HALLMARK FINANCIAL SERVICES INC (Form: 10-Q)

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, 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 August 13, 2009.

PART I

FINANCIAL INFORMATION

Item 1. Financial Statements

INDEX TO FINANCIAL STATEMENTS

		Page Number

Consolidated Balance Sheets at June 30, 2009 (unaudited) and December 31, 2008		3

Consolidated Statements of Operations (unaudited) for the three months and six months ended June 30, 2009 and June 30, 2008		4

Consolidated Statements of Stockholders’ Equity and Comprehensive Income (unaudited) for the three months and six months ended June 30, 2009 and June 30, 2008		5

Consolidated Statements of Cash Flows (unaudited) for the six months ended June 30, 2009 and June 30, 2008		6

Notes to Consolidated Financial Statements (unaudited)		7

Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Balance Sheets

($ in thousands)

	June 30			December 31
	2009			2008
	(unaudited)
ASSETS

Investments:
Debt securities, available-for-sale, at fair value	$	274,677		$	268,513
Equity securities, available-for-sale, at fair value		38,718			25,003

Total investments		313,395			293,516

Cash and cash equivalents		83,150			59,134
Restricted cash and cash equivalents		9,848			8,033
Premiums receivable		52,598			44,032
Accounts receivable		3,752			4,531
Receivable for securities		71			1,031
Prepaid reinsurance premiums		6,467			1,349
Reinsurance recoverable		14,072			8,218
Deferred policy acquisition costs		23,432			19,524
Excess of cost over fair value of net assets acquired		41,080			41,080
Intangible assets, net		30,705			28,969
Current federal income tax recoverable		2,169			696
Deferred federal income taxes		3,254			6,696
Prepaid expenses		993			1,007
Other assets		18,498			20,582

Total assets	$	603,484		$	538,398

LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Notes payable	$	59,502		$	60,919
Reserves for unpaid losses and loss adjustment expenses		180,366			156,363
Unearned premiums		126,595			102,192
Unearned revenue		605			2,037
Accrued agent profit sharing		1,318			2,151
Accrued ceding commission payable		8,600			8,605
Pension liability		4,388			4,309
Payable for securities		4,246			3,606
Accounts payable and other accrued expenses		6,749			18,067

Total liabilities		392,369			358,249

Commitments and Contingencies (Note 15)

Redeemable non-controlling interest		891			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		120,736			119,928
Retained earnings		84,972			72,242
Accumulated other comprehensive income (loss)		836			(16,432	)
Treasury stock, at cost (7,828 shares in 2009 and 2008)		(77	)		(77	)

Total stockholders’ equity		210,224			179,412

	$	603,484		$	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						Six Months Ended
	June 30						June 30

	2009			2008			2009			2008

Gross premiums written	$	75,053		$	63,115		$	146,532		$	127,352
Ceded premiums written		(3,260	)		(2,006	)		(5,492	)		(4,010	)
Net premiums written		71,793			61,109			141,040			123,342
Change in unearned premiums		(9,474	)		(1,345	)		(19,291	)		(4,334	)
Net premiums earned		62,319			59,764			121,749			119,008

Investment income, net of expenses		3,467			3,957			7,736			7,582
Net realized gains		867			232			519			1,091
Finance charges		1,449			1,323			2,799			2,587
Commission and fees		2,627			6,669			8,816			13,153
Processing and service fees		11			36			26			78
Other income		4			3			9			6

Total revenues		70,744			71,984			141,654			143,505

Losses and loss adjustment expenses		38,131			36,029			74,973			71,533
Other operating expenses		23,878			23,608			47,628			47,073
Interest expense		1,150			1,186			2,309			2,371
Amortization of intangible assets		782			573			1,496			1,146

Total expenses		63,941			61,396			126,406			122,123

Income before tax		6,803			10,588			15,248			21,382
Income tax expense		2,519			3,178			4,181			6,707
Net income		4,284			7,410			11,067			14,675
Less: Net income attributable to non-controlling interest		9			-			2			-

