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, 2007
 
Commission file number 001-11252
 
Hallmark Financial Services, Inc.
(Exact name of registrant as specified in its charter)
 
Nevada        
 87-0447375
(State or other jurisdiction 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, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer o     Accelerated filer o     Non-accelerated filer x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes  o     No x
 
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: Common Stock, par value $.18 per share - 20,768,238 shares outstanding as of May 8, 2007.


PART I
FINANCIAL INFORMATION

Item 1.   Financial Statements
 
INDEX TO FINANCIAL STATEMENTS
 
   
Page Number
     
Consolidated Balance Sheets at March 31, 2007 (unaudited) and December 31, 2006
 
3
     
Consolidated Statements of Operations (unaudited) for the three months ended March 31, 2007 and March 31, 2006
 
4
     
Consolidated Statements of Stockholders’ Equity and Comprehensive Income (unaudited) for the three months ended March 31, 2007 and March 31, 2006
 
5
     
Consolidated Statements of Cash Flows (unaudited) for the three months ended March 31, 2007 and March 31, 2006
 
6
     
Notes to Consolidated Financial Statements (unaudited)
 
7

2

Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Balance Sheets
($ in thousands)
 
   
March 31
2007
 
December 31
2006
 
   
(unaudited)
 
(audited)
 
ASSETS
         
Investments:
         
Debt securities, available-for-sale, at market value
 
$
133,122
 
$
125,784
 
Equity securities, available-for-sale, at market value
   
37,448
   
4,580
 
Short-term investments, available-for-sale, at market value
   
10,325
   
25,275
 
               
Total investments
   
180,895
   
155,639
 
               
Cash and cash equivalents
   
75,823
   
81,474
 
Restricted cash and investments
   
17,013
   
31,815
 
Premiums receivable
   
49,497
   
44,644
 
Accounts receivable
   
11,425
   
13,223
 
Prepaid reinsurance premium
   
1,637
   
1,629
 
Reinsurance balances receivable
   
5,083
   
-
 
Reinsurance recoverable
   
5,283
   
5,930
 
Deferred policy acquisition costs
   
18,929
   
17,145
 
Excess of cost over fair value of net assets acquired
   
31,427
   
31,427
 
Intangible assets
   
25,501
   
26,074
 
Prepaid expenses
   
1,418
   
1,769
 
Other assets
   
8,240
   
5,184
 
               
Total assets
 
$
432,171
 
$
415,953
 
               
LIABILITIES AND STOCKHOLDERS' EQUITY
             
Liabilities:
             
Notes payable
 
$
36,016
 
$
35,763
 
Structured settlements
   
9,691
   
24,587
 
Unpaid losses and loss adjustment expenses
   
90,840
   
77,564
 
Unearned premiums
   
100,581
   
91,606
 
Unearned revenue
   
4,508
   
5,734
 
Reinsurance balances payable
   
-
   
1,060
 
Accrued agent profit sharing
   
594
   
1,784
 
Accrued ceding commission payable
   
7,206
   
3,956
 
Pension liability
   
3,121
   
3,126
 
Deferred federal income taxes
   
3,708
   
2,310
 
Current federal income tax payable
   
1,684
   
2,132
 
Accounts payable and other accrued expenses
   
18,108
   
15,600
 
               
Total liabilities
   
276,057
   
265,222
 
               
Commitments and Contingencies
         
               
Stockholders' equity:
             
Common stock, $.18 par value (authorized 33,333,333 shares in 2007 and 2006;
             
issued 20,776,066 shares in 2007 and 2006)
   
3,740
   
3,740
 
Additional paid in capital
   
117,983
   
117,932
 
Retained earnings
   
36,450
   
31,480
 
Accumulated other comprehensive loss
   
(1,982
)
 
(2,344
)
Treasury stock, at cost (7,828 shares in 2007 and 2006)
   
(77
)
 
(77
)
               
Total stockholders' equity
   
156,114
   
150,731
 
               
   
