**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**




**FORM
      10-Q**





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


Securities
      Exchange Act of 1934




For
      the
      quarterly period ended June 30, 2007




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 ofIncorporation or organization)
            
            (I.R.S.
                EmployerIdentification 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
o




Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
      one):


Large
      accelerated filer o   Accelerated
      filer o   Non-accelerated
      filer x




Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act). Yes o 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
      - 20,768,252 shares outstanding as of August 8, 2007.








**PART
      I**


**FINANCIAL
      INFORMATION**





Item
      1.  Financial
      Statements




INDEX
      TO FINANCIAL
      STATEMENTS


Page
                NumberConsolidated
                Balance Sheets at June 30, 2007 (unaudited) and December 31,
                2006
            
            
            3Consolidated
                Statements of Operations (unaudited) for the three months and six
                months
                ended June 30, 2007 and June 30, 2006
            
            
            4Consolidated
                Statements of Stockholders’ Equity and Comprehensive Income (Loss)
                (unaudited) for the three months and six months ended June 30, 2007
                and
                June 30, 2006
            
            
            5Consolidated
                Statements of Cash Flows (unaudited) for the six months ended June
                30,
                2007 and June 30, 2006
            
            
            6Notes
                to Consolidated Financial Statements (unaudited)
            
            
            7





2




**Hallmark
      Financial Services, Inc. and Subsidiaries**


**Consolidated
      Balance Sheets**


($
      in
      thousands)




**June
                30**
            
            
            **December 31****2007**
            
            
            **2006**(unaudited)
            
            
            (audited )ASSETSInvestments:Debt
                securities, available-for-sale, at market value
            
            $
            160,547
            
            $
            133,030Equity
                securities, available-for-sale, at market value
            
            
            30,192
            
            
            4,580Short-term
                investments, available-for-sale, at market value
            
            
            64,086
            
            
            25,275Total
                investments
            
            
            254,825
            
            
            162,885Cash
                and cash equivalents
            
            
            41,792
            
            
            81,474Restricted
                cash and cash equivalents
            
            
            10,042
            
            
            24,569Premiums
                receivable
            
            
            54,569
            
            
            44,644Accounts
                receivable
            
            
            12,441
            
            
            13,223Prepaid
                reinsurance premium
            
            
            1,773
            
            
            1,629Reinsurance
                recoverable
            
            
            6,505
            
            
            5,930Deferred
                policy acquisition costs
            
            
            20,214
            
            
            17,145Excess
                of cost over fair value of net assets acquired
            
            
            31,427
            
            
            31,427Intangible
                assets
            
            
            24,927
            
            
            26,074Prepaid
                expenses
            
            
            1,187
            
            
            1,769Other
                assets
            
            
            10,639
            
            
            5,184Total
                assets
            
            $
            470,341
            
            $
            415,953LIABILITIES
                AND STOCKHOLDERS' EQUITYLiabilities:Notes
                payable
            
            $
            35,130
            
            $
            35,763Structured
                settlements
            
            
            9,794
            
            
            24,587Unpaid
                losses and loss adjustment expenses
            
            
            104,388
            
            
            77,564Unearned
                premiums
            
            
            107,859
            
            
            91,606Unearned
                revenue
            
            
            3,777
            
            
            5,734Reinsurance
                balances payable
            
            
            1,271
            
            
            1,060Accrued
                agent profit sharing
            
            
            1,256
            
            
            1,784Accrued
                ceding commission payable
            
            
            7,059
            
            
            3,956Pension
                liability
            
            
            2,895
            
            
            3,126Deferred
                federal income taxes
            
            
            1,225
            
            
            2,310Current
                federal income tax payable
            
            
            4,652
            
            
            2,132Accounts
                payable and other accrued expenses
            
            
            26,768
            
            
            15,600Total
                liabilities
            
            
            306,074
            
            
            265,222Commitments
                and ContingenciesStockholders'
                equity:Common
                  stock, $.18 par value (authorized 33,333,333 shares in 2007 and
                  2006;
                  issued 20,776,080 shares in 2007 and 2006)
            
            
            3,740
            
            
            3,740Additional
                paid in capital
            
            
            118,085
            
            
            117,932Retained
                earnings
            
            
            45,265
            
            
            31,480Accumulated
                other comprehensive loss
            
            
            (2,746
            )
            
            (2,344
            )Treasury
                stock, at cost (7,828 shares in 2007 and 2006)
            
            
            (77
            )
            
            (77
            )Total
                stockholders' equity
            
            
            164,267
            
            
            150,731$
            470,341
            
            $
            415,953




The
      accompanying notes are an integral part


of
      the
      consolidated financial statements





3




**Hallmark
      Financial Services, Inc. and Subsidiaries** **Consolidated
      Statements of Operations**


(Unaudited)


($
      in
      thousands, except per share amounts)








**Three
                Months Ended**
            
            **Six
                Months Ended****June
                30**
            
            **June
                30****2007**
            
            **2006**
            
            **2007**
            
            **2006**Gross
                premiums written
            
            $
            66,577
            
            $
            47,876
            
            $
            131,235
            
            $
            95,611Ceded
                premiums written
            
            
            (4,281
            )
            
            (2,484
            )
            
            (8,168
            )
            
            (4,440
            )Net
                premiums written
            
            
            62,296
            
            
            45,392
            
            
            123,067
            
            
            91,171Change
                in unearned premiums
            
            
            (6,986
            )
            
            (11,133
            )
            
            (16,109
            )
            
            (28,478
            )Net
                premiums earned
            
            
            55,310
            
            
            34,259
            
            
            106,958
            
            
            62,693Investment
                income, net of expenses
            
            
            3,047
            
            
            2,236
            
            
            6,037
            
            
            4,593Realized
                gain (loss)
            
            
            828
            
            
            (1,283
            )
            
            881
            
            
            (1,366
            )Finance
                charges
            
            
            1,185
            
            
            1,216
            
            
            2,271
            
            
            1,903Commission
                and fees
            
            
            8,159
            
            
            10,016
            
            
            16,064
            
            
            22,280Processing
                and service fees
            
            
            203
            
            
            727
            
            
            475
            
            
            1,584Other
                income
            
            
            4
            
            
            16
            
            
            8
            
            
            20Total
                revenues
            
            
            68,736
            
            
            47,187
            
            
            132,694
            
            
            91,707Losses
                and loss adjustment expenses
            
            
            30,712
            
            
            20,199
            
            
            62,897
            
            
            36,889Other
                operating expenses
            
            
            23,723
            
            
            20,027
            
            
            46,424
            
            
            41,053Interest
                expense
            
            
            796
            
            
            1,662
            
            
            1,582
            
            
            3,247Interest
                expense from amortization of discount on convertible notes
            
            
            -
            
            
            8,508
            
            
            -
            
            
            9,625Amortization
                of intangible asset
            
            
            573
            
            
            573
            
            
            1,146
            
            
            1,146Total
                expenses
            
            
            55,804
            
            
            50,969
            
            
            112,049
            
            
            91,960Income
                (loss) before tax
            
            
            12,932
            
            
            (3,782
            )
            
            20,645
            
            
            (253
            )Income
                tax expense (benefit)
            
            
            4,117
            
            
            (940
            )
            
            6,860
            
            
            163Net
                income (loss)
            
            $
            8,815
            
            $
            (2,842
            )
            $
            13,785
            
            $
            (416
            )Common
                stockholders net income (loss) per share:Basic
            
            $
            0.42
            
            $
            (0.18
            )
            $
            0.66
            
            $
            (0.03
            )Diluted
            
            $
            0.42
            
            $
            (0.18
            )
            $
            0.66
            
            $
            (0.03
            )




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
        (Loss)**
 (Unaudited)
 ($
        in
        thousands)
  **Three
                  Months Ended**
              
              **Six
                  Months Ended****June
                  30,**
              
              **June
                  30,****2007**
              
              **2006**
              
              **2007**
              
              **2006****Common
                  Stock**Balance,
                  beginning of period
              
              $
              3,740
              
              $
              2,609
              
              $
              3,740
              
              $
              2,606Conversion
                  of note payable to common stock
              
              
              -
              
              
              589
              
              
              -
              
              
              589Issuance
                  of common stock upon option exercises
              
              
              -
              
              
              -
              
              
              -
              
              
              3Balance,
                  end of period
              
              
              3,740
              
              
              3,198
              
              
              3,740
              
              
              3,198**Additional
                  Paid-In Capital**Balance,
                  beginning of period
              
              
              117,983
              
              
              69,034
              
              
              117,932
              
              
              62,907Discount
                  on convertible notes, net of tax
              
              
              -
              
              
              34
              
              
              -
              
              
              6,066Conversion
                  of note payable to common stock
              
              
              -
              
              
              24,562
              
              
              -
              
              
              24,562Equity
                  based compensation
              
              
              102
              
              
              33
              
              
              153
              
              
              57Exercise
                  of stock options
              
              
              -
              
              
              -
              
              
              -
              
              
              71Balance,
                  end of period
              
              
              118,085
              
              
              93,663
              
              
              118,085
              
              
              93,663**Retained
                  Earnings**Balance,
                  beginning of period
              
              
              36,450
              
              
              24,715
              
              
              31,480
              
              
              22,289Net
                  income (loss)
              
              
              8,815
              
              
              (2,842
              )
              
              13,785
              
              
              (416
              )Balance,
                  end of period
              
              
              45,265
              
              
              21,873
              
              
              45,265
              
              
              21,873**Accumulated
                  Other Comprehensive Loss**Balance,
                  beginning of period
              
              
              (1,982
              )
              
              (3,417
              )
              
              (2,344
              )
              
              (2,597
              )Additional
                  minimum pension liability, net of tax
              
              
              64
              
              
              32
              
              
              64
              
              
              32Unrealized
                  losses on securities, net of tax
              
              
              (828
              )
              
              (283
              )
              
              (466
              )
              
              (1,103
              )Balance,
                  end of period
              
              
              (2,746
              )
              
              (3,668
              )
              
              (2,746
              )
              
              (3,668
              )**Treasury
                  Stock**Balance,
                  beginning of period
              
              
              (77
              )
              
              (77
              )
              
              (77
              )
              
              (17
              )Acquisition
                  of treasury shares
              
              
              -
              
              
              -
              
              
              -
              
              
              (100
              )Exercise
                  of stock options
              
              
              -
              
              
              -
              
              
              -
              
              
              40Balance,
                  end of period
              
              
              (77
              )
              
              (77
              )
              
              (77
              )
              
              (77
              )**Stockholders'
                  Equity**
              
              $
              164,267
              
              $
              114,989
              
              $
              164,267
              
              $
              114,989Net
                  income (loss)
              
              $
              8,815
              
              $
              (2,842
              )
              $
              13,785
              
              $
              (416
              )Additional
                  minimum pension liability, net of tax
              
              
              64
              
              
              32
              
              
              64
              
              
              32Unrealized
                  losses on securities, net of tax
              
              
              (828
              )
              
              (283
              )
              
              (466
              )
              
              (1,103
              )**Comprehensive
                  Income (Loss)**
              
              $
              8,051
              
              $
              (3,093
              )
              $
              13,383
              
              $
              (1,487
              )
  The
        accompanying notes are an integral part
 of
        the
        consolidated financial statements
  5


**Hallmark
      Financial Services, Inc. and Subsidiaries**


**Consolidated
      Statement of Cash Flows**


(Unaudited)


($
      in
      thousands)




**Six
                Months Ended****June
                30****2007**
            
            **2006**Cash
                flows from operating activities:Net
                income (loss)
            
            $
            13,785
            
            $
            (416
            )Adjustments
                to reconcile net income (loss) to cash provided by operating
                activities:Depreciation
                and amortization expense
            
            
            1,564
            
            
            1,605Amortization
                of beneficial conversion feature
            
            
            -
            
            
            9,625Amortization
                of discount on structured settlement
            
            
            207
            
            
            523Deferred
                federal income tax benefit
            
            
            (916
            )
            
            (5,671
            )Realized
                (gain) loss on investments
            
            
            (881
            )
            
            1,366Change
                in prepaid reinsurance premiums
            
            
            (144
            )
            
            (818
            )Change
                in premiums receivable
            
            
            (9,925
            )
            
            (20,346
            )Change
                in accounts receivable
            
            
            796
            
            
            (269
            )Change
                in deferred policy acquisition costs
            
            
            (3,069
            )
            
            (3,400
            )Change
                in unpaid losses and loss adjustment expenses
            
            
            26,824
            
            
            16,288Change
                in unearned premiums
            
            
            16,253
            
            
            29,293Change
                in unearned revenue
            
            
            (1,957
            )
            
            (4,088
            )Change
                in accrued agent profit sharing
            
            
            (528
            )
            
            (920
            )Change
                in reinsurance recoverable
            
            
            (575
            )
            
            (446
            )Change
                in reinsurance balances payable
            
            
            211
            
            
            (252
            )Change
                in current federal income tax payable
            
            
            2,520
            
            
            751Change
                in accrued ceding commission payable
            
            
            3,103
            
            
            8Excess
                tax benefits from share-based payments
            
            
            -
            
            
            (25
            )Change
                in all other liabilities
            
            
            2,059
            
            
            6,331Change
                in all other assets
            
            
            (4,733
            )
            
            534Net
                cash provided by operating activities
            
            
            44,594
            
            
            29,673Cash
                flows from investing activities:Purchases
                of property and equipment
            
            
            (269
            )
            
            (249
            )Premium
                finance notes repaid, net of finance notes originated
            
            
            (633
            )
            
            (2,368
            )Acquisition
                of subsidiaries, net of cash acquired
            
            
            -
            
            
            (25,964
            )Change
                in restricted cash
            
            
            14,527
            
            
            180Purchases
                of debt and equity securities
            
            
            (106,636
            )
            
            (60,430
            )Maturities
                and redemptions of investment securities
            
            
            62,506
            
            
            13,268Net
                purchases of short-term investments
            
            
            (38,771
            )
            
            (37,776
            )Net
                cash used in investing activities
            
            
            (69,276
            )
            
            (113,339
            )Cash
                flows from financing activities:Proceeds
                from exercise of employee stock options
            
            
            -
            
            
            40Payment
                of structured settlement
            
            
            (15,000
            )
            
            -Proceeds
                from issuance of convertible debt
            
            
            -
            
            
            25,000Proceeds
                from note payable to related party
            
            
            -
            
            
            12,500Proceeds
                from revolving loan on credit facility
            
            
            -
            
            
            15,000Net
                cash (used in) provided by financing activities
            
            
            (15,000
            )
            
            52,540Decrease
                in cash and cash equivalents
            
            
            (39,682
            )
            
            (31,126
            )Cash
                and cash equivalents at beginning of period
            
            
            81,474
            
            
            44,528Cash
                and cash equivalents at end of period
            
            $
            41,792
            
            $
            13,402Supplemental
                Cash Flow Information:Interest
                paid
            
            $
            1,372
            
            $
            2,384Taxes
                paid
            
            $
            5,256
            
            $
            5,082




The
        accompanying notes are an integral part
 of
          the
          consolidated financial statements
  6




**Hallmark
      Financial Services, Inc. and Subsidiaries**


**Notes
      to Consolidated Financial Statements (Unaudited)**





**1.
      General**




Hallmark
      Financial Services, Inc. (“Hallmark” and, together with subsidiaries, “we,” “us”
or “our”) is an insurance holding company which, through its subsidiaries,
      engages in the sale of property/casualty insurance products to businesses and
      individuals. Our business involves marketing, distributing, underwriting and
      servicing commercial insurance in Texas, New Mexico, Idaho, Oregon, Montana,
      Louisiana, Oklahoma, Arkansas and Washington; marketing, distributing,
      underwriting and servicing non-standard personal automobile insurance in Texas,
      New Mexico, Arizona, Oklahoma, Arkansas, Louisiana, Idaho, Oregon, Montana,
      Missouri and Washington; marketing, distributing, underwriting and servicing
      general aviation insurance in 47 states; and providing other insurance related
      services.





