UNITED
STATES



SECURITIES
AND EXCHANGE COMMISSION



WASHINGTON,
D.C. 20549



FORM 10-Q



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



Securities Exchange Act of 1934



For the quarterly period ended June 30,
2012



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



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



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



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 – 19,263,457 shares outstanding
as of August 6, 2012.











PART I

FINANCIAL INFORMATION



| | Item 1. | Financial Statements
| | ------- | --------------------



INDEX TO FINANCIAL STATEMENTS



|                                                                                                                                             | Page Number
|-------------------------------------------------------------------------------------------------------------------------------------------- | -----------
|                                                                                                                                             |            
|Consolidated Balance Sheets at June 30, 2012 (unaudited) and December 31, 2011                                                               | 3          
|                                                                                                                                             |            
|Consolidated Statements of Operations (unaudited) for the three months and six months ended June 30, 2012 and June 30, 2011                  | 4          
|                                                                                                                                             |            
|Consolidated Statements of Comprehensive Income (Loss) (unaudited) for the three months and six months ended June 30, 2012 and June 30, 2011 | 5          
|                                                                                                                                             |            
|Consolidated Statements of Stockholders’ Equity (unaudited) for the three months and six months ended June 30, 2012 and June 30, 2011        | 6          
|                                                                                                                                             |            
|Consolidated Statements of Cash Flows (unaudited) for the six months ended June 30, 2012 and June 30, 2011                                   | 7          
|                                                                                                                                             |            
|Notes to Consolidated Financial Statements (unaudited)                                                                                       | 8          



2







Hallmark Financial Services, Inc. and
Subsidiaries

Consolidated Balance Sheets

($ in thousands, except share amounts)



|                                                                                                                |  | June 30     |         |   | December 31   |  
|--------------------------------------------------------------------------------------------------------------- |  | ----------- | ------- | - | ------------- | -
|                                                                                                                |  | 2012        |         |   | 2011          |  
|                                                                                                                |  | (unaudited) |         |   | (as adjusted) |  
|ASSETS                                                                                                          |  |             |         |   |               |  
|Investments:                                                                                                    |  |             |         |   |               |  
|Debt securities, available-for-sale, at fair value (cost: $397,052 in 2012 and $380,578 in 2011)                |  | $           | 399,069 |   |               | $
|Equity securities, available-for-sale, at fair value (cost: $30,119 in 2012 and $30,465 in 2011)                |  |             | 40,715  |   |               |  
|                                                                                                                |  |             |         |   |               |  
|Total investments                                                                                               |  |             | 439,784 |   |               |  
|                                                                                                                |  |             |         |   |               |  
|Cash and cash equivalents                                                                                       |  |             | 76,230  |   |               |  
|Restricted cash                                                                                                 |  |             | 10,793  |   |               |  
|Ceded unearned premiums                                                                                         |  |             | 21,692  |   |               |  
|Premiums receivable                                                                                             |  |             | 68,882  |   |               |  
|Accounts receivable                                                                                             |  |             | 3,495   |   |               |  
|Receivable for securities                                                                                       |  |             | 2,334   |   |               |  
|Reinsurance recoverable                                                                                         |  |             | 47,808  |   |               |  
|Deferred policy acquisition costs                                                                               |  |             | 25,481  |   |               |  
|Goodwill                                                                                                        |  |             | 44,695  |   |               |  
|Intangible assets, net                                                                                          |  |             | 24,861  |   |               |  
|Deferred federal income taxes, net                                                                              |  |             | 1,940   |   |               |  
|Federal income tax recoverable                                                                                  |  |             | 1,119   |   |               |  
|Prepaid expenses                                                                                                |  |             | 1,651   |   |               |  
|Other assets                                                                                                    |  |             | 12,579  |   |               |  
|                                                                                                                |  |             |         |   |               |  
|Total assets                                                                                                    |  | $           | 783,344 |   |               | $
|                                                                                                                |  |             |         |   |               |  
|LIABILITIES AND STOCKHOLDERS' EQUITY                                                                            |  |             |         |   |               |  
|Liabilities:                                                                                                    |  |             |         |   |               |  
|Revolving credit facility payable                                                                               |  | $           | 1,550   |   |               | $
|Subordinated debt securities                                                                                    |  |             | 56,702  |   |               |  
|Reserves for unpaid losses and loss adjustment expenses                                                         |  |             | 314,109 |   |               |  
|Unearned premiums                                                                                               |  |             | 163,371 |   |               |  
|Unearned revenue                                                                                                |  |             | 63      |   |               |  
|Reinsurance balances payable                                                                                    |  |             | 6,189   |   |               |  
|Accrued agent profit sharing                                                                                    |  |             | 929     |   |               |  
|Accrued ceding commission payable                                                                               |  |             | 1,200   |   |               |  
|Pension liability                                                                                               |  |             | 3,660   |   |               |  
|Payable for securities                                                                                          |  |             | 6,419   |   |               |  
|Deferred federal income taxes, net                                                                              |  |             | -       |   |               |  
|Accounts payable and other accrued expenses                                                                     |  |             | 14,354  |   |               |  
|                                                                                                                |  |             |         |   |               |  
|Total liabilities                                                                                               |  |             | 568,546 |   |               |  
|                                                                                                                |  |             |         |   |               |  
|Commitments and Contingencies (Note 17)                                                                         |  |             |         |   |               |  
|                                                                                                                |  |             |         |   |               |  
|Redeemable non-controlling interest                                                                             |  |             | 1,274   |   |               |  
|                                                                                                                |  |             |         |   |               |  
|Stockholders' equity:                                                                                           |  |             |         |   |               |  
|Common stock, $.18 par value, authorized 33,333,333 shares in 2012 and 2011; issued 20,872,831 in 2012 and 2011 |  |             | 3,757   |   |               |  
|Additional paid-in capital                                                                                      |  |             | 122,669 |   |               |  
|Retained earnings                                                                                               |  |             | 92,768  |   |               |  
|Accumulated other comprehensive income                                                                          |  |             | 5,888   |   |               |  
|Treasury stock (1,609,374 shares in 2012 and 2011), at cost                                                     |  |             | (11,558 | ) |               |  
|                                                                                                                |  |             |         |   |               |  
|Total stockholders' equity                                                                                      |  |             | 213,524 |   |               |  
|                                                                                                                |  |             |         |   |               |  
|                                                                                                                |  | $           | 783,344 |   |               | $



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



3







Hallmark Financial Services, Inc. and
Subsidiaries

Consolidated Statements of Operations

(Unaudited)

($ in thousands, except per share amounts)



|                                                           |  | Three Months Ended |         |   | Six Months Ended |  
|---------------------------------------------------------- |  | ------------------ | ------- | - | ---------------- | -
|                                                           |  | June 30            |         |   | June 30          |  
|                                                           |  | 2012               |         |   | 2011             |  
|                                                           |  |                    |         |   | (as adjusted)    |  
|                                                           |  |                    |         |   |                  |  
|Gross premiums written                                     |  | $                  | 100,815 |   |                  | $
|Ceded premiums written                                     |  |                    | (15,678 | ) |                  |  
|Net premiums written                                       |  |                    | 85,137  |   |                  |  
|Change in unearned premiums                                |  |                    | (6,888  | ) |                  |  
|Net premiums earned                                        |  |                    | 78,249  |   |                  |  
|                                                           |  |                    |         |   |                  |  
|Investment income, net of expenses                         |  |                    | 3,932   |   |                  |  
|Net realized gains                                         |  |                    | 991     |   |                  |  
|Finance charges                                            |  |                    | 1,524   |   |                  |  
|Commission and fees                                        |  |                    | (184    | ) |                  |  
|Other income                                               |  |                    | 59      |   |                  |  
|                                                           |  |                    |         |   |                  |  
|Total revenues                                             |  |                    | 84,571  |   |                  |  
|                                                           |  |                    |         |   |                  |  
|Losses and loss adjustment expenses                        |  |                    | 61,229  |   |                  |  
|Other operating expenses                                   |  |                    | 25,419  |   |                  |  
|Interest expense                                           |  |                    | 1,178   |   |                  |  
|Amortization of intangible assets                          |  |                    | 896     |   |                  |  
|                                                           |  |                    |         |   |                  |  
|Total expenses                                             |  |                    | 88,722  |   |                  |  
|                                                           |  |                    |         |   |                  |  
|Loss before tax                                            |  |                    | (4,151  | ) |                  |  
|Income tax benefit                                         |  |                    | (2,351  | ) |                  |  
|Net loss                                                   |  |                    | (1,800  | ) |                  |  
|                                                           |  |                    |         |   |                  |  
|Less: Net income attributable to non-controlling interest  |  |                    | 43      |   |                  |  
|                                                           |  |                    |         |   |                  |  
|Net loss attributable to Hallmark Financial Services, Inc. |  | $                  | (1,843  | ) |                  | $
|                                                           |  |                    |         |   |                  |  
|Net loss per share attributable to Hallmark Financial      |  |                    |         |   |                  |  
|Services, Inc. common stockholders:                        |  |                    |         |   |                  |  
|Basic                                                      |  | $                  | (0.10   | ) |                  | $
|Diluted                                                    |  | $                  | (0.10   | ) |                  | $



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



4







HALLMARK FINANCIAL SERVICES, INC. AND
SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE
INCOME (LOSS)

(Unaudited)

($ in thousands)



|                                                                            |  | Three Months Ended |        |   | Six Months Ended |  
|--------------------------------------------------------------------------- |  | ------------------ | ------ | - | ---------------- | -
|                                                                            |  | June 30            |        |   | June 30          |  
|                                                                            |  | 2012               |        |   | 2011             |  
|                                                                            |  |                    |        |   | (as adjusted)    |  
|                                                                            |  |                    |        |   |                  |  
|Net loss                                                                    |  | $                  | (1,800 | ) |                  | $
|Other comprehensive loss:                                                   |  |                    |        |   |                  |  
|Change in net actuarial gain                                                |  |                    | 122    |   |                  |  
|Tax effect on change in net actuarial gain                                  |  |                    | (43    | ) |                  |  
|Unrealized holding gains (losses) arising during the period                 |  |                    | (2,006 | ) |                  |  
|Tax effect on unrealized holding gains (losses) arising during the period   |  |                    | 702    |   |                  |  
|Reclassification adjustment for losses included in net income               |  |                    | (1,219 | ) |                  |  
|Tax effect on reclassification adjustment for losses included in net income |  |                    | 427    |   |                  |  
|Other comprehensive loss, net of tax                                        |  |                    | (2,017 | ) |                  |  
|Comprehensive loss                                                          |  | $                  | (3,817 | ) |                  | $
|Less: comprehensive income attributable to non-controlling interest         |  |                    | 43     |   |                  |  
|Comprehensive loss attributable to Hallmark Financial Services, Inc.        |  | $                  | (3,860 | ) |                  | $



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



5







Hallmark Financial Services, Inc. and
Subsidiaries

Consolidated Statements of Stockholders'
Equity

(Unaudited)

