UNITED
STATES





SECURITIES
AND EXCHANGE COMMISSION





WASHINGTON,
D.C. 20549





FORM
10-Q





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





Securities
Exchange Act of 1934





For the
quarterly period ended March 31, 2009





Commission
file number 001-11252





Hallmark
Financial Services, Inc.




(Exact
name of registrant as specified in its charter)





Nevada
              
              87-0447375(State
      or other jurisdiction of
              
              (I.R.S.
      EmployerIncorporation
      or organization)
              
              Identification
      No.)




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




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




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




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





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


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





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




Indicate
the number of shares outstanding of each of the issuer's classes of common
stock, as of the latest practicable date: Common Stock, par value $.18 per share
– 20,863,670 shares outstanding as of May15, 2009.





PART
I


FINANCIAL
INFORMATION





Item
1.       Financial Statements





INDEX
TO FINANCIAL STATEMENTS





Page NumberConsolidated
      Balance Sheets at March 31, 2009 (unaudited) and December 31,
      2008
                
                3Consolidated
      Statements of Operations (unaudited) for the three months ended March 31,
      2009 and March 31, 2008
                
                4Consolidated
      Statements of Stockholders’ Equity and Comprehensive Income (unaudited)
      for the three months ended March 31, 2009 and March 31,
    2008
                
                5Consolidated
      Statements of Cash Flows (unaudited) for the three months ended March 31,
      2009 and March 31, 2008
                
                6Notes
      to Consolidated Financial Statements (unaudited)
                
                7


2





Hallmark
Financial Services, Inc. and Subsidiaries


Consolidated
Balance Sheets


($ in
thousands)





March
      31
                                      
                                      
                                      December
      312009
                                      
                                      
                                      2008(unaudited)ASSETSInvestments:Debt
      securities, available-for-sale, at fair value
                                      
                                      $
                                      279,895
                                      
                                      
                                      $
                                      268,513Equity
      securities, available-for-sale, at fair value
                                      
                                      
                                      25,983
                                      
                                      
                                      
                                      25,003Total
      investments
                                      
                                      
                                      305,878
                                      
                                      
                                      
                                      293,516Cash
      and cash equivalents
                                      
                                      
                                      56,317
                                      
                                      
                                      
                                      59,134Restricted
      cash and cash equivalents
                                      
                                      
                                      6,220
                                      
                                      
                                      
                                      8,033Premiums
      receivable
                                      
                                      
                                      48,932
                                      
                                      
                                      
                                      44,032Accounts
      receivable
                                      
                                      
                                      3,937
                                      
                                      
                                      
                                      4,531Receivable
      for securities
                                      
                                      
                                      1,064
                                      
                                      
                                      
                                      1,031Prepaid
      reinsurance premiums
                                      
                                      
                                      1,671
                                      
                                      
                                      
                                      1,349Reinsurance
      recoverable
                                      
                                      
                                      7,478
                                      
                                      
                                      
                                      8,218Deferred
      policy acquisition costs
                                      
                                      
                                      21,002
                                      
                                      
                                      
                                      19,524Excess
      of cost over fair value of net assets acquired
                                      
                                      
                                      41,080
                                      
                                      
                                      
                                      41,080Intangible
      assets, net
                                      
                                      
                                      28,255
                                      
                                      
                                      
                                      28,969Current
      federal income tax recoverable
                                      
                                      
                                      -
                                      
                                      
                                      
                                      696Deferred
      federal income taxes
                                      
                                      
                                      5,680
                                      
                                      
                                      
                                      6,696Prepaid
      expenses
                                      
                                      
                                      1,044
                                      
                                      
                                      
                                      1,007Other
      assets
                                      
                                      
                                      22,721
                                      
                                      
                                      
                                      20,582$
                                      551,279
                                      
                                      
                                      $
                                      538,398LIABILITIES AND STOCKHOLDERS'
      EQUITYLiabilities:Notes
      payable
                                      
                                      $
                                      59,650
                                      
                                      
                                      $
                                      60,919Reserves
      for unpaid losses and loss adjustment expenses
                                      
                                      
                                      164,839
                                      
                                      
                                      
                                      156,363Unearned
      premiums
                                      
                                      
                                      112,183
                                      
                                      
                                      
                                      102,192Unearned
      revenue
                                      
                                      
                                      1,170
                                      
                                      
                                      
                                      2,037Accrued
      agent profit sharing
                                      
                                      
                                      751
                                      
                                      
                                      
                                      2,151Accrued
      ceding commission payable
                                      
                                      
                                      8,592
                                      
                                      
                                      
                                      8,605Pension
      liability
                                      
                                      
                                      4,348
                                      
                                      
                                      
                                      4,309Current
      federal income tax
                                      
                                      
                                      1,649
                                      
                                      
                                      
                                      -Payable
      for securities
                                      
                                      
                                      1,115
                                      
                                      
                                      
                                      3,606Accounts
      payable and other accrued expenses
                                      
                                      
                                      5,603
                                      
                                      
                                      
                                      18,067359,900
                                      
                                      
                                      
                                      358,249Commitments
      and Contingencies (Note 15)Redeemable
      non-controlling interest
                                      
                                      
                                      824
                                      
                                      
                                      
                                      737Stockholders'
      equity:Common
      stock, $.18 par value (authorized 33,333,333 shares in 2009 and
      2008;issued
      20,871,498 shares in 2009 and 20,841,782 shares in 2008)
                                      
                                      
                                      3,757
                                      
                                      
                                      
                                      3,751Capital
      in excess of par value
                                      
                                      
                                      120,200
                                      
                                      
                                      
                                      119,928Retained
      earnings
                                      
                                      
                                      79,032
                                      
                                      
                                      
                                      72,242Accumulated
      other comprehensive loss
                                      
                                      
                                      (12,357
                                      )
                                      
                                      
                                      (16,432
                                      )Treasury
      stock, at cost (7,828 shares in 2009 and 2008)
                                      
                                      
                                      (77
                                      )
                                      
                                      
                                      (77
                                      )Total
      stockholders' equity
                                      
                                      
                                      190,555
                                      
                                      
                                      
                                      179,412$
                                      551,279
                                      
                                      
                                      $
                                      538,398





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 EndedMarch 312009
                          
                          
                          2008Gross
      premiums written
                          
                          $
                          71,479
                          
                          
                          $
                          64,237Ceded
      premiums written
                          
                          
                          (2,232
                          )
                          
                          
                          (2,004
                          )Net
      premiums written
                          
                          
                          69,247
                          
                          
                          
                          62,233Change
      in unearned premiums
                          
                          
                          (9,817
                          )
                          
                          
                          (2,989
                          )Net
      premiums earned
                          
                          
                          59,430
                          
                          
                          
                          59,244Investment
      income, net of expenses
                          
                          
                          4,269
                          
                          
                          
                          3,625Net
      realized gains (impairments and realized losses)
                          
                          
                          (348
                          )
                          
                          
                          859Finance
      charges
                          
                          
                          1,350
                          
                          
                          
                          1,264Commission
      and fees
                          
                          
                          6,189
                          
                          
                          
                          6,484Processing
      and service fees
                          
                          
                          15
                          
                          
                          
                          42Other
      income
                          
                          
                          5
                          
                          
                          
                          3Total
      revenues
                          
                          
                          70,910
                          
                          
                          
                          71,521Losses
      and loss adjustment expenses
                          
                          
                          36,842
                          
                          
                          
                          35,504Other
      operating expenses
                          
                          
                          23,750
                          
                          
                          
                          23,465Interest
      expense
                          
                          
                          1,159
                          
                          
                          
                          1,185Amortization
      of intangible assets
                          
                          
                          714
                          
                          
                          
                          573Total
      expenses
                          
                          
                          62,465
                          
                          
                          
                          60,727Income
      before tax
                          
                          
                          8,445
                          
                          
                          
                          10,794Income
      tax expense
                          
                          
                          1,662
                          
                          
                          
                          3,529Net
      income
                          
                          
                          6,783
                          
                          
                          
                          7,265Less:
      Net loss attributable tonon-controlling  interest
                          
                          
                          (7
                          )
                          
                          
                          -Net
      income attributable to Hallmark Financial Services, Inc.
                          