We
      pursue
      our business activities through subsidiaries whose operations are organized
      into
      four operating units which are supported by our three insurance company
      subsidiaries. Our HGA Operating Unit handles standard lines commercial insurance
      products and services and is comprised of Hallmark General Agency, Inc.
      (“Hallmark General Agency”) and Effective Claims Management, Inc. Our TGA
      Operating Unit handles primarily excess and surplus lines commercial insurance
      products and services and is comprised of Texas General Agency, Inc. (“Texas
      General Agency”), Pan American Acceptance Corporation (“PAAC”) and TGA Special
      Risk, Inc. (“TGASRI”). Our Aerospace Operating Unit handles general aviation
      insurance products and services and is comprised of Aerospace Insurance
      Managers, Inc. (“Aerospace Insurance Managers”), Aerospace Special Risk, Inc.
      (“ASRI”) and Aerospace Claims Management Group, Inc. (“ACMG”). Our Phoenix
      Operating Unit handles non-standard personal automobile insurance products
      and
      services and is comprised solely of American Hallmark General Agency, Inc.
      (which does business as Phoenix Indemnity Insurance Company).





These
      four operating units are segregated into three reportable industry segments
      for
      financial accounting purposes. The Standard Commercial Segment presently
      consists solely of the HGA Operating Unit and the Personal Segment presently
      consists solely of our Phoenix Operating Unit. The Specialty Commercial Segment
      includes both our TGA Operating Unit and our Aerospace Operating Unit.





**2.
      Basis of Presentation**





Our
      unaudited consolidated financial statements included herein have been prepared
      in accordance with U.S. generally accepted accounting principles (“GAAP”) and
      include our accounts and the accounts of our subsidiaries. All significant
      intercompany accounts and transactions have been eliminated in consolidation.
      Certain information and footnote disclosures normally included in financial
      statements prepared in accordance with GAAP have been condensed or omitted
      pursuant to rules and regulations of the Securities and Exchange Commission
      (“SEC”) for interim financial reporting. These financial statements should be
      read in conjunction with our audited financial statements for the year ended
      December 31, 2006 included in our Annual Report on Form 10-K filed with the
      SEC.





The
      interim financial data as of June 30, 2007 and 2006 is unaudited. However,
      in
      the opinion of management, the interim data includes all adjustments, consisting
      only of normal recurring adjustments, necessary for a fair statement of the
      results for the interim periods. The results of operations for the period ended
      June 30, 2007 are not necessarily indicative of the operating results to be
      expected for the full year.





7




***Reclassification***





Certain
      previously reported amounts have been reclassified in order to conform to
      current year presentation. Such reclassification had no effect on net income
      or
      stockholders’ equity. Investment balances that were previously reported in
      Restricted Cash and Investments on the balance sheet have been reclassified
      to
      debt securities, available-for-sale, at market value during the current period.
      The amount reclassified for December 31, 2006 was $7.2 million.





***Redesignation
      of Segments***





Each
      of
      our four operating units was reported as a separate segment during the first
      three quarters of 2006. Commencing in the fourth quarter of 2006, our HGA
      Operating Unit was designated as the sole component of the Standard Commercial
      Segment, our TGA Operating Unit and our Aerospace Operating Unit were aggregated
      in the Specialty Commercial Segment, and our Phoenix Operating Unit was
      designated as the sole component of the Personal Segment.




***Reverse
      Stock Split***





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





***Use
      of Estimates in the Preparation of the Financial
      Statements***





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





***Recently
      Issued Accounting Standards***





In
      September 2005, the American Institute of Certified Public Accountants issued
      Statement of Position 05-1 “Accounting by Insurance Enterprises for Deferred
      Acquisition Costs in Connection With Modifications or Exchanges of Insurance
      Contracts” (“SOP 05-1”). This statement provides guidance on accounting for
      deferred acquisition costs on internal replacements of insurance and investment
      contracts other than those specifically described in Statement of Financial
      Accounting Standards No. 97 “Accounting and Reporting by Insurance Enterprises
      for Certain Long-Duration Contracts and for Realized Gains and Losses from
      the
      Sale of Investments,” previously issued by the Financial Accounting Standards
      Board (“FASB”). SOP 05-01 is effective for internal replacements occurring in
      fiscal years beginning after December 15, 2006. The adoption of SOP 05-01 had
      no
      material impact on our financial condition or results of
      operations.





In
      June
      2006, FASB Interpretation No. 48, “Accounting for Uncertainty in Income
      Taxes –
      An Interpretation of FASB Statement No. 109” (“FIN 48”), was issued. FIN 48
      clarifies the accounting for uncertainty in income taxes recognized in a
      company’s financial statements in accordance with FASB Statement of Financial
      Accounting Standards No. 109, Accounting for Income Taxes. FIN 48 also
      prescribes a recognition threshold and measurement attribute for the financial
      statement recognition and measurement of a tax position taken or expected to
      be
      taken in a tax return, as well as providing guidance on derecognition,
      classification, interest and penalties, accounting in interim periods,
      disclosure and transition. FIN 48 is effective for fiscal years beginning after
      December 15, 2006 with earlier application permitted as long as the company
      has
      not yet issued financial statements, including interim financial statements,
      in
      the period of adoption. We adopted the provisions of FIN 48 on January 1, 2007.
      Since we had no unrecognized tax benefits, we recognized no additional liability
      or reduction in deferred tax asset as a result of the adoption of FIN 48. We
      are
      no longer subject to U. S. federal, state, local or non-U.S. income tax
      examinations by tax authorities for years prior to 2003.





8


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





In
      February 2007, FASB issued Statement of Financial Accounting Standards No.
      159,
“The Fair Value Option for Financial Assets and Liabilities” (“SFAS 159”). SFAS
      159 permits entities to choose to measure many financial instruments and certain
      other items at fair value with changes in fair value included in current
      earnings. The election is made on specified election dates, can be made on
      an
      instrument-by- instrument basis, and is irrevocable. SFAS 159 is effective
      for
      financial statements issued for fiscal years beginning after November 15, 2007.
      We are currently evaluating the impact of adopting SFAS 159 on our financial
      statements.





**3.
      Business Combinations**





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




9




**4.
      Supplemental Cash Flow Information**





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





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





**5.
      Pledged Investments**





We
      have
      certain of our debt securities pledged for the benefit of various state
      insurance departments, reinsurers and the sellers of our TGA Operating Unit.
      These securities are included with our available-for-sale debt securities as
      we
      have the ability to trade these securities. We retain the interest earned on
      these securities. These securities had a carrying value of $16.2 million at
      June
      30, 2007.





**6.
      Share-Based Payment Arrangements**





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





As
      of
      June 30, 2007, there were incentive stock options to purchase 657,499 shares
      of
      our common stock outstanding and non-qualified stock options to purchase 40,000
      shares of our common stock outstanding under the 2005 LTIP, leaving 135,834
      shares reserved for future issuance. As of June 30, 2007, there were incentive
      stock options to purchase 93,001 shares outstanding under the 1994 Employee
      Plan
      and non-qualified stock options to purchase 23,334 shares outstanding under
      the
      1994 Director Plan. In addition, as of June 30, 2007, there were outstanding
      non-qualified stock options to purchase 16,666 shares of our common stock
      granted to certain non-employee directors outside the 1994 Director Plan in
      lieu
      of fees for service on our board of directors in 1999. The exercise price of
      all
      such outstanding stock options is equal to the fair market value of our common
      stock on the date of grant.





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




10


A
        summary
        of the status of our stock options as of and changes during the year-to-date
        ended June 30, 2007 is presented below:
 
 Average
              
              Contractual
              
              IntrinsicNumber of
              
              Exercise
              
              Term
              
              ValueShares
              
              Price
              
              (Years)
              
              ($000)Outstanding
                  at January 1, 2007
              
              
              332,334
              
              $
              7.04Granted
              
              
              500,000
              
              $
              12.52Exercised
              
              
              -
              
              $
              -Forfeited
                  or expired
              
              
              (1,834
              )
              $
              5.05Outstanding
                  at June 30, 2007
              
              
              830,500
              
              $
              10.35
              
              
              8.3
              
              $
              1,674Exercisable
                  at June 30, 2007
              
              
              138,751
              
              $
              4.79
              
              
              3.9
              
              $
              1,017
  The
        following table details the intrinsic value of options exercised, total cost
        of
        share-based payments charged against income before income tax benefit and
        the
        amount of related income tax benefit recognized in income for the periods
        indicated (in thousands):
 
 Three
                  Months Ended
              
              Six
                  Months EndedJune
                  30,
              
              June
                  30,2007
              
              2006
              
              2007
              
              2006Intrinsic
                  value of options exercised
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              103Cost
                  of share-based payments (non-cash)
              
              $
              102
              
              $
              33
              
              $
              153
              
              $
              57Income
                    tax benefit of share-based payments recognized in
                    income
              
              $
              36
              
              $
              11
              
              $
              54
              
              $
              20
  As
        of
        June 30, 2007 there was $2.9 million of total unrecognized compensation cost
        related to non-vested share-based compensation arrangements granted under
        our
        plans, of which $0.4 million is expected to be recognized in the remainder
        of
        2007, $0.6 million is expected to be recognized in 2008, $0.8 million is
        expected to be recognized in each of 2009 and 2010 and $0.3 million is expected
        to be recognized in 2011.
  11
  The
        fair
        value of each stock option granted is estimated on the date of grant using
        the
        Black-Scholes option pricing model. Expected volatilities are based on
        historical volatility of our common stock. The risk- free interest rates
        for
        periods within the contractual term of the options are based on rates for
        U.S.
        Treasury Notes with maturity dates corresponding to the options’ expected lives
        on the dates of grant.
 
 The
        following table details the weighted average grant date fair value and related
        assumptions for the periods indicated. There were no options granted in either
        the first quarter of 2007 or 2006.
  Three
                  Months Ended
              
              Six
                  Months EndedJune
                  30,
              
              June
                  30,2007
              
              2006
              
              2007
              
              2006Grant
                  date fair value per share
              
              $
              4.04
              
              $
              6.26
              
              $
              4.04
              
              $
              6.26Expected
                  term (in years)
              
              
              6.4
              
              
              5.0
              
              
              6.4
              
              
              5.0Expected
                  volatility
              
              
              19.4
              %
              
              59.1
              %
              
              19.4
              %
              
              59.1
              %Risk
                  free interest rate
              
              
              4.5
              %
              
              4.9
              %
              
              4.5
              %
              
              4.9
              %
  **7.
        Segment Information**
 
 The
        following is business segment information for the three months ended March
        31,
        2007 and 2006 (in thousands):
  Three
                  Months Ended
              
              Six
                  Months EndedJune
                  30,
              
              June
                  30,2007
              
              2006
              
              2007
              
              2006Revenues:Standard
                  Commercial Segment
              
              $
              20,003
              
              $
              19,264
              
              $
              41,770
              
              $
              36,804Specialty
                  Commercial Segment
              
              
              32,978
              
              
              17,146
              
              
              61,076
              
              
              33,114Personal
                  Segment
              
              
              14,696
              
              
              11,890
              
              
              28,469
              
              
              22,687Corporate
              
              
              1,059
              
              
              (1,113
              )
              
              1,379
              
              
              (898
              )Consolidated
              
              $
              68,736
              
              $
              47,187
              
              $
              132,694
              
              $
              91,707Pre-tax
                  income (loss):Standard
                  Commercial Segment
              
              $
              2,664
              
              $
              2,773
              
              $
              5,423
              
              $
              6,133Specialty
                  Commercial Segment
              
              
              9,441
              
              
              3,439
              
              
              14,127
              
              
              5,058Personal
                  Segment
              
              
              2,176
              
              
              2,393
              
              
              4,294
              
              
              4,444Corporate
              
              
              (1,349
              )
              
              (12,387
              )
              
              (3,199
              )
              
              (15,888
              )Consolidated
              
              $
              12,932
              
              $
              (3,782
              )
              $
              20,645
              
              $
              (253
              )
 
 12
  The
        following is additional business segment information as of the dates indicated
        (in thousands):
 
 June
                  30,
                2007
              
              December 31,
                2006AssetsStandard
                  Commercial Segment
              
              $
              132,303
              
              $
              130,764Specialty
                  Commercial Segment
              
              
              235,178
              
              
              167,675Personal
                  Segment
              
              
              87,465
              
              
              85,391Corporate
              
              
              15,395
              
              
              32,123$
              470,341
              
              $
              415,953
 
 **8.
        Reinsurance**
 
 We
        reinsure a portion of the risk we underwrite in order to control the exposure
        to
        losses and to protect capital resources. We cede to reinsurers a portion
        of
        these risks and pay premiums based upon the risk and exposure of the policies
        subject to such reinsurance. Ceded reinsurance involves credit risk and is
        generally subject to aggregate loss limits. Although the reinsurer is liable
        to
        us to the extent of the reinsurance ceded, we are ultimately liable as the
        direct insurer on all risks reinsured. Reinsurance recoverables are reported
        after allowances for uncollectible amounts. We monitor the financial condition
        of reinsurers on an ongoing basis and review our reinsurance arrangements
        periodically. Reinsurers are selected based on their financial condition,
        business practices and the price of their product offerings. Refer to Note
        6 of
        our Form 10-K for the year ended December 31, 2006 for more discussion of
        our
        reinsurance.
 