($ in thousands)



|                                                                                                           |  | Three Months Ended |         |   | Six Months Ended |  
|---------------------------------------------------------------------------------------------------------- |  | ------------------ | ------- | - | ---------------- | -
|                                                                                                           |  | June 30,           |         |   | June 30,         |  
|                                                                                                           |  | 2012               |         |   | 2011             |  
|                                                                                                           |  |                    |         |   | (as adjusted)    |  
|Common Stock                                                                                               |  |                    |         |   |                  |  
|Balance, beginning of period                                                                               |  | $                  | 3,757   |   |                  | $
|                                                                                                           |  |                    |         |   |                  |  
|Balance, end of period                                                                                     |  |                    | 3,757   |   |                  |  
|                                                                                                           |  |                    |         |   |                  |  
|Additional Paid-In Capital                                                                                 |  |                    |         |   |                  |  
|Balance, beginning of period                                                                               |  |                    | 122,644 |   |                  |  
|Accretion of redeemable noncontrolling interest                                                            |  |                    | (90     | ) |                  |  
|Equity based compensation                                                                                  |  |                    | 115     |   |                  |  
|Exercise of stock options                                                                                  |  |                    | -       |   |                  |  
|                                                                                                           |  |                    |         |   |                  |  
|Balance, end of period                                                                                     |  |                    | 122,669 |   |                  |  
|                                                                                                           |  |                    |         |   |                  |  
|Retained Earnings                                                                                          |  |                    |         |   |                  |  
|Balance, beginning of period                                                                               |  |                    | 94,611  |   |                  |  
|Cumulative effect of adjustments resulting from adoption of change in accounting principle, net
    of tax |  |                    | -       |   |                  |  
|Net loss attributable to Hallmark Financial Services, Inc.                                                 |  |                    | (1,843  | ) |                  |  
|                                                                                                           |  |                    |         |   |                  |  
|Balance, end of period                                                                                     |  |                    | 92,768  |   |                  |  
|                                                                                                           |  |                    |         |   |                  |  
|Accumulated Other Comprehensive Income                                                                     |  |                    |         |   |                  |  
|Balance, beginning of period                                                                               |  |                    | 7,905   |   |                  |  
|Additional minimum pension liability, net of tax                                                           |  |                    | 79      |   |                  |  
|Net unrealized holding (losses) gains arising during period, net of tax                                    |  |                    | (1,304  | ) |                  |  
|Reclassification adjustment for (gains) losses included in net income, net of tax                          |  |                    | (792    | ) |                  |  
|                                                                                                           |  |                    |         |   |                  |  
|Balance, end of period                                                                                     |  |                    | 5,888   |   |                  |  
|                                                                                                           |  |                    |         |   |                  |  
|Treasury Stock                                                                                             |  |                    |         |   |                  |  
|Balance, beginning of period                                                                               |  |                    | (11,558 | ) |                  |  
|Acquistion of treasury shares                                                                              |  |                    | -       |   |                  |  
|Issuance of treasury stock upon option exercises                                                           |  |                    | -       |   |                  |  
|Balance, end of period                                                                                     |  |                    | (11,558 | ) |                  |  
|                                                                                                           |  |                    |         |   |                  |  
|Total Stockholders' Equity                                                                                 |  | $                  | 213,524 |   |                  | $



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



6







Hallmark Financial Services, Inc. and
Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

($ in thousands)



|                                                                                                              |  | Six Months Ended |        
|------------------------------------------------------------------------------------------------------------- |  | ---------------- | -------
|                                                                                                              |  | June 30          |        
|                                                                                                              |  | 2012             |        
|                                                                                                              |  |                  |        
|Cash flows from operating activities:                                                                         |  |                  |        
|Net loss                                                                                                      |  | $                | (1,606 
|                                                                                                              |  |                  |        
|Adjustments to reconcile net loss to cash provided by operating activities:                                   |  |                  |        
|Depreciation and amortization expense                                                                         |  |                  | 2,360  
|Deferred federal income taxes                                                                                 |  |                  | (2,201 
|Net realized gains                                                                                            |  |                  | (872   
|Shared-based payments expense                                                                                 |  |                  | 253    
|Change in ceded unearned premiums                                                                             |  |                  | (2,222 
|Change in premiums receivable                                                                                 |  |                  | (17,164
|Change in accounts receivable                                                                                 |  |                  | 451    
|Change in deferred policy acquisition costs                                                                   |  |                  | (2,927 
|Change in unpaid losses and loss adjustment expenses                                                          |  |                  | 17,164 
|Change in unearned premiums                                                                                   |  |                  | 16,864 
|Change in unearned revenue                                                                                    |  |                  | 8      
|Change in accrued agent profit sharing                                                                        |  |                  | (30    
|Change in reinsurance recoverable                                                                             |  |                  | (5,074 
|Change in reinsurance payable                                                                                 |  |                  | 3,050  
|Change in current federal income tax recoverable                                                              |  |                  | 5,619  
|Change in accrued ceding commission payable                                                                   |  |                  | 129    
|Change in all other liabilities                                                                               |  |                  | 372    
|Change in all other assets                                                                                    |  |                  | 3,048  
|                                                                                                              |  |                  |        
|Net cash provided by operating activities                                                                     |  |                  | 17,222 
|                                                                                                              |  |                  |        
|Cash flows from investing activities:                                                                         |  |                  |        
|Purchases of property and equipment                                                                           |  |                  | (183   
|Net transfers into restricted cash                                                                            |  |                  | (1,421 
|Payment for acquisition of subsidiaries                                                                       |  |                  | -      
|Purchases of investment securities                                                                            |  |                  | (76,102
|Maturities, sales and redemptions of investment securities                                                    |  |                  | 64,890 
|                                                                                                              |  |                  |        
|Net cash used in investing activities                                                                         |  |                  | (12,816
|                                                                                                              |  |                  |        
|Cash flows from financing activities:                                                                         |  |                  |        
|Proceeds from exercise of employee stock options                                                              |  |                  | -      
|Purchase of treasury shares                                                                                   |  |                  | -      
|Activity under revolving credit facility                                                                      |  |                  | (2,500 
|Distribution to non-controlling interest                                                                      |  |                  | (147   
|                                                                                                              |  |                  |        
|Net cash used in financing activities                                                                         |  |                  | (2,647 
|                                                                                                              |  |                  |        
|Increase (decrease) in cash and cash equivalents                                                              |  |                  | 1,759  
|Cash and cash equivalents at beginning of period                                                              |  |                  | 74,471 
|Cash and cash equivalents at end of period                                                                    |  | $                | 76,230 
|                                                                                                              |  |                  |        
|Supplemental cash flow information:                                                                           |  |                  |        
|                                                                                                              |  |                  |        
|Interest paid                                                                                                 |  | $                | 2,313  
|                                                                                                              |  |                  |        
|Income taxes (recovered) paid                                                                                 |  | $                | (6,045 
|                                                                                                              |  |                  |        
|Supplemental schedule of non-cash investing activities:                                                       |  |                  |        
|                                                                                                              |  |                  |        
|Change in receivable for securities related to investment disposals that settled after the balance sheet date |  | $                | (283   
|                                                                                                              |  |                  |        
|Change in payable for securities related to investment purchases that settled after the balance sheet date    |  | $                | 6,216  



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



7







Hallmark Financial Services, Inc. and
Subsidiaries

Notes to Consolidated Financial Statements
(Unaudited)



1. General



Hallmark Financial
Services, Inc. (“Hallmark” and, together with subsidiaries, “we,” “us” or “our”)
is an insurance holding company engaged in the sale of property/casualty insurance products to businesses and individuals. Our
business involves marketing, distributing, underwriting and servicing our insurance products, as well as providing other insurance
related services.



We pursue our business
activities through subsidiaries whose operations are organized into six business units that are supported by our insurance company
subsidiaries. Our Standard Commercial business unit handles commercial insurance products and services in the standard market.
Our Workers Compensation business unit specializes in small and middle market workers compensation business. Our E&S Commercial
business unit handles primarily commercial and medical professional liability insurance products and services in the excess and
surplus lines market. Our General Aviation business unit handles general aviation insurance products and services. Our Excess &
Umbrella business unit offers low and middle market commercial umbrella and excess liability insurance on both an admitted and
non-admitted basis focusing primarily on trucking, specialty automobile and non-fleet automobile coverage. Our Personal Lines business
unit handles personal insurance products and services. Our insurance company subsidiaries supporting these operating units are
American Hallmark Insurance Company of Texas (“AHIC”), Hallmark Insurance Company (“HIC”), Hallmark Specialty
Insurance Company (“HSIC”), Hallmark County Mutual Insurance Company (“HCM”), Hallmark National Insurance
Company (“HNIC”) and Texas Builders Insurance Company (“TBIC”).



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



2. Basis of Presentation



Our unaudited consolidated
financial statements included herein have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”)
and include our accounts and the accounts of our subsidiaries. All significant intercompany accounts and transactions have been
eliminated in consolidation. Certain information and footnote disclosures normally included in financial statements prepared in
accordance with GAAP have been condensed or omitted pursuant to rules and regulations of the Securities and Exchange Commission
(“SEC”) for interim financial reporting. These unaudited consolidated financial statements should be read in conjunction
with our audited consolidated financial statements for the year ended December 31, 2011 included in our Annual Report on Form 10-K
filed with the SEC.



The interim financial
data as of June 30, 2012 and 2011 is unaudited. However, in the opinion of management, the interim data includes all adjustments,
consisting of normal recurring adjustments, necessary for a fair statement of the results for the interim periods. The results
of operations for the period ended June 30, 2012 are not necessarily indicative of the operating results to be expected for the
full year.



8







Redeemablenon-controlling
interest



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



Income taxes



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



Use of Estimates in the Preparation
of the Financial Statements



Our preparation of
financial statements in conformity with GAAP requires us to make estimates and assumptions that affect our reported amounts of
assets and liabilities and our disclosure of contingent assets and liabilities at the date of our consolidated financial statements,
as well as our reported amounts of revenues and expenses during the reporting period. Refer to “Critical Accounting Estimates
and Judgments” under Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2011 for information on accounting
policies that we consider critical in preparing our consolidated financial statements. Actual results could differ materially from
those estimates.



Fair Value of Financial Instruments



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



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



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



Revolving Credit Facility
Payable: The carrying value of our bank revolving credit facility of $1.6 million approximates the fair value based on the current
interest rate.



9







Subordinated Debt Securities:
Our trust preferred securities have a carried value of $56.7 million and a fair value of $48.2 million as of June 30, 2012. The
fair value of our trust preferred securities is based on discounted cash flows using a current yield to maturity of 8.0% based
on similar issues to discount future cash flows and would be classified as Level 3 in the fair value hierarchy.



For reinsurance recoverable,
federal income tax payable and receivable, other assets and other liabilities, the carrying amounts approximate fair value because
of the short maturity of such financial instruments.



Variable Interest Entities



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



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



We evaluate on an ongoing
basis our investments in Trust I and II (collectively the “Trusts”) and we do not have a variable interest in the Trusts.  Therefore,
the Trusts are not included in our consolidated financial statements.



We are also involved
in the normal course of business with variable interest entities (“VIE’s”) primarily as a passive investor in
mortgage-backed securities and certain collateralized corporate bank loans issued by third party VIE’s. The maximum exposure
to loss with respect to these investments is the investment carrying values included in the consolidated balance sheets.



Adoption of New Accounting Pronouncements



Effective January 1,
2012, the Company adopted new guidance issued by the Financial Accounting Standards Board (“FASB”) related to the accounting
for costs associated with acquiring or renewing insurance contracts. The guidance identifies those costs relating to the successful
acquisition of new or renewal insurance contracts that should be capitalized. This guidance may be applied prospectively or retrospectively.
The Company elected retrospective application of this guidance. The adoption of this guidance decreased deferred policy acquisition
costs by $0.9 million, decreased deferred federal income taxes, net by $0.3 million and decreased stockholders’ equity by
$0.6 million as of December 31, 2011. Amortization of deferred policy acquisition costs included in other operating expenses and
income tax benefit for the three months and six months ended June 30, 2011 were retrospectively restated to conform to the change
in accounting guidance, the effect of which on previously reported net loss for the three months and six months ended June 30,
2011 was immaterial. In this Form 10-Q, interim financial information for the three and six-months ended June 30, 2011 and balances
at December 31, 2011 have been adjusted in accordance with the adoption of this guidance.



10







In May 2011, the FASB
issued amendments to achieve common fair value measurement and disclosure requirements in GAAP and International Financial Reporting
Standards. New disclosures, with a particular focus on Level 3 measurement were required. All transfers between Level 1 and Level
2 were required to be disclosed. Information about when the current use of a non-financial asset measured at fair value differs
from its highest and best use is to be disclosed. The amendments in this update are to be applied prospectively. The amendments
are effective during interim and annual periods beginning after December 15, 2011. The adoption of this amendment did not have
a material impact on our financial position or results of operations.



In June 2011, the FASB
issued amendments to the presentation of comprehensive income. The amendments provide the option to present other comprehensive
income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The components
of other comprehensive income have not changed, nor has the guidance on when other comprehensive income items are reclassified
to net income. All reclassification adjustments from other comprehensive income to net income are required to be presented on the
face of the statement of comprehensive income. The adoption of this new guidance did not have a material impact on our financial
position or results of operations but did require additional disclosures and impact financial statement presentation.



In September 2011,
the FASB issued an accounting update to simplify how entities test goodwill for impairment. Under the update, an entity is not
required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its
fair value is less than its carrying amount. The update permits an entity to first assess qualitative factors to determine whether
it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining
whether it is necessary to perform the current two-step goodwill impairment test. The update is effective for annual and interim
goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The adoption of this update did not
have a material impact on our financial position or results of operations.



3. Business Combinations



We account for business
combinations using the purchase method of accounting pursuant to ASC Topic 805, “Business Combinations.” The cost of
an acquired entity is allocated to the assets acquired (including identified intangible assets) and liabilities assumed based on
their estimated fair values. The excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired
and liabilities assumed is an asset referred to as “Goodwill.” Indirect and general expenses related to business combinations
are expensed as incurred.