                          $
                          6,790
                          
                          
                          $
                          7,265Net
      income per share attributable to Hallmark FinancialServices,
      Inc. common stockholders:Basic
                          
                          $
                          0.33
                          
                          
                          $
                          0.35Diluted
                          
                          $
                          0.33
                          
                          
                          $
                          0.35





The
accompanying notes are an integral part


of the
consolidated  financial statements


4





Hallmark
Financial Services, Inc. and Subsidiaries


Consolidated
Statements of Stockholders' Equity and Comprehensive Income


(Unaudited)


($ in
thousands)





Three
      Months EndedMarch
      31,2009
                            
                            
                            2008Common
      StockBalance,
      beginning of period
                            
                            $
                            3,751
                            
                            
                            $
                            3,740Issuance
      of common stock upon option exercises
                            
                            
                            6
                            
                            
                            
                            6Balance,
      end of period
                            
                            
                            3,757
                            
                            
                            
                            3,746Additional
      Paid-In CapitalBalance,
      beginning of period
                            
                            
                            119,928
                            
                            
                            
                            118,459Accretion
      of redeemable noncontrolling interest
                            
                            
                            (94
                            )
                            
                            
                            -Equity
      based compensation
                            
                            
                            262
                            
                            
                            
                            547Exercise
      of stock options
                            
                            
                            104
                            
                            
                            
                            114Balance,
      end of period
                            
                            
                            120,200
                            
                            
                            
                            119,120Retained
      EarningsBalance,
      beginning of period
                            
                            
                            72,242
                            
                            
                            
                            59,343Net
      income attributable to Hallmark Financial Services, Inc.
                            
                            
                            6,790
                            
                            
                            
                            7,265Balance,
      end of period
                            
                            
                            79,032
                            
                            
                            
                            66,608Accumulated
      Other Comprehensive LossBalance,
      beginning of period
                            
                            
                            (16,432
                            )
                            
                            
                            (1,844
                            )Additional
      minimun pension liability, net of tax
                            
                            
                            80
                            
                            
                            
                            10Unrealized
      gains (losses) on securities, net of tax
                            
                            
                            3,995
                            
                            
                            
                            (1,252
                            )Balance,
      end of period
                            
                            
                            (12,357
                            )
                            
                            
                            (3,086
                            )Treasury
      StockBalance,
      beginning and end of period
                            
                            
                            (77
                            )
                            
                            
                            (77
                            )Total
      Stockholders' Equity
                            
                            $
                            190,555
                            
                            
                            $
                            186,311Net
      income
                            
                            $
                            6,783
                            
                            
                            $
                            7,265Additional
      minimum pension liablilty, net of tax
                            
                            
                            80
                            
                            
                            
                            10Unrealized
      gains (losses) on securities, net of tax
                            
                            
                            3,995
                            
                            
                            
                            (1,252
                            )Comprehensive
      income
                            
                            
                            10,858
                            
                            
                            
                            6,023Less:
      Comprehensive loss attributable tonon-controlling
      interest
                            
                            
                            (7
                            )
                            
                            
                            -Comprehensive
      income attributable toHallmark
      Financial Services, Inc.
                            
                            $
                            10,865
                            
                            
                            $
                            6,023





The
accompanying notes are an integral part


of the
consolidated  financial statements


5


Hallmark
Financial Services, Inc. and Subsidiaries


Consolidated
Statements of Cash Flows


(Unaudited)


($ in
thousands)





Three
      Months EndedMarch 312009
                  
                  
                  2008Cash
      flows from operating activities:Net
      income
                  
                  $
                  6,783
                  
                  
                  $
                  7,265Adjustments
      to reconcile net income to cash provided by operating
      activites:Depreciation
      and amortization expense
                  
                  
                  928
                  
                  
                  
                  767Deferred
      federal income tax benefit
                  
                  
                  (1,103
                  )
                  
                  
                  (156
                  )Realized
      loss (gain) on investments and impairment losses
                  
                  
                  348
                  
                  
                  
                  (859
                  )Change
      in prepaid reinsurance premiums
                  
                  
                  (322
                  )
                  
                  
                  (2,251
                  )Change
      in premiums receivable
                  
                  
                  (4,900
                  )
                  
                  
                  (1,714
                  )Change
      in accounts receivable
                  
                  
                  594
                  
                  
                  
                  (125
                  )Change
      in deferred policy acquisition costs
                  
                  
                  (1,478
                  )
                  
                  
                  (659
                  )Change
      in reserves for unpaid losses and loss adjustment expenses
                  
                  
                  8,476
                  
                  
                  
                  8,410Change
      in unearned premiums
                  
                  
                  9,991
                  
                  
                  
                  3,011Change
      in unearned revenue
                  
                  
                  (867
                  )
                  
                  
                  (502
                  )Change
      in accrued agent profit sharing
                  
                  
                  (1,400
                  )
                  
                  
                  (2,177
                  )Change
      in reinsurance recoverable
                  
                  
                  740
                  
                  
                  
                  483Change
      in current federal income tax payable
                  
                  
                  2,345
                  
                  
                  
                  2,903Change
      in accrued ceding commission payable
                  
                  
                  (13
                  )
                  
                  
                  86Change
      in all other liabilities
                  
                  
                  (9,081
                  )
                  
                  
                  (4,059
                  )Change
      in all other assets
                  
                  
                  (2,190
                  )
                  
                  
                  1,965Net
      cash provided by operating activities
                  
                  
                  8,851
                  
                  
                  
                  12,388Cash
      flows from investing activities:Purchases
      of property and equipment
                  
                  
                  (428
                  )
                  
                  
                  (174
                  )Change
      in restricted cash
                  
                  
                  2,833
                  
                  
                  
                  11,361Purchases
      of debt and equity securities
                  
                  
                  (22,014
                  )
                  
                  
                  (235,781
                  )Maturities,
      sales and redemptions of investment securities
                  
                  
                  12,443
                  
                  
                  
                  137,398Payment
      for acquisition of subsidiaries
                  
                  
                  (3,343
                  )
                  
                  
                  -Net
      cash used in investing activities
                  
                  
                  (10,509
                  )
                  
                  
                  (87,196
                  )Cash
      flows from financing activities:Proceeds
      from exercise of employee stock options
                  
                  
                  110
                  
                  
                  
                  120Premium
      finance notes originated, net of finance notes repaid
                  
                  
                  (1,269
                  )
                  
                  
                  107Repayment
      of structured settlement
                  
                  
                  -
                  
                  
                  
                  (10,000
                  )Net
      cash used in financing activities
                  
                  
                  (1,159
                  )
                  
                  
                  (9,773
                  )Decrease
      in cash and cash equivalents
                  
                  
                  (2,817
                  )
                  
                  
                  (84,581
                  )Cash
      and cash equivalents at beginning of period
                  
                  
                  59,134
                  
                  
                  
                  145,884Cash
      and cash equivalents at end of period
                  
                  $
                  56,317
                  
                  
                  $
                  61,303Supplemental
      Cash Flow Information:Interest
      paid
                  
                  $
                  1,186
                  
                  
                  $
                  1,190Taxes
      paid
                  
                  $
                  419
                  
                  
                  $
                  781Supplemental
      schedule of non-cash investing activities:Change
      in receivable for securities related to investment disposals that settled
      after the balance sheet date
                  
                  $
                  (33
                  )
                  
                  $
                  27,395Change
      in payable for securities related to investment purchases that settled
      after the balance sheet date
                  
                  $
                  (3,511
                  )
                  
                  $
                  (91,401
                  )





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, personal insurance and general aviation insurance, as well as
providing other insurance related services. Our business is geographically
concentrated in the south central and northwest regions of the United States,
except for our general aviation business which is written on a national
basis.





We pursue our business activities
through subsidiaries whose operations are organized into five operating units
which are supported by our three insurance company subsidiaries. Our AHIS
Operating Unit handles standard lines commercial insurance products and services
and is comprised of American Hallmark Insurance Services, Inc. and Effective
Claims Management, Inc. Our TGA Operating Unit handles primarily excess and
surplus lines commercial insurance products and services and is comprised of TGA
Insurance Managers, Inc., Pan American Acceptance Corporation (“PAAC”) and TGA
Special Risk, Inc. Our Aerospace Operating Unit handles general aviation
insurance products and services and is comprised of Aerospace Insurance
Managers, Inc., Aerospace Special Risk, Inc. and Aerospace Claims Management
Group, Inc. Our Heath XS Operating Unit handles excess commercial automobile and
commercial umbrella risks on both an admitted and non-admitted basis and is
comprised of Heath XS, LLC and Hardscrabble Data Solutions, LLC. Our Personal
Lines Operating Unit handles non-standard personal automobile insurance and
complementary personal insurance products and services and is comprised of
American Hallmark General Agency, Inc. and Hallmark Claims Services, Inc., both
of which do business as Hallmark Insurance Company.




These five operating units are segregated into three reportable industry
segments for financial accounting purposes. The Standard Commercial Segment
presently consists solely of the AHIS Operating Unit and the Personal Segment
presently consists solely of our Personal Lines Operating Unit. The Specialty
Commercial Segment includes our TGA Operating Unit, Aerospace Operating Unit,
and Heath XS 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 unaudited consolidated financial
statements should be read in conjunction with our audited consolidated financial
statements for the year ended December 31, 2008 included in our Annual Report on
Form 10-K filed with the SEC.