$
432,171
 
$
415,953
 
 
The accompanying notes are an integral part
of the consolidated financial statements

3


Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Statements of Operations
(Unaudited)
($ in thousands, except per share amounts)

   
Three Months Ended
March 31
 
   
2007
 
  2006
 
            
Gross premiums written
 
$
64,658
 
$
47,735
 
Ceded premiums written
   
(3,887
)
 
(1,956
)
Net premiums written
   
60,771
   
45,779
 
Change in unearned premiums
   
(9,123
)
 
(17,345
)
Net premiums earned
   
51,648
   
28,434
 
               
Investment income, net of expenses
   
2,990
   
2,357
 
Realized gain (loss)
   
53
   
(83
)
Finance charges
   
1,086
   
687
 
Commission and fees
   
7,905
   
12,264
 
Processing and service fees
   
272
   
857
 
Other income
   
4
   
4
 
               
Total revenues
   
63,958
   
44,520
 
               
Losses and loss adjustment expenses
   
32,185
   
16,690
 
Other operating costs and expenses
   
22,701
   
21,026
 
Interest expense
   
786
   
1,585
 
Interest expense from amortization of discount on convertible notes
   
-
   
1,117
 
Amortization of intangible asset
   
573
   
573
 
               
Total expenses
   
56,245
   
40,991
 
               
Income before tax
   
7,713
   
3,529
 
               
Income tax expense
   
2,743
   
1,103
 
               
Net income
 
$
4,970
 
$
2,426
 
               
Common stockholders net income per share:
             
Basic
 
$
0.24
 
$
0.14
 
Diluted
 
$
0.24
 
$
0.14
 
               
Convertible noteholders net income per share:
             
Basic
 
$
n/a
 
$
0.14
 
Diluted
 
$
n/a
 
$
0.14
 
The accompanying notes are an integral part
of the consolidated financial statements
 
4
 
Consolidated Statements of Stockholders' Equity and Comprehensive Income
(Unaudited)
($ in thousands)
 
   
Three Months Ended
 
 
 
March 31,
 
 
 
2007
 
2006
 
 
 
 
 
 
 
Common Stock
 
 
 
 
 
Balance, beginning of period
 
$
3,740
 
$
2,606
 
Issuance of common stock upon option exercises
   
-
   
3
 
Balance, end of period
   
3,740
   
2,609
 
 
         
Additional Paid-In Capital
         
Balance, beginning of period
   
117,932
   
62,907
 
Discount on convertible notes, net of tax
   
-
   
6,032
 
Equity based compensation
   
51
   
24
 
Exercise of stock options
   
-
   
71
 
Balance, end of period
   
117,983
   
69,034
 
 
         
Retained Earnings
         
Balance, beginning of period
   
31,480
   
22,289
 
Net income
   
4,970
   
2,426
 
Balance, end of period
   
36,450
   
24,715
 
 
         
Accumulated Other Comprehensive Loss
         
Balance, beginning of period
   
(2,344
)
 
(2,597
)
Unrealized gains (losses) on securities, net of tax
   
362
   
(820
)
Balance, end of period
   
(1,982
)
 
(3,417
)
 
         
Treasury Stock
         
Balance, beginning of period
   
(77
)
 
(17
)
Acquisition of treasury shares
   
-
   
(100
)
Exercise of stock options
   
-
   
40
 
Balance, end of period
   
(77
)
 
(77
)
 
         
Stockholders' Equity
 
$
156,114
 
$
92,864
 
 
         
Net income
 
$
4,970
 
$
2,426
 
Unrealized gains (losses) on securities, net of tax
   
362
   
(820
)
Comprehensive Income
 
$
5,332
 
$
1,606
 
 
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
 
   
2007
 
2006
 
Cash flows from operating activities:
         
Net income
 
$
4,970
 
$
2,426
 
               
Adjustments to reconcile net income to cash provided by operating activities:
             