Effective August 29,
2008, we acquired 80% of the issued and outstanding membership interests in the subsidiaries now comprising our Excess & Umbrella
business unit for consideration of $15.0 million. In connection with the acquisition, we executed an operating agreement for each
subsidiary. The operating agreements grant us the right to purchase the remaining 20% membership interests in the subsidiaries
and grant to an affiliate of the seller the right to require us to purchase such remaining membership interests (the “Put/Call
Option”). The Put/Call Option becomes exercisable by either us or the affiliate of the seller upon the earlier of August
29, 2012, the termination of the employment of the seller by the Excess & Umbrella business unit or a change of control of
Hallmark. If the Put/Call Option is exercised, we will have the right or obligation to purchase the remaining 20% membership interests
in the Excess & Umbrella business unit for an amount equal to nine times the average Pre-Tax Income (as defined in the operating
agreements) for the previous 12 fiscal quarters. We estimate the ultimate redemption value of the Put/Call Option to be $1.6 million
at June 30, 2012.



11







Effective December
31, 2010, we acquired all of the issued and outstanding capital stock of HNIC for initial consideration of $14.0 million paid in
cash on January 3, 2011 to State Auto Financial Corporation, Inc. (“SAFCI”). In addition, an earnout of up to $2.0
million is payable to SAFCI quarterly in an amount equal to 2% of gross collected premiums on new or renewal personal lines insurance
policies written by HNIC agents during the three years following closing. HNIC is an Ohio domiciled insurance company that writes
non-standard personal automobile policies through independent agents in 21 states.



Effective July 1, 2011,
we acquired all of the issued and outstanding capital stock of TBIC Holding Corporation (“TBIC Holding”) for
initial consideration of $1.6 million paid in cash on July 1, 2011. In addition, a holdback purchase price of up to $350 thousand
may become payable following four full calendar quarters after closing and a contingent purchase price of up to $3.0 million may
become payable following 16 full calendar quarters after closing, in each case based upon a formula contained in the acquisition
agreement. As of June 30, 2012 we had accrued the maximum holdback purchase price of $350 thousand which is expected to be paid
to the sellers during the third quarter of 2012. We recorded a bargain purchase gain of $165 thousand on the acquisition which
was reported in other income. The gain resulted from the difference in the estimated purchase price and the fair value of the net
assets acquired and liabilities assumed as of July 1, 2011.



4. Fair Value



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



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



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



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



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



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



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



12







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



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



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



The following table presents for each of
the fair value hierarchy levels, our assets that are measured at fair value on a recurring basis at June 30, 2012 (in thousands):



13







|                                                            |  | Quoted Prices in   |        |  | Other      |   |         |              |  |   |        | 
|----------------------------------------------------------- |  | ------------------ | ------ |  | ---------- | - | ------- | ------------ |  | - | ------ | 
|                                                            |  | Active Markets for |        |  | Observable |   |         | Unobservable |  |   |        | 
|                                                            |  | Identical Assets   |        |  | Inputs     |   |         | Inputs       |  |   |        | 
|                                                            |  | (Level 1)          |        |  | (Level 2)  |   |         | (Level 3)    |  |   | Total  | 
|                                                            |  |                    |        |  |            |   |         |              |  |   |        | 
|U.S. Treasury securities and obligations of U.S. Government |  | $                  | -      |  |            | $ | 15,127  |              |  | $ | -      | 
|Corporate bonds                                             |  |                    | -      |  |            |   | 102,022 |              |  |   | -      | 
|Collateralized corporate bank loans                         |  |                    | -      |  |            |   | 107,810 |              |  |   | 1,053  | 
|Municipal bonds                                             |  |                    | -      |  |            |   | 150,689 |              |  |   | 18,766 | 
|Mortgage-backed                                             |  |                    | -      |  |            |   | 3,602   |              |  |   | -      | 
|Total debt securities                                       |  |                    | -      |  |            |   | 379,250 |              |  |   | 19,819 | 
|                                                            |  |                    |        |  |            |   |         |              |  |   |        | 
|Financial services                                          |  |                    | 14,294 |  |            |   | -       |              |  |   | -      | 
|All other                                                   |  |                    | 26,421 |  |            |   | -       |              |  |   | -      | 
|Total equity securities                                     |  |                    | 40,715 |  |            |   | -       |              |  |   | -      | 
|                                                            |  |                    |        |  |            |   |         |              |  |   |        | 
|Total debt and equity securities                            |  | $                  | 40,715 |  |            | $ | 379,250 |              |  | $ | 19,819 | 



Due to significant
unobservable inputs into the valuation model for certain municipal bonds and a collateralized corporate bank loan in illiquid markets,
we classified these investments as level 3 in the fair value hierarchy. We used an income approach in order to derive an estimated
fair value of the municipal bonds classified as Level 3, which included inputs such as expected holding period, benchmark swap
rate, benchmark discount rate and a discount rate premium for illiquidity. The fair value of the collateralized corporate bank
loan classified as level 3 is based on discounted cash flows using current yield to maturity of 9.4%, which is based on the relevant
spread over LIBOR for this particular loan to discount future cash flows.



The following table summarizes the changes
in fair value for all financial assets measured at fair value on a recurring basis using significant unobservable inputs (Level
3) during the six months ended June 30, 2012 (in thousands):



|Beginning balance as of January 1, 2012                |  | $ | 20,608 |  
|------------------------------------------------------ |  | - | ------ | -
|                                                       |  |   |        |  
|Settlements                                            |  |   | (236   | )
|Total realized/unrealized gains included in net income |  |   | (553   | )
|Net losses included in other comprehensive income      |  |   | -      |  
|Transfers into Level 3                                 |  |   | -      |  
|Transfers out of Level 3                               |  |   | -      |  
|                                                       |  |   |        |  
|Ending balance as of June 30, 2012                     |  | $ | 19,819 |  





14











5. Investments



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



|                                                            |  |           |         |  | Gross      |   |        | Gross      |  |   |        |  
|----------------------------------------------------------- |  | --------- | ------- |  | ---------- | - | ------ | ---------- |  | - | ------ | -
|                                                            |  | Amortized |         |  | Unrealized |   |        | Unrealized |  |   | Fair   |  
|As of June 30, 2012                                         |  | Cost      |         |  | Gains      |   |        | Losses     |  |   | Value  |  
|                                                            |  |           |         |  |            |   |        |            |  |   |        |  
|U.S. Treasury securities and obligations of U.S. Government |  | $         | 15,119  |  |            | $ | 13     |            |  | $ | (5     | )
|Corporate bonds                                             |  |           | 100,613 |  |            |   | 2,602  |            |  |   | (1,193 | )
|Collateralized corporate bank loans                         |  |           | 109,853 |  |            |   | 320    |            |  |   | (1,310 | )
|Municipal bonds                                             |  |           | 167,940 |  |            |   | 4,280  |            |  |   | (2,765 | )
|Mortgage-backed                                             |  |           | 3,527   |  |            |   | 86     |            |  |   | (11    | )
|                                                            |  |           |         |  |            |   |        |            |  |   |        |  
|Total debt securities                                       |  |           | 397,052 |  |            |   | 7,301  |            |  |   | (5,284 | )
|                                                            |  |           |         |  |            |   |        |            |  |   |        |  
|Financial services                                          |  |           | 10,999  |  |            |   | 3,298  |            |  |   | (3     | )
|All other                                                   |  |           | 19,120  |  |            |   | 7,509  |            |  |   | (208   | )
|                                                            |  |           |         |  |            |   |        |            |  |   |        |  
|Total equity securities                                     |  |           | 30,119  |  |            |   | 10,807 |            |  |   | (211   | )
|                                                            |  |           |         |  |            |   |        |            |  |   |        |  
|Total debt and equity securities                            |  | $         | 427,171 |  |            | $ | 18,108 |            |  | $ | (5,495 | )
|                                                            |  |           |         |  |            |   |        |            |  |   |        |  
|As of December 31, 2011                                     |  |           |         |  |            |   |        |            |  |   |        |  
|                                                            |  |           |         |  |            |   |        |            |  |   |        |  
|U.S. Treasury securities and obligations of U.S. Government |  | $         | 11,152  |  |            | $ | 24     |            |  | $ | -      |  
|Corporate bonds                                             |  |           | 93,272  |  |            |   | 2,305  |            |  |   | (1,655 | )
|Collateralized corporate bank loans                         |  |           | 94,638  |  |            |   | 175    |            |  |   | (1,920 | )
|Municipal bonds                                             |  |           | 177,432 |  |            |   | 3,458  |            |  |   | (2,549 | )
|Mortgage-backed                                             |  |           | 4,084   |  |            |   | 80     |            |  |   | (27    | )
|                                                            |  |           |         |  |            |   |        |            |  |   |        |  
|Total debt securities                                       |  |           | 380,578 |  |            |   | 6,042  |            |  |   | (6,151 | )
|                                                            |  |           |         |  |            |   |        |            |  |   |        |  
|Financial services                                          |  |           | 11,618  |  |            |   | 4,463  |            |  |   | (260   | )
|All other                                                   |  |           | 18,847  |  |            |   | 9,554  |            |  |   | (63    | )
|                                                            |  |           |         |  |            |   |        |            |  |   |        |  
|Total equity securities                                     |  |           | 30,465  |  |            |   | 14,017 |            |  |   | (323   | )
|                                                            |  |           |         |  |            |   |        |            |  |   |        |  
|Total debt and equity securities                            |  | $         | 411,043 |  |            | $ | 20,059 |            |  | $ | (6,474 | )



15







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



|                                                            |  | Three Months Ended |       |   | Six Months Ended |  
|----------------------------------------------------------- |  | ------------------ | ----- | - | ---------------- | -
|                                                            |  | June 30            |       |   | June 30          |  
|                                                            |  | 2012               |       |   | 2011             |  
|                                                            |  |                    |       |   |                  |  
|U.S. Treasury securities and obligations of U.S. Government |  | $                  | -     |   |                  | $
|Corporate bonds                                             |  |                    | (36   | ) |                  |  
|Collateralized corporate bank loans                         |  |                    | 135   |   |                  |  
|Municipal bonds                                             |  |                    | (163  | ) |                  |  
|Mortgage-backed                                             |  |                    | -     |   |                  |  
|Equity securities-financial services                        |  |                    | (22   | ) |                  |  
|Equity securities-all other                                 |  |                    | 1,305 |   |                  |  
|Gain on investments                                         |  |                    | 1,219 |   |                  |  
|Other-than-temporary impairments                            |  |                    | (228  | ) |                  |  
|Net realized gains                                          |  | $                  | 991   |   |                  | $



We realized gross gains on investments
of $1.4 million and $1.7 million during the three months ended June 30, 2012 and 2011, respectively and $1.5 million and $2.9 million
for the six months ended June 30, 2012 and 2011, respectively. We realized gross losses on investments of $0.2 million and $43
thousand for the three months ended June 30, 2012 and 2011.  We realized gross losses on investments of $0.4 million
and $0.1 million for the six months ended June 30, 2012 and 2011. We recorded proceeds from the sale of investment securities of
$6.0 million and $10.2 million during the three months ended June 30, 2012 and 2011, respectively, and $6.2 million and $42.9 million
for the six months ended June 30, 2012 and 2011, respectively. Realized investment gains and losses are recognized in operations
on the specific identification method.



