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, 2008

Commission file number 001-11252

Hallmark Financial Services, Inc.

(Exact name of registrant as specified in its charter)

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

777 Main Street, Suite 1000, Fort Worth, Texas
 
76102
     
(Address of principal executive offices)
 
(Zip Code)
 
Registrant's telephone number, including area code: (817) 348-1600
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

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 o No x

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: Common Stock, par value $.18 per share - 20,808,954 shares outstanding as of May 14, 2008.


PART I
FINANCIAL INFORMATION

Item 1.   Financial Statements
 
INDEX TO FINANCIAL STATEMENTS
 
Page Number
   
Consolidated Balance Sheets at March 31, 2008 (unaudited) and December 31, 2007
3
   
Consolidated Statements of Operations (unaudited) for the three months ended March 31, 2008 and March 31, 2007
4
   
Consolidated Statements of Stockholders’ Equity and Comprehensive Income (unaudited) for the three months ended March 31, 2008 and March 31, 2007
5
   
Consolidated Statements of Cash Flows (unaudited) for the three months ended March 31, 2008 and March 31, 2007
6
   
Notes to Consolidated Financial Statements (unaudited)
7

2

Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Balance Sheets
($ in thousands)
 
   
March 31
 
December 31
 
 
 
2008
 
2007
 
ASSETS
   
(unaudited
)
     
Investments:
             
Debt securities, available-for-sale, at fair value
 
$
167,108
 
$
248,069
 
Equity securities, available-for-sale, at fair value
   
35,566
   
15,166
 
Short-term investments, available-for-sale, at fair value
   
95,060
   
2,625
 
               
Total investments
   
297,734
   
265,860
 
               
Cash and cash equivalents
   
61,303
   
145,884
 
Restricted cash and cash equivalents
   
4,682
   
16,043
 
Premiums receivable
   
47,740
   
46,026
 
Accounts receivable
   
5,344
   
5,219
 
Receivable for securities
   
-
   
27,395
 
Prepaid reinsurance premiums
   
2,197
   
274
 
Reinsurance recoverable
   
4,469
   
4,952
 
Deferred policy acquisition costs
   
20,416
   
19,757
 
Excess of cost over fair value of net assets acquired
   
30,025
   
30,025
 
Intangible assets
   
23,208
   
23,781
 
Deferred federal income taxes
   
1,075
   
275
 
Prepaid expenses
   
1,319
   
1,240
 
Other assets
   
19,541
   
19,583
 
               
Total assets
 
$
519,053
 
$
606,314
 
               
LIABILITIES AND STOCKHOLDERS' EQUITY
             
Liabilities:
             
Notes payable
 
$
60,921
 
$
60,814
 
Structured settlements
   
-
   
10,000
 
Reserves for unpaid losses and loss adjustment expenses
   
133,748
   
125,338
 
Unearned premiums
   
106,009
   
102,998
 
Unearned revenue
   
2,447
   
2,949
 
Accrued agent profit sharing
   
667
   
2,844
 
Accrued ceding commission payable
   
12,185
   
12,099
 
Pension liability
   
1,584
   
1,669
 
Current federal income tax payable
   
3,418
   
630
 
Payable for securities
   
-
   
91,401
 
Accounts payable and other accrued expenses
   
12,410
   
16,385
 
               
Total liabilities
   
333,389
   
427,127
 
               
Commitments and Contingencies (Note 15)
   
   
 
               
Stockholders' equity:
             
Common stock, $.18 par value (authorized 33,333,333 shares in 2008 and 2007; issued 20,809,415 and 20,776,080 shares in 2008 and 2007)
   
3,746
   
3,740
 
Capital in excess of par value
   
119,120
   
118,459
 
Retained earnings
   
65,961
   
58,909
 
Accumulated other comprehensive loss
   
(3,086
)
 
(1,844
)
Treasury stock, at cost (7,828 shares in 2008 and 2007)
   
(77
)
 