 The
        following table shows earned premiums ceded and reinsurance loss recoveries
        by
        period (in thousands):
  Three
                    Months Ended
                
                Six
                    Months EndedJune
                    30,
                
                June
                    30,2007
                
                
                2006
                
                
                2007
                
                
                2006Ceded
                    earned premiums
                
                $
                4,144
                
                $
                2,199
                
                $
                8,024
                
                $
                3,596Reinsurance
                    recoveries
                
                $
                2,349
                
                $
                118
                
                $
                3,436
                
                $
                894
  **9.
        Notes Payable**
 
 On
        June
        21, 2005, our newly formed trust entity completed a private placement of
        $30.0
        million of 30-year floating rate trust preferred securities. Simultaneously,
        we
        borrowed $30.9 million from the trust subsidiary and contributed $30.0 million
        to one of our insurance company subsidiaries in order to increase policyholder
        surplus. The note bears an initial interest rate of 7.725% until June 15,
        2015,
        at which time interest will adjust quarterly to the three month LIBOR rate
        plus
        3.25 percentage points. As of June 30, 2007, the note balance was $30.9
        million.
 
 On
        January 27, 2006, we borrowed $15.0 million under our revolving credit facility
        to fund the cash required to close the acquisition of the subsidiaries
        comprising our TGA Operating Unit. As of June 30, 2007, the balance on the
        revolving note was $2.8 million, which currently bears interest at 7.36%
        per
        annum. Also included in notes payable is $1.4 million outstanding under PAAC’s
        revolving credit sub-facility, which also currently bears interest at 7.36%
        per
        annum. (See Note 11, “Credit Facilities”). ****
  13
  **10.
        Structured Settlements**
 
 In
        connection with the acquisition of the subsidiaries comprising our TGA Operating
        Unit, we recorded a payable for future guaranteed payments of $25.0 million
        discounted at 4.4%, the rate of two-year U.S. Treasuries (the only investment
        permitted on the trust account securing such future payments). As of June
        30,
        2007, the balance of the structured settlements was $9.8 million.
 
 **11.
        Credit Facilities**
 
 On
        June
        29, 2005, we entered into a credit facility with The Frost National Bank.
        The
        credit facility was amended and restated on January 27, 2006 to a $20.0 million
        revolving credit facility, with a $5.0 million letter of credit sub-facility.
        The credit facility was further amended effective May 31, 2007 to increase
        the
        revolving credit facility to $25.0 million and establish a new $5.0 million
        revolving credit sub-facility for the premium finance operations of PAAC.
        Principal outstanding under the revolving credit facility generally bears
        interest at the three month Eurodollar rate plus 2.00%, payable quarterly
        in
        arrears. We pay letter of credit fees at the rate of 1.00% per annum. Our
        obligations under the revolving credit facility are secured by a security
        interest in the capital stock of all of our subsidiaries, guaranties of all
        of
        our subsidiaries and the pledge of substantially all of our assets. The
        revolving credit facility contains covenants which, among other things, require
        us to maintain certain financial and operating ratios and restrict certain
        distributions, transactions and organizational changes. The amended and restated
        credit agreement terminates on January 27, 2008. The new premium finance
        sub-facility terminates May 31, 2009. As of June 30, 2007, we were in compliance
        with all of our covenants. In the third quarter of 2005, we issued a $4.0
        million letter of credit under this facility to collateralize certain
        obligations under the agency agreement between our HGA Operating Unit and
        Clarendon National Insurance Company effective July 1, 2004.
  PAAC
        had
        a $5.0 million revolving credit facility with JPMorgan Chase Bank which
        terminated June 30, 2007. This facility was replaced with the new $5.0 million
        premium finance sub-facility with The Frost National Bank as discussed
        above.
 
 **11.
        Deferred Policy Acquisition Costs**
 
 The
        following table shows total deferred and amortized policy acquisition costs
        by
        period (in thousands):
 
 Three
                  Months Ended
              
              Six
                  Months EndedJune
                  30,
              
              June
                  30,2007
              
              2006
              
              2007
              
              2006Deferred
              
              $
              (12,606
              )
              $
              (8,678
              )
              $
              (24,966
              )
              $
              (17,590
              )Amortized
              
              
              11,321
              
              
              6,653
              
              
              21,897
              
              
              14,190Net
              
              $
              (1,285
              )
              $
              (2,025
              )
              $
              (3,069
              )
              $
              (3,400
              )
  14
  **12.
        Earnings per Share**
 
 The
        following table sets forth basic and diluted weighted average shares outstanding
        for the periods indicated (in thousands):
  Three
                  Months Ended
              
              Six
                  Months EndedJune
                  30,
              
              June
                  30,2007
              
              2006
              
              2007
              
              2006Weighted
                  average shares - basic
              
              
              20,768
              
              
              15,780
              
              
              20,768
              
              
              15,133Effect
                  of dilutive securities
              
              
              -
              
              
              -
              
              
              -
              
              
              -Weighted
                  average shares - assuming dilution
              
              
              20,768
              
              
              15,780
              
              
              20,768
              
              
              15,133
 
 For
        the
        three and six months ended June 30, 2007, 500,000 shares attributable to
        outstanding stock options were excluded from the calculation of diluted earnings
        per share because the exercise prices of the stock options were greater than
        the
        average price of the common shares and, therefore, their inclusion would
        have
        been anti-dilutive. For the three and six months ended June 30, 2006, we
        reported a net loss and therefore, excluded the effect of dilutive securities
        in
        the calculation of diluted loss per share as the inclusion of these securities
        would have been anti-dilutive.
 
 **13.
        Net Periodic Pension Cost**
 
 The
        following table details the net periodic pension cost incurred by period
        (in
        thousands):
 
 Three
                  Months Ended
              
              Six
                  Months EndedJune
                  30,
              
              June
                  30,2007
              
              2006
              
              2007
              
              2006Interest
                  cost
              
              $
              180
              
              $
              172
              
              $
              360
              
              $
              343Amortization
                  of net loss
              
              
              50
              
              
              40
              
              
              100
              
              
              80Expected
                  return on plan assets
              
              
              (160
              )
              
              (157
              )
              
              (321
              )
              
              (314
              )Net
                  periodic pension cost
              
              $
              70
              
              $
              55
              
              $
              139
              
              $
              109
 
 We
        contributed $74 thousand to our frozen defined benefit cash balance plan
        (“Cash
        Balance Plan”) during each of the three months ended June 30, 2007 and 2006. We
        contributed $270 thousand and $106 thousand to our Cash Balance Plan during
        the
        six months ended June 30, 2007 and 2006, respectively. Refer to Note 14 of
        our
        Form 10-K for the year ended December 31, 2006 for more discussion of our
        retirement plans.
  15
  **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” and “Item 1A. Risk Factors” 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”, “our”) is an insurance holding company which, through its subsidiaries,
        engages in the sale of property/casualty insurance products to businesses
        and
        individuals. Our business involves marketing, distributing, underwriting
        and
        servicing commercial insurance in Texas, New Mexico, Idaho, Oregon, Montana,
        Louisiana, Oklahoma, Arkansas and Washington; marketing, distributing,
        underwriting and servicing non-standard personal automobile insurance in
        Texas,
        New Mexico, Arizona, Oklahoma, Arkansas, Louisiana, Idaho, Oregon, Montana,
        Missouri and Washington; marketing, distributing, underwriting and servicing
        general aviation insurance in 47 states; and providing other insurance related
        services. We pursue our business activities through subsidiaries whose
        operations are organized into four operating units which are supported by
        our
        insurance company subsidiaries.
  Our
        non-carrier insurance activities are segregated by operating units into the
        following reportable segments:
  ·
              ***Standard
                  Commercial Segment.***Our Standard Commercial Segment includes the standard lines commercial
                  property/casualty insurance products and services handled by our
                  HGA
                  Operating Unit which is comprised of our Hallmark General Agency,
                  Inc. and
                  Effective Claims Management, Inc. subsidiaries.
 
 ·
              ***Specialty
                  Commercial Segment.***Our Specialty Commercial Segment includes the excess and surplus
                  lines
                  commercial property/casualty insurance products and services handled
                  by
                  our TGA Operating Unit and the general aviation insurance products
                  and
                  services handled by our Aerospace Operating Unit. Our TGA Operating
                  Unit
                  is comprised of our Texas General Agency, Inc., Pan American Acceptance
                  Corporation and TGA Special Risk, Inc. subsidiaries. Our Aerospace
                  Operating Unit is comprised of our Aerospace Insurance Managers,
                  Inc.,
                  Aerospace Special Risk, Inc. and Aerospace Claims Management Group,
                  Inc.
                  subsidiaries.
 
 ·
              ***Personal
                  Segment.***Our Personal Segment includes the non-standard personal automobile
                  insurance products and services handled by our Phoenix Operating
                  Unit
                  which is comprised solely of American Hallmark General Agency,
                  Inc., which
                  does business as Phoenix Indemnity Insurance
                  Company.
 
 The
        retained premium produced by our operating units is supported by the following
        insurance company subsidiaries:
 
 ·
              ***American
                  Hallmark Insurance Company of Texas********(“AHIC”)*******presently
                  retains all of the risks on the commercial property/casualty policies
                  marketed by our HGA Operating Unit, assumes a portion of the risks
                  on the
                  commercial property/casualty policies marketed by our TGA Operating
                  Unit
                  and assumes a portion of the risks on the aviation property/casualty
                  products marketed by our Aerospace Operating Unit.
  16
  ·
              ***Gulf
                  States Insurance Company (“GSIC”)***presently assumes a portion of the risks on the commercial
                  property/casualty policies marketed by our TGA Operating
                  Unit.
 
 ·
              ***Phoenix
                  Indemnity Insurance Company******(“PIIC”)***presently
                  assumes all of the risks on the non-standard personal automobile
                  policies
                  marketed by our Phoenix Operating Unit and assumes a portion of
                  the risks
                  on the aviation property/casualty products marketed by our Aerospace
                  Operating Unit.
 
 Effective
        January 1, 2006, our insurance company subsidiaries entered into a pooling
        arrangement, which was subsequently amended on December 15, 2006, pursuant
        to
        which AHIC retains 46% of the total net premiums written by all of our operating
        units, PIIC retains 34% of our total net premiums written and GSIC retains
        20%
        of our total net premiums written.
  All
        share
        and per share amounts have been adjusted to reflect a one-for-six reverse
        split
        of all issued and unissued shares of our authorized common stock effected
        July
        31, 2006.
  Each
        of
        our four operating units was reported as a separate segment during the first
        three quarters of 2006. Commencing in the fourth quarter of 2006, our HGA
        Operating Unit was designated as the sole component of the Standard Commercial
        Segment, our TGA Operating Unit and our Aerospace Operating Unit were aggregated
        in the Specialty Commercial Segment and our Phoenix Operating Unit was
        designated as the sole component of the Personal Segment.
 
 **Results
        of Operations**
 
 **Management
        Overview.** During
        the three months and six months ended June 30, 2007, our total revenues were
        $68.7 million and $132.7 million, representing a 46% and 45% increase over
        the
        $47.2 million and $91.7 million in total revenues, respectively, for the
        same
        periods of 2006. Increased retention of business produced by our Specialty
        Commercial Segment and increased production by our Personal Segment were
        the
        primary causes of the increase in revenue. Specialty Commercial Segment revenues
        increased $15.8 million and $28.0 million, or 92% and 84%, during the three
        months and six months ended June 30, 2007, respectively, as compared to the
        same
        periods of 2006. Revenues from our Personal Segment increased $2.8 million
        and
        $5.8 million, or 24% and 25%, during the three and six months ended June
        30,
        2007, respectively, due largely to geographic expansion into new states.
        The
        retention of business produced by the Standard Commercial Segment that was
        previously retained by third parties was the primary reason for that segment’s
        $0.7 million and $5.0 million increase in revenue for the three months and
        six
        months ended June 30, 2007, respectively. Realized gains of $0.8 million
        and
        $0.9 million for the three months and six months ended June 30, 2007,
        respectively, as compared to realized losses of $1.4 million recognized for
        both
        the same periods the prior year, were the primary reason for an increase
        in
        revenue for Corporate.
 
