HALLMARK FINANCIAL SERVICES INC (Form: 10-Q, Received: 05/15/2009 14:47:28)

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. 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 ¨

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 Number

Consolidated Balance Sheets at March 31, 2009 (unaudited) and December 31, 2008		3

Consolidated Statements of Operations (unaudited) for the three months ended March 31, 2009 and March 31, 2008		4

Consolidated Statements of Stockholders’ Equity and Comprehensive Income (unaudited) for the three months ended March 31, 2009 and March 31, 2008		5

Consolidated Statements of Cash Flows (unaudited) for the three months ended March 31, 2009 and March 31, 2008		6

Notes to Consolidated Financial Statements (unaudited)		7

Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Balance Sheets

($ in thousands)

	March 31			December 31
	2009			2008
	(unaudited)
ASSETS
Investments:
Debt securities, available-for-sale, at fair value	$	279,895		$	268,513
Equity securities, available-for-sale, at fair value		25,983			25,003

Total investments		305,878			293,516

Cash and cash equivalents		56,317			59,134
Restricted cash and cash equivalents		6,220			8,033
Premiums receivable		48,932			44,032
Accounts receivable		3,937			4,531
Receivable for securities		1,064			1,031
Prepaid reinsurance premiums		1,671			1,349
Reinsurance recoverable		7,478			8,218
Deferred policy acquisition costs		21,002			19,524
Excess of cost over fair value of net assets acquired		41,080			41,080
Intangible assets, net		28,255			28,969
Current federal income tax recoverable		-			696
Deferred federal income taxes		5,680			6,696
Prepaid expenses		1,044			1,007
Other assets		22,721			20,582

	$	551,279		$	538,398

LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Notes payable	$	59,650		$	60,919
Reserves for unpaid losses and loss adjustment expenses		164,839			156,363
Unearned premiums		112,183			102,192
Unearned revenue		1,170			2,037
Accrued agent profit sharing		751			2,151
Accrued ceding commission payable		8,592			8,605
Pension liability		4,348			4,309
Current federal income tax		1,649			-
Payable for securities		1,115			3,606
Accounts payable and other accrued expenses		5,603			18,067

		359,900			358,249

Commitments and Contingencies (Note 15)

Redeemable non-controlling interest		824			737

Stockholders' 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			3,751
Capital in excess of par value		120,200			119,928
Retained earnings		79,032			72,242
Accumulated 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

Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Statements of Operations

(Unaudited)

($ in thousands, except per share amounts)

	Three Months Ended
	March 31
	2009			2008

Gross premiums written	$	71,479		$	64,237
Ceded premiums written		(2,232	)		(2,004	)
Net premiums written		69,247			62,233
Change in unearned premiums		(9,817	)		(2,989	)
Net premiums earned		59,430			59,244

Investment income, net of expenses		4,269			3,625
Net realized gains (impairments and realized losses)		(348	)		859
Finance charges		1,350			1,264
Commission and fees		6,189			6,484
Processing and service fees		15			42
Other income		5			3

Total revenues		70,910			71,521

Losses and loss adjustment expenses		36,842			35,504
Other operating expenses		23,750			23,465
Interest expense		1,159			1,185
Amortization of intangible assets		714			573

Total expenses		62,465			60,727

Income before tax		8,445			10,794
Income tax expense		1,662			3,529
Net income		6,783			7,265
Less: Net loss attributable to
non-controlling interest		(7	)		-

Net income attributable to Hallmark Financial Services, Inc.	$	6,790		$	7,265

Net income per share attributable to Hallmark Financial
Services, Inc. common stockholders:
Basic	$	0.33		$	0.35
Diluted	$	0.33		$	0.35

The accompanying notes are an integral part

of the consolidated financial statements

Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Statements of Stockholders' Equity and Comprehensive Income

(Unaudited)

($ in thousands)

	Three Months Ended
	March 31,
	2009			2008

Common Stock
Balance, beginning of period	$	3,751		$	3,740
Issuance of common stock upon option exercises		6			6
Balance, end of period		3,757			3,746

Additional Paid-In Capital
Balance, beginning of period		119,928			118,459
Accretion of redeemable noncontrolling interest		(94	)		-
Equity based compensation		262			547
Exercise of stock options		104			114

Balance, end of period		120,200			119,120

Retained Earnings
Balance, beginning of period		72,242			59,343
Net income attributable to Hallmark Financial Services, Inc.		6,790			7,265

Balance, end of period		79,032			66,608

Accumulated Other Comprehensive Loss
Balance, beginning of period		(16,432	)		(1,844	)
Additional minimun pension liability, net of tax		80			10
Unrealized gains (losses) on securities, net of tax		3,995			(1,252	)
Balance, end of period		(12,357	)		(3,086	)

