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 September 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 November 12, 2008.


PART I
FINANCIAL INFORMATION

Item 1.   Financial Statements

INDEX TO FINANCIAL STATEMENTS
   
Page Number
     
Consolidated Balance Sheets at September 30, 2008 (unaudited) and December 31, 2007
 
3
     
Consolidated Statements of Operations (unaudited) for the three months and nine months ended September 30, 2008 and September 30, 2007
 
4
     
Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss) (unaudited) for the three months and nine months ended September 30, 2008 and September 30, 2007
 
5
     
Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2008 and September 30, 2007
 
6
     
Notes to Consolidated Financial Statements (unaudited)
 
7
 
2
 
Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Balance Sheets
($ in thousands)

   
September 30
 
December 31
 
   
2008
 
2007
 
   
(unaudited)
     
ASSETS
             
               
Investments:
             
Debt securities, available-for-sale, at fair value
 
$
180,954
 
$
248,069
 
Equity securities, available-for-sale, at fair value
   
41,568
   
15,166
 
Short-term investments, available-for-sale, at fair value
   
112,965
   
2,625
 
               
Total investments
   
335,487
   
265,860
 
               
Cash and cash equivalents
   
24,191
   
145,884
 
Restricted cash and cash equivalents
   
8,963
   
16,043
 
Premiums receivable
   
47,052
   
46,026
 
Accounts receivable
   
5,243
   
5,219
 
Receivable for securities
   
-
   
27,395
 
Prepaid reinsurance premiums
   
2,636
   
942
 
Reinsurance recoverable
   
11,525
   
4,952
 
Deferred policy acquisition costs
   
20,149
   
19,757
 
Excess of cost over fair value of net assets acquired
   
37,738
   
30,025
 
Intangible assets
   
29,683
   
23,781
 
Current federal income tax recoverable
   
1,586
   
-
 
Deferred federal income taxes
   
4,371
   
275
 
Prepaid expenses
   
941
   
1,240
 
Other assets
   
20,115
   
19,583
 
               
Total assets
 
$
549,680
 
$
606,982
 
               
LIABILITIES AND STOCKHOLDERS' EQUITY
             
Liabilities:
             
Notes payable
 
$
61,760
 
$
60,814
 
Structured settlements
   
-
   
10,000
 
Reserves for unpaid losses and loss adjustment expenses
   
155,288
   
125,338
 
Unearned premiums
   
105,293
   
102,998
 
Unearned revenue
   
2,126
   
2,949
 
Accrued agent profit sharing
   
1,935
   
2,844
 
Accrued ceding commission payable
   
12,193
   
12,099
 
Pension liability
   
1,017
   
1,669
 
Current federal income tax
   
-
   
864
 
Payable for securities
   
5,504
   
91,401
 
Accounts payable and other accrued expenses
   
14,439
   
16,385
 
               
Total liabilities
   
359,555
   
427,361
 
               
Commitments and Contingencies (Note 17)
             
               
Redeemable minority interest
   
619
   
-
 
               
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
   
119,649
   
118,459
 
Retained earnings
   
74,649
   
59,343
 
Accumulated other comprehensive loss
   
(8,462
)
 
(1,844
)
Treasury stock, at cost (7,828 shares in 2008 and 2007)
   
(77
)
 
(77
)
               
Total stockholders' equity
   
189,506
   
179,621
 
               
   
$
549,680
 
$
606,982
 

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
 
Nine Months Ended
 
 
 
September 30
 
September 30
 
 
 
2008
 
2007
 
2008
 
2007
 
                   
Gross premiums written
 
$
59,005
 
$
62,304
 
$
186,357
 
$
193,539
 
Ceded premiums written
   
(2,493
)
 
(441
)
 
(6,503
)
 
(8,609
)
Net premiums written
   
56,512
   
61,863
   
179,854
   
184,930
 
Change in unearned premiums
   
2,416
   
(2,100
)
 
(1,918
)
 
(18,209
)
Net premiums earned
   
58,928
   
59,763
   
177,936
   
166,721
 
                           
Investment income, net of expenses
   
4,100
   
3,774
   
11,682
   
9,811
 
Net realized gains (impairments and realized losses)
   
(2,496
)
 
