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 March 31, 2010





Commission
file number 001-11252





Hallmark
Financial Services, Inc.





(Exact
name of registrant as specified in its charter)





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





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





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




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





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


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





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




Indicate
the number of shares outstanding of each of the issuer's classes of common
stock, as of the latest practicable date: Common Stock, par value $.18 per share
– 20,123,336 shares outstanding as of May 13, 2010.





PART
I


FINANCIAL
INFORMATION





Item
1.  Financial Statements





INDEX
TO FINANCIAL STATEMENTS





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


2





Hallmark
Financial Services, Inc. and Subsidiaries


Consolidated
Balance Sheets


($ in
thousands, except share amounts)





March 31
                        
                        
                        December 312010
                        
                        
                        2009(unaudited)ASSETSInvestments:Debt
      securities, available-for-sale, at fair value (cost; $305,355 in 2010 and
      $287,108 in 2009)
                        
                        $
                        310,474
                        
                        
                        $
                        291,876Equity
      securities, available-for-sale, at fair value (cost; $24,367 in 2010 and
      $27,251 in 2009)
                        
                        
                        36,343
                        
                        
                        
                        35,801Total
      investments
                        
                        
                        346,817
                        
                        
                        
                        327,677Cash
      and cash equivalents
                        
                        
                        110,556
                        
                        
                        
                        112,270Restricted
      cash and cash equivalents
                        
                        
                        7,505
                        
                        
                        
                        5,458Premiums
      receivable
                        
                        
                        53,439
                        
                        
                        
                        46,635Accounts
      receivable
                        
                        
                        3,308
                        
                        
                        
                        3,377Receivable
      for securities
                        
                        
                        2,704
                        
                        
                        
                        -Prepaid
      reinsurance premiums
                        
                        
                        14,296
                        
                        
                        
                        12,997Reinsurance
      recoverable
                        
                        
                        10,999
                        
                        
                        
                        10,008Deferred
      policy acquisition costs
                        
                        
                        22,198
                        
                        
                        
                        20,792Goodwill
                        
                        
                        41,080
                        
                        
                        
                        41,080Intangible
      assets, net
                        
                        
                        27,956
                        
                        
                        
                        28,873Prepaid
      expenses
                        
                        
                        1,524
                        
                        
                        
                        923Other
      assets
                        
                        
                        13,241
                        
                        
                        
                        18,779Total
      assets
                        
                        $
                        655,623
                        
                        
                        $
                        628,869LIABILITIES AND STOCKHOLDERS'
      EQUITYLiabilities:Note
      payable
                        
                        $
                        2,800
                        
                        
                        $
                        2,800Subordinated
      debt securities
                        
                        
                        56,702
                        
                        
                        
                        56,702Reserves
      for unpaid losses and loss adjustment expenses
                        
                        
                        196,546
                        
                        
                        
                        184,662Unearned
      premiums
                        
                        
                        132,167
                        
                        
                        
                        125,089Unearned
      revenue
                        
                        
                        180
                        
                        
                        
                        191Reinsurance
      balances payable
                        
                        
                        713
                        
                        
                        
                        3,281Accrued
      agent profit sharing
                        
                        
                        612
                        
                        
                        
                        1,790Accrued
      ceding commission payable
                        
                        
                        4,233
                        
                        
                        
                        8,600Pension
      liability
                        
                        
                        2,655
                        
                        
                        
                        2,628Deferred
      federal income taxes, net
                        
                        
                        2,368
                        
                        
                        
                        942Federal
      income tax payable
                        
                        
                        2,588
                        
                        
                        
                        1,266Payable
      for securities
                        
                        
                        7,001
                        
                        
                        
                        19Accounts
      payable and other accrued expenses
                        
                        
                        10,459
                        
                        
                        
                        13,258Total
      liabilities
                        
                        
                        419,024
                        
                        
                        
                        401,228Commitments
      and Contingencies (Note 17)Redeemable
      non-controlling interest
                        
                        
                        1,063
                        
                        
                        
                        1,124Stockholders'
      equity:Common
      stock, $0.18 par value (authorized 33,333,333 shares in 2010 and
      2009; issued 20,872,831 in 2010 and 2009)
                        
                        
                        3,757
                        
                        
                        
                        3,757Additional
      paid-in capital
                        
                        
                        121,196
                        
                        
                        
                        121,016Retained
      earnings
                        
                        
                        104,768
                        
                        
                        
                        98,482Accumulated
      other comprehensive income
                        
                        
                        11,083
                        
                        
                        
                        8,589Treasury
      stock, at cost (749,495 shares in 2010 and 757,828 in
2009)
                        
                        
                        (5,268
                        )
                        
                        
                        (5,327
                        )Total
      stockholders' equity
                        
                        
                        235,536
                        
                        
                        
                        226,517$
                        655,623
                        
                        
                        $
                        628,869





The
accompanying notes are an integral part


of the
consolidated financial statements


3





Hallmark
Financial Services, Inc. and Subsidiaries


Consolidated
Statements of Operations


(Unaudited)


($ in
thousands, except per share amounts)





Three Months EndedMarch312010
                
                
                2009Gross
      premiums written
                
                $
                81,859
                
                
                $
                71,479Ceded
      premiums written
                
                
                (9,064
                )
                
                
                (2,232
                )Net
      premiums written
                
                
                72,795
                
                
                
                69,247Change
      in unearned premiums
                
                
                (5,780
                )
                
                
                (9,817
                )Net
      premiums earned
                
                
                67,015
                
                
                
                59,430Investment
      income, net of expenses
                
                
                3,201
                
                
                
                4,269Net
      realized gains (losses)
                
                
                3,803
                
                
                
                (348
                )Finance
      charges
                
                
                1,643
                
                
                
                1,350Commission
      and fees
                
                
                151
                
                
                
                6,189Processing
      and service fees
                
                
                3
                
                
                
                15Other
      income
                
                
                7
                
                
                
                5Total
      revenues
                
                
                75,823
                
                
                
                70,910Losses
      and loss adjustment expenses
                
                
                43,098
                
                
                
                36,842Other
      operating expenses
                
                
                21,482
                
                
                
                23,750Interest
      expense
                
                
                1,146
                
                
                
                1,159Amortization
      of intangible assets
                
                
                916
                
                
                
                714Total
      expenses
                
                
                66,642
                
                
                
                62,465Income
      before tax
                
                
                9,181
                
                
                
                8,445Income
      tax expense
                
                
                2,890
                
                
                
                1,662Net
      income
                
                
                6,291
                
                
                
                6,783Less:
      Net income (loss) attributable to
      non-controlling  interest
                
                
                5
                
                
                
                (7
                )Net
      income attributable to Hallmark Financial Services, Inc.
                
                $
                6,286
                
                
                $
                6,790Net
      income per share attributable to Hallmark Financial Services, Inc. common
      stockholders:Basic
                
                $
                0.31
                
                
                $
                0.33Diluted
                
                $
                0.31
                
                
                $
                0.33





The
accompanying notes are an integral part


of the
consolidated  financial statements


4





Hallmark
Financial Services, Inc. and Subsidiaries


Consolidated
Statements of Stockholders' Equity and Comprehensive Income


(Unaudited)


($ in
thousands)





Three Months EndedMarch 31,2010
                    
                    
                    2009Common
      StockBalance,
      beginning of period
                    
                    $
                    3,757
                    
                    
                    $
                    3,751Issuance
      of common stock upon option exercises
                    
                    
                    -
                    
                    
                    
                    6Balance,
      end of period
                    
                    
                    3,757
                    
                    
                    
                    3,757Additional
      Paid-In CapitalBalance,
      beginning of period
                    
                    
                    121,016
                    
                    
                    
                    119,928Accretion
      of redeemable noncontrolling interest
                    
                    
                    (78
                    )
                    
                    
                    (94
                    )Equity
      based compensation
                    
                    
                    298
                    
                    
                    
                    262Exercise
      of stock options
                    
                    
                    (40
                    )
                    
                    
                    104Balance,
      end of period
                    
                    
                    121,196
                    
                    
                    
                    120,200Retained
      EarningsBalance,
      beginning of period
                    
                    
                    98,482
                    
                    
                    
                    72,242Net
      income attributable to Hallmark Financial Services, Inc.
                    