16







The following schedules
summarize the gross unrealized losses showing the length of time that investments have been continuously in an unrealized loss
position as of June 30, 2012 and December 31, 2011 (in thousands):



|                                                            |  | As of June 30, 2012 |        
|----------------------------------------------------------- |  | ------------------- | -------
|                                                            |  | 12 months or less   |        
|                                                            |  |                     |        
|                                                            |  | Fair Value          |        
|                                                            |  |                     |        
|U.S. Treasury securities and obligations of U.S. Government |  | $                   | 10,073 
|Corporate bonds                                             |  |                     | 27,175 
|Collateralized corporate bank loans                         |  |                     | 55,213 
|Municipal bonds                                             |  |                     | 21,745 
|Mortgage-backed                                             |  |                     | 688    
|Total debt securities                                       |  |                     | 114,894
|                                                            |  |                     |        
|Financial services                                          |  |                     | 90     
|All other                                                   |  |                     | 1,128  
|Total equity securities                                     |  |                     | 1,218  
|                                                            |  |                     |        
|Total debt and equity securities                            |  | $                   | 116,112



|                                                            |  | As of December 31, 2011 |        
|----------------------------------------------------------- |  | ----------------------- | -------
|                                                            |  | 12 months or less       |        
|                                                            |  |                         |        
|                                                            |  | Fair Value              |        
|                                                            |  |                         |        
|U.S. Treasury securities and obligations of U.S. Government |  | $                       | -      
|Corporate bonds                                             |  |                         | 21,752 
|Collateralized corporate bank loans                         |  |                         | 69,717 
|Municipal bonds                                             |  |                         | 26,780 
|Municipal bonds                                             |  |                         | 740    
|Total debt securities                                       |  |                         | 118,989
|                                                            |  |                         |        
|Financial services                                          |  |                         | 1,789  
|All other                                                   |  |                         | 2,959  
|Total equity securities                                     |  |                         | 4,748  
|                                                            |  |                         |        
|Total debt and equity securities                            |  | $                       | 123,737



At June 30, 2012, the
gross unrealized losses more than twelve months old were attributable to 59 debt security positions. At December 31, 2011, the
gross unrealized losses more than twelve months old were attributable to 25 debt security positions. We consider these losses as
a temporary decline in value as they are predominately on bonds that we do not intend to sell and do not believe we will be required
to sell prior to recovery of our amortized cost basis. We see no other indications that the decline in values of these securities
is other-than-temporary.



17







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



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



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



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



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



The amortized cost
and estimated fair value of debt securities at June 30, 2012 by contractual maturity are as follows. Expected maturities may differ
from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties.



18







|                                       |  | Amortized      |         |  | Fair  |  
|-------------------------------------- |  | -------------- | ------- |  | ----- | -
|                                       |  | Cost           |         |  | Value |  
|                                       |  | (in thousands) |        
|                                       |  |                |         |  |       |  
|Due in one year or less                |  | $              | 48,230  |  |       | $
|Due after one year through five years  |  |                | 181,967 |  |       |  
|Due after five years through ten years |  |                | 111,172 |  |       |  
|Due after ten years                    |  |                | 52,156  |  |       |  
|Mortgage-backed                        |  |                | 3,527   |  |       |  
|                                       |  | $              | 397,052 |  |       | $



6. Pledged Investments



We have pledged certain
of our securities for the benefit of various state insurance departments and reinsurers. These securities are included with our
available-for-sale debt securities because we have the ability to trade these securities. We retain the interest earned on these
securities. These securities had a carrying value of $26.5 million and $27.5 million at June 30, 2012 and December 31, 2011, respectively.



7. Reserves for Unpaid Losses and Loss Adjustment Expenses



Unpaid losses and loss
adjustment expenses (“LAE”) represent the estimated ultimate net cost of all reported and unreported losses incurred
through each balance sheet date. The reserves for unpaid losses and LAE are estimated using individual case-basis valuations and
statistical analyses. These reserves are revised periodically and are subject to the effects of trends in loss severity and frequency.
Due to the inherent uncertainty in estimating unpaid losses and LAE, the actual ultimate amounts may differ from the recorded amounts.
The estimates are periodically reviewed and adjusted as experience develops or new information becomes known. Such adjustments
are included in current operations.



We recorded $1.6 million
of unfavorable prior years’ loss development during the three months ended June 30, 2012. We recorded $1.4 million of favorable
prior years’ loss development during the six months ended June 30, 2012. For the year to date, our General Aviation business
unit experienced $2.7 million of favorable prior years’ loss development related to our liability and aircraft lines of business.
Our Standard Commercial business unit experienced $1.9 million of favorable prior years’ loss development primarily related
to commercial property and auto liability partially offset by the late development of a general liability claim. Our Workers Compensation
business unit experienced $0.9 million of favorable prior years’ loss development. These favorable developments were partially
offset by unfavorable prior year loss development in our Personal Lines business unit and our E&S Commercial business unit
for the six months ended June 30, 2012. Our Personal Lines business unit experienced $2.3 million of unfavorable prior years’
loss development of which $1.6 million is the result of unfavorable development in auto liability claims spread throughout various
states. The remaining unfavorable prior years’ loss development for our Personal Lines business unit was the result of $0.7
million of unfavorable prior years’ loss development in our low value dwelling/homeowners line of business. For the year
to date, our E&S Commercial business unit had $1.8 million of unfavorable prior years’ loss development related primarily
to commercial auto liability and physical damage.



19







We recorded $0.7 million
and $15.8 million of unfavorable prior years’ loss development during the three and six months ended June 30, 2011, respectively.
For the first half of fiscal 2011, our Personal Lines business unit experienced $14.3 million of unfavorable prior years’
loss development of which $9.5 million was attributable to Florida developing much worse than expected due primarily to rapid growth
in the claim volume from Florida and the complexity related to Florida personal injury protection coverage claims. The remaining
unfavorable prior years’ loss development for our Personal Lines business unit was primarily due to development of auto liability
claims spread throughout our other states. For the first half of fiscal 2011, our E&S Commercial business unit had $3.1 million
of unfavorable prior years’ loss development related primarily to commercial auto liability and physical damage, while our
Standard Commercial business unit experienced $0.5 million of unfavorable prior years’ loss development driven by a late
developing umbrella claim and large loss developments in a commercial property claim and a commercial auto liability claim. These
unfavorable developments were partially offset by $2.1 million of favorable prior years’ loss development in our General
Aviation business unit related to our liability lines of business.



8. Share-Based Payment Arrangements



Our 2005 Long Term
Incentive Plan (“2005 LTIP”) is a stock compensation plan for key employees and non-employee directors that was approved
by the shareholders on May 26, 2005. There are 2,000,000 shares authorized for issuance under the 2005 LTIP. As of June 30, 2012,
there were incentive stock options to purchase 1,100,832 shares of our common stock outstanding and non-qualified stock options
to purchase 319,157 shares of our common stock outstanding and there were 564,178 shares reserved for future issuance under the
2005 LTIP. 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.



Incentive stock options
granted under the 2005 LTIP prior to 2009 vest 10%, 20%, 30% and 40% on the first, second, third and fourth anniversary dates of
the grant, respectively, and terminate five to ten years from the date of grant. Incentive stock options granted in 2009 and one
grant of 5,000 incentive stock options in 2011 vest in equal annual increments on each of the first seven anniversary dates and
terminate ten years from the date of grant. One grant of 25,000 incentive stock options in 2010 and one grant of 10,000 incentive
stock options in 2011 vest in equal annual increments on each of the first three anniversary dates and terminate ten years from
the date of grant. Non-qualified stock options granted under the 2005 LTIP generally vest 100% six months after the date of grant
and terminate ten years from the date of grant. One grant of 200,000 non-qualified stock options in 2009 vests in equal annual
increments on each of the first seven anniversary dates and terminates ten years from the date of grant.



A summary of the status
of our stock options as of and changes during the six months ended June 30, 2012 is presented below:



20







|                               |  |           |           |  |          |   |       | Average     |  |  |           | 
|------------------------------ |  | --------- | --------- |  | -------- | - | ----- | ----------- |  |  | --------- | 
|                               |  |           |           |  | Weighted |   |       | Remaining   |  |  | Aggregate | 
|                               |  |           |           |  | Average  |   |       | Contractual |  |  | Intrinsic | 
|                               |  | Number of |           |  | Exercise |   |       | Term        |  |  | Value     | 
|                               |  | Shares    |           |  | Price    |   |       | (Years)     |  |  | ($000)    | 
|                               |  |           |           |  |          |   |       |             |  |  |           | 
|Outstanding at January 1, 2012 |  |           | 1,419,989 |  |          | $ | 9.66  |             |  |  |           | 
|Granted                        |  |           | -         |  |          |   |       |             |  |  |           | 
|Exercised                      |  |           | -         |  |          |   |       |             |  |  |           | 
|Forfeited or expired           |  |           | -         |  |          |   |       |             |  |  |           | 
|Outstanding at June 30, 2012   |  |           | 1,419,989 |  |          | $ | 9.66  |             |  |  | 5.7       | 
|Exercisable at June 30, 2012   |  |           | 1,126,418 |  |          | $ | 10.42 |             |  |  | 5.4       | 



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

|                                                                |  | Three Months Ended |     |  | Six Months Ended |  
|--------------------------------------------------------------- |  | ------------------ | --- |  | ---------------- | -
|                                                                |  | June 30,           |     |  | June 30,         |  
|                                                                |  | 2012               |     |  | 2011             |  
|                                                                |  |                    |     |  |                  |  
|Intrinsic value of options exercised                            |  | $                  | -   |  |                  | $
|                                                                |  |                    |     |  |                  |  
|Cost of share-based payments (non-cash)                         |  | $                  | 115 |  |                  | $
|                                                                |  |                    |     |  |                  |  
|Income tax benefit of share-based payments recognized in income |  | $                  | 12  |  |                  | $



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



The fair value of each
stock option granted is estimated on the date of grant using the Black-Scholes option pricing model. Expected volatilities are
based on the historical volatility of the Hallmark’s and similar companies’ common stock for a period equal to the
expected term. The risk-free interest rates for periods within the contractual term of the options are based on rates for U.S.
Treasury Notes with maturity dates corresponding to the options’ expected lives on the dates of grant. Expected term is determined
based on the simplified method as we do not have sufficient historical exercise data to provide a basis for estimating the expected
term. There were no options granted during the first half of 2012. There were no options granted during the first quarter of 2011.
There were two options granted during the second quarter of 2011 with a weighted average grant date fair value per share of $3.50,
a weighted average expected term of 6.3 years, a weighted average expected volatility of 38.0% and a weighted average risk free
interest rate of 2.6%.



21









9. Segment Information



The following is business
segment information for the three and six months ended June 30, 2012 and 2011 (in thousands):

|                                                        |  | Three Months Ended |        |   | Six Months Ended |  
|------------------------------------------------------- |  | ------------------ | ------ | - | ---------------- | -
|                                                        |  | June 30,           |        |   | June 30,         |  
|                                                        |  | 2012               |        |   | 2011             |  
|Revenues:                                               |  |                    |        |   |                  |  
|Standard Commercial Segment                             |  | $                  | 17,924 |   |                  | $
|Specialty Commercial Segment                            |  |                    | 43,046 |   |                  |  
|Personal Segment                                        |  |                    | 22,905 |   |                  |  
|Corporate                                               |  |                    | 696    |   |                  |  
|Consolidated                                            |  | $                  | 84,571 |   |                  | $
|                                                        |  |                    |        |   |                  |  
|Pre-tax income (loss), net of non-controlling interest: |  |                    |        |   |                  |  
|Standard Commercial Segment                             |  | $                  | (710   | ) |                  | $
|Specialty Commercial Segment                            |  |                    | 2,929  |   |                  |  
|Personal Segment                                        |  |                    | (4,211 | ) |                  |  
|Corporate                                               |  |                    | (2,202 | ) |                  |  
|Consolidated                                            |  | $                  | (4,194 | ) |                  | $



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



|                             |  | June 30, |         |  | December 31, |  
|---------------------------- |  | -------- | ------- |  | ------------ | -
|                             |  | 2012     |         |  | 2011         |  
|Assets                       |  |          |         |  |              |  
|                             |  |          |         |  |              |  
|Standard Commercial Segment  |  | $        | 148,750 |  |              | $
|Specialty Commercial Segment |  |          | 384,744 |  |              |  
|Personal Segment             |  |          | 228,262 |  |              |  
|Corporate                    |  |          | 21,588  |  |              |  
|                             |  | $        | 783,344 |  |              | $



10. 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. In order to mitigate credit risk to reinsurance companies, most of our reinsurance recoverable balance
as of June 30, 2012 was with reinsurers that had an A.M. Best rating of “A–” or better.