418
   
(1,405
)
 
1,299
 
Finance charges
   
1,307
   
1,206
   
3,894
   
3,477
 
Commission and fees
   
3,127
   
7,280
   
16,280
   
23,344
 
Processing and service fees
   
20
   
111
   
98
   
586
 
Other income
   
3
   
4
   
9
   
12
 
                           
Total revenues
   
64,989
   
72,556
   
208,494
   
205,250
 
                           
Losses and loss adjustment expenses
   
38,981
   
36,723
   
110,514
   
99,620
 
Other operating expenses
   
24,041
   
24,087
   
71,114
   
70,511
 
Interest expense
   
1,186
   
1,026
   
3,557
   
2,608
 
Amortization of intangible assets
   
620
   
573
   
1,766
   
1,719
 
                           
Total expenses
   
64,828
   
62,409
   
186,951
   
174,458
 
                           
Income before tax and minority interest
   
161
   
10,147
   
21,543
   
30,792
 
Income tax expense (benefit)
   
(485
)
 
3,345
   
6,222
   
10,205
 
Income before minority interest
   
646
   
6,802
   
15,321
   
20,587
 
Minority interest
   
15
   
-
   
15
   
-
 
                           
                           
Net income
 
$
631
 
$
6,802
 
$
15,306
 
$
20,587
 
                           
Common stockholders net income per share:
                         
Basic
 
$
0.03
 
$
0.33
 
$
0.74
 
$
0.99
 
Diluted
 
$
0.03
 
$
0.33
 
$
0.73
 
$
0.99
 

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

4

Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Statement of Stockholders' Equity and Comprehensive Income (Loss)
(Unaudited)
($ in thousands)
 
   
Three Months Ended
 
Nine Months Ended
 
   
September 30,
 
September 30,
 
   
2008
 
2007
 
2008
 
2007
 
                   
Common Stock
                         
Balance, beginning of period
 
$
3,747
 
$
3,740
 
$
3,740
 
$
3,740
 
Issuance of common stock upon option exercises
   
-
   
-
   
7
   
-
 
Balance, end of period
   
3,747
   
3,740
   
3,747
   
3,740
 
                           
Additional Paid-In Capital
                         
Balance, beginning of period
   
119,369
   
118,085
   
118,459
   
117,932
 
Accretion of redeemable minority interest to redemption value
   
(25
)
 
-
   
(25
)
 
-
 
Equity based compenstion
   
305
   
198
   
1,078
   
351
 
Exercise of stock options
   
-
   
-
   
137
   
-
 
                           
Balance, end of period
   
119,649
   
118,283
   
119,649
   
118,283
 
                           
Retained Earnings
                         
Balance, beginning of period
   
74,018
   
45,265
   
59,343
   
31,480
 
Net income
   
631
   
6,802
   
15,306
   
20,587
 
                           
Balance, end of period
   
74,649
   
52,067
   
74,649
   
52,067
 
                           
Accumulated Other Comprehensive Loss
                         
Balance, beginning of period
   
(4,756
)
 
(2,746
)
 
(1,844
)
 
(2,344
)
Additional minimun pension liability, net of tax
   
10
   
33
   
31
   
97
 
Unrealized gains (losses) on securities, net of tax
   
(3,716
)
 
1,006
   
(6,649
)
 
540
 
Balance, end of period
   
(8,462
)
 
(1,707
)
 
(8,462
)
 
(1,707
)
                           
Treasury Stock
                         
Balance, beginning of period
   
(77
)
 
(77
)
 
(77
)
 
(77
)
Acquisition of treasury shares
   
-
   
-
   
-
   
-
 
                           
Balance, end of period
   
(77
)
 
(77
)
 
(77
)
 
(77
)
                       
Stockholders' Equity
 
$
189,506
 
$
172,306
 
$
189,506
 
$
172,306
 
                           
Net income
 
$
631
 
$
6,802
 
$
15,306
 
$
20,587
 
Additional minimum pension liablilty, net of tax
   
10
   
33
   
31
   
97
 
Unrealized gains (losses) on securities, net of tax
   
(3,716
)
 
1,006
   
(6,649
)
 
540
 
Comprehensive Income (Loss)
 