                    
                    6,286
                    
                    
                    
                    6,790Balance,
      end of period
                    
                    
                    104,768
                    
                    
                    
                    79,032Accumulated
      Other Comprehensive Income (Loss)Balance,
      beginning of period
                    
                    
                    8,589
                    
                    
                    
                    (16,432
                    )Additional
      minimum pension liability, net of tax
                    
                    
                    36
                    
                    
                    
                    80Net
      unrealized holding gains arising during period
                    
                    
                    6,261
                    
                    
                    
                    8,713Reclassification
      adjustment for losses included in net income
                    
                    
                    (3,803
                    )
                    
                    
                    (4,718
                    )Balance,
      end of period
                    
                    
                    11,083
                    
                    
                    
                    (12,357
                    )Treasury
      StockBalance,
      beginning of period
                    
                    
                    (5,327
                    )
                    
                    
                    (77
                    )Issuance
      of treasury stock upon option exercises
                    
                    
                    59
                    
                    
                    
                    -Balance,
      end of period
                    
                    
                    (5,268
                    )
                    
                    
                    (77
                    )Total
      Stockholders' Equity
                    
                    $
                    235,536
                    
                    
                    $
                    190,555Net
      income
                    
                    $
                    6,291
                    
                    
                    $
                    6,783Additional
      minimum pension liablilty, net of tax
                    
                    
                    36
                    
                    
                    
                    80Net
      unrealized holding gains arising during period
                    
                    
                    6,261
                    
                    
                    
                    8,713Reclassification
      adjustment for losses included in net income
                    
                    
                    (3,803
                    )
                    
                    
                    (4,718
                    )Comprehensive
      income
                    
                    
                    8,785
                    
                    
                    
                    10,858Less:
      Comprehensive income (loss) attributable to non-controlling
      interest
                    
                    
                    5
                    
                    
                    
                    (7
                    )Comprehensive
      income attributable toHallmark
      Financial Services, Inc.
                    
                    $
                    8,780
                    
                    
                    $
                    10,865





The
accompanying notes are an integral part


of the
consolidated  financial statements




5




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




Three Months EndedMarch 312010
                
                
                2009Cash
      flows from operating activities:Net
      income
                
                $
                6,291
                
                
                $
                6,783Adjustments
      to reconcile net income to cash provided by operating
      activities:Depreciation
      and amortization expense
                
                
                1,155
                
                
                
                928Deferred
      federal income taxes
                
                
                89
                
                
                
                (1,103
                )Realized
      (gains) losses on investments
                
                
                (3,803
                )
                
                
                348Change
      in prepaid reinsurance premiums
                
                
                (1,299
                )
                
                
                (322
                )Change
      in premiums receivable
                
                
                (6,804
                )
                
                
                (4,900
                )Change
      in accounts receivable
                
                
                2,724
                
                
                
                594Change
      in deferred policy acquisition costs
                
                
                (1,406
                )
                
                
                (1,478
                )Change
      in reserves for unpaid losses and loss adjustment expenses
                
                
                11,884
                
                
                
                8,476Change
      in unearned premiums
                
                
                7,078
                
                
                
                9,991Change
      in unearned revenue
                
                
                (11
                )
                
                
                (867
                )Change
      in accrued agent profit sharing
                
                
                (1,178
                )
                
                
                (1,400
                )Change
      in reinsurance recoverable
                
                
                (991
                )
                
                
                740Change
      in reinsurance payable
                
                
                (2,568
                )
                
                
                -Change
      in current federal income tax recoverable/payable
                
                
                1,322
                
                
                
                2,345Change
      in accrued ceding commission payable
                
                
                (4,367
                )
                
                
                (13
                )Change
      in all other liabilities
                
                
                (2,772
                )
                
                
                (9,081
                )Change
      in all other assets
                
                
                6,666
                
                
                
                (2,190
                )Net
      cash provided by operating activities
                
                
                12,010
                
                
                
                8,851Cash
      flows from investing activities:Purchases
      of property and equipment
                
                
                (268
                )
                
                
                (428
                )Net
      transfers (into)/from restricted cash and cash equivalents
                
                
                (2,047
                )
                
                
                2,833Purchases
      of investment securities
                
                
                (51,965
                )
                
                
                (22,014
                )Maturities,
      sales and redemptions of investment securities
                
                
                40,681
                
                
                
                12,443Payment
      for acquisition of subsidiaries
                
                
                -
                
                
                
                (3,343
                )Net
      cash used in investing activities
                
                
                (13,599
                )
                
                
                (10,509
                )Cash
      flows from financing activities:Proceeds
      from exercise of employee stock options
                
                
                19
                
                
                
                110Net
      repayments of notes payable
                
                
                -
                
                
                
                (1,269
                )Distribution
      to non-controlling interest
                
                
                (144
                )
                
                
                -Net
      cash used in financing activities
                
                
                (125
                )
                
                
                (1,159
                )Decrease
      in cash and cash equivalents
                
                
                (1,714
                )
                
                
                (2,817
                )Cash
      and cash equivalents at beginning of period
                
                
                112,270
                
                
                
                59,134Cash
      and cash equivalents at end of period
                
                $
                110,556
                
                
                $
                56,317Supplemental
      cash flow information:Interest
      paid
                
                $
                1,151
                
                
                $
                1,186Taxes
      paid
                
                $
                1,479
                
                
                $
                419Supplemental
      schedule of non-cash investing activities:Change
      in receivable for securities related to investment disposals settled after
      the balance sheet date
                
                $
                (2,655
                )
                
                $
                (33
                )Change
      in payable for securities related to investment purchases settled after
      the balance sheet date
                
                $
                6,982
                
                
                $
                (3,511
                )




The
accompanying notes are an integral part


of the
consolidated financial statements




6


Hallmark
Financial Services, Inc. and Subsidiaries


Notes
to Consolidated Financial Statements (Unaudited)





1.
General





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





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





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





2.
Basis of Presentation





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





The
interim financial data as of March 31, 2010 and 2009 is
unaudited.  However, in the opinion of management, the interim data
includes all adjustments, consisting of normal recurring adjustments, necessary
for a fair statement of the results for the interim periods.  The
results of operations for the period ended March 31, 2010 are not necessarily
indicative of the operating results to be expected for the full
year.


7





Redeemablenon-controlling
interest





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





Reclassification





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





Income
taxes





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





Use of Estimates in the
Preparation of the Financial Statements





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





Fair Value of Financial
Instruments





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





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


8





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





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





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





Subordinated
Debt Securities:  Our trust preferred securities have a carried value
of $56.7 million and a fair value of $55.6 million as of March 31,
2010.  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.





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





Variable Interest
Entities





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





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





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





Recently Issued Accounting
Standards





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


9





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





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





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





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


10





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





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





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





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





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


11





3.
Business Combinations





We account for business combinations
using the purchase method of accounting pursuant to ASC 805. The cost of an
acquired entity is allocated to the assets acquired (including identified
intangible assets) and liabilities assumed based on their estimated fair
values.  The excess of the cost of an acquired entity over the net of
the amounts assigned to assets acquired and liabilities assumed is an asset
referred to as “goodwill.” Indirect and general expenses related to business
combinations are expensed as incurred for acquisitions in 2009 and
after.  Prior to 2009, indirect and general expenses were
capitalized.