 We
        reported net income of $8.8 million and $13.8 million for the three months
        and
        six months ended June 30, 2007 as compared to net loss of $2.8 million and
        $0.4
        million reported for the three and six months ended June 30, 2006. On a diluted
        per share basis, net income was $0.42 and $0.66 for the three months and
        six
        months ended June 30, 2007 as compared to net loss per share of $0.18 and
        $0.03
        for the same periods in 2006. During the three months and six months ended
        June
        30, 2006, we recorded $8.5 million and $9.6 million, respectively, of interest
        expense from amortization attributable to the deemed discount on convertible
        promissory notes issued in January, 2006 and subsequently converted to common
        stock during the second quarter of 2006. The increase in net income was also
        attributable to increased revenue as discussed above and to prior year favorable
        loss reserve development of $1.9 million and $2.1 million for the three months
        and six months ended June 30, 2007 as compared to $0.9 million and $0.8 million
        of prior year favorable development recognized during the same periods of
        2006.
        Lower interest expense and additional investment income from a larger investment
        portfolio resulting from increased retention of premiums also contributed
        to the
        increase in net income.
  17
  **Second
        Quarter 2007 as Compared to Second Quarter 2006**
 
 The
        following is additional business segment information for the three months
        ended
        June 30, 2007 and 2006 (in thousands):
 
 **Three
                  Months Ended June 30, 2007****Standard**
              
              **Specialty****Commercial**
              
              **Commercial**
              
              **Personal****Segment**
              
              **Segment**
              
              **Segment**
              
              **Corporate**
              
              **Consolidated**Produced
                  premium
              
              
              24,751
              
              
              40,956
              
              
              13,298
              
              
              -
              
              
              79,005Gross
                  premiums written
              
              
              24,740
              
              
              28,540
              
              
              13,297
              
              
              -
              
              
              66,577Ceded
                  premiums written
              
              
              (2,804
              )
              
              (1,477
              )
              
              -
              
              
              -
              
              
              (4,281
              )Net
                  premiums written
              
              
              21,936
              
              
              27,063
              
              
              13,297
              
              
              -
              
              
              62,296Change
                  in unearned premiums
              
              
              (1,731
              )
              
              (5,474
              )
              
              219
              
              
              -
              
              
              (6,986
              )Net
                  premiums earned
              
              
              20,205
              
              
              21,589
              
              
              13,516
              
              
              -
              
              
              55,310Total
                  revenues
              
              
              20,003
              
              
              32,978
              
              
              14,696
              
              
              1,059
              
              
              68,736Losses
                  and loss adjustment expenses
              
              
              11,267
              
              
              10,635
              
              
              8,813
              
              
              (3
              )
              
              30,712Pre-tax
                  income (loss)
              
              
              2,664
              
              
              9,441
              
              
              2,176
              
              
              (1,349
              )
              
              12,932Net
                  loss ratio (1)
              
              
              55.8
              %
              
              49.3
              %
              
              65.2
              %
              
              
              
              
              55.5
              %Net
                  expense ratio (1)
              
              
              27.0
              %
              
              32.0
              %
              
              22.8
              %
              
              
              
              
              27.9
              %Net
                  combined ratio (1)
              
              
              82.8
              %
              
              81.3
              %
              
              88.0
              %
              
              
              
              
              83.4
              %
  **Three
                    Months Ended June 30, 2006****Standard**
                
                **Specialty****Commercial**
                
                **Commercial**
                
                **Personal****Segment**
                
                **Segment**
                
                **Segment**
                
                **Corporate**
                
                **Consolidated**Produced
                    premium
                
                
                23,488
                
                
                35,285
                
                
                10,739
                
                
                -
                
                
                69,512Gross
                    premiums written
                
                
                23,453
                
                
                13,684
                
                
                10,739
                
                
                -
                
                
                47,876Ceded
                    premiums written
                
                
                (2,067
                )
                
                (417
                )
                
                -
                
                
                -
                
                
                (2,484
                )Net
                    premiums written
                
                
                21,386
                
                
                13,267
                
                
                10,739
                
                
                -
                
                
                45,392Change
                    in unearned premiums
                
                
                (4,532
                )
                
                (6,258
                )
                
                (343
                )
                
                -
                
                
                (11,133
                )Net
                    premiums earned
                
                
                16,854
                
                
                7,009
                
                
                10,396
                
                
                -
                
                
                34,259Total
                    revenues
                
                
                19,264
                
                
                17,146
                
                
                11,890
                
                
                (1,113
                )
                
                47,187Losses
                    and loss adjustment expenses
                
                
                10,018
                
                
                3,707
                
                
                6,482
                
                
                (8
                )
                
                20,199Pre-tax
                    income (loss)
                
                
                2,773
                
                
                3,439
                
                
                2,393
                
                
                (12,387
                )
                
                (3,782
                )Net
                    loss ratio (1)
                
                
                59.4
                %
                
                52.9
                %
                
                62.4
                %
                
                
                
                
                59.0
                %Net
                    expense ratio (1)
                
                
                28.9
                %
                
                22.4
                %
                
                26.2
                %
                
                
                
                
                26.8
                %Net
                    combined ratio (1)
                
                
                88.3
                %
                
                75.3
                %
                
                88.6
                %
                
                
                
                
                85.8
                %
 (1)
        The
        net loss ratio is calculated as incurred losses and loss adjustment expenses
        divided by net premiums earned, each determined in accordance with GAAP.
        The net
        expense ratio is calculated as total underwriting expenses of our insurance
        company subsidiaries, including allocated overhead expenses and 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.
  18
  ***Standard
        Commercial Segment***
 
 Gross
        premiums written for the Standard Commercial Segment were $24.7 million for
        the
        three months ended June 30, 2007, or 5% more than the $23.5 million reported
        for
        the same period in 2006. Net premiums written were $21.9 million for the
        three
        months ended June 30, 2007, or 3% more than the $21.4 million reported for
        the
        same period in 2006. Increased competition and rate pressure continue to
        challenge premium volume growth by the Standard Commercial Segment.
 
 Total
        revenue for the Standard Commercial Segment of $20.0 million for the second
        quarter of 2007 was $0.7 million more than the $19.3 million reported in
        the
        second quarter of 2006. This 4% increase in total revenue was primarily due
        to
        increased net premiums earned of $3.4 million for the quarter and increased
        net
        investment income of $0.3 million. These increases in revenue were partially
        offset by lower ceding commission revenue of $1.7 million due to a contingent
        commission adjustment related to adverse development on prior accident years,
        as
        well as lower ceding commission revenue of $0.7 million and processing and
        service fees of $0.5 million, in both cases due to the shift from a third
        party
        agency structure to an insurance underwriting structure.
 
 Pre-tax
        income for our Standard Commercial Segment of $2.7 million for the second
        quarter of 2007 decreased $0.1 million, or 4%, from the $2.8 million reported
        for the second quarter of 2006. This decrease in pre-tax income was primarily
        attributable to the contingent commission adjustment discussed above partially
        offset by additional earned premium volume net of related incurred losses,
        production related expenses, ceding commissions and processing fees of $0.5
        million, increased net investment income of $0.3 million discussed above,
        and
        improved net loss results as evidenced by a net loss ratio of 55.8% for the
        three months ended June 30, 2007 as compared to 59.4% for the same period
        of
        2006.
 
 The
        net
        loss ratio was favorably impacted by higher ceded losses of $1.8 million
        for the
        three months ended June 30, 2007 as compared to only $38 thousand for the
        same
        period in 2006. The gross loss ratio before reinsurance was 57.3% for the
        three
        months ended June 30, 2007 as compared to 53.9% for the same period the prior
        year. The gross loss results for the three months ended June 30, 2007 included
        $0.6 million of favorable prior year development as compared to favorable
        prior
        year development of $0.3 million recognized during the same period of 2006.
        Absent prior year development, the gross incurred losses and loss adjustment
        expense before reinsurance for the Standard Commercial Segment were higher
        by
        $1.4 million due to the higher gross loss experience.
 
 The
        Standard Commercial Segment reported net expense ratios of 27.0% and 28.9%
        for
        the second quarters of 2007 and 2006, respectively. The net expense ratio
        for
        2006 was higher primarily due to costs to assume from Clarendon National
        Insurance Company the unearned premium previously produced by the Standard
        Commercial Segment.
 
 ***Specialty
        Commercial Segment***
 
 Gross
        premiums written for the Specialty Commercial Segment for the second quarter
        of
        2007 were $28.5 million or 109% more than the $13.7 million reported for
        the
        same period in 2006. Net premiums written for the second quarter of 2007
        were
        $27.1 million or 104% more than the $13.3 million reported for the same period
        in 2006. The increase in premium volume was due to the increased retention
        of
        business produced by our TGA Operating Unit from 50% in 2006 to 60% in 2007,
        as
        well as the retention of the business produced by our Aerospace Operating
        Unit
        beginning in the third quarter of 2006.
  19
  Total
        revenue for the Specialty Commercial Segment of $33.0 million for the second
        quarter of 2007 was $15.8 million more than the $17.1 million reported in
        the
        second quarter of 2006. This 92% increase in revenue was largely due to
        increased net premiums earned of $14.6 million for the quarter as a result
        of
        the increased retention of business. The Specialty Commercial Segment recognized
        $2.9 million of contingent ceding commission under the 2006 quota share
        agreement with Republic Underwriters Insurance Company due to improved
        underwriting results. Increased net investment income contributed an additional
        $0.6 million to the increase in revenue for the quarter. These increases
        in
        revenue were partially offset by lower ceding commission revenue of $2.1
        million
        due to the shift from a third party agency structure to an insurance
        underwriting structure.
  Pre-tax
        income for the Specialty Commercial Segment of $9.4 million for the second
        quarter of 2007 increased $6.0 million, or 175%, from the $3.4 million reported
        for the same period in 2006. Increased revenue, discussed above, was the
        primary
        reason for the increase in pre-tax income, partially offset by increased
        losses
        and loss adjustment expenses of $6.9 million and increased operating expenses
        of
        $2.9 million due mostly to production related expenses that are directly
        related
        to increased earned premium. The Specialty Commercial Segment reported a
        net
        loss ratio of 49.3% for the second quarter of 2007 as compared to 52.9% for
        the
        second quarter of 2006. Favorable prior year development of $1.4 million
        for the
        three months ended June 30, 2007 as compared to favorable prior year development
        of $0.5 million for the same period of 2006 was the primary cause for the
        decrease in the net loss ratio. The Specialty Commercial Segment reported
        a net
        expense ratio of 32.0% for the second quarter of 2007 as compared to 22.4%
        for
        the second quarter of 2006. The increase in the net expense ratio was primarily
        due to the 2006 second quarter expense ratio being depressed by the amortization
        of the fair value adjustment of the deferred policy acquisition cost asset,
        which was recognized in the application of FASB Statement of Financial
        Accounting Standard No. 141 “Business Combinations” (“SFAS No. 141”) in the 2006
        acquisition of the TGA Operating Unit. This impacted the reported operating
        expenses during the second quarter of 2006. In addition, amortization of
        the
        fair value adjustment of the unearned premium reserve, also recognized pursuant
        to SFAS No. 141, affected the reported net premiums earned during the second
        quarter of 2006.
 
 ***Personal
        Segment***
 
 Net
        premium written for our Personal Segment increased $2.6 million during the
        second quarter of 2007 to $13.3 million compared to $10.7 million in the
        second
        quarter of 2006. The increase in premium was due mostly to geographic expansion
        that began in 2006.
 
 Total
        revenue for the Personal Segment increased 24% to $14.7 million for the second
        quarter of 2007 from $11.9 million for the same period in 2006. Higher earned
        premium of $3.1 million was the primary reason for the increase in revenue
        for
        the period. Increased finance charges of $0.2 million were offset by lower
        third
        party commission revenue of $0.2 million and investment income was $0.3 million
        lower due to the reallocation of capital to other segments for their increased
        retention of premium.
 
 Pre-tax
        income for the Personal Segment was $2.2 million for the three months ended
        June
        30, 2007 as compared to $2.4 million for the same period in 2006. The increased
        revenue, as discussed above, was offset by increased losses and loss adjustment
        expenses of $2.3 million and increased operating expenses of $0.7 million
        due
        mostly to production related expenses attributable to the increased earned
        premium. The Personal Segment reported a net loss ratio of 65.2% for the
        second
        quarter of 2007 as compared to 62.4% for the same period in 2006. A competitive
        pricing environment and the new business impact associated with geographic
        expansion were the primary reasons for the increase in the net loss ratio.
        We
        recognized $0.1 million of adverse prior accident year development in the
        second
        quarter 2007 as compared to $31 thousand of favorable prior year development
        in
        the second quarter of 2006. The Personal Segment reported a net expense ratio
        of
        22.8% for the second quarter of 2007 as compared to 26.2% for the second
        quarter
        of 2006. The decrease in the net expense ratio was mainly due to increased
        finance charges in relation to earned premium, as well as fixed overhead
        allocations to PIIC in each period.
  20
  ***Corporate***
 
 Corporate
        revenue increased $2.2 million for the second quarter of 2007 as compared
        to the
        same period in 2006. The increase was primarily due to $0.8 million of net
        gains
        realized on our investment portfolio during the quarter as compared to $1.4
        million of net losses realized during the second quarter of 2006.
 
