UNITED
STATES





SECURITIES
AND EXCHANGE COMMISSION





WASHINGTON,
D.C. 20549





FORM
10-Q





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





Securities
Exchange Act of 1934





For the
quarterly period ended September 30, 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
– 20,124,169 shares outstanding as of November 10, 2010.





PART
I


FINANCIAL
INFORMATION





Item
1.  Financial Statements





INDEX
TO FINANCIAL STATEMENTS





Page NumberConsolidated
      Balance Sheets at September 30, 2010 (unaudited) and December 31,
      2009
                        
                        3Consolidated
      Statements of Operations (unaudited) for the three months and nine months
      ended September 30, 2010 and September 30, 2009
                        
                        4Consolidated
      Statements of Stockholders’ Equity and Comprehensive Income (unaudited)
      for the three months and nine months ended September 30, 2010 and
      September 30, 2009
                        
                        5Consolidated
      Statements of Cash Flows (unaudited) for the nine months ended September
      30, 2010 and September 30, 2009
                        
                        6Notes
      to Consolidated Financial Statements (unaudited)
                        
                        7


2


Hallmark
Financial Services, Inc. and Subsidiaries


Consolidated
Balance Sheets


($ in
thousands, except share amounts)





September 30
                                
                                
                                December 312010
                                
                                
                                2009(unaudited)ASSETSInvestments:Debt
      securities, available-for-sale, at fair value (cost;
      $353,659  in 2010 and $287,108 in 2009)
                                
                                $
                                360,238
                                
                                
                                $
                                291,876Equity
      securities, available-for-sale, at fair value (cost; $34,366 in 2010 and
      $27,251 in 2009)
                                
                                
                                44,025
                                
                                
                                
                                35,801Total
      investments
                                
                                
                                404,263
                                
                                
                                
                                327,677Cash
      and cash equivalents
                                
                                
                                81,984
                                
                                
                                
                                112,270Restricted
      cash and cash equivalents
                                
                                
                                5,991
                                
                                
                                
                                5,458Premiums
      receivable
                                
                                
                                52,288
                                
                                
                                
                                46,635Accounts
      receivable
                                
                                
                                2,958
                                
                                
                                
                                3,377Receivable
      for securities
                                
                                
                                7
                                
                                
                                
                                -Ceded
      unearned premiums
                                
                                
                                15,520
                                
                                
                                
                                12,997Reinsurance
      recoverable
                                
                                
                                19,684
                                
                                
                                
                                10,008Deferred
      policy acquisition costs
                                
                                
                                23,181
                                
                                
                                
                                20,792Goodwill
                                
                                
                                41,080
                                
                                
                                
                                41,080Intangible
      assets, net
                                
                                
                                26,124
                                
                                
                                
                                28,873Federal
      income tax recoverable
                                
                                
                                3,120
                                
                                
                                
                                -Prepaid
      expenses
                                
                                
                                1,733
                                
                                
                                
                                923Other
      assets
                                
                                
                                15,437
                                
                                
                                
                                18,779Total
      assets
                                
                                $
                                693,370
                                
                                
                                $
                                628,869LIABILITIES AND STOCKHOLDERS'
      EQUITYLiabilities:Note
      payable
                                
                                $
                                2,800
                                
                                
                                $
                                2,800Subordinated
      debt securities
                                
                                
                                56,702
                                
                                
                                
                                56,702Reserves
      for unpaid losses and loss adjustment expenses
                                
                                
                                223,828
                                
                                
                                
                                184,662Unearned
      premiums
                                
                                
                                138,218
                                
                                
                                
                                125,089Unearned
      revenue
                                
                                
                                140
                                
                                
                                
                                191Reinsurance
      balances payable
                                
                                
                                1,141
                                
                                
                                
                                3,281Accrued
      agent profit sharing
                                
                                
                                1,772
                                
                                
                                
                                1,790Accrued
      ceding commission payable
                                
                                
                                4,232
                                
                                
                                
                                8,600Pension
      liability
                                
                                
                                2,367
                                
                                
                                
                                2,628Deferred
      federal income taxes, net
                                
                                
                                1,366
                                
                                
                                
                                942Federal
      income tax payable
                                
                                
                                -
                                
                                
                                
                                1,266Payable
      for securities
                                
                                
                                11,609
                                
                                
                                
                                19Accounts
      payable and other accrued expenses
                                
                                
                                12,209
                                
                                
                                
                                13,258Total
      liabilities
                                
                                
                                456,384
                                
                                
                                
                                401,228Commitments
      and contingencies (Note 17)Redeemable
      non-controlling interest
                                
                                
                                1,288
                                
                                
                                
                                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
                                
                                
                                121,589
                                
                                
                                
                                121,016Retained
      earnings
                                
                                
                                105,396
                                
                                
                                
                                98,482Accumulated
      other comprehensive income
                                
                                
                                10,218
                                
                                
                                
                                8,589Treasury
      stock, at cost (748,662 shares in 2010 and 757,828 in
2009)
                                
                                
                                (5,262
                                )
                                
                                
                                (5,327
                                )Total
      stockholders' equity
                                
                                
                                235,698
                                
                                
                                
                                226,517$
                                693,370
                                
                                
                                $
                                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 Ended
                    
                    
                    Nine Months EndedSeptember 30
                    
                    
                    September
      302010
                    
                    
                    2009
                    
                    
                    2010
                    
                    
                    2009Gross
      premiums written
                    
                    $
                    82,199
                    
                    
                    $
                    74,013
                    
                    
                    $
                    247,238
                    
                    
                    $
                    220,545Ceded
      premiums written
                    
                    
                    (10,152
                    )
                    
                    
                    (11,222
                    )
                    
                    
                    (29,263
                    )
                    
                    
                    (16,714
                    )Net
      premiums written
                    
                    
                    72,047
                    
                    
                    
                    62,791
                    
                    
                    
                    217,975
                    
                    
                    
                    203,831Change
      in unearned premiums
                    
                    
                    (1,641
                    )
                    
                    
                    1,447
                    
                    
                    
                    (10,606
                    )
                    
                    
                    (17,844
                    )Net
      premiums earned
                    
                    
                    70,406
                    
                    
                    
                    64,238
                    
                    
                    
                    207,369
                    
                    
                    
                    185,987Investment
      income, net of expenses
                    
                    
                    4,036
                    
                    
                    
                    3,467
                    
                    
                    
                    10,513
                    
                    
                    
                    11,203Net
      realized gains
                    
                    
                    311
                    
                    
                    
                    597
                    
                    
                    
                    5,757
                    
                    
                    
                    1,116Finance
      charges
                    
                    
                    1,833
                    
                    
                    
                    1,525
                    
                    
                    
                    5,247
                    
                    
                    
                    4,324Commission
      and fees
                    
                    
                    (392
                    )
                    
                    
                    2,018
                    
                    
                    
                    (1,204
                    )
                    
                    
                    10,834Other
      income
                    
                    
                    23
                    
                    
                    
                    58
                    
                    
                    
                    45
                    
                    
                    
                    93Total
      revenues
                    
                    
                    76,217
                    
                    
                    
                    71,903
                    
                    
                    
                    227,727
                    
                    
                    
                    213,557Losses
      and loss adjustment expenses
                    
                    
                    51,293
                    
                    
                    
                    40,579
                    
                    
                    
                    146,449
                    
                    
                    
                    115,552Operating
      expenses
                    
                    
                    21,602
                    
                    
                    
                    23,428
                    
                    
                    
                    65,956
                    
                    
                    
                    71,056Interest
      expense
                    
                    
                    1,151
                    
                    
                    
                    1,147
                    
                    
                    
                    3,447
                    
                    
                    
                    3,456Amortization
      of intangible assets
                    
                    
                    917
                    
                    
                    
                    916
                    
                    
                    
                    2,749
                    
                    
                    
                    2,412Total
      expenses
                    
                    
                    74,963
                    
                    
                    
                    66,070
                    
                    
                    
                    218,601
                    
                    
                    
                    192,476Income
      before tax
                    
                    
                    1,254
                    
                    
                    
                    5,833
                    
                    
                    
                    9,126
                    
                    
                    
                    21,081Income
      tax expense
                    
                    
                    205
                    
                    
                    
                    1,585
                    
                    
                    
                    2,142
                    
                    
                    
                    5,766Net
      income
                    
                    
                    1,049
                    
                    
                    
                    4,248
                    
                    
                    
                    6,984
                    
                    
                    
                    15,315Less:
      Net income attributable tonon-controlling  interest
                    
                    
                    33
                    
                    
                    
                    34
                    
                    
                    
                    70
                    
                    
                    
                    36Net
      income attributable to Hallmark Financial Services, Inc.
                    