Effective
August 29, 2008, we acquired 80% of the issued and outstanding membership
interests in the subsidiaries now comprising our Excess & Umbrella business
unit for consideration of $15.0 million.  In connection with the
acquisition, we executed an operating agreement for each
subsidiary.  The operating agreements grant us the right to purchase
the remaining 20% membership interests in the subsidiaries and grant to an
affiliate of the seller the right to require us to purchase such remaining
membership interests (the “Put/Call Option”).  The Put/Call Option
becomes exercisable by either us or the affiliate of the seller upon the earlier
of August 29, 2012, the termination of the employment of the seller by the
Excess & Umbrella business unit or a change of control of Hallmark. If the
Put/Call Option is exercised, we will have the right or obligation to purchase
the remaining 20% membership interests in the Excess & Umbrella business
unit  for an amount equal to nine times the average Pre-Tax Income (as
defined in the operating agreements) for the previous 12 fiscal
quarters.  We estimate the ultimate redemption value of the Put/Call
Option to be $2.2 million at March 31, 2010.





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





4.
Fair Value





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





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


12





·
            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.





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




The
following table presents for each of the fair value hierarchy levels, our assets
that are measured at fair value on a recurring basis at March 31, 2010 (in
thousands).


13




Quoted Prices in
                    
                    
                    OtherActive Markets for
                    
                    
                    Observable
                    
                    
                    UnobservableIdentical Assets
                    
                    
                    Inputs
                    
                    
                    Inputs(Level1)
                    
                    
                    (Level2)
                    
                    
                    (Level3)
                    
                    
                    TotalU.S.
      Treasury securities and obligations of U.S. Government
                    
                    $
                    -
                    
                    
                    $
                    6,511
                    
                    
                    $
                    -
                    
                    
                    $
                    6,511Corporate
      debt securities
                    
                    
                    -
                    
                    
                    
                    133,312
                    
                    
                    
                    -
                    
                    
                    
                    133,312Municipal
      bonds
                    
                    
                    -
                    
                    
                    
                    145,908
                    
                    
                    
                    24,107
                    
                    
                    
                    170,015Asset
      backed
                    
                    
                    -
                    
                    
                    
                    636
                    
                    
                    
                    -
                    
                    
                    
                    636Total
      debt securities
                    
                    
                    -
                    
                    
                    
                    286,367
                    
                    
                    
                    24,107
                    
                    
                    
                    310,474Financial
      services
                    
                    
                    20,764
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    20,764All
      other
                    
                    
                    15,579
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    15,579Total
      equity securities
                    
                    
                    36,343
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    36,343Total
      debt and equity securities
                    
                    $
                    36,343
                    
                    
                    $
                    286,367
                    
                    
                    $
                    24,107
                    
                    
                    $
                    346,817




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





The
following table summarizes the changes in fair value for all financial assets
measured at fair value on a recurring basis using significant unobservable
inputs (Level 3) during the three months ended March 31, 2010 (in
thousands).





Beginning
      balance as of January 1, 2010
                    
                    $
                    25,272Net
      purchases, issuances, sales and settlements
                    
                    
                    (2,000
                    )Total
      realized/unrealized gains included in net income
                    
                    
                    -Net
      gains included in other comprehensive income
                    
                    
                    835Transfers
      in and/or out of Level 3
                    
                    
                    -Ending
      balance as of March 31, 2010
                    
                    $
                    24,107


14





5.
Investments





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




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




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.




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


15




Three Months EndedMarch312010
                    
                    
                    2009U.S.
      Treasury securities and obligations of U.S. Government
                    
                    $
                    -
                    
                    
                    $
                    -Corporate
      debt securities
                    
                    
                    3,294
                    
                    
                    
                    137Municipal
      bonds
                    
                    
                    (96
                    )
                    
                    
                    (4
                    )Equity
      securities-financial services
                    
                    
                    566
                    
                    
                    
                    50Equity
      securities- all other
                    
                    
                    39
                    
                    
                    
                    8Net
      realized gain
                    
                    
                    3,803
                    
                    
                    
                    191Other-than-temporary
      impairments
                    
                    
                    -
                    
                    
                    
                    (539
                    )Gain
      (loss) on investments
                    
                    $
                    3,803
                    
                    
                    $
                    (348
                    )




We
realized gross gains on investments of $3.9 million and $0.3 million during the
three months ended March 31, 2010 and 2009, respectively. We realized gross
losses on investments of $0.1 million and $0.6 million during the three months
ended March 31, 2010 and 2009, respectively. We recorded proceeds from the sale
of investment securities of $47.1 million and $12.7 million during the three
months ended March 31, 2010 and 2009, respectively. Realized investment gains
and losses are recognized in operations on the specific identification
method.


16




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




Gross
                                    
                                    
                                    GrossAmortized
                                    
                                    
                                    Unrealized
                                    
                                    
                                    Unrealized
                                    
                                    
                                    FairCost
                                    
                                    
                                    Gains
                                    
                                    
                                    Losses
                                    
                                    
                                    ValueAs of March 31, 2010U.S.
      Treasury securities and obligations of U.S. Government
                                    
                                    $
                                    6,511
                                    
                                    
                                    $
                                    1
                                    
                                    
                                    $
                                    (1
                                    )
                                    
                                    $
                                    6,511Corporate
      debt securities
                                    
                                    
                                    129,741
                                    
                                    
                                    
                                    4,637
                                    
                                    
                                    
                                    (1,066
                                    )
                                    
                                    
                                    133,312Municipal
      bonds
                                    
                                    
                                    168,486
                                    
                                    
                                    
                                    3,114
                                    
                                    
                                    
                                    (1,585
                                    )
                                    
                                    
                                    170,015Asset
      backed
                                    
                                    
                                    617
                                    
                                    
                                    
                                    19
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    636Total
      debt securities
                                    
                                    
                                    305,355
                                    
                                    
                                    
                                    7,771
                                    
                                    
                                    
                                    (2,652
                                    )
                                    
                                    
                                    310,474Financial
      services
                                    
                                    
                                    15,178
                                    
                                    
                                    
                                    5,651
                                    
                                    
                                    
                                    (65
                                    )
                                    
                                    
                                    20,764All
      other
                                    
                                    
                                    9,189
                                    
                                    
                                    
                                    6,406
                                    
                                    
                                    
                                    (16
                                    )
                                    
                                    
                                    15,579Total
      equity securities
                                    
                                    
                                    24,367
                                    
                                    
                                    
                                    12,057
                                    
                                    
                                    
                                    (81
                                    )
                                    
                                    
                                    36,343Total
      debt and equity securities
                                    
                                    $
                                    329,722
                                    
                                    
                                    $
                                    19,828
                                    
                                    
                                    $
                                    (2,733
                                    )
                                    
                                    $
                                    346,817As
      of December 31, 2009U.S.
      Treasury securities and obligations of U.S. Government
                                    
                                    $
                                    6,830
                                    
                                    
                                    $
                                    23
                                    
                                    
                                    $
                                    (17
                                    )
                                    
                                    $
                                    6,836Corporate
      debt securities
                                    
                                    
                                    94,560
                                    
                                    
                                    
                                    7,190
                                    
                                    
                                    
                                    (2,201
                                    )
                                    
                                    
                                    99,549Municipal
      bonds
                                    
                                    
                                    185,036
                                    
                                    
                                    
                                    2,543
                                    
                                    
                                    
                                    (2,786
                                    )
                                    