 Corporate
        pre-tax loss was $1.3 million for the second quarter of 2007 as compared
        to
        $12.4 million for the same period in 2006. The decreased loss was mostly
        due to
        the absence of the $8.5 million of interest expense incurred in the second
        quarter of 2006 from amortization attributable to the deemed discount on
        convertible promissory notes issued in January, 2006. These notes were converted
        to common stock during the second quarter of 2006. Also contributing to the
        decreased loss were the realized gains discussed above and lower interest
        expense of $0.8 million due to the permanent financing of debt used to acquire
        the subsidiaries comprising the Specialty Commercial Segment in 2006. Most
        of
        this debt was either converted to equity in the second quarter of 2006 or
        repaid
        with proceeds from our public equity offering in the fourth quarter of 2006.
        Partially offsetting these improvements were increased operating expenses
        of
        $0.5 million for the second quarter 2007 due mostly to increased consulting
        costs related to compliance with Sarbanes-Oxley section 404 requirements
        and new
        employees.
  21
  **Six
        Months Ended June 30, 2007 as Compared to Six Months Ended June 30,
        2006**
 
 The
        following is additional business segment information for the six months ended
        June 30, 2007 and 2006 (in thousands):
 
 **Six
                  Months Ended June 30, 2007****Standard**
              
              **Specialty****Commercial**
              
              **Commercial**
              
              **Personal****Segment**
              
              **Segment**
              
              **Segment**
              
              **Corporate**
              
              **Consolidated**Produced
                  premium
              
              
              48,301
              
              
              80,313
              
              
              28,374
              
              
              -
              
              
              156,988Gross
                  premiums written
              
              
              48,221
              
              
              54,641
              
              
              28,373
              
              
              -
              
              
              131,235Ceded
                  premiums written
              
              
              (5,439
              )
              
              (2,729
              )
              
              -
              
              
              -
              
              
              (8,168
              )Net
                  premiums written
              
              
              42,782
              
              
              51,912
              
              
              28,373
              
              
              -
              
              
              123,067Change
                  in unearned premiums
              
              
              (2,655
              )
              
              (11,230
              )
              
              (2,224
              )
              
              
              
              
              (16,109
              )Net
                  premiums earned
              
              
              40,127
              
              
              40,682
              
              
              26,149
              
              
              -
              
              
              106,958Total
                  revenues
              
              
              41,770
              
              
              61,076
              
              
              28,469
              
              
              1,379
              
              
              132,694Losses
                  and loss adjustment expenses
              
              
              24,108
              
              
              21,716
              
              
              17,080
              
              
              (7
              )
              
              62,897Pre-tax
                  income (loss)
              
              
              5,423
              
              
              14,127
              
              
              4,294
              
              
              (3,199
              )
              
              20,645Net
                  loss ratio (1)
              
              
              60.1
              %
              
              53.4
              %
              
              65.3
              %
              
              
              
              
              58.8
              %Net
                  expense ratio (1)
              
              
              27.5
              %
              
              31.8
              %
              
              23.2
              %
              
              
              
              
              28.1
              %Net
                  combined ratio (1)
              
              
              87.6
              %
              
              85.2
              %
              
              88.5
              %
              
              
              
              
              86.9
              %
  **Six
                    Months Ended June 30, 2006****Standard**
                
                **Specialty****Commercial**
                
                **Commercial**
                
                **Personal****Segment**
                
                **Segment**
                
                **Segment**
                
                **Corporate**
                
                **Consolidated**Produced
                    premium
                
                
                47,152
                
                
                74,290
                
                
                21,838
                
                
                -
                
                
                143,280Gross
                    premiums written
                
                
                46,917
                
                
                26,856
                
                
                21,838
                
                
                -
                
                
                95,611Ceded
                    premiums written
                
                
                (3,852
                )
                
                (588
                )
                
                -
                
                
                -
                
                
                (4,440
                )Net
                    premiums written
                
                
                43,065
                
                
                26,268
                
                
                21,838
                
                
                -
                
                
                91,171Change
                    in unearned premiums
                
                
                (11,899
                )
                
                (14,880
                )
                
                (1,699
                )
                
                -
                
                
                (28,478
                )Net
                    premiums earned
                
                
                31,166
                
                
                11,388
                
                
                20,139
                
                
                -
                
                
                62,693Total
                    revenues
                
                
                36,804
                
                
                33,114
                
                
                22,687
                
                
                (898
                )
                
                91,707Losses
                    and loss adjustment expenses
                
                
                17,818
                
                
                6,519
                
                
                12,568
                
                
                (16
                )
                
                36,889Pre-tax
                    income (loss)
                
                
                6,133
                
                
                5,058
                
                
                4,444
                
                
                (15,888
                )
                
                (253
                )Net
                    loss ratio (1)
                
                
                57.2
                %
                
                57.3
                %
                
                62.4
                %
                
                
                
                
                58.8
                %Net
                    expense ratio (1)
                
                
                29.8
                %
                
                24.3
                %
                
                26.4
                %
                
                
                
                
                27.7
                %Net
                    combined ratio (1)
                
                
                87.0
                %
                
                81.6
                %
                
                88.8
                %
                
                
                
                
                86.5
                %
  (1)
        The
        net loss ratio is calculated as incurred losses and loss adjustment expenses
        divided by net premiums earned, each determined in accordance with GAAP.
        The net
        expense ratio is calculated as total underwriting expenses of our insurance
        company subsidiaries, including allocated overhead expenses and 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.
  22
  ***Standard
        Commercial Segment***
 
 Gross
        premiums written for the Standard Commercial Segment were $48.2 million for
        the
        six months ended June 30, 2007, or 3% more than the $46.9 million reported
        for
        the same period in 2006. Net premiums written were $42.8 million for the
        six
        months ended June 30, 2007 as compared to $43.1 million reported for the
        same
        period in 2006. Increased competition and rate pressure continue to challenge
        premium volume growth by the Standard Commercial Segment.
 
 Total
        revenue for the Standard Commercial Segment of $41.8 million for the six
        months
        ended June 30, 2007 was $5.0 million more than the $36.8 million reported
        during
        the six months ended June 30, 2006. This 13% increase in total revenue was
        primarily due to increased net premiums earned of $9.0 million and increased
        net
        investment income of $0.6 million. These increases in revenue were partially
        offset by lower ceding commission revenue of $1.6 million due to contingent
        commission adjustments related to adverse development on prior accident years,
        as well as lower ceding commission revenue of $2.0 million and lower processing
        and service fees of $1.0 million, in both cases due to the shift from a third
        party agency structure to an insurance underwriting structure.
 
 Pre-tax
        income for our Standard Commercial Segment of $5.4 million for the six months
        ended June 30, 2007 decreased $0.7 million, or 12%, from the $6.1 million
        reported for the same period of 2006. This decrease in pre-tax income was
        primarily attributable to the contingent commission adjustment discussed
        above
        as well as higher net loss results. These decreases were partially offset
        by
        additional earned premium volume net of related incurred losses, production
        related expenses, ceding commissions and processing fees of $1.2 million
        and
        increased net investment income of $0.6 million discussed above.
 
 The
        net
        loss ratio for the six months ended June 30, 2007 was 60.1% as compared to
        the
        57.2% reported for the same period of 2006. The net loss ratio was favorably
        impacted by higher ceded losses of $2.0 million for the six months ended
        June
        30, 2007 as compared to only $0.6 million for the same period in 2006. The
        gross
        loss ratio before reinsurance was 57.5% for the six months ended June 30,
        2007
        as compared to 53.9% for the same period the prior year. The gross loss results
        for the six months ended June 30, 2007 included $0.6 million of favorable
        prior
        year development as compared to favorable prior year development of $0.3
        million
        recognized during the same period of 2006. Absent prior year development,
        the
        gross incurred losses and loss adjustment expense before reinsurance for
        the
        Standard Commercial Segment were higher by $2.9 million due to the higher
        gross
        loss experience.
 
 The
        Standard Commercial Segment reported net expense ratios of 27.5% and 29.8%
        for
        the six months ended June 30, 2007 and 2006, respectively. The net expense
        ratio
        for 2006 was higher primarily due to costs to assume from Clarendon National
        Insurance Company the unearned premium previously produced by the Standard
        Commercial Segment.
 
 ***Specialty
        Commercial Segment***
 
 Gross
        premiums written for the Specialty Commercial Segment for the first six months
        of 2007 were $54.6 million or 103% more than the $26.9 million reported for
        the
        same period in 2006. Net premiums written for the first six months of 2007
        were
        $51.9 million or 98% more than the $26.3 million reported for the same period
        in
        2006. The increase in premium volume was due to the increased retention of
        business produced by our TGA Operating Unit from 50% in 2006 to 60% in 2007,
        as
        well as the retention of the business produced by our Aerospace Operating
        Unit
        beginning in the third quarter of 2006.
  23
  Total
        revenue for the Specialty Commercial Segment of $61.1 million for the first
        six
        months of 2007 was $28.0 million more than the $33.1 million reported in
        the
        first six months of 2006. This 84% increase in revenue was largely due to
        increased net premiums earned of $29.3 million for the first six months of
        2007
        as a result of the increased retention of business. The Specialty Commercial
        Segment recognized $3.3 million of contingent ceding commission under the
        2006
        quota share agreement with Republic Underwriters Insurance Company due to
        improved underwriting results. Increased net investment income contributed
        an
        additional $1.4 million to the increase in revenue for the quarter. These
        increases in revenue were partially offset by lower ceding commission and
        fee
        revenue of $5.8 million due to the shift from a third party agency structure
        to
        an insurance underwriting structure.
  Pre-tax
        income for the Specialty Commercial Segment of $14.1 million for the first
        six
        months of 2007 increased $9.1 million, or 179%, from the $5.1 million reported
        for the same period in 2006. Increased revenue, discussed above, was the
        primary
        reason for the increase in pre-tax income, partially offset by increased
        losses
        and loss adjustment expenses of $15.2 million and increased operating expenses
        of $3.8 million due mostly to production related expenses that are directly
        related to increased earned premium. The Specialty Commercial Segment reported
        a
        net loss ratio of 53.4% for the first six months of 2007 as compared to 57.3%
        for the first six months of 2006. Favorable prior year development of $1.4
        million for the six months ended June 30, 2007 as compared to favorable prior
        year development of $0.5 million for the same period of 2006 was the primary
        cause for the decrease in the net loss ratio. The Specialty Commercial Segment
        reported a net expense ratio of 31.8% for the first six months of 2007 as
        compared to 24.3% for the first six months of 2006. The increase in the net
        expense ratio was primarily due to the 2006 net expense ratio being depressed
        by
        the amortization of the fair value adjustment of the deferred policy acquisition
        cost asset, which was recognized in the application of SFAS No. 141 in the
        2006
        acquisition of the TGA Operating Unit. This impacted the reported operating
        expenses during the first six months of 2006. In addition, amortization of
        the
        fair value adjustment of the unearned premium reserve, also recognized pursuant
        to SFAS No. 141, affected the reported net premiums earned during the first
        six
        months of 2006.
  ***Personal
        Segment***
 
 Net
        premium written for our Personal Segment increased $6.5 million during the
        first
        six months of 2007 to $28.4 million compared to $21.8 million in the first
        six
        months of 2006. The increase in premium was due mostly to geographic expansion
        that began in 2006.
 
 Total
        revenue for the Personal Segment increased 25% to $28.5 million for the first
        six months of 2007 from $22.7 million for the same period in 2006. Higher
        earned
        premium of $6.0 million was the primary reason for the increase in revenue
        for
        the period. Increased finance charges of $0.5 million were offset by lower
        investment income of $0.5 million due to the reallocation of capital to other
        segments for their increased retention of premium and lower third party
        commission revenue of $0.2 million.
 
 Pre-tax
        income for the Personal Segment was $4.3 million for the six months ended
        June
        30, 2007 as compared to $4.4 million for the same period in 2006. The increased
        revenue, as discussed above, was offset by increased losses and loss adjustment
        expenses of $4.5 million and increased operating expenses of $1.4 million
        due
        mostly to production related expenses attributable to the increased earned
        premium. The Personal Segment reported a net loss ratio of 65.3% for the
        first
        six months of 2007 as compared to 62.4% for the same period in 2006. A
        competitive pricing environment and the new business impact associated with
        geographic expansion were the primary reasons for the increase in the net
        loss
        ratio. We recognized $0.1 million of favorable prior accident year development
        during the first six months 2007 as compared to $1 thousand of favorable
        prior
        year development during the first six months of 2006. The Personal Segment
        reported a net expense ratio of 23.2% for the first six months of 2007 as
        compared to 26.4% for the first six months of 2006. The decrease in the net
        expense ratio was mainly due to increased finance charges in relation to
        earned
        premium, as well as fixed overhead allocations to PIIC in each
        period.
  24
  ***Corporate***
 
 Corporate
        revenue increased $2.3 million for the first six months of 2007 as compared
        to
        the same period in 2006. The increase was primarily due to $0.9 million of
        net
        gains realized on our investment portfolio during the first six months of
        2007
        as compared to $1.4 million of net losses realized during the same period
        of
        2006.
 
 Corporate
        pre-tax loss was $3.2 million for the first six months of 2007 as compared
        to
        $15.9 million for the same period in 2006. The decreased loss was mostly
        due to
        the absence of the $9.6 million of interest expense incurred in the first
        six
        months of 2006 from amortization attributable to the deemed discount on
        convertible promissory notes issued in January, 2006. These notes were converted
        to common stock during the second quarter of 2006. Also contributing to the
        decreased loss were the realized gains discussed above and lower interest
        expense of $1.6 million due to the permanent financing of debt used to acquire
        the subsidiaries comprising the Specialty Commercial Segment in 2006. Most
        of
        this debt was either converted to equity in the second quarter of 2006 or
        repaid
        with proceeds from our public equity offering in the fourth quarter of 2006.
        Partially offsetting these improvements were increased operating expenses
        of
        $0.8 million for the first six months of 2007 due mostly to increased consulting
        costs related to compliance with Sarbanes-Oxley section 404 requirements
        and new
        employees.
  25
  **Financial
        Condition and Liquidity**
 
 ***Sources
        and Uses of Funds***
 
 Our
        sources of funds are from insurance-related operations, financing activities
        and
        investing activities. Major sources of funds from operations include premiums
        collected (net of policy cancellations and premiums ceded), commissions,
        and
        processing and service fees. As a holding company, Hallmark is dependent
        on
        dividend payments and management fees from its subsidiaries to meet operating
        expenses and debt obligations. As of June 30, 2007, Hallmark had $2.0 million
        in
        unrestricted cash and invested assets. Unrestricted cash and invested assets
        of
        our non-insurance subsidiaries were $5.1 million as of June 30, 2007.
 
 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. PIIC, 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. GSIC, domiciled in Oklahoma, is limited in the payment of dividends
        to the greater of 10% of prior year surplus or prior year’s statutory net
        income, without prior written approval from the Oklahoma Insurance Department.
        During 2007, our insurance company subsidiaries’ ordinary dividend capacity is
        $12.4 million. None of our insurance company subsidiaries paid a dividend
        to
        Hallmark during the first six months of 2007 or the 2006 fiscal
        year.
 