Depreciation and amortization expense
   
781
   
800
 
Amortization of beneficial conversion feature
   
-
   
1,117
 
Amortization of discount on structured settlement
   
104
   
262
 
Deferred federal income tax expense (benefit)
   
1,200
   
(1,756
)
Realized (gain) loss on investments
   
(53
)
 
83
 
Change in prepaid reinsurance premiums
   
(8
)
 
(547
)
Change in premiums receivable
   
(4,853
)
 
(17,430
)
Change in accounts receivable
   
1,798
   
(4,230
)
Change in deferred policy acquisition costs
   
(1,784
)
 
(1,927
)
Change in unpaid losses and loss adjustment expenses
   
13,276
   
7,861
 
Change in unearned premiums
   
8,975
   
17,882
 
Change in unearned revenue
   
(1,226
)
 
(2,230
)
Change in accrued agent profit sharing
   
(1,190
)
 
(1,654
)
Change in reinsurance recoverable
   
647
   
(493
)
Change in reinsurance balances payable
   
(6,143
)
 
(455
)
Change in current federal income tax payable/recoverable
   
(449
)
 
1,008
 
Change in accrued ceding commission payable
   
3,250
   
220
 
Excess tax benefits from share-based payments
   
-
   
25
 
Change in all other liabilities
   
2,503
 
 
7,644
 
Change in all other assets
   
(2,823
)
 
976
 
               
Net cash provided by operating activities
   
18,975
   
9,582
 
               
Cash flows from investing activities:
             
Purchases of property and equipment
   
(72
)
 
(106
)
Premium finance notes repaid, net of finance notes originated
   
252
   
(1,745
)
Acquisition of subsidiaries, net of cash acquired
   
-
   
(25,964
)
Change in restricted cash and investments
   
14,802
   
(25,138
)
Purchases of debt and equity securities
   
(48,251
)
 
(4,532
)
Maturities and redemptions of investment securities
   
8,643
   
3,923
 
Net redemptions of short-term investments
   
15,000
   
11,946
 
               
Net cash used in investing activities
   
(9,626
)
 
(41,616
)
               
Cash flows from financing activities:
             
Proceeds from exercise of employee stock options
   
-
   
40
 
Payment of structured settlement
   
(15,000
)
 
-
 
Proceeds from issuance of convertible debt
   
-
   
25,000
 
Proceeds from note payable to related party
   
-
   
12,500
 
Proceeds from revolving loan on credit facility
   
-
   
15,000
 
               
Net cash (used in) provided by financing activities
   
(15,000
)
 
52,540
 
               
Increase (decrease) in cash and cash equivalents
   
(5,651
)
 
20,506
 
Cash and cash equivalents at beginning of period
   
81,474
   
44,528
 
               
Cash and cash equivalents at end of period
 
$
75,823
 
$
65,034
 
               
Supplemental Cash Flow Information:
             
Interest paid
 
$
687
 
$
983
 
Taxes paid
 
$
1,992
 
$
1,800
 
 
The accompanying notes are an integral part
of the consolidated financial statements

6

Hallmark Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)

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

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

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

2. Basis of Presentation

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

The interim financial data as of March 31, 2007 and 2006 is unaudited. However, in the opinion of management, the interim data includes all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the results for the interim periods. The results of operations for the period ended March 31, 2007 are not necessarily indicative of the operating results to be expected for the full year.
 
7

Reclassification

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

Redesignation of Segments

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

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

Use of Estimates in the Preparation of the Financial Statements

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

Recently Issued Accounting Standards

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

In June 2006, FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109” (“FIN 48”), was issued. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with FASB Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes.” FIN 48 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, as well as providing guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006 with earlier application permitted as long as the company has not yet issued financial statements, including interim financial statements, in the period of adoption. We adopted the provisions of FIN 48 on January 1, 2007. Since we had no unrecognized tax  benefits, we recognized no additional liability or reduction in deferred tax asset as a result of the adoption of FIN 48.  We are no longer subject to U. S. federal, state, local or non-U.S. income tax examinations by tax authorities for years prior to 2003.
 
