)


 8. Notes Payable

      On June 21, 2005, our newly formed 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  AHIC in  order  to  increase
 policyholder surplus.   The note bears  an initial interest  rate of  7.725%
 until June 15, 2015, at which  time  interest will  adjust quarterly to  the
 three month LIBOR  rate plus 3.25  percentage points.  As  of September  30,
 2006, 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  September 30, 2006,
 the balance on the revolving note was $15.0 million.  (See Note 3, "Business
 Combinations" and Note 12, "Credit Facilities.")  In October 2006, we repaid
 $12.2 million  of the  principal  balance of  this  note from  the  proceeds
 received from our public equity offering. (See Note 16, "Subsequent Event.")
 Also  included in  notes payable is  $2.6 million  outstanding under  PAAC's
 revolving credit facility, which currently bears  8.25% interest.  (See Note
 12, "Credit Facilities").


 9.  Note Payable to Related Party

      On January 3, 2006, we executed a promissory note payable to  Newcastle
 Partners, L.P. in the amount of $12.5 million in order to obtain funding  to
 complete the  acquisition  of  the  subsidiaries  comprising  our  Aerospace
 Operating Unit.  The promissory note bears  interest at the rate  of 10% per
 annum.  The  principal of  the promissory  note, together  with accrued  and
 unpaid interest, became due and payable on demand  as of June 30, 2006.   As
 of September 30,  2006 the promissory  note balance was  $12.5  million.  We
 repaid this note in October 2006 from the proceeds received from our  public
 equity offering. (See Note 16, "Subsequent Event.")


 10.  Convertible Notes Payable

      On  January  27,  2006,  we   issued  $25.0  million  in   subordinated
 convertible promissory notes to Newcastle  Special Opportunity Fund I,  L.P.
 and Newcastle  Special  Opportunity  Fund II,  L.P.,  which  are  investment
 partnerships managed  by  an  entity controlled  by  Mark  E.  Schwarz,  our
 Executive Chairman.  Each  convertible note bore interest  at 4% per  annum,
 which rate increased to 10% per annum in the event of default.  Interest was
 payable quarterly in arrears commencing March 31, 2006.  Principal  and  all
 accrued but unpaid  interest was  due at  maturity on  July 27,  2007.   The
 principal and accrued  interest on the  convertible notes  was converted  to
 approximately 3.3  million shares  of our  common  stock during  the  second
 quarter of 2006.

      In accordance with the FASB Emerging  Issues Task Force ("EITF")  Issue
 No. 98-5 "Accounting for  Convertible Securities with Beneficial  Conversion
 Features or Contingently  Adjustable Conversion Ratios"  and EITF Issue  No.
 00-27 "Application of  Issue No. 98-5  to Certain Convertible  Instruments,"
 the convertible notes contained a beneficial conversion feature requiring  a
 discount to the  carrying amount of  the notes equal  to (i) the  difference
 between the stated conversion rate and the market price of our common  stock
 on the date of issuance, multiplied by (ii) the number of shares into  which
 the notes were convertible.  Per EITF Issue No. 98-5 and EITF Issue No.  00-
 27, upon issuance  we recorded a  $9.6 million discount  to the  convertible
 notes which was amortized straight line as interest expense over the term of
 the convertible notes, with the unamortized balance of the discount expensed
 upon conversion of the notes in the second quarter of 2006.  The discount to
 the convertible notes  was offset by  increases to  deferred federal  income
 taxes and additional paid in capital.  The discount on the convertible notes
 had no ultimate effect on our book value.

      Interest expense resulting  from amortization  of the  discount on  the
 convertible notes during the  first nine months of  2006  was  $9.6 million.
 This interest expense had  the effect of reducing  our operating income  for
 the period, but had no effect on our cash flow.


 11.  Structured Settlements

      In connection with the acquisition  of the subsidiaries comprising  our
 TGA Operating Unit, we recorded a payable for the future guaranteed payments
 of $25.0 million discounted  at 4.4%, the rate  of two-year U.S.  Treasuries
 (the only investment  permitted on the  trust account  securing such  future
 payments and which is classified in  restricted cash and investments on  our
 balance sheet).  (See Note 3, "Business Combinations.")  As of September 30,
 2006, the balance of the structured settlements was $24.3 million.


 12. Credit Facilities

      On June 29, 2005,  we  entered into a  credit facility  with The  Frost
 National Bank.  The credit facility was amended and restated on January  27,
 2006 to  a $20.0  million revolving  credit facility,  with a  $5.0  million
 letter  of  credit  sub-facility.   We  borrowed  $15.0  million  under  the
 revolving credit facility to fund the cash required to close the acquisition
 of   the  subsidiaries  comprising   our   TGA  Operating  Unit.   Principal
 outstanding under the revolving credit facility generally bears interest  at
 the  three  month Eurodollar rate plus  2.00%, payable quarterly in arrears.
 We  pay  letter  of  credit fees  at  the  rate of  1.00%  per  annum.   Our
 obligations under the revolving  credit facility are  secured by a  security
 interest in the capital stock of all of our subsidiaries, guaranties of  all
 of our subsidiaries and the pledge of substantially all of our assets.   The
 revolving credit  facility contains  covenants  which, among  other  things,
 require us to maintain certain financial  and operating ratios and  restrict
 certain distributions, transactions and organizational changes.  The amended
 and  restated  credit  agreement  terminates  on  January  27, 2008.  As  of
 September 30, 2006, there was $15.0 million outstanding under our  revolving
 credit facility, and we were  in compliance with all  of our  covenants.  In
 October 2006, we repaid $12.2 million  of the outstanding principal  balance
 under our revolving credit facility with  proceeds received from our  public
 equity offering. (See Note 16, "Subsequent Event.")  In the third quarter of
 2005, we  issued a  $4.0 million  letter of  credit under  this facility  to
 collateralize certain obligations under the agency agreement between our HGA
 Operating Unit and  Clarendon National Insurance  Company effective July  1,
 2004.

      PAAC has a $5.0 million revolving credit facility  with JPMorgan  Chase
 Bank  which  terminates  June 30, 2007.  Principal  outstanding  under  this
 revolving credit facility  generally bears interest  at 1%  above the  prime
 rate.  PAAC's obligations under this  revolving credit facility are  secured
 by its premium finance  notes receivables.   This revolving credit  facility
 contains various restrictive  covenants which, among  other things,  require
 PAAC to maintain minimum amounts of tangible net worth and working  capital.
 As  of September 30, 2006, $2.6 million was outstanding under this revolving
 credit facility and PAAC was in  compliance with or had obtained waivers  of
 all of its covenants.


 13. Deferred Policy Acquisition Costs

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

                                  Three Months Ended      Nine Months Ended
                                     September 30,           September 30,
                                  -------------------     -------------------
                                   2006         2005       2006         2005
                                  -------     -------     -------     -------
        Deferred                 $(10,709)   $(14,252)   $(28,299)   $(25,877)
        Amortized                   8,531       8,751      22,721      19,747
                                  -------     -------     -------     -------
        Net                      $ (2,178)   $ (5,501)   $ (5,578)   $ (6,130)
                                  =======     =======     =======     =======


 14. Earnings per Share

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

                                  Three Months Ended      Nine Months Ended
                                     September 30,           September 30,
                                  -------------------     -------------------
                                   2006         2005       2006         2005
                                  -------------------     -------------------
 Weighted average shares - basic   17,760      14,474      16,019      10,841
 Effect of dilutive securities         26         104          19         100
                                  -------------------     -------------------
 Weighted average shares -
   assuming dilution               17,786      14,578      16,038      10,941
                                  ===================     ===================

      For the three and nine months ended September 30, 2006, 109,166  shares
 attributable to outstanding stock options were excluded from the calculation
 of diluted  earnings per  share because  the exercise  prices of  the  stock
 options were  greater than  the  average price  of  the common  shares  and,
 therefore, their inclusion  would have been  anti-dilutive.   For the  three
 months and nine months ended September  30, 2005, no shares attributable  to
 outstanding stock  options were  excluded from  the calculation  of  diluted
 earnings per share.


 15. Net Periodic Pension Cost

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

                                  Three Months Ended      Nine Months Ended
                                     September 30,           September 30,
                                  -------------------     -------------------
                                   2006         2005       2006         2005
                                  -------------------     -------------------
 Interest cost                   $    172    $    181    $   515      $   544
 Amortization of net loss              40          19        121           57
 Expected return on plan assets      (157)       (184)      (472)        (552)
                                  -------------------     -------------------
 Net periodic pension cost       $     55    $     16    $   164      $    49
                                  ===================     ===================

     We  contributed $0.2  million and  $49 thousand  to our  frozen  defined
 benefit cash balance plan during the  three months ended September 30,  2006
 and 2005, respectively, and contributed $0.3 million and $0.1 million during
 the nine months ended September 30,  2006 and 2005, respectively.  Refer  to
 Note 13 of  our Form  10-K for the  year ended  December 31,  2005 for  more
 discussion of our retirement plans.