 ***Comparison
        of June 30, 2007 to December 31, 2006***
 
 On
        a
        consolidated basis, our cash and investments (excluding restricted cash)
        at June
        30, 2007 were $296.6 million compared to $244.4 million at December 31, 2006.
        Net cash provided by our operating activities was the primary driver of the
        increase in our cash and investments for the six months ended June 30,
        2007.
  ***Comparison
        of Six Months Ended June 30, 2007 and June 30, 2006***
 
 Net
        cash
        provided by our consolidated operating activities was $44.6 million for the
        first six months of 2007 compared to $29.7 million for the first six months
        of
        2006. The increase in operating cash flow was primarily due to increased
        collected premiums resulting from increased retained premium volume, partially
        offset by additional retained paid losses and loss adjustment expenses and
        additional paid operating expenses.
  26
  Cash
        used
        in investing activities during the first six months of 2007 was $69.3 million
        as
        compared to $113.3 million for the same period in 2006. The higher cash used
        in
        investing activities during the first half of 2006 was mostly due to the
        acquisitions of the subsidiaries comprising our Specialty Commercial Segment
        which used $26.0 million, net of cash acquired. Also contributing to the
        reduction in cash used by investing activities during the first six months
        of
        2007 was the withdrawal of $15.0 million from a trust account securing the
        future guaranteed payments to the sellers of the subsidiaries comprising
        our TGA
        Operating Unit to make the first installment payment in the first quarter
        of
        2007. Net premium finance notes repaid of $0.6 million during the first six
        months of 2007 versus net premium finance notes repaid of $2.4 million during
        the first six months of 2006 also contributed to the reduction in cash used
        in
        investing activities.
 
 Cash
        used
        in financing activities during the first six months of 2007 was $15.0 million
        as
        compared to $52.5 million provided by financing activities for the same period
        of 2006. The cash used in 2007 was for the payment of a portion of the
        structured settlement to the sellers of the subsidiaries comprising our TGA
        Operating Unit. The cash provided in 2006 was primarily from the issuance
        of
        three debt instruments in January. The first was a promissory note payable
        to
        Newcastle Partners, L.P. (“Newcastle Partners”) in the amount of $12.5 million
        to fund the cash required to close the acquisition of the subsidiaries now
        comprising our Aerospace Operating Unit. The second debt instrument was $25.0
        million in subordinated convertible promissory notes to the Newcastle Special
        Opportunity Fund I, L.P. and Newcastle Special Opportunity Fund II, L.P.
        (the
“Opportunity Funds”). The principal and accrued interest on the convertible
        notes was converted to 3.3 million shares of our common stock during the
        second
        quarter of 2006. The $25.0 million raised with these notes was used to fund
        a
        trust account securing future guaranteed payments to the sellers of the
        subsidiaries now comprising our TGA Operating Unit. The third debt instrument
        was $15.0 million borrowed under our revolving credit facility to fund the
        cash
        required to close the acquisition of the subsidiaries now comprising our
        TGA
        Operating Unit. In October 2006, we repaid the promissory note to Newcastle
        Partners and repaid $12.2 million of the outstanding principal balance of
        our
        revolving credit facility, in each case with proceeds received from our public
        equity offering. Newcastle Partners and the Opportunity Funds are each an
        affiliate of our Executive Chairman, Mark E. Schwarz.
 
 ***Credit
        Facilities***
 
 On
        June
        29, 2005, we entered into a credit facility with The Frost National Bank.
        The
        credit facility was amended and restated on January 27, 2006 to a $20.0 million
        revolving credit facility, with a $5.0 million letter of credit sub-facility.
        The credit facility was further amended effective May 31, 2007 to increase
        the
        revolving credit facility to $25.0 million and establish a new $5.0 million
        revolving credit sub-facility for the premium finance operations of PAAC.
        Principal outstanding under the revolving credit facility generally bears
        interest at the three month Eurodollar rate plus 2.00%, payable quarterly
        in
        arrears. We pay letter of credit fees at the rate of 1.00% per annum. Our
        obligations under the revolving credit facility are secured by a security
        interest in the capital stock of all of our subsidiaries, guaranties of all
        of
        our subsidiaries and the pledge of substantially all of our assets. The
        revolving credit facility contains covenants which, among other things, require
        us to maintain certain financial and operating ratios and restrict certain
        distributions, transactions and organizational changes. The amended and restated
        credit agreement terminates on January 27, 2008. The new premium finance
        sub-facility terminates May 31, 2009. As of June 30, 2007, we were in compliance
        with all of our covenants. In the third quarter of 2005, we issued a $4.0
        million letter of credit under this facility to collateralize certain
        obligations under the agency agreement between our HGA Operating Unit and
        Clarendon National Insurance Company effective July 1, 2004.
  PAAC
        had
        a $5.0 million revolving credit facility with JPMorgan Chase Bank which
        terminated June 30, 2007. This facility was replaced with the new $5.0 million
        premium finance sub-facility with The Frost National Bank as discussed
        above.
 
 27
  ***Trust
        Preferred Securities***
 
 On
        June
        21, 2005, our newly formed trust entity completed a private placement of
        $30.0
        million of 30-year floating rate trust preferred securities. Simultaneously,
        we
        borrowed $30.9 million from the trust subsidiary and contributed $30.0 million
        to one of our insurance company subsidiaries in order to increase policyholder
        surplus. The note bears an initial interest rate of 7.725% until June 15,
        2015,
        at which time interest will adjust quarterly to the three month LIBOR rate
        plus
        3.25 percentage points. As of June 30, 2007, the note balance was $30.9
        million.
 
 ***Structured
        Settlements***
 
 In
        connection with our acquisition of the subsidiaries now comprising our TGA
        Operating Unit, we issued to the sellers promissory notes in the aggregate
        principal amount of $23.7 million, of which $14.2 million was paid on January
        2,
        2007, and $9.5 million is due on or before January 1, 2008. We were also
        obligated to pay to the sellers an additional $1.3 million, of which $0.8
        million was paid on January 2, 2007 and an additional $0.5 million is due
        on or
        before January 1, 2008, in consideration of the sellers’ compliance with certain
        restrictive covenants, including a covenant not to compete for a period of
        five
        years after closing. We secured payment of these future installments of purchase
        price and restrictive covenant consideration by depositing $25.0 million
        in a
        trust account for the benefit of the sellers. We recorded a payable for future
        guaranteed payments to the sellers of $25.0 million discounted at 4.4%, the
        rate
        of two-year U.S. Treasuries (the only permitted investment of the trust
        account). As of June 30, 2007, the balance of the structured settlements
        was
        $9.8 million.
 
 ***Conclusion***
 
 Based
        on
        budgeted and year-to-date cash flow information, we believe that we have
        sufficient liquidity to meet our projected insurance obligations, operational
        expenses and capital expenditure requirements for the next 12 months.
  **Item
        3. Quantitative and Qualitative Disclosures About Market
        Risk.**
 
 As
        of
        June 30, 2007, there had been no material changes in the market risks described
        in the Company’s Form 10-K for the year ended December 31, 2006.
 
 **Item
        4T. Controls and Procedures.**
 
 The
        principal executive officer and principal financial officer of the Company
        have
        evaluated the Company’s disclosure controls and procedures and have concluded
        that, as of the end of the period covered by this report, such disclosure
        controls and procedures were effective in ensuring that information required
        to
        be disclosed by the Company in the reports that it files or submits under
        the
        Securities Exchange Act of 1934 is timely recorded, processed, summarized
        and
        reported. The principal executive officer and principal financial officer
        also
        concluded that such disclosure controls and procedures were effective in
        ensuring that information required to be disclosed by the Company in the
        reports
        that it files or submits under such Act is accumulated and communicated to
        the
        Company’s management, including its principal executive officer and principal
        financial officer, as appropriate, to allow timely decisions regarding required
        disclosure. During the most recent fiscal quarter, there have been no changes
        in
        the Company’s internal controls over financial reporting that have materially
        affected, or are reasonably likely to materially affect, the Company’s internal
        control over financial reporting.
  28
  **Risks
        Associated with Forward-Looking Statements Included in this Form
        10-Q**
 
 This
        Form
        10-Q contains certain forward-looking statements within the meaning of Section
        27A of the Securities Act of 1933 and Section 21E of the Securities Exchange
        Act
        of 1934, which are intended to be covered by the safe harbors created thereby.
        These statements include the plans and objectives of management for future
        operations, including plans and objectives relating to future growth of the
        Company's business activities and availability of funds. The forward-looking
        statements included herein are based on current expectations that involve
        numerous risks and uncertainties. Assumptions relating to the foregoing involve
        judgments with respect to, among other things, future economic, competitive
        and
        market conditions, regulatory framework, weather-related events and future
        business decisions, all of which are difficult or impossible to predict
        accurately and many of which are beyond the control of the Company. Although
        the
        Company believes that the assumptions underlying the forward-looking statements
        are reasonable, any of the assumptions could be inaccurate and, therefore,
        there
        can be no assurance that the forward-looking statements included in this
        Form
        10-Q will prove to be accurate. In light of the significant uncertainties
        inherent in the forward-looking statements included herein, the inclusion
        of
        such information should not be regarded as a representation by the Company
        or
        any other person that the objectives and plans of the Company will be
        achieved.
  29
  **PART
        II**
 **OTHER
        INFORMATION**
 
 **Item
        1.**  **Legal
        Proceedings.**
 
 The
        Company is engaged in legal proceedings in the ordinary course of business,
        none
        of which, either individually or in the aggregate, are believed likely to
        have a
        material adverse effect on the consolidated financial position of the Company
        or
        the results of operations, in the opinion of management. The various legal
        proceedings to which the Company is a party are routine in nature and incidental
        to the Company’s business.
 
 **Item
        1A.**  **Risk
        Factors.**
 
 In
        addition to the other information set forth in this report, you should carefully
        consider the following risk factors:
 
 ***Our
        success depends on our ability to price accurately the risks we
        underwrite*** .
 
 Our
        results of operations and financial condition depend on our ability to
        underwrite and set premium rates accurately for a wide variety of risks.
        Adequate rates are necessary to generate premiums sufficient to pay losses,
        loss
        settlement expenses and underwriting expenses and to earn a profit. To price
        our
        products accurately, we must collect and properly analyze a substantial amount
        of data; develop, test and apply appropriate pricing techniques; closely
        monitor
        and timely recognize changes in trends; and project both severity and frequency
        of losses with reasonable accuracy. Our ability to undertake these efforts
        successfully, and as a result price our products accurately, is subject to
        a
        number of risks and uncertainties, some of which are outside our control,
        including:
 
 •  the
        availability of sufficient reliable data and our ability to properly analyze
        available data;
 
 •  the
        uncertainties that inherently characterize estimates and
        assumptions;
 
 •  our
        selection and application of appropriate pricing techniques; and
 
 •  changes
        in applicable legal liability standards and in the civil litigation system
        generally.
 
 Consequently,
        we could under-price risks, which would adversely affect our profit margins,
        or
        we could overprice risks, which could reduce our sales volume and
        competitiveness. In either case, our profitability could be materially and
        adversely affected.
 
 ***Our
        results may fluctuate as a result of cyclical changes in the property/casualty
        insurance industry.***
 
 Our
        revenue is primarily attributable to property/casualty insurance, which as
        an
        industry is cyclical in nature and has historically been characterized by
        soft
        markets followed by hard markets. A soft market is a period of relatively
        high
        levels of price competition, less restrictive underwriting standards and
        generally low premium rates. A hard market is a period of capital shortages
        resulting in lack of insurance availability, relatively low levels of
        competition, more selective underwriting of risks and relatively high premium
        rates. If we find it necessary to reduce premiums or limit premium increases
        due
        to competitive pressures on pricing in a softening market, we may experience
        a
        reduction in our premiums written and in our profit margins and revenues,
        which
        could adversely affect our financial results.
  30
  ***Estimating
        reserves is inherently uncertain. If our loss reserves are not adequate,
        it will
        have an unfavorable impact on our results.***
 
 We
        maintain loss reserves to cover our estimated ultimate liability for unpaid
        losses and loss adjustment expenses for reported and unreported claims incurred
        as of the end of each accounting period. Reserves represent management’s
        estimates of what the ultimate settlement and administration of claims will
        cost
        and are not reviewed by an independent actuary. These estimates, which generally
        involve actuarial projections, are based on management’s assessment of facts and
        circumstances then known, as well as estimates of future trends in claim
        severity and frequency, judicial theories of liability, and other factors.
        These
        variables are affected by both internal and external events, such as changes
        in
        claims handling procedures, inflation, judicial trends and legislative changes.
        Many of these factors are not quantifiable. Additionally, there may be a
        significant reporting lag between the occurrence of an event and the time
        it is
        reported to us. The inherent uncertainties of estimating reserves are greater
        for certain types of liabilities, particularly those in which the various
        considerations affecting the type of claim are subject to change and in which
        long periods of time may elapse before a definitive determination of liability
        is made. Reserve estimates are continually refined in a regular and ongoing
        process as experience develops and further claims are reported and settled.
        Adjustments to reserves are reflected in the results of the periods in which
        such estimates are changed. For example, a 1% change in June 30, 2007 unpaid
        losses and loss adjustment expenses would have produced a $1.0 million change
        to
        pretax earnings. Our gross loss and loss adjustment expense reserves totaled
        $104.4 million at June 30, 2007. Our loss and loss adjustment expense reserves,
        net of reinsurance recoverables, were $97.9 million at that date. Because
        setting reserves is inherently uncertain, there can be no assurance that
        the
        current reserves will prove adequate.
 