                    $
                    1,016
                    
                    
                    $
                    4,214
                    
                    
                    $
                    6,914
                    
                    
                    $
                    15,279Net
      income per share attributable to Hallmark FinancialServices,
      Inc. common stockholders:Basic
                    
                    $
                    0.05
                    
                    
                    $
                    0.20
                    
                    
                    $
                    0.34
                    
                    
                    $
                    0.73Diluted
                    
                    $
                    0.05
                    
                    
                    $
                    0.20
                    
                    
                    $
                    0.34
                    
                    
                    $
                    0.73





The
accompanying notes are an integral part


of the
consolidated  financial statements


4





Hallmark
Financial Services, Inc. and Subsidiaries


Consolidated
Statements of Stockholders' Equity and Comprehensive Income


(Unaudited)


($ in
thousands)





Three Months Ended
                    
                    
                    Nine Months EndedSeptember 30,
                    
                    
                    September 30,2010
                    
                    
                    2009
                    
                    
                    2010
                    
                    
                    2009Common
      StockBalance,
      beginning of period
                    
                    $
                    3,757
                    
                    
                    $
                    3,757
                    
                    
                    $
                    3,757
                    
                    
                    $
                    3,751Issuance
      of common stock upon option exercises
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    6Balance,
      end of period
                    
                    
                    3,757
                    
                    
                    
                    3,757
                    
                    
                    
                    3,757
                    
                    
                    
                    3,757Additional
      Paid-In CapitalBalance,
      beginning of period
                    
                    
                    121,403
                    
                    
                    
                    120,736
                    
                    
                    
                    121,016
                    
                    
                    
                    119,928Accretion
      of redeemable noncontrolling interest
                    
                    
                    (77
                    )
                    
                    
                    (87
                    )
                    
                    
                    (239
                    )
                    
                    
                    (259
                    )Equity
      based compensation
                    
                    
                    263
                    
                    
                    
                    612
                    
                    
                    
                    852
                    
                    
                    
                    1,488Exercise
      of stock options
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    (40
                    )
                    
                    
                    104Balance,
      end of period
                    
                    
                    121,589
                    
                    
                    
                    121,261
                    
                    
                    
                    121,589
                    
                    
                    
                    121,261Retained
      EarningsBalance,
      beginning of period
                    
                    
                    104,380
                    
                    
                    
                    84,972
                    
                    
                    
                    98,482
                    
                    
                    
                    72,242Adjustment
      to opening balance, net of tax (Note 2)
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    1,665104,380
                    
                    
                    
                    84,972
                    
                    
                    
                    98,482
                    
                    
                    
                    73,907Net
      income attributable to Hallmark Financial Services, Inc.
                    
                    
                    1,016
                    
                    
                    
                    4,214
                    
                    
                    
                    6,914
                    
                    
                    
                    15,279Balance,
      end of period
                    
                    
                    105,396
                    
                    
                    
                    89,186
                    
                    
                    
                    105,396
                    
                    
                    
                    89,186Accumulated
      Other Comprehensive Income (Loss)Balance,
      beginning of period
                    
                    
                    6,966
                    
                    
                    
                    836
                    
                    
                    
                    8,589
                    
                    
                    
                    (16,432
                    )Adjustment
      to opening balance, net of tax (Note 2)
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    (1,665
                    )Adjusted
      balance, beginning of period
                    
                    
                    6,966
                    
                    
                    
                    836
                    
                    
                    
                    8,589
                    
                    
                    
                    (18,097
                    )Additional
      minimum pension liability, net of tax
                    
                    
                    36
                    
                    
                    
                    80
                    
                    
                    
                    109
                    
                    
                    
                    239Net
      unrealized holding gains arising during period
                    
                    
                    3,527
                    
                    
                    
                    7,881
                    
                    
                    
                    7,277
                    
                    
                    
                    27,197Reclassification
      adjustment for gains included in net income
                    
                    
                    (311
                    )
                    
                    
                    (636
                    )
                    
                    
                    (5,757
                    )
                    
                    
                    (1,178
                    )Balance,
      end of period
                    
                    
                    10,218
                    
                    
                    
                    8,161
                    
                    
                    
                    10,218
                    
                    
                    
                    8,161Treasury
      StockBalance,
      beginning of period
                    
                    
                    (5,262
                    )
                    
                    
                    (77
                    )
                    
                    
                    (5,327
                    )
                    
                    
                    (77
                    )Acquisition
      of treasury shares
                    
                    
                    -
                    
                    
                    
                    (5,250
                    )
                    
                    
                    -
                    
                    
                    
                    (5,250
                    )Issuance
      of treasury stock upon option exercises
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    65
                    
                    
                    
                    -Balance,
      end of period
                    
                    
                    (5,262
                    )
                    
                    
                    (5,327
                    )
                    
                    
                    (5,262
                    )
                    
                    
                    (5,327
                    )Total
      Stockholders' Equity
                    
                    $
                    235,698
                    
                    
                    $
                    217,038
                    
                    
                    $
                    235,698
                    
                    
                    $
                    217,038Net
      income
                    
                    $
                    1,049
                    
                    
                    $
                    4,248
                    
                    
                    $
                    6,984
                    
                    
                    $
                    15,315Additional
      minimum pension liability, net of tax
                    
                    
                    36
                    
                    
                    
                    80
                    
                    
                    
                    109
                    
                    
                    
                    239Net
      unrealized holding gains arising during period
                    
                    
                    3,527
                    
                    
                    
                    7,881
                    
                    
                    
                    7,277
                    
                    
                    
                    27,197Reclassification
      adjustment for gains included in net income
                    
                    
                    (311
                    )
                    
                    
                    (636
                    )
                    
                    
                    (5,757
                    )
                    
                    
                    (1,178
                    )Comprehensive
      income
                    
                    
                    4,301
                    
                    
                    
                    11,573
                    
                    
                    
                    8,613
                    
                    
                    
                    41,573Less:
      Comprehensive income attributable tonon-controlling
      interest
                    
                    
                    33
                    
                    
                    
                    34
                    
                    
                    
                    70
                    
                    
                    
                    36Comprehensive
      income attributable toHallmark
      Financial Services, Inc.
                    
                    $
                    4,268
                    
                    
                    $
                    11,539
                    
                    
                    $
                    8,543
                    
                    
                    $
                    41,537





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)




Nine
      Months EndedSeptember
      302010
                        
                        
                        2009Cash
      flows from operating activities:Net
      income
                        
                        $
                        6,984
                        
                        
                        $
                        15,315Adjustments
      to reconcile net income to cash provided by operating
      activities:Depreciation
      and amortization expense
                        
                        
                        3,527
                        
                        
                        
                        2,979Deferred
      federal income taxes
                        
                        
                        (1,034
                        )
                        
                        
                        (1,117
                        )Realized
      gains on investments
                        
                        
                        (5,757
                        )
                        
                        
                        (1,116
                        )Change
      in ceded unearned premiums
                        
                        
                        (2,523
                        )
                        
                        
                        (5,036
                        )Change
      in premiums receivable
                        
                        
                        (5,653
                        )
                        
                        
                        (4,787
                        )Change
      in accounts receivable
                        
                        
                        370
                        
                        
                        
                        815Change
      in deferred policy acquisition costs
                        
                        
                        (2,389
                        )
                        
                        
                        (3,105
                        )Change
      in reserves for unpaid losses and loss adjustment expenses
                        
                        
                        39,166
                        
                        
                        
                        15,252Change
      in unearned premiums
                        
                        
                        13,129
                        
                        
                        
                        23,462Change
      in unearned revenue
                        
                        
                        (51
                        )
                        
                        
                        (1,771
                        )Change
      in accrued agent profit sharing
                        
                        
                        (18
                        )
                        
                        
                        (243
                        )Change
      in reinsurance recoverable
                        
                        
                        (9,676
                        )
                        
                        
                        5,087Change
      in reinsurance balances payable
                        
                        
                        (2,140
                        )
                        
                        
                        2,680Change
      in current federal income tax recoverable/payable
                        
                        
                        (4,386
                        )
                        
                        
                        (384
                        )Change
      in accrued ceding commission payable
                        
                        
                        (4,368
                        )
                        
                        
                        (5
                        )Change
      in all other liabilities
                        
                        
                        (1,310
                        )
                        
                        
                        (8,094
                        )Change
      in all other assets
                        
                        
                        5,063
                        
                        
                        
                        5,763Net
      cash provided by operating activities
                        
                        
                        28,934
                        
                        
                        
                        45,695Cash
      flows from investing activities:Purchases
      of property and equipment
                        
                        
                        (1,155
                        )
                        
                        
                        (907
                        )Net
      transfers (into)/from restricted cash and cash equivalents
                        
                        
                        (533
                        )
                        
                        
                        3,470Purchases
      of investment securities
                        
                        
                        (157,332
                        )
                        
                        
                        (74,430
                        )Maturities,
      sales and redemptions of investment securities
                        
                        
                        99,919
                        
                        
                        
                        65,283Payment
      for acquisition of subsidiaries
                        
                        
                        -
                        
                        
                        
                        (7,246
                        )Net
      cash used in investing activities
                        
                        
                        (59,101
                        )
                        
                        
                        (13,830
                        )Cash
      flows from financing activities:Proceeds
      from exercise of employee stock options
                        
                        
                        25
                        
                        
                        
                        110Net
      repayments of notes payable
                        
                        
                        -
                        
                        
                        
                        (1,417
                        )Distribution
      to non-controlling interest
                        
                        
                        (144
                        )
                        
                        
                        (20
                        )Purchase
      of treasury shares
                        
                        
                        -
                        
                        
                        
                        (5,250
                        )Net
      cash used in financing activities
                        
                        
                        (119
                        )
                        
                        
                        (6,577
                        )Increase
      (Decrease) in cash and cash equivalents
                        
                        
                        (30,286
                        )
                        
                        
                        25,288Cash
      and cash equivalents at beginning of period
                        
                        
                        112,270
                        
                        
                        
                        59,134Cash
      and cash equivalents at end of period
                        
                        $
                        81,984
                        
                        
                        $
                        84,422Supplemental
      cash flow information:Interest
      paid
                        
                        $
                        3,442
                        
                        
                        $
                        3,494Taxes
      paid
                        
                        $
                        7,564
                        
                        
                        $
                        7,267Supplemental
      schedule of non-cash investing activities:Change
      in receivable for securities related to investment disposals settled after
      the balance sheet date
                        
                        $
                        42
                        
                        
                        $
                        850Change
      in payable for securities related to investment purchases settled after
      the balance sheet date
                        
                        $
                        11,590
                        
                        
                        $
                        (2,918
                        )




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 business 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 September 30, 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 September 30, 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 reclassifications 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 amounts reported in the
balance sheet for these instruments approximate their fair values.





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 $54.8 million as of September 30,
2010.  The fair value of our trust preferred securities is based on
discounted cash flows using a current yield to maturity of 7.50% based on
similar issues to discount future cash flows.