 16. Subsequent Event

     In October 2006,  we completed a public  offering of 3.0 million  shares
 of our common  stock for  $9.00 per  share.   We have  used all  of the  net
 proceeds to (1) pay off the  $12.5 million principal balance of the  related
 party note to  Newcastle Partners, L.P.,  and (2) pay  $12.2 million of  the
 outstanding principal balance  of our revolving  line of  credit with  Frost
 Bank. (See Note 8, "Notes Payable," Note 9, "Notes Payable to Related Party"
 and Note 12, "Credit Facilities.")


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

 Introduction

      Hallmark  Financial  Services,  Inc.  ("Hallmark"  and,  together  with
 subsidiaries, "we",  "us", "our")  is an  insurance holding  company  which,
 through its subsidiaries, engages in the sale of property/casualty insurance
 products to  businesses and  individuals. Our  business involves  marketing,
 distributing, underwriting and servicing commercial insurance in Texas,  New
 Mexico,  Idaho,  Oregon,  Montana,   Louisiana,  Oklahoma  and   Washington;
 marketing, distributing,  underwriting and  servicing non-standard  personal
 automobile insurance  in Texas,  New Mexico,  Arizona, Oklahoma  and  Idaho;
 marketing,  distributing,  underwriting   and  servicing  general   aviation
 insurance in 48 states; and providing  other insurance related services.  We
 pursue our  business activities  through subsidiaries  whose operations  are
 organized into producing units  and are supported  by our insurance  company
 subsidiaries.

      Our non-carrier insurance activities are organized by producing units
 into the following operational segments:

   *  HGA Operating Unit.  Our HGA Operating Unit includes the standard lines
      commercial property/casualty insurance products and services handled by
      our Hallmark General Agency, Inc. and Effective Claims Management, Inc.
      subsidiaries.

   *  TGA Operating Unit.  Our TGA Operating Unit includes the excess
      and surplus lines commercial property/casualty insurance products
      and services handled by our Texas General Agency, Inc., Pan
      American Acceptance Corporation ("PAAC") and TGA Special Risk, Inc.
      subsidiaries.  Our TGA Operating Unit also includes a relatively small
      amount of personal lines insurance handled by these subsidiaries.  The
      subsidiaries comprising our TGA Operating Unit were acquired effective
      January 1, 2006.

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

   *  Aerospace Operating Unit.  Our Aerospace Operating Unit includes
      the general aviation insurance products and services handled by our
      Aerospace Insurance Managers, Inc., Aerospace Special Risk, Inc. and
      Aerospace Claims Management Group, Inc. subsidiaries.  The subsidiaries
      comprising our Aerospace Operating Unit were acquired effective January
      1, 2006.

 The retained premium produced by these producing units is supported by the
 following insurance company subsidiaries:

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

   *  Gulf States Insurance Company ("GSIC"), which was acquired effective
      January 1, 2006, presently assumes a portion of the risks on the
      commercial property/casualty policies marketed by our TGA Operating
      Unit.

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

      Effective January 1, 2006,  our insurance company subsidiaries  entered
 into a pooling arrangement pursuant to which AHIC retains 59.9% of the total
 net premiums written by  all of our operating  units, PIIC retains 34.1%  of
 our total  net premiums  written and  GSIC  retains 6.0%  of our  total  net
 premiums written.

      Prior to January 1, 2006, our HGA Operating Unit was referred to as our
 Commercial Insurance Operation and our  Phoenix Operating Unit was  referred
 to as our Personal  Insurance Operation.  The  retained premium produced  by
 our  operating  units  was  supported  by   our  AHIC  and  PIIC   insurance
 subsidiaries.  Discussions  for  periods prior  to  January 1, 2006  do  not
 include the operations of our TGA Operating Unit or our Aerospace  Operating
 Unit, each of which was acquired effective  January 1, 2006.  All share  and
 per share amounts have been adjusted to reflect a one-for-six reverse  split
 of all issued and  unissued shares of our  authorized common stock  effected
 July 31, 2006.

 Results of Operations

     Management Overview.   During  the three  months and  nine months  ended
 September 30,  2006,  our  total revenues  were  $56.4  million  and  $148.1
 million,  respectively,   representing  a   124.0%  and   145.2%   increase,
 respectively, over the $25.2 million and $60.4 million in total revenues for
 the comparable periods of 2005.  The acquisitions of the TGA Operating  Unit
 and the Aerospace Operating  Unit in the first  quarter of 2006  contributed
 $22.9 million and $56.0  million to the increase  in total revenues for  the
 three months  and nine  months ended  September 30,  2006, respectively,  as
 compared  to  the  same  periods  in  2005.  The  following  table  provides
 additional information concerning  the increases in  revenue contributed  by
 these acquisitions (in thousands):

                                                Three Months    Nine Months
                                                    Ended           Ended
                                               Sept. 30, 2006  Sept. 30, 2006
                                               --------------  --------------
      Third party commission revenue              $    9,737      $   29,692
      Earned premium on retained business             11,774          23,162
      Investment income, finance charges
        and other revenue items                        1,378           3,149
                                                   ---------       ---------
      Revenue contributions from acquisitions     $   22,889      $   56,003
                                                   =========       =========

     The retention of  business produced by the  HGA Operating Unit that  was
 previously retained by third parties also contributed $9.1 million and $40.3
 million to the  increase in  revenue for the  three months  and nine  months
 ended September 30, 2006, respectively.  Increased finance charge revenue of
 $0.1 million  also contributed to the increased revenues for the nine months
 ended  September 30, 2006.  These increases were partially  offset  by lower
 ceding commission  revenue of $2.4  million  and  $10.0  million  and  lower
 processing and services fees of $0.6 million and $2.1 million for the  three
 and nine months ended September 30, 2006, respectively, attributable to  the
 shift from  a  third-party agency  structure  to an  insurance  underwriting
 structure.  Earned premiums from our Phoenix Operating Unit contributed $2.3
 million and $2.7 million to the increase  in revenue for the three and  nine
 months ended September 30, 2006, respectively, as well as increased  finance
 charge  revenue  of  $0.1  million  and  $0.2  million  for  the  three  and
 nine  months ended September 30, 2006,  respectively.  These  increases were
 partially offset by lower ceding commission revenue of $0.5 million and $1.0
 million and  lower processing  and service  fees of  $0.1 million  and  $0.3
 million  for  the  three   and  nine  months   ended  September  30,   2006,
 respectively.  The investment  of funds derived  from the implementation  of
 our  2005  capital  plan  contributed another  $0.5 million and $3.4 million
 to revenue  for  the  three  and  nine  months  ended  September  30,  2006,
 respectively.  These increases were partially offset by other-than-temporary
 impairment charges on our  equity investment portfolio  of $1.2 million  for
 the nine months ended September 30, 2006  and increased net realized  losses
 on our investment portfolio of $0.1  million and $0.4 million for the  three
 and nine months ended September 30, 2006.

       We reported net income of $4.9 million and $4.5 million for the  three
 months and nine months ended September  30, 2006, respectively, as  compared
 to net income of $2.5 million  and $6.3 million in  the same periods in  the
 prior year.  On a diluted  per share basis, net  income was $0.27 and  $0.28
 for the three months and nine months ended September 30, 2006, respectively,
 as compared to $0.17  and $0.58 for the  same periods in  2005.  During  the
 nine months ended September 30, 2006,  we recorded $9.6 million of  interest
 expense from amortization attributable to the deemed discount on convertible
 promissory notes  issued in  January, 2006  and  converted to  common  stock
 during  the  second  quarter  of  2006.  (See Note  10,  "Convertible  Notes
 Payable.")  In the absence of this non-cash expense, our net income for  the
 nine months  ended  September  30,  2006  would  have  been  $10.5  million,
 representing  a  67.3%  increase  over  the  similar  period  of  2005.  The
 following  is  a reconciliation of  our net  income  without  such  interest
 expense to our reported  results (in thousands).   Management believes  this
 reconciliation provides useful  supplemental information  in evaluating  the
 operating results of our business.  This disclosure should not be viewed  as
 a substitute for net income determined in accordance with GAAP:

