UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

Securities Exchange Act of 1934

For the quarterly period ended June 30, 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 ¨

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.
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 - 20,808,954 shares outstanding as of August 11, 2008.


PART I
FINANCIAL INFORMATION

Item 1.   Financial Statements

INDEX TO FINANCIAL STATEMENTS

 
Page Number
   
Consolidated Balance Sheets at June 30, 2008 (unaudited) and December 31, 2007
3
   
Consolidated Statements of Operations (unaudited) for the three months and six months ended June 30, 2008 and June 30, 2007
4
   
Consolidated Statements of Stockholders’ Equity and Comprehensive Income (unaudited) for the three months and six months ended June 30, 2008 and June 30, 2007
5
   
Consolidated Statements of Cash Flows (unaudited) for the six months ended June 30, 2008 and June 30, 2007
6
   
Notes to Consolidated Financial Statements (unaudited)
7

2

Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Balance Sheets
($ in thousands)

   
June 30
 
December 31
 
 
 
2008
 
2007
 
   
(unaudited)
     
ASSETS
             
Investments:
             
Debt securites, available-for-sale, at fair value
 
$
164,137
 
$
248,069
 
Equity securites, available-for-sale, at fair value
   
51,694
   
15,166
 
Short-Term investments, available-for-sale, at fair value
   
121,440
   
2,625
 
               
Total investments
   
337,271
   
265,860
 
               
Cash and cash equivalents
   
33,599
   
145,884
 
Restricted cash and cash equivalents
   
11,588
   
16,043
 
Premiums receivable
   
47,090
   
46,026
 
Accounts receivable
   
5,257
   
5,219
 
Receivable for securities
   
200
   
27,395
 
Prepaid reinsurance premiums
   
682
   
274
 
Reinsurance recoverable
   
3,791
   
4,952
 
Deferred policy acquisition costs
   
20,652
   
19,757
 
Excess of cost over fair value of net assets acquired
   
30,025
   
30,025
 
Intangible assets
   
22,634
   
23,781
 
Current federal income tax recoverable
   
724
   
-
 
Deferred federal income taxes
   
2,413
   
275
 
Prepaid expenses
   
1,212
   
1,240
 
Other assets
   
21,402
   
19,583
 
               
Total assets
 
$
538,540
 
$
606,314
 
               
LIABILITES AND STOCKHOLDERS' EQUITY
             
Liabilites:
             
Notes payable
 
$
60,592
   
60,814
 
Structured settlements
   
-
   
10,000
 
Reserves for unpaid losses and loss adjustment expenses
   
144,374
   
125,338
 
Unearned premiums
   
107,369
   
102,998
 
Unearned revenue
   
2,253
   
2,949
 
Accrued agent profit sharing
   
1,335
   
2,844
 
Accrued ceding commission payable
   
12,189
   
12,099
 
Pension liability
   
1,432
   
1,669
 
Current federal income tax
   
-
   
630
 
Payable for securities
   
3,401
   
91,401
 
Accounts payable and other accrued expenses
   
14,150
   
16,385
 
               
Total liabilities
   
347,095
   
427,127
 
               
Commitments and Contingencies (Note 16)
             
               
Stockholders' equity:
             
Common stock, $.18 par value (authorized 33,333,333 shares in 2008 and 2007; issued 20,816,782 in 2008 and 20,776,080 shares in 2007)
   
3,747
   
3,740
 
Capital in excess of par value
   
119,369
   
118,459
 
Retained earnings
   
73,162
   
58,909
 
Accumulated other comprehensive loss
   
(4,756
)
 
(1,844
)
Treasury stock, at cost (7,828 shares in 2008 and 2007)
   
(77
)
 
(77
)
               
Total stockholders' equity
   
191,445
   
179,187
 
               
   
$
538,540
 
$
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
 
Six Months Ended
 
   
June 30
 
June 30
 
   
2008
 
2007
 
2008
 
2007
 
                   
Gross premiums written
 
$
63,115
 
$
66,577
 
$
127,352
 
$
131,235
 
Ceded premiums written
   
(2,327
)
 
(4,281
)
 
(4,659
)
 
(8,168
)
Net premiums written
   
60,788
   
62,296
   
122,693
   
123,067
 
Change in unearned premiums
   
(1,345
)
 
(6,986
)
 
(4,334
)
 