(77
)
               
Total stockholders' equity
   
185,664
   
179,187
 
               
   
$
519,053
 
$
606,314
 

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

3
Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Statements of Operations
(Unaudited)
($ in thousands, except per share amounts)
 
   
Three Months Ended
 
 
 
March 31
 
 
 
 
 
 
 
2008
 
2007
 
           
Gross premiums written
 
$
64,237
 
$
64,658
 
Ceded premiums written
   
(2,332
)
 
(3,887
)
Net premiums written
   
61,905
   
60,771
 
Change in unearned premiums
   
(2,989
)
 
(9,123
)
Net premiums earned
   
58,916
   
51,648
 
               
Investment income, net of expenses
   
3,625
   
2,990
 
Gain on investments
   
859
   
53
 
Finance charges
   
1,264
   
1,086
 
Commission and fees
   
6,484
   
7,905
 
Processing and service fees
   
42
   
272
 
Other income
   
3
   
4
 
               
Total revenues
   
71,193
   
63,958
 
               
Losses and loss adjustment expenses
   
35,504
   
32,185
 
Other operating expenses
   
23,465
   
22,701
 
Interest expense
   
1,185
   
786
 
Amortization of intangible asset
   
573
   
573
 
               
Total expenses
   
60,727
   
56,245
 
               
Income before tax
   
10,466
   
7,713
 
Income tax expense
   
3,414
   
2,743
 
               
Net income
 
$
7,052
 
$
4,970
 
               
Net income per share:
             
Basic
 
$
0.34
 
$
0.24
 
Diluted
 
$
0.34
 
$
0.24
 


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

4

Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Statement of Stockholders’ Equity and Comprehensive Income
(Unaudited)
($ in thousands)
 
   
Three Months Ended
 
 
 
March 31,
 
 
 
2008
 
2007
 
           
Common Stock
             
Balance, beginning of period
 
$
3,740
 
$
3,740
 
Issuance of common stock upon option exercises
   
6
   
-
 
Balance, end of period
   
3,746
   
3,740
 
               
Additional Paid-In Capital
             
Balance, beginning of period
   
118,459
   
117,932
 
Equity based compensation
   
547
   
51
 
Exercise of stock options
   
114
   
-
 
Balance, end of period
   
119,120
   
117,983
 
               
Retained Earnings
             
Balance, beginning of period
   
58,909
   
31,480
 
Net income
   
7,052
   
4,970
 
Balance, end of period
   
65,961
   
36,450
 
               
Accumulated Other Comprehensive Loss
             
Balance, beginning of period
   
(1,844
)
 
(2,344
)
Amortization of net actuarial loss, net of tax
   
10
   
-
 
Unrealized (losses) gains on securities, net of tax
   
(1,252
)
 
362
 
Balance, end of period
   
(3,086
)
 
(1,982
)
               
Treasury Stock
             
Balance, beginning and end of period
   
(77
)
 
(77
)
               
Stockholders' Equity
 
$
185,664
 
$
156,114
 
               
Net income
 
$
7,052
 
$
4,970
 
Amortization of net actuarial loss, net of tax
   
10
   
-
 
Unrealized (losses) gains on securities, net of tax
   
(1,252
)
 
362
 
Comprehensive Income
 
$
5,810
 
$
5,332
 

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

5

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

   
Three Months Ended
 
 
 
March 31
 
 
 
2008
 
2007
 
Cash flows from operating activities:
             
Net income
 
$
7,052
 
$
4,970
 
               
Adjustments to reconcile net income to cash provided by operating activities:
             
Depreciation and amortization expense
   
767
   
781
 
Amortization of discount on structured settlement
   
-
   
104
 
Deferred federal income tax expense (benefit)
   
(156
)
 
1,200
 
Gain on investments
   
(859
)
 
(53
)
Change in prepaid reinsurance premiums
   
(1,923
)
 
(8
)
Change in premiums receivable
   
(1,714
)
 