                                                Three Months    Nine Months
                                                    Ended           Ended
                                               Sept. 30, 2006  Sept. 30, 2006
                                               --------------  --------------
      Income excluding interest expense from
        amortization of discount, net of tax       $  4,877        $ 10,527
                                                -------------   -------------
      Interest expense from amortization
        of discount                                       -           9,625
      Less related tax effect                             -          (3,559)
                                                -------------   -------------
                                                          -           6,066

                                                -------------   -------------
      Net income                                   $  4,877        $  4,461
                                                =============   =============

     Excluding  the  interest expense  from  amortization  of  discount,  the
 increase in net  income for the  three and nine  months  ended September 30,
 2006 versus  the same  periods in  2005 was  primarily attributable  to  the
 results of  our  newly  acquired TGA  and  Aerospace  Operating  Units,  the
 retention of business produced  by our HGA Operating  Unit beginning  in the
 third quarter of 2005,  and additional investment  income.  These  increases
 were partially offset by additional income tax due to higher taxable  income
 and an increase  in our  federal statutory  rate from  34% to  35% in  2006,
 other-than-temporary impairments realized in the  second quarter of 2006  on
 our investment  portfolio,  additional  interest expense  on  borrowings  to
 finance the acquisitions of our TGA  Operating Unit and Aerospace  Operating
 Unit, lower  results  from  our Phoenix  Operating  Unit  due  primarily  to
 favorable prior accident year  loss development recognized  in 2005 and  the
 runoff of third party revenue recognized  in 2005 from assuming 100% of  the
 Texas non-standard auto business  beginning in the  fourth quarter of  2004,
 and increased corporate operating expenses.

     Our  effective  tax  rates  for  the  three months and nine months ended
 September 30, 2006 were 36.1% and 39.5%, respectively,  as compared to 32.3%
 and 32.8% for the similar  periods  of  2005.  The increase in our effective
 tax rates was  the  combined result of the increase in our federal statutory
 rate  attributable to higher taxable income and an increase in the valuation
 allowance  on our deferred tax assets.  During the third quarter of 2006, we
 realized a $1.1 million loss from the sale of an equity investment for which
 we had recognized  an  other-than-temporary  impairment  during the previous
 quarter.  We increased our deferred  tax  asset  valuation allowance by $0.3
 million  to  reflect  the  uncertainty  of future capital gains  which  this
 capital loss could be used to offset.


 Third Quarter 2006 as Compared to Third Quarter 2005

<TABLE>
     The following is additional  business segment information for the  three
 months ended September 30, 2006 and 2005 (in thousands):

                                                         Three Months Ended September 30, 2006
                                        ----------------------------------------------------------------------
                                          HGA         TGA       Phoenix    Aerospace   Corporate  Consolidated
                                        --------    --------    --------   ---------   ---------  ------------
 <S>                                   <C>         <C>         <C>         <C>         <C>         <C>
 Produced premium                      $  22,206   $  34,825   $  12,278   $   6,495   $       -   $  75,804
                                        --------    --------    --------    --------    --------    --------
 Gross premiums written                   21,967      17,269      12,278       6,593           -      58,107
 Ceded premiums written                   (2,270)       (747)          -         (85)          -      (3,102)
                                        --------    --------    --------    --------    --------    --------
 Net premiums written                     19,697      16,522      12,278       6,508           -      55,005
 Change in unearned premiums                (497)     (5,764)     (1,058)     (5,492)                (12,811)
                                        --------    --------    --------    --------    --------    --------
 Net premiums earned                      19,200      10,758      11,220       1,016           -      42,194

 Total revenues                           20,964      19,403      12,257       3,486         255      56,365

 Loss and loss adjustment expenses         9,347       6,863       6,800         587          (8)     23,589

 Pre-tax income                        $   5,112   $   1,998   $   2,316   $     869   $  (2,663)  $   7,632
                                        --------    --------    --------    --------    --------    --------

 Net loss ratio (1)                         48.7%       63.8%       60.6%       57.8%                   55.9%
 Net expense ratio (1)                      28.9%       29.1%       28.9%       35.1%                   29.1%
                                        --------    --------    --------    --------                    --------
 Net combined ratio                         77.6%       92.9%       89.5%       92.9%                   85.0%
                                        ========    ========    ========    ========                    ========


                                                         Three Months Ended September 30, 2005
                                        ----------------------------------------------------------------------
                                          HGA         TGA       Phoenix    Aerospace   Corporate  Consolidated
                                        --------    --------    --------   ---------   ---------  ------------
 <S>                                   <C>         <C>         <C>         <C>         <C>         <C>
 Produced premium                      $  19,662   $       -   $   8,643   $       -   $       -   $  28,305
                                        --------    --------    --------    --------    --------    --------

 Gross premiums written                   34,869           -       8,643           -           -      43,512
 Ceded premiums written                     (552)          -           -           -           -        (552)
                                        --------    --------    --------    --------    --------    --------
 Net premiums written                     34,317           -       8,643           -           -      42,960
 Change in unearned premiums             (24,250)          -         314           -                 (23,936)
                                        --------    --------    --------    --------    --------    --------
 Net premiums earned                      10,067           -       8,957           -           -      19,024

 Total revenues                           14,339           -      10,814           -          14      25,167

 Loss and loss adjustment expenses         5,630           -       5,429           -         (16)     11,043

 Pre-tax income                        $   2,196   $       -   $   2,790   $       -   $  (1,335)  $   3,651
                                        --------    --------    --------    --------    --------    --------

 Net loss ratio (1)                         55.9%                   60.6%                               58.0%
 Net expense ratio (1)                      37.5%                   33.5%                               35.6%
                                        --------                --------                            --------
 Net combined ratio                         93.4%                   94.1%                               93.6%
                                        ========                ========                            ========

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

 HGA Operating Unit

       Beginning in the third quarter  of 2005, our HGA Operating Unit  began
 retaining written premium through AHIC that was previously retained by third
 parties.  On July 1, 2005, our  HGA Operating Unit assumed $20.1 million  of
 in-force  policies  it  had  previously  produced  for  Clarendon   National
 Insurance Company which resulted  in the written  premium for third  quarter
 2005 being larger  than third quarter  2006.  This  was partially offset  by
 increased retained written premium that was produced in the third quarter of
 2006 over the  retained written  premium produced  in the  third quarter  of
 2005.

     Total revenue for the HGA Operating Unit of $21.0 million for the  third
 quarter of 2006 was $6.6 million more than the $14.3 million reported in the
 third quarter of 2005.  This  46.2% increase in total revenue was  primarily
 due  to  increased  net  premiums earned  of $9.1  million for  the quarter.
 Increased net investment  income contributed an  additional $0.4 million  to
 the increase  in revenue  for the quarter.  These increases in revenue  were
 partially offset  by lower  ceding commission  revenue of  $2.4 million  and
 lower processing and service fees of $0.6 million, in both cases due  to the
 shift from  a third  party agency  structure  to an  insurance  underwriting
 structure.

     Pre-tax income for our HGA Operating Unit of $5.1 million for the  third
 quarter of 2006  increased $2.9 million,  or 132.8%, over  the $2.2  million
 reported for the  third quarter of  2005.  Increased  revenue, as  discussed
 above, was the primary reason for the increase in pre-tax income,  partially
 offset by increased loss and loss adjustment expenses of $3.7 million.   The
 HGA Operating Unit reported a net loss ratio of 48.7% for the third  quarter
 of 2006 as compared  to a net loss  ratio of 55.9% for  the same period  the
 prior year.  The loss ratios gross  of reinsurance were 58.2% and 54.6%  for
 the third quarter of 2006 and 2005, respectively.  The increase in the gross
 loss ratio  was  due to  four  large  property losses  that  penetrated  our
 reinsurance coverages.  Partially offsetting the increase in the loss  ratio
 gross of reinsurance was  $0.5 million of  favorable reserve development  on
 prior accident years during the third quarter  of 2006.  There was no  prior
 year reserve development in 2005 as we began retaining this business  during
 the third quarter  of 2005.   The HGA  Operating Unit  reported net  expense
 ratios of  28.9%  and  37.5%  for  the third  quarters  of  2006  and  2005,
 respectively.   The net  expense ratio  for the  third quarter  of 2005  was
 higher due to costs to assume from Clarendon National Insurance Company  the
 unearned premium produced by our HGA Operating Unit.

 TGA Operating Unit

     The subsidiaries  comprising our TGA  Operating Unit  were all  acquired
 effective January 1, 2006.  The $19.4 million of revenues was derived mostly
 from third  party commission  revenue  of $7.7  million  on the  portion  of
 business produced  by the  TGA Operating  Unit that  was retained  by  third
 parties and from $10.8 million of  earned premium on produced business  that
 was assumed by  GSIC or AHIC.   The remaining  $0.9 million  of revenue  was
 primarily derived from investment income and finance charges.