(16,109
)
Net premiums earned
   
59,443
   
55,310
   
118,359
   
106,958
 
                           
Investment income, net of expenses
   
3,957
   
3,047
   
7,582
   
6,037
 
Realized gain
   
232
   
828
   
1,091
   
881
 
Finance charges
   
1,323
   
1,185
   
2,587
   
2,271
 
Commission and fees
   
6,669
   
8,159
   
13,153
   
16,064
 
Processing and service fees
   
36
   
203
   
78
   
475
 
Other income
   
3
   
4
   
6
   
8
 
                           
Total revenues
   
71,663
   
68,736
   
142,856
   
132,694
 
                           
Losses and loss adjustment expenses
   
36,029
   
30,712
   
71,533
   
62,897
 
Other operating expenses
   
23,608
   
23,723
   
47,073
   
46,424
 
Interest expense
   
1,186
   
796
   
2,371
   
1,582
 
Amortization of intangible assets
   
573
   
573
   
1,146
   
1,146
 
                           
Total expenses
   
61,396
   
55,804
   
122,123
   
112,049
 
                           
Income before tax
   
10,267
   
12,932
   
20,733
   
20,645
 
                           
Income tax expense
   
3,066
   
4,117
   
6,480
   
6,860
 
                           
Net income
 
$
7,201
 
$
8,815
 
$
14,253
 
$
13,785
 
                           
Common stockholders net income per share:
                         
Basic
 
$
0.35
 
$
0.42
 
$
0.69
 
$
0.66
 
Diluted
 
$
0.34
 
$
0.42
 
$
0.68
 
$
0.66
 

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

4

Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Statements of Stockholders’ Equity and Comprehensive Income
(Unaudited)
($ in thousands)

   
Three Months Ended
 
Six Months Ended
 
   
June 30,
 
June 30,
 
   
2008
 
2007
 
2008
 
2007
 
                   
Common Stock
                         
Balance, beginning of period
 
$
3,746
 
$
3,740
 
$
3,740
 
$
3,740
 
Issuance of common stock upon option exercises
   
1
   
-
   
7
   
-
 
Balance, end of period
   
3,747
   
3,740
   
3,747
   
3,740
 
                           
Additional Paid-In Capital
                         
Balance, beginning of period
   
119,120
   
117,983
   
118,459
   
117,932
 
Equity based compensation
   
226
   
102
   
773
   
153
 
Exercise of stock options
   
23
   
-
   
137
   
-
 
Balance, end of period
   
119,369
   
118,085
   
119,369
   
118,085
 
                           
Retained Earnings
                         
Balance, beginning of period
   
65,961
   
36,450
   
58,909
   
31,480
 
Net income
   
7,201
   
8,815
   
14,253
   
13,785
 
Balance, end of period
   
73,162
   
45,265
   
73,162
   
45,265
 
                           
Accumulated Other Comprehensive Loss
                         
Balance, beginning of period
   
(3,086
)
 
(1,982
)
 
(1,844
)
 
(2,344
)
Additional minimum pension liability, net of tax
   
11
   
64
   
21
   
64
 
Unrealized losses on securities, net of tax
   
(1,681
)
 
(828
)
 
(2,933
)
 
(466
)
Balance, end of period
   
(4,756
)
 
(2,746
)
 
(4,756
)
 
(2,746
)
                           
Treasury Stock
                         
Balance, beginning of period
   
(77
)
 
(77
)
 
(77
)
 
(77
)
Acquisition of treasury shares
   
-
   
-
   
-
   
-
 
Exercise of stock options
   
-
   
-
   
-
   
-
 
Balance, end of period
   
(77
)
 
(77
)
 
(77
)
 
(77
)
                              
Stockholders' Equity
 
$
191,445
 
$
164,267
 
$
191,445
 
$
164,267
 
                           
Net income
 
$
7,201
 
$
8,815
 
$
14,253
 
$
13,785
 
Additional minimum pension liability, net of tax
   
11
   
64
   
21
   
64
 
Unrealized losses on securities, net of tax
   
(1,681
)
 
(828
)
 
(2,933
)
 
(466
)
Comprehensive Income
 
$
5,531
 
$
8,051
 
$
11,341
 
$
13,383
 

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

5

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

   
Six Months Ended
 
   
June 30
 
   
2008
 
  2007
 
Cash flows from operating activities:
             
Net income
 
$
14,253
 
$
13,785
 
               
Adjustments to reconcile net income to cash provided by operating activities:
             
Depreciation and amortization expense
   
1,517
   
1,564
 
Amortization of discount on structured settlement
   
-
   
207
 
Deferred federal income tax benefit
   
(641
)
 
(916
)
Realized gain on investments
   
(1,091
)
 
(881
)
Change in prepaid reinsurance premiums
   
(408
)
 
(144
)
Change in premiums receivable
   
(1,064
)
 
(9,925
)
Change in accounts receivable
   
(38
)
 