7


The
interim financial data as of March 31, 2009 and 2008 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
March 31, 2009 are not necessarily indicative of the operating results to be
expected for the full year.





Redeemable
non-controlling
interest





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





Reclassification





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





Income
taxes





Income taxes are accounted for under
the asset and liability method. At December 31, 2008, we had recorded a
valuation allowance of $4.5 million primarily attributable to capital losses
from investments, impairments and unrealized losses in excess of gains. The
valuation allowance was decreased by $0.9 million at March 31, 2009, due to
changes in unrealized and realized gains and losses on investments. The changes
in valuation allowance attributable to continuing operations and to accumulated
comprehensive income were approximately $0.8 million and $49 thousand,
respectively.





Immaterial Correction of an
Error





We maintain catastrophe
reinsurance for business produced by both our AHIS and TGA Operating Units.
Prior to July 1, 2007, the subject premium for our catastrophe reinsurance
contracts was based on all business produced by both operating units. The
subject premium for our catastrophe reinsurance contract which became effective
July 1, 2007 is based only on business produced in Texas. However in error, we
continued to record ceded premium for this coverage as if the subject premium
was based on all business produced by the AHIS and TGA Operating Units. This
understated our earned premium for each quarter since July 1, 2007 through June
30, 2008.





We have corrected our prior period’s
financial statements and notes to reflect the reduction of ceded premium.
Because the error was not material to any prior year financial statements, the
corrections to prior periods will be presented in future filings, pursuant to
SEC Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year
Misstatements when Quantifying Misstatements in Current Year Financial
Statements.”




8




The following table presents the
effect of the correction on our previously reported consolidated statements of
operations for the three months ended March 31, 2008.





March
      31,2008As previously reported:Ceded
      premiums written
                                
                                $
                                (2,332
                                )Net
      premiums written
                                
                                
                                61,905Net
      premiums earned
                                
                                
                                58,916Total
      revenues
                                
                                
                                71,193Income
      before tax
                                
                                
                                10,466Income
      tax expense
                                
                                
                                3,414Net
      income
                                
                                $
                                7,052Common
      stockholders net income per share:Basic
                                
                                $
                                0.34Diluted
                                
                                $
                                0.34Adjustments:Ceded
      premiums written
                                
                                $
                                328Income
      tax expense
                                
                                
                                115Net
      income impact
                                
                                $
                                213As revised:Ceded
      premiums written
                                
                                $
                                (2,004
                                )Net
      premiums written
                                
                                
                                62,233Net
      premiums earned
                                
                                
                                59,244Total
      revenues
                                
                                
                                71,521Income
      before tax
                                
                                
                                10,794Income
      tax expense
                                
                                
                                3,529Net
      income
                                
                                $
                                7,265Common
      stockholders net income per share:Basic
                                
                                $
                                0.35Diluted
                                
                                $
                                0.35


9





The
following table presents the effect of the correction on our previously reported
consolidated balance sheet as of March 31, 2008.





As
      previouslyreported
                    
                    
                    Adjustment
                    
                    
                    As revisedBalances as of March 31,
    2008Prepaid
      reinsurance premiums
                    
                    $
                    2,197
                    
                    
                    $
                    996
                    
                    
                    $
                    3,193Total
      assets
                    
                    
                    519,053
                    
                    
                    
                    996
                    
                    
                    
                    520,049Current
      federal income tax payable
                    
                    
                    3,418
                    
                    
                    
                    349
                    
                    
                    
                    3,767Total
      liabilities
                    
                    
                    333,389
                    
                    
                    
                    349
                    
                    
                    
                    333,738Retained
      earnings
                    
                    
                    65,961
                    
                    
                    
                    647
                    
                    
                    
                    66,608Total
      stockholders' equity
                    
                    
                    185,664
                    
                    
                    
                    647
                    
                    
                    
                    186,311





The following table presents the
effect of the correction on our previously reported consolidated statements of
cash flows for the three months ended March 31, 2008.





For
      the ThreeMonths
      EndedMarch
      31,2008As previously reported:Net
      income
                          
                          $
                          7,052Change
      in prepaid reinsurance premiums
                          
                          
                          (1,923
                          )Change
      in current federal income tax payable
                          
                          
                          2,788Net
      cash provided by operating activities
                          
                          
                          12,388Adjustments:Net
      income
                          
                          $
                          213Change
      in prepaid reinsurance premiums
                          
                          
                          (328
                          )Change
      in current federal income tax payable
                          
                          
                          115Net
      cash provided by operating activities
                          
                          
                          -As revised:Net
      income
                          
                          $
                          7,265Change
      in prepaid reinsurance premiums
                          
                          
                          (2,251
                          )Change
      in current federal income tax payable
                          
                          
                          2,903Net
      cash provided by operating activities
                          
                          
                          12,388





Use of Estimates in the
Preparation of the Financial Statements





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


10





Recently Issued Accounting
Standards





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. The adoption of SFAS
157 had no impact on our financial statements or results of operations but did
require additional disclosures. (See Note 5, “Fair Value”).





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. The adoption of SFAS 159 had no impact
on our financial statements or results of operations as we did not elect to
apply SFAS 159 to any eligible items.




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





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





In
April 2009, FASB issued FASB Staff Position No. FAS 157-4,
“Determining Fair Value When the Volume and Level of Activity for the Asset or
Liability Have Significantly Decreased and Identifying Transactions That Are Not
Orderly” (“FSP 157-4”), which provides guidance for estimating fair value in
accordance with SFAS 157 when the volume and level of activity for the asset or
liability have significantly decreased and identifying circumstances that may
indicate that a transaction is not orderly. FSP 157-4 is effective for interim
and annual reporting periods ending after June 15, 2009, and is applied
prospectively. We do not anticipate that the adoption of FSP 157-4 will have a
material impact on our consolidated financial statements.





11





In April
2009, FASB issued FASB Staff Position No. FAS 115-2 and FAS 124-2, “Recognition
and Presentation of Other-Than-Temporary Impairments” (“FSP FAS 115-2 and FAS
124-2”), which amends current other-than-temporary impairment guidance for debt
securities to make the guidance more operational and to improve the presentation
and disclosure of other-than-temporary impairments in the financial
statements. This FSP does not amend existing recognition and measurement
guidance related to other-than-temporary impairments of equity
securities. The provisions of FSP FAS 115-2 and FAS 124-2 are effective for
interim periods ending after June 15, 2009. We are currently
evaluating the effect that the provisions of FSP FAS 115-2 and FAS 124-2 may
have on our consolidated financial statements.




In
April 2009, FASB issued FASB Staff Position No. FAS 107-1 and APB Opinion
No. 28-1, “Interim Disclosures about Fair Value of Financial Instruments”
which requires disclosures about fair value of financial instruments for interim
reporting periods as well as in annual financial statements. This FSP is
effective for interim periods ending after June 15, 2009 but will not
impact the Company’s consolidated financial statements. However, additional
footnote disclosures to our interim and annual financial statements may be
required.





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 amounts assigned to assets acquired and
liabilities assumed is an asset referred to as “Excess of cost over fair value
of net assets acquired.” Indirect and general expenses related to business
combinations are expensed as incurred.





Effective
August 29, 2008, we acquired 80% of the issued and outstanding membership
interests in the subsidiaries now comprising the Heath XS Operating Unit for
consideration of $15.0 million. In connection with the acquisition of membership
interests in the subsidiaries comprising the Heath XS Operating Unit, we
executed an operating agreement for each subsidiary. The operating agreements
grant us the right to purchase the remaining 20% membership interests in the
subsidiaries comprising the Heath XS Operating Unit and grant to an affiliate of
the seller the right to require us to purchase such remaining membership
interests (the “Put/Call Option”). The Put/Call Option becomes exercisable by
either us or the affiliate of the seller upon the earlier of August 29, 2012,
the termination of the employment of the seller by the Heath XS Operating Unit
or a change of control of Hallmark. If the Put/Call Option is exercised, we
would have the right or obligation to purchase the remaining 20% membership
interests in the Heath XS Operating Unit for an amount equal to nine times the
average Pre-Tax Income (as defined in the operating agreements) for the previous
12 fiscal quarters. We estimate the ultimate redemption value of the Put/Call
Option to be $2.9 million at March 31, 2009.


12





The fair
value of the amortizable intangible assets acquired and respective amortization
periods are as follows ($ in thousands):





Tradename
                  
                  $
                  757
                  
                  15
      yearsNon-compete
      agreement
                  
                  $
                  526
                  
                  6
      yearsAgency
      relationships
                  
                  $
                  6,385
                  
                  15
      years





The Heath XS Operating Unit is an
underwriting organization that produces lower hazard, middle market, excess
commercial automobile and commercial umbrella insurance policies on both an
admitted and non-admitted basis through a network of independent wholesale
agencies throughout the United States.