                                    
                                    184,793Asset
      backed
                                    
                                    
                                    682
                                    
                                    
                                    
                                    17
                                    
                                    
                                    
                                    (1
                                    )
                                    
                                    
                                    698Total
      debt securities
                                    
                                    
                                    287,108
                                    
                                    
                                    
                                    9,773
                                    
                                    
                                    
                                    (5,005
                                    )
                                    
                                    
                                    291,876Financial
      services
                                    
                                    
                                    17,156
                                    
                                    
                                    
                                    5,008
                                    
                                    
                                    
                                    (232
                                    )
                                    
                                    
                                    21,932All
      other
                                    
                                    
                                    10,095
                                    
                                    
                                    
                                    3,790
                                    
                                    
                                    
                                    (16
                                    )
                                    
                                    
                                    13,869Total
      equity securities
                                    
                                    
                                    27,251
                                    
                                    
                                    
                                    8,798
                                    
                                    
                                    
                                    (248
                                    )
                                    
                                    
                                    35,801Total
      debt and equity securities
                                    
                                    $
                                    314,359
                                    
                                    
                                    $
                                    18,571
                                    
                                    
                                    $
                                    (5,253
                                    )
                                    
                                    $
                                    327,677


17





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





AsofMarch31,201012monthsorless
                  
                  
                  Longerthan12months
                  
                  
                  TotalUnrealized
                  
                  
                  
                  
                  
                  Unrealized
                  
                  
                  
                  
                  
                  UnrealizedFairValue
                  
                  
                  Losses
                  
                  
                  FairValue
                  
                  
                  Losses
                  
                  
                  FairValue
                  
                  
                  LossesU.S.
      Treasury securities and obligations of U.S. Government
                  
                  $
                  5,713
                  
                  
                  $
                  (1
                  )
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  5,713
                  
                  
                  $
                  (1
                  )Corporate
      debt securities
                  
                  
                  36,319
                  
                  
                  
                  (76
                  )
                  
                  
                  5,472
                  
                  
                  
                  (990
                  )
                  
                  
                  41,791
                  
                  
                  
                  (1,066
                  )Municipal
      bonds
                  
                  
                  26,850
                  
                  
                  
                  (654
                  )
                  
                  
                  35,833
                  
                  
                  
                  (931
                  )
                  
                  
                  62,683
                  
                  
                  
                  (1,585
                  )Total
      debt securities
                  
                  
                  68,882
                  
                  
                  
                  (731
                  )
                  
                  
                  41,305
                  
                  
                  
                  (1,921
                  )
                  
                  
                  110,187
                  
                  
                  
                  (2,652
                  )Financial
      services
                  
                  
                  1,585
                  
                  
                  
                  (65
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1,585
                  
                  
                  
                  (65
                  )All
      other
                  
                  
                  657
                  
                  
                  
                  (16
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  657
                  
                  
                  
                  (16
                  )Total
      equity securities
                  
                  
                  2,242
                  
                  
                  
                  (81
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2,242
                  
                  
                  
                  (81
                  )Total
      debt and equity securities
                  
                  $
                  71,124
                  
                  
                  $
                  (812
                  )
                  
                  $
                  41,305
                  
                  
                  $
                  (1,921
                  )
                  
                  $
                  112,429
                  
                  
                  $
                  (2,733
                  )





AsofDecember31,200912monthsorless
                  
                  
                  Longerthan12months
                  
                  
                  TotalUnrealized
                  
                  
                  
                  
                  
                  Unrealized
                  
                  
                  
                  
                  
                  UnrealizedFairValue
                  
                  
                  Losses
                  
                  
                  FairValue
                  
                  
                  Losses
                  
                  
                  FairValue
                  
                  
                  LossesU.S.
      Treasury securities and obligations of U.S. Government
                  
                  $
                  3,202
                  
                  
                  $
                  (17
                  )
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  3,202
                  
                  
                  $
                  (17
                  )Corporate
      debt securities
                  
                  
                  18,924
                  
                  
                  
                  (166
                  )
                  
                  
                  9,642
                  
                  
                  
                  (2,035
                  )
                  
                  
                  28,566
                  
                  
                  
                  (2,201
                  )Municipal
      bonds
                  
                  
                  28,940
                  
                  
                  
                  (1,524
                  )
                  
                  
                  42,183
                  
                  
                  
                  (1,262
                  )
                  
                  
                  71,123
                  
                  
                  
                  (2,786
                  )Asset
      backed
                  
                  
                  51
                  
                  
                  
                  (1
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  51
                  
                  
                  
                  (1
                  )Total
      debt securities
                  
                  
                  51,117
                  
                  
                  
                  (1,708
                  )
                  
                  
                  51,825
                  
                  
                  
                  (3,297
                  )
                  
                  
                  102,942
                  
                  
                  
                  (5,005
                  )Financial
      services
                  
                  
                  1,417
                  
                  
                  
                  (232
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1,417
                  
                  
                  
                  (232
                  )All
      other
                  
                  
                  658
                  
                  
                  
                  (16
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  658
                  
                  
                  
                  (16
                  )Equity
      securities
                  
                  
                  2,075
                  
                  
                  
                  (248
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2,075
                  
                  
                  
                  (248
                  )Total
      debt and equity securities
                  
                  $
                  53,192
                  
                  
                  $
                  (1,956
                  )
                  
                  $
                  51,825
                  
                  
                  $
                  (3,297
                  )
                  
                  $
                  105,017
                  
                  
                  $
                  (5,253
                  )





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


18





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





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





The
amortized cost and estimated fair value of debt securities at March 31, 2010 by
contractual maturity are as follows. Expected maturities may differ from
contractual maturities because certain borrowers may have the right to call or
prepay obligations with or without penalties.





Amortized
                        
                        
                        FairCost
                        
                        
                        Value(in thousands)Due
      in one year or less
                        
                        $
                        22,663
                        
                        
                        $
                        23,566Due
      after one year through five years
                        
                        
                        166,561
                        
                        
                        
                        171,199Due
      after five years through ten years
                        
                        
                        57,867
                        
                        
                        
                        57,461Due
      after ten years
                        
                        
                        57,647
                        
                        
                        
                        57,612Asset
      backed
                        
                        
                        617
                        
                        
                        
                        636$
                        305,355
                        
                        
                        $
                        310,474





Activity
related to the credit component recognized in earnings for the three months
ended March 31, 2010, on debt securities held by us for which a portion of
other-than-temporary impairment was previously recognized in other comprehensive
income is as follows (in thousands):





Balance,
      January 1, 2010
                        
                        $
                        1,168Reductions
      for securities sold or matured during the period
                        
                        
                        (1,168
                        )Balance,
      March 31, 2010
                        
                        $
                        -


19





6.
Pledged Investments





We have certain of our securities
pledged for the benefit of various state insurance departments and
reinsurers.  These securities are included with our available-for-sale
debt securities because we have the ability to trade these
securities.  We retain the interest earned on these
securities.  These securities had a carrying value of $34.3 million at
March 31, 2010 and a carrying value of $29.7 million at December 31,
2009.





7.
Share-Based Payment Arrangements





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





As of
March 31, 2010, there were incentive stock options to purchase 1,262,499 shares
of our common stock outstanding and non-qualified stock options to purchase
320,000 shares of our common stock outstanding under the 2005 LTIP, leaving
417,501 shares reserved for future issuance.  As of March 31, 2010,
there were incentive stock options to purchase 2,500 shares outstanding under
the 1994 Employee Plan and non-qualified stock options to purchase 20,834 shares
outstanding under the 1994 Director Plan.  The exercise price of all
such outstanding stock options is equal to the fair market value of our common
stock on the date of grant.