Net income attributable to Hallmark Financial Services, Inc.	$	4,275		$	7,410		$	11,065		$	14,675

Net income per share attributable to Hallmark Financial Services, Inc. common stockholders:
Basic	$	0.20		$	0.36		$	0.53		$	0.71
Diluted	$	0.20		$	0.35		$	0.53		$	0.70

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						Six Months Ended
	June 30,						June 30,
	2009			2008			2009			2008

Common Stock
Balance, beginning of period	$	3,757		$	3,746		$	3,751		$	3,740
Issuance of common stock upon option exercises		-			1			6			7
Balance, end of period		3,757			3,747			3,757			3,747

Additional Paid-In Capital
Balance, beginning of period		120,200			119,120			119,928			118,459
Accretion of redeemable noncontrolling interest		(78	)		-			(172	)		-
Equity based compensation		614			226			876			773
Exercise of stock options		-			23			104			137

Balance, end of period		120,736			119,369			120,736			119,369

Retained Earnings
Balance, beginning of period		79,032			66,608			72,242			59,343
Adjustment to opening balance, net of tax (note 2)		1,665			-			1,665			-
Adjusted balance, beginning of period		80,697			66,608			73,907			59,343
Net income attributable to Hallmark Financial Services, Inc.		4,275			7,410			11,065			14,675

Balance, end of period		84,972			74,018			84,972			74,018

Accumulated Other Comprehensive Income (Loss)
Balance, beginning of period		(12,357	)		(3,086	)		(16,432	)		(1,844	)
Adjustment to opening balance, net of tax (note 2)		(1,665	)		-			(1,665	)		-
Adjusted balance, beginning of period		(14,022	)		(3,086	)		(18,097	)		(1,844	)
Additional minimun pension liability, net of tax		79			11			159			21
Net unrealized holding gains (losses) arising during period		15,138			(783	)		19,324			(1,905	)
Reclassification adjustment for losses included in net income		(359	)		(898	)		(550	)		(1,028	)

Balance, end of period		836			(4,756	)		836			(4,756	)

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

Total Stockholders' Equity	$	210,224		$	192,301		$	210,224		$	192,301

Net income	$	4,275		$	7,410		$	11,065		$	14,675
Additional minimum pension liablilty, net of tax		79			11			159			21
Net unrealized holding gains (losses) arising during period		15,138			(783	)		19,324			(1,905	)
Reclassification adjustment for losses included in net income		(359	)		(898	)		(550	)		(1,028	)
Comprehensive income		19,133			5,740			29,998			11,763
Less: Comprehensive income attributable to non-controlling interest		9			-			2			-
Comprehensive income attributable to
Hallmark Financial Services, Inc.	$	19,124		$	5,740		$	29,996		$	11,763

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)

	Six Months Ended
	June 30
	2009			2008
Cash flows from operating activities:
Net income	$	11,067		$	14,675

Adjustments to reconcile net income to cash provided by operating activities:
Depreciation and amortization expense		1,930			1,517
Deferred federal income tax benefit		(391	)		(641	)
Realized gain on investments		(519	)		(1,091	)
Change in prepaid reinsurance premiums		(5,118	)		(1,057	)
Change in premiums receivable		(8,591	)		(1,064	)
Change in accounts receivable		791			(38	)
Change in deferred policy acquisition costs		(3,908	)		(895	)
Change in reserves for unpaid losses and loss adjustment expenses		24,003			19,036
Change in unearned premiums		24,403			4,371
Change in unearned revenue		(1,432	)		(696	)
Change in accrued agent profit sharing		(833	)		(1,509	)
Change in reinsurance recoverable		(5,854	)		1,161
Change in current federal income tax recoverable		(1,473	)		(1,127	)
Change in accrued ceding commission payable		(5	)		90
Change in all other liabilities		(9,197	)		(4,258	)
Change in all other assets		3,909			1,275
Net cash provided by operating activities		28,782			29,749