For
accrued investment income, amounts recoverable from reinsurers, federal income
tax recoverable/payable and other assets and 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
January 2010, the FASB updated Accounting Standards Codification (“ASC”) Topic
820, “Fair Value Measurements and Disclosures” (“ASC 820”) to require 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 did not have and is not expected to have a material impact on our
financial position or results of operations but does require additional
disclosures.  (See Note 4, “Fair Value.”)


9





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 ASC Topic 810, “Noncontrolling Interests” (“ASC 810”).  ASC 810
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.  These provisions of ASC 810 were
effective for calendar year end companies beginning on January 1, 2010 with
earlier application prohibited.  The adoption of ASC 810 did not have
a material impact on our financial position or results of
operations.





Accounting
Pronouncements Not Yet Adopted





In
October 2010, the FASB issued new guidance related to the accounting for costs
associated with acquiring or renewing insurance contracts.  The
guidance identifies those costs relating to the successful acquisition of
new or renewal insurance contracts which are to be capitalized.  The
guidance is effective for the Company for the year beginning January 1, 2012 and
may be applied prospectively or retrospectively.  The Company is in
the process of assessing the effect that the implementation of the new guidance
will have on its financial position and results of operations.  The
amount of acquisition costs the Company would defer under the new guidance may
be less than the amount deferred under the Company’s current accounting
practice.





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 $1.7 million at September 30,
2010.


10





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:





·
            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.


11





Level 2
investment securities include corporate bonds, municipal bonds and U.S. Treasury
securities for which quoted prices are not available on active exchanges for
identical instruments.  We use a third party pricing service to
determine fair values for each Level 2 investment security in all asset
classes.  Since quoted prices in active markets for identical assets
are not available, these prices are determined by the pricing service using
observable market information such as quotes from less active markets and/or
quoted prices of securities with similar characteristics, among other things. We
have reviewed the processes used by the pricing service and have determined that
they result in fair values consistent with the requirements of  ASC
820 for Level 2 investment 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 September 30, 2010 (in
thousands):




Quoted Prices in
                      
                      
                      OtherActive Markets for
                      
                      
                      Observable
                      
                      
                      UnobservableIdentical Assets
                      
                      
                      Inputs
                      
                      
                      Inputs(Level
      1)
                      
                      
                      (Level
      2)
                      
                      
                      (Level
      3)
                      
                      
                      TotalU.S.
      Treasury securities and obligations of U.S. Government
                      
                      $
                      -
                      
                      
                      $
                      6,545
                      
                      
                      $
                      -
                      
                      
                      $
                      6,545Corporate
      debt securities
                      
                      
                      -
                      
                      
                      
                      198,402
                      
                      
                      
                      -
                      
                      
                      
                      198,402Municipal
      bonds
                      
                      
                      -
                      
                      
                      
                      134,419
                      
                      
                      
                      20,024
                      
                      
                      
                      154,443Asset
      backed
                      
                      
                      -
                      
                      
                      
                      848
                      
                      
                      
                      -
                      
                      
                      
                      848Total
      debt securities
                      
                      
                      -
                      
                      
                      
                      340,214
                      
                      
                      
                      20,024
                      
                      
                      
                      360,238Financial
      services
                      
                      
                      21,356
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      21,356All
      other
                      
                      
                      22,669
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      22,669Total
      equity securities
                      
                      
                      44,025
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      44,025Total
      debt and equity securities
                      
                      $
                      44,025
                      
                      
                      $
                      340,214
                      
                      
                      $
                      20,024
                      
                      
                      $
                      404,263




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 nine months ended September 30, 2010 (in
thousands):


12





Beginning
      balance as of January 1, 2010
                    
                    $
                    25,272Net
      purchases, issuances, sales and settlements
                    
                    
                    (5,125
                    )Total
      realized/unrealized gains included in net income
                    
                    
                    -Net
      losses included in other comprehensive income
                    
                    
                    (123
                    )Transfers
      in and/or out of Level 3
                    
                    
                    -Ending
      balance as of September 30, 2010
                    
                    $
                    20,024





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.




Debt
Investments:




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.


13




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




Three Months Ended
                
                
                Nine Months EndedSeptember 30
                
                
                September
      302010
                
                
                2009
                
                
                2010
                
                
                2009U.S.
      Treasury securities and obligations of U.S. Government
                
                $
                -
                
                
                $
                -
                
                
                $
                -
                
                
                $
                -Corporate
      debt securities
                
                
                281
                
                
                
                239
                
                
                
                3,650
                
                
                
                1,269Municipal
      bonds
                
                
                -
                
                
                
                -
                
                
                
                (74
                )
                
                
                (48
                )Equity
      securities-financial services
                
                
                -
                
                
                
                58
                
                
                
                1,767
                
                
                
                115Equity
      securities-all other
                
                
                30
                
                
                
                300
                
                
                
                414
                
                
                
                318Net
      realized gain before other-than-temporary impairments
                
                
                311
                
                
                
                597
                
                
                
                5,757
                
                
                
                1,654Other-than-temporary
      impairments
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (538
                )Net
      realized gain
                
                $
                311
                
                
                $
                597
                
                
                $
                5,757
                
                
                $
                1,116




We
realized gross gains on investments of $0.3 million and $0.7 million during the
three months ended September 30, 2010 and 2009, respectively, and $5.9 and $2.0
million for the nine months ended September 30, 2010 and 2009, respectively. We
did not realize gross losses on investments for the three months ended September
30, 2010. We realized gross losses on investments of $0.1 million during the
three months ended September 30, 2009 and $0.1 million and $0.9 million for the
nine months ended September 30, 2010 and 2009, respectively. We recorded
proceeds from the sale of investment securities of $26.3 million and $25.3
million during the three months ended September 30, 2010 and 2009, respectively,
and $99.9 million and $66.2 million for the nine months ended September 30, 2010
and 2009, respectively. Realized investment gains and losses are recognized in
operations on the specific identification method.


14




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




Gross
                            
                            
                            GrossAmortized
                            
                            
                            Unrealized
                            
                            
                            Unrealized
                            
                            
                            FairAs of September 30, 2010
                            
                            Cost
                            
                            
                            Gains
                            
                            
                            Losses
                            
                            
                            ValueU.S.
      Treasury securities andobligations
      of U.S. Government
                            
                            $
                            6,509
                            
                            
                            $
                            36
                            
                            
                            $
                            -
                            
                            
                            $
                            6,545Corporate
      debt securities
                            
                            
                            193,469
                            
                            
                            
                            5,854
                            
                            
                            
                            (921
                            )
                            
                            
                            198,402Municipal
      bonds
                            
                            
                            152,877
                            
                            
                            
                            3,621
                            
                            
                            
                            (2,055
                            )
                            
                            
                            154,443Asset
      backed
                            
                            
                            804
                            
                            
                            
                            44
                            
                            
                            
                            -
                            
                            
                            
                            848Total
      debt securities
                            
                            
                            353,659
                            
                            
                            
                            9,555
                            
                            
                            
                            (2,976
                            )
                            
                            
                            360,238Financial
      services
                            
                            
                            16,834
                            
                            
                            
                            4,727
                            
                            
                            
                            (205
                            )
                            
                            
                            21,356All
      other
                            
                            
                            17,532
                            
                            
                            
                            5,465
                            
                            
                            
                            (328
                            )
                            
                            
                            22,669Total
      equity securities
                            
                            
                            34,366
                            
                            
                            
                            10,192
                            
                            
                            
                            (533
                            )
                            
                            
                            44,025Total
      debt and equity securities
                            
                            $
                            388,025
                            
                            
                            $
                            19,747
                            
                            
                            $
                            (3,509
                            )
                            
                            $
                            404,263As of December 31, 2009U.S.
      Treasury securities andobligations
      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




15




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 September 30, 2010 and December 31, 2009 (in thousands):





As
      of September 30, 201012
      months or less
                  
                  
                  Longer
      than 12 months
                  
                  
                  TotalUnrealized
                  
                  
                  
                  
                  
                  Unrealized
                  
                  
                  
                  
                  
                  UnrealizedFair
      Value
                  
                  
                  Losses
                  
                  
                  Fair
      Value
                  
                  
                  Losses
                  
                  
                  Fair
      Value
                  
                  
                  LossesU.S.
      Treasury securities and obligations of U.S. Government
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -Corporate
      debt securities
                  
                  
                  28,953
                  
                  
                  
                  (229
                  )
                  
                  
                  4,774
                  
                  
                  
                  (692
                  )
                  
                  
                  33,727
                  
                  
                  
                  (921
                  )Municipal
      bonds
                  
                  
                  7,356
                  
                  
                  
                  (32
                  )
                  
                  
                  48,391
                  
                  
                  
                  (2,023
                  )
                  
                  
                  55,747
                  
                  
                  
                  (2,055
                  )Total
      debt securities
                  
                  
                  36,309
                  
                  
                  
                  (261
                  )
                  
                  
                  53,165
                  
                  
                  
                  (2,715
                  )
                  
                  
                  89,474
                  
                  
                  
                  (2,976
                  )Financial
      services
                  
                  
                  1,259
                  
                  
                  
                  (205
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  1,259
                  
                  
                  
                  (205
                  )All
      other
                  
                  
                  4,611
                  
                  
                  
                  (328
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  4,611
                  
                  
                  
                  (328
                  )Total
      equity securities
                  
                  
                  5,870
                  
                  
                  
                  (533
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  5,870
                  
                  
                  
                  (533
                  )Total
      debt and equity securities
                  
                  $
                  42,179
                  
                  
                  $
                  (794
                  )
                  
                  $
                  53,165
                  
                  
                  $
                  (2,715
                  )
                  
                  $
                  95,344
                  
                  
                  $
                  (3,509
                  )





As
      of December 31, 200912
      months or less
                  
                  
                  Longer
      than 12 months
                  
                  
                  TotalUnrealized
                  
                  
                  
                  
                  
                  Unrealized
                  
                  
                  
                  
                  
                  UnrealizedFair
      Value
                  
                  
                  Losses
                  
                  
                  Fair
      Value
                  
                  
                  Losses
                  
                  
                  Fair
      Value
                  
                  
                  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
September 30, 2010, the gross unrealized losses more than twelve months old were
attributable to 35 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.