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





A summary
of the status of our stock options as of and changes during the three months
ended March 31, 2010 is presented below:


20





Average
                    
                    
                    Contractual
                    
                    
                    IntrinsicNumber of
                    
                    
                    Exercise
                    
                    
                    Term
                    
                    
                    ValueShares
                    
                    
                    Price
                    
                    
                    (Years)
                    
                    
                    ($000)Outstanding
      at January 1, 2010
                    
                    
                    1,614,166
                    
                    
                    $
                    9.62Granted
                    
                    
                    -
                    
                    
                    $
                    -Exercised
                    
                    
                    (8,333
                    )
                    
                    $
                    2.25Forfeited
      or expired
                    
                    
                    -
                    
                    
                    $
                    -Outstanding
      at March 31, 2010
                    
                    
                    1,605,833
                    
                    
                    $
                    9.65
                    
                    
                    
                    7.7
                    
                    
                    $
                    1,700Exercisable
      at March 31, 2010
                    
                    
                    466,167
                    
                    
                    $
                    10.05
                    
                    
                    
                    6.7
                    
                    
                    $
                    421





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





Three
      Months EndedMarch 31,2010
                          
                          
                          2009Intrinsic
      value of options exercised
                          
                          $
                          44
                          
                          
                          $
                          107Cost
      of share-based payments (non-cash)
                          
                          $
                          298
                          
                          
                          $
                          262Income
      tax benefit of share-based payments recognized in income
                          
                          $
                          8
                          
                          
                          $
                          -





As of
March 31, 2010, there was $2.6 million of total unrecognized compensation cost
related to non-vested share-based compensation arrangements granted under our
plans, of which $0.8 million is expected to be recognized during the remainder
of 2010, $0.7 million is expected to be recognized in 2011, $0.4 million is
expected to be recognized in 2012, $0.2 million is expected to be recognized
each year from 2013 through 2015 and $0.1 million is expected to be recognized
in 2016.





The fair
value of each stock option granted is estimated on the date of grant using the
Black-Scholes option pricing model.  Expected volatilities are based
on the historical volatility of 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 in
either the first quarter of 2010 or 2009.


21





8.
Segment Information





The
following is business segment information for the three months ended March 31,
2010 and 2009 (in thousands):




Three Months EndedMarch31,2010
                          
                          
                          2009Revenues:Standard
      Commercial Segment
                          
                          $
                          18,034
                          
                          
                          $
                          20,020Specialty
      Commercial Segment
                          
                          
                          32,487
                          
                          
                          
                          32,825Personal
      Segment
                          
                          
                          21,214
                          
                          
                          
                          17,535Corporate
                          
                          
                          4,088
                          
                          
                          
                          530Consolidated
                          
                          $
                          75,823
                          
                          
                          $
                          70,910Pre-tax income (loss), net of non-controlling
      interest:Standard
      Commercial Segment
                          
                          $
                          (939
                          )
                          
                          $
                          2,576Specialty
      Commercial Segment
                          
                          
                          6,347
                          
                          
                          
                          5,682Personal
      Segment
                          
                          
                          2,650
                          
                          
                          
                          2,619Corporate
                          
                          
                          1,118
                          
                          
                          
                          (2,425
                          )Consolidated
                          
                          $
                          9,176
                          
                          
                          $
                          8,452





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





March 31,
                          
                          
                          December 31,2010
                          
                          
                          2009AssetsStandard
      Commercial Segment
                          
                          $
                          132,640
                          
                          
                          $
                          136,745Specialty
      Commercial Segment
                          
                          
                          285,883
                          
                          
                          
                          280,970Personal
      Segment
                          
                          
                          127,352
                          
                          
                          
                          109,844Corporate
                          
                          
                          109,748
                          
                          
                          
                          101,310$
                          655,623
                          
                          
                          $
                          628,869





9.
Reinsurance





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


22





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




Three Months EndedMarch 31,2010
                  
                  
                  2009Ceded
      earned premiums
                  
                  $
                  5,952
                  
                  
                  $
                  2,058Reinsurance
      recoveries
                  
                  $
                  2,989
                  
                  
                  $
                  1,333





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




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




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




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




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




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




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




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




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




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




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


23




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




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




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




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





·
            Excess &
      Umbrella.  Effective July 1, 2009, in states where we are
      admitted, we directly insure policies written by our Excess & Umbrella
      business unit and reinsure a portion of the risk with third party
      carriers.  In states where we are not admitted, our Excess &
      Umbrella business unit writes policies under fronting arrangements
      pursuant to which we assume all of the risk and then retrocede a portion
      of the risk to third party reinsurers.  We reinsure or retrocede 79%
      of the risk on policies written by our Excess & Umbrella business
      unit.  Through June 30, 2009, our Excess & Umbrella business
      unit wrote policies under a fronting arrangement pursuant to which we
      assumed 35% of the risk.





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





10.
Note Payable





On
January 27, 2006, we borrowed $15.0 million under our revolving credit facility
to fund the cash required to close the acquisition of the subsidiaries
comprising our E&S Commercial
business unit. As of March 31, 2010, the balance on the revolving note
was $2.8 million, which currently bears interest at 2.18% per annum. (See Note
12, “Credit Facilities.”)





11.  Subordinated
Debt Securities





On June
21, 2005, we entered into a trust preferred securities transaction pursuant to
which we issued $30.9 million aggregate principal amount of subordinated debt
securities due in 2035.  To effect the transaction, we formed Trust I
as a Delaware statutory trust.  Trust I issued $30.0 million of
preferred securities to investors and $0.9 million of common securities to
us.  Trust I used the proceeds from these issuances to purchase the
subordinated debt securities.  Our Trust I subordinated debt
securities bear an initial interest rate of 7.725% until June 15, 2015, at which
time interest will adjust quarterly to the three-month LIBOR rate plus 3.25
percentage points.  Trust I pays dividends on its preferred securities
at the same rate.  Under the terms of our Trust I subordinated debt
securities, we pay interest only each quarter and the principal of the note at
maturity.  The subordinated debt securities are uncollaterized and do
not require maintenance of minimum financial covenants. As of March 31, 2010,
the balance of our Trust I subordinated debt was $30.9 million.


24





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 March 31, 2010, the balance of our Trust II subordinated debt
was $25.8 million.





12.
Credit Facilities





We have a credit facility with The
Frost National Bank which was amended and restated on January 27, 2006 to
provide a $20.0 million revolving credit facility with a $5.0 million letter of
credit sub-facility.  The credit facility was further amended
effective May 31, 2007 to increase the revolving credit facility to $25.0
million and establish a new $5.0 million revolving credit sub-facility for
premium finance operations.  The credit agreement was again amended
effective February 20, 2008 to extend the termination to January 27, 2010,
revise various affirmative and negative covenants and decrease the interest rate
in most instances to the three month Eurodollar rate plus 1.90 percentage
points, payable quarterly in arrears.  The credit agreement was again
amended January 21, 2010 in order to extend certain expiration, maturity, and
termination dates for a period of 120 days.  We pay letter of credit
fees at the rate of 1.00% per annum.  Our obligations under the
revolving credit facility are secured by a security interest in the capital
stock of all of our subsidiaries, guarantees of all of our subsidiaries and the
pledge of all of our non-insurance company assets.  The revolving
credit facility contains covenants that, among other things, require us to
maintain certain financial and operating ratios and restrict certain
distributions, transactions and organizational changes.  As of March
31, 2010, we were in compliance with all of our covenants.  As of
March 31, 2010, we had $2.8 million outstanding under this
facility.