22







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



|                       |  | Three Months Ended |        |  | Six Months Ended |  
|---------------------- |  | ------------------ | ------ |  | ---------------- | -
|                       |  | June 30,           |        |  | June 30,         |  
|                       |  | 2012               |        |  | 2011             |  
|                       |  |                    |        |  |                  |  
|Ceded earned premiums  |  | $                  | 13,504 |  |                  | $
|Reinsurance recoveries |  | $                  | 9,073  |  |                  | $



We currently reinsure
the following exposures on business generated by our business units:



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



| | o | We retain the first $6.0 million of property catastrophe losses; and
| | - | --------------------------------------------------------------------



| | o | Our reinsurers reimburse us 100% for any loss in excess of our $6.0 million retention up to $34.0
million for each catastrophic occurrence, subject to an aggregate limit of $68.0 million.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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



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



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



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



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



23







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



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



| | o | We retain the first $1.0 million of each aircraft hull or liability loss or airport liability loss;
and
| | - | -------------------------------------------------------------------------------------------------------



| | o | Our reinsurers reimburse us for the next $5.5 million of each combined aircraft hull and liability
loss and for the next $4.0 million of each airport liability loss.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · | Workers Compensation. We purchase excess of loss reinsurance specific to the workers compensation
risks underwritten by our Workers Compensation business unit. The terms of our workers compensation reinsurance are:
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | o | We retain the first $1.0 million of each workers compensation loss; and
| | - | -----------------------------------------------------------------------



| | o | Our reinsurers reimburse us 100% for the next $14.0 million for each workers compensation loss,
subject to a maximum limit of $10.0 million for any one person and an aggregate limit of $28.0 million for all workers compensation
losses.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · | Standard Commercial. We purchase proportional reinsurance where we cede 100% of the risks
to reinsurers on the equipment breakdown coverage on our commercial multi-peril property and business owners risks and on the employment
practices liability coverage on certain commercial multi-peril, general liability and business owners risks.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · | Excess & Umbrella.We purchase proportional reinsurance where we retain 20% of each
risk and cede the remaining 80% to reinsurers.  In states where we are not yet licensed to offer a non-admitted product, we
utilize a fronting arrangement pursuant to which we assume all of the risk and then retrocede a portion of that risk under the
same proportional reinsurance treaty.  Through June 30, 2009, our Excess & Umbrella business unit wrote policies pursuant
to a general agency agreement with an unaffiliated carrier and we assumed 35% of the risk from that carrier.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · | E&S Commercial. Effective June 1, 2012 we purchase
proportional reinsurance on our medical professional liability risks where we retain 50% of
each risk and cede the remaining 50% to reinsurers. Prior to June 1, 2012 we retained 40% of each risk and ceded the remaining
60% to reinsurers. In states where we are not yet licensed to offer a non-admitted product, we utilize a fronting arrangement pursuant
to which we assume all of the risk and then retrocede a portion of that risk under the same proportional reinsurance treaty. In
addition, we purchase facultative reinsurance on our commercial umbrella and excess liability risks where we retain 10% of the
first $1.0 million of risk and cede the remaining 90% to reinsurers. We cede 100% of our commercial umbrella and excess liability
risks in excess of $1.0 million.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| | · | Hallmark National Insurance Company. Simultaneous with the December 31, 2010 closing of
our acquisition of HNIC, HNIC entered into reinsurance contracts with an affiliate of the seller pursuant to which such affiliate
of the seller handles all claims and assumes all liabilities arising under policies issuedby
HNIC prior to closing or during a transition period of up to six months following the closing.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------





24











11.Revolving Credit Facility Payable



Our First Restated
Credit Agreement with The Frost National Bank dated January 27, 2006, as amended to date, provides a revolving credit facility
of $15.0 million. We pay interest on the outstanding balance at our election at a rate of the prime rate or LIBOR plus 2.5%.  We
pay an annual fee of 0.25% of the average daily unused balance of the credit facility. We pay letter of credit fees at the rate
of 1.00% per annum.  Our obligations under the revolving credit facility are secured by a security interest in the capital
stock of all of our subsidiaries, guarantees of all of our subsidiaries and the pledge of all of our non-insurance company assets.  The
revolving credit facility contains covenants that, among other things, require us to maintain certain financial and operating ratios
and restrict certain distributions, transactions and organizational changes.  We are in compliance with or have obtained
waivers of all of our covenants.  As of June 30, 2012, the balance on the revolving note was $1.6 million. The revolving note
currently bears interest at 2.97% per annum.



12.Subordinated Debt Securities



On June 21, 2005, we
entered into a trust preferred securities transaction pursuant to which we issued $30.9 million aggregate principal amount of subordinated
debt securities due in 2035. To effect the transaction, we formed Trust I as a Delaware statutory trust. Trust I issued $30.0 million
of preferred securities to investors and $0.9 million of common securities to us. Trust I used the proceeds from these issuances
to purchase the subordinated debt securities. Our Trust I subordinated debt securities bear an initial interest rate of 7.725%
until June 15, 2015, at which time interest will adjust quarterly to the three-month LIBOR rate plus 3.25 percentage points. Trust
I pays dividends on its preferred securities at the same rate. Under the terms of our Trust I subordinated debt securities, we
pay interest only each quarter and the principal of the note at maturity. The subordinated debt securities are uncollaterized and
do not require maintenance of minimum financial covenants. As of June 30, 2012, the balance of our Trust I subordinated debt was
$30.9 million.



On August 23, 2007,
we entered into a trust preferred securities transaction pursuant to which we issued $25.8 million aggregate principal amount of
subordinated debt securities due in 2037. To effect the transaction, we formed Trust II as a Delaware statutory trust. Trust II
issued $25.0 million of preferred securities to investors and $0.8 million of common securities to us. Trust II used the proceeds
from these issuances to purchase the subordinated debt securities. Our Trust II subordinated debt securities bear an initial interest
rate of 8.28% until September 15, 2017, at which time interest will adjust quarterly to the three-month LIBOR rate plus 2.90 percentage
points. Trust II pays dividends on its preferred securities at the same rate. Under the terms of our Trust II subordinated debt
securities, we pay interest only each quarter and the principal of the note at maturity. The subordinated debt securities are uncollaterized
and do not require maintenance of minimum financial covenants. As of June 30, 2012, the balance of our Trust II subordinated debt
was $25.8 million.



25







13.Deferred Policy Acquisition Costs



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



|          |  | Three Months Ended |        |   | Six Months Ended |  
|--------- |  | ------------------ | ------ | - | ---------------- | -
|          |  | June 30,           |        |   | June 30,         |  
|          |  | 2012               |        |   | 2011             |  
|          |  |                    |        |   |                  |  
|Deferred  |  | $                  | (7,584 | ) |                  | $
|Amortized |  |                    | 6,646  |   |                  |  
|          |  |                    |        |   |                  |  
|Net       |  | $                  | (938   | ) |                  | $



14.Earnings per Share



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



|                                            |  | Three Months Ended |        |  | Six Months Ended | 
|------------------------------------------- |  | ------------------ | ------ |  | ---------------- | 
|                                            |  | June 30,           |        |  | June 30,         | 
|                                            |  | 2012               |        |  | 2011             | 
|                                            |  |                    |        |  |                  | 
|Weighted average shares - basic             |  |                    | 19,263 |  |                  | 
|Effect of dilutive securities               |  |                    | -      |  |                  | 
|Weighted average shares - assuming dilution |  |                    | 19,263 |  |                  | 



For the three months
and six months ended June 30, 2012, 809,999 shares of common stock potentially issuable upon the exercise of employee stock options
were excluded from the weighted average number of shares outstanding on a diluted basis because the effect of such options would
be anti-dilutive. For the three months and six months ended June 30, 2011, 939,166 shares of common stock potentially issuable
upon the exercise of employee stock options were excluded from the weighted average number of shares outstanding on a diluted basis
because the effect of such options would be anti-dilutive.



26







15.Net
Periodic Pension Cost



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



|                               |  | Three Months Ended |      |   | Six Months Ended |  
|------------------------------ |  | ------------------ | ---- | - | ---------------- | -
|                               |  | June 30,           |      |   | June 30,         |  
|                               |  | 2012               |      |   | 2011             |  
|Interest cost                  |  | $                  | 141  |   |                  | $
|Amortization of net loss       |  |                    | 121  |   |                  |  
|Expected return on plan assets |  |                    | (146 | ) |                  |  
|Net periodic pension cost      |  | $                  | 116  |   |                  | $



We contributed $175
thousand and $301 thousand to our frozen defined benefit cash balance plan during the three months and six months ended June 30,
2012, respectively. We contributed $126 thousand and $220 thousand to our frozen defined benefit cash balance plan during the three
months and six months ended June 30, 2011, respectively. Refer to Note 14 to the consolidated financial statements in our Annual
Report on Form 10-K for the year ended December 31, 2011 for more discussion of our retirement plans.



16.Income Taxes



Our effective income
tax rate for the six months ended June 30, 2012 was 59.2%, which varied from the statutory income tax rate primarily as a result
of our tax exempt income increasing the tax benefit from our pre-tax loss. Our effective income tax rate for the six months
ended June 30, 2011 was 46.1%, which varied from the statutory income tax rate utilized primarily due to the increase in the tax
exempt income relative to lower pre-tax income and the recognition of a tax benefit related to the disposal of certain securities.



17.Commitments and Contingencies



In December 2010, our E&S Commercial
business unit was informed by the Texas Comptroller of Public Accounts that a surplus lines tax audit covering the period January
1, 2007 through December 31, 2009 was complete. A subsidiary within our E&S Commercial business unit (“TGA”) frequently
acts as a managing general underwriter (“MGU”) authorized to underwrite policies on behalf of Republic Vanguard Insurance
Company and HSIC, both Texas eligible surplus lines insurance carriers. In its role as the MGU, TGA underwrites policies on behalf
of these carriers while other agencies located in Texas, generally referred to as “producing agents,” deliver the policies
to the insureds and collect all premiums due from the insureds. During the period under audit, the producing agents also collected
the surplus lines premium taxes due on the policies from the insureds, held them in trust, and timely remitted those taxes to the
Comptroller. We believe this system for collecting and paying the required surplus lines premium taxes complies in all respects
with the Texas Insurance Code and other regulations, which clearly require that the same party who delivers the policies and collects
the premiums will also collect premium taxes, hold premium taxes in trust, and pay premium taxes to the Comptroller. It also complies
with long standing industry practice. The Comptroller asserts that TGA is liable for the surplus lines premium taxes related to
policy transactions and premiums collected from surplus lines insureds during the audit period and that TGA owes $4.5 million in
premium taxes, as well as $0.9 million in penalties and interest for the audit period.



27







We disagree
with the Comptroller and intend to vigorously fight their assertion that TGA is liable for the surplus lines premium taxes.
During the past several months we have been engaged in conversations with the Comptroller’s counsel and are waiting on
the Comptroller’s position paper. At this stage, we cannot predict the course of any proceedings, the timing of any
rulings or other significant events relating to such surplus lines tax audit.  Given these limitations and the
inherent difficulty of projecting the outcome of regulatory disputes, we are presently unable to reasonably estimate the
possible loss or legal costs that are likely to arise out of the surplus lines tax audit or any future proceedings relating
to this matter. Also, based on current information, we believe that a favorable outcome of this dispute is at least
reasonably possible. Therefore we have not accrued any amount as of June 30, 2012 related to this matter.



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



28







18.Changes in Accumulated Other Comprehensive Income Balances



The
changes in accumulated other comprehensive income balances as of June 30, 2012 and 2011 were as follows (in thousands):



|                                                                                    |  | Minimum   |        |   |              |   |        | Accumulated Other | 
|----------------------------------------------------------------------------------- |  | --------- | ------ | - | ------------ | - | ------ | ----------------- | 
|                                                                                    |  | Pension   |        |   | Unrealized   |   |        | Comprehensive     | 
|                                                                                    |  | Liability |        |   | Gains (Loss) |   |        | Income (Loss)     | 
|                                                                                    |  |           |        |   |              |   |        |                   | 
|Balance at December 31, 2010                                                        |  | $         | (2,024 | ) |              | $ | 11,661 |                   | 
|Other comprehensive income (loss):                                                  |  |           |        |   |              |   |        |                   | 
|Change in net actuarial loss                                                        |  |           | 143    |   |              |   | -      |                   | 
|Tax effect on change in net actuarial loss                                          |  |           | (50    | ) |              |   | -      |                   | 
|Net unrealized holding losses arising during the period                             |  |           | -      |   |              |   | (120   | )                 | 
|Tax effect on unrealized losses arising during the period                           |  |           | -      |   |              |   | 42     |                   | 
|Reclassification adjustment for gains (losses) included in net income               |  |           | -      |   |              |   | (2,783 | )                 | 
|Tax effect on reclassification adjustment for gains (losses) included in net income |  |           | -      |   |              |   | 974    |                   | 
|Other comprehensive income (loss), net of tax                                       |  |           | 93     |   |              |   | (1,887 | )                 | 
|                                                                                    |  |           |        |   |              |   |        |                   | 
|Balance at June 30, 2011                                                            |  | $         | (1,931 | ) |              | $ | 9,774  |                   | 
|                                                                                    |  |           |        |   |              |   |        |                   | 
|Balance at December 31, 2011                                                        |  | $         | (2,978 | ) |              | $ | 9,424  |                   | 
|Other comprehensive income (loss):                                                  |  |           |        |   |              |   |        |                   | 
|Change in net actuarial loss                                                        |  |           | 242    |   |              |   | -      |                   | 
|Tax effect on change in net actuarial loss                                          |  |           | (85    | ) |              |   | -      |                   | 
|Net unrealized holding gains arising during the period                              |  |           | -      |   |              |   | 17     |                   | 
|Tax effect on unrealized gains arising during the period                            |  |           | -      |   |              |   | (6     | )                 | 
|Reclassification adjustment for gains (losses) included in net income               |  |           | -      |   |              |   | (1,117 | )                 | 
|Tax effect on reclassification adjustment for gains (losses) included in net income |  |           | -      |   |              |   | 391    |                   | 
|Other comprehensive income (loss), net of tax                                       |  |           | 157    |   |              |   | (715   | )                 | 
|                                                                                    |  |           |        |   |              |   |        |                   | 
|Balance at June 30, 2012                                                            |  | $         | (2,821 | ) |              | $ | 8,709  |                   | 