16





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 September 30, 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
                  
                  $
                  27,776
                  
                  
                  $
                  28,312Due
      after one year through five years
                  
                  
                  184,429
                  
                  
                  
                  190,046Due
      after five years through ten years
                  
                  
                  96,305
                  
                  
                  
                  97,434Due
      after ten years
                  
                  
                  44,345
                  
                  
                  
                  43,598Asset
      backed
                  
                  
                  804
                  
                  
                  
                  848$
                  353,659
                  
                  
                  $
                  360,238





Activity
related to the credit component recognized in earnings for the nine months ended
September 30, 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,
      September 30, 2010
                    
                    $
                    -


17





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 $26.8 million at
September 30, 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 the shareholders on
May 26, 2005.  There are 2,000,000 shares authorized for issuance
under the 2005 LTIP.  Our 1994 Key Employee Long Term Incentive Plan
(the “1994 Employee Plan”) and 1994 Non-Employee Director Stock Option Plan (the
“1994 Director Plan”) both expired in 2004 but have unexercised options
outstanding.





As of
September 30, 2010, there were incentive stock options to purchase 1,286,666
shares of our common stock outstanding and non-qualified stock options to
purchase 320,000 shares of our common stock outstanding and there were 392,501
shares reserved for future issuance under the 2005 LTIP.  As of
September 30, 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.  There was one grant of
25,000 incentive stock options in 2010 under the 2005 LTIP that vest in equal
annual increments on each of the first three anniversary dates and terminates
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.  There was one grant of
200,000 non-qualified stock options in 2009 under the 2005 LTIP that vest in
equal annual increments on each of the first seven anniversary dates and
terminate ten years from the date of grant.  All non-qualified stock
options granted under the 1994 Director Plan vested 40% six months from the date
of grant and an additional 10% on each of the first six anniversary dates of the
grant and terminate ten years from the date of grant.


18


A summary
of the status of our stock options as of and changes during the nine months
ended September 30, 2010 is presented below:





Average
                    
                    
                    Contractual
                    
                    
                    IntrinsicNumber
      of
                    
                    
                    Exercise
                    
                    
                    Term
                    
                    
                    ValueShares
                    
                    
                    Price
                    
                    
                    (Years)
                    
                    
                    $
                    (000
                    )Outstanding
      at January 1, 2010
                    
                    
                    1,614,166
                    
                    
                    $
                    9.62Granted
                    
                    
                    25,000
                    
                    
                    $
                    9.12Exercised
                    
                    
                    (9,166
                    )
                    
                    $
                    2.69Forfeited
      or expired
                    
                    
                    -
                    
                    
                    $
                    -Outstanding
      at September 30, 2010
                    
                    
                    1,630,000
                    
                    
                    $
                    9.65
                    
                    
                    
                    7.3
                    
                    
                    $
                    1,515Exercisable
      at September 30, 2010
                    
                    
                    779,427
                    
                    
                    $
                    10.34
                    
                    
                    
                    6.6
                    
                    
                    $
                    538





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





Three
      Months Ended
                        
                        
                        Nine
      Months EndedSeptember
      30,
                        
                        
                        September
      30,2010
                        
                        
                        2009
                        
                        
                        2010
                        
                        
                        2009Intrinsic
      value of options exercised
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        47
                        
                        
                        $
                        107Cost
      of share-based payments (non-cash)
                        
                        $
                        263
                        
                        
                        $
                        612
                        
                        
                        $
                        852
                        
                        
                        $
                        1,488Income
      tax benefit of share-basedpayments
      recognized in income
                        
                        $
                        8
                        
                        
                        $
                        118
                        
                        
                        $
                        23
                        
                        
                        $
                        231





As of
September 30, 2010 there was $2.2 million of total unrecognized compensation
cost related to non-vested share-based compensation arrangements granted under
our plans, of which $0.3 million is expected to be recognized during the
remainder of 2010, $0.8 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 the Company’s and similar companies’ common
stock for a period equal to the expected term.  The risk- free
interest rates for periods within the contractual term of the options are based
on rates for U.S. Treasury Notes with maturity dates corresponding to the
options’ expected lives on the dates of grant.  Expected term is
determined based on the simplified method as the Company does not have
sufficient historical exercise data to provide a basis for estimating the
expected term.


19





The
following table details the weighted average grant date fair value and related
assumptions for the periods indicated.  No options were granted in the
third quarter of 2010 or 2009.





Nine
      Months EndedSeptember
      30,2010
                    
                    
                    2009Grant
      date fair value per share
                    
                    $
                    3.62
                    
                    
                    $
                    2.84Expected
      term (in years)
                    
                    
                    6.0
                    
                    
                    
                    6.2Expected
      volatility
                    
                    
                    35.0
                    %
                    
                    
                    40.0
                    %Risk
      free interest rate
                    
                    
                    3.2
                    %
                    
                    
                    2.5
                    %





8.
Segment Information





The
following is business segment information for the three and nine months ended
September 30, 2010 and 2009 (in thousands):


Three Months Ended
                      
                      
                      Nine Months EndedSeptember 30,
                      
                      
                      September 30,2010
                      
                      
                      2009
                      
                      
                      2010
                      
                      
                      2009Revenues:Standard
      Commercial Segment
                      
                      $
                      17,211
                      
                      
                      $
                      19,569
                      
                      
                      $
                      52,510
                      
                      
                      $
                      57,783Specialty
      Commercial Segment
                      
                      
                      32,892
                      
                      
                      
                      32,346
                      
                      
                      
                      97,503
                      
                      
                      
                      97,601Personal
      Segment
                      
                      
                      25,418
                      
                      
                      
                      18,735
                      
                      
                      
                      71,386
                      
                      
                      
                      54,971Corporate
                      
                      
                      696
                      
                      
                      
                      1,253
                      
                      
                      
                      6,328
                      
                      
                      
                      3,202Consolidated
                      
                      $
                      76,217
                      
                      
                      $
                      71,903
                      
                      
                      $
                      227,727
                      
                      
                      $
                      213,557Pre-tax income (loss), net of non-controlling
      interest:Standard
      Commercial Segment
                      
                      $
                      (234
                      )
                      
                      $
                      2,164
                      
                      
                      $
                      (3,043
                      )
                      
                      $
                      5,987Specialty
      Commercial Segment
                      
                      
                      2,515
                      
                      
                      
                      3,588
                      
                      
                      
                      9,829
                      
                      
                      
                      14,280Personal
      Segment
                      
                      
                      743
                      
                      
                      
                      2,225
                      
                      
                      
                      4,525
                      
                      
                      
                      7,738Corporate
                      
                      
                      (1,803
                      )
                      
                      
                      (2,178
                      )
                      
                      
                      (2,255
                      )
                      
                      
                      (6,960
                      )Consolidated
                      
                      $
                      1,221
                      
                      
                      $
                      5,799
                      
                      
                      $
                      9,056
                      
                      
                      $
                      21,045


20





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





September 30,
                      
                      
                      December 31,2010
                      
                      
                      2009AssetsStandard
      Commercial Segment
                      
                      $
                      130,916
                      
                      
                      $
                      136,745Specialty
      Commercial Segment
                      
                      
                      316,040
                      
                      
                      
                      280,970Personal
      Segment
                      
                      
                      165,692
                      
                      
                      
                      109,844Corporate
                      
                      
                      80,722
                      
                      
                      
                      101,310$
                      693,370
                      
                      
                      $
                      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.





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





Three Months Ended
                  
                  
                  Nine Months EndedSeptember 30,
                  
                  
                  September 30,2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Ceded
      earned premiums
                  
                  $
                  9,483
                  
                  
                  $
                  7,137
                  
                  
                  $
                  26,740
                  
                  
                  $
                  12,331Reinsurance
      recoveries
                  
                  $
                  6,247
                  
                  
                  $
                  4,166
                  
                  
                  $
                  16,825
                  
                  
                  $
                  7,388





We
currently reinsure the following exposures on business generated by our Standard
Commercial, E&S Commercial, Excess & Umbrella, Personal Lines 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:




21


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 $30.0 million for each catastrophic occurrence, subject to
      an aggregate limit of $54.0
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.




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




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




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




·
            Excess &
      Umbrella.  Currently, we purchase proportional
      reinsurance where we retain 21% of each risk and cede the remaining 79% to
      reinsurers.  In states where we are not yet licensed to offer a
      non-admitted product, we utilize a fronting arrangement pursuant to which
      we assume all of the risk and then retrocede a portion of that risk under
      the same proportional reinsurance treaty.  Through June 30, 2009, our
      Excess & Umbrella business unit wrote policies pursuant to a general
      agency agreement with an unaffiliated carrier and we assumed 35% of
      the risk from that carrier.





·
            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.


22





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 September 30, 2010, the balance on the
revolving note was $2.8 million, which currently bears interest at 2.79% 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 September 30,
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 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 September 30, 2010, the balance of our Trust II subordinated
debt was $25.8 million.