4.
Fair Value





SFAS 157
defines fair value, establishes a consistent framework for measuring fair value
and expands disclosure requirements about fair value measurements.
SFAS 157, among other things, requires us to maximize the use of observable
inputs and minimize the use of unobservable inputs when measuring fair value. In
addition, SFAS 157 precludes the use of block discounts when measuring the
fair value of instruments traded in an active market, which were previously
applied to large holdings of publicly traded equity securities. It also requires
recognition of trade-date gains related to certain derivative transactions whose
fair value has been determined using unobservable market inputs. This guidance
supersedes the guidance in Emerging Issues Task Force Issue No. 02-3,
“Issues Involved in Accounting for Derivative Contracts Held for Trading
Purposes and Contracts Involved in Energy Trading and Risk Management
Activities”, which prohibited the recognition of trade-date gains for such
derivative transactions when determining the fair value of instruments not
traded in an active market.





Effective
January 1, 2008, we determine the fair value of our financial instruments based
on the fair value hierarchy established in SFAS 157.  In accordance
with SFAS 157, we utilize the following fair value hierarchy:





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





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





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





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





Under
SFAS 157, we determine fair value based on the price that would be received for
an asset or paid to transfer a liability in an orderly transaction between
market participants on the measurement date.  It is our policy to
maximize the use of observable inputs and minimize the use of unobservable
inputs when developing fair value measurements, in accordance with the fair
value hierarchy described above.  Fair value measurements for assets
and liabilities where there exists limited or no observable market data are
calculated based upon our pricing policy, the economic and competitive
environment, the characteristics of the asset or liability and other factors as
appropriate.  These estimated fair values may not be realized upon
actual sale or immediate settlement of the asset or liability.


13





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




The following table presents for each
of the fair value hierarchy levels, our assets that are measured at fair value
on a recurring basis at March 31, 2009 (in thousands).




Quoted Prices in
                    
                    
                    OtherActive Markets for
                    
                    
                    Observable
                    
                    
                    UnobservableIdentical Assets
                    
                    
                    Inputs
                    
                    
                    Inputs(Level 1)
                    
                    
                    (Level 2)
                    
                    
                    (Level 3)
                    
                    
                    TotalDebt
      securities
                    
                    $
                    -
                    
                    
                    $
                    232,950
                    
                    
                    $
                    46,945
                    
                    
                    $
                    279,895Equity
      securities
                    
                    
                    25,983
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    25,983Total
                    
                    $
                    25,983
                    
                    
                    $
                    232,950
                    
                    
                    $
                    46,945
                    
                    
                    $
                    305,878




Due to
significant unobservable inputs into the valuation model for certain municipal
bonds in illiquid markets, we classified these as level 3 in the fair value
hierarchy.  We used an income approach in order to derive an estimated
fair value of such securities, which included inputs such as expected holding
period, benchmark swap rate, benchmark discount rate and a discount rate premium
for illiquidity.  The following table summarizes the changes in fair
value for all financial assets measured at fair value on a recurring basis using
significant unobservable inputs (Level 3) during the three months ended March
31, 2009 (in thousands).





Beginning
      balance as of January 1, 2009
                    
                    $
                    46,104Purchases,
      issuances, sales and settlements
                    
                    
                    -Total
      realized/unrealized gains included in net income
                    
                    
                    -Net
      gains included in other comprehensive income
                    
                    
                    841Transfers
      in and/or out of Level 3
                    
                    
                    -Ending
      balance as of March 31, 2009
                    
                    $
                    46,945




14




5.
Investments




We complete a detailed analysis each
quarter to assess whether any decline in the fair value of any investment below
cost is deemed other-than-temporary. All securities with an unrealized loss are
reviewed.  We recognize an impairment loss when an investment's value
declines below cost, adjusted for accretion, amortization and previous
other-than-temporary impairments  and it is determined that the
decline is other-than-temporary. Some of the factors considered in evaluating
whether a decline in fair value is other-than-temporary include: (1) our
ability and intent to retain the investment for a period of time sufficient to
allow for an anticipated recovery in value; (2) the recoverability of
principal and interest for fixed maturity securities, or cost for equity
securities; (3) the length of time and extent to which the fair value has
been less than amortized cost for fixed maturity securities, or cost for equity
securities; and (4) the financial condition and near-term and long-term
prospects for the issuer, including the relevant industry conditions and trends,
and implications of rating agency actions and offering prices. When it is
determined that an invested asset is other-than-temporarily impaired, the
invested asset is written down to fair value, and the amount of the impairment
is included in earnings as a realized investment loss. The fair value then
becomes the new cost basis of the investment, and any subsequent recoveries in
fair value, other than amounts accreted to the expected recovery amount, are
recognized at disposition. We recognize a realized loss when impairment is
deemed to be other-than-temporary even if a decision to sell an investment has
not been made. When we decide to sell a temporarily impaired available-for-sale
investment and we do not expect the fair value of the investment to fully
recover prior to the expected time of sale, the investment is deemed to be
other-than-temporarily impaired in the period in which the decision to sell is
made. For the three months ended March 31, 2009 and 2008, we recognized
approximately $0.5 million and $0.1 million, respectively, of
other-than-temporary impairments on investments.





The
following schedules summarize the gross unrealized losses showing the length of
time that investments have been continuously in an unrealized loss position as
of March 31, 2009 and December 31, 2008:





As of March 31, 200912 months or less
                
                
                Longer than 12 months
                
                
                TotalUnrealized
                
                
                
                
                
                Unrealized
                
                
                
                
                
                UnrealizedFair Value
                
                
                Losses
                
                
                Fair Value
                
                
                Losses
                
                
                Fair Value
                
                
                LossesCorporate
      debt securities
                
                $
                27,562
                
                
                $
                (5,509
                )
                
                $
                14,670
                
                
                $
                (2,170
                )
                
                $
                42,232
                
                
                $
                (7,679
                )Municipal
      bonds
                
                
                48,848
                
                
                
                (2,522
                )
                
                
                36,491
                
                
                
                (1,551
                )
                
                
                85,339
                
                
                
                (4,073
                )Equity
      securities
                
                
                19,970
                
                
                
                (4,270
                )
                
                
                -
                
                
                
                -
                
                
                
                19,970
                
                
                
                (4,270
                )Total
                
                $
                96,380
                
                
                $
                (12,301
                )
                
                $
                51,161
                
                
                $
                (3,721
                )
                
                $
                147,541
                
                
                $
                (16,022
                )





As of December 31, 200812 months or less
                
                
                Longer than 12 months
                
                
                TotalUnrealized
                
                
                
                
                
                Unrealized
                
                
                
                
                
                UnrealizedFair Value
                
                
                Losses
                
                
                Fair Value
                
                
                Losses
                
                
                Fair Value
                
                
                LossesCorporate
      debt securities
                
                $
                34,314
                
                
                $
                (5,175
                )
                
                $
                9,786
                
                
                $
                (1,830
                )
                
                $
                44,100
                
                
                $
                (7,005
                )Municipal
      bonds
                
                
                106,175
                
                
                
                (7,258
                )
                
                
                10,295
                
                
                
                (665
                )
                
                
                116,470
                
                
                
                (7,923
                )Equity
      securities
                
                
                8,932
                
                
                
                (4,411
                )
                
                
                -
                
                
                
                -
                
                
                
                8,932
                
                
                
                (4,411
                )Total
                
                $
                149,421
                
                
                $
                (16,844
                )
                
                $
                20,081
                
                
                $
                (2,495
                )
                
                $
                169,502
                
                
                $
                (19,339
                )




15





At
March 31, 2009, the gross unrealized losses more than twelve months old were
attributable to 32 bond positions.  At December 31, 2008, the gross
unrealized losses more than twelve months old were attributable to 15 bond
positions.  We consider these losses as a temporary decline in value
as they are predominately on bonds where we believe we have the ability to hold
our positions until maturity and the debt issuers have the ability to make all
contractual payments.  We see no other indications that the decline in
values of these securities is other-than-temporary.





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





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





6.
Pledged Investments





We have certain of our securities
pledged for the benefit of various state insurance departments and
reinsurers.  These securities are included with our available-for-sale
debt securities because we have the ability to trade these
securities.  We retain the interest earned on these
securities.  These securities had a carrying value of $21.5 million at
March 31, 2009 and a carrying value of $26.4 million at December 31,
2008.





7.
Share-Based Payment Arrangements





Our 2005
Long Term Incentive Plan (“2005 LTIP”) is a stock compensation plan for key
employees and non-employee directors that was initially approved by the
shareholders on May 26, 2005.  Presently, there are 1,500,000 shares
authorized for issuance under the 2005 LTIP.  Our 1994 Key Employee
Long Term Incentive Plan (the “1994 Employee Plan”) and 1994 Non-Employee
Director Stock Option Plan (the “1994 Director Plan”) both expired in 2004 but
have unexercised options outstanding.