29







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



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



Introduction



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



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



| | · | Standard
                                                                                                               Commercial Segment.Our
                                                                                                               Standard Commercial
                                                                                                               Segment includes
                                                                                                               the standard lines
                                                                                                               commercial property/casualty
                                                                                                               insurance products
                                                                                                               and services handled
                                                                                                               by our Standard
                                                                                                               Commercial business
                                                                                                               unit and the workers
                                                                                                               compensation insurance
                                                                                                               products handled
                                                                                                               by our Workers
                                                                                                               Compensation business
                                                                                                               unit.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · | Specialty
                                                                                                               Commercial Segment.Our
                                                                                                               Specialty Commercial
                                                                                                               Segment includes
                                                                                                               the excess and
                                                                                                               surplus lines commercial
                                                                                                               property/casualty,
                                                                                                               medical professional
                                                                                                               liability and satellite
                                                                                                               launch insurance
                                                                                                               products and services
                                                                                                               handled by our
                                                                                                               E&S Commercial
                                                                                                               business unit,
                                                                                                               the general aviation
                                                                                                               insurance products
                                                                                                               and services handled
                                                                                                               by our General
                                                                                                               Aviation business
                                                                                                               unit, and the commercial
                                                                                                               excess liability
                                                                                                               and umbrella insurance
                                                                                                               products handled
                                                                                                               by our Excess &
                                                                                                               Umbrella business
                                                                                                               unit.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · | Personal
                                                                                                               Segment.
                                                                                                               Our Personal Segment
                                                                                                               includes the non-standard
                                                                                                               personal automobile
                                                                                                               insurance,low value
                                                                                                               dwelling/homeowners,
                                                                                                               renters, motorcycle
                                                                                                               and business auto
                                                                                                               insurance products
                                                                                                               and services handled
                                                                                                               by our Personal
                                                                                                               Lines business
                                                                                                               unit.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| | · | American
                                                                                                               Hallmark Insurance
                                                                                                               Company of Texas
                                                                                                               (“AHIC”)presently
                                                                                                               retains a portion
                                                                                                               of the risks on
                                                                                                               the commercial
                                                                                                               property/casualty
                                                                                                               and workers compensation
                                                                                                               policies marketed
                                                                                                               within the Standard
                                                                                                               Commercial Segment,
                                                                                                               retains a portion
                                                                                                               of the risks on
                                                                                                               personal policies
                                                                                                               marketed within
                                                                                                               the Personal Segment
                                                                                                               and retains a portion
                                                                                                               of the risks on
                                                                                                               the commercial,
                                                                                                               medical professional
                                                                                                               liability, aviation
                                                                                                               and satellite launch
                                                                                                               property/casualty
                                                                                                               policies marketed
                                                                                                               within the Specialty
                                                                                                               Commercial Segment.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



30







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



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



| | · | Hallmark
                                                                                                               National Insurance
                                                                                                               Company(“HNIC”)was
                                                                                                               acquired on December
                                                                                                               31, 2010. Simultaneous
                                                                                                               with the closing
                                                                                                               of the acquisition,
                                                                                                               HNIC entered into
                                                                                                               reinsurance contracts
                                                                                                               with an affiliate
                                                                                                               of the seller,
                                                                                                               pursuant to which
                                                                                                               such affiliate
                                                                                                               of the seller will
                                                                                                               handle all claims
                                                                                                               and assume all
                                                                                                               liabilities arising
                                                                                                               under policies
                                                                                                               issued by HNIC
                                                                                                               prior to the closing
                                                                                                               or during a transition
                                                                                                               period of up to
                                                                                                               six months following
                                                                                                               the closing. Commencing
                                                                                                               January 1, 2011,
                                                                                                               HNIC retains a
                                                                                                               portion of the
                                                                                                               risks on the personal
                                                                                                               policies marketed
                                                                                                               within the Personal
                                                                                                               Segment.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · | Hallmark
                                                                                                               County Mutual Insurance
                                                                                                               Company(“HCM”)control
                                                                                                               and management
                                                                                                               is maintained through
                                                                                                               our wholly owned
                                                                                                               subsidiary CYR
                                                                                                               Insurance Management
                                                                                                               Company (“CYR”).
                                                                                                               CYR has as its
                                                                                                               primary asset a
                                                                                                               management agreement
                                                                                                               with HCM, which
                                                                                                               provides for CYR
                                                                                                               to have management
                                                                                                               and control of
                                                                                                               HCM. HCM is used
                                                                                                               to front certain
                                                                                                               lines of business
                                                                                                               in our Specialty
                                                                                                               Commercial and
                                                                                                               Personal Segments
                                                                                                               in Texas. HCM does
                                                                                                               not retain any
                                                                                                               business.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · | Texas
                                                                                                               Builders Insurance
                                                                                                               Company(“TBIC”)was
                                                                                                               acquired on July
                                                                                                               1, 2011 and retains
                                                                                                               a portion of the
                                                                                                               risks on the workers
                                                                                                               compensation policies
                                                                                                               marketed within
                                                                                                               our Standard Commercial
                                                                                                               Segment.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



AHIC,
HIC, HSIC and HNIC have entered into a pooling arrangement pursuant to which AHIC retains 33% of the total net premiums written
by any of them, HIC retains 28% of our total net premiums written by any of them, HSIC retains 28% of our total net premiums written
by any of them and HNIC retains 11% of our total premiums written by any of them. Neither HCM nor TBIC is a party to the intercompany
pooling arrangement.This pooling arrangement has no impact on our consolidated
financial statements reported in accordance with U.S. generally accepted accounting principles (“GAAP”).



Results of Operations



Management OverviewDuring the three and six months ended June 30, 2012, our total revenues were $84.6 million and $167.6 million, representing
an 8% and 7% increase, respectively, from the $78.5 million and $155.9 million in total revenues for the same period of 2011. 
This increase in revenue was primarily attributable to increased earned premium largely from increased production by our E&S
Commercial business unit and the acquisition of our Workers Compensation business unit during the third quarter of 2011. These
increases in revenue were partially offset by lower net realized gains and lower finance charges and earned premium in our Personal
Lines business unit due mostly to the impact of rate increases, the reduction of premium written in Florida and exiting certain
other underperforming states and programs.



31







The increase in revenue
for the three months and six months ended June 30, 2012 was complemented by slightly decreased loss and loss adjustment expenses
(“LAE”) due primarily to lower current accident year loss trends. During the three months ended June 30, 2012 we recorded
$1.6 million unfavorable prior year loss development. During the six months ended June 30, 2012 we recorded $1.4 million of favorable
prior year loss development. During the three and six months ended June 30, 2011 we recorded $0.7 million and $15.8 million, respectively,
of unfavorable prior year loss development. Of the $15.8 million unfavorable development recognized for the six months ended June
30, 2011, $9.5 million was a result of adverse prior year loss reserve development in our Personal Lines Segment in Florida. In
addition, the results for the six months ended June 30, 2012 and 2011 included $10.4 million and $9.4 million, respectively, in
net losses from weather related claims.



We reported a $1.8 million net
loss attributable to Hallmark for the three months ended June 30, 2012 as compared to $87 thousand net loss attributable to Hallmark
for the same period during 2011. We reported a net loss attributable to Hallmark of $1.7 million for the six months ended June
30, 2012, which was $9.6 million lower than the $11.3 million net loss reported for the six months ended June 30, 2011.  On
a diluted basis per share, we reported a net loss of $0.10 per share for the three months ended June 30, 2012, as compared to net
loss of $0.00 per share for the same period in 2011.   On a diluted basis per share, net loss per share was $0.09 for
the six months ended June 30, 2012 as compared to net loss per share of $0.56 for the same period during 2011. We reported an income
tax benefit of $2.3 million, or an effective income tax rate of 59.2%, for the six months ended June 30, 2012, as compared to income
tax benefit of $9.7 million, or an effective rate of 46.1%, for the same period during 2011.



32







Second Quarter 2012 as Compared to
Second Quarter 2011



The following is additional
business segment information for the three months ended June 30, 2012 and 2011 (in thousands):



Hallmark Financial Services,
Inc

Consolidated Segment Data



|                                                       |  | Three Months Ended June 30, 2012 |       
|------------------------------------------------------ |  | -------------------------------- | ------
|                                                       |  | Standard                         |       
|                                                       |  | Commercial                       |       
|                                                       |  | Segment                          |       
|                                                       |  |                                  |       
|Gross premiums written                                 |  | $                                | 20,739
|Ceded premiums written                                 |  |                                  | (1,730
|Net premiums written                                   |  |                                  | 19,009
|Change in unearned premiums                            |  |                                  | (2,369
|Net premiums earned                                    |  |                                  | 16,640
|                                                       |  |                                  |       
|Total revenues                                         |  |                                  | 17,924
|                                                       |  |                                  |       
|Losses and loss adjustment expenses                    |  |                                  | 13,013
|                                                       |  |                                  |       
|Pre-tax income (loss), net of non-controlling interest |  |                                  | (710  
|                                                       |  |                                  |       
|Net loss ratio (1)                                     |  |                                  | 78.2  
|Net expense ratio (1)                                  |  |                                  | 34.2  
|Net combined ratio (1)                                 |  |                                  | 112.4 



|                                                       |  | Three Months Ended June 30, 2011 |       
|------------------------------------------------------ |  | -------------------------------- | ------
|                                                       |  | Standard                         |       
|                                                       |  | Commercial                       |       
|                                                       |  | Segment                          |       
|                                                       |  |                                  |       
|Gross premiums written                                 |  | $                                | 18,549
|Ceded premiums written                                 |  |                                  | (1,392
|Net premiums written                                   |  |                                  | 17,157
|Change in unearned premiums                            |  |                                  | (1,796
|Net premiums earned                                    |  |                                  | 15,361
|                                                       |  |                                  |       
|Total revenues                                         |  |                                  | 16,241
|                                                       |  |                                  |       
|Losses and loss adjustment expenses                    |  |                                  | 15,789
|                                                       |  |                                  |       
|Pre-tax income (loss), net of non-controlling interest |  |                                  | (4,767
|                                                       |  |                                  |       
|Net loss ratio (1)                                     |  |                                  | 102.8 
|Net expense ratio (1)                                  |  |                                  | 34.0  
|Net combined ratio (1)                                 |  |                                  | 136.8 



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



33







Standard Commercial Segment



Gross premiums written
for the Standard Commercial Segment were $20.7 million for the three months ended June 30, 2012, which was $2.2 million, or 12%,
more than the $18.5 million reported for the same period in 2011. Net premiums written were $19.0 million for the three months
ended June 30, 2012 as compared to $17.2 million reported for the same period in 2011. The increase in premium volume was primarily
due to the acquisition of our Workers Compensation business unit during the third quarter of 2011.



Total revenue for
the Standard Commercial Segment of $17.9 million for the three months ended June 30, 2012 was $1.7 million more than the $16.2
million reported during the same period in 2011. This 10% increase in total revenue was mostly due to increased net premiums earned
of $1.3 million due primarily to the acquisition of our Workers Compensation business unit during the third quarter of 2011, higher
net investment income of $0.3 million, and a $0.1 million lower adverse profit share commission revenue adjustment as compared
to the second quarter of 2011.



Our Standard Commercial
Segment reported a pre-tax loss of $0.7 million for the three months ended June 30, 2012 as compared to a pre-tax loss of $4.8
million for the same period of 2011. This decrease in pre-tax loss was primarily the result of lower loss and LAE of $2.8 million
and the increased revenue discussed above, partially offset by higher operating expenses of $0.4 million due primarily to the acquisition
of our Workers Compensation business unit during the third quarter of 2011.