12.
Credit Facilities





Our First Restated Credit Agreement
with The Frost National Bank dated January 27, 2006 was most recently amended
effective May 27, 2010 to extend the term of the facility until May 27, 2012,
provide for the repayment of all amounts outstanding at termination on or before
April 30, 2015, reduce the revolving commitment to $5.0 million from $25.0
million and eliminate the credit sub-facility for premium finance operations.
This amendment further revised various affirmative and negative covenants and
changed the interest rate, at our election, to either the prime rate or LIBOR
plus 2.5%. We pay an annual average fee of 0.25% of the average daily unused
balance of the credit facility. We pay letter of credit fees at the rate of
1.00% per annum.  Our obligations under the revolving credit facility
are secured by a security interest in the capital stock of all of our
subsidiaries, guarantees of all of our subsidiaries and the pledge of all of our
non-insurance company assets.  The revolving credit facility contains
covenants that, among other things, require us to maintain certain financial and
operating ratios and restrict certain distributions, transactions and
organizational changes.  As of September 30, 2010, we were in
compliance with or had obtained waivers of all of our covenants.  As
of September 30, 2010, we had $2.8 million outstanding under this
facility.


23




13.
Deferred Policy Acquisition Costs





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





Three
      Months Ended
                  
                  
                  Nine
      Months EndedSeptember 30,
                  
                  
                  September 30,2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Deferred
                  
                  $
                  (10,725
                  )
                  
                  $
                  (7,454
                  )
                  
                  $
                  (38,422
                  )
                  
                  $
                  (38,539
                  )Amortized
                  
                  
                  10,280
                  
                  
                  
                  8,257
                  
                  
                  
                  36,033
                  
                  
                  
                  35,434Net
                  
                  $
                  (445
                  )
                  
                  $
                  803
                  
                  
                  $
                  (2,389
                  )
                  
                  $
                  (3,105
                  )





14.
Earnings per Share





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





Three
      Months Ended
                  
                  
                  Nine
      Months EndedSeptember 30,
                  
                  
                  September 30,2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Weighted
      average shares - basic
                  
                  
                  20,124
                  
                  
                  
                  20,652
                  
                  
                  
                  20,122
                  
                  
                  
                  20,790Effect
      of dilutive securities
                  
                  
                  62
                  
                  
                  
                  14
                  
                  
                  
                  56
                  
                  
                  
                  32Weighted
      average shares - assuming dilution
                  
                  
                  20,186
                  
                  
                  
                  20,666
                  
                  
                  
                  20,178
                  
                  
                  
                  20,822





For the three months and nine months
ended September 30, 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.


24


15.
Net Periodic Pension Cost





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





Three
      Months Ended
                        
                        
                        Nine
      Months EndedSeptember 30,
                        
                        
                        September 30,2010
                        
                        
                        2009
                        
                        
                        2010
                        
                        
                        2009Interest
      cost
                        
                        $
                        163
                        
                        
                        $
                        160
                        
                        
                        $
                        488
                        
                        
                        $
                        482Amortization
      of net loss
                        
                        
                        56
                        
                        
                        
                        122
                        
                        
                        
                        168
                        
                        
                        
                        366Expected
      return on plan assets
                        
                        
                        (136
                        )
                        
                        
                        (121
                        )
                        
                        
                        (409
                        )
                        
                        
                        (363
                        )Net
      periodic pension cost
                        
                        $
                        83
                        
                        
                        $
                        161
                        
                        
                        $
                        247
                        
                        
                        $
                        485





We contributed $246 thousand and $340
thousand to our frozen defined benefit cash balance plan (“Cash Balance Plan”)
during the three months and nine months ended September 30, 2010,
respectively.  We did not make any contributions to the Cash Balance
Plan during the three months and nine months ended September 30,
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 nine months ended September 30, 2010 was
23.5%, which varied from the statutory income tax rate utilized primarily due to
an increase in the proportion of tax exempt income relative to total pre-tax
income and the recognition of a tax benefit related to the disposal of certain
securities.  Our effective income tax rate for the nine months ended
September 30, 2009 was 27.4%, 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.





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.




On August
9, 2010 we announced the execution of an agreement for our wholly-owned
subsidiary, HIC, to acquire State Auto National Insurance Company (“SAN”) from
State Auto Financial Corporation.  SAN is an Ohio domiciled insurance
company which writes  non-standard personal automobile policies through
independent agents in 21 states.  Closing of the acquisition is subject to
regulatory approval and other customary closing conditions.




The
purchase price for the acquisition will be $14.0 million cash at closing plus an
earn-out of up to $2.0 million.  We expect to fund the acquisition out of
working capital.  The cash portion of the purchase price is subject to
post-closing adjustment to the extent the statutory capital and surplus of SAN
is greater or less than $10.0 million.  The earn-out is payable quarterly
in an amount equal to 2% of gross collected premiums on new or renewal personal
lines insurance policies written by SAN agents during the three years following
closing.  In connection with the closing, SAN will enter into reinsurance
agreements with an affiliate of the seller pursuant to which the affiliate will
handle all claims and assume all liabilities arising under policies issued by
SAN prior to the closing and during a transition period of up to six months
following the closing.




25





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.


26


·
            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
      commercial and 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.Duringthe three and nine
months ended September 30, 2010, our total revenues were $76.2 million and
$227.7 million, representing a 6% and 7% increase, respectively, from the $71.9
million and $213.6 million in total revenues for the same periods of 2009. 
The increase in revenue for the three months ended September 30, 2010 was
primarily attributable to increased production in our Personal Segment due to
geographic expansion.  The increase in revenue for the nine months
ended September 30, 2010 was primarily attributable to increased production in
our Personal Segment due to geographic expansion, increased retention of
business in our E&S Commercial business unit, increased earned premium in
our Excess & Umbrella business unit 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 income attributable to Hallmark of $1.0 million and $6.9 million
for the three and nine months ended September 30, 2010, respectively, which was
$3.2 million and $8.4 million lower than the $4.2 million and $15.3 million net
income attributable to Hallmark reported for the same periods of 2009.  On
a diluted basis per share, net income was $0.05 and $0.34 per share for the
three and nine months ended September 30, 2010, respectively, as compared to net
income of $0.20 and $0.73 per share for the same periods in
2009.    The decrease in net income for the three and nine
months ending September 30, 2010 was primarily due to increased loss and loss
adjustment expenses (“LAE”) due to higher current accident year loss estimates,
as well as unfavorable prior year loss development of $0.5 million and $7.0
million recognized during the three and nine months ended September 30, 2010,
respectively, as compared to $1.7 million and $3.5 million unfavorable
development recognized for the three and nine months ended September 30,
2009.  Partially offsetting the increased loss and LAE was the
increase in revenue for the three and nine months ending September 30, 2010, as
well as lower operating expenses due to lower production related expenses in our
Standard Commercial, E&S Commercial  and  General
Aviation business units and lower general and administrative costs in our
Standard Commercial Segment as a result of ongoing cost reduction
initiatives.  The Company’s effective income tax rate for the nine
months ending September 30, 2010 was 23.5% as compared to the 27.4% effective
income tax rate for the same period during 2009.  The decrease in the
effective tax rate was primarily due to an increase in the proportion of tax
exempt income relative to total pre-tax income and the recognition of a tax
benefit related to the disposal of certain securities.


27


Third
Quarter 2010 as Compared to Third Quarter 2009





The
following is additional business segment information for the three months ended
September 30, 2010 and 2009 (in thousands):





Hallmark
Financial Services, Inc.


Consolidated
Segment Data





Three
      Months Ended September 30, 2010Standard
                                    
                                    
                                    SpecialtyCommercial
                                    
                                    
                                    Commercial
                                    
                                    
                                    PersonalSegment
                                    
                                    
                                    Segment
                                    
                                    
                                    Segment
                                    
                                    
                                    Corporate
                                    
                                    
                                    ConsolidatedProduced
      premium (1)
                                    
                                    $
                                    15,586
                                    
                                    
                                    $
                                    39,653
                                    
                                    
                                    $
                                    25,188
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    80,427Gross
      premiums written
                                    
                                    
                                    15,586
                                    
                                    
                                    
                                    41,425
                                    
                                    
                                    
                                    25,188
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    82,199Ceded
      premiums written
                                    
                                    
                                    (1,147
                                    )
                                    
                                    
                                    (8,915
                                    )
                                    
                                    
                                    (90
                                    )
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (10,152
                                    )Net
      premiums written
                                    
                                    
                                    14,439
                                    
                                    
                                    
                                    32,510
                                    
                                    
                                    
                                    25,098
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    72,047Change
      in unearned premiums
                                    
                                    
                                    1,626
                                    
                                    
                                    
                                    (1,368
                                    )
                                    
                                    
                                    (1,899
                                    )
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (1,641
                                    )Net
      premiums earned
                                    
                                    
                                    16,065
                                    
                                    
                                    
                                    31,142
                                    
                                    
                                    
                                    23,199
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    70,406Total
      revenues
                                    
                                    
                                    17,211
                                    
                                    
                                    
                                    32,892
                                    
                                    
                                    
                                    25,418
                                    
                                    
                                    
                                    696
                                    
                                    
                                    
                                    76,217Losses
      and loss adjustment expenses
                                    
                                    
                                    12,183
                                    
                                    
                                    
                                    20,788
                                    
                                    
                                    
                                    18,322
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    51,293Pre-tax  income
      (loss), net ofnon-controlling
      interest
                                    
                                    
                                    (234
                                    )
                                    
                                    
                                    2,515
                                    
                                    
                                    
                                    743
                                    
                                    
                                    
                                    (1,803
                                    )
                                    
                                    
                                    1,221Net
      loss ratio (2)
                                    
                                    
                                    75.8
                                    %
                                    
                                    
                                    66.8
                                    %
                                    
                                    
                                    79.0
                                    %
                                    
                                    
                                    
                                    
                                    
                                    
                                    72.9
                                    %Net
      expense ratio (2)
                                    
                                    
                                    32.2
                                    %
                                    
                                    
                                    30.1
                                    %
                                    
                                    
                                    21.0
                                    %
                                    
                                    
                                    