 ***Our
        failure to maintain favorable financial strength ratings could negatively
        impact
        our ability to compete successfully.***
 
 Third-party
        rating agencies assess and rate the claims-paying ability of insurers based
        upon
        criteria established by the agencies. During 2005, A.M. Best, a nationally
        recognized insurance industry rating service and publisher, upgraded the
        financial strength rating of PIIC, from “B” (Fair) to “B+” (Very Good), and
        upgraded the financial strength rating of AHIC, from “B” (Fair) to “A-”
(Excellent). Our insurance company subsidiaries have historically been rated
        on
        an individual basis. However, effective January 1, 2006, our insurance company
        subsidiaries entered into a pooling arrangement, which was subsequently amended
        December 15, 2006, whereby AHIC would retain 46% of the net premiums written,
        PIIC would retain 34% of the net premiums written and GSIC would retain 20%
        of
        the net premiums written. As a result, in June 2006, A.M. Best notified us
        that
        our insurance company subsidiaries would be rated on a pooled basis and assigned
        a rating of “A-” (Excellent) to each of our individual insurance company
        subsidiaries and to the pool formed by our insurance company
        subsidiaries.
 
 These
        financial strength ratings are used by policyholders, insurers, reinsurers
        and
        insurance and reinsurance intermediaries as an important means of assessing
        the
        financial strength and quality of insurers. These ratings are not evaluations
        directed to potential purchasers of our common stock and are not recommendations
        to buy, sell or hold our common stock. Our ratings are subject to change
        at any
        time and could be revised downward or revoked at the sole discretion of the
        rating agencies. We believe that the ratings assigned by A.M. Best are an
        important factor in marketing our products. Our ability to retain our existing
        business and to attract new business in our insurance operations depends
        largely
        on these ratings. Our failure to maintain our ratings, or any other adverse
        development with respect to our ratings, could cause our current and future
        independent agents and insureds to choose to transact their business with
        more
        highly rated competitors. If A.M. Best downgrades our ratings or publicly
        indicates that our ratings are under review, it is likely that we would not
        be
        able to compete as effectively with our competitors, and our ability to sell
        insurance policies could decline. If that happens, our sales and earnings
        would
        decrease. For example, many of our agencies and insureds have guidelines
        that
        require us to have an A.M. Best financial strength rating of “A-” or higher. A
        reduction of our A.M. Best rating below “A-” would prevent us from issuing
        policies to insureds or potential insureds with such ratings requirements.
        Because lenders and reinsurers will use our A.M. Best ratings as a factor
        in
        deciding whether to transact business with us, the failure of our insurance
        company subsidiaries to maintain their current ratings could dissuade a lender
        or reinsurance company from conducting business with us or might increase
        our
        interest or reinsurance costs. In addition, a ratings downgrade by A.M. Best
        below “A-” would require us to post collateral in support of our obligations
        under certain of our reinsurance agreements pursuant to which we assume
        business.
  31
  ***The
        loss of key executives could disrupt our business.***
 
 Our
        success will depend in part upon the continued service of certain key
        executives. Our success will also depend on our ability to attract and retain
        additional executives and personnel. We do not have employment agreements
        with
        our Chief Executive Officer or any other of our executive officers other
        than
        employment agreements entered into in connection with the acquisitions of
        the
        subsidiaries now comprising our TGA Operating Unit and our Aerospace Operating
        Unit. The loss of key personnel, or our inability to recruit and retain
        additional qualified personnel, could cause disruption in our business and
        could
        prevent us from fully implementing our business strategies, which could
        materially and adversely affect our business, growth and
        profitability.
 
 ***Our
        industry is very competitive, which may unfavorably impact our results of
        operations.***
 
 The
        property/casualty insurance market, our primary source of revenue, is highly
        competitive and, except for regulatory considerations, has very few barriers
        to
        entry. According to A.M. Best, there were 3,173 property/casualty insurance
        companies and 2,065 property/casualty insurance groups operating in North
        America as of July 24, 2006. Our HGA Operating Unit competes with a variety
        of
        large national standard commercial lines carriers such as The Hartford, Zurich
        North America, St. Paul Travelers and Safeco, as well as numerous smaller
        regional companies. The primary competition for our TGA Operating Unit’s excess
        and surplus lines products includes such carriers as Atlantic Casualty Insurance
        Company, Colony Insurance Company, Burlington Insurance Company, Penn America
        Insurance Group and, to a lesser extent, a number of national standard lines
        carriers such as Zurich North America and The Hartford. Our Aerospace Operating
        Unit considers its primary competitors to be Houston Casualty Corp., Phoenix
        Aviation, W. Brown & Company, AIG and London Aviation Underwriters. Although
        our Phoenix Operating Unit competes with large national insurers such as
        Allstate, State Farm and Progressive, as a participant in the non-standard
        personal automobile marketplace its competition is most directly associated
        with
        numerous regional companies and managing general agencies. Our competitors
        include entities which have, or are affiliated with entities which have,
        greater
        financial and other resources than we have. In addition, competitors may
        attempt
        to increase market share by lowering rates. In that case, we could experience
        reductions in our underwriting margins, or sales of our insurance policies
        could
        decline as customers purchase lower-priced products from our competitors.
        Losing
        business to competitors offering similar products at lower prices, or having
        other competitive advantages, could adversely affect our results of
        operations.
  32
  ***Our
        results may be unfavorably impacted if we are unable to obtain adequate
        reinsurance*** .
 
 As
        part
        of our overall risk and capacity management strategy, we purchase reinsurance
        for significant amounts of risk, especially catastrophe risks that we and
        our
        insurance company subsidiaries underwrite. Our catastrophe and non-catastrophe
        reinsurance facilities are subject to annual renewal. We may be unable to
        maintain our current reinsurance facilities or to obtain other reinsurance
        facilities in adequate amounts and at favorable rates. The amount, availability
        and cost of reinsurance are subject to prevailing market conditions beyond
        our
        control and may affect our ability to write additional premiums as well as
        our
        profitability. If we are unable to obtain adequate reinsurance protection
        for
        the risks we have underwritten, we will either be exposed to greater losses
        from
        these risks or we will reduce the level of business that we underwrite, which
        will reduce our revenue.
 
 ***If
        the companies that provide our reinsurance do not pay our claims in a timely
        manner, we could incur severe losses.***
 
 We
        purchase reinsurance by transferring, or ceding, part of the risk we have
        assumed to a reinsurance company in exchange for part of the premium we receive
        in connection with the risk. Although reinsurance makes the reinsurer liable
        to
        us to the extent the risk is transferred or ceded to the reinsurer, it does
        not
        relieve us of our liability to our policyholders. Accordingly, we bear credit
        risk with respect to our reinsurers. We cannot assure that our reinsurers
        will
        pay all of our reinsurance claims, or that they will pay our claims on a
        timely
        basis. At June 30, 2007, we had a total of $6.5 million due us from reinsurers
        for recovery of losses. The largest amount due us from a single reinsurer
        as of
        June 30, 2007 was $1.4 million from QBE Reinsurance Corporation. If any of
        our
        reinsurers are unable or unwilling to pay amounts they owe us in a timely
        fashion, we could suffer a significant loss or a shortage of liquidity, which
        would have a material adverse effect on our business and results of
        operations.
 
 ***Catastrophic
        losses are unpredictable and may adversely affect our results of operations,
        liquidity and financial condition*** .
 
 Property/casualty
        insurance companies are subject to claims arising out of catastrophes that
        may
        have a significant effect on their results of operations, liquidity and
        financial condition. Catastrophes can be caused by various events, including
        hurricanes, windstorms, earthquakes, hail storms, explosions, severe winter
        weather and fires, and may include man-made events, such as the September
        11,
        2001 terrorist attacks on the World Trade Center. The incidence, frequency,
        and
        severity of catastrophes are inherently unpredictable. The extent of losses
        from
        a catastrophe is a function of both the total amount of insured exposure
        in the
        area affected by the event and the severity of the event. Claims from
        catastrophic events could reduce our net income, cause substantial volatility
        in
        our financial results for any fiscal quarter or year or otherwise adversely
        affect our financial condition, liquidity or results of operations. Catastrophes
        may also negatively affect our ability to write new business. Increases in
        the
        value and geographic concentration of insured property and the effects of
        inflation could increase the severity of claims from catastrophic events
        in the
        future.
 
 33
  ***Catastrophe
        models may not accurately predict future losses*** .
 
 Along
        with other insurers in the industry, we use models developed by third-party
        vendors in assessing our exposure to catastrophe losses that assume various
        conditions and probability scenarios. However, these models do not necessarily
        accurately predict future losses or accurately measure losses currently
        incurred. Catastrophe models, which have been evolving since the early 1990s,
        use historical information about various catastrophes and detailed information
        about our in-force business. While we use this information in connection
        with
        our pricing and risk management activities, there are limitations with respect
        to their usefulness in predicting losses in any reporting period. Examples
        of
        these limitations are significant variations in estimates between models
        and
        modelers and material increases and decreases in model results due to changes
        and refinements of the underlying data elements and assumptions. Such
        limitations lead to questionable predictive capability and post-event
        measurements that have not been well understood or proven to be sufficiently
        reliable. In addition, the models are not necessarily reflective of company
        or
        state-specific policy language, demand surge for labor and materials or loss
        settlement expenses, all of which are subject to wide variation by catastrophe.
        Because the occurrence and severity of catastrophes are inherently unpredictable
        and may vary significantly from year to year, historical results of operations
        may not be indicative of future results of operations.
 
 ***We
        are subject to comprehensive regulation, and our results may be unfavorably
        impacted by these regulations.***
 
 We
        are
        subject to comprehensive governmental regulation and supervision. Most insurance
        regulations are designed to protect the interests of policyholders rather
        than
        of the stockholders and other investors of the insurance companies. These
        regulations, generally administered by the department of insurance in each
        state
        in which we do business, relate to, among other things:
 
 •  approval
        of policy forms and rates;
 
 •  standards
        of solvency, including risk-based capital measurements, which are a measure
        developed by the National Association of Insurance Commissioners and used
        by the
        state insurance regulators to identify insurance companies that potentially
        are
        inadequately capitalized;
 
 •  licensing
        of insurers and their agents;
 
 •  restrictions
        on the nature, quality and concentration of investments;
 
 •  restrictions
        on the ability of insurance company subsidiaries to pay dividends;
 
 •  restrictions
        on transactions between insurance company subsidiaries and their
        affiliates;
 
 •  requiring
        certain methods of accounting;
 
 •  periodic
        examinations of operations and finances;
 
 •  the
        use
        of non-public consumer information and related privacy issues;
 
 •  the
        use
        of credit history in underwriting and rating;
  34
  •  limitations
        on the ability to charge policy fees;
 
 •  the
        acquisition or disposition of an insurance company or of any company controlling
        an insurance company;
 
 •  involuntary
        assignments of high-risk policies, participation in reinsurance facilities
        and
        underwriting associations, assessments and other governmental
        charges;
 
 •  restrictions
        on the cancellation or non-renewal of policies and, in certain jurisdictions,
        withdrawal from writing certain lines of business;
 
 •  prescribing
        the form and content of records of financial condition to be filed;
 
 •  requiring
        reserves for unearned premium, losses and other purposes; and
 
 •  with
        respect to premium finance business, the federal Truth-in-Lending Act and
        similar state statutes. In states where specific statutes have not been enacted,
        premium finance is generally subject to state usury laws that are applicable
        to
        consumer loans.
 
 State
        insurance departments also conduct periodic examinations of the affairs of
        insurance companies and require filing of annual and other reports relating
        to
        the financial condition of insurance companies, holding company issues and
        other
        matters. Our business depends on compliance with applicable laws and regulations
        and our ability to maintain valid licenses and approvals for our operations.
        Regulatory authorities may deny or revoke licenses for various reasons,
        including violations of regulations. Changes in the level of regulation of
        the
        insurance industry or changes in laws or regulations themselves or
        interpretations by regulatory authorities could have a material adverse affect
        on our operations. In addition, we could face individual, group and class-action
        lawsuits by our policyholders and others for alleged violations of certain
        state
        laws and regulations. Each of these regulatory risks could have an adverse
        effect on our profitability.
 
 ***State
        statutes limit the aggregate amount of dividends that our subsidiaries may
        pay
        Hallmark, thereby limiting its funds to pay expenses and
        dividends.***
 
 Hallmark
        is a holding company and a legal entity separate and distinct from its
        subsidiaries. As a holding company without significant operations of its
        own,
        Hallmark’s principal sources of funds are dividends and other sources of funds
        from its subsidiaries. State insurance laws limit the ability of Hallmark’s
        insurance company subsidiaries to pay dividends and require our insurance
        company subsidiaries to maintain specified minimum levels of statutory capital
        and surplus. The aggregate maximum amount of dividends permitted by law to
        be
        paid by an insurance company does not necessarily define an insurance company’s
        actual ability to pay dividends. The actual ability to pay dividends may
        be
        further constrained by business and regulatory considerations, such as the
        impact of dividends on surplus, by our competitive position and by the amount
        of
        premiums that we can write. Without regulatory approval, the aggregate maximum
        amount of dividends that could be paid to Hallmark in 2007 by our insurance
        company subsidiaries is $12.4 million. State insurance regulators have broad
        discretion to limit the payment of dividends by insurance companies and
        Hallmark’s right to participate in any distribution of assets of one of our
        insurance company subsidiaries is subject to prior claims of policyholders
        and
        creditors except to the extent that its rights, if any, as a creditor are
        recognized. Consequently, Hallmark’s ability to pay debts, expenses and cash
        dividends to our stockholders may be limited.
  35
  ***Our
        insurance company subsidiaries are subject to minimum capital and surplus
        requirements. Failure to meet these requirements could subject us to regulatory
        action.***
 
 Our
        insurance company subsidiaries are subject to minimum capital and surplus
        requirements imposed under the laws of their respective states of domicile
        and
        each state in which they issue policies. Any failure by one of our insurance
        company subsidiaries to meet minimum capital and surplus requirements imposed
        by
        applicable state law will subject it to corrective action, which may include
        requiring adoption of a comprehensive financial plan, revocation of its license
        to sell insurance products or placing the subsidiary under state regulatory
        control. Any new minimum capital and surplus requirements adopted in the
        future
        may require us to increase the capital and surplus of our insurance company
        subsidiaries, which we may not be able to do.
 