The Standard Commercial Segment reported
a net loss ratio of 78.2% for the three months ended June 30, 2012 as compared to 102.8% for the same period of 2011. The gross
loss ratio before reinsurance for the three months ended June 30, 2012 was 86.4% as compared to the 90.3% reported for the same
period of 2011. The decrease in the net loss ratio was impacted by lower current accident year loss trends excluding catastrophe
losses during the second quarter of 2012 as compared to the same period in 2011. The gross and net loss results for the three months
ended June 30, 2012 and 2011 include $4.8 million and $3.7 million, respectively, of weather related losses. During the three months
ended June 30, 2012, the Standard Commercial Segment reported unfavorable loss reserve development of $0.2 million as compared
to $0.8 million favorable loss development during the same period of 2011.



Specialty Commercial Segment



The $43.0 million
of total revenue for the three months ended June 30, 2012 was $8.5 million higher than the $34.5 million reported by the Specialty
Commercial Segment for the same period in 2011. This increase in revenue was primarily due to higher net premiums earned of $8.2
million largely from increased production in our E&S Commercial business unit, Excess & Umbrella business unit and a new
space risk program entered into during the first quarter of 2011. Further contributing to this increased revenue was higher net
investment income of $0.4 million.



Pre-tax income for
the Specialty Commercial Segment of $2.9 million for the second quarter of 2012 was $2.1 million higher than the $0.8 million reported
for the same period in 2011. The increase in pre-tax income was primarily due to the increased revenue discussed above partially
offset by higher loss and LAE expenses of $4.7 million and higher operating expenses of $1.8 million. Our E&S Commercial business
unit reported a $6.2 million increase in loss and LAE due primarily to increased premium production as well as higher current accident
year loss trends. Our General Aviation business unit reported a $1.9 million decrease in loss and LAE due primarily to weather
related losses during the three months ended June 30, 2011, as well as increased favorable prior year loss development of $2.7
million during the three months ended June 30, 2012 as compared to $2.1 million favorable development recognized during the second
quarter of 2011, partially offset by higher current accident year loss trends. The increase in operating expenses for the three
months ended June 30, 2012 were primarily the result of increased production related expenses of $1.5 million and increased salary
and related expenses of $0.3 million.



34







The Specialty Commercial
Segment reported a net loss ratio of 69.5% for the three months ended June 30, 2012 as compared to 72.5% for the same period during
2011. The gross loss ratio before reinsurance was 66.1% for the three months ended June 30, 2012 as compared to 68.8% for the same
period in 2011. Our E&S Commercial business unit reported $2.6 million and $2.1 million of unfavorable prior years’ loss
development, respectively, for the three months ended June 30, 2012 and 2011. Our General Aviation business unit reported $2.7
million and $2.1 million of favorable prior years’ loss development, respectively, for the three months ended June 30, 2012
and 2011.



Personal Segment



Net premiums written
for our Personal Segment decreased $5.7 million during the second quarter of 2012 to $18.4 million compared to $24.1 million for
the second quarter of 2011. The decrease in premium was due mostly to the impact of rate increases, the reduction of premium written
in Florida and exiting certain other underperforming states and programs. Total revenue for the Personal Segment decreased 11%
to $22.9 million for the second quarter of 2012 from $25.9 million for the second quarter of 2011. Lower earned premium of $2.8
million and lower finance charges of $0.2 million were the primary reason for the decrease in revenue for the period.



Pre-tax loss for the
Personal Segment was $4.2 million for the three months ended June 30, 2012 as compared to pre-tax loss of $4.6 million for the
same period of 2011. The decreased pre-tax loss was driven by decreased losses and LAE of $2.7 million and lower operating expenses
of $0.7 million due mostly to decreased production related expense, partially offset by the lower revenue discussed above.



The Personal Segment
reported a net loss ratio of 95.3% for the three months ended June 30, 2012 as compared to 95.2% for the second quarter of 2011.
The loss ratio for the three months ended June 30, 2012 includes favorable current accident year loss trends in our non-standard
auto line of business offset by increased weather and fire related losses in our low value dwelling/homeowners line of business.
The loss and LAE during the three months ended June 30, 2012 and 2011 included $1.5 million of adverse prior year development.
The Personal Segment reported a net expense ratio of 28.8% for the three months ended June 30, 2012 as compared to 27.7% for the
second quarter of 2011. The increase in the expense ratio was due predominately to growth in headcount.



Corporate



Total revenue for
Corporate decreased by $1.2 million for the three months ended June 30, 2012 as compared to the same period the prior year. This
decrease in total revenue was due to lower net investment income of $0.5 million and lower net realized gains of $0.7 million for
the three months ended June 30, 2012 as compared to the same period of the prior year.



Corporate pre-tax
loss was $2.2 million for the three months ended June 30, 2012 as compared to $0.8 million pre-tax loss for the same period the
prior year. The increase in pre-tax loss was the result of the decreased revenue discussed above and higher operating expenses
of $0.2 million due primarily to an adjustment to the expected earn-out payable in conjunction with the acquisition of HNIC during
the second quarter of 2011.



35







Six Months Ended June 30, 2012 as Compared to Six Months
Ended June 30, 2011



The following is additional
business segment information for the six months ended June 30, 2012 and 2011 (in thousands):



Hallmark Financial Services,
Inc.

Consolidated Segment Data



|                                                       |  | Six Months Ended June 30, 2012 |       
|------------------------------------------------------ |  | ------------------------------ | ------
|                                                       |  | Standard                       |       
|                                                       |  | Commercial                     |       
|                                                       |  | Segment                        |       
|                                                       |  |                                |       
|Gross premiums written                                 |  | $                              | 39,586
|Ceded premiums written                                 |  |                                | (3,187
|Net premiums written                                   |  |                                | 36,399
|Change in unearned premiums                            |  |                                | (2,930
|Net premiums earned                                    |  |                                | 33,469
|                                                       |  |                                |       
|Total revenues                                         |  |                                | 36,030
|                                                       |  |                                |       
|Losses and loss adjustment expenses                    |  |                                | 26,777
|                                                       |  |                                |       
|Pre-tax income (loss), net of non-controlling interest |  |                                | (2,072
|                                                       |  |                                |       
|Net loss ratio (1)                                     |  |                                | 80.0  
|Net expense ratio (1)                                  |  |                                | 34.0  
|Net combined ratio (1)                                 |  |                                | 114.0 



|                                                        |  | Six Months Ended June 30, 2011 |       
|------------------------------------------------------- |  | ------------------------------ | ------
|                                                        |  | Standard                       |       
|                                                        |  | Commercial                     |       
|                                                        |  | Segment                        |       
|                                                        |  |                                |       
|Gross premiums written                                  |  | $                              | 36,004
|Ceded premiums written                                  |  |                                | (2,564
|Net premiums written                                    |  |                                | 33,440
|Change in unearned premiums                             |  |                                | (2,187
|Net premiums earned                                     |  |                                | 31,253
|                                                        |  |                                |       
|Total revenues                                          |  |                                | 33,668
|                                                        |  |                                |       
|Losses and loss adjustment expenses                     |  |                                | 28,414
|                                                        |  |                                |       
|Pre-tax income (loss), net of  non-controlling interest |  |                                | (5,150
|                                                        |  |                                |       
|Net loss ratio (1)                                      |  |                                | 90.9  
|Net expense ratio (1)                                   |  |                                | 32.7  
|Net combined ratio (1)                                  |  |                                | 123.6 



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



36







Standard Commercial Segment



Gross premiums written
for the Standard Commercial Segment were $39.6 million for the six months ended June 30, 2012, which was $3.6 million, or 10%,
more than the $36.0 million reported for the same period in 2011. Net premiums written were $36.4 million for the six months ended
June 30, 2012 as compared to $33.4 million reported for the same period in 2011. The increase in premium volume was primarily due
to the acquisition of our Workers Compensation business unit during the third quarter of 2011.



Total revenue for
the Standard Commercial Segment of $36.0 million for the six months ended June 30, 2012 was $2.3 million more than the $33.7 million
reported during the same period in 2011. This 7% increase in total revenue was mostly due to increased net premiums earned of $2.2
million due primarily to the acquisition of our Workers Compensation business unit during the third quarter of 2011, higher net
investment income of $0.5 million, partially offset by an adverse profit share commission revenue adjustment of $0.1 million during
the second quarter of 2012 related to unfavorable development on the treaty year beginning July 1, 2003 as compared to a $0.2 million
favorable profit share commission adjustment during the same period the prior year.



Our Standard Commercial
Segment reported a pre-tax loss of $2.1 million for the six months ended June 30, 2012 as compared to pre-tax loss of $5.2 million
for the same period of 2011. Lower loss and LAE expenses of $1.6 million and increased revenue contributed to this decrease in
pre-tax loss for the six months ended June 30, 2012. Partially offsetting the decline in pre-tax loss were higher operating expenses
of $0.9 million primarily due to the acquisition of our Workers Compensation business unit during the third quarter of 2011.



The Standard Commercial Segment reported
a net loss ratio of 80.0% for the six months ended June 30, 2012 as compared to 90.9% for the same period in 2011. The gross loss
ratio before reinsurance for the six months ended June 30, 2012 was 79.3% as compared to the 92.3% reported for the same period
of 2011. The lower gross and net loss ratios for the six months ended June 30, 2012 were aided by lower current accident year loss
trends excluding catastrophe losses. The gross and net loss results for the six months ended June 30, 2012 and 2011 include $8.8
million and $6.7 million, respectively, of weather related losses. During the six months ended June 30, 2012 the Standard Commercial
Segment reported favorable loss reserve development of $2.8 million, as compared to unfavorable development of $0.5 million for
the same period during 2011.



Specialty Commercial Segment



The $83.4 million
of total revenue for the Specialty Commercial Segment during the six months ended June 30, 2012 was $15.8 million higher than the
$67.6 million reported for the same period in 2011. This increase in revenue was due to higher net premiums earned of $15.0 million
due predominately to increased production in our E&S Commercial business unit, Excess & Umbrella business unit and a new
space risk program entered into during the first quarter of 2011. Further contributing to this increased revenue was higher net
investment income of $0.7 million.



37







Pre-tax income for
the Specialty Commercial Segment of $8.9 million for the first six months of 2012 was $4.6 million higher than the $4.3 million
reported for the same period in 2011. The increase in pre-tax income was primarily due to the increased revenue discussed above
partially offset by higher loss and LAE expenses of $7.9 million and higher operating expenses of $3.3 million. Our E&S Commercial
business unit reported a $9.6 million increase in loss and LAE due primarily to increased premium volume as well as higher current
accident year loss trends. Our General Aviation business unit reported a $2.2 million decrease in loss and LAE due primarily to
weather related losses during the six months ended June 30, 2011, as well as favorable prior year loss development of $2.7 million
during the six months ended June 30, 2012 as compared to $2.1 million favorable development recognized during the same period the
prior year, partially offset by higher current accident year loss trends. The increased operating expenses for the first six months
of 2012 were primarily the result of increased production related expenses of $2.8 million and higher salary and related expense
of $0.5 million.



The Specialty Commercial
Segment reported a net loss ratio of 65.2% for the six months ended June 30, 2012 as compared to 68.1% for the same period during
2011. The lower net loss ratio was impacted by lower weather related claims for the six months ended June 30, 2012, partially offset
by higher current accident year loss trends predominately in our commercial auto and general aviation lines of business. The Specialty
Commercial Segment reported $0.9 million of favorable prior year development for the six months ended June 30, 2012 as compared
to $1.0 million of unfavorable development for the same period during 2011.



Personal Segment



Net premiums written
for our Personal Segment decreased $9.8 million during the first six months of 2012 to $41.9 million compared to $51.7 million
for the first six months of 2011. The decrease in premium was due mostly to the impact of rate increases, the reduction of premium
written in Florida and exiting certain other underperforming states and programs. Total revenue for the Personal Segment decreased
7% to $47.3 million for the first six months of 2012 from $50.9 million for the first six months of 2011. Lower earned premium
of $3.5 million and lower finance charges of $0.2 million were the primary reason for the decrease in revenue for the period. The
decrease in revenue was partially offset by increased net investment income of $0.1 million during the first six months of 2012.



Pre-tax loss for the
Personal Segment was $5.4 million for the six months ended June 30, 2012 as compared to pre-tax loss of $17.8 million for the same
period of 2011. The lower pre-tax loss was the result of lower losses and LAE of $16.0 million partially offset by lower revenue
discussed above.