As of
March 31, 2009, there were incentive stock options to purchase 927,499 shares of
our common stock outstanding and non-qualified stock options to purchase 60,000
shares of our common stock outstanding under the 2005 LTIP, leaving 512,501
shares reserved for future issuance.  As of March 31, 2009, there were
incentive stock options to purchase 5,916 shares outstanding under the 1994
Employee Plan and non-qualified stock options to purchase 20,834 shares
outstanding under the 1994 Director Plan.  In addition, as of March
31, 2009, there were outstanding non-qualified stock options to purchase 8,333
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.


16





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 vested 40% six
months from the date of grant and an additional 10% on each of the first six
anniversary dates of the grant and terminate ten years from the date of
grant.  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.





A summary
of the status of our stock options as of and changes during the year-to-date
ended March 31, 2009 is presented below:





Average
                    
                    
                    Contractual
                    
                    
                    IntrinsicNumber
      of
                    
                    
                    Exercise
                    
                    
                    Term
                    
                    
                    ValueShares
                    
                    
                    Price
                    
                    
                    (Years)
                    
                    
                    ($000)Outstanding
      at January 1, 2009
                    
                    
                    1,052,298
                    
                    
                    $
                    11.12Granted
                    
                    
                    -
                    
                    
                    $
                    -Exercised
                    
                    
                    (29,716
                    )
                    
                    $
                    3.66Forfeited
      or expired
                    
                    
                    -
                    
                    
                    $
                    -Outstanding
      at March 31, 2009
                    
                    
                    1,022,582
                    
                    
                    $
                    11.34
                    
                    
                    
                    7.9
                    
                    
                    $
                    122Exercisable
      at March 31, 2009
                    
                    
                    228,333
                    
                    
                    $
                    9.62
                    
                    
                    
                    6.6
                    
                    
                    $
                    122





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





Three
      Months EndedMarch 31,2009
                  
                  
                  2008Intrinsic
      value of options exercised
                  
                  $
                  107
                  
                  
                  $
                  278Cost
      of share-based payments (non-cash)
                  
                  $
                  262
                  
                  
                  $
                  547Income
      tax benefit of share-basedpayments recognized in
income
                  
                  $
                  92
                  
                  
                  $
                  191





As of
March 31, 2009 there was $2.2 million of total unrecognized compensation cost
related to non-vested share-based compensation arrangements granted under our
plans, of which $0.7 million is expected to be recognized during the remainder
of 2009, $0.9 million is expected to be recognized in 2010, $0.5 million is
expected to be recognized in 2011 and $0.1 million is expected to be recognized
in 2012.


17





The fair
value of each stock option granted is estimated on the date of grant using the
Black-Scholes option pricing model.  Expected volatilities are based
on the historical volatility of similar companies’ common stock for a period
equal to the expected term.  The risk- free interest rates for periods
within the contractual term of the options are based on rates for U.S. Treasury
Notes with maturity dates corresponding to the options’ expected lives on the
dates of grant.  Expected term is determined based on the simplified
method as we do not have sufficient historical exercise data to provide a basis
for estimating the expected term.  There were no options granted in
either the first quarter of 2009 or 2008.





8.
Segment Information





The following is business segment
information for the three months ended March 31, 2009 and 2008 (in
thousands):





Three Months EndedMarch 31,2009
                        
                        
                        2008Revenues:Standard
      Commercial Segment
                        
                        $
                        20,020
                        
                        
                        $
                        22,006Specialty
      Commercial Segment
                        
                        
                        32,825
                        
                        
                        
                        32,238Personal
      Segment
                        
                        
                        17,535
                        
                        
                        
                        15,726Corporate
                        
                        
                        530
                        
                        
                        
                        1,551Consolidated
                        
                        $
                        70,910
                        
                        
                        $
                        71,521Pre-tax income (loss), net of non-controlling
      interest:Standard
      Commercial Segment
                        
                        $
                        2,576
                        
                        
                        $
                        4,058Specialty
      Commercial Segment
                        
                        
                        5,682
                        
                        
                        
                        5,444Personal
      Segment
                        
                        
                        2,619
                        
                        
                        
                        2,590Corporate
                        
                        
                        (2,425
                        )
                        
                        
                        (1,298
                        )Consolidated
                        
                        $
                        8,452
                        
                        
                        $
                        10,794





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





March
      31,
                      
                      
                      December
      31,2009
                      
                      
                      2008AssetsStandard
      Commercial Segment
                      
                      $
                      139,646
                      
                      
                      $
                      146,415Specialty
      Commercial Segment
                      
                      
                      237,577
                      
                      
                      
                      230,130Personal
      Segment
                      
                      
                      94,885
                      
                      
                      
                      84,456Corporate
                      
                      
                      79,171
                      
                      
                      
                      77,397$
                      551,279
                      
                      
                      $
                      538,398





18





9.
Reinsurance





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





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





Three
      Months EndedMarch 31,2009
                    
                    
                    2008Ceded
      earned premiums
                    
                    $
                    2,058
                    
                    
                    $
                    1,982Reinsurance
      recoveries
                    
                    $
                    1,333
                    
                    
                    $
                    107




Our
insurance company subsidiaries presently retain 100% of the risk associated with
all non-standard personal automobile policies marketed by our Personal Lines
Operating Unit. We currently reinsure the following exposures on business
generated by our AHIS Operating Unit, our TGA Operating Unit and our Aerospace
Operating Unit:




·
            Property
      catastrophe.  Our property catastrophe reinsurance
      reduces the financial impact a catastrophe could have on our commercial
      property insurance lines.  Catastrophes might include multiple
      claims and policyholders.  Catastrophes include hurricanes,
      windstorms, earthquakes, hailstorms, explosions, severe winter weather and
      fires.  Our property catastrophe reinsurance is excess-of-loss
      reinsurance, which provides us reinsurance coverage for losses in excess
      of an agreed-upon amount.  We utilize catastrophe models to
      assist in determining appropriate retention and limits to
      purchase.  The terms of our property catastrophe reinsurance,
      effective July 1, 2008, are:




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




o
            Our
      reinsurers reimburse us 100% for any loss in excess of our $3.0 million
      retention up to $10.0 million for each catastrophic occurrence, subject to
      an aggregate limit of $14.0 million.  As a result of hurricane
      losses, we have ceded to our reinsurers losses of approximately $8.2
      million and have approximately $5.8 million of coverage remaining under
      this layer of catastrophe reinsurance at March 31,
  2009.




o
            Our
      reinsurers reimburse us 100% for any loss in excess of $10.0 million up to
      $25.0 million for each catastrophic occurrence subject to an aggregate
      limit of $50.0 million.




·
            Commercial
      property.  Our commercial property reinsurance is
      excess-of-loss coverage intended to reduce the financial impact a
      single-event or catastrophic loss may have on our results.  The
      terms of our commercial property reinsurance, effective July 1, 2008,
      are:




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




o
            Our
      reinsurers reimburse us for the next $5.0 million for each commercial
      property risk; and




19




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




·
            Commercial
      casualty.  Our commercial casualty reinsurance is
      excess-of-loss coverage intended to reduce the financial impact a
      single-event loss may have on our results.  The terms of our
      commercial casualty reinsurance, effective July 1, 2008,
    are:




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




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




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




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




o
            Our
      reinsurers reimburse us for the next $2.15 million of each combined
      aircraft hull and liability loss and for the next $650,000 of each airport
      liability loss; and




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





10.
Notes Payable





On June
21, 2005, an unconsolidated trust subsidiary completed a private placement of
$30.0 million of 30-year floating rate trust preferred
securities.  Simultaneously, we borrowed $30.9 million from the trust
subsidiary and contributed $30.0 million to 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.  Under the terms of the note, we pay interest only
each quarter and the principal of the note at maturity. As of March 31, 2009,
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 March 31, 2009, the balance
on the revolving note was $2.8 million, which currently bears interest at 3.10%
per annum. Also included in notes payable is $0.1 million outstanding as of
March 31, 2009 under PAAC’s revolving credit sub-facility, which also currently
bears interest at 3.10% per annum.  (See Note 11, “Credit
Facilities.”)





On August
23, 2007, an unconsolidated trust subsidiary completed a private placement of
$25.0 million of 30-year floating rate trust preferred
securities.  Simultaneously, we borrowed $25.8 million from the trust
subsidiary for working capital and general corporate purposes. The note bears an
initial interest rate of 8.28% until September 15, 2017, at which time interest
will adjust quarterly to the three-month LIBOR rate plus 2.90 percentage
points.  Under the terms of the note, we pay interest only each
quarter and the principal of the note at maturity. As of March 31, 2009 the note
balance was $25.8 million.