8

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

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

3. Business Combinations

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

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

   
TGA
 
Aerospace
 
   
Operating Unit
 
Operating Unit
 
           
Fair value of tangible assets excluding cash
         
and cash equivalents
 
$
52,906
 
$
8,391
 
Fair value of intangible assets acquired
   
31,585
   
12,575
 
Capitalized direct expenses
   
232
   
36
 
Structured settlement
   
(23,542
)
 
-
 
Liabilities assumed
   
(48,522
)
 
(7,697
)
               
Cash and cash equivalents used in acquisitions
 
$
12,659
 
$
13,305
 
 
9
 
5. Share-Based Payment Arrangements

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

As of March 31, 2007, there were incentive stock options to purchase 197,499 shares of our common stock outstanding under the 2005 LTIP, leaving 635,834 shares reserved for future issuance. As of March 31, 2007, there were incentive stock options to purchase 93,168 shares outstanding under the 1994 Employee Plan and non-qualified stock options to purchase 23,334 shares outstanding under the 1994 Director Plan. In addition, as of March 31, 2007, there were outstanding non-qualified stock options to purchase 16,666 shares of our common stock granted to certain non-employee directors outside the 1994 Director Plan in lieu of fees for service on our board of directors in 1999. The exercise price of all such outstanding stock options is equal to the fair market value of our common stock on the date of grant.

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

A summary of the status of our stock options as of and changes during the year-to-date ended March 31, 2007 is presented below:


   
 
 
Average
 
Contractual
 
Intrinsic
 
 
 
Number of
 
Exercise
 
Term
 
Value
 
 
 
Shares
 
Price
 
(Years)
 
($000)
 
                   
Outstanding at January 1, 2007
   
332,334
 
$
7.04
             
Granted
   
-
 
$
-
             
Exercised
   
-
 
$
-
             
Forfeited or expired
   
(1,667
)
$
5.10
             
Outstanding at March 31, 2007
   
330,667
 
$
7.05
   
6.1
 
$
1,649
 
Exercisable at March 31, 2007
   
82,418
 
$
3.82
   
3.2
 
$
678
 
 
10

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,
 
   
2007
 
2006
 
           
Intrinsic value of options exercised
 
$
-
 
$
103
 
               
Cost of share-based payments (non-cash)
 
$
51
 
$
24
 
               
Income tax benefit of share-based
             
payments recognized in income
 
$
18
 
$
8
 

As of March 31, 2007 there was $0.9 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under our plans, of which $0.2 million is expected to be recognized in the remainder of 2007, $0.3 million is expected to be recognized in each of 2008 and 2009 and $0.1 million is expected to be recognized in 2010.

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 quarters of 2007 or 2006.
 
6. Segment Information

The following is business segment information for the three months ended March 31, 2007 and 2006 (in thousands):

   
Three Months Ended
 
 
 
March 31,
 
 
 
2007
 
2006
 
Revenues:
         
Standard Commercial Segment
 
$
21,767
 
$
17,540
 
Specialty Commercial Segment
   
28,098
   
15,968
 
Personal Segment
   
13,773
   
10,797
 
Corporate
   
320
   
215
 
Consolidated
 
$
63,958
 
$
44,520
 
               
Pre-tax income (loss):
             
Standard Commercial Segment
 
$
2,759
 
$
3,360
 
Specialty Commercial Segment
   
4,686
   
1,619
 
Personal Segment
   
2,118
   
2,051
 
Corporate
   
(1,850
)
 
(3,501
)
Consolidated
 
$
7,713
 
$
3,529
 

11
 
The following is additional business segment information as of the dates indicated (in thousands):