Cash flows from investing activities:
Purchases of property and equipment		(634	)		(273	)
Change in restricted cash and cash equivalents		(460	)		6,241
Purchases of debt and equity securities		(35,833	)		(552,067	)
Maturities, sales and redemptions of investment securities		40,734			414,144
Payment for acquisition of subsidiaries		(7,246	)		-
Net cash used in investing activities		(3,439	)		(131,955	)

Cash flows from financing activities:
Proceeds from exercise of employee stock options		110			143
Repayment of notes payable		(1,417	)		(222	)
Distribution of non-controlling interest		(20	)		-
Repayment of structured settlement		-			(10,000	)
Net cash used in financing activities		(1,327	)		(10,079	)

Increase (decrease) in cash and cash equivalents		24,016			(112,285	)
Cash and cash equivalents at beginning of period		59,134			145,884
Cash and cash equivalents at end of period	$	83,150		$	33,599

Supplemental cash flow information:
Interest paid	$	2,345		$	2,387
Taxes paid	$	6,045		$	8,402

Supplemental schedule of non-cash investing activities:
Change in receivable for securities related to investment disposals settled after the balance sheet date	$	961		$	27,195
Change in payable for securities related to investment purchases settled after the balance sheet date	$	(695	)	$	(88,000	)

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 three of our 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 June 30, 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 June 30, 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 $4.5 million during the six months ended June 30, 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 $0.4 million and $4.1 million, respectively, for the six months ended June 30, 2009.

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 premium for our catastrophe reinsurance contracts was based on all business produced by both operating units. The premium for our catastrophe reinsurance contract which became effective July 1, 2007 is based only on business produced in Texas. However in error for the periods between July 1, 2007 to June 30, 2008 we continued to record ceded premium for this coverage as if the premium was based on all business produced by the AHIS and TGA Operating Units. This understated our earned premium for each quarter from 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 and six months ended June 30, 2008 (in thousands, except per share amounts).

	For the Three			For the Six
	Months Ended			Months Ended
	June 30,			June 30,
	2008			2008
As previously reported:
Ceded premiums written	$	(2,327	)	$	(4,659	)
Net premiums written		60,788			122,693
Net premiums earned		59,443			118,359
Total revenues		71,663			142,856

Income before tax		10,267			20,733
Income tax expense		3,066			6,480
Net income	$	7,201		$	14,253

Common stockholders net income per share:
Basic	$	0.35		$	0.69
Diluted	$	0.34		$	0.68

Adjustments:
Ceded premiums written	$	321		$	649
Income tax expense		112			227
Net income impact	$	209		$	422

As revised:
Ceded premiums written	$	(2,006	)	$	(4,010	)
Net premiums written		61,109			123,342
Net premiums earned		59,764			119,008
Total revenues		71,984			143,505

Income before tax		10,588			21,382
Income tax expense		3,178			6,707
Net income	$	7,410		$	14,675

Common stockholders net income per share:
Basic	$	0.36		$	0.71
Diluted	$	0.35		$	0.70

The following table presents the effect of the correction on our previously reported consolidated balance sheet as of June 30, 2008 (in thousands).

	As previously
	reported		Adjustment			As revised
Balances as of June 30, 2008
Prepaid reinsurance premiums	$	682	$	1,317		$	1,999
Current federal income tax recoverable		724		(461	)		263
Total assets		538,540		856			539,396
Total liabilities		347,095		-			347,095
Retained earnings		73,162		856			74,018
Total stockholders' equity		191,445		856			192,301

The following table presents the effect of the correction on our previously reported consolidated statements of cash flows for the six months ended June 30, 2008 (in thousands).

	For the Six
	Months Ended
	June 30,
	2008
As previously reported:
Net income	$	14,253
Change in prepaid reinsurance premiums		(408	)
Change in current federal income tax payable		(1,354	)
Net cash provided by operating activities		29,749

Adjustments:
Net income	$	422
Change in prepaid reinsurance premiums		(649	)
Change in current federal income tax payable