                                    
                                    
                                    
                                    29.4
                                    %Net
      combined ratio (2)
                                    
                                    
                                    108.0
                                    %
                                    
                                    
                                    96.9
                                    %
                                    
                                    
                                    100.0
                                    %
                                    
                                    
                                    
                                    
                                    
                                    
                                    102.3
                                    %Three
      Months Ended September 30, 2009Standard
                                    
                                    
                                    SpecialtyCommercial
                                    
                                    
                                    Commercial
                                    
                                    
                                    PersonalSegment
                                    
                                    
                                    Segment
                                    
                                    
                                    Segment
                                    
                                    
                                    Corporate
                                    
                                    
                                    ConsolidatedProduced
      premium (1)
                                    
                                    $
                                    17,309
                                    
                                    
                                    $
                                    36,064
                                    
                                    
                                    $
                                    17,424
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    70,797Gross
      premiums written
                                    
                                    
                                    17,309
                                    
                                    
                                    
                                    39,280
                                    
                                    
                                    
                                    17,424
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    74,013Ceded
      premiums written
                                    
                                    
                                    (1,144
                                    )
                                    
                                    
                                    (10,078
                                    )
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (11,222
                                    )Net
      premiums written
                                    
                                    
                                    16,165
                                    
                                    
                                    
                                    29,202
                                    
                                    
                                    
                                    17,424
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    62,791Change
      in unearned premiums
                                    
                                    
                                    1,627
                                    
                                    
                                    
                                    92
                                    
                                    
                                    
                                    (272
                                    )
                                    
                                    
                                    -
                                    
                                    
                                    
                                    1,447Net
      premiums earned
                                    
                                    
                                    17,792
                                    
                                    
                                    
                                    29,294
                                    
                                    
                                    
                                    17,152
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    64,238Total
      revenues
                                    
                                    
                                    19,569
                                    
                                    
                                    
                                    32,346
                                    
                                    
                                    
                                    18,735
                                    
                                    
                                    
                                    1,253
                                    
                                    
                                    
                                    71,903Losses
      and loss adjustment expenses
                                    
                                    
                                    11,425
                                    
                                    
                                    
                                    17,641
                                    
                                    
                                    
                                    11,513
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    40,579Pre-tax  income
      (loss), net ofnon-controlling
      interest
                                    
                                    
                                    2,164
                                    
                                    
                                    
                                    3,588
                                    
                                    
                                    
                                    2,225
                                    
                                    
                                    
                                    (2,178
                                    )
                                    
                                    
                                    5,799Net
      loss ratio (2)
                                    
                                    
                                    64.2
                                    %
                                    
                                    
                                    60.2
                                    %
                                    
                                    
                                    67.1
                                    %
                                    
                                    
                                    
                                    
                                    
                                    
                                    63.2
                                    %Net
      expense ratio (2)
                                    
                                    
                                    32.8
                                    %
                                    
                                    
                                    29.8
                                    %
                                    
                                    
                                    22.4
                                    %
                                    
                                    
                                    
                                    
                                    
                                    
                                    31.0
                                    %Net
      combined ratio (2)
                                    
                                    
                                    97.0
                                    %
                                    
                                    
                                    90.0
                                    %
                                    
                                    
                                    89.5
                                    %
                                    
                                    
                                    
                                    
                                    
                                    
                                    94.2
                                    %





(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.  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.


28


Standard
Commercial Segment





Gross
premiums written for the Standard Commercial Segment were $15.6 million for the
three months ended September 30, 2010, which was $1.7 million, or 10%, less than
the $17.3 million reported for the same period in 2009.  Net premiums
written were $14.4 million for the three months ended September 30, 2010 as
compared to $16.2 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 $17.2 million for the three
months ended September 30, 2010 was $2.4 million less than the $19.6 million
reported during the same period in 2009.  This 12% decrease in total
revenue was mostly due to decreased net premiums earned of $1.7 million and
reduced profit sharing commissions of $0.7 million related to unfavorable loss
development on prior treaty years.





Our
Standard Commercial Segment reported a pre-tax loss of $0.2 million for the
three months ended September 30, 2010 as compared to pre-tax income of $2.2
million for the same period of 2009. Higher loss and LAE of $0.8 million,
primarily as a result of weather related losses and unfavorable prior year
development, and decreased revenue were the primary drivers of the pre-tax loss
for the three months ended September 30, 2010. Partially offsetting the decline
in pre-tax results were lower operating expenses of $0.7 million driven by lower
general and administrative costs and lower production related
expenses.





The
Standard Commercial Segment reported a net loss ratio of 75.8% for the three
months ended September 30, 2010 as compared to 64.2% for 2009. The gross loss
ratio before reinsurance for the three months ended September 30, 2010 was 80.1%
as compared to the 66.2% reported for the same period of 2009.  The
higher gross and net loss ratio for the three months ended September 30, 2010
was driven by development of weather related losses. The loss and LAE during the
three months ended September 30, 2010 for the Standard Commercial Segment
included unfavorable loss reserve development of $0.8 million as compared to
unfavorable development of $0.4 million for the same period in
2009.





Specialty
Commercial Segment





The $32.9 million of total
revenue for the Specialty Commercial Segment during the three months ended
September 30, 2010 was $0.6 million higher than the $32.3 million reported for
the same period in 2009. This increase in revenue was primarily comprised of
higher earned premiums of $1.8 million as a result of the increased earned
premium in our E&S Commercial business unit as well as increased net
investment income of $0.5 million. These increases in revenues were partially
offset by lower commission and fee income of $1.7 million primarily related to
the shift from a third party agency structure to an insurance underwriting
structure.





Pre-tax income for the Specialty
Commercial Segment of $2.5 million for the third quarter of 2010 was $1.1
million lower than the $3.6 million reported for the same period in
2009.  The decrease in pre-tax income was primarily due to higher loss
and LAE expenses of $3.1 million primarily as a result of higher current
accident year loss estimates.  This increase in loss and LAE was
partially offset by lower operating expenses of $1.7 million.  The
decrease in operating expense was the combined result of (i) lower production
related expenses of $1.9 million due primarily to lower fronting fees in our
E&S Commercial business unit as we began direct writing this business during
2009 and to increased quota share ceding commissions in our Excess &
Umbrella business unit due to increased ceded premiums, (ii) lower salary and
related expenses of $0.1 million, partially offset by (iii) increased other
operating expenses of $0.3 million, primarily increased professional
fees.  In addition increased amortization of intangible assets of $0.2
million related to our acquisition of CYR on June 5, 2009 further contributed to
the decrease in pre-tax income.


29


The Specialty Commercial Segment
reported a net loss ratio of 66.8% for the three months ended September 30, 2010
as compared to 60.2% for the same period during 2009. The gross loss ratio
before reinsurance was 64.6% for the three months ended September 30, 2010 as
compared to 59.6% for the same period during 2009. The higher gross and net loss
ratio was impacted by increased volatility in large general liability,
commercial automobile and aircraft hull losses in the current accident year.
During the three months ended September 30, 2010 the Specialty Commercial
Segment reported $0.8 million of favorable prior year loss development as
compared to $1.2 million of unfavorable prior loss development for the same
period during 2009.





Personal
Segment





Net premiums written for our Personal
Segment increased $7.7 million during the third quarter of 2010 to $25.1 million
as compared to $17.4 million for the third quarter of 2009.  The
increase in premium was due mostly to continued geographic
expansion.





Total revenue for the Personal
Segment increased 36% to $25.4 million for the third quarter of 2010 from $18.7
million for the third quarter of 2009.  Higher earned premium of $6.0
million was the primary reason for the increase in revenue for the
period.  Increased finance charges and net investment income of $0.4
million and $0.3 million, respectively, further contributed to the increase in
revenue during the third quarter of 2010.





Pre-tax income for the Personal
Segment was $0.7 million for the three months ended September 30, 2010 as
compared to $2.2 million for the same period of 2009.  Increased
revenue was offset by increased losses and LAE of $6.8 million and increased
operating expenses of $1.3 million due primarily to increased production related
expenses and salary and related expenses due to continued geographic
expansion.





The Personal Segment reported a net
loss ratio of 79.0% for the three months ended September 30, 2010 as compared to
67.1% for the third quarter of 2009.  The increase in the net loss
ratio was due primarily to continued geographic expansion as the resulting
growth has created a larger portion of new and maturing business as compared to
our mature legacy business.  Our current accident year loss ratio
reflects the near term loss ratio penalty associated with this change in mix of
seasoned versus less seasoned business.  During the three months ended
September 30, 2010, the Personal Segment reported $0.5 million of unfavorable
prior loss development as compared to $0.1 million unfavorable prior year
development reported for the same period in 2009.





Corporate





Total revenue for Corporate decreased
by $0.6 million for the three months ended September 30, 2010 as compared to the
same period the prior year.  This decrease in total revenue was due
primarily to gains of $0.3 million recognized on our investment portfolio for
the three months ended September 30, 2010 as compared to gains of $0.6 million
recognized during the same period in 2009.  Further contributing to
this decrease in revenue was lower net investment income of $0.3 million for the
three months ended September 30, 2010 as compared to the same period of the
prior year.


30


Corporate pre-tax loss was $1.8
million for the three months ended September 30, 2010 as compared to a $2.2
million pre-tax loss for the same period the prior year.  The decrease
in pre-tax loss was the result of a $0.7 million reduction in operating expenses
during the third quarter of 2010 as compared to the same period during
2009.   The operating expense reduction for the quarter came
primarily from lower professional fees of $0.4 million, lower expense related to
stock options granted to employees and directors of $0.3 million, lower salary
and related expenses of $0.2 million and lower travel expenses of $0.1
million.  These decreases in operating expenses were partially offset
by a $0.4 million recovery of advances for a cancelled start-up program during
the third quarter of 2009. In addition further contributing to the lower
expenses during the third quarter of 2010 as compared to the same period during
2009 was decreased amortization of intangible assets of $0.2 million. Decreased
revenue discussed above partially offset the decreased operating
expenses.