13.
Deferred Policy Acquisition Costs





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




Three Months EndedMarch31,2010
                    
                    
                    2009Deferred
                    
                    $
                    (15,855
                    )
                    
                    $
                    (15,526
                    )Amortized
                    
                    
                    14,449
                    
                    
                    
                    14,048Net
                    
                    $
                    (1,406
                    )
                    
                    $
                    (1,478
                    )


25





14.
Earnings per Share





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




Three Months EndedMarch31,2010
                  
                  
                  2009Weighted
      average shares - basic
                  
                  
                  20,119
                  
                  
                  
                  20,856Effect
      of dilutive securities
                  
                  
                  20
                  
                  
                  
                  17Weighted
      average shares - assuming dilution
                  
                  
                  20,139
                  
                  
                  
                  20,873





For the
three months ended March 31, 2010 and 2009, 899,166 shares of common stock
potentially issuable upon the exercise of employee stock options were excluded
from the weighted average number of shares outstanding on a diluted basis
because the effect of such options would be anti-dilutive.





15.
Net Periodic Pension Cost





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





Three Months EndedMarch31,2010
                  
                  
                  2009Interest
      cost
                  
                  $
                  162
                  
                  
                  $
                  161Amortization
      of net loss
                  
                  
                  56
                  
                  
                  
                  122Expected
      return on plan assets
                  
                  
                  (136
                  )
                  
                  
                  (121
                  )Net
      periodic pension cost
                  
                  $
                  82
                  
                  
                  $
                  162





We did
not make any contributions to our frozen defined benefit cash balance plan
during the three months ended March 31, 2010 and 2009.  Refer to Note
13 to the consolidated financial statements in our Annual Report on Form 10-K
for the year ended December 31, 2009 for more discussion of our retirement
plans.





16.   Income
Taxes





Our
effective income tax rate for the three months ended March 31, 2010 was 31.5%
which varied from the statutory income tax rate utilized primarily because of
our investments in tax exempt securities.  Our effective income tax
rate for the three months ended March 31, 2009 was 19.7% which varied from the
statutory income tax rate utilized primarily because of our investments in tax
exempt securities and a reduction in the valuation allowance.


26





17.
Commitments and Contingencies





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





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 five
business units, which are supported by our four insurance company
subsidiaries.




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




·
            Standard
      Commercial Segment.  Our Standard Commercial Segment
      includes the standard lines commercial property/casualty insurance
      products and services handled by our Standard Commercial business unit
      (formerly known as our AHIS Operating
Unit).





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





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





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





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


27





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





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





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





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





Results
of Operations





Management
Overview.During the three months ended March 31, 2010, our
total revenues were $75.8 million, representing a 7% increase from the $70.9
million in total revenues for the same period of 2009.  This increase in
revenue was primarily attributable to increased earned premium due to increased
production by our Personal Segment and gains realized on our investment
portfolio. These increases in revenue were partially offset by reduced earned
premium in our Standard Commercial Segment due to the deterioration of the
general economic environment in our major markets.





We
reported net earnings of $6.3 million for the three months ended March 31, 2010,
which were $0.5 million lower than the $6.8 million reported for the first
quarter of 2009.  On a diluted basis per share, net earnings were $0.31 per
share for the three months ended March 31, 2010, as compared to $0.33 for the
same period in 2009.   The increase in revenue for the three months
ending March 31, 2010 was offset by increased loss and loss adjustment expenses
(“LAE”), including unfavorable prior year loss development of $2.2 million
recognized during the three months ended March 31, 2010.  Partially
offsetting this increase in loss and LAE were lower operating expenses due to
lower production related expenses in our E&S Commercial business unit and
our General Aviation business unit and lower information technology costs in our
Standard Commercial Segment.  The Company’s effective income tax rate
for the three months ending March 31, 2010 was 31.5% as compared to the 19.7%
effective income tax rate for the three month period ended March 31,
2009.  The increase in the effective tax rate was primarily due to a
reduction in the valuation allowance during the three months ended March 31,
2009, which resulted in an income tax benefit and to decreased yields on tax
exempt securities.


28





First
Quarter 2010 as Compared to First Quarter 2009





The
following is additional business segment information for the three months ended
March 31, 2010 and 2009 (in thousands):





Hallmark
Financial Services, Inc


Consolidated
Segment Data





ThreeMonthsEndedMarch31,2010Standard
                  
                  
                  SpecialtyCommercial
                  
                  
                  Commercial
                  
                  
                  PersonalSegment
                  
                  
                  Segment
                  
                  
                  Segment
                  
                  
                  Corporate
                  
                  
                  ConsolidatedProduced
      premium (1)
                  
                  $
                  18,097
                  
                  
                  $
                  35,282
                  
                  
                  $
                  27,131
                  
                  
                  $
                  -
                  
                  
                  $
                  80,510Gross
      premiums written
                  
                  
                  18,097
                  
                  
                  
                  36,631
                  
                  
                  
                  27,131
                  
                  
                  
                  -
                  
                  
                  
                  81,859Ceded
      premiums written
                  
                  
                  (1,036
                  )
                  
                  
                  (8,024
                  )
                  
                  
                  (4
                  )
                  
                  
                  -
                  
                  
                  
                  (9,064
                  )Net
      premiums written
                  
                  
                  17,061
                  
                  
                  
                  28,607
                  
                  
                  
                  27,127
                  
                  
                  
                  -
                  
                  
                  
                  72,795Change
      in unearned premiums
                  
                  
                  (180
                  )
                  
                  
                  2,116
                  
                  
                  
                  (7,716
                  )
                  
                  
                  -
                  
                  
                  
                  (5,780
                  )Net
      premiums earned
                  
                  
                  16,881
                  
                  
                  
                  30,723
                  
                  
                  
                  19,411
                  
                  
                  
                  -
                  
                  
                  
                  67,015Total
      revenues
                  
                  
                  18,034
                  
                  
                  
                  32,487
                  
                  
                  
                  21,214
                  
                  
                  
                  4,088
                  
                  
                  
                  75,823Losses
      and loss adjustment expenses
                  
                  
                  13,616
                  
                  
                  
                  16,396
                  
                  
                  
                  13,086
                  
                  
                  
                  -
                  
                  
                  
                  43,098Pre-tax  income
      (loss), net of  non-controlling interest
                  
                  
                  (939
                  )
                  
                  
                  6,347
                  
                  
                  
                  2,650
                  
                  
                  
                  1,118
                  
                  
                  
                  9,176Net
      loss ratio (2)
                  
                  
                  80.6
                  %
                  
                  
                  53.4
                  %
                  
                  
                  67.4
                  %
                  
                  
                  
                  
                  
                  
                  64.3
                  %Net
      expense ratio (2)
                  
                  
                  30.9
                  %
                  
                  
                  28.0
                  %
                  
                  
                  21.6
                  %
                  
                  
                  
                  
                  
                  
                  28.9
                  %Net
      combined ratio (2)
                  
                  
                  111.5
                  %
                  
                  
                  81.4
                  %
                  
                  
                  89.0
                  %
                  
                  
                  
                  
                  
                  
                  93.2
                  %





ThreeMonthsEndedMarch31,2009Standard
                  
                  
                  SpecialtyCommercial
                  
                  
                  Commercial
                  
                  
                  PersonalSegment
                  
                  
                  Segment
                  
                  
                  Segment
                  
                  
                  Corporate
                  
                  
                  ConsolidatedProduced
      premium (1)
                  
                  $
                  19,147
                  
                  
                  $
                  34,282
                  
                  
                  $
                  20,626
                  
                  
                  $
                  -
                  
                  
                  $
                  74,055Gross
      premiums written
                  
                  
                  19,147
                  
                  
                  
                  31,706
                  
                  
                  
                  20,626
                  
                  
                  
                  -
                  
                  
                  