(4,853
)
Change in accounts receivable
   
(125
)
 
1,798
 
Change in deferred policy acquisition costs
   
(659
)
 
(1,784
)
Change in unpaid losses and loss adjustment expenses
   
8,410
   
13,276
 
Change in unearned premiums
   
3,011
   
8,975
 
Change in unearned revenue
   
(502
)
 
(1,226
)
Change in accrued agent profit sharing
   
(2,177
)
 
(1,190
)
Change in reinsurance recoverable
   
483
   
647
 
Change in reinsurance balances payable
   
-
   
(6,143
)
Change in current federal income tax payable
   
2,788
   
(449
)
Change in accrued ceding commission payable
   
86
   
3,250
 
Change in all other liabilities
   
(4,059
)
 
2,503
 
Change in all other assets
   
1,965
   
(2,836
)
               
Net cash provided by operating activities
   
12,388
   
18,962
 
               
Cash flows from investing activities:
             
Purchases of property and equipment
   
(174
)
 
(72
)
Change in restricted cash
   
11,361
   
14,815
 
Purchases of debt and equity securities
   
(135,411
)
 
(48,251
)
Maturities and redemptions of investment securities
   
129,463
   
8,643
 
Net purchases of short-term investments
   
(92,435
)
 
15,000
 
               
Net cash used in investing activities
   
(87,196
)
 
(9,865
)
               
Cash flows from financing activities:
             
Proceeds from exercise of employee stock options
   
120
   
-
 
Premium finance notes originated, net of finance notes repaid
   
107
   
252
 
Payment of structured settlement
   
(10,000
)
 
(15,000
)
               
Net cash used by financing activities
   
(9,773
)
 
(14,748
)
               
Decrease in cash and cash equivalents
   
(84,581
)
 
(5,651
)
Cash and cash equivalents at beginning of period
   
145,884
   
81,474
 
               
Cash and cash equivalents at end of period
 
$
61,303
 
$
75,823
 
               
Supplemental Cash Flow Information:
             
Interest paid
 
$
1,190
 
$
687
 
Taxes paid
 
$
781
 
$
1,992
 
 
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, non-standard automobile 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 four operating units which are supported by our three insurance company subsidiaries. Our HGA Operating Unit handles standard lines commercial insurance products and services and is comprised of 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 Phoenix Operating Unit handles non-standard personal automobile insurance products and services and is comprised solely of American Hallmark General Agency, Inc. (which does business as Phoenix Indemnity Insurance Company).

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

2. Basis of Presentation

Our unaudited consolidated financial statements included herein have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and include our accounts and the accounts of our subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to rules and regulations of the Securities and Exchange Commission (“SEC”) for interim financial reporting. These financial statements should be read in conjunction with our audited financial statements for the year ended December 31, 2007 included in our Annual Report on Form 10-K filed with the SEC.

The interim financial data as of March 31, 2008 and 2007 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, 2008 are not necessarily indicative of the operating results to be expected for the full year.

7

Reclassification

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

Use of Estimates in the Preparation of the Financial Statements

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

Recently Issued Accounting Standards

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

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

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 3, “Fair Value”).

8
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 the Company 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. We do not expect the provisions of SFAS 141R to have a material effect on its results of operations, financial position 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. We do not expect the provisions of SFAS 160 to have a material effect on its results of operations, financial position or liquidity.

3. 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.

9

Assets and Liabilities Recorded at Fair Value on a Recurring Basis

Effective January 1, 2008, the Company determines the fair value of its financial instruments based on the fair value hierarchy established in SFAS 157 which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our market assumptions. In accordance with SFAS 157, these two types of inputs have created 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

 
·
Level 3: inputs to the valuation methodology 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 as described above. Fair value measurements for assets and liabilities where there exists limited or no observable market data are calculated based upon our pricing policy, the economic and competitive environment, the characteristics of the asset or liability and other factors as appropriate. These estimated fair values may not be realized upon actual sale or immediate settlement of the asset or liability.