     Pre-tax  income for  our TGA  Operating  Unit of  $2.0 million  was  due
 primarily to revenue  as discussed  above less  (i) incurred  loss and  loss
 adjustment expenses of $6.9 million on  the portion of the business  assumed
 by GSIC or AHIC, (ii) $10.0 million in operating expenses, comprised  mostly
 of commission expense and salary related expenses, and (iii) $0.5 million of
 amortization of  intangible  assets  acquired  in  the  acquisition  of  the
 subsidiaries comprising  our TGA  Operating Unit.  The  TGA  Operating  Unit
 reported a net loss ratio of 63.8% and a net expense ratio of 29.1% for  the
 third quarter of 2006.  We do not have comparable loss or expense ratios for
 the same period in 2005 as  we acquired the subsidiaries comprising the  TGA
 Operating Unit effective January 1, 2006.

 Phoenix Operating Unit

     Net  premium written  for  our  Phoenix Operating  Unit  increased  $3.6
 million during the third quarter of  2006 to $12.3 million compared to  $8.6
 million in the third quarter of 2005.  The increase in premium is due mostly
 to premium from  new states that  our Phoenix Operating  Unit expanded  into
 this year.

     Total revenue  for the Phoenix Operating  Unit increased 13.3% to  $12.3
 million for the third quarter of 2006 from $10.8 million for the same period
 in 2005.   Higher earned  premium of $2.3  million was  partially offset  by
 lower third party commission revenue of  $0.5 million and lower service  fee
 revenue of $0.1 million recognized in the  third quarter of 2006 due to  the
 100% assumption  of  the  Texas  non-standard  personal  automobile  premium
 beginning  late  in  2004.  Lower investment  income  of $0.3  million  also
 partially offset the increase in earned premium.

     Pre-tax income  for the Phoenix Operating  Unit decreased $0.5  million,
 or 17.0%, for the  third quarter of  2006 compared to  the third quarter  of
 2005.  The primary reason for the decline in pre-tax income for the  quarter
 was the runoff of third party revenue recognized in 2005 from assuming  100%
 of the Texas non-standard auto business  beginning in the fourth quarter  of
 2004  of $0.6 million,  as well as  lower investment income of $0.3 million.
 This was partially offset by additional underwriting margin of $0.4  million
 realized on  the  increased earned  premium.   The  Phoenix  Operating  Unit
 reported net loss ratio of 60.6% for the third quarters of 2006 and 2005 and
 net  expense  ratios  of  28.9%  and  33.5%  for the third  quarters of 2006
 and 2005, respectively.  The third quarter 2006  loss  and  loss  adjustment
 expenses included $0.7 million of  favorable reserve development from  prior
 accident  years  as  compared  to  $0.2  million  of  favorable  development
 recognized in the third quarter of 2005.

 Aerospace Operating Unit

     The  subsidiaries  comprising our  Aerospace  Operating  Unit  were  all
 acquired  effective  January 1, 2006.   The  $3.5  million of  revenues  was
 derived primarily from third party commission revenue of $2.1 million on the
 portion of  business retained  by third  parties and  from $1.0  million  of
 earned premium on produced business that was retained by Hallmark.  We began
 retaining  100%  of this  business beginning  July 1, 2006.   The  remaining
 revenue was derived primarily from investment income.

     Pre-tax income for the Aerospace Operating Unit of $0.9 million for  the
 third quarter of 2006 was due  to revenue discussed above less (i)  incurred
 loss and loss  adjustment expenses  of $0.6 million  on the  portion of  the
 business assumed by PIIC or AHIC,  (ii) $1.9 million in operating  expenses,
 comprised mostly  of commission  expense and  salary related  expenses,  and
 (iii) $0.1  million of  amortization of  intangible assets  acquired in  the
 acquisition  of  the  subsidiaries comprising our  Aerospace Operating Unit.
 The Aerospace Operating Unit reported  a net loss ratio  of 57.8% and a  net
 expense ratio of 35.1% for the third quarter of 2006.  The net expense ratio
 includes $16 thousand  of costs to  license PIIC for  aviation insurance  in
 various states where the Aerospace Operating Unit produces business.   These
 costs are not directly attributable to producing the premium that was earned
 during the period.  Excluding these costs, the net expense ratio was  33.6%.
  We do not have  comparable loss or  expense ratios for  the same period  in
 2005 as we acquired the subsidiaries comprising the Aerospace Operating Unit
 effective January 1, 2006.

 Corporate

      Corporate revenue increased $0.2 million for the third quarter of  2006
 as compared to the same period in 2005.   The increase was primarily due  to
 $0.3 million in interest earned on a trust account established in the  first
 quarter of 2006 securing  the guaranteed future payments  to the sellers  of
 the subsidiaries  now  comprising  our TGA  Operating  Unit.  (See  Note  3,
 "Business Combinations" and Note 11, "Structured Settlements.")

      Corporate pre-tax loss was $2.7 million  for the third quarter of  2006
 as compared to $1.3 million for the same period in 2005.  The increased loss
 was primarily due  to additional  interest expense  of $0.9  million in  the
 third quarter of 2006 comprised of: (i) $0.3 million from the related  party
 promissory note issued in January 2006 (see Note 9, "Note Payable to Related
 Party"); (ii) $0.3  million of amortization  of the discount  on the  future
 guaranteed payments to the  sellers of the  subsidiaries now comprising  the
 TGA Operating Unit (see Note 11,  "Structured Settlements"); and (iii)  $0.3
 million from borrowings under our revolving credit facility in January  2006
 (see Note  8, "Notes  Payable"  and  Note  12,  "Credit  Facilities").  Also
 contributing to  the  increase in  pre-tax  loss was  increased  salary  and
 related expenses of $0.4 million and travel expenses of $0.2 million.  These
 were partially offset by the increased investment income discussed above.


 Year-to-Date 2006 as Compared to Year-to-Date 2005

<TABLE>
     The following is  additional business segment  information for the  nine
 months ended September 30, 2006 and 2005 (in thousands):

                                                        Nine Months Ended September 30, 2006
                                        ----------------------------------------------------------------------
                                          HGA         TGA       Phoenix    Aerospace   Corporate  Consolidated
                                        --------    --------    --------   ---------   ---------  ------------
 <S>                                   <C>         <C>         <C>         <C>         <C>         <C>
 Produced premium                      $  69,357   $  93,254   $  34,116   $  22,356   $       -   $ 219,083
                                        --------    --------    --------    --------    --------    --------

 Gross premiums written                   68,884      43,773      34,116       6,945           -     153,718
 Ceded premiums written                   (6,122)     (1,309)          -        (111)          -      (7,542)
                                        --------    --------    --------    --------    --------    --------
 Net premiums written                     62,762      42,464      34,116       6,834           -     146,176
 Change in unearned premiums             (12,396)    (20,662)     (2,757)     (5,474)                (41,289)
                                        --------    --------    --------    --------    --------    --------
 Net premiums earned                      50,366      21,802      31,359       1,360           -     104,887

 Total revenues                           57,768      48,686      34,944       7,317        (643)    148,072

 Loss and loss adjustment expenses        27,165      13,186      19,369         783         (25)     60,478

 Pre-tax income                        $  11,245   $   7,152   $   6,760   $     773   $ (18,551)  $   7,379
                                        --------    --------    --------    --------    --------    --------

 Net loss ratio (1)                         53.9%       60.5%       61.8%       57.6%                   57.7%
 Net expense ratio (1)                      30.1%       30.6%       30.4%       38.1%                   30.4%
                                        --------    --------    --------    --------                --------
 Net combined ratio                         84.0%       91.1%       92.2%       95.7%                   88.1%
                                        ========    ========    ========    ========                ========


                                                        Nine Months Ended September 30, 2005
                                        ----------------------------------------------------------------------
                                          HGA         TGA       Phoenix    Aerospace   Corporate  Consolidated
                                        --------    --------    --------   ---------   ---------  ------------
 <S>                                   <C>         <C>         <C>         <C>         <C>         <C>
 Produced premium                      $  62,209   $       -   $  28,008   $       -   $       -   $  90,217
                                        --------    --------    --------    --------    --------    --------

 Gross premiums written                   34,869           -      28,116           -           -      62,985
 Ceded premiums written                     (552)          -           -           -           -        (552)
                                        --------    --------    --------    --------    --------    --------
 Net premiums written                     34,317           -      28,116           -           -      62,433
 Change in unearned premiums             (24,250)          -         544           -           -     (23,706)
                                        --------    --------    --------    --------    --------    --------
 Net premiums earned                      10,067           -      28,660           -           -      38,727

 Total revenues                           27,194           -      33,169           -          34      60,397

 Loss and loss adjustment expenses         5,631           -      17,002           -         (49)     22,584

 Pre-tax income                        $   4,761   $       -   $   7,666   $       -   $  (3,061)  $   9,366
                                        --------    --------    --------    --------    --------    --------

 Net loss ratio (1)                         55.9%                   59.3%                               58.3%
 Net expense ratio (1)                      37.5%                   32.8%                               34.0%
                                        --------                --------                            --------
 Net combined ratio                          93.4%                   92.1%                               92.3%
                                        ========                ========                            ========

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

 HGA Operating Unit

       Beginning in the third quarter  of 2005, our HGA Operating Unit  began
 retaining written premium through AHIC that was previously retained by third
 parties.  However,  on July 1,  2005, our HGA  Operating Unit assumed  $20.1
 million of  in-force  policies  it had  previously  produced  for  Clarendon
 National Insurance  Company. The  net  effect of  these  changes was  an  in
 increase in net written premium for the HGA Operating Unit of $28.4  million
 for the nine months ended September 30, 2006 over the same period in 2005.