31


Nine
Months Ended September 30, 2010 as Compared to Nine Months Ended September 30,
2009





The
following is additional business segment information for the nine months ended
September 30, 2010 and 2009 (in thousands):





Hallmark
Financial Services, Inc.


Consolidated
Segment Data





Nine
      Months Ended September 30, 2010Standard
                                    
                                    
                                    SpecialtyCommercial
                                    
                                    
                                    Commercial
                                    
                                    
                                    PersonalSegment
                                    
                                    
                                    Segment
                                    
                                    
                                    Segment
                                    
                                    
                                    Corporate
                                    
                                    
                                    ConsolidatedProduced
      premium (1)
                                    
                                    $
                                    52,487
                                    
                                    
                                    $
                                    115,286
                                    
                                    
                                    $
                                    74,932
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    242,705Gross
      premiums written
                                    
                                    
                                    52,475
                                    
                                    
                                    
                                    119,831
                                    
                                    
                                    
                                    74,932
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    247,238Ceded
      premiums written
                                    
                                    
                                    (3,092
                                    )
                                    
                                    
                                    (26,062
                                    )
                                    
                                    
                                    (109
                                    )
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (29,263
                                    )Net
      premiums written
                                    
                                    
                                    49,383
                                    
                                    
                                    
                                    93,769
                                    
                                    
                                    
                                    74,823
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    217,975Change
      in unearned premiums
                                    
                                    
                                    200
                                    
                                    
                                    
                                    (1,288
                                    )
                                    
                                    
                                    (9,518
                                    )
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (10,606
                                    )Net
      premiums earned
                                    
                                    
                                    49,583
                                    
                                    
                                    
                                    92,481
                                    
                                    
                                    
                                    65,305
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    207,369Total
      revenues
                                    
                                    
                                    52,510
                                    
                                    
                                    
                                    97,503
                                    
                                    
                                    
                                    71,386
                                    
                                    
                                    
                                    6,328
                                    
                                    
                                    
                                    227,727Losses
      and loss adjustment expenses
                                    
                                    
                                    39,451
                                    
                                    
                                    
                                    58,415
                                    
                                    
                                    
                                    48,583
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    146,449Pre-tax  income
      (loss), net ofnon-controlling
      interest
                                    
                                    
                                    (3,043
                                    )
                                    
                                    
                                    9,829
                                    
                                    
                                    
                                    4,525
                                    
                                    
                                    
                                    (2,255
                                    )
                                    
                                    
                                    9,056Net
      loss ratio (2)
                                    
                                    
                                    79.6
                                    %
                                    
                                    
                                    63.2
                                    %
                                    
                                    
                                    74.4
                                    %
                                    
                                    
                                    
                                    
                                    
                                    
                                    70.6
                                    %Net
      expense ratio (2)
                                    
                                    
                                    31.9
                                    %
                                    
                                    
                                    29.2
                                    %
                                    
                                    
                                    21.7
                                    %
                                    
                                    
                                    
                                    
                                    
                                    
                                    29.5
                                    %Net
      combined ratio (2)
                                    
                                    
                                    111.5
                                    %
                                    
                                    
                                    92.4
                                    %
                                    
                                    
                                    96.1
                                    %
                                    
                                    
                                    
                                    
                                    
                                    
                                    100.1
                                    %Nine
      Months Ended September 30, 2009Standard
                                    
                                    
                                    SpecialtyCommercial
                                    
                                    
                                    Commercial
                                    
                                    
                                    PersonalSegment
                                    
                                    
                                    Segment
                                    
                                    
                                    Segment
                                    
                                    
                                    Corporate
                                    
                                    
                                    ConsolidatedProduced
      premium (1)
                                    
                                    $
                                    56,881
                                    
                                    
                                    $
                                    110,598
                                    
                                    
                                    $
                                    54,968
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    222,447Gross
      premiums written
                                    
                                    
                                    56,881
                                    
                                    
                                    
                                    108,696
                                    
                                    
                                    
                                    54,968
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    220,545Ceded
      premiums written
                                    
                                    
                                    (3,331
                                    )
                                    
                                    
                                    (13,383
                                    )
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (16,714
                                    )Net
      premiums written
                                    
                                    
                                    53,550
                                    
                                    
                                    
                                    95,313
                                    
                                    
                                    
                                    54,968
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    203,831Change
      in unearned premiums
                                    
                                    
                                    419
                                    
                                    
                                    
                                    (13,692
                                    )
                                    
                                    
                                    (4,571
                                    )
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (17,844
                                    )Net
      premiums earned
                                    
                                    
                                    53,969
                                    
                                    
                                    
                                    81,621
                                    
                                    
                                    
                                    50,397
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    185,987Total
      revenues
                                    
                                    
                                    57,783
                                    
                                    
                                    
                                    97,601
                                    
                                    
                                    
                                    54,971
                                    
                                    
                                    
                                    3,202
                                    
                                    
                                    
                                    213,557Losses
      and loss adjustment expenses
                                    
                                    
                                    33,890
                                    
                                    
                                    
                                    48,422
                                    
                                    
                                    
                                    33,240
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    115,552Pre-tax  income
      (loss), net ofnon-controlling
      interest
                                    
                                    
                                    5,987
                                    
                                    
                                    
                                    14,280
                                    
                                    
                                    
                                    7,738
                                    
                                    
                                    
                                    (6,960
                                    )
                                    
                                    
                                    21,045Net
      loss ratio (2)
                                    
                                    
                                    62.8
                                    %
                                    
                                    
                                    59.3
                                    %
                                    
                                    
                                    66.0
                                    %
                                    
                                    
                                    
                                    
                                    
                                    
                                    62.1
                                    %Net
      expense ratio (2)
                                    
                                    
                                    32.4
                                    %
                                    
                                    
                                    30.0
                                    %
                                    
                                    
                                    21.4
                                    %
                                    
                                    
                                    
                                    
                                    
                                    
                                    30.8
                                    %Net
      combined ratio (2)
                                    
                                    
                                    95.2
                                    %
                                    
                                    
                                    89.3
                                    %
                                    
                                    
                                    87.4
                                    %
                                    
                                    
                                    
                                    
                                    
                                    
                                    92.9
                                    %





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


32


Standard
Commercial Segment





Gross
premiums written for the Standard Commercial Segment were $52.5 million for the
nine months ended September 30, 2010, which was $4.4 million, or 8%, less than
the $56.9 million reported for the same period in 2009.  Net premiums
written were $49.4 million for the nine months ended September 30, 2010 as
compared to $53.6 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 $52.5 million for the nine months
ended September 30, 2010 was $5.3 million less than the $57.8 million reported
during the same period in 2009.  This 9% decrease in total revenue was
primarily due to lower net premiums earned of $4.4 million, decreased profit
sharing commission of $0.5 million related to unfavorable loss development on
prior treaty years and lower net investment income of $0.4 million.





Our
Standard Commercial Segment reported a pre-tax loss of $3.0 million for the nine
months ended September 30, 2010 as compared to pre-tax income of $6.0 million
for the same period of 2009. Higher loss and LAE of $5.6 million, primarily as a
result of weather related losses and unfavorable prior year development, and
decreased revenue contributed to this pre-tax loss reported for the nine months
ended September 30, 2010. Partially offsetting the decline in results were lower
operating expenses of $1.8 million driven by lower general and administrative
costs and lower production related expenses.





The
Standard Commercial Segment reported a net loss ratio of 79.6% for the nine
months ended September 30, 2010 as compared to 62.8% for 2009. The gross loss
ratio before reinsurance for the nine months ended September 30, 2010 was 83.2%
as compared to the 62.7% reported for the same period of 2009.  The
higher gross and net loss ratio for the nine months ended September 30, 2010 was
impacted by an increased number of large property losses, including weather
related losses.  Further contributing to the higher gross and net loss
ratio during the nine months ended September 30, 2010 was unfavorable loss
reserve development of $4.1 million, as compared to favorable development of
$0.2 million for the same period during 2009.





Specialty
Commercial Segment





The $97.5 million of total
revenue for the Specialty Commercial Segment during the nine months ended
September 30, 2010 was $0.1 million lower than the $97.6 million reported for
the same period in 2009. This decrease in revenue was primarily comprised of
lower commission and fee income of $11.6 million primarily related to the shift
from a third party agency structure to an insurance underwriting structure.
Decreased finance charges of $0.2 million further contributed to this decrease
in revenue. This decrease in revenue was partially offset by increased net
premiums earned of $10.9 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 and increased net investment income of
$0.9 million.


33


Pre-tax income for the Specialty
Commercial Segment of $9.8 million for the first nine months of 2010 was $4.5
million lower than the $14.3 million reported for the same period in
2009.  The decrease in pre-tax income was primarily due to decreased
revenue and higher loss and LAE expenses of $10.0 million.  The
decrease in pre-tax income was partially offset by lower operating expenses of
$6.1 million.  The decrease in operating expense was the combined
result of (i)lower production related expenses of $6.2 million due primarily to
lower commission expense and fronting fees in our E&S Commercial business
unit as we began direct writing and retaining 100% of this business during 2009,
and to increased quota share ceding commissions in our Excess & Umbrella
business unit due to increased ceded premiums, (ii) lower salary and related
expenses of $0.3 million, partially offset by (iii) increased other operating
expenses of $0.4 million, primarily due to increased professional fees. In
addition increased amortization of intangible assets of $0.5 million related to
our acquisition of CYR on June 5, 2009 further contributed to the decrease in
pre-tax income.