The Personal Segment
reported a net loss ratio of 87.7% for the six months ended June 30, 2012 as compared to 115.4% for the same period of 2011. The
decrease in the net loss ratio was primarily due to normalizing claims experience during the first six months of 2012 as compared
to extremely adverse claims development during the same period in 2011 due to rapid growth in the Florida claim volume and the
complexity related to Florida personal injury protection claims. The net loss ratio for our Florida related business was 314.0%
for the six months ended June 30, 2011, which equates to approximately 39.6% of the net loss ratio reported as of June 30, 2011.
The loss ratio for the six months ended June 30, 2012 included improving current accident year loss trends in our non-standard
auto line of business partially offset by increased weather and fire related losses in our low value dwelling/homeowners line of
business. The loss and LAE during the six months ended June 30, 2012 included $2.3 million of adverse prior year development as
compared to $14.3 million of adverse prior year development for the same period during 2011. The Personal Segment reported a net
expense ratio of 28.1% for the six months ended June 30, 2012 as compared to 25.8% for the same period of 2011. The increase in
the expense ratio was due predominately to growth in headcount.



38







Corporate



Total revenue for
Corporate decreased by $3.0 million for the six months ended June 30, 2012 as compared to the same period the prior year. This
decrease in total revenue was due primarily to gains of $0.9 million recognized on our investment portfolio for the six months
ended June 30, 2012 as compared to $2.8 million of gains recognized during the same period in 2011. Further contributing to this
decrease in revenue was lower net investment income of $1.3 million for the six months ended June 30, 2012 as compared to the same
period of the prior year.



Corporate pre-tax
loss was $5.4 million for the six months ended June 30, 2012 as compared to a $2.3 million pre-tax loss for the same period the
prior year. The increase in pre-tax loss was the result of the decreased revenue discussed above and higher operating expenses
of $0.2 million due to a reduced adjustment to the expected earn-out payable in conjunction with the acquisition of HNIC during
the six months ended June 30, 2012 as compared to the same period the prior year.



Financial Condition and Liquidity



Sources and
Uses of Funds



Our sources of funds
are from insurance-related operations, financing activities and investing activities. Major sources of funds from operations include
premiums collected (net of policy cancellations and premiums ceded), commissions, and processing and service fees. As a holding
company, Hallmark is dependent on dividend payments and management fees from its subsidiaries to meet operating expenses and debt
obligations. As of June 30, 2012, Hallmark had $4.2 million in unrestricted cash and invested assets at the holding company. Unrestricted
cash and invested assets of our non-insurance subsidiaries were $5.6 million as of June 30, 2012. As of that date, our insurance
subsidiaries held $66.4 million of cash and cash equivalents as well as $399.1 million in debt securities with an average modified
duration of 2.9 years. Accordingly, we do not anticipate selling long-term debt instruments to meet any liquidity needs.



AHIC and TBIC, domiciled
in Texas, are limited in the payment of dividends to their stockholders 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. HIC, 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. HSIC, 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, not including
realized capital gains, without prior written approval from the Oklahoma Insurance Department. HNIC, domiciled in Ohio, is limited
in the payment of dividends to the greater of 10% of statutory policyholders’ surplus as of the prior December 31 or
statutory net income as of the prior December 31 without prior written approval from the Ohio Insurance Department. During 2012,
the aggregate ordinary dividend capacity of these subsidiaries is $20.3 million, of which $15.0 million is available to Hallmark.
As a county mutual, dividends from HCM are payable to policyholders. None of our insurance company subsidiaries paid a dividend
to Hallmark during the first six months of 2012 or the 2011 fiscal year.



39







Comparison
of June 30, 2012 to December 31, 2011



On a consolidated
basis, our cash and investments (excluding restricted cash) at June 30, 2012 were $516.0 million compared to $499.1 million at
December 31, 2011. The acquisition of debt securities for which $6.2 million settled subsequent to quarter end and a $6.5 million
federal income tax refund during the second quarter of 2012 were the primary reasons for this increase, as well as other cash flow
from operations.



Comparison
of Six Months Ended June 30, 2012 and June 30, 2011



Net cash provided
by our consolidated operating activities was $17.2 million for the first six months of 2012 compared to net cash provided by operating
activities of $11.0 million for the first six months of 2011. The increase in operating cash flow was primarily due to a $6.5 million
federal income tax refund during the second quarter of 2012.



Net cash used
in investing activities during the first six months of 2012 and 2011 was $12.8 million and $15.7 million, respectively.  The
decrease in cash used in investing activities during the first six months of 2012 was due to a decrease in purchases of debt and
equity securities of $90.7 million, a $14.0 million payment for the acquisition of HNIC during the first quarter 2011, and a decrease
in purchases of property and equipment of $1.0 million, partially offset by a decrease in maturities, sales and redemptions of
investment securities of $102.5 million and a $0.3 million increase in transfers to restricted cash.



Cash used in financing
activities during the first three months of 2012 was $2.6 million as a result of a $2.5 million repayment on our revolving credit
facility and a distribution to non-controlling interest for our Excess & Umbrella business unit. Cash used in financing activities
during the first six months of 2011 was $5.0 million primarily related to the repurchase of the Company’s common stock during
the second quarter of 2011.



Credit Facilities



Our First Restated
Credit Agreement with The Frost National Bank dated January 27, 2006, as amended to date, provides a revolving credit facility
of $15.0 million. We pay interest on the outstanding balance at our election at a rate of the prime rate or LIBOR plus 2.5%.  We
pay an annual fee of 0.25% of the average daily unused balance of the credit facility. We pay letter of credit fees at the rate
of 1.00% per annum.  Our obligations under the revolving credit facility are secured by a security interest in the capital
stock of all of our subsidiaries, guarantees of all of our subsidiaries and the pledge of all of our non-insurance company assets.  The
revolving credit facility contains covenants that, among other things, require us to maintain certain financial and operating ratios
and restrict certain distributions, transactions and organizational changes.  We are in compliance with or have obtained
waivers of all of our covenants.  As of June 30, 2012, the balance on the revolving note was $1.6 million. The revolving note
currently bears interest at 2.97% per annum.



40







Subordinated
Debt Securities



On June 21, 2005, we
entered into a trust preferred securities transaction pursuant to which we issued $30.9 million aggregate principal amount of subordinated
debt securities due in 2035. To effect the transaction, we formed a Delaware statutory trust, Hallmark Statutory Trust I (“Trust
I”). Trust I issued $30.0 million of preferred securities to investors and $0.9 million of common securities to us. Trust
I used the proceeds from these issuances to purchase the subordinated debt securities. Our Trust I subordinated debt securities
bear an initial interest rate of 7.725% until June 15, 2015, at which time interest will adjust quarterly to the three-month LIBOR
rate plus 3.25 percentage points. Trust I pays dividends on its preferred securities at the same rate. Under the terms of our Trust
I subordinated debt securities, we pay interest only each quarter and the principal of the note at maturity. The subordinated debt
securities are uncollaterized and do not require maintenance of minimum financial covenants. As of June 30, 2012, the balance of
our Trust I subordinated debt was $30.9 million.



On August 23, 2007,
we entered into a trust preferred securities transaction pursuant to which we issued $25.8 million aggregate principal amount of
subordinated debt securities due in 2037. To effect the transaction, we formed a Delaware statutory trust, Hallmark Statutory Trust
II (“Trust II”). Trust II issued $25.0 million of preferred securities to investors and $0.8 million of common securities
to us. Trust II used the proceeds from these issuances to purchase the subordinated debt securities. Our Trust II subordinated
debt securities bear an initial interest rate of 8.28% until September 15, 2017, at which time interest will adjust quarterly to
the three-month LIBOR rate plus 2.90 percentage points. Trust II pays dividends on its preferred securities at the same rate. Under
the terms of our Trust II subordinated debt securities, we pay interest only each quarter and the principal of the note at maturity.
The subordinated debt securities are uncollaterized and do not require maintenance of minimum financial covenants. As of June 30,
2012, the balance of our Trust II subordinated debt was $25.8 million.



Item 3. Quantitative and Qualitative
Disclosures About Market Risk.



There have been no material changes
to the market risks discussed in Item 7A to Part II of our Form 10-K for the fiscal year ended December 31, 2011.



Item 4. Controls and Procedures.



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



41







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



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



PART
II

OTHER
INFORMATION



| | Item 1. | Legal Proceedings.
| | ------- | ------------------



In December 2010,
our E&S Commercial business unit was informed by the Texas Comptroller of Public Accounts that a surplus lines tax audit covering
the period January 1, 2007 through December 31, 2009 was complete. A subsidiary within our E&S Commercial business unit (“TGA”)
frequently acts as a managing general underwriter (“MGU”) authorized to underwrite policies on behalf of Republic Vanguard
Insurance Company and HSIC, both Texas eligible surplus lines insurance carriers. In its role as the MGU, TGA underwrites policies
on behalf of these carriers while other agencies located in Texas, generally referred to as “producing agents,” deliver
the policies to the insureds and collect all premiums due from the insureds. During the period under audit, the producing agents
also collected the surplus lines premium taxes due on the policies from the insureds, held them in trust, and timely remitted those
taxes to the Comptroller. We believe this system for collecting and paying the required surplus lines premium taxes complies in
all respects with the Texas Insurance Code and other regulations, which clearly require that the same party who delivers the policies
and collects the premiums will also collect premium taxes, hold premium taxes in trust, and pay premium taxes to the Comptroller.
It also complies with long standing industry practice. The Comptroller asserts that TGA is liable for the surplus lines premium
taxes related to policy transactions and premiums collected from surplus lines insureds during the audit period and that TGA owes
$4.5 million in premium taxes, as well as $0.9 million in penalties and interest for the audit period.



We disagree with the
Comptroller and intend to vigorously fight their assertion that TGA is liable for the surplus lines premium taxes. During the past
several months we have been engaged in conversations with the Comptroller’s counsel and are waiting on the Comptroller’s
position paper. At this stage, we cannot predict the course of any proceedings, the timing of any rulings or other significant
events relating to such surplus lines tax audit.  Given these limitations and the inherent difficulty of projecting the outcome
of regulatory disputes, we are presently unable to reasonably estimate the possible loss or legal costs that are likely to arise
out of the surplus lines tax audit or any future proceedings relating to this matter. Also, based on current information, we believe that a favorable outcome of this dispute is at least
reasonably possible. Therefore we have not accrued any amount
as of June 30, 2012 related to this matter.



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



42







| | Item 1A. | Risk
                                                                                                                                          Factors.
| | -------- | -------------------------------------------------------------------------------------------------------------------------------------------------------



There have been no
material changes to the risk factors discussed in Item 1A to Part 1 of our Form 10-K for the fiscal year ended December 31, 2011.



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



None.



| | Item 3. | Defaults
                                                                                                                                         Upon
                                                                                                                                         Senior
                                                                                                                                         Securities.
| | ------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



None.



| | Item 4. | Mine
                                                                                                                                         Safety
                                                                                                                                         Disclosures.
| | ------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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)                   |  | Restated Articles of Incorporation of the registrant, as amended (incorporated by reference to Exhibit 3.1 to the registrant’s Registration Statement on Form S-1 [Registration No. 333-136414] filed September 8, 2006).                    
|                       |  |                                                                                                                                                                                                                                              
|3(b)                   |  | Amended and Restated By-Laws of the registrant (incorporated by reference to Exhibit 3.1 to the registrant’s Current Report on Form 8-K filed October 1, 2007).                                                                              
|                       |  |                                                                                                                                                                                                                                              
|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.                                                                                                                                                                     
|                       |  |                                                                                                                                                                                                                                              
|101 +                  |  | Interactive Data files                                                                                                                                                                                                                       
|                       |  |                                                                                                                                                                                                                                              
|+                      |  | XBRL Interactive Data files with detailed tagging will be filed by amendment to this Quarterly Report on Form 10-Q within 30 days of the filing date of this Quarterly Report on Form 10-Q, as permitted by Rule 405(a)(2) of Regulation S-T.



43







SIGNATURES



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



HALLMARK FINANCIAL SERVICES, INC.

(Registrant)



|Date: August 6, 2012 |  | /s/ Mark J. Morrison                                                     | 
|-------------------- |  | ------------------------------------------------------------------------ | 
|                     |  | Mark J. Morrison, Chief Executive Officer and President                 
|                     |  |                                                                         
|Date: August 6, 2012 |  | /s/ Jeffrey R. Passmore                                                  | 
|                     |  | Jeffrey R. Passmore, Chief Accounting Officer and Senior Vice
 President



44