     Total revenue for our HGA Operating Unit of $57.8 million for the  first
 nine months of 2006 was $30.6  million more than the $27.2 million  reported
 in the same  period of  2005.   This 112.4%  increase in  total revenue  was
 primarily  due  to an  increase of  $40.3 million  in net  premiums  earned.
 Increased net investment  income contributed an  additional $2.3 million  to
 the increase in revenue for the nine months ended September 30, 2006.  These
 increases in  revenue  were  partially offset  by  lower  ceding  commission
 revenue of  $10.0 million  and lower  processing and  service fees  of  $2.1
 million, in both cases due to the shift from a third party agency  structure
 to an insurance underwriting structure.

     Pre-tax  income for  our HGA  Operating Unit  of $11.2  million for  the
 first nine months of 2006 increased  $6.5 million, or 136.2%, over the  $4.8
 million reported for the first nine  months of 2005.  Increased revenue,  as
 discussed above, was the primary reason for the increase in pre-tax  income,
 partially offset by  increased loss and  loss adjustment  expenses of  $21.5
 million and additional operating expenses,  mostly due to increased  premium
 production, of $2.6  million.  The  HGA Operating Unit  reported a net  loss
 ratio of 53.9% for the first nine months of  2006 as compared to a net  loss
 ratio of 55.9% for the same period the prior year.  The loss ratios gross of
 reinsurance were 55.6% and 54.6% for the first nine months of 2006 and 2005,
 respectively.  The increase in  the gross loss ratio  was due to four  large
 property  losses  that  penetrated  our  reinsurance  coverages.   Partially
 offsetting the increase  in the  loss ratio  gross of  reinsurance was  $0.8
 million  of  favorable  reserve   development  from  prior  accident   years
 recognized during the first nine  months of 2006.   There was no prior  year
 reserve development recognized during  the first nine months  of 2005 as  we
 began retaining this  business during the  third quarter of  2005.  The  HGA
 Operating Unit reported net expense ratios  of 30.1% and 37.5% for the  nine
 months ended September  30, 2006 and  2005, respectively.   The net  expense
 ratio for the nine months ended September 30, 2005 is higher due to costs to
 assume from  Clarendon  National  Insurance  Company  the  unearned  premium
 produced by our HGA Operating Unit.

 TGA Operating Unit

     The subsidiaries  comprising our TGA  Operating Unit  were all  acquired
 effective January 1, 2006.  The $48.7 million of revenues was derived mostly
 from third  party commission  revenue of  $24.3 million  on the  portion  of
 business produced  by our  TGA Operating  Unit that  was retained  by  third
 parties and from $21.8 million of  earned premium on produced business  that
 was assumed by  GSIC or AHIC.   The remaining  $2.6 million  of revenue  was
 primarily derived from investment income and finance charges.

     Pre-tax income for the TGA Operating Unit of $7.2 million was  primarily
 due to  revenue  as  discussed  above  less:  (i)  incurred  loss  and  loss
 adjustment expenses of $13.2 million on the portion of the business  assumed
 by GSIC or AHIC; (ii) $26.7 million in operating expenses, comprised  mostly
 of commission expense  and salary related  expenses; (iii)  $0.2 million  in
 interest expense, and (iv) $1.4 million of amortization of intangible assets
 acquired in the acquisition of the subsidiaries comprising our TGA Operating
 Unit.  The TGA Operating Unit reported a net  loss ratio of 60.5% and a  net
 expense ratio of 30.6% for the nine months ended September 30, 2006.  We  do
 not have comparable loss and expense ratios  for the same period in 2005  as
 we acquired the  subsidiaries comprising  the TGA  Operating Unit  effective
 January 1, 2006.

 Phoenix Operating Unit

     Net  premium written  for  our  Phoenix Operating  Unit  increased  $6.0
 million during the first  nine months of 2006  to $34.1 million compared  to
 $28.1 million in the first nine months of 2005.  The increase in premium was
 due mostly  to premium  from  new states  that  our Phoenix  Operating  Unit
 expanded into this year.

     Revenue for the Phoenix  Operating Unit increased 5.4% to $34.9  million
 for the first nine months of 2006 from $33.2 million for the same period  in
 2005.  Higher earned premium of $2.7 million and higher investment income of
 $0.3 million was partially offset by lower ceding commission revenue of $1.0
 million and lower processing and lower  service fees of $0.3 million due  to
 the 100% assumption of the  Texas non-standard automobile premium  beginning
 late in 2004.

     Pre-tax income  for the Phoenix Operating  Unit decreased $0.9  million,
 or 11.8%, for  the first  nine months  of 2006  compared to  the first  nine
 months of 2005.  The  primary reason for the  decline in pre-tax income  for
 the first  nine months  of 2006  was increased  losses and  loss  adjustment
 expenses of $2.4 million as evidenced by  an increase in the net loss  ratio
 to 61.8%  versus  59.3%  reported  in  the first  nine  months  of  2005.  A
 competitive pricing environment  with a  bias towards  decreasing  rates, as
 well as favorable reserve development of $1.2 million recognized during  the
 first nine months of 2005 as compared to $0.7 million recognized during  the
 first nine months of 2006, were the primary reasons for the increase  in the
 loss  ratio.   The increase  in  losses  and loss  adjustment  expenses  was
 partially offset by the  increase in revenue discussed  above.  The  Phoenix
 Operating Unit reported net expense ratios  of 30.4% and 32.8% for the  nine
 months ended September 30, 2006 and 2005, respectively.

 Aerospace Operating Unit

     The  subsidiaries  comprising our  Aerospace  Operating  Unit  were  all
 acquired  effective  January 1, 2006.   The  $7.3  million of  revenues  was
 derived primarily from third party commission revenue of $5.4 million on the
 portion of  business retained  by third  parties and  from $1.4  million  of
 earned premium on produced business that was retained by Hallmark.  We began
 retaining  100%  of this  business  beginning  July 1, 2006.  The  remaining
 revenue was derived  $0.4 million from  investment income  and $0.1  million
 from third party processing and service fees.

     Pre-tax income  for our Aerospace Operating Unit of $0.8 million for the
 first  nine  months of 2006 was  due  to  revenue  discussed above less: (i)
 operating  expenses  of $5.5 million, comprised mostly of commission expense
 and  salary  related  expenses;  (ii) loss  and  loss adjustment expenses of
 $0.8  million;  and  (iii) $0.2 million of amortization of intangible assets
 acquired in the acquisition of the subsidiaries now comprising our Aerospace
 Operating Unit.  The Aerospace Operating Unit reported a  net  loss ratio of
 57.6%  and  a net expense ratio of 38.1% for the first nine  months of 2006.
 The  net  expense  ratio  includes $57 thousand of costs to license PIIC for
 aviation insurance in  various  states  where the  Aerospace  Operating Unit
 produces business.  These costs were not directly attributable  to producing
 the premium that was earned during  the period.  Excluding these  costs, the
 expense ratio  was 34.0%.  We do not have comparable  loss or expense ratios
 for the same period in 2005 as we acquired  the  subsidiaries comprising the
 Aerospace Operating Unit effective January 1, 2006.

 Corporate

      Corporate revenue decreased $0.7 million for  the first nine months  of
 2006 as compared to the same period in 2005.  The decrease was primarily due
 to $1.2 million  in other-than-temporary  impairment charges  on our  equity
 investment portfolio.  This was partially offset by $0.8 million in interest
 earned on a trust account established in the first quarter of 2006  securing
 the guaranteed  future  payments to  the  sellers of  the  subsidiaries  now
 comprising our TGA Operating Unit. (See Note 3, "Business Combinations"  and
 Note 11, "Structured Settlements.")