Where quoted prices are available on active exchanges for identical instruments, investment securities are classified within Level 1 of the valuation hierarchy. Level 1 investment securities include common and preferred stock. If quoted prices are not available from active exchanges for identical instruments, then fair values are estimated using quoted prices from less active markets, quoted prices of securities with similar characteristics or by pricing models utilizing other significant observable inputs. Examples of such instruments, which would generally be classified within Level 2 of the valuation hierarchy, include corporate bonds, municipal bonds and U.S. Treasury securities. In cases where there is limited activity or less transparency around inputs to the valuation, investment securities are classified within Level 3 of the valuation hierarchy. Level 3 investments are valued based on the best available data in order to approximate fair value. This data may be internally developed and considers 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, 2008. (in thousands)

10
 
 
 
Quoted Prices in
 
Other
 
 
 
 
 
 
 
Active Markets for
 
Observable
 
Unobservable
 
 
 
 
 
Identical Assets
 
Inputs
 
Inputs
 
 
 
 
 
(Level 1)
 
(Level 2)
 
(Level 3)
 
Total
 
                   
Debt securities
 
$
-
 
$
163,108
 
$
4,000
 
$
167,108
 
Equity securities
   
35,566
   
-
   
-
   
35,566
 
Short-term investments
   
-
   
95,060
   
-
   
95,060
 
Total Assets
 
$
35,566
 
$
258,168
 
$
4,000
 
$
297,734
 


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, 2008.

Beginning balance as of January 1, 2008
 
$
4,000
 
         
Purchases, issuances, sales and settlements
   
-
 
Total realized/unrealized gains/(losses) included in net income
   
-
 
Net gains/(losses) included on other comprehensive income
   
-
 
Transfers in and/or out of Level 3
   
-
 
            
Ending balance as of March 31, 2008
 
$
4,000
 

4. Business Combinations

We account for business combinations using the purchase method of accounting. The cost of an acquired entity is allocated to the assets acquired (including identified intangible assets) and liabilities assumed based on their estimated fair values. The excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed is an asset referred to as “excess of cost over net assets acquired” or “goodwill.” Indirect and general expenses related to business combinations are expensed as incurred.
 
5. 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 $15.4 million at March 31, 2008.

6. Share-Based Payment Arrangements

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

11

As of March 31, 2008, there were incentive stock options to purchase 677,499 shares of our common stock outstanding and non-qualified stock options to purchase 40,000 shares of our common stock outstanding under the 2005 LTIP, leaving 115,834 shares reserved for future issuance. As of March 31, 2008, there were incentive stock options to purchase 59,666 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, 2008, there were outstanding non-qualified stock options to purchase 16,666 shares of our common stock granted to certain non-employee directors outside the 1994 Director Plan in lieu of fees for service on our board of directors in 1999. The exercise price of all such outstanding stock options is equal to the fair market value of our common stock on the date of grant.

Options granted under the 1994 Employee Plan prior to October 31, 2003, vest 40% six months from the date of grant and an additional 20% on each of the first three anniversary dates of the grant and terminate ten years from the date of grant. Incentive stock options granted under the 2005 LTIP and the 1994 Employee Plan after October 31, 2003, vest 10%, 20%, 30% and 40% on the first, second, third and fourth anniversary dates of the grant, respectively, and terminate five to ten years from the date of grant. Non-qualified stock options granted under the 2005 LTIP vested 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.

During the first quarter of 2008, we determined our previous recognition of compensation expense on share based arrangements did not conform to GAAP. As a result, we corrected our calculation to properly record compensation expense on a straight line basis over the requisite service period for the entire award in accordance with SFAS No. 123R “Share-Based Payment”. The cumulative impact of this correction was recorded during the first quarter of 2008 resulting in additional compensation expense of approximately $354 thousand which is not considered to have a material impact on our financial position or results of operations.