$
(3,075
)
$
7,841
 
$
8,688
 
$
21,224
 

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)
 
   
Nine Months Ended
 
   
September 30
 
   
2008
 
2007
 
Cash flows from operating activities:
             
Net income
 
$
15,306
 
$
20,587
 
               
Adjustments to reconcile net income to cash provided by operating activites:
             
Depreciation and amortization expense
   
2,311
   
2,344
 
Minority interest
   
15
   
-
 
Amortization of discount on structured settlement
   
-
   
310
 
Deferred federal income tax benefit
   
(1,849
)
 
(1,170
)
Realized (gain) loss on investments and impairment losses
   
1,405
   
(1,299
)
Change in prepaid reinsurance premiums
   
(1,694
)
 
137
 
Change in prepaid commissions
   
-
   
487
 
Change in premiums receivable
   
(1,026
)
 
(8,492
)
Change in accounts receivable
   
(24
)
 
1,604
 
Change in deferred policy acquisition costs
   
(392
)
 
(3,631
)
Change in unpaid losses and loss adjustment expenses
   
29,950
   
38,572
 
Change in unearned premiums
   
2,295
   
16,759
 
Change in unearned revenue
   
(823
)
 
(2,378
)
Change in accrued agent profit sharing
   
(909
)
 
206
 
Change in reinsurance recoverable
   
(6,573
)
 
149
 
Change in reinsurance payable
   
-
   
(1,060
)
Change in current federal income tax payable
   
(2,451
)
 
(1,678
)
Change in accrued ceding commission payable
   
94
   
3,096
 
Change in all other liabilities
   
(2,599
)
 
3,059
 
Change in all other assets
   
4,122
   
(5,835
)
               
Net cash provided by operating activities
   
37,158
   
61,767
 
               
Cash flows from investing activities:
             
Purchases of property and equipment
   
(477
)
 
(367
)
Acquisition of subsidiaries, net of cash acquired
   
(14,799
)
 
-
 
Change in restricted cash
   
7,080
   
12,244
 
Purchases of debt and equity securities
   
(258,465
)
 
(187,256
)
Maturities and redemptions of investment securities
   
227,061
   
115,288
 
Net purchases of short-term investments
   
(110,340
)
 
(30,713
)
               
Net cash (used in) investing activities
   
(149,940
)
 
(90,804
)
               
Cash flows from financing activities:
             
Proceeds from exercise of employee stock options
   
143
   
-
 
Net borrowings (repayment) of notes payable
   
946
   
(856
)
Payment of structured settlement
   
(10,000
)
 
(15,000
)
Proceeds from issuance of trust preferred securities
   
-
   
25,774
 
Debt issuance costs
   
-
   
(674
)
               
Net cash (used in) provided by financing activities
   
(8,911
)
 
9,244
 
               
Decrease in cash and cash equivalents
   
(121,693
)
 
(19,793
)
Cash and cash equivalents at beginning of period
   
145,884
   
81,474
 
Cash and cash equivalents at end of period
 
$
24,191
 
$
61,681
 
               
Supplemental Cash Flow Information:
             
               
Interest paid
 
$
3,576
 
$
2,184
 
Taxes paid
 
$
10,521
 
$
13,053
 
               
Supplemental schedule of non-cash investing activities:
             
               
Change in receivable for securities related to investment disposals that settled after the balance sheet date
 
$
27,395
 
$
(14
)
               
Change in payable for securities related to investment purchases that settled after the balance sheet date
 
$
(85,897
)
$
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 five 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 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 (collectively, “Heath Group”). 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 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 HGA Operating Unit and the Personal Segment presently consists solely of our Phoenix 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 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 September 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 September 30, 2008 are not necessarily indicative of the operating results to be expected for the full year.

7

Redeemable   minority interest

We are accreting the redeemable minority 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 minority 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.

Immaterial Correction of an Error

We maintain catastrophe reinsurance for business produced by both our HGA and TGA Operating Units. Prior to July 1, 2007, the premium for our catastrophe reinsurance was based on all business produced by both operating units. Effective July 1, 2007, the premium for our catastrophe reinsurance is based only on business produced in Texas. However, in error we continued to record ceded premium for this coverage based on all business produced by the HGA and TGA Operating Units. This understated our earned premium for each quarter since July 1, 2007 through June 30, 2008.