796
 
Change in deferred policy acquisition costs
   
(895
)
 
(3,069
)
Change in unpaid losses and loss adjustment expenses
   
19,036
   
26,824
 
Change in unearned premiums
   
4,371
   
16,253
 
Change in unearned revenue
   
(696
)
 
(1,957
)
Change in accrued agent profit sharing
   
(1,509
)
 
(528
)
Change in reinsurance recoverable
   
1,161
   
(575
)
Change in current federal income tax payable
   
(1,354
)
 
2,520
 
Change in accrued ceding commission payable
   
90
   
3,103
 
Change in all other liabilities
   
(4,258
)
 
2,059
 
Change in all other assets
   
1,275
   
(4,522
)
               
Net cash provided by operating activities
   
29,749
   
44,594
 
               
Cash flows from investing activities:
             
Purchases of property and equipment
   
(273
)
 
(269
)
Change in restricted cash
   
6,241
   
14,527
 
Purchases of debt and equity securities
   
(218,022
)
 
(106,636
)
Maturities and redemptions of investment securities
   
198,914
   
62,506
 
Net purchases of short-term investments
   
(118,815
)
 
(38,771
)
               
Net cash used in investing activities
   
(131,955
)
 
(68,643
)
               
Cash flows from financing activities:
             
Proceeds from exercise of employee stock options
   
143
   
-
 
Note payable
   
(222
)
 
(633
)
Payment of structured settlement
   
(10,000
)
 
(15,000
)
               
Net cash used by financing activities
   
(10,079
)
 
(15,633
)
               
Decrease in cash and cash equivalents
   
(112,285
)
 
(39,682
)
Cash and cash equivalents at beginning of period
   
145,884
   
81,474
 
               
Cash and cash equivalents at end of period
 
$
33,599
 
$
41,792
 
               
Supplemental cash flow information:
             
Interest paid
 
$
2,387
 
$
1,372
 
Taxes paid
 
$
8,402
 
$
5,256
 
               
Supplemental schedule of non cash investing activities:
             
Change in receivable for securities for investment disposals that settled after the balance sheet date
 
$
27,195
 
$
(14
)
Change in payable for securities for investment purchases that settled after the balance sheet date
 
$
(88,000
)
$
8,878
 

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 June 30, 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 June 30, 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 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. We do not expect the provisions of SFAS 141R to have a material effect on our 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 our 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, we determine the fair value of our 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; and

 
·
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 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.

10

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 June 30, 2008 (in thousands).
 
   
Quoted Prices in
 
Other
         
   
Active Markets for
 
Observable
 
Unobservable
     
   
Identical Assets
 
Inputs
 
Inputs
     
   
(Level 1)
 
(Level 2)
 
(Level 3)
 
Total
 
                   
Debt securities
 
$
-
 
$
164,137
 
$
-
 
$
164,137
 
Equity securities
   
51,694
   
-
   
-
   
51,694
 
Short-term investments
   
-
   
121,440
   
-
   
121,440
 
Total
 
$
51,694
 
$
285,577
 
$
-
 
$
337,271
 

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 six months ended June 30, 2008 (in thousands).

Beginning balance as of January 1, 2008
 
$
4,000
 
         
Purchases, issuances, sales and settlements
   
(4,000
)
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 June 30, 2008
 
$
-
 

4. 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. Unless other factors cause us to reach a contrary conclusion, investments with a fair market value significantly less than cost for more than 180 days are deemed to have a decline in value that is other-than-temporary. A decline in value that is considered to be other-than-temporary is charged to earnings based on the fair value of the security at the time of assessment, resulting in a new cost basis for the security.
 
11
 
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 June 30, 2008 and December 31, 2007:

   
As of June 30, 2008
 
 
 
Less than 12 months
 
12 months or longer
 
Total
 
 
 
 
 
Unrealized
 
 
 
Unrealized
 
 
 
Unrealized
 
 
 
Fair Value
 
Losses
 
Fair Value
 
Losses
 
Fair Value
 
Losses
 
                           
Corporate debt securities
 
$
18,036
 
$
708
 
$
21,958
 
$
1,775
 
$
39,994
 
$
2,483
 
Municipal bonds
   
74,537
   
1,589
   
4,508
   
89
   
79,045
   
1,678
 
Equity securities
   
29,569
   
3,044
   
-
   
-
   
29,569
   
3,044
 
Short term securities
   
-
   
-
   
-
   
-
   
-
   
-
 
Total
 
$
122,142
 
$
5,341
 
$
26,466
 
$
1,864
 
$
148,608
 
$
7,205
 

   
As of December 31, 2007
 
 
 