   
March 31, 2007
 
December 31, 2006
 
Assets
         
Standard Commercial Segment
 
$
126,369
 
$
130,764
 
Specialty Commercial Segment
   
199,855
   
167,675
 
Personal Segment
   
90,183
   
85,391
 
Corporate
   
15,764
   
32,123
 
   
$
432,171
 
$
415,953
 

7. Reinsurance

We reinsure a portion of the risk we underwrite in order to control the exposure to losses and to protect capital resources. We cede to reinsurers a portion of these risks and pay premiums based upon the risk and exposure of the policies subject to such reinsurance. Ceded reinsurance involves credit risk and is generally subject to aggregate loss limits. Although the reinsurer is liable to us to the extent of the reinsurance ceded, we are ultimately liable as the direct insurer on all risks reinsured. Reinsurance recoverables are reported after allowances for uncollectible amounts. We monitor the financial condition of reinsurers on an ongoing basis and review our reinsurance arrangements periodically. Reinsurers are selected based on their financial condition, business practices and the price of their product offerings. Refer to Note 6 of our Form 10-K for the year ended December 31, 2006 for more discussion of our reinsurance.

12
 
The following table shows earned premiums ceded and reinsurance loss recoveries by period (in thousands):
 
   
Three Months Ended
March 31,
 
   
2007
 
  2006
 
            
Ceded earned premiums
 
$
3,879
 
$
1,397
 
Reinsurance recoveries
 
$
1,095
 
$
776
 

8. Notes Payable

On June 21, 2005, our newly formed trust entity completed a private placement of $30.0 million of 30-year floating rate trust preferred securities. Simultaneously, we borrowed $30.9 million from the trust subsidiary and contributed $30.0 million to one of our insurance company subsidiaries in order to increase policyholder surplus. The note bears an initial interest rate of 7.725% until June 15, 2015, at which time interest will adjust quarterly to the three month LIBOR rate plus 3.25 percentage points. As of March 31, 2007, the note balance was $30.9 million.

On January 27, 2006, we borrowed $15.0 million under our revolving credit facility to fund the cash required to close the acquisition of the subsidiaries comprising our TGA Operating Unit. As of March 31, 2007, the balance on the revolving note was $2.8 million, which currently bears interest at 7.34% per annum. Also included in notes payable is $2.3 million outstanding under PAAC’s revolving credit facility, which currently bears 8.25% interest. (See Note 10, “Credit Facilities”).  

9. 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 and which is classified in restricted cash and investments on our balance sheet). As of March 31, 2007, the balance of the structured settlements was $9.7 million.

10. 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. Principal outstanding under the revolving credit facility generally bears interest at the three month Eurodollar rate plus 2.00%, payable quarterly in arrears. We pay letter of credit fees at the rate of 1.00% per annum. Our obligations under the revolving credit facility are secured by a security interest in the capital stock of all of our subsidiaries, guaranties of all of our subsidiaries and the pledge of substantially all of our assets. The revolving credit facility contains covenants which, among other things, require us to maintain certain financial and operating ratios and restrict certain distributions, transactions and organizational changes. The amended and restated credit agreement terminates on January 27, 2008. As of March 31, 2007, we were in compliance with all of our covenants. In the third quarter of 2005, we issued a $4.0 million letter of credit under this facility to collateralize certain obligations under the agency agreement between our HGA Operating Unit and Clarendon National Insurance Company effective July 1, 2004.
 
13
 
PAAC has a $5.0 million revolving credit facility with JPMorgan Chase Bank which terminates June 30, 2007. Principal outstanding under this revolving credit facility generally bears interest at 1% above the prime rate. PAAC’s obligations under this revolving credit facility are secured by its premium finance notes receivables. This revolving credit facility contains various restrictive covenants which, among other things, require PAAC to maintain minimum amounts of tangible net worth and working capital. As of March 31, 2007, PAAC was in compliance with of all of its covenants.