                  71,479Ceded
      premiums written
                  
                  
                  (1,103
                  )
                  
                  
                  (1,129
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (2,232
                  )Net
      premiums written
                  
                  
                  18,044
                  
                  
                  
                  30,577
                  
                  
                  
                  20,626
                  
                  
                  
                  -
                  
                  
                  
                  69,247Change
      in unearned premiums
                  
                  
                  406
                  
                  
                  
                  (5,626
                  )
                  
                  
                  (4,597
                  )
                  
                  
                  -
                  
                  
                  
                  (9,817
                  )Net
      premiums earned
                  
                  
                  18,450
                  
                  
                  
                  24,951
                  
                  
                  
                  16,029
                  
                  
                  
                  -
                  
                  
                  
                  59,430Total
      revenues
                  
                  
                  20,020
                  
                  
                  
                  32,825
                  
                  
                  
                  17,535
                  
                  
                  
                  530
                  
                  
                  
                  70,910Losses
      and loss adjustment expenses
                  
                  
                  11,346
                  
                  
                  
                  14,933
                  
                  
                  
                  10,563
                  
                  
                  
                  -
                  
                  
                  
                  36,842Pre-tax  income
      (loss), net of  non-controlling interest
                  
                  
                  2,576
                  
                  
                  
                  5,682
                  
                  
                  
                  2,619
                  
                  
                  
                  (2,425
                  )
                  
                  
                  8,452Net
      loss ratio (2)
                  
                  
                  61.5
                  %
                  
                  
                  59.8
                  %
                  
                  
                  65.9
                  %
                  
                  
                  
                  
                  
                  
                  62.0
                  %Net
      expense ratio (2)
                  
                  
                  32.3
                  %
                  
                  
                  30.0
                  %
                  
                  
                  21.0
                  %
                  
                  
                  
                  
                  
                  
                  30.8
                  %Net
      combined ratio (2)
                  
                  
                  93.8
                  %
                  
                  
                  89.8
                  %
                  
                  
                  86.9
                  %
                  
                  
                  
                  
                  
                  
                  92.8
                  %





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





(2)  The
net loss ratio is calculated as incurred losses and LAE divided by net premiums
earned, each determined in accordance  with GAAP.  During
the second quarter of 2009 we changed the method in which the net expense ratio
is calculated.  The net  expense ratio is now calculated for
our 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.  All prior periods have been restated to conform to the new
method, resulting in an increase to the consolidated net expense ratio of 1.3%
for the three months ended March 31, 2009.


29


Standard
Commercial Segment





Gross
premiums written for the Standard Commercial Segment were $18.1 million for the
three months ended March 31, 2010, which was $1.0 million, or 5%, less than the
$19.1 million reported for the same period in 2009.  Net premiums
written were $17.1 million for the three months ended March 31, 2010 as compared
to $18.0 million reported for the same period in 2009.  The decrease
in premium volume was predominately due to the deterioration of the general
economic environment, particularly in the construction industry, reducing the
available insured exposures.





Total
revenue for the Standard Commercial Segment of $18.0 million for the three
months ended March 31, 2010 was $2.0 million less than the $20.0 million
reported during the same period in 2009.  This 10% decrease in total
revenue was mostly due to decreased net premiums earned of $1.6 million and
decreased net investment income of $0.4 million.





Our
Standard Commercial Segment reported a pre-tax loss of $0.9 million for the
three months ended March 31, 2010 as compared to pre-tax income of $2.6 million
for the same period of 2009. Higher loss and LAE expenses of $2.3 million,
primarily as a result of unfavorable prior year development, and decreased
revenue discussed above contributed to this pre-tax loss reported for the three
months ended March 31, 2010. Partially offsetting the decline in results were
lower operating expenses of $0.7 million driven by lower information technology
costs and lower production related expenses.





The
Standard Commercial Segment reported a net loss ratio of 80.6% for the three
months ended March 31, 2010 as compared to 61.5% for 2009. The gross loss ratio
before reinsurance for the three months ended March 31, 2010 was 78.1% as
compared to the 62.3% reported for the same period of 2009.  Gross
incurred losses include twelve large property losses amounting to $4.7
million.  These property losses are comprised mostly of fire losses
and to a lesser extent weather related losses.  During the three
months ended March 31, 2010, the Standard Commercial Segment reported
unfavorable loss reserve development of $2.2 million, primarily on losses
occurring in late December 2009. The Standard Commercial Segment reported a
lower net expense ratio of 30.9% for the three months ended March 31, 2010 as
compared to 32.3% for the same period in 2009 due mostly to lower information
technology costs.





Specialty
Commercial Segment





The $32.5
million of total revenue for the three months ended March 31, 2010 was $0.3
million lower than the $32.8 million reported for the same period in 2009. This
decrease in revenue was comprised of lower commission and fee income of $6.0
million primarily related to profit share commission adjustments reported during
the first quarter of 2009 as well as the increased retention of
business.  This decrease was partially offset by increased net
premiums earned of $5.8 million as a result of the increased retention of
business in our E&S Commercial business unit and increased earned premium in
our Excess & Umbrella business unit.





Pre-tax
income for the Specialty Commercial Segment of $6.3 million for the first
quarter of 2010 was $0.6 million higher than the $5.7 million reported for the
same period in 2009.  The increase in pre-tax income was primarily due
to lower operating expenses of $2.6 million.  The decrease in
operating expense was the combined result of (i) increased quota share ceding
commission of $1.6 million in our Excess & Umbrella business unit, (ii)
lower other production related expenses of $0.8 million, and (iii) lower salary
related expenses of $0.2 million.  The lower operating expenses were
partially offset by $1.5 million higher loss and LAE expenses and lower revenue
as discussed above.


30





The Specialty Commercial Segment
reported a net loss ratio of 53.4% for the three months ended March 31, 2010 as
compared to 59.8% for the same period during 2009 as a result of overall
improved loss trends.  The Specialty Commercial Segment reported a net
expense ratio of 28.0% for the first quarter of 2010 as compared to 30.0%
reported for the same period the prior year.  The decrease in the
expense ratio is due primarily to increased earned premium.




Personal
Segment





Net
premiums written for our Personal Segment increased $6.5 million during the
first quarter of 2010 to $27.1 million compared to $20.6 million for the first
quarter of 2009.  The increase in premium was due mostly to continued
geographic expansion.





Total
revenue for the Personal Segment increased 21% to $21.2 million for the first
quarter of 2010 from $17.5 million for the first quarter of
2009.  Higher earned premium of $3.4 million was the primary reason
for the increase in revenue for the period.  Increased finance charges
of $0.4 million further contributed to the increase in revenue during the first
quarter of 2010.





Pre-tax
income for the Personal Segment was $2.7 million for the three months ended
March 31, 2010 as compared to $2.6 million for the same period of
2009.  Increased revenue discussed above was offset by increased
losses and LAE of $2.5 million and increased operating expenses of $1.1 million
due mostly to increased production and salary expense related to continued
geographic expansion.





The
Personal Segment reported a net loss ratio of 67.4% for the three months ended
March 31, 2010 as compared to 65.9% for the first quarter of
2009.  The increase in the net loss ratio is due primarily to the
change in the product mix of business.  The Personal Segment reported
a net expense ratio of 21.6% for the three months ended March 31, 2010 as
compared to 21.0% for the first quarter of 2009.





Corporate





Total
revenue for Corporate increased by $3.6 million for the three months ended March
31, 2010 as compared to the same period the prior year.  This increase
in total revenue was due primarily to gains of $3.8 million recognized on our
investment portfolio for the three months ended March 31, 2010 as compared to
losses of $0.3 million recognized during the same period in
2009.  This increase in revenue was offset by lower net investment
income of $0.6 million for the three months ended March 31, 2010 as compared to
the same period of the prior year.