      Corporate pre-tax loss was $18.6 million  for the first nine months  of
 2006 as compared to $3.1 million for the same period in 2005.  The increased
 loss was primarily  due to decreased  revenue and $9.6  million in  interest
 expense from amortization attributable to the deemed discount on convertible
 promissory notes issued in January, 2006.  (See Note 10, "Convertible  Notes
 Payable.")  This interest expense had no impact on our cash flow or our book
 value.   Also  contributing to  the  increased corporate  pre-tax  loss  was
 additional interest expense of $3.9 million in the first nine months of 2006
 comprised of: (i) $1.1 million from the trust preferred securities issued in
 the second quarter of 2005 (see Note 8, "Notes Payable"); (ii) $0.9  million
 from the related party promissory note  issued in January 2006 (see Note  9,
 "Note Payable to Related Party"); (iii) $0.8 million of amortization of  the
 discount  on  the  future  guaranteed  payments   to  the  sellers  of   the
 subsidiaries now comprising our TGA Operating Unit (see Note 11, "Structured
 Settlements"); (iv) $0.8 million from borrowings under our revolving  credit
 facility in January 2006 (see Note  8, "Notes Payable" and Note 12,  "Credit
 Facilities"); and (v) $0.3  million from the  issuance of convertible  notes
 issued in January 2006  (see Note  10, "Convertible  Notes  Payable").  Also
 contributing to  the  increase in  pre-tax  loss was  increased  salary  and
 related  expenses  of  $0.7  million,  travel  expenses  of  $0.2   million,
 professional services of $0.2 million, and director fees of $0.1 million.


 Financial Condition and Liquidity

     Sources and Uses of Funds

     Our sources  of funds are  from insurance-related operations,  financing
 activities and investing activities.  Major sources of funds from operations
 include premiums collected (net of policy cancellations and premiums ceded),
 commissions,  and  processing  and  service  fees.  As  a  holding  company,
 Hallmark  is dependent on  dividend payments  and management  fees from  its
 subsidiaries to  meet  operating  expenses  and  debt  obligations.   As  of
 September 30, 2006,  Hallmark  had $2.2 million in cash and invested assets.
 Cash and invested assets of our non-insurance subsidiaries were $5.7 million
 as of September 30, 2006.

     Property  and casualty  insurance companies  domiciled in  the State  of
 Texas are limited in the payment  of dividends to their shareholders 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 policyholders  surplus as of  the prior year  end.
 Dividends may only  be paid  from unassigned  surplus funds.   During  2006,
 AHIC's ordinary  dividend capacity  is $6.4  million.   PIIC,  domiciled  in
 Arizona, is limited  in the payment  of dividends to  the lesser  of 10%  of
 prior year  policyholders surplus  or prior  year's net  investment  income,
 without prior written approval  from the Arizona  Department  of  Insurance.
 During 2006,  PIIC's  ordinary  dividend capacity  is  $1.6  million.  GSIC,
 domiciled in Oklahoma, is limited in the payment of dividends to the greater
 of 10% of  prior year policyholders  surplus or prior  year's statutory  net
 income,  without  prior  written   approval  from  the  Oklahoma   Insurance
 Department.  During 2006, GSIC's ordinary dividend capacity is $0.1 million.
 None  of AHIC, PIIC  or GSIC paid  a dividend to  Hallmark during the  first
 nine months of  2006.  Neither  AHIC nor PIIC  paid a  dividend to  Hallmark
 during 2005.

     The Texas Department  of Insurance, the Arizona Department of  Insurance
 and  the  Oklahoma  Insurance  Department  regulate  financial  transactions
 between  our  insurance   subsidiaries  and   their  affiliated   companies.
 Applicable regulations require approval of management fees, expense  sharing
 contracts and similar transactions. Phoenix General Agency paid $0.8 million
 in management fees to Hallmark during the first nine months of 2006 and paid
 $0.3 million in management fees during the  same period of 2005.  PIIC  paid
 $0.9 million in management fees to  Phoenix General Agency during the  first
 nine months of 2006 and 2005.  AHIC  did not pay any management fees  during
 the first nine months of 2006 or 2005. GSIC did not pay any management  fees
 during the first nine months of 2006.


     Comparison of September 30, 2006 to December 31, 2005

     On a consolidated basis, our cash and investments (excluding  restricted
 cash and investments) at September 30, 2006 were $208.9 million compared  to
 $139.6 million at December 31, 2005.   The acquisitions of the  subsidiaries
 comprising our TGA Operating Unit and our Aerospace Operating Unit accounted
 for $21.0 million of this increase, while the remainder of the increase  was
 primarily the  result of  the  retention of  business  produced by  our  HGA
 Operating Unit and our TGA Operating Unit.


    Comparison of Nine Months Ended September 30, 2006 and September 30, 2005

     Net cash  provided by our  consolidated operating  activities was  $45.6
 million for the first nine months of  2006 compared to $5.6 million for  the
 first nine months of  2005.  The increase  in operating cash flow  primarily
 resulted from the retention of the HGA  Operating Unit and a portion of  the
 TGA Operating Unit business in  the first nine months  of 2006 that was  not
 retained by us in the same period in 2005.  The net effect on operating cash
 flow was  an  increase  of  $63.1 million  resulting  from  an  increase  in
 collected premiums net of paid losses and loss adjustment expenses partially
 offset by  lower collected  commission  and  claim  fee  revenue.  Increased
 collected commission revenue of  $23.3 million from  the acquisition of  the
 subsidiaries comprising our TGA Operating Unit and Aerospace Operating Unit,
 increased  collected  investment  income  of  $2.0  million  and   increased
 collected finance charges of $1.4 million  primarily for the acquisition  of
 PAAC were partially  offset by  an increase  in paid  operating expenses  of
 $40.8 million driven primarily from these acquisitions, additional  interest
 paid on debt financing these acquisitions of $3.1 million and increased  tax
 payments of $5.9 million due to higher taxable earnings.

     Cash used in investing activities  during the first nine months of  2006
 was $103.5 million as compared to $59.0 million for the same period in 2005.
 The  increase in  cash used  in investing activities  is mostly  due to  the
 acquisitions of the subsidiaries comprising our  TGA Operating Unit and  our
 Aerospace Operating  Unit in  the first  quarter of  2006 which  used  $26.0
 million, net of cash  acquired.  Also contributing  to the increase in  cash
 used by investing  activities was the  funding of $25.0  million to a  trust
 account securing  the  future guaranteed  payments  to the  sellers  of  the
 subsidiaries comprising our TGA Operating Unit, additional net purchases  of
 short-term investments  of $27.8  million as  well  as PAAC's  $2.2  million
 repayment of premium finance notes, net of premium finance notes originated.
 Partially  offsetting these uses was a $16.9 million increase in  maturities
 and redemptions, a $16.8  million decrease in purchases  of debt and  equity
 securities and  a  net  $2.9  million  released  from  restricted  cash  and
 investments accounts.

     Cash provided  by financing activities during  the first nine months  of
 2006 was $52.5 million as compared to  $75.1 million for the same period  of
 2005.  The cash provided  in 2006 was primarily  from the issuance of  three
 debt instruments in  January.  The  first was a  promissory note payable  to
 Newcastle Partners,  L.P.  ("Newcastle Partners")  in  the amount  of  $12.5
 million to fund the cash required to close the Aerospace acquisition.   This
 note bears interest  at the rate  of 10% per  annum.   The unpaid  principal
 balance of  the  promissory  note, together  with  all  accrued  and  unpaid
 interest, became due and payable on demand as of June 30, 2006.  The  second
 debt instrument  was $25.0  million in  subordinated convertible  promissory
 notes to  the  Newcastle Special  Opportunity  Fund I,  L.P.  and  Newcastle
 Special Opportunity Fund II, L.P, (the "Opportunity Funds").  The  principal
 and accrued interest on the convertible notes was converted to approximately
 3.3 million  shares  of our common stock  during the second quarter of 2006.
 The $25.0 million raised with these notes  was used to fund a trust  account
 securing future guaranteed payments to the  sellers of the subsidiaries  now
 comprising our TGA  Operating  Unit.  The  third debt  instrument was  $15.0
 million borrowed  under  our revolving  credit  facility to  fund  the  cash
 required to close the acquisition of the subsidiaries now comprising our TGA
 Operating Unit.  In October 2006, we repaid the promissory note to Newcastle
 Partners and repaid $12.2  million of the  outstanding principal balance  of
 our revolving credit facility, in each case with proceeds received from  our
 public equity offering.   Newcastle Partners and  the Opportunity Funds  are
 each an affiliate of our Executive Chairman, Mark E. Schwarz.