Treasury Stock
Balance, beginning and end of period		(77	)		(77	)

Total Stockholders' Equity	$	190,555		$	186,311

Net income	$	6,783		$	7,265
Additional minimum pension liablilty, net of tax		80			10
Unrealized gains (losses) on securities, net of tax		3,995			(1,252	)
Comprehensive income		10,858			6,023
Less: Comprehensive loss attributable to
non-controlling interest		(7	)		-
Comprehensive income attributable to
Hallmark Financial Services, Inc.	$	10,865		$	6,023

The accompanying notes are an integral part

of the consolidated financial statements

Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(Unaudited)

($ in thousands)

	Three Months Ended
	March 31
	2009			2008
Cash flows from operating activities:
Net income	$	6,783		$	7,265

Adjustments to reconcile net income to cash provided by operating activites:
Depreciation and amortization expense		928			767
Deferred 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			8,410
Change in unearned premiums		9,991			3,011
Change in unearned revenue		(867	)		(502	)
Change in accrued agent profit sharing		(1,400	)		(2,177	)
Change in reinsurance recoverable		740			483
Change in current federal income tax payable		2,345			2,903
Change in accrued ceding commission payable		(13	)		86
Change in all other liabilities		(9,081	)		(4,059	)
Change in all other assets		(2,190	)		1,965

Net cash provided by operating activities		8,851			12,388

Cash flows from investing activities:
Purchases of property and equipment		(428	)		(174	)
Change in restricted cash		2,833			11,361
Purchases of debt and equity securities		(22,014	)		(235,781	)
Maturities, sales and redemptions of investment securities		12,443			137,398
Payment 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			120
Premium finance notes originated, net of finance notes repaid		(1,269	)		107
Repayment 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			145,884
Cash and cash equivalents at end of period	$	56,317		$	61,303

Supplemental Cash Flow Information:

Interest paid	$	1,186		$	1,190

Taxes paid	$	419		$	781

Supplemental schedule of non-cash investing activities:

Change in receivable for securities related to investment disposals that settled after the balance sheet date	$	(33	)	$	27,395

Change 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

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.

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.”

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,
	2008
As previously reported:
Ceded premiums written	$	(2,332	)
Net premiums written		61,905
Net premiums earned		58,916
Total revenues		71,193

Income before tax		10,466
Income tax expense		3,414
Net income	$	7,052

Common stockholders net income per share:
Basic	$	0.34
Diluted	$	0.34

Adjustments:
Ceded premiums written	$	328
Income tax expense		115
Net income impact	$	213

As revised:
Ceded premiums written	$	(2,004	)
Net premiums written		62,233
Net premiums earned		59,244
Total revenues		71,521

Income before tax		10,794
Income tax expense		3,529
Net income	$	7,265

Common stockholders net income per share:
Basic	$	0.35
Diluted	$	0.35

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

	As previously
	reported		Adjustment		As revised
Balances as of March 31, 2008
Prepaid reinsurance premiums	$	2,197	$	996	$	3,193
Total assets		519,053		996		520,049
Current federal income tax payable		3,418		349		3,767
Total liabilities		333,389		349		333,738
Retained earnings		65,961		647		66,608
Total 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 Three
	Months Ended
	March 31,
	2008
As previously reported:
Net income	$	7,052
Change in prepaid reinsurance premiums		(1,923	)
Change in current federal income tax payable		2,788
Net cash provided by operating activities		12,388

Adjustments:
Net income	$	213
Change in prepaid reinsurance premiums		(328	)
Change in current federal income tax payable		115
Net cash provided by operating activities		-

As revised:
Net income	$	7,265
Change in prepaid reinsurance premiums		(2,251	)
Change in current federal income tax payable		2,903
Net 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.

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.

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.

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

Tradename	$	757	15 years
Non-compete agreement	$	526	6 years
Agency 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.

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		Other
	Active Markets for		Observable		Unobservable
	Identical Assets		Inputs		Inputs
	(Level 1)		(Level 2)		(Level 3)		Total

Debt securities	$	-	$	232,950	$	46,945	$	279,895
Equity securities		25,983		-		-		25,983
Total	$	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	$	46,104

Purchases, issuances, sales and settlements		-
Total realized/unrealized gains included in net income		-
Net gains included in other comprehensive income		841
Transfers in and/or out of Level 3		-

Ending balance as of March 31, 2009	$	46,945

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, 2009

	12 months or less					Longer than 12 months					Total

			Unrealized					Unrealized					Unrealized
	Fair Value		Losses			Fair Value		Losses			Fair Value		Losses

Corporate 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, 2008

12 months or less

Longer than 12 months

Total

Unrealized

Fair Value

Losses

Fair Value

Losses

Fair Value

Losses

Corporate debt securities

34,314

(5,175

)

9,786