Corporate
pre-tax income was $1.1 million for the three months ended March 31, 2010 as
compared to a $2.4 million pre-tax loss for the same period the prior
year.  The increase in pre-tax income was the result of the increased
revenue discussed above.


31





Financial
Condition and Liquidity





Sources
and Uses of Funds





Our
sources of funds are from insurance-related operations, financing activities and
investing activities.  Major sources of funds from operations include
premiums collected (net of policy cancellations and premiums ceded),
commissions, and processing and service fees.  As a holding company,
Hallmark is dependent on dividend payments and management fees from its
subsidiaries to meet operating expenses and debt obligations.  As of
March 31, 2010, Hallmark had $14.0 million in unrestricted cash and invested
assets at the holding company. Unrestricted cash and invested assets of our
non-insurance subsidiaries were $4.8 million as of March 31, 2010.





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





Comparison of March 31, 2010 to
December 31, 2009





On a
consolidated basis, our cash and investments (excluding restricted cash) at
March 31, 2010 were $457.4 million compared to $439.9 million at December 31,
2009.  An increase in the fair market value of our investment
portfolio for the period and cash from operating activities were the primary
reasons for this increase.





Comparison of Three Months
Ended March 31, 2010 and March 31, 2009





Net cash
provided by our consolidated operating activities was $12.0 million for the
first three months of 2010 compared to $8.9 million for the first three months
of 2009.  The increase in operating cash flow was primarily due to the
timing of profit share commission settlements with third party insurance
carriers.





Net cash
used in investing activities during the first three months of 2010 was $13.6
million as compared to $10.5 million for the same period in 2009. Contributing
to the increase in cash used in investing activities was an increase of $30.0
million in purchases of debt and equity securities and a reduction in the change
in restricted cash of $4.9 million, partially offset by (i) a $28.2 million
increase in maturities, sales and redemptions of investment securities, (ii) a
$0.2 million decrease in purchases of property and equipment, and (iii) a $3.3
million payment of contingent consideration during the first quarter 2009 to the
sellers of the subsidiaries comprising our E&S Commercial business
unit.


32





Cash used
in financing activities during the first three months of 2010 was $0.1 million
as compared to $1.2 million for the same period of 2009.  The cash
used during the first three months of 2009 was primarily for the payment of a
note payable by our premium finance operation.





Credit
Facilities





On June
29, 2005, we entered into a credit facility with The Frost National
Bank.  The credit facility was amended and restated on January 27,
2006 to a $20.0 million revolving credit facility, with a $5.0 million letter of
credit sub-facility.  The credit facility was further amended
effective May 31, 2007 to increase the revolving credit facility to $25.0
million and establish a new $5.0 million revolving credit sub-facility for our
premium finance operations.  The credit agreement was again amended
effective February 20, 2008 to extend the termination to January 27, 2010,
revise various affirmative and negative covenants and decrease the interest rate
in most instances to the three month Eurodollar rate plus 1.90 percentage
points, payable quarterly in arrears.  The credit agreement was again
amended January 21, 2010 in order to extend certain expiration, maturity, and
termination dates for a period of 120 days. We pay letter of credit fees at the
rate of 1.00% per annum.  Our obligations under the revolving credit
facility are secured by a security interest in the capital stock of all of our
subsidiaries, guarantees of all of our subsidiaries and the pledge of all of our
non-insurance company assets.  The revolving credit facility contains
covenants that, among other things, require us to maintain certain financial and
operating ratios and restrict certain distributions, transactions and
organizational changes.  As of March 31, 2010, we were in compliance
with all of our covenants.  As of March 31, 2010, we had $2.8 million
outstanding under this credit facility.





Trust
Preferred Securities





On June
21, 2005, we entered into a trust preferred securities transaction pursuant to
which we issued $30.9 million aggregate principal amount of subordinated debt
securities due in 2035.  To effect the transaction, we formed a
Delaware statutory trust, Hallmark Statutory Trust I (“Trust
I”).  Trust I issued $30.0 million of preferred securities to
investors and $0.9 million of common securities to us.  Trust I used
the proceeds from these issuances to purchase the subordinated debt
securities.  Our Trust I subordinated debt securities bear an initial
interest rate of 7.725% until June 15, 2015, at which time interest will adjust
quarterly to the three-month LIBOR rate plus 3.25 percentage
points.  Trust I pays dividends on its preferred securities at the
same rate.  Under the terms of our Trust I subordinated debt
securities, we pay interest only each quarter and the principal of the note at
maturity.  The subordinated debt securities are uncollaterized and do
not require maintenance of minimum financial covenants. As of March 31, 2010,
the balance of our Trust I subordinated debt was $30.9 million.





On August
23, 2007, we entered into a trust preferred securities transaction pursuant to
which we issued $25.8 million aggregate principal amount of subordinated debt
securities due in 2037.  To effect the transaction, we formed a
Delaware statutory trust, Hallmark Statutory Trust II (“Trust
II”).  Trust II issued $25.0 million of preferred securities to
investors and $0.8 million of common securities to us.  Trust II used
the proceeds from these issuances to purchase the subordinated debt
securities.  Our Trust II subordinated debt securities bear an initial
interest rate of 8.28% until September 15, 2017, at which time interest will
adjust quarterly to the three-month LIBOR rate plus 2.90 percentage
points.  Trust II pays dividends on its preferred securities at the
same rate.  Under the terms of our Trust II subordinated debt
securities, we pay interest only each quarter and the principal of the note at
maturity.  The subordinated debt securities are uncollaterized and do
not require maintenance of minimum financial covenants. As of March 31, 2010,
the balance of our Trust II subordinated debt was $25.8
million.


33





Item
3.  Quantitative and Qualitative Disclosures About Market
Risk.





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





Item
4T.  Controls and Procedures.





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





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





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


34


PART
II


OTHER
INFORMATION





Item
      1.
            Legal
      Proceedings.





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





Item
      1A.
            Risk
      Factors.





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





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





None.





Item
      3.
            Defaults
      Upon Senior Securities.





None.





Item
      4.
            (Removed
      and Reserved.)








Item
      5.
            Other
      Information.





None.





Item
      6.
            Exhibits.





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





Exhibit
                  Number
                
                Description3(a)
                
                Restated
      Articles of Incorporation of the registrant, as amended (incorporated by
      reference to Exhibit 3.1 to the registrant’s Registration Statement on
      Form S-1 [Registration No. 333-136414] filed September 8,
      2006).3(b)
                
                Amended
      and Restated By-Laws of the registrant (incorporated by reference to
      Exhibit 3.1 to the registrant’s Current Report on Form 8-K filed October
      1, 2007).4(a)
                
                Specimen
      certificate for Common Stock, $0.18 par value per share, of the registrant
      (incorporated by reference to Exhibit 4.1 to Amendment No. 1 to the
      registrant’s Registration Statement on Form S-1 [Registration No.
      333-136414] filed September 8, 2006).4(b)
                
                Indenture
      dated as of June 21, 2005, between Hallmark Financial Services, Inc. and
      JPMorgan Chase Bank, National Association (incorporated by reference to
      Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed June 27,
      2005).


35





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


36





SIGNATURES





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





HALLMARK
      FINANCIAL SERVICES, INC.(Registrant)Date:
      May 13, 2010
              
              
              /s/ Mark J. MorrisonMark
      J. Morrison, Chief Executive Officer and President(Principal
      Executive Officer)Date:
      May 13, 2010
              
              
              /s/ Jeffrey R. PassmoreJeffrey
      R. Passmore, Chief Accounting Officer and Senior VicePresident(Principal
      Financial Officer)


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