A summary of the status of our stock options as of and changes during the year-to-date ended March 31, 2008 is presented below:

12

 
 
 
 
Average
 
Contractual
 
Intrinsic
 
 
 
Number of
 
Exercise
 
Term
 
Value
 
 
 
Shares
 
Price
 
(Years)
 
($000)
 
                   
Outstanding at January 1, 2008
   
848,000
 
$
10.41
             
Granted
   
-
 
$
-
             
Exercised
   
(33,335
)
$
3.61
             
Forfeited or expired
   
-
 
$
-
             
Outstanding at March 31, 2008
   
814,665
 
$
10.69
   
7.9
 
$
1,110
 
Exercisable at March 31, 2008
   
174,582
 
$
6.56
   
4.6
 
$
861
 

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

   
Three Months Ended
 
   
March 31,
 
   
2008
 
2007
 
           
Intrinsic value of options exercised
 
$
278
 
$
-
 
               
Cost of share-based payments (non-cash)
 
$
547
 
$
51
 
               
Income tax benefit of share-based
             
payments recognized in income
 
$
191
 
$
18
 


As of March 31, 2008 there was $2.1 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under our plans, of which $0.6 million is expected to be recognized in the remainder of 2008, $0.7 million is expected to be recognized in 2009, $0.6 million is expected to be recognized in 2010 and $0.2 million is expected to be recognized in 2011.

The fair value of each stock option granted is estimated on the date of grant using the Black-Scholes option pricing model. Expected volatilities are based on historical volatility of our common stock. The risk- free interest rates for periods within the contractual term of the options are based on rates for U.S. Treasury Notes with maturity dates corresponding to the options’ expected lives on the dates of grant. There were no options granted in either the first quarter of 2008 or 2007.

7. Segment Information

The following is business segment information for the three months ended March 31, 2008 and  2007 (in thousands):

13

   
Three Months Ended
 
 
 
March 31,
 
 
 
2008
 
2007
 
Revenues:
 
 
 
 
 
   
Standard Commercial Segment
 
$
21,829
 
$
21,767
 
Specialty Commercial Segment
   
32,087
   
28,098
 
Personal Segment
   
15,726
   
13,773
 
Corporate
   
1,551
   
320
 
Consolidated
 
$
71,193
 
$
63,958
 
               
Pre-tax income (loss):
             
Standard Commercial Segment
 
$
3,881
 
$
2,759
 
Specialty Commercial Segment
   
5,293
   
4,686
 
Personal Segment
   
2,590
   
2,118
 
Corporate
   
(1,298
)
 
(1,850
)
Consolidated
 
$
10,466
 
$
7,713
 

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

   
March 31,
 2008
 
December 31, 
2007
 
Assets
         
Standard Commercial Segment
 
$
163,569
 
$
211,428
 
Specialty Commercial Segment
   
192,764
   
229,138
 
Personal Segment
   
87,995
   
100,986
 
Corporate
   
74,725
   
64,762
 
   
$
519,053
 
$
606,314
 

8. Reinsurance

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

14

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

   
Three Months Ended
 
 
 
March 31,
 
 
 
2008
 
2007
 
           
Ceded earned premiums
 
$
2,310
 
$
3,879
 
Reinsurance recoveries
 
$
107
 
$
1,084
 

Our insurance company subsidiaries presently retain 100% of the risk associated with all non-standard personal automobile policies marketed by our Phoenix Operating Unit. We currently reinsure the following exposures on business generated by our HGA 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, 2007, are:

 
o
We retain the first $2.0 million of property catastrophe losses; and

 
o
Our reinsurers reimburse us 100% for each $1.00 of loss in excess of our $2.0 million retention up to $28.0 million for each catastrophic occurrence, subject to a maximum of two events for the contractual term.