20





11.
Credit Facilities





We have a credit facility with The
Frost National Bank which was amended and restated on January 27, 2006 to
provide a $20.0 million revolving credit facility with a $5.0 million letter of
credit sub-facility.  The credit facility was further amended
effective May 31, 2007 to increase the revolving credit facility to $25.0
million and establish a new $5.0 million revolving credit sub-facility for the
premium finance operations of PAAC.  The credit agreement was again
amended effective February 20, 2008 to extend the termination to January 27,
2010, revise various affirmative and negative covenants and decrease the
interest rate in most instances to the three month Eurodollar rate plus 1.90
percentage points, payable quarterly in arrears.  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 all of our non-insurance company 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.  As of March
31, 2009, we were in compliance with all of our covenants.  As of
March 31, 2009 we had $2.9 million outstanding under this facility.





12.
Deferred Policy Acquisition Costs





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




Three
      Months EndedMarch 31,2009
                      
                      
                      2008Deferred
                      
                      $
                      (15,526
                      )
                      
                      $
                      (14,405
                      )Amortized
                      
                      
                      14,048
                      
                      
                      
                      13,746Net
                      
                      $
                      (1,478
                      )
                      
                      $
                      (659
                      )




13.
Earnings per Share





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





Three
      Months EndedMarch 31,2009
                  
                  
                  2008Weighted
      average shares - basic
                  
                  
                  20,856
                  
                  
                  
                  20,781Effect
      of dilutive securities
                  
                  
                  17
                  
                  
                  
                  106Weighted
      average shares - assuming dilution
                  
                  
                  20,873
                  
                  
                  
                  20,887





For the three months ended March 31,
2009, 899,166 shares of common stock potentially issuable upon the exercise of
employee stock options were excluded from the weighted average number of shares
outstanding on a diluted basis because the effect of such options would be
anti-dilutive. For the three months ended March 31, 2008, 140,494 shares of
common stock potentially issuable upon exercise of employee stock options were
excluded from the weighted average number of shares outstanding on a diluted
basis because the effect of such options would be
anti-dilutive.


21





14.
Net Periodic Pension Cost





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





Three Months EndedMarch 31,2009
                  
                  
                  2008Interest
      cost
                  
                  $
                  161
                  
                  
                  $
                  167Amortization
      of net (gain) loss
                  
                  
                  122
                  
                  
                  
                  16Expected
      return on plan assets
                  
                  
                  (121
                  )
                  
                  
                  (168
                  )Net
      periodic pension cost
                  
                  $
                  162
                  
                  
                  $
                  15





We did not make any contributions to
our frozen defined benefit cash balance plan during the three months ended March
31, 2009 and we contributed $84 thousand during the three months ended March 31,
2008. Refer to Note 14 to the consolidated financial statements in our Annual
Report on Form 10-K for the year ended December 31, 2008 for more discussion of
our retirement plans.





15.
Contingencies





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





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





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





Introduction





Hallmark Financial Services, Inc.
(“Hallmark” and, together with subsidiaries, “we,” “us” or “our”) is an
insurance holding company 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, personal insurance and general aviation insurance, as well as
providing other insurance related services.  Our business is
geographically concentrated in the south central and northwest regions of the
United States, except for our general aviation business which is written on a
national basis.  We pursue our business
activities through subsidiaries whose operations are organized into five
operating units which are supported by our three insurance company
subsidiaries.




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


22




·
            Standard
      Commercial Segment.  Our Standard Commercial Segment
      includes the standard lines commercial property/casualty insurance
      products and services handled by our AHIS Operating Unit which is
      comprised of our American Hallmark Insurance Services, 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, the
      general aviation insurance products and services handled by our Aerospace
      Operating Unit, and the excess commercial automobile and commercial
      umbrella insurance products handled by our Heath XS Operating
      Unit.  Our TGA Operating Unit is comprised of our TGA Insurance
      Managers, Inc., Pan American Acceptance Corporation (“PAAC”) 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.  Our Heath XS Operating Unit is compromised of our
      Heath XS, LLC and Hardscrabble Data Solutions, LLC
      subsidiaries.





·
            Personal
      Segment.  Our Personal Segment includes the non-standard
      personal automobile insurance and complementary personal insurance
      products and services handled by our Personal Lines Operating Unit which
      is comprised of American Hallmark General Agency, Inc. and Hallmark Claims
      Services, Inc., both of which do business as Hallmark 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
      within the Standard Commercial Segment and assumes a portion of the risks
      on the commercial and aviation property/casualty policies marketed within
      the Specialty Commercial Segment.





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





·
            Hallmark
      Insurance Company (“HIC”)presently assumes all of the risks on the
      personal property/casualty policies marketed by our Personal Lines
      Operating Unit and assumes a portion of the risks on the aviation
      property/casualty products marketed within the Specialty Commercial
      Segment.





Our insurance company
subsidiaries have entered into a pooling arrangement  pursuant to
which AHICretains 46% of the total net premiums written by all of our
operating units, HIC retains 34% of our total net premiums written and HSIC
retains 20% of our total net premiums written.   This pooling
arrangement has no impact on our consolidated financial statements under
GAAP.


23


Results
of Operations





Management
Overview.During the three months ended March 31, 2009, our
total revenues were $70.9 million, representing a $0.6 million decrease over the
$71.5 million in total revenues for the same period of 2008.  The
decrease in total revenue for the period was primarily due to recognized losses
on our investment portfolio and lower commission income partially offset by
higher earned premium and investment income. Standard Commercial revenues
decreased $2.0 million during the three months ended March 31, 2009 due
primarily to lower earned premium as a result of increased competition, rate
pressure, and deterioration of the economic environment in our major markets.
The acquisition of our Heath XS Operating Unit in 2008 drove the $0.6 million
increase in revenue by our Specialty Commercial Segment during the three months
ended March 31, 2009 as compared to the same period during 2008. Revenues from
our Personal Segment increased $1.8 million during the three months ended March
31, 2009 as compared to the same period during 2008, due largely to geographic
expansion into new states. Corporate revenue decreased $1.0 million during the
three months ended March 31, 2009 as compared to the same period during 2008 due
to recognized losses on our investment portfolio of $0.3 million as compared to
recognized gains of $0.9 million during the same period of 2008.




We reported net income attributable
to Hallmark of $6.8 million for the three months ended March 31, 2009, compared
to $7.3 million for the same period in 2008.  On a diluted per share
basis, net income was $0.33 for the three months ended March 31, 2009 as
compared to $0.35 for the same period in 2008.   The decrease in
net income attributable to Hallmark was primarily attributable to decreased
revenue discussed above and a modestly higher loss and loss adjustment expenses
(“LAE”) due to $1.6 million of favorable prior year loss development recognized
during the three months ended March 31, 2008.  These factors were
partially offset by a lower effective tax rate driven primarily by a $0.8
million reduction in the deferred tax asset valuation allowance during the first
three months of 2009.





First
Quarter 2009 as Compared to First Quarter 2008





The
following is additional business segment information for the three months ended
March 31, 2009 and 2008 (in thousands):


24




Hallmark
Financial Services, Inc.


Consolidated
Segment Data





Three Months Ended March 31, 2009Standard
                  
                  
                  SpecialtyCommercial
                  
                  
                  Commercial
                  
                  
                  PersonalSegment
                  
                  
                  Segment
                  
                  
                  Segment
                  
                  
                  Corporate
                  
                  
                  ConsolidatedProduced
      premium (1)
                  
                  $
                  19,147
                  
                  
                  $
                  34,282
                  
                  
                  $
                  20,626
                  
                  
                  $
                  -
                  
                  
                  $
                  74,055Gross
      premiums written
                  
                  
                  19,147
                  
                  
                  
                  31,706
                  
                  
                  
                  20,626
                  
                  
                  
                  -
                  
                  
                  
                  71,479Ceded
      premiums written
                  
                  
                  (1,103
                  )
                  
                  
                  (1,129
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (2,232
                  )Net
      premiums written
                  
                  
                  18,044
                  
                  
                  
                  30,577
                  
                  
                  
                  20,626
                  
                  
                  
                  -
                  
                  
                  
                  69,247Change
      in unearned premiums
                  
                  
                  406
                  
                  
                  
                  (5,626
                  )
                  
                  
                  (4,597
                  )
                  
                  
                  -
                  
                  
                  
                  (9,817
                  )Net
      premiums earned
                  
                  
                  18,450
                  
                  
                  
                  24,951
                  
                  
                  
                  16,029
                  
                  
                  
                  -
                  
                  
                  
                  59,430Total
      revenues
                  
                  
                  20,020
                  
                  
                  