The Specialty Commercial Segment
reported a net loss ratio of 63.2% for the nine months ended September 30, 2010
as compared to 59.3% for the same period during 2009.  The higher net
loss ratio was impacted by (i) late emerging general liability claims and (ii)
increased volatility in large general liability claims, aircraft hull losses and
commercial automobile claims (partially weather related) in the current accident
year. The Specialty Commercial Segment reported $1.7 million of unfavorable
prior year development for the nine months ended September 30, 2010 as compared
to $3.9 million of unfavorable development for the same period during
2009.




Personal
Segment





Net premiums written for our Personal
Segment increased $19.8 million during the first nine months of 2010 to $74.8
million as compared to $55.0 million for the first nine months of
2009.  The increase in premium was due mostly to continued geographic
expansion.





Total revenue for the Personal
Segment increased 30% to $71.4 million for the first nine months of 2010 from
$55.0 million for the first nine months of 2009.  Higher earned
premium of $14.9 million was the primary reason for the increase in revenue for
the period.  Increased finance charges of $1.2 million and net
investment income of $0.3 million further contributed to the increase in revenue
during the first nine months of 2010.





Pre-tax income for the Personal
Segment was $4.5 million for the nine months ended September 30, 2010 as
compared to $7.7 million for the same period of 2009.  Increased
revenue was offset by increased losses and LAE of $15.3 million and increased
operating expenses of $4.2 million due mostly to increased production and salary
expense related to continued geographic expansion.





The Personal Segment reported a net
loss ratio of 74.4% for the nine months ended September 30, 2010 as compared to
66.0% for the same period of 2009.  The increase in the net loss ratio
was due primarily to continued geographic expansion as the resulting growth has
created a larger portion of new and maturing business as compared to our mature
legacy business.  Our current accident year loss ratio reflects the
near term loss ratio penalty associated with this change in mix of seasoned
versus less seasoned business.  During the nine months ended September
30, 2010, the Personal Segment reported $1.2 million of unfavorable prior loss
development driven in large part by legal expense related to a 2001 bad faith
claim as compared to $0.2 million favorable prior year development reported for
the same period in 2009.





Corporate





Total revenue for Corporate increased
by $3.1 million for the nine months ended September 30, 2010 as compared to the
same period the prior year.  This increase in total revenue was due
primarily to gains of $5.8 million recognized on our investment portfolio for
the nine months ended September 30, 2010 as compared to $1.1 million of gains
recognized during the same period in 2009.  This increase in revenue
was offset by lower net investment income of $1.5 million for the nine months
ended September 30, 2010 as compared to the same period of the prior
year.


34


Corporate pre-tax loss was $2.3
million for the nine months ended September 30, 2010 as compared to a $7.0
million pre-tax loss for the same period the prior year.  The decrease
in pre-tax loss was the result of increased revenue, as well as a $1.4 million
reduction in operating expenses.  The reduction in operating expenses
during the nine months ended September 30, 2010 as compared to the same period
in the prior year came primarily from lower expense related to stock options
granted to employees and directors of $0.6 million, lower professional fees of
$0.5 million and lower salary and related expenses of $0.3
million.  In addition further contributing to the lower expenses was
decreased amortization of intangible assets of $0.2 million.





Financial
Condition and Liquidity





Sources
and Uses of Funds





Our
sources of funds are from insurance-related operations, financing activities and
investing activities.  Major sources of funds from operations include
premiums collected (net of policy cancellations and premiums ceded),
commissions, and processing and service fees.  As a holding company,
Hallmark is dependent on dividend payments and management fees from its
subsidiaries to meet operating expenses and debt obligations.  As of
September 30, 2010, Hallmark had $12.9 million in unrestricted cash and invested
assets at the holding company. Unrestricted cash and invested assets of our
non-insurance subsidiaries were $4.0 million as of September 30,
2010.  As of that date, our insurance subsidiaries held $65.1 million
of cash and cash equivalents as well as $360.2 million in debt securities with
an average modified duration of 2.7 years.  Accordingly, we do not
anticipate selling long-term debt instruments to meet any liquidity
needs.





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 nine months of 2010 or
the 2009 fiscal year.





Comparison of September 30, 2010 to
December 31, 2009





On a
consolidated basis, our cash and investments (excluding restricted cash) at
September 30, 2010 were $486.2 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.


35


Comparison of Nine Months Ended
September 30, 2010 and September 30, 2009





Net cash
provided by our consolidated operating activities was $28.9 million for the
first nine months of 2010 compared to $45.7 million for the first nine months of
2009.  The decrease in operating cash flow was primarily due to higher
paid losses and lower collected ceding commissions, partially offset by more
collected premiums.





Net cash used in investing activities
during the first nine months of 2010 was $59.1 million as compared to $13.8
million for the same period in 2009.  Contributing to the increase in
cash used in investing activities were an increase of $82.9 million in purchases
of debt and equity securities, partially offset by a $34.6 million increase in
maturities, sales and redemptions of investment securities during
2010.





Cash used in financing activities
during the first nine months of 2010 was $0.1 million as compared to $6.6
million for the same period of 2009.  The cash used during the first
nine months of 2009 was primarily for the payment of a note payable by our
premium finance operation and for the repurchase of the Company’s common
stock.





Credit
Facilities





Our
First Restated Credit Agreement with The Frost National Bank was most recently
amended effective May 27, 2010 to extend the term of the facility until May 27,
2012, provide for the repayment of all amounts outstanding at termination on or
before April 30, 2015, reduce the revolving commitment to $5.0 million from
$25.0 million and eliminate the credit sub-facility for premium finance
operations. This amendment further revised various affirmative and negative
covenants and changed the interest rate, at our election, to either the prime
rate or LIBOR plus 2.5%. We pay an annual average fee of 0.25% of the average
daily unused balance of the credit facility. We pay letter of credit fees at the
rate of 1.00% per annum.  Our obligations under the revolving credit
facility are secured by a security interest in the capital stock of all of our
subsidiaries, guarantees of all of our subsidiaries and the pledge of all of our
non-insurance company assets.  The revolving credit facility contains
covenants that, among other things, require us to maintain certain financial and
operating ratios and restrict certain distributions, transactions and
organizational changes.  As of September 30, 2010, we were in
compliance with or had obtained waivers of all of our covenants.  As
of September 30, 2010, we had $2.8 million outstanding under this
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 September 30,
2010, the balance of our Trust I subordinated debt was $30.9
million.


36


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 September 30,
2010, the balance of our Trust II subordinated debt was $25.8
million.





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
4.  Controls and Procedures.





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





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.


37


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).


38





Exhibit
                Number
              
              Description4(b)
              
              Indenture
      dated as of June 21, 2005, between Hallmark Financial Services, Inc. and
      JPMorgan Chase Bank, National Association (incorporated by reference to
      Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed June 27,
      2005).4(c)
              
              Amended
      and Restated Declaration of Trust of Hallmark Statutory Trust I dated as
      of June 21, 2005, among Hallmark Financial Services, Inc., as sponsor,
      Chase Bank USA, National Association, as Delaware trustee, and JPMorgan
      Chase Bank, National Association, as institutional trustee, and Mark
      Schwarz and Mark Morrison, as administrators (incorporated by reference to
      Exhibit 4.2 to the registrant’s Current Report on Form 8-K filed June 27,
      2005).4(d)
              
              Form
      of Junior Subordinated Debt Security Due 2035 (incorporated by reference
      to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed June
      27, 2005).4(e)
              
              Form
      of Capital Security Certificate (incorporated by reference to Exhibit 4.2
      to the registrant’s Current Report on Form 8-K filed June 27,
      2005).4(f)
              
              First
      Restated Credit Agreement dated January 27, 2006, between Hallmark
      Financial Services, Inc. and The Frost National Bank (incorporated by
      reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K
      filed February 2, 2006).4(g)
              
              Form
      of Registration Rights Agreement dated January 27, 2006, between Hallmark
      Financial Services, Inc. and Newcastle Special Opportunity Fund I, L.P.
      and Newcastle Special Opportunity Fund II, L.P. (incorporated by reference
      to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed
      February 2, 2006).4(h)
              
              Indenture
      dated as of August 23, 2007, between Hallmark Financial Services, Inc. and
      The Bank of New York Trust Company, National Association (incorporated by
      reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K
      filed August 24, 2007).4(i)
              
              Amended
      and Restated Declaration of Trust of Hallmark Statutory Trust II dated as
      of August 23, 2007, among Hallmark Financial Services, Inc., as sponsor,
      The Bank of New York (Delaware), as Delaware trustee, and The Bank of New
      York Trust Company, National Association, as institutional trustee, and
      Mark Schwarz and Mark Morrison, as administrators (incorporated by
      reference to Exhibit 4.2 to the registrant’s Current Report on Form 8-K
      filed August 24, 2007).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).4(l)
              
              Seventh
      Amendment to First Restated Credit Agreement dated May 27, 2010, between
      Hallmark Financial Services, Inc. and The Frost National Bank
      (incorporated by reference to Exhibit 10.1 to the registrant’s Current
      Report on Form 8-K filed June 17, 2010).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).


39




Exhibit
                Number
              
              Description32(a)
              
              Certification
      of principal executive officer Pursuant to 18 U.S.C.
  1350.32(b)
              
              Certification
      of principal financial officer Pursuant to 18 U.S.C.
  1350.





SIGNATURES





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





HALLMARK
FINANCIAL SERVICES, INC.


(Registrant)





Date:  November
      10, 2010
              
              /s/ Mark J. MorrisonMark
      J. Morrison, Chief Executive Officer and President(Principal
      Executive Officer)Date:  November
      10, 2010
              
              /s/ Jeffrey R. PassmoreJeffrey
      R. Passmore, Chief Accounting Officer andSenior
      Vice President(Principal
      Financial Officer)


40