 
·
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 the commercial property reinsurance, effective July 1, 2007, 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

 
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, 2007, are:

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

15

 
o
Our reinsurers reimburse us for the next $5.0 million for each commercial casualty 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 or airport liability loss;

 
o
Our reinsurers reimburse us for the next $1.15 million of each aircraft hull or liability loss and for the next $650,000 of each airport liability loss; and

 
o
Our reinsurers provide additional reimbursement of $4.0 million for each airport liability loss and aircraft liability loss, excluding passenger liability.

9. 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, 2008, 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, 2008, the balance on the revolving note was $2.8 million, which currently bears interest at 6.50% per annum. Also included in notes payable is $1.4 million outstanding as of March 31, 2008 under PAAC’s revolving credit sub-facility, which also currently bears interest at 6.50% 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 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. Under the terms of the note, we pay interest only each quarter and the principal of the note at maturity. As of March 31, 2008 the note balance was $25.8 million.

10. Structured Settlements

In connection with the acquisition of the subsidiaries comprising our TGA Operating Unit, we recorded a payable for future guaranteed payments of $25.0 million discounted at 4.4%, the rate of two-year U.S. Treasuries (the only investment permitted on the trust account securing such future payments). As of March 31, 2008 we had fully repaid our obligation to the sellers.

16

11. Credit Facilities

On June 29, 2005, we entered into a credit facility with The Frost National Bank. The credit facility was amended and restated on January 27, 2006 to a $20.0 million revolving credit facility, with a $5.0 million letter of credit sub-facility. The credit facility was further amended effective May 31, 2007 to increase the revolving credit facility to $25.0 million and establish a new $5.0 million revolving credit sub-facility for the premium finance operations of PAAC. 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 substantially all of our assets. The revolving credit facility contains covenants which, among other things, require us to maintain certain financial and operating ratios and restrict certain distributions, transactions and organizational changes. As of March 31, 2008, we were in compliance with all of our covenants. (See Note 9, “Notes Payable”).

12. Deferred Policy Acquisition Costs

The following table shows total deferred and amortized policy acquisition costs by period (in thousands):
 
   
Three Months Ended
 
   
March 31,
 
   
2008
 
2007
 
           
Deferred
 
$
(14,405
)
$
(12,360
)
Amortized
   
13,746
   
10,576
 
               
Net
 
$
(659
)
$
(1,784
)

13. Earnings per Share

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

17


   
Three Months Ended
 
   
March 31,
 
   
2008
 
2007
 
           
Weighted average shares - basic
   
20,781
   
20,768
 
Effect of dilutive securities
   
106
   
23
 
Weighted average shares - assuming dilution
   
20,887
   
20,791
 

For the three months ended March 31, 2008 and 2007, 140,494 shares and 109,166 shares, respectively, 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.

14. Net Periodic Pension Cost

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

   
Three Months Ended
 
   
March 31,
 
   
2008
 
2007
 
Interest cost
 
$
167
 
$
180
 
Amortization of net (gain) loss
   
(168
)
 
50
 
Expected return on plan assets
   
16
   
(161
)
Net periodic pension cost
 
$
15
 
$
69
 

We contributed $84 thousand and $74 thousand to our frozen defined benefit cash balance plan during each of the three months ended March 31, 2008 and 2007, respectively. Refer to Note 13 to the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2007 for more discussion of our retirement plans.

15. Contingencies

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

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

The following discussion should be read together with our consolidated financial statements and the notes thereto. This discussion contains forward-looking statements. Please see “Risks Associated with Forward-Looking Statements in this Form 10-Q” and “Item 1A. Risk Factors” for a discussion of some of the uncertainties, risks and assumptions associated with these statements.

18

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, non-standard automobile 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 four operating units which are supported by our insurance company subsidiaries.
 
Our non-carrier insurance activities are segregated by operating units into the following reportable segments:
 
 
·
Standard Commercial Segment. Our Standard Commercial Segment includes the standard lines commercial property/casualty insurance products and services handled by our HGA Operating Unit which is comprised of our 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 and the general aviation insurance products and services handled by our Aerospace 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.