                  32,825
                  
                  
                  
                  17,535
                  
                  
                  
                  530
                  
                  
                  
                  70,910Losses
      and loss adjustment expenses
                  
                  
                  11,346
                  
                  
                  
                  14,933
                  
                  
                  
                  10,563
                  
                  
                  
                  -
                  
                  
                  
                  36,842Pre-tax  income
      (loss), net ofnon-controlling
      interest
                  
                  
                  2,576
                  
                  
                  
                  5,682
                  
                  
                  
                  2,619
                  
                  
                  
                  (2,425
                  )
                  
                  
                  8,452Net
      loss ratio (2)
                  
                  
                  61.5
                  %
                  
                  
                  59.8
                  %
                  
                  
                  65.9
                  %
                  
                  
                  
                  
                  
                  
                  62.0
                  %Net
      expense ratio (2)
                  
                  
                  27.3
                  %
                  
                  
                  30.6
                  %
                  
                  
                  23.1
                  %
                  
                  
                  
                  
                  
                  
                  29.5
                  %Net
      combined ratio (2)
                  
                  
                  88.8
                  %
                  
                  
                  90.4
                  %
                  
                  
                  89.0
                  %
                  
                  
                  
                  
                  
                  
                  91.5
                  %





Three Months Ended March 31, 2008Standard
                
                
                SpecialtyCommercial
                
                
                Commercial
                
                
                PersonalSegment
                
                
                Segment
                
                
                Segment
                
                
                Corporate
                
                
                ConsolidatedProduced
      premium (1)
                
                $
                21,749
                
                
                $
                32,020
                
                
                $
                17,727
                
                
                $
                -
                
                
                $
                71,496Gross
      premiums written
                
                
                21,749
                
                
                
                24,761
                
                
                
                17,727
                
                
                
                -
                
                
                
                64,237Ceded
      premiums written
                
                
                (1,187
                )
                
                
                (817
                )
                
                
                -
                
                
                
                -
                
                
                
                (2,004
                )Net
      premiums written
                
                
                20,562
                
                
                
                23,944
                
                
                
                17,727
                
                
                
                -
                
                
                
                62,233Change
      in unearned premiums
                
                
                404
                
                
                
                (155
                )
                
                
                (3,238
                )
                
                
                -
                
                
                
                (2,989
                )Net
      premiums earned
                
                
                20,966
                
                
                
                23,789
                
                
                
                14,489
                
                
                
                -
                
                
                
                59,244Total
      revenues
                
                
                22,006
                
                
                
                32,238
                
                
                
                15,726
                
                
                
                1,551
                
                
                
                71,521Losses
      and loss adjustment expenses
                
                
                11,310
                
                
                
                15,003
                
                
                
                9,191
                
                
                
                -
                
                
                
                35,504Pre-tax  income
      (loss)
                
                
                4,058
                
                
                
                5,444
                
                
                
                2,590
                
                
                
                (1,298
                )
                
                
                10,794Net
      loss ratio (2)
                
                
                53.9
                %
                
                
                63.1
                %
                
                
                63.4
                %
                
                
                
                
                
                
                59.9
                %Net
      expense ratio (2)
                
                
                27.2
                %
                
                
                30.5
                %
                
                
                22.5
                %
                
                
                
                
                
                
                28.9
                %Net
      combined ratio (2)
                
                
                81.1
                %
                
                
                93.6
                %
                
                
                85.9
                %
                
                
                
                
                
                
                88.8
                %




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





(2)  The
net loss ratio is calculated as incurred losses and LAE divided by net premiums
earned, each determined in accordance with GAAP.  The net expense
ratio is calculated as underwriting expenses of our insurance company
subsidiaries (which include provisional ceding commissions, direct agent
commissions, premium taxes and assessments, professional fees, other general
underwriting expenses and 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.




25


Standard
Commercial Segment





Gross
premiums written for the Standard Commercial Segment were $19.1 million for the
three months ended March 31, 2009, which was $2.6 million, or 12% less than the
$21.7 million reported for the same period in 2008.  Net premiums
written were $18.0 million for the three months ended March 31, 2009 as compared
to $20.6 million reported for the same period in 2008.  The decrease
in premium volume was due to increased competition, rate pressure and the
deterioration of the general economic environment.





Total
revenue for the Standard Commercial Segment of $20.0 million for the three
months ended March 31, 2009 was $2.0 million less than the $22.0 million
reported during the same period in 2008.  This 9% decrease in total
revenue was primarily due to decreased net premiums earned of $2.5
million.  The decrease in net premiums earned was partially offset by
a contingent commission adjustment reducing revenue by $0.4 million during the
three months ended March 31, 2008.  The contingent commission
adjustment related to adverse loss development on prior accident years.
Increased net investment income of $0.1 million during the three months ended
March 31, 2009 also partially offset the decrease in net premiums
earned.





Pre-tax
income for our Standard Commercial Segment of $2.6 million for the three months
ended March 31, 2009 decreased $1.5 million, or 37%, from the $4.1 million
reported for the same period of 2008.  Decreased revenue as discussed
above was the primary reason for the decrease in pre-tax income, offset by lower
operating expenses of $0.5 million, mostly due to lower premium volume during
the three months ended March 31, 2009 as compared to the same period during
2008.





The
Standard Commercial Segment reported  a net loss ratio of 61.5% for
the three months ended March 31, 2009 as compared to 53.9% for 2008. The gross
loss ratio before reinsurance for the three months ended March 31, 2009 was
62.3% as compared to the 50.4% reported for the same period of
2008.  The higher net and gross loss ratios for the first quarter of
fiscal 2009 as compared to the same period in fiscal 2008 were largely the
result of the recognition of $1.8 million in favorable prior year loss
development during the first quarter of fiscal 2008, which represented 8.4% of
net earned premiums and 8.0% of gross earned premiums for that
period.  The Standard Commercial Segment reported net expense ratios
of 27.3% and 27.2% for the first quarters of 2009 and 2008,
respectively.





Specialty
Commercial Segment





The $32.8 million of total revenue
for the three months ended March 31, 2009 was $0.6 million higher than the $32.2
million reported for the same period in 2008. This increase in revenue was
largely due to increased net premiums earned of $1.2 million as a result of the
increased retention of business and the acquisition of the Heath XS Operating
Unit during the third quarter of 2008 and increased net investment income of
$0.2 million. These increases were offset by lower commission income of $0.8
million due primarily to the shift from a third party agency structure to an
insurance underwriting structure partially offset by increased commission income
in our newly acquired Heath XS Operating Unit.





Pre-tax income for the Specialty
Commercial Segment of $5.7 million was $0.3 million higher than the $5.4 million
reported for the same period in 2008. Increased revenue, discussed above, and
lower loss and LAE of $0.1 million, was partially offset by increased operating
expenses of $0.3 million due mostly to increased production related expenses
related to the acquisition of our Heath XS Operating Unit partially offset by
reduced production related expenses in our TGA and Aerospace Operating Units and
increased amortization of intangible assets of $0.1 million related to our
acquisition of the Heath XS Operating Unit during 2008.




The Specialty Commercial Segment
reported a net loss ratio of 59.8% for the three months ended March 31, 2009 as
compared to 63.1% for 2008.  The gross loss ratio before reinsurance
was 59.6% for the three months ended March 31, 2009 as compared to 62.0% for the
same period the prior year.  The gross loss results for the three
months ended March 31, 2008 included $0.5 million of adverse prior year
development.  The Specialty Commercial Segment reported a net expense
ratio of 30.6% for the first quarter of 2009 as compared to 30.5% for the first
quarter of 2007.




26


Personal
Segment





Net premiums written for our Personal
Segment increased $2.9 million during the first quarter of 2009 to $20.6 million
compared to $17.7 million for the first quarter of 2008.  The increase
in premium was due mostly to continued geographic expansion that began in
2006.





Total revenue for the Personal
Segment increased 12% to $17.5 million for the first quarter of 2009 from $15.7
million for the first quarter of 2008.  Higher earned premium of $1.5
million was the primary reason for the increase in revenue for the
period.  Increased finance charges of $0.2 million and higher
investment income of $0.1 million further contributed to the increase in revenue
during the first quarter of 2009.





Pre-tax income for the Personal
Segment was $2.6 million for the three months ended March 31, 2009 and
2008.  The increased revenue, as discussed above, was offset by
increased losses and LAE of $1.4 million and increased operating expenses of
$0.4 million due mostly to production related expenses attributable to the
increased earned premium.





The Personal Segment reported a net
loss ratio of 65.9% for the three months ended March 31, 2009 as compared to
63.4% for the first quarter of 2008.  We recognized $0.3 million of
favorable prior accident year development for the three months ended March 31,
2008. The Personal Segment reported a net expense ratio of 23.1% for the three
months ended March 31, 2009 as compared to 22.5% for the first quarter of
2008.