11. Deferred Policy Acquisition Costs

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

   
Three Months Ended
 
 
 
March 31,
 
   
2007
 
2006
 
           
Deferred
 
$
(12,360
)
$
(8,720
)
Amortized
   
10,576
   
6,793
 
               
Net
 
$
(1,784
)
$
(1,927
)
 
12. Earnings per Share

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

   
Three Months Ended
 
 
 
March 31,
 
 
 
2007
 
2006
 
           
Common Stockholders:
         
Weighted average shares - basic
   
20,768
   
14,479
 
Effect of dilutive securities
   
23
   
131
 
Weighted average shares - assuming dilution
   
20,791
   
14,610
 
               
Convertible Noteholders:
             
Weighted average shares - basic and assuming dilution
   
-
   
3,255
 
 
For the three months ended March 31, 2007, 109,166 shares attributable to outstanding stock options were excluded from the calculation of diluted earnings per share because the exercise prices of the stock options were greater than the average price of the common shares and, therefore, their inclusion would have been anti-dilutive. For the three months ended March 31, 2006 no shares attributable to outstanding stock options were excluded from the calculation of diluted earnings per share. For the basic and diluted earnings per share calculation for the three months ended March 31, 2006, net income was allocated $2.0 million to common stockholders and $0.4 million to holders of convertible notes.

14
 
13. Net Periodic Pension Cost

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

   
Three Months Ended
 
 
 
March 31,
 
   
2007
 
2006
 
Interest cost
 
$
180
 
$
171
 
Amortization of net loss
   
50
   
40
 
Expected return on plan assets
   
(161
)
 
(157
)
Net periodic pension cost
 
$
69
 
$
54
 

We contributed $74 thousand and $32 thousand to our frozen defined benefit cash balance plan during the three months ended March 31, 2007 and 2006, respectively. Refer to Note 14 of our Form 10-K for the year ended December 31, 2006 for more discussion of our retirement plans.

15
 
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

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

Introduction

Hallmark Financial Services, Inc. (“Hallmark” and, together with subsidiaries, “we”, “us”, “our”) is an insurance holding company which, through its subsidiaries, engages in the sale of property/casualty insurance products to businesses and individuals. Our business involves marketing, distributing, underwriting and servicing commercial insurance in Texas, New Mexico, Idaho, Oregon, Montana, Louisiana, Oklahoma, Arkansas and Washington; marketing, distributing, underwriting and servicing non-standard personal automobile insurance in Texas, New Mexico, Arizona, Oklahoma, Arkansas, Idaho, Oregon and Washington; marketing, distributing, underwriting and servicing general aviation insurance in 47 states; and providing other insurance related services. We pursue our business activities through subsidiaries whose operations are organized into four operating units which are supported by our insurance company subsidiaries.
 
Our non-carrier insurance activities are segregated by operating units into the following reportable segments:
 
 
·
Standard Commercial Segment. Our Standard Commercial Segment includes the standard lines commercial property/casualty insurance products and services handled by our HGA Operating Unit which is comprised of our Hallmark General Agency, Inc. and Effective Claims Management, Inc. subsidiaries.

 
·
Specialty Commercial Segment. Our Specialty Commercial Segment includes the excess and surplus lines commercial property/casualty insurance products and services handled by our TGA Operating Unit and the general aviation insurance products and services handled by our Aerospace Operating Unit. Our TGA Operating Unit is comprised of our Texas General Agency, Inc., Pan American Acceptance Corporation and TGA Special Risk, Inc. subsidiaries. Our Aerospace Operating Unit is comprised of our Aerospace Insurance Managers, Inc., Aerospace Special Risk, Inc. and Aerospace Claims Management Group, Inc. subsidiaries.

 
·
Personal Segment. Our Personal Segment includes the non-standard personal automobile insurance products and services handled by our Phoenix Operating Unit which is comprised of American Hallmark General Agency, Inc. and Hallmark Claims Services, Inc., both of which do business as Phoenix General Agency.

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 and assumes a portion of the risks on the commercial property/casualty policies marketed by our TGA Operating Unit.
 
16
 
 
·
Gulf States Insurance Company (“GSIC”) presently assumes a portion of the risks on the commercial property/casualty policies marketed by our TGA Operating Unit.