 
·
Personal Segment. Our Personal Segment includes the non-standard personal automobile insurance products and services handled by our Phoenix Operating Unit which is comprised solely of American Hallmark General Agency, Inc., which does business as Phoenix Indemnity Insurance Company.

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

 
·
American Hallmark Insurance Company of Texas   (“AHIC”)   presently retains all of the risks on the commercial property/casualty policies marketed by our HGA Operating Unit, assumes a portion of the risks on the commercial property/casualty policies marketed by our TGA Operating Unit and assumes a portion of the risks on the aviation property/casualty products marketed by our Aerospace Operating Unit.

 
·
Hallmark Specialty Insurance Company (“HSIC”) presently assumes a portion of the risks on the commercial property/casualty policies marketed by our TGA Operating Unit.

19

 
·
Hallmark Insurance Company (“HIC”) (formerly known as Phoenix Indemnity Insurance Company) presently assumes all of the risks on the non-standard personal automobile policies marketed by our Phoenix Operating Unit and assumes a portion of the risks on the aviation property/casualty products marketed by our Aerospace Operating Unit.

Effective January 1, 2006, our insurance company subsidiaries entered into a pooling arrangement, which was subsequently amended on December 15, 2006, pursuant to which AHIC retains 46% of the total net premiums written by all of our operating units, HIC retains 34% of our total net premiums written and HSIC retains 20% of our total net premiums written.  The impact of this pooling arrangement had no impact on our consolidated financial statements under GAAP.
 
Results of Operations

Management Overview. During the three months ended March 31, 2008, our total revenues were $71.2 million, representing an 11% increase over the $64.0 million in total revenues for the same period of 2007. Increased retention of business produced by our Specialty Commercial Segment, increased production by our Personal Segment and increased Corporate revenue were the primary causes of the increase in revenue. Specialty Commercial Segment revenues increased $4.0 million, or 14%, during the three months ended March 31, 2008 as compared to the same period of 2007. Revenues from our Personal Segment increased $2.0 million, or 14%, during the three months ended March 31, 2008 as compared to the same period during 2007, due largely to geographic expansion into new states. Net gains on investments of $0.9 million for the three months ended March 31, 2008, as compared to net gains on investments of $0.1 million for the same period the prior year, were the primary reason for the $1.2 million increase in revenue for Corporate.

We reported net income of $7.1 million for the three months ended March 31, 2008, which was $2.1 million higher than the $5.0 million reported for the same period in 2007. On a basic and diluted basis, net income was $0.34 per share for the three months ended March 31, 2008 as compared to $0.24 per share for the same period in 2007. The increase in net income was primarily attributable to the increased revenue discussed above as well as favorable prior year loss reserve development of $1.6 million during the first quarter of 2008. We did not record any prior year loss development during the first quarter of 2007.

20

First Quarter 2008 as Compared to First Quarter 2007

The following is additional business segment information for the three months ended March 31, 2008 and 2007 (in thousands):

Hallmark Financial Services, Inc.
Consolidated Segment Data

 
 
Three Months Ended March 31, 2008
 
 
 
Standard
 
Specialty
 
 
 
 
 
 
 
 
 
Commercial
 
Commercial
 
Personal
 
 
 
 
 
 
 
Segment
 
Segment
 
Segment
 
Corporate
 
Consolidated
 
                       
Produced premium
 
$
21,749
 
$
32,020
 
$
17,727
 
$
-
 
$
71,496
 
                                 
Gross premiums written
   
21,749
   
24,761
   
17,727
   
-
   
64,237
 
Ceded premiums written
   
(1,364
)
 
(968
)
 
-
   
-
   
(2,332
)
Net premiums written
   
20,385
   
23,793
   
17,727
   
-
   
61,905
 
Change in unearned premiums
   
404
   
(155
)
 
(3,238
)
 
-
   
(2,989
)
Net premiums earned
   
20,789
   
23,638
   
14,489