 ***We
        are subject to assessments and other surcharges from state guaranty funds,
        mandatory reinsurance arrangements and state insurance facilities, which
        may
        reduce our profitability.***
 
 Virtually
        all states require insurers licensed to do business therein to bear a portion
        of
        the unfunded obligations of impaired or insolvent insurance companies. These
        obligations are funded by assessments, which are levied by guaranty associations
        within the state, up to prescribed limits, on all member insurers in the
        state
        on the basis of the proportionate share of the premiums written by member
        insurers in the lines of business in which the impaired, insolvent or failed
        insurer was engaged. Accordingly, the assessments levied on us by the states
        in
        which we are licensed to write insurance may increase as we increase our
        premiums written. In addition, as a condition to the ability to conduct business
        in certain states, insurance companies are required to participate in mandatory
        reinsurance funds. The effect of these assessments and mandatory reinsurance
        arrangements, or changes in them, could reduce our profitability in any given
        period or limit our ability to grow our business.
 
 We
        are
        currently monitoring developments with respect to various state facilities,
        such
        as the Texas FAIR Plan and the Texas Windstorm Insurance Association, and
        the
        various guaranty funds in which we participate. The ultimate impact of recent
        catastrophe experience on these facilities is currently uncertain but could
        result in the facilities recognizing a financial deficit or a financial deficit
        greater than the level currently estimated. They may, in turn, have the ability
        to assess participating insurers when financial deficits occur, adversely
        affecting our results of operations. While these facilities are generally
        designed so that the ultimate cost is borne by policyholders, the exposure
        to
        assessments and the availability of recoupments or premium rate increases
        from
        these facilities may not offset each other in our financial statements.
        Moreover, even if they do offset each other, they may not offset each other
        in
        financial statements for the same fiscal period due to the ultimate timing
        of
        the assessments and recoupments or premium rate increases, as well as the
        possibility of policies not being renewed in subsequent years.
  36
  ***Adverse
        securities market conditions can have a significant and negative impact on
        our
        investment portfolio*** .
 
 Our
        results of operations depend in part on the performance of our invested assets.
        As of June 30, 2007, 88% of our investment portfolio was invested in
        fixed-income securities. Certain risks are inherent in connection with
        fixed-income securities, including loss upon default and price volatility
        in
        reaction to changes in interest rates and general market factors. In general,
        the fair market value of a portfolio of fixed-income securities increases
        or
        decreases inversely with changes in the market interest rates, while net
        investment income realized from future investments in fixed-income securities
        increases or decreases along with interest rates. In addition, 11% of our
        fixed-income securities have call or prepayment options. This subjects us
        to
        reinvestment risk should interest rates fall and issuers call their securities.
        Furthermore, actual net investment income and/or cash flows from investments
        that carry prepayment risk, such as mortgage-backed and other asset-backed
        securities, may differ from those anticipated at the time of investment as
        a
        result of interest rate fluctuations. An investment has prepayment risk when
        there is a risk that cash flows from the repayment of principal might occur
        earlier than anticipated because of declining interest rates or later than
        anticipated because of rising interest rates.
 
 In
        addition to the general risks described above, although 90% of our fixed-income
        portfolio is investment-grade, our fixed-income securities are nonetheless
        subject to credit risk. If any of the issuers of our fixed-income securities
        suffer financial setbacks, the ratings on the fixed-income securities could
        fall
        (with a concurrent fall in market value) and, in a worst case scenario, the
        issuer could default on its obligations. Hallmark has no exposure in its
        investment portfolio to sub-prime mortgages and less than $5 thousand total
        exposure in mortgage backed securities.  Future changes in the fair market
        value of our available-for-sale securities will be reflected in other
        comprehensive income. Similar treatment is not available for liabilities.
        Therefore, interest rate fluctuations could adversely affect our stockholders’
equity, total comprehensive income and/or our cash flows.
 
 As
        of
        June 30, 2007, 12% of our investment portfolio was invested in equity
        securities. The equity securities that we hold are subject to economic loss
        from
        a decline in share price. As a result, the values of these equity securities
        are
        heavily influenced by the specific financial prospects of each issuer. In
        addition, general economic conditions, stock market conditions and other
        factors
        may adversely affect the value of our equity investments. As a result, we
        may
        not realize the desired returns on our equity investments, may incur losses
        on
        sales of our equity securities or may be required to write down the value
        of our
        equity securities.
 
 ***We
        rely on independent agents and specialty brokers to market our products and
        their failure to do so would have a material adverse effect on our results
        of
        operations.***
 
 We
        market
        and distribute our insurance programs exclusively through independent insurance
        agents and specialty insurance brokers. As a result, our business depends
        in
        large part on the marketing efforts of these agents and brokers and on our
        ability to offer insurance products and services that meet the requirements
        of
        the agents, the brokers and their customers. However, these agents and brokers
        are not obligated to sell or promote our products and many sell or promote
        competitors’ insurance products in addition to our products. Some of our
        competitors have higher financial strength ratings, offer a larger variety
        of
        products, set lower prices for insurance coverage and/or offer higher
        commissions than we do. Therefore, we may not be able to continue to attract
        and
        retain independent agents and brokers to sell our insurance products. The
        failure or inability of independent agents and brokers to market our insurance
        products successfully could have a material adverse impact on our business,
        financial condition and results of operations.
 
 ***We
        may experience difficulty in integrating recent or future acquisitions into
        our
        operations.***
 
 We
        completed the acquisitions of the subsidiaries now comprising both our TGA
        Operating Unit and our Aerospace Operating Unit during January 2006. We may
        pursue additional acquisitions in the future. The successful integration
        of
        newly acquired businesses into our operations will require, among other things,
        the retention and assimilation of their key management, sales and other
        personnel; the coordination of their lines of insurance products and services;
        the adaptation of their technology, information systems and other processes;
        and
        the retention and transition of their customers. Unexpected difficulties
        in
        integrating any acquisition could result in increased expenses and the diversion
        of management time and resources. If we do not successfully integrate any
        acquired business into our operations, we may not realize the anticipated
        benefits of the acquisition, which could have a material adverse impact on
        our
        financial condition and results of operations. Further, any potential
        acquisitions may require significant capital outlays and, if we issue equity
        or
        convertible debt securities to pay for an acquisition, the issuance may be
        dilutive to our existing stockholders.
  37
  ***Our
        geographic concentration ties our performance to the business, weather, economic
        and regulatory conditions of certain states*** .
 
 The
        following five states accounted for 81% of our gross written premiums for
        the
        three months ended June 30, 2007: Texas (44%), Oregon (14%), New Mexico (10%),
        Idaho (7%) and Arizona (6%). Our revenues and profitability are subject to
        the
        prevailing regulatory, legal, economic, political, demographic, competitive,
        weather and other conditions in the principal states in which we do business.
        Changes in any of these conditions could make it less attractive for us to
        do
        business in such states and would have a more pronounced effect on us compared
        to companies that are more geographically diversified. In addition, our exposure
        to severe losses from localized natural perils, such as windstorms or
        hailstorms, is increased in those areas where we have written significant
        numbers of property/casualty insurance policies.
 
 ***The
        exclusions and limitations in our policies may not be
        enforceable.***
 
 Many
        of
        the policies we issue include exclusions or other conditions that define
        and
        limit coverage, which exclusions and conditions are designed to manage our
        exposure to certain types of risks and expanding theories of legal liability.
        In
        addition, many of our policies limit the period during which a policyholder
        may
        bring a claim under the policy, which period in many cases is shorter than
        the
        statutory period under which these claims can be brought by our policyholders.
        While these exclusions and limitations help us assess and control our loss
        exposure, it is possible that a court or regulatory authority could nullify
        or
        void an exclusion or limitation, or legislation could be enacted modifying
        or
        barring the use of these exclusions and limitations. This could result in
        higher
        than anticipated losses and loss adjustment expenses by extending coverage
        beyond our underwriting intent or increasing the number or size of claims,
        which
        could have a material adverse effect on our operating results. In some
        instances, these changes may not become apparent until some time after we
        have
        issued the insurance policies that are affected by the changes. As a result,
        the
        full extent of liability under our insurance contracts may not be known for
        many
        years after a policy is issued.
 
 ***We
        rely on our information technology and telecommunications systems and the
        failure or disruption of these systems could disrupt our operations and
        adversely affect our results of operations*** .
 
 Our
        business is highly dependent upon the successful and uninterrupted functioning
        of our information technology and telecommunications systems. We rely on
        these
        systems to process new and renewal business, provide customer service, make
        claims payments and facilitate collections and cancellations, as well as
        to
        perform actuarial and other analytical functions necessary for pricing and
        product development. Our systems could fail of their own accord or might
        be
        disrupted by factors such as natural disasters, power disruptions or surges,
        computer hackers or terrorist attacks. Failure or disruption of these systems
        for any reason could interrupt our business and adversely affect our results
        of
        operations.
 
 38
 
 **Item
        2.** **Unregistered
        Sales of Equity Securities and Use of Proceeds.**
 
 None.
  **Item
        3.** **Defaults
        Upon Senior Securities.**
 
 None.
 
 **Item
        4.** **Submission
        of Matters to a Vote of Security Holders.**
 
 The
        Company’s Annual Meeting of Shareholders was held on May 24, 2007. Of the
        20,768,252 shares of common stock of the Company entitled to vote at the
        meeting, 19,006,010 shares were present in person or by proxy.
 
 At
        the
        Annual Meeting, the following individuals were elected to serve as directors
        of
        the Company and received the number of votes set forth opposite their respective
        names:
  Director
              
              Votes
                  For
              
              Votes WithheldMark
                  E. Schwarz
              
              
              17,245,440
              
              
              36,172Scott
                  T. Berlin
              
              
              18,023,770
              
              
              36,172James
                  H. Graves
              
              
              18,969,765
              
              
              36,172George
                  R. Manser
              
              
              18,023,068
              
              
              36,172
 
 **Item
        5.** **Other
        Information.**
 
 None.
  39
  **Item
        6.** **Exhibits.**
 
 The
        following exhibits are filed herewith or incorporated herein by
        reference:
  Exhibit
                  Number
                
                Description3(a)
                
                Articles
                    of Incorporation of the registrant, as amended (incorporated
                    by reference
                    to Exhibit 3(a) to the registrant’s Annual Report on Form 10-KSB for the
                    fiscal year ended December 31, 1993).3(b)
                
                Restated
                    By-Laws of the registrant, as amended (incorporated by reference
                    to
                    Exhibit 3.2 to the registrant’s Registration Statement on Form S-1 filed
                    August 8, 2006).4(a)
                
                Specimen
                    certificate for Common Stock, $0.18 par value per share, of the
                    registrant
                    (incorporated by reference to Exhibit 4.1 to the registrant’s
                    Post-Effective Amendment No. 1 to Registration Statement on Form
                    S-1 filed
                    October 3, 2006).4(b)
                
                Indenture
                    dated as of June 21, 2005, between Hallmark Financial Services,
                    Inc. and
                    JPMorgan Chase Bank, National Association (incorporated by reference
                    to
                    Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed June 27,
                    2005).4(c)
                
                Amended
                    and Restated Declaration of Trust of Hallmark Statutory Trust
                    I dated as
                    of June 21, 2005, among Hallmark Financial Services, Inc., as
                    sponsor,
                    Chase Bank USA, National Association, as Delaware trustee, and
                    JPMorgan
                    Chase Bank, National Association, as institutional trustee, and
                    Mark
                    Schwarz and Mark Morrison, as administrators (incorporated by
                    reference to
                    Exhibit 4.2 to the registrant’s Current Report on Form 8-K filed June 27,
                    2005).4(d)
                
                Form
                    of Junior Subordinated Debt Security Due 2035 (incorporated by
                    reference
                    to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed June
                    27, 2005).4(e)
                
                Form
                    of Capital Security Certificate (incorporated by reference to
                    Exhibit 4.2
                    to the registrant’s Current Report on Form 8-K filed June 27,
                    2005).
  40
  Exhibit
                  Number
                
                Description4(f)
                
                Form
                    of Registration Rights Agreement dated January 27, 2006, between
                    Hallmark
                    Financial Services, Inc. and Newcastle Special Opportunity Fund
                    I, L.P.
                    and Newcastle Special Opportunity Fund II, L.P. (incorporated
                    by reference
                    to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed
                    February 2, 2006).31(a)
                
                Certification
                    of principal executive officer required by Rule 13a-14(a) or
                  Rule
                    15d-14(a).31(b)
                
                Certification
                    of principal financial officer required by Rule 13a-14(a) or
                  Rule
                    15d-14(a).32(a)
                
                Certification
                    of principal executive officer Pursuant to 18 U.S.C.
                    1350.32(b)
                
                Certification
                    of principal financial officer Pursuant to 18 U.S.C. 1350.99(a)
                
                Third
                    Amendment to First Restated Credit Agreement among Hallmark Financial
                    Services, Inc. and its subsidiaries and The Frost National Bank
                    dated May
                    31, 2007 (incorporated by reference to Exhibit 99.1 to the registrant’s
                    Current Report on Form
                  8-K
                    filed June 8, 2007).
  41
  SIGNATURES
 
 In
        accordance with the requirements of the Exchange Act, the registrant has
        caused
        this report to be signed on its behalf by the undersigned, thereunto duly
        authorized.
  HALLMARK
                  FINANCIAL SERVICES, INC.
                (Registrant)Date:
                  August 9, 2007
              
              /s/ Mark
                J.
                MorrisonMark
                  J.
                  Morrison, Chief Executive Officer and President
                (Principal
                  Executive Officer)
 Date:
                      August 9, 2007
                
                /s/
                  Jeffrey R. PassmoreJeffrey
                      R. Passmore, Chief Accounting Officer and Senior Vice
                      President
                  (Principal
                      Financial Officer)
  42