We are correcting 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.” Financial statements for the year ended December 31, 2007 will be revised in the December 31, 2008 Annual Report on Form 10-K.

The following table presents the effect of the correction on our previously reported consolidated statements of operations for the three months ended September 30, 2007, December 31, 2007, March 31, 2008 and June 30, 2008.
 
8
 
   
For the Three Months Ended
 
   
September 30,
 
December 31,
 
March 31,
 
June 30,
 
   
2007
 
2007
 
2008
 
2008
 
As previously reported:
                         
Ceded premiums written
 
$
(779
)
$
(2,382
)
$
(2,332
)
$
(2,327
)
Net premiums written
   
61,525
   
53,551
   
61,905
   
60,788
 
Net premiums earned
   
59,425
   
58,920
   
58,916
   
59,443
 
Total revenues
   
72,218
   
69,586
   
71,193
   
71,663
 
                           
Income before tax
   
9,809
   
10,647
   
10,466
   
10,267
 
Income tax expense
   
3,227
   
3,585
   
3,414
   
3,066
 
Net income
 
$
6,582
 
$
7,062
 
$
7,052
 
$
7,201
 
                           
Common stockholders net income per share:
                         
Basic
 
$
0.32
 
$
0.34
 
$
0.34
 
$
0.35
 
Diluted
 
$
0.32
 
$
0.34
 
$
0.34
 
$
0.34
 
                           
Adjustments:
                         
Ceded premiums written
 
$
338
 
$
330
 
$
328
 
$
321
 
Income tax expense
   
118
   
116
   
115
   
112
 
Net income impact
 
$
220
 
$
214
 
$
213
 
$
209
 
                           
As revised:
                         
Ceded premiums written
 
$
(441
)
$
(2,052
)
$
(2,004
)
$
(2,006
)
Net premiums written
   
61,863
   
53,881
   
62,233
   
61,109
 
Net premiums earned
   
59,763
   
59,250
   
59,244
   
59,764
 
Total revenues
   
72,556
   
69,916
   
71,521
   
71,984
 
                           
Income before tax
   
10,147
   
10,977
   
10,794
   
10,588
 
Income tax expense
   
3,345
   
3,701
   
3,529
   
3,178
 
Net income
 
$
6,802
 
$
7,276
 
$
7,265
 
$
7,410
 
                           
Common stockholders net income per share:
                         
Basic
 
$
0.33
 
$
0.35
 
$
0.35
 
$
0.36
 
Diluted
 
$
0.33
 
$
0.35
 
$
0.35
 
$
0.35
 
 
The following table presents the effect of the correction on our previously reported consolidated statements of operations for the nine months ended September 30, 2007, the year ended December 31, 2007, and the six months ended June 30, 2008.

9

   
For the Nine
 
For the Year
 
For the Six
 
   
Months Ended
 
Ended
 
Months Ended
 
   
September 30,
 
December 31,
 
June 30,
 
   
2007
 
2007
 
2008
 
As previously reported:
                   
Ceded premiums written
 
$
(8,947
)
$
(11,329
)
$
(4,659
)
Net premiums written
   
184,592
   
238,143
   
122,693
 
Net premiums earned
   
166,383
   
225,303
   
118,359
 
Total revenues
   
204,912
   
274,498
   
142,856
 
                     
Income before tax
   
30,454
   
41,101
   
20,733
 
Income tax expense
   
10,087
   
13,672
   
6,480
 
Net income
 
$
20,367
 
$
27,429
 
$
14,253
 
                     
Common stockholders net income per share:
                   
Basic
 
$
0.98
 
$
1.32
 
$
0.69
 
Diluted
 
$
0.98
 
$
1.32
 
$
0.68
 
                     
Adjustments:
                   
Ceded premiums written
 
$
338
 
$
668
 
$
649
 
Income tax expense
   
118
   
234
   
227
 
Net income impact
 
$
220
 
$
434
 
$
422
 
                     
As revised:
                   
Ceded premiums written
 
$
(8,609
)
$
(10,661
)
$
(4,010
)
Net premiums written
   
184,930