Less than 12 months
 
12 months or longer
 
Total
 
 
 
 
 
Unrealized
 
 
 
Unrealized
 
 
 
Unrealized
 
 
 
Fair Value
 
Losses
 
Fair Value
 
Losses
 
Fair Value
 
Losses
 
                           
Corporate debt securities
 
$
19,021
 
$
840
 
$
18,329
 
$
896
 
$
37,350
 
$
1,736
 
Municipal bonds
   
24,392
   
122
   
7,780
   
130
   
32,172
   
252
 
Equity securities
   
6,954
   
318
   
-
   
-
   
6,954
   
318
 
Short term securities
   
352
   
1
   
-
   
-
   
352
   
1
 
Total
 
$
50,719
 
$
1,281
 
$
26,109
 
$
1,026
 
$
76,828
 
$
2,307
 

Of the gross unrealized loss at June 30, 2008, $1.9 million is more than twelve months old, consisting of 16 bond positions. Of the gross unrealized loss at December 31, 2007, $1.0 million is more than twelve months old, consisting of 22 bond positions. We consider these losses as a temporary decline in value as they are predominately on bonds where we believe we have the ability to hold our positions until maturity and whose decline in fair value is driven by interest rate increases. We see no other indications that the decline in values of these securities is other than temporary.

5. 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.
 
6. Pledged Investments

We have certain of our securities pledged for the benefit of various state insurance departments and reinsurers. These securities are included with our available-for-sale debt securities because we have the ability to trade these securities. We retain the interest earned on these securities. These securities had a carrying value of $17.5 million at June 30, 2008 and a carrying value of $18.5 million at December 31, 2007.

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7. Share-Based Payment Arrangements

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

As of June 30, 2008, there were incentive stock options to purchase 927,499 shares of our common stock outstanding and non-qualified stock options to purchase 60,000 shares of our common stock outstanding under the 2005 LTIP, leaving 512,501 shares reserved for future issuance. As of June 30, 2008, there were incentive stock options to purchase 52,299 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 June 30, 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 vest 100% six months after the date of grant and terminate ten years from the date of grant. All non-qualified stock options granted under the 1994 Director Plan vested 40% six months from the date of grant and an additional 10% on each of the first six anniversary dates of the grant and terminate ten years from the date of grant. The options granted to non-employee directors outside the 1994 Director Plan fully vested six months after the date of grant and terminate ten years from the date of grant.

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.

13

A summary of the status of our stock options as of and changes during the year-to-date ended June 30, 2008 is presented below:

       
Average
 
Contractual
 
Intrinsic
 
   
Number of
 
Exercise
 
Term
 
Value
 
   
Shares
 
Price
 
(Years)
 
($000)
 
                   
Outstanding at January 1, 2008
   
848,000
 
$
10.41
             
Granted
   
270,000
 
$
11.46
             
Exercised
   
(40,702
)
$
3.54
             
Forfeited or expired
   
-
 
$
-
             
Outstanding at June 30, 2008
   
1,077,298
 
$
11.20
   
8.3
 
$
786
 
Exercisable at June 30, 2008
   
261,549
 
$
8.15
   
5.8
 
$
696
 

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

   
Three Months Ended
 
Six Months Ended
 
   
June 30,
 
June 30,
 
   
2008
 
2007
 
2008
 
2007
 
                   
Intrinsic value of options exercised
 
$
59
 
$
-
 
$
337
 
$
-
 
                           
Cost of share-based payments (non-cash)
 
$
226
 
$
102
 
$
773
 
$
153
 
                           
Income tax benefit of share-based
                         
payments recognized in income
 
$
79
 
$
36
 
$
270
 
$
54
 

As of June 30, 2008 there was $3.1 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, $1.0 million is expected to be recognized in 2009, $0.9 million is expected to be recognized in 2010, $0.5 million is expected to be recognized in 2011 and $0.1 million is expected to be recognized in 2012.

The fair value of each stock option granted is estimated on the date of grant using the Black-Scholes option pricing model. Expected volatilities are based on the historical volatility of similar companies' common stock for a period equal to the expected term. The risk- free interest rates for periods within the contractual term of the options are based on rates for U.S. Treasury Notes with maturity dates corresponding to the options’ expected lives on the dates of grant. Expected term is determined base on the simplified method as the Company does not have sufficient historical exercise data to provide a basis for estimating the expected term.

14

The following table details the weighted average grant date fair value and related assumptions for the periods indicated:

   
Three Months Ended
 
Six Months Ended
 
   
June 30,
 
June 30,
 
   
2008
 
2007
 
2008
 
2007
 
                   
Grant date fair value per share
 
$