Corporate





Total revenue for corporate decreased
by $1.0 million for the three months ended March 31, 2009 as compared to the
same period the prior year.  Recognized losses of $0.3 million on our
investment portfolio as compared to recognized gains of $0.9 million during the
same period in 2008 was partially offset by increased investment income of $0.2
million primarily due to changes in capital allocation.





Corporate pre-tax loss was $2.4
million for the three months ended March 31, 2009 as compared to $1.3 million
for the same period the prior year.  The increased loss was mostly due
to the decreased revenues discussed above as well as increased operating
expenses of $0.1 million.





Financial
Condition and Liquidity





Sources
and Uses of Funds





Our
sources of funds are from insurance-related operations, financing activities and
investing activities.  Major sources of funds from operations include
premiums collected (net of policy cancellations and premiums ceded),
commissions, and processing and service fees.  As a holding company,
Hallmark is dependent on dividend payments and management fees from its
subsidiaries to meet operating expenses and debt obligations.  As of
March 31, 2009, Hallmark had $12.1 million in unrestricted cash and invested
assets at the holding company. Unrestricted cash and invested assets of our
non-insurance subsidiaries were $3.8 million as of March 31, 2009.




27


AHIC,
domiciled in Texas, is limited in the payment of dividends in any 12-month
period, without the prior written consent of the Texas Department of Insurance,
to the greater of statutory net income for the prior calendar year or 10% of
statutory surplus as of the prior year end. Dividends may only be paid from
unassigned surplus funds.  HIC, domiciled in Arizona, is limited in
the payment of dividends to the lesser of 10% of prior year surplus or prior
year’s net investment income, without prior written approval from the Arizona
Department of Insurance.  HSIC, domiciled in Oklahoma, is limited in
the payment of dividends to the greater of 10% of prior year surplus or prior
year’s statutory net income, without prior written approval from the Oklahoma
Insurance Department.  During 2009, our insurance company
subsidiaries’ ordinary dividend capacity is $18.4 million, of which $13.8
million is available to Hallmark.  None of our insurance company
subsidiaries paid a dividend to Hallmark during the first three months of 2009
or the 2008 fiscal year.





Comparison of March 31, 2009 to
December 31, 2008





On a
consolidated basis, our cash and investments (excluding restricted cash) at
March 31, 2009 were $362.2 million compared to $352.7 million at December 31,
2008.  An increase in market value of our investment portfolio for the
period was the primary reason for this increase.





Comparison of Three Months Ended
March 31, 2009 and March 31, 2008





Net cash
provided by our consolidated operating activities was $8.9 million for the first
three months of 2009 compared to $12.4 million for the first three months of
2008.  The decrease in operating cash flow was primarily due to the
timing of premium settlements with third party insurance carriers.





Net cash used in investing
activities during the first three months of 2009 was $10.5 million as compared
to $87.2 million for the same period in 2008.  Contributing to the
decrease in cash used in investing activities was a decrease of $213.8 million
in purchases of debt and equity securities, offset by a $8.5 million reduction
in the change in restricted cash, $125.0 million reduction in maturities, sales
and redemptions of investment securities and $3.3 million for the payment of
contingent consideration to the sellers of the subsidiaries comprising our TGA
Operating Unit.





Cash used in financing
activities during the first three months of 2009 was $1.2 million as compared to
$9.8 million for the same period of 2008.  The cash used during the
first three months of 2008 was primarily for the payment of consideration to the
sellers of the subsidiaries comprising our TGA Operating Unit.  As of
March 31, 2009 we had fully repaid our obligation to the
sellers.


28


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.  The credit agreement was again
amended effective February 20, 2008 to extend the termination to January 27,
2010, revise various affirmative and negative covenants and decrease the
interest rate in most instances to the three month Eurodollar rate plus 1.90
percentage points, payable quarterly in arrears.  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 all of our non-insurance company 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.  As of March
31, 2009 we were in compliance with all of our covenants.  As of March
31, 2009, we had $2.9 million outstanding under this credit
facility.





Trust
Preferred Securities





On June 21, 2005, an unconsolidated
trust subsidiary completed a private placement of $30.0 million of 30-year
floating rate trust preferred securities.  Simultaneously, we borrowed
$30.9 million from the trust subsidiary and contributed $30.0 million to 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 March 31, 2009, the note
balance was $30.9 million.  Under the terms of the note, we pay
interest only each quarter and the principal of the note at
maturity.





On August
23, 2007, an unconsolidated trust subsidiary completed a private placement of
$25.0 million of 30-year floating rate trust preferred
securities.  Simultaneously, we borrowed $25.8 million from the trust
subsidiary for working capital and general corporate purposes. The note bears an
initial interest rate at 8.28% until September 15, 2017, at which time interest
will adjust quarterly to the three-month LIBOR rate plus 2.90 percentage
points.  As of March 31, 2009, the note balance was $25.8
million.  Under the terms of the note, we pay interest only each
quarter and the principal of the note at maturity.





Item
3.  Quantitative and Qualitative Disclosures About Market
Risk.





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





Item
4T.  Controls and Procedures.





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




29


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





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


30


PART
II


OTHER
INFORMATION





Item
      1.
            Legal
      Proceedings.





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





Item
      1A.
            Risk
      Factors.





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




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





None.




Item
      3.
            Defaults
      Upon Senior Securities.





None.





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




None.





Item
      5.
            Other
      Information.





None.





Item
      6.
            Exhibits.





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





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




31





Exhibit
                  Number
                
                Description4(c)
                
                Amended
      and Restated Declaration of Trust of Hallmark Statutory Trust I dated as
      of June 21, 2005, among Hallmark Financial Services, Inc., as sponsor,
      Chase Bank USA, National Association, as Delaware trustee, and JPMorgan
      Chase Bank, National Association, as institutional trustee, and Mark
      Schwarz and Mark Morrison, as administrators (incorporated by reference to
      Exhibit 4.2 to the registrant’s Current Report on Form 8-K filed June 27,
      2005).4(d)
                
                Form
      of Junior Subordinated Debt Security Due 2035 (incorporated by reference
      to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed June
      27, 2005).4(e)
                
                Form
      of Capital Security Certificate (incorporated by reference to Exhibit 4.2
      to the registrant’s Current Report on Form 8-K filed June 27,
      2005).4(f)
                
                First
      Restated Credit Agreement dated January 27, 2006, between Hallmark
      Financial Services, Inc. and The Frost National Bank (incorporated by
      reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K
      filed February 2, 2006).4(g)
                
                Form
      of Registration Rights Agreement dated January 27, 2006, between Hallmark
      Financial Services, Inc. and Newcastle Special Opportunity Fund I, L.P.
      and Newcastle Special Opportunity Fund II, L.P. (incorporated by reference
      to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed
      February 2, 2006).4(h)
                
                Indenture
      dated as of August 23, 2007, between Hallmark Financial Services, Inc. and
      The Bank of New York Trust Company, National Association (incorporated by
      reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K
      filed August 24, 2007).4(i)
                
                Amended
      and Restated Declaration of Trust of Hallmark Statutory Trust II dated as
      of August 23, 2007, among Hallmark Financial Services, Inc., as sponsor,
      The Bank of New York (Delaware), as Delaware trustee, and The Bank of New
      York Trust Company, National Association, as institutional trustee, and
      Mark Schwarz and Mark Morrison, as administrators (incorporated by
      reference to Exhibit 4.2 to the registrant’s Current Report on Form 8-K
      filed August 24, 2007).4(j)
                
                Form
      of Junior Subordinated Debt Security Due 2037 (incorporated by reference
      to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed August
      24, 2007).4(k)
                
                Form
      of Capital Security Certificate (incorporated by reference to Exhibit 4.2
      to the registrant’s Current Report on Form 8-K filed August 24,
      2007).31(a)
                
                Certification
      of principal executive officer required by Rule 13a-14(a) or
                  Rule
      15d-14(a).31(b)
                
                Certification
      of principal financial officer required by Rule 13a-14(a) or
                  Rule
      15d-14(a).32(a)
                
                Certification
      of principal executive officer Pursuant to 18 U.S.C.
  1350.32(b)
                
                Certification
      of principal financial officer Pursuant to 18 U.S.C.
  1350.




32


SIGNATURES





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




HALLMARK
      FINANCIAL SERVICES, INC.(Registrant)Date:
      May 15, 2009
                  
                  /s/ Mark J. MorrisonMark
      J. Morrison, Chief Executive Officer and President(Principal
      Executive Officer)/s/ Jeffrey R. PassmoreDate:
      May 15, 2009
                  
                  Jeffrey
      R. Passmore, Chief Accounting Officer and Senior Vice
      President(Principal
      Financial
Officer)




33