      Credit Facilities

      On June 29,  2005, we  entered into a  credit facility  with The  Frost
 National Bank.  The credit facility was amended and restated on January  27,
 2006 to  a $20.0  million revolving  credit facility,  with a  $5.0  million
 letter  of  credit  sub-facility.   We  borrowed  $15.0  million  under  the
 revolving credit facility to fund the cash required to close the acquisition
 of  the  subsidiaries  now  comprising  our  TGA Operating  Unit.  Principal
 outstanding under the revolving credit facility generally bears interest  at
 the  three  month Eurodollar rate plus  2.00%, payable quarterly in arrears.
 We  pay  letter  of  credit  fees  at  the  rate of  1.00%  per  annum.  Our
 obligations under the revolving  credit facility are  secured by a  security
 interest in the capital stock of all of our subsidiaries, guaranties  of all
 of our subsidiaries and the pledge of substantially all  of our assets.  The
 revolving credit  facility contains  covenants  which, among  other  things,
 require us to maintain certain financial  and operating ratios and  restrict
 certain distributions, transactions and organizational changes.  The amended
 and  restated  credit  agreement  terminates  on  January  27, 2008.  As  of
 September 30, 2006, there was $15.0 million outstanding under our  revolving
 credit facility, and we were  in compliance with all  of our covenants.   In
 October 2006, we repaid $12.2 million  of the outstanding principal  balance
 under our revolving credit facility with  proceeds received from our  public
 equity offering.  In  the third quarter  of 2005, we  issued a $4.0  million
 letter of credit  under this facility  to collateralize certain  obligations
 under the  agency agreement  between our  HGA Operating  Unit and  Clarendon
 National Insurance Company effective July 1, 2004.

      PAAC has a $5.0 million revolving  credit facility with JPMorgan  Chase
 Bank  which  terminates  June 30, 2007.  Principal  outstanding  under  this
 revolving credit facility  generally bears interest  at 1%  above the  prime
 rate.  PAAC's obligations under this  revolving credit facility are  secured
 by its premium finance  notes receivables.   This revolving credit  facility
 contains various restrictive  covenants which, among  other things,  require
 PAAC to maintain minimum amounts of tangible net worth and working  capital.
 As  of September 30, 2006, $2.6 million was outstanding under this revolving
 credit facility and PAAC was in  compliance with or had obtained waivers  of
 all of its covenants.

     Trust Preferred Securities

     On  June 21, 2005,  our newly formed  trust entity  completed a  private
 placement  of  $30.0  million  of  30-year  floating  rate  trust  preferred
 securities.   Simultaneously,  we  borrowed $30.9  million  from  the  trust
 subsidiary and  contributed  $30.0 million  to  AHIC in  order  to  increase
 policyholder  surplus.  The note bears  an initial interest  rate of  7.725%
 until June 15, 2015,  at which  time interest will  adjust quarterly to  the
 three month LIBOR  rate  plus 3.25  percentage  points.  As of September 30,
 2006, the note balance was $30.9 million.

     Other Debt Obligations

     On January 3, 2006, we  executed a promissory note payable to  Newcastle
 Partners in  the amount  of $12.5  million  in order  to obtain  funding  to
 complete the acquisition  of the subsidiaries  now comprising the  Aerospace
 Operating Unit. The promissory note bears interest at 10% per annum prior to
 maturity and at the maximum rate allowed under applicable law upon  default.
 Interest is payable on the first  business day of each month. The  principal
 of the promissory note,  together with accrued  but unpaid interest,  became
 due on demand as of June 30, 2006.  We repaid this note in October 2006 from
 proceeds received from our public equity offering.

     On  January  27, 2006,  we  issued  an aggregate  of  $25.0  million  in
 subordinated convertible  promissory notes  to the  Opportunity Funds.  Each
 convertible note bore interest at 4% per annum, which rate increased to  10%
 per annum in the event of default. Interest was payable quarterly in arrears
 commencing March 31, 2006. Principal and all accrued but unpaid interest was
 due at maturity on July 27, 2007. The principal and accrued interest  on the
 convertible notes was converted to approximately  3.3 million shares of  our
 common stock during the second quarter of 2006.

     Structured Settlements

     In connection  with our acquisition of  the subsidiaries now  comprising
 our TGA Operating  Unit, we issued  to the sellers  promissory notes in  the
 aggregate principal  amount of  $23.7 million  payable $14.2  million on  or
 before  January 1, 2007, and $9.5 million on  or before January 1, 2008.  We
 are also obligated to pay  to the sellers an  additional $0.8 million  on or
 before January 1, 2007 and an  additional $0.5 million on or before  January
 1, 2008 in consideration of the sellers' compliance with certain restrictive
 covenants, including a covenant  not to compete for  a period of five  years
 after closing.  We secured payment of these future installments of  purchase
 price and restrictive covenant consideration by depositing $25.0 million  in
 a trust account for the benefit of the  sellers.  We recorded a payable  for
 future guaranteed payments  to the sellers  of $25.0  million discounted  at
 4.4%, the rate of two-year U.S.  Treasuries purchased as the only  permitted
 investment  of  the  trust  account.  The  trust account  is  classified  in
 restricted cash and investments  on our balance sheet.  As of September  30,
 2006, the balance of the structured settlements was $24.3 million.

     Conclusion

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


 Item 3.  Quantitative and Qualitative Disclosures About Market Risk.

      As of September  30, 2006, there  had been no  material changes in  the
 market risks  described  in the  Company's  Form  10-K for  the  year  ended
 December 31, 2005.


 Item 4.  Controls and Procedures.

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

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

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


                                   PART II
                              OTHER INFORMATION

 Item 1.   Legal Proceedings.

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


 Item 1A.  Risk Factors.

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


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

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

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

 *  the uncertainties that inherently characterize estimates and
    assumptions;

 *  our selection and application of appropriate pricing techniques; and

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

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


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

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


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

 We maintain  loss reserves  to cover  our estimated  ultimate liability  for
 unpaid losses  and  loss adjustment  expenses  for reported  and  unreported
 claims incurred as of the end of each accounting period. Reserves  represent
 management's estimates of what the ultimate settlement and administration of
 claims will  cost and  are not  reviewed by  an independent  actuary.  These
 estimates, which  generally  involve  actuarial projections,  are  based  on
 management's assessment of facts  and circumstances then  known, as well  as
 estimates of  future  trends  in  claim  severity  and  frequency,  judicial
 theories of liability, and  other factors. These  variables are affected  by
 both internal  and  external events,  such  as changes  in  claims  handling
 procedures, inflation,  judicial trends  and  legislative changes.  Many  of
 these factors are not quantifiable. Additionally, there may be a significant
 reporting lag between the occurrence of an event and the time it is reported
 to us. The  inherent uncertainties of  estimating reserves  are greater  for
 certain types  of  liabilities,  particularly those  in  which  the  various
 considerations affecting the  type of  claim are  subject to  change and  in
 which long periods of time may  elapse before a definitive determination  of
 liability is made. Reserve  estimates are continually  refined in a  regular
 and ongoing process as experience develops  and further claims are  reported
 and settled. Adjustments  to reserves are  reflected in the  results of  the
 periods in which  such estimates are  changed. For example,  a 1% change  in
 September 30, 2006  unpaid losses and  loss adjustment  expenses would  have
 produced a $0.7 million change to  pretax earnings. Our gross loss and  loss
 adjustment expense reserves totaled $65.6 million at September 30, 2006. Our
 loss and loss adjustment expense reserves, net of reinsurance  recoverables,
 were $61.1  million at  that date.  Because setting  reserves is  inherently
 uncertain, there can be  no assurance that the  current reserves will  prove
 adequate.


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

 Third-party rating agencies  assess and  rate the  claims-paying ability  of
 insurers based upon criteria established by the agencies. During 2005,  A.M.
 Best,  a  nationally  recognized  insurance  industry  rating  service   and
 publisher, upgraded the financial strength rating  of PIIC, from "B"  (Fair)
 to "B+" (Very  Good), and upgraded  the financial strength  rating of  AHIC,
 from "B" (Fair) to "A-" (Excellent). Our insurance company subsidiaries have
 historically been rated on an  individual basis. However, effective  January
 1,  2006,  our  insurance  company  subsidiaries  entered  into  a   pooling
 arrangement whereby AHIC  would retain 59.9%  of the  net premiums  written,
 PIIC would retain 34.1%  of the net premiums  written and GSIC would  retain
 6.0% of the  net premiums  written. As  a result,  in June  2006, A.M.  Best
 notified us that  our insurance  company subsidiaries  would be  rated on  a
 pooled basis  and assigned  a rating  of  "A-" (Excellent)  to each  of  our
 individual insurance  company subsidiaries  and to  the pool  formed by  our
 insurance company subsidiaries.