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

Effective January 1, 2006, our insurance company subsidiaries entered into a pooling arrangement, which was subsequently amended on December 15, 2006, pursuant to which AHIC retains 46% of the total net premiums written by all of our operating units, PIIC retains 34% of our total net premiums written and GSIC retains 20% of our total net premiums written.
 
All share and per share amounts have been adjusted to reflect a one-for-six reverse split of all issued and unissued shares of our authorized common stock effected July 31, 2006.
 
Each of our four operating units was reported as a separate segment during the first three quarters of 2006. Commencing in the fourth quarter of 2006, our HGA Operating Unit was designated as the sole component of the Standard Commercial Segment, our TGA Operating Unit and our Aerospace Operating Unit were aggregated in the Specialty Commercial Segment and our Phoenix Operating Unit was designated as the sole component of the Personal Segment.

Results of Operations

Management Overview. During the three months ended March 31, 2007, our total revenues were $64.0 million, representing a 44% increase over the $44.5 million in total revenues for the same period of 2006. Increased retention of business produced by our Specialty Commercial Segment was the primary cause of the increase in revenue. Specialty Commercial Segment revenues increased $12.1 million, or 76% during the three months ended March 31, 2007 as compared to the same period of 2006. The retention of business produced by the Standard Commercial Segment that was previously retained by third parties was the primary reason for that segment’s $4.2 million increase in revenue for the three months ended March 31, 2007. Earned premiums from our Personal Segment contributed $2.9 million to the increase in revenue for the three months ended March 31, 2007.

We reported net income of $5.0 million for the three months ended March 31, 2007, representing a 105% increase over net income of $2.4 million in the same period of 2006. On a diluted basis, net income to the common stockholders was $0.24 per share for the three months ended March 31, 2007 as compared to $0.14 per share for the same period in 2006. During the three months ended March 31, 2006, we recorded $1.1 million of interest expense from amortization attributable to the deemed discount on convertible promissory notes issued in January, 2006 and subsequently converted to common stock during the second quarter of 2006. The increase in net income was also attributable to the results of our Specialty Commercial Segment, as well as additional investment income from a larger investment portfolio resulting from increased retention of premiums. These increases were partially offset by lower results from our Standard Commercial Segment.

17

First Quarter 2007 as Compared to First Quarter 2006

The following is additional business segment information for the three months ended March 31, 2007 and 2006 (in thousands):

   
Three Months Ended March 31, 2007
 
   
Standard
 
Specialty
             
   
Commercial
 
Commercial
 
Personal
         
   
Segment
 
Segment
 
Segment
 
Corporate
 
Consolidated
 
                       
Produced premium
   
23,550
   
39,357
   
15,076
   
-
   
77,983
 
 
                               
Gross premiums written
   
23,481
   
26,101
   
15,076
   
-
   
64,658
 
Ceded premiums written
   
(2,635
)
 
(1,252
)
 
-
   
-
   
(3,887
)
Net premiums written
   
20,846
   
24,849
   
15,076
   
-
   
60,771
 
Change in unearned premiums
   
(924
)
 
(5,756
)
 
(2,443
)
       
(9,123
)
Net premiums earned
   
19,922
   
19,093
   
12,633
   
-
   
51,648
 
 
                               
Total revenues
   
21,767
   
28,098
   
13,773
   
320
   
63,958
 
 
                               
Losses and loss adjustment expenses
   
12,841
   
11,081
   
8,267
   
(4
)
 
32,185
 
 
                               
Pre-tax income
   
2,759
   
4,686
   
2,118
   
(1,850
)
 
7,713
 
                                 
Net loss ratio (1)
   
64.5
%
 
58.0
%
 
65.4
%
       
62.3
%
Net expense ratio (1)
   
28.0
%
 
31.5
%
 
23.6
%
       
28.2
%
Net combined ratio(1)
   
92.5
%
 
89.5
%
 
89.0
%
       
90.5
%
 
   
Three Months Ended March 31, 2006
 
   
Standard
 
Specialty
             
   
Commercial
 
Commercial
 
Personal
         
   
Segment