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


 The loss of key executives could disrupt our business.

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


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

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


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

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


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

 We purchase reinsurance by transferring, or ceding, part of the risk we have
 assumed to a  reinsurance company  in exchange for  part of  the premium  we
 receive  in  connection  with  the  risk.  Although  reinsurance  makes  the
 reinsurer liable to us to the extent the risk is transferred or ceded to the
 reinsurer, it does  not relieve us  of our liability  to our  policyholders.
 Accordingly, we bear credit risk with  respect to our reinsurers. We  cannot
 assure that our reinsurers will pay  all of our reinsurance claims, or  that
 they will pay our claims on a timely basis. At September 30, 2006, we had  a
 total of $6.1  million due  us from  reinsurers, including  $4.5 million  of
 recoverables from losses and $1.6  million in prepaid reinsurance  premiums.
 The largest amount due us from a  single reinsurer as of September 30,  2006
 was $1.9 million  reinsurance and  premium recoverable  from GE  Reinsurance
 Corp.  If any of our reinsurers are unable or unwilling to pay amounts  they
 owe us in a timely fashion, we could suffer a significant loss or a shortage
 of liquidity, which would have a material adverse effect on our business and
 results of operations.


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

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


 Catastrophe models may not accurately predict future losses.

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


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

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

 *  approval of policy forms and rates;

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

 *  licensing of insurers and their agents;

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

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

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

 *  requiring certain methods of accounting;

 *  periodic examinations of operations and finances;

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

 *  the use of credit history in underwriting and rating;

 *  limitations on the ability to charge policy fees;

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

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

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

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

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

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

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


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

 Hallmark is a holding company and a legal entity separate and distinct  from
 its subsidiaries. As a holding company without significant operations of its
 own, Hallmark's principal sources of funds  are dividends and other  sources
 of funds from its  subsidiaries. State insurance laws  limit the ability  of
 Hallmark's insurance company subsidiaries to  pay dividends and require  our
 insurance company  subsidiaries  to  maintain specified  minimum  levels  of
 statutory capital and  surplus. The  aggregate maximum  amount of  dividends
 permitted by law  to be paid  by an insurance  company does not  necessarily
 define an insurance company's  actual ability to  pay dividends. The  actual
 ability to  pay  dividends  may  be  further  constrained  by  business  and
 regulatory considerations, such as  the impact of  dividends on surplus,  by
 our competitive position and  by the amount of  premiums that we can  write.
 Without regulatory approval, the aggregate maximum amount of dividends  that
 could be paid to Hallmark in  2006 by our insurance company subsidiaries  is
 $8.1 million. State insurance regulators have broad discretion to limit  the
 payment  of  dividends  by  insurance  companies  and  Hallmark's  right  to
 participate in any distribution  of assets of one  of our insurance  company
 subsidiaries is  subject  to prior  claims  of policyholders  and  creditors
 except to the extent that its rights, if any, as a creditor are  recognized.
 Consequently, Hallmark's ability to pay  debts, expenses and cash  dividends
 to our stockholders may be limited.


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

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


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

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

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


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

 Our results of operations depend in part on the performance of our  invested
 assets. As of  September 30,  2006, 77.7%  of our  investment portfolio  was
 invested  in  fixed-income  securities.   Certain  risks  are  inherent   in
 connection with  fixed-income securities,  including loss  upon default  and
 price volatility in reaction to changes in interest rates and general market
 factors. In general, the  fair market value of  a portfolio of  fixed-income
 securities increases  or  decreases inversely  with  changes in  the  market
 interest rates, while net investment income realized from future investments
 in fixed-income securities increases or decreases along with interest rates.
 In addition, 8.5%  of our fixed-income  securities have  call or  prepayment
 options. This subjects us  to reinvestment risk  should interest rates  fall
 and issuers call their securities. Furthermore, actual net investment income
 and/or cash  flows from  investments that  carry  prepayment risk,  such  as
 mortgage-backed and  other asset-backed  securities, may  differ from  those
 anticipated at  the  time  of  investment  as  a  result  of  interest  rate
 fluctuations. An investment has  prepayment risk when there  is a risk  that
 cash flows  from  the  repayment  of  principal  might  occur  earlier  than
 anticipated because of  declining interest rates  or later than  anticipated
 because of rising interest rates.

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


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

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


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

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


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

 The following five states  account for 91.0% of  our gross written  premiums
 for the nine months ended September 30, 2006: Texas (48.8%), Oregon (17.0%),
 New Mexico  (11.6%),  Idaho (7.8%)  and  Arizona (5.8%).  Our  revenues  and
 profitability are  subject to  the prevailing  regulatory, legal,  economic,
 political, demographic,  competitive, weather  and other  conditions in  the
 principal states in which we do business. Changes in any of these conditions
 could make it less attractive for us to do business in such states and would
 have a more  pronounced effect  on us compared  to companies  that are  more
 geographically diversified. In addition, our exposure to severe losses  from
 localized natural perils, such as windstorms or hailstorms, is increased  in
 those areas where we have  written significant numbers of  property/casualty
 insurance policies.


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

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


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

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


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

    None.


 Item 3. Defaults Upon Senior Securities.

    None.


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

     None.


 Item 5. Other Information.

    None.


 Item 6. Exhibits.

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

 Exhibit
 Number                          Description
 ------                          -----------

 3(a)         Articles of Incorporation of the registrant, as amended
              (incorporated by reference to Exhibit 3(a) to the registrant's
              Annual Report on Form 10-KSB for the fiscal year ended
              December 31, 1993).

 3(b)         Restated By-Laws of the registrant, as amended (incorporated
              by reference to Exhibit 3.2 to the registrant's Registration
              Statement on Form S-1 filed August 8, 2006).

 4(a)         Specimen certificate for Common Stock, $0.18 par value per
              share, of the registrant (incorporated by reference to Exhibit
              4.1 to the registrant's Post-Effective Amendment No. 1 to
              Registration Statement on Form S-1 filed October 3, 2006).

 4(b)         Indenture dated as of June 21, 2005, between Hallmark
              Financial Services, Inc. and JPMorgan Chase Bank, National
              Association (incorporated by reference to Exhibit 4.1 to the
              registrant's Current Report on Form 8-K filed June 27, 2005).

 4(c)         Amended and Restated Declaration of Trust of Hallmark
              Statutory Trust I dated as of June 21, 2005, among Hallmark
              Financial Services, Inc., as sponsor, Chase Bank USA, National
              Association, as Delaware trustee, and JPMorgan Chase Bank,
              National Association, as institutional trustee, and Mark
              Schwarz and Mark Morrison, as administrators (incorporated by
              reference to Exhibit 4.2 to the registrant's Current Report on
              Form 8-K filed June 27, 2005).

 4(d)         Form of Junior Subordinated Debt Security Due 2035
              (incorporated by reference to Exhibit 4.1 to the registrant's
              Current Report on Form 8-K filed June 27, 2005).

 4(e)         Form of Capital Security Certificate (incorporated by
              reference to Exhibit 4.2 to the registrant's Current Report
              on Form 8-K filed June 27, 2005).

 4(f)         Promissory Note dated January 3, 2006, between Hallmark
              Financial Services, Inc. and Newcastle Partners, L.P.
              (incorporated by reference to Exhibit 4.1 to the registrant's
              Current Report on Form 8-K filed January 5, 2006).

 4(g)         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(h)         Form of Registration Rights Agreement dated January 27, 2006,
              between Hallmark Financial Services, Inc. and Newcastle
              Special Opportunity Fund I, L.P. and Newcastle Special
              Opportunity Fund II, L.P. (incorporated by reference to
              Exhibit 4.1 to the registrant's Current Report on Form 8-K
              filed February 2, 2006).

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

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

 32(a)        Certification of principal executive officer Pursuant to 18
              U.S.C. 1350.

 32(b)        Certification of principal financial officer Pursuant to 18
              U.S.C. 1350.


                                  SIGNATURES

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

                      HALLMARK FINANCIAL SERVICES, INC.
                                 (Registrant)


 Date: November 13, 2006     /s/ Mark J. Morrison
                             ---------------------------------------------
                             Mark J. Morrison, Chief Executive Officer
                             and President
                             (Principal Executive Officer)


 Date: November 13, 2006     /s/ Jeffrey R. Passmore
                             ---------------------------------------------
                             Jeffrey R. Passmore, Chief Accounting Officer
                             and Senior Vice President
                             